Chapter 1
Appendix
1
Indifference Curve Analysis

Market Baskets are combinations of
various goods.

Indifference Curves are curves
connecting various market basket
combinations of goods that make an
individual equally happy.
2
Assumptions about Preferences




Persons can rank market baskets.
Rankings are transitive.
More is preferred to less.
The marginal rate of substitution is
diminishing.
3
Indifference Curves and
Indifference Maps
4
Expenditure on Other Goods
per Month (Dollars)
Figure 1A.1 Indifference Curves
60
50
B1
B2
U1
0
40 50
Gasoline per Month (Gallons)
U2
U3
Qx
5
The Marginal Rate of
Substitution
The amount of expenditure on
other goods that a person will give
up in order to get an additional unit
of one good is called the marginal
rate of substitution.
6
The Budget Constraint
The budget constraint is the
combination of goods that a person can
afford.
7
The Budget Constraint
in Algebraic Terms
I = PxQx + SPiQi
Where: I is income
Pi is the price of good i
Qi is the amount of good i purchased
8
Expenditure on All Expenditure on
Other Goods Except Gasoline per
Gasoline per Month
Month
Expenditure on Other Goods
per Month (Dollars)
Figure 1A.2 The Budget Constraint
100
60
A
C
F
D
B
Qx
0
40
100
Gasoline per Month (Gallons)
9
Expenditure on Other Goods
per Month (Dollars)
Figure 1A.3 Consumer Equilibrium
A
E
40
U3
U2
U1
B
0
60
Qx
Gasoline per Month (Gallons)
10
Equilibrium Condition
PX = MBX
11
Expenditure on Other Goods
per Month (Dollars)
Figure 1A.4 Changes in Income
A'
A
0
B
Qx per Month
B'
12
Expenditure on Other Goods
per Month (Dollars)
Figure 1A.5 Changes in the Price of Good X
A
0
B''
B
Qx per Month
B'
13
Income and Substitution Effects


The income effect is the change in the monthly
(or other period) consumption of a good due to
changing purchasing power of fixed income
caused by the good’s price change.
The substitution effect is the change in the
monthly (or other period) consumption of the
good due to the change in its price relative to
other goods.
14
Figure 1A.6 Income and Substitution Effects
Expenditure on Other Goods
per Month (Dollars)
150
50
100
E'
E1
20
E2
40 45
The Income Effect
U2
U1
60
The Substitution Effect
Qx
Gasoline
per Month
(Gallons)
15
The Law of Demand


The demand curve slopes downward.
As the price rises, the quantity
demanded falls.
16
Price
Figure 1A.7 The Law of Demand
D = MB
0
Qx per Month
17
Price Elasticity of Demand
ED =
% Change in Quantity Demanded
% Change in Price
=
DQD/QD
DP/P
18
Consumer Surplus

Net benefit that consumers obtain from
a good

Total benefit to consumers from obtaining
a good, less the money they give up to
get the good.
19
Figure 1A.8 Consumer Surplus
A
Price
Consumer Surplus
B
P
Market Price
D = MB
0
Q1
Gasoline per Month
20
Figure 1A.9 The Work Leisure Choice
Income per Day
A
40
0
E
U3
U2
U1
16
Leisure Hours per Day
B
24
21
Budget line for time allocation
I = w(24 – L)
Where:
I is income
W is wage
L is the amount of
time devoted to leisure
22
Analysis of Production and Cost



The Production Function is the
expression of the maximum output
obtainable from any combination of
inputs.
The Short Run is the period of time in
which some inputs cannot be changed.
The Long Run is the period of time in
which all inputs can be changed.
23
Marginal Product

The increase in output
associated with a one unit
increase in an input is called
the Marginal Product.
24
Isoquants


Isoquants are curves that show alternative
combinations of variable inputs that can be
used to produce a given amount of output.
The Marginal Technical Rate of Substitution
is the amount of one input that can be given
up with one additional unit of another input
while keeping output constant.

It is the slope of the isoquant.
25
Isocost Lines
Lines that show combinations of variable inputs that
cost the same are called Isocost Lines.
C = PLL + PKK
Where: C is the total cost
PL is the price of labor (typically the wage).
L is the units of labor employed.
PK is the price of capital (typically a rental price or an interest rate to
reflect the opportunity cost of that capital).
K is the units of capital employed.
26
Figure 1A.10 Isoquant Analysis
Labor Hours per Month
Isocost Lines
E
L*
Monthly Output = Q1
0
K*
Machine Hours per Month
27
Cost Minimization
Costs are minimized for every level of
output where:
MRTSKL = PK/PL
28
Cost Functions






Total Cost
Variable Cost
Average Cost
Average Variable Cost
Average Fixed Cost
Marginal Cost
29
Returns to Scale

Constant Returns to Scale



Increasing Returns to Scale



AC = MC
AC and MC are constant.
AC < MC
AC is diminishing.
Decreasing Returns to Scale


AC > MC
AC is increasing.
30
Profit Maximization
Assumption: All firms seek to maximize profits.
Operationally, that means that firms will
set production where Marginal Revenue
equals Marginal Cost; MC = MR.
31
Perfect Competition
The situation where:
 There are many buyers and sellers so that
no one buyer or seller has market power.
 The product being sold is homogenous.
 There are no legal or economic barriers to
entry.
 Information is freely available.
In such a case, the market price is the Marginal
Revenue to the firm and that firm will maximize
profits where P = MC.
32
Figure 1A.11 Short-Run Cost Curves and Profit
Maximization under Perfect Competition
MC
Price and Cost
Producer
Surplus
AC
E
P
D = MR
AVC min = F
0
Q*
Output per Month
33
Short-Run Supply

Under perfect competition,
Supply is the Marginal Cost
curve emanating from the
minimum of average variable
cost curve.
34
Producer Surplus

Producer Surplus is the difference
between the market price and the
minimum price for which the firm would
sell the product. It is the area under
the price line and above the marginal
cost curve. It also represents the profit
(less fixed costs) to the firm.
35
Normal and Economic Profit

Normal Profit is the opportunity cost of
resources of owner-supplied inputs. The
value of the firm owners’ time (typically
measured by their next job opportunity) plus
any other inputs provided by the owner(s).

Economic Profit is any profit to the firm that
is above normal profit.
36
Long Run Supply


In the long run, economic profit is
driven to zero under competition.
P = LRMC = LRACmin
37
Figure 1A.12 Long-Run Competitive Equilibrium
LRMC
Price
LRAC
LRAC min = P
0
D = MR
Q*
Output per Month
38
Figure 1A.13 Long-Run Supply: The Case of A
Constant-Costs Competitive Industry
Price
Long-Run Supply
LRACmin = P
0
Output per Year
39
Figure 1A.14 A Perfectly Inelastic Supply Curve
Price
Supply
0
Q1
Output per Year
40
Price Elasticity of Supply
ES =
% Change in Quantity Supplied
% Change in Price
=
DQS/QS
DP/P
41