Welcome to Day 12
Principles of
Microeconomics
What do we want the economy to
do?
1) Produce a lot of stuff
2)Produce the stuff we want the
most
3)Distribute various things to
people who value those things
highly
An economy that does these things
is operating efficiently.
Efficient
The allocation of resources when
the net benefits of all economic
activities are maximized.
An economy that is operating
efficiently has both:
1) Efficient production
2) Efficient allocation of goods.
Will a market economy do these
things?
How does a business make money?
Producing a lot of what people
want the most and selling it.
The better a business correctly
estimates what its customers
value, and makes a lot of those
things, the higher its profit.
And of course, we want the
economy to be able to adjust to
changing circumstances. Will a
market economy do that?
Rainy Winter Increases Demand
P
$16.00
$14.00
S
$12.00
P2 $10.00
P1 $8.00
D2
$6.00
$4.00
D1
$2.00
$0.00
0
100000
Q1 Q2
200000
300000
Q
Can a command economy do this?
The incentive problem and the
information problem.
The Incentive Problem
What does an umbrella businessman
get if he gets umbrellas quickly out
to a rainy area?
What does the 2nd undersecretary of
umbrellas in Washington get if he
gets umbrellas quickly out to a rainy
area?
The Information Problem
How does the 2nd Undersecretary of
Umbrellas know we need more
umbrellas in Bakersfield?
How do private business owners of
umbrella companies know?
Every time you go shopping, it is
a transfer of information fest!!!
You are letting sellers know
what you want.
Sellers are letting you know
what they can make at what
cost.
The Invisible Hand
Adam Smith – 1776
The Wealth of Nations
Because trades are voluntary, in
helping yourself, when you are helping
yourself, you help others also.
The way for the businessman to
make money is to most effectively
serve his customers.
In doing what is best for him, he is
being lead, as if by an “invisible
hand” to help society.
So what can go wrong?
Market Failure - The failure of
private decisions in the
marketplace to achieve an efficient
allocation of scarce resources.
In other words, we are making too
much or too little of something
because of a failure to properly take
account of its benefits and costs.
What markets does the government
heavily regulate in the U.S.
economy?
Externalities – an action taken by a
person or firm that imposes
benefits or costs outside of any
market exchange.
We’ve seen these pictures earlier
this semester, but we didn’t have a
name for what they were yet. Now
we do.
Welcome to Day 13
Principles of
Microeconomics
Quiz today?
Magic 8 ball says ….
So what to do?
We have seen one solution, which is
government regulation of the industry.
There is another, which is to charge, or
tax, people for the harm they are
doing to others. This will “internalize
the externality.
Here is our
factory causing
$100,000 worth
of harm to the
people around the factory. It could cut
the pollution in half by spending
$25,000 on scrubbers. Will the owner
do it?
What if he had to pay $1 in taxes for
each $1 harm done by his pollution?
Some people have proposed a
“carbon tax” as part of the solution
to global warming.
Welcome to Day 14
Principles of
Microeconomics
Quiz today?
Magic 8 ball says ….
Besides externalities, there is
another type of marked failure is
known as public goods.
Public Goods
A good for which the cost of
exclusion is prohibitive and for
which the marginal cost of an
additional user is zero.
For example, a streetlight placed
on a block.
Examples of Public Goods
1) Streetlights
2) Roads
3) National Defense
4) Light Houses
5) Free Television
The Free Rider Problem
Free Riders – People or firms that
consume a public good without
paying for it.
The government gets around the
problem by not asking you to pay,
but telling you to pay.
In theory, the government can
handle this problem. In practice,
we still have our old problems of:
1) information.
2) incentive.
Tragedy of the Commons - What
happens when property rights are
not assigned?
Once property rights are assigned,
problem solved. This is why the
cow population is thriving and
whales are hunted almost to
extinction.
The air is a commons.
Unless the government enforces
regulation or taxes.
Of course, we have talked about air
pollution before, under
externalities.
The tragedy of the commons isn’t
really a new thing, it is a subset of
externalities.
Who owns the air?
1. THE CONCEPT OF UTILITY
Learning Objectives
1. Define what economists mean by utility.
2. Distinguish between the concepts of total utility
and marginal utility.
3. State the law of diminishing marginal utility and
illustrate it graphically.
4. State, explain, and illustrate algebraically the
utility-maximizing condition.
1.1 Total Utility
•
Total utility is the number of units of utility that a
consumer gains from consuming a given quantity of
a good, service, or activity during a particular time
period.
Total Utility and Marginal Utility
Curves
1.2 Marginal Utility
•
•
Marginal utility is the amount by which total utility
rises with consumption of an additional unit of a
good, service, or activity, all other things
unchanged.
The law of diminishing marginal utility is the
tendency of marginal utility to decline beyond some
level of consumption during a period.
Welcome to Day 15
Principles of
Microeconomics
Quiz today?
Magic 8 ball says ….
Write your name, class day and
time, and Quiz #5 at the top of the
paper.
The Invisible Hand can work
because price allows for the
effective use of
1) ____ and 2) ____ in a
market economy. Hint: both
answers start with the letter
“i”.
We’ve seen that when the thing
is free, the best thing to do is
just take it until marginal utility
hits zero.
But what if you have to pay a
price?
Now the amount of things you
can take is limited, so the
question is “is getting one more
of this worth giving up some of
that?”
How do you decide what to buy at the
store? From an economist’s point of
view, it is all about comparing how
much you like the thing to its price.
Buy the things you really like
compared to their prices, and don’t
buy what you don’t like very much
compared to its price.
How much you like the thing is
measured by its marginal utility.
So the mathematical way to
write out the comparison of
how much you like one more
unit of X compared to the price
of X is MUX
PX
MUX
PX
Can also be understood as the utils
you get in return for spending $1
more on the good.
Spend your dollars on whatever
gets you the higher return on those
dollars.
1.3 Maximizing Utility
•
•
•
The budget constraint is a restriction that total
spending cannot exceed the budget available
Applying the marginal decision rule
The utility gained by spending an additional dollar on
good X: MU X
PX
•
MU X MU Y

PX
PY
EQUATION 1.1
•
EQUATION 1.2
•
EQUATION 1.3
MU X MU Y

PX
PY
MU n
MU A MU B MU C


 ... 
PA
PB
PC
Pn
1.3 Maximizing Utility
• Equation 1.3 states:
– Utility maximizing condition: Utility is
maximized when total outlays equal the budget
available and when the ratios of marginal utilities
to prices are equal for all goods and services.
• The problem of divisibility:
– The marginal decision rule to utility maximization can be
applied only when the goods are divisible
2. UTILITY MAXIMIZATION AND
DEMAND
Learning Objectives
1. Derive an individual demand curve from utilitymaximizing adjustments to changes in price.
2. Derive the market demand curve from the
demand curves of individuals.
3. Explain the substitution and income effects of a
price change.
4. Explain the concepts of normal and inferior
goods in terms of the income effect.
2.1 Deriving an Individual’s
Demand Curve
• Example: Mary Andrews consumes only apples,
denoted by A and oranges, denoted by O
– Apples cost $2 per pound
– Oranges cost $1 per pound
– Budget allows her to spend $20 per month on the two
goods
MU A MU O

• Equation 2.1
$2
$1
• Equation 2.2
MU A MU O

$1
$1
• Equation 2.3
MU A MU O

$1
$1
Utility Maximization and an
Individual’s Demand Curve
Deriving a Market Demand Curve
1. PRODUCTION CHOICES AND
COSTS: THE SHORT RUN
Learning Objectives
1.
Understand the terms associated with the short-run production
function—total product, average product, and marginal
product—and explain and illustrate how they are related to each
other.
2.
