Limits, Alternatives, and Choices
People's want are numerous and varied. Our wants
extend to a wide range of product from necessities to
luxuries. Wants tend to change and multiply all the time.
Economic wants far exceed the productive capacity of our
scare resource (Unlimited want but limited resources). The Economic Perspective
is the social science concerned with how individuals,
institutions, and society make optimal choices under
conditions of scarcity.
1. Scarcity and Choice
It means limited goods and services. Scarcity forcing
people to make a choices because we can't have it all, we
must decide what we will have and what we must forgo. At
the core of economics is the idea that "there is no free for
lunch". Economists call such sacrifices "Opportunities Cost".
Opportunities Cost means to obtain more of one thing,
society forgo the opportunities of getting the next best thing.
Example : What is your opportunity cost of attending classes?
Available choices: Go shopping, watch movie(s), sleep
If sleeping is your second choice after attending classes,
then SLEEPING is simply your opportunity cost of attending
classes.
2.Purposeful Behavior
Economics assumes that human behavior reflects "rational
self-interest". Rational self-interest is individuals look for and
pursue opportunities to maximize their utility. Consumer
weigh costs and benefits, their economic decisions are
purposeful or rational.
3.Marginal Analysis: Comparing benefits and Costs
Comparison of marginal benefit(MB) and marginal
cost(MC) ! Do it when MB ≥ MC.
Example : Suppose you own a bakery shop. If your cost of one
loaf of bread is 15 baht and 30 minutes before closing, you
s4ll have 10 unsold, and you cannot keep the bread for sale
tomorrow. a. If con4nue to sell at 30 baht each, 2 loaves will
be sold. b. If drop to 20 baht, 4 loaves will be sold. c. If only
10 baht is the price, 10 loaves will be sold. So, what should
you do? What should be the price to charge now? Should you
take the original 15 baht pricing into account?
we need to compare MB and MC.
Economic Theories, Principles, and Models
1.Other-things-equal (ceteris paribus).
The assumption that factors other than those being
considered do not change, assume that all variables except
those under immediate consideration are held constant.
2.Generalization
Economics principles are expressed as the tendencies of
typical or average consumers, workers, or business firms.
3.Graphical expression
Often use graphs to illustrate rela4onships among variables
Some Pitfalls of faulty Economics Analysis
1. Biases
Biases are preconcep4ons that are not based on facts.
Need to put aside the biases for an objec4ve evalua4on of
the economy.
2. Loaded Terminology
Loaded Terminology The news oPen uses loaded terminology
to catch the audience’s interest. Examples: greedy owners,
obscene profits, exploited workers, mindless bureaucrats,
costly regula4ons, creeping socialism. We have to be
careful of the exaggera4ons that this oPen implies.
3.Fallacy of Composition
What is true for one individual (or part of a whole) is not
necessarily true for other individuals (or a whole). So, we
run the risk of fallacy of composi4on when we assume that
what is true for one individual (or part of a whole) will also
be true for other individuals (or a whole).
Example: Traffic jam When there is a traffic jam on the
highway, it will benefit me to take the back roads if I am
the only one who does that. If everyone gets off of the
highway and tries to take the back roads, then the back
roads will become very congested and it could actually take
longer.
4. Post Hoc Fallacy
Post hoc, ergo procter hoc means “after this, therefore
because of this” When two events occur in 4me sequence,
the first event is not necessarily the cause of the second
event. We run the risk of post hoc fallacy when we assume
that because event A precedes event B, then A is the cause
of B.
Example: construction of the new public park
After the construction of the new public park, the values
of surrounding property increase. We cannot conclude that
the establishment of a new public park is a solely cause to
an increase in property value. It could other factors that
has brought about the increase in property value.
5. Correlation but not Causation
Events may be related without a causal rela4onship. That is,
there may be correla4on but not causa4on. The fact that Y
increases when X increases does not means that an increase in
X causes an increase in Y.
Microeconomics and Macroeconomics
Microeconomics is the study of individual (or other
individual units such as firm) choice.
studies such things as:
It
• The pricing policy of firms
• Household’s decisions on what to buy
• How markets allocate resources among alternative
ends
Macroeconomics is the study of the economy as a whole
or the determina4on of economic aggregates such as total
output, the price level, employment, and growth.