Explain the concepts of increasing, diminishing, and negative
marginal returns and explain the law of diminishing marginal
returns.
3.
Understand the terms associated with costs in the short run—
total variable cost, total fixed cost, total cost, average variable
cost, average fixed cost, average total cost, and marginal cost—
and explain and illustrate how they are related to each other.
4.
Explain and illustrate how the product and cost curves are
related to each other and to determine in what ranges on these
curves marginal returns are increasing, diminishing, or
negative.
1. PRODUCTION CHOICES AND
COSTS: THE SHORT RUN
•
•
•
•
•
Firms are organizations that produce goods and
services.
The short run refers to a planning period over
which the managers of a firm must consider one or
more of their factors of production as fixed in
quantity.
A fixed factor of production is a factor of
production whose quantity cannot be changed
during a particular period.
A variable factor of production is a factor of
production whose quantity can be changed during a
particular period.
The long run is the planning period over which a
firm can consider all factors of production as
variable.
Welcome to Day 16
Principles of
Microeconomics
Quiz today?
Magic 8 ball says ….
1.1 The Short-Run Production
Function
A production function captures the relationship
between factors of production and the output of a
firm.
Total, marginal, and average products
•
•
–
–
–
The total product curve is a graph that shows the
quantities of output that can be obtained from different
amounts of a variable factor of production, assuming other
factors of production are fixed.
Slope of the total product curve = ΔQ/ΔL
The marginal product is the amount by which output rises
with an additional unit of a variable factor.
The marginal product of labor is the amount by which
output rises with an additional unit of labor.
EQUATION 1.1
MPL  Q / L
1.1 The Short-Run Production
Function
•
•
The average product is the output per unit of
variable factor.
The average product of labor is the ratio of
output to the number of units of labor (Q/L).
EQUATION 1.2
APL  Q / L
1.1 The Short-Run Production
Function
Point on graph
A
B
C
D
E
F
G
H
I
Units of labor per day
0
1
2
3
4
5
6
7
8
Jackets per day
0.0
1.0
3.0
7.0
9.0
10.0
10.7
11.0
10.5
From Total Product to the Average
and Marginal Product of Labor
Panel (a)
Units of
labor per
day
0
1
2
3
4
5
6
7
8
Jackets per
day
0
1.0
3.0
7.0
9.0
10.0
10.7
11.0
10.5
Marginal
product
Average
product
1.0
2.0
1.0
4.0
1.5
2.0
2.33
1.0
2.25
0.7
2.0
0.3
1.78
-0.5
1.57
1.31
Total Product and Marginal
Product Curves
Slope = 0.7
Slope = -0.5
Total product
Slope = 2
Slope = 2
Slope = 0.3
Slope = 1
Slope = 4
Slope = 1
Average
product
Marginal
product
Welcome to Day 17
Principles of
Microeconomics
Quiz today?
Magic 8 ball says ….
Write your name, class day and
time, and Quiz #6 at the top of the
paper.
Answer whether the following
statement is true, false, or uncertain,
and explain your answer.
A person at the donut shop will buy
donuts until the marginal utility of the
next donut is zero or negative.
Increasing, Diminishing, and
Negative Marginal Returns
•
•
•
•
Firms experience increasing marginal returns when
the range over which each additional unit of a variable
factor adds more to total output than the previous unit.
Firms experience diminishing marginal returns when
the range over which each additional unit of a variable
factor adds less to total output than the previous unit.
Firms experience negative marginal returns when the
range over which additional units of a variable factor
reduce total output, given constant quantities of all other
factors.
The law of diminishing marginal returns state that
the marginal product of any variable factor of production
will eventually decline, assuming the quantities of other
factors of production are unchanged.
Increasing
marginal
returns
Diminishing
marginal
returns
Negative marginal returns
Increasing, Diminishing, and
Negative Marginal Returns
1.2 Costs in the Short Run
•
•
•
•
•
Variable costs are the costs associated with the use of
variable factors of production.
Fixed costs are the costs associated with the use of
fixed factors of production.
Total variable cost is a cost that varies with the level of
output.
Total fixed cost is a cost that does not vary with output.
Total cost is the sum of total variable cost and total
fixed cost.
EQUATION 1.3
TVC  TFC  TC
From Total Production to Total
Cost
11 jackets: variable cost=$700
10 jackets: variable cost=$500
9 jackets: variable cost=$400
9 jackets: variable cost=$400
D
3 jackets: variable cost=$200
’
1 jacket: variable cost=$100
0 jackets: variable cost=$0
From Total Production to Total
Cost
Quantity/day
0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
11.0
Labor/day
0
1.00
1.63
2.00
2.33
2.58
2.80
3.00
3.38
4.00
5.00
7.00
Total variable cost
$0
$100
$163
$200
$233
$258
$280
$300
$338
$400
$500
$700
Increasing marginal returns
Diminishing
marginal returns
Total cost curve
$200
From Variable Cost to Total Cost
$200
Total Fixed
cost = $200
Total variable cost curve
Increasing marginal returns
Diminishing
marginal returns
Marginal and Average Costs
•
Average total cost is total cost divided by quantity; it is
the firms total cost per unit of output.
EQUATION 1.4
ATC  TC / Q
•
Average variable cost is total variable cost dIvided by
quantity; it is the firm’s total variable cost per unit of
output.
EQUATION 1.5
AVC  TVC / Q
•
Average fixed cost is total fixed cost divided by quantity.
EQUATION 1.6
AFC  TFC / Q
EQUATION 1.7
MC  TC / Q
EQUATION 1.8
AVC  AFC  ATC
Marginal cost curve
Slope=$200
Slope=$100
Slope=$62
Slope=$38
Slope=$20
Slope=$22
Slope=$25
Slope=$33
Slope=$37
Slope=$63
Slope=$100
Total Cost and Marginal Cost
Marginal Cost, Average Fixed Cost, Average
Variable Cost, and Average Total Cost in the
Short Run
Welcome to Day 18
Principles of
Microeconomics
Quiz today?
Magic 8 ball says ….
2. PRODUCTION CHOICES AND
COSTS: THE LONG RUN
Learning Objectives
1.
Apply the marginal decision rule to explain how a firm chooses
its mix of factors of production in the long run.
2.
Define the long-run average cost curve and explain how it
relates to economies and diseconomies or scale.
2.2 Costs in the Long Run
•
The Long run average cost curve is a graph showing the
firms lowest cost per unit at each level of output, assuming
that all factors of production are variable.
ATC20
ATC30
ATC40
Long-run
average cost
(LRAC)
ATC50
Economies and Diseconomies of
Scale
•
•
•
Economies of scale refers to a situation in which the long run
average cost declines as the firm expands its output.
Diseconomies of scale refers to a situation in which the long
run average cost increases as the firm expands its output.
Constant returns to scale refers to a situation in which the
long run average cost stays the same over an output range.
Economies and
diseconomies of
scale affect the
sizes of firms
operating in a
market.
Economies
of scale
Constant
returns to
scale
Diseconomies
of scale
Reasons for Economies of Scale
1) Mass Production Assembly Line
Machines.
2) Specialization of Labor.
Reasons for Diseconomies of Scale
1) Command and Control Problems.
2) Law of Increasing Opportunity Cost
(the additional workers are getting
worse).
Welcome to Day 19
Principles of
Microeconomics
Quiz today?
Magic 8 ball says ….
Write your name, class day and
time, and Quiz #7 at the top of the
paper.
1) This is a reason that marginal product
of labor rises in the short run.
2) This is a reason that marginal cost
rises in the short run.
A) Diminishing marginal returns.
B) Law of increasing opportunity costs
C) Command and control problems.
D) Specialization of labor.
1. PERFECT COMPETITION: A
MODEL
Learning Objectives
1. Explain what economists mean by perfect competition.
2. Identify the basic assumptions of the model of perfect
competition and explain why they imply price-taking
behavior.
1. PERFECT COMPETITION: A
MODEL
•
Perfect competition is a model of the market
based on the assumption that a large number of
firms produce identical goods consumed by a large
number of buyers.
1.1 Assumptions of the Model
• Price takers are individuals or
firms who must take the market
price as given.
– Identical goods
– A large number of buyers and
sellers
– Ease of entry and exit
2. OUTPUT DETERMINATION IN
THE SHORT RUN
Learning Objectives
1. Show graphically how an individual firm in a
perfectly competitive market can use total revenue
and total cost curves or marginal revenue and
marginal cost curves to determine the level of
output that will maximize its economic profit.
2. Explain when a firm will shut down in the short run
and when it will operate even if it is incurring
economic losses.
3. Derive the firm’s supply curve from the firm’s
marginal cost curve and the industry supply curve
from the supply curves of individual firms.
The Market for Radishes
Total Revenue
• Total revenue is a firm’s output
multiplied by the price at which it
sells that output.
• EQUATION 2.1
TR  P  Q
Total Revenue, Marginal Revenue,
and Average Revenue
Total Revenue, Marginal Revenue,
and Average Revenue
Price, Marginal Revenue, and
Average Revenue
• Marginal revenue is the increase in
total revenue when the quantity
supplied is raised by one unit.
• For a perfectly competitive firm, the
marginal revenue is equal to the price
per unit of the good being sold.
• In a perfectly competitive market,
marginal revenue curve is the
demand curve that a firm faces.
Price, Marginal Revenue, and
Demand
Total Revenue, Total Cost, and
Economic Profit
2.3 Applying the Marginal
Decision Rule
• The slope of the total revenue curve is marginal
revenue
• The slope of the total cost curve is marginal cost
• When marginal revenue equals marginal cost
– Economic profit, the difference between total
revenue and total cost, is maximized
• Economic profit per unit is the difference
between price and average total cost.
Applying the Marginal Decision
Rule
Suffering Economic Losses in the
Short Run
Welcome to Day 20
Principles of
Microeconomics
Quiz today?
Magic 8 ball says ….
Write your name, class day and
time, and Quiz #8 at the top of the
paper.
Write down one of the two
reasons given in class for
average total costs to rise in the
long run. This question is worth
1 point.
Economic Profit = Total Revenue
minus Total Cost.
Total cost includes all the
implicit costs of production also,
such as the value of your time
and the rental/sales value of
resources you own.
Shutdown Point
•TR goes below TVC
• P goes below AVC
Marginal Cost and Supply
In the long-run, if there are
economic profits, there will be
entry.
If there are economic losses, there
will exit.
3.1 Economic Profit and Economic
Loss in the Long Run
• The long run and zero
economic profits • Economic profits in a system
of perfectly competitive
markets will, in the long
run, be driven to zero in all
industries
Eliminating Economic Profits in the
Long Run
Eliminating Economic Losses in the
Long Run
3.1 Economic Profit and Economic
Loss
•
Entry, exit, and production costs
–
Constant-cost industry is when expansion of the
industry does not affect the prices of factors of
production
–
Increasing-cost industry is an industry in which the
entry of new firms bids up the prices of factors of
production and thus increases production costs
–
Decreasing-cost industry is an industry in which
production costs fall as firms enter in the long run
–
Long-run industry supply curve is a curve that
relates the price of a good or service to the quantity
produced after all long-run adjustments to a price
change have been completed.
Long-Run Supply Curves in Perfect
Competition
3.2 Changes in Demand
Changes in demand occur due to a change in:
•
Preferences
•
Incomes
•
The price of a related good
•
Population
•
Consumer expectations
•
A change in demand causes a change in the
market price
– Thus shifting the marginal revenue curves of
firms in the industry
•
Short-Run and Long-Run Adjustments
to an Increase in Demand