It studies such things as:
• Inflation
• Unemployment
• Economic growth
Positive and Normative Economics
Both microeconomics and macroeconomics contain
elements of positive and normative.
1.Positive Economics
• Deals with economic facts (what is statement).
•There is no subjectivity.
2.Normative Economics
• Is what “ought to be” or “should be.”
• It is a standard or a norm for the economy to achieve.
• This is subjective since everybody has different
opinions about what is acceptable.
Individual’s Economizing Problem ---- A Budget Line
The economizing problem faced by an individual is built
by microeconomics model. The problem arises from “Limited
income” but “Unlimited Wants”
Limited income = We have finite amount of income,
even the wealthiest among us. Our income comes in the form
of wages, interest, rent and profit. So, we have to choose
goods and services that maximize our satisfaction given the
limitation we face.
We use a budget line (or budget constraint) to visualize this
problem we face.
Budget Line is a schedule or curve that shows the
greatest combinations of two goods (and services) that can be
purchased with a certain amount of income. For simplicity, we
normally assumes two goods, e.g. DVDs and books.
Location of a budget line depends on a consumer’s money
income prices of the goods.
Slope of the budget line is the ratio of the price of the good
measured on the horizontal axis (PB in the text) to the price
of the good measured on the vertical axis (PDVD). Change in
the price of one good will change the slope of the budget line
and change the purchasing power of the consumer.
Budget Line
.Price changes will change the slope.
.Income changes will shift the budget line.
.An increase in income will shift the line out (or to the
right), allowing consumers to purchase more of both
goods.
-Attainable = all combinations inside and on the budget line.
-Unattainable = all combinations beyond the budget line.
-Straight-line budget constraint with its constant slope,
indicates constant opportunity cost
Production Possibilities Model
1. Points on, along the PPC = Attainable, Full
employment
2. Points inside the PPC = Attainable but inefficient
(Unemployment)
3. Points beyond, or outside the PPC = Unattainable
A Growing Economy
Is an expansion in the economics capacity – can produce
more of both goods (larger total output)
Economic Growth results from each of the following
1.Increasing in resource supplies
2.Improvements in resource quality
3.Advances in technology
What can shift the production possibility curve?
1.Changes in resource supplies
2.Changes in resource qualities
3.Changes in technology
Chapter 3 Demand, Supply and Market Equilibrium
Markets
• Markets bring together buyers and sellers.
• Market may be local , national or international.
• Price is discovered through the interacting decisions of
buyers and sellers.
Demand
• Demand is a schedule or curve that show amount
consumers are willing and able to purchase at a given
price.
• Demand and wants (willing) are not the same.
The law of demand
• The law of demand say that price and quantity
demanded are inversely or negatively related so the
demand curve slopes downward.
• When other things equal, as price falls the quantity
demanded rises, and as price rises the quantity
demanded falls.
• The reasons from
1.Common sense because price is an obstacle that
deter consumers from buying.
2.Law of diminishing marginal utility because
successive units of a particular product yields less
and less marginal utility, so consumers will buy more
only if the price is reduced.
3.Income effect and substitution effects
•
Income effect explains income = purchasing
power. If price rises
purchasing power fall.
•
Substitution effects explains if price of
something goes up
people will buy less of it
and buy something else instead.
Demand schedule and Demand curve
Change in quantity demanded (movement along the
demand curve)
• Quantity demanded tells us how much will be bought at a
specific price.
• A change in price changes quantity demanded
Price
decrease
Quantity demanded increases (move
right)
Price increase Quantity demanded decreases (move left)
Change in demand (shift factors of demand)
• Demand tells us how much will be bought at various
prices.
• There are 5 determinants of demand.
1.Change in buyers’ tastes and preferences
Change in tastes that
favors a good
demanded increases ( shift
right)
Change in tastes that
against a good
demanded decreases (shift left)
the number of buyers
increases
demanded increases ( shift
right)
the number of buyers
decreases
demanded decreases (shift left)
Change in the number of buyers
3.Change in income
• Normal goods are goods that demand varies
directly with income
• Inferior goods are goods that demand varies
inversely with income
Income increases
-Demand for normal goods
increases ( shift right)
-Demand for inferior goods
decreases (shift left)
Income decreases
-Demand for normal goods
decreases ( shift left)
-Demand for inferior goods
increases (shift right)
4.Change in the prices of related goods
• Substitutes are goods that serve as replacement
for one another. Ex. Pepsi and Coke
• Compliments are goods that go together ,use in
combination. Ex. Hamburger and Tomato sauces
• Independent goods are a change in price of one
has little or no effect on the demand for other
Price of x increases
-Demand for y (substitute)
increases (shift right)
-Demand for y (compliment)
decreases (shift left)
Price of x decreases
-Demand for y (substitute)
decreases (shift left)
-Demand for y (compliment)
increases (shift right)
5.Change in consumers’ expectations (about Price
and Income)
-Expect that price will
increase in the future
- Expect that price will
decrease in the future
-Expect that income will
increase in the future
- Expect that income will
decrease in the future
-Demand at the present will
increases ( shift right)
-Demand at the present will
decreases (shift left)
-Demand at the present will
increases ( shift right)
-Demand at the present will
decreases (shift left)
Anything -except the price of good itself that affects
demand is a shift factor.
Supply
• Supply is a schedule or curve that show amount producers
are willing and able to sell at a given price.
The law of supply
• The law of supply say that price and quantity supplied
are directly or positively related so the demand curve
slopes upward.
• When other things equal, as the price rises the quantity
supplied rises, and as the price falls the quantity
supplied falls.
• The reasons from
1.Price acts as an incentive to producers, the firm will
produce the more costly units only if it receives a
higher price.
2.At some point, costs will rise
Supply schedule and Supply curve
Change in quantity supply (movement along the supply
curve)
• Quantity supplied tells us how much will be supplied at a
specific price.
• A change in price changes quantity supplied
Price increase Quantity supplied increases (move right)
Price
decrease
Quantity supplied decreases (move left)
Change in supply (shift factors of supply)
• Demand tells us how much will be supplied at various
prices.
• There are 6 determinants of supply.
1.Change in technology- to reduce cost of production
Change in technology
supply increases ( shift right)
2.Change in resource prices
Cost increase
supply decreases (shift left)
Cost decrease supply increases (shift right)
3.Change in producer expectations
-Expect that price will
increase in the future
-Supply at the present will
decreases ( shift left)
- Expect that price will
decrease in the future
-Supply at the present will
increases (shift right)
4.Change in taxes and subsidies
• Taxes are increase the cost of production so
reduce supply for those goods.
• Subsidies are taxes in reverse.
-Taxes on
-Supply for that good decreases (shift
supplier increase left)
- Taxes on
-Supply for that good increases (shift
supplier decrease right)
-Subsidies to
-Supply for that good increases (shift
supplier increase right)
- Subsidies to
supplier decrease -Supply for that good decreases (shift
left)
5.Change in prices of other goods
• Substitute in production is goods that use some of
the same resources as other goods.
Price of other good
increases
-Supply for x decreases (shift
left)
Price of other good
increases
-Supply for x increases (shift
right)
6.Change in the number of suppliers
the number of suppliers
increases
Supply increases ( shift right)
the number of suppliers
decreases
Supply decreases (shift left)
Anything -except the price of good itself that affects
supply is a shift factor.
Market Equilibrium – The interaction of Demand and
Supply
• Equilibrium occurs where the demand curve
and supply curve intersect.
• There is no shortage or surplus, no pressure
to change price or quantity.
Surplus (Qs > Qd)- usually forces the price down.
Shortage (Qd > Qs)- usually forces the price up.
Shift of Demand curve
Shift of Supply curve
Government Set Price – Price Floor and Price Ceiling
• Price Floors
- When the government wants to push
prices up.
- Prices are set above the
market price.
- Used to provide more income
to favor suppliers.
- Ex. Agricultural goods ,
the minimum wages.
- Effect is Chronic surpluses
• Price Ceiling
- When the government wants to
hold price down.
- Prices are set below equilibrium price.
- Used to enable consumers to obtain more of
some essential goods and services.
- Ex. Rent in the city , Important goods and
services
- Effects are Rationing problem and Black markets
Income elasticity of demand
Introduction
Income elasticity of demand measures the relationship
between a change in quantity demanded and a change in
income. The basic formula for calculating the coefficient of
income elasticity is:
Percentage change in quantity demanded of good X divided by
the percentage change in real consumers' income
Normal Goods
Normal goods have a positive income elasticity of demand so
as income rise more is demand at each price level. We make a
distinction between normal necessities and normal luxuries
(both have a positive coefficient of income elasticity).
Necessities have an income elasticity of demand of between 0
and +1. Demand rises with income, but less than
proportionately. Often this is because we have a limited need
to consume additional quantities of necessary goods as our
real living standards rise. The class examples of this would be
the demand for fresh vegetables, toothpaste and newspapers.
Demand is not very sensitive at all to fluctuations in income in
this sense total market demand is relatively stable following
changes in the wider economic (business) cycle.
Luxuries on the other hand are said to have an income
elasticity of demand > +1. (Demand rises more than
proportionate to a change in income). Luxuries are items we
can (and often do) manage to do without during periods of
below average income and falling consumer confidence. When
incomes are rising strongly and consumers have the
confidence to go ahead with “big-ticket” items of spending,
so the demand for luxury goods will grow. Conversely in a
recession or economic slowdown, these items of discretionary
spending might be the first victims of decisions by consumers
to rein in their spending and rebuild savings and household
financial balance sheets.
Many luxury goods also deserve the sobriquet of “positional
goods”. These are products where the consumer derives
satisfaction (and utility) not just from consuming the good or
service itself, but also from being seen to be a consumer by
others.
Inferior Goods
Inferior goods have a negative income elasticity of demand.
Demand falls as income rises. In a recession the demand for
inferior products might actually grow (depending on the
severity of any change in income and also the absolute coefficient of income elasticity of demand). For example if we
find that the income elasticity of demand for cigarettes is
-0.3, then a 5% fall in the average real incomes of consumers
might lead to a 1.5% fall in the total demand for cigarettes
(ceteris paribus).
Within a given market, the income elasticity of demand for
various products can vary and of course the perception of a
product must differ from consumer to consumer. The hugely
important market for overseas holidays is a great example to
develop further in this respect.
What to some people is a necessity might be a luxury to
others. For many products, the final income elasticity of
demand might be close to zero, in other words there is a very
weak link at best between fluctuations in income and
spending decisions. In this case the “real income effect”
arising from a fall in prices is likely to be relatively small.
Most of the impact on demand following a change in price will
be due to changes in the relative prices of substitute goods
and services.The income elasticity of demand for a product
will also change over time – the vast majority of products
have a finite life-cycle. Consumer perceptions of the value
and desirability of a good or service will be influenced not
just by their own experiences of consuming it (and the
feedback from other purchasers) but also the appearance of
new products onto the market. Consider the income elasticity
of demand for flat-screen colour televisions as the market for
plasma screens develops and the income elasticity of demand
for TV services provided through satellite dishes set against
the growing availability and falling cost (in nominal and real
terms) and integrated digital televisions.
Cross price elasticity (CPed)
measures the responsiveness of demand for good X
following a change in the price of a related good Y.
We are looking here at the effect that changes in relative
prices within a market have on the pattern of demand.
With cross elasticity we make a distinction between
substitute and complementary products.
Cross price elasticity of demand – analysis diagrams
Substitutes:
With substitute goods such as brands of cereal, an increase in
the price of one good will lead to an increase in demand for
the rival product. The cross price elasticity for two substitutes
will be positive.
For example, the iPhone now provides genuine competition
for the Blackberry in providing users with ‘push technology’ to
send all emails through to a mobile device.
Another good example is the cross price elasticity of demand
for music. Sales of digital music downloads have been soaring
with the growth of broadband and falling prices for
downloads. As a result, sales of traditional music CDs are
declining at a steep rate.
Complements:
Complements are in joint demand
The CPED for two complements is negative.
The stronger the relationship between two products, the
higher is the co-efficient of cross-price elasticity of demand.
When there is a strong complementary relationship between
two products, the cross-price elasticity will be highly
negative. An example might be games consoles and software
games
Unrelated products
Unrelated products have a zero cross elasticity for example
the effect of changes in taxi fares on the market demand for
cheese!
Pricing for substitutes:
If a competitor cuts the price of a rival product, firms use
estimates of CPED to predict the effect on demand and total
revenue of their own product.
Pricing for complementary goods:
Popcorn, soft drinks and cinema tickets have a high negative
value for cross elasticity– they are strong complements.
Popcorn has a high mark up i.e. pop corn costs pennies to
make but sells for more than a pound. If firms have a reliable
estimate for CPed they can estimate the effect, say, of a twofor-one cinema ticket offer on the demand for popcorn.
The additional profit from extra popcorn sales may more than
compensate for the lower cost of entry into the cinema. For
some movie theatres, the revenue from concessions stalls
selling popcorn; drinks and other refreshments can generate
as much as 40 per cent of their annual turnover.
Brand and cross price elasticity
When consumers become habitual purchasers of a
product, the cross price elasticity of demand against rival
products will decrease.
This reduces the size of the substitution effect following a
price change and makes demand less sensitive to price. The
result is that firms may be able to charge a higher price,
increase their total revenue and achieve higher profits.
Chapter 9 Consumer Behavior
Law of Diminishing Marginal Utility
• Law of Diminishing Marginal Utility is the more of a good a
person consume per period, the less satisfaction (MU)
generated, and the smaller the increase in total utility.
• It simply means that as you consume more, you enjoy less
than you did in the initial unit.
Terminology
• Utility is the satisfaction one gets from consuming a good
or service.
• The characteristics of Utility
1.Utility and Usefulness are not the synonymous.
2.Utility is difficult to quantity but we can assume
that people can measure satisfaction in numerical
values. The units called “Utils” that is one unit of
satisfaction or pleasure.
3.Utility is subjective.
Total Utility and Marginal Utility
• Total utility (TU) is the total
Amount of satisfaction that
consumer gets from consuming
a product.
(The sum of the marginal utilities)
• Marginal utility(MU) is the extra
satisfaction from an additional
unit of the good. MU = ΔTU/ΔQ
Theory of Consumer Behavior
• Consumer Choice and the Budget Constraint – 4
Assumptions
1.Rational behavior- Consumers are rational people,
they try to maximize utility.
2.Preferences – Each consumer has clear-cut preference.
3.Budget constraint – Consumer has fixed money income.
4.Prices – Every good carries a price tag. Each person
buys a tiny part of total demand, so price are
unaffected by the amount purchased by any particular
consumer.
Rational Choice and Utility Maximizing Rule
• Rational individuals want to maximize satisfaction within
their budget constraint.
The principle of Rational Choice : Utility Maximizing Rule
The budget must be completely spent.
1.Spend money on good that gives the most marginal
utility(MU) per dollar. Ex. We should consume more A.
If
MU of product A
>
MU of product B
Price of A
Price of B
2.Consumer should allocate his or her income so that the
last dollar spent on each product yields the same
amount of extra (marginal) utility
MU of product A
=
MU of
product B
Price of A
Price
of B
This point is called “Consumer Equilibrium”- Maximize
Utility.
For example
How to make decision
To conclude, we spend money to buy 2 apples and 4
oranges in order to maximize utility under the budget
constraint ($10).
Utility Maximization and the Demand Curve
• The rational choice of the utility analysis leads to the law
of demand.
• The basic determinants of an individual’s demand for a
specific product are
1.Income Effects : the impact that a price change has on
a consumer’s real income
• Higher price = real income decrease = can buy less
• lower price = real income increase = can buy
more
2.Substitution Effect : the impact that a change in a
product’s price has on its relative expensiveness
• Higher price = MU/dollar decrease = buy less of that
product
• lower price = MU/dollar increase = buy more of that
product
Applications and Extensions
• Many real-world phenomena can be explained by applying
the theory of consumer behavior.
iPods
• Introduction of iPod disrupted consumer equilibrium.
Consumer concluded that MU/ dollar ratio of iPod is
higher than the ratio of other alternative goods. They
shift away spending of other goods toward iPods to
increase their total utility
• However, MU of second , third is quite low, so most
consumers purchased only a single iPod.
• That’s why Apple continued to enhance the iPod , enticing
some of buyers of older model to buy new models.
The Diamond-Water Paradox
• Why would water, essential to life, be priced below
diamonds?
• There 2 reasons
1.Water is in great supply relative to demand, so the
price is low.
We consume water intensively
water consumed is very low .
MU of last unit of
2.Diamond is rare relative to demand, so the price is
high
MU of last unit of diamond consumed is very
high.
However, total Utility(TU) of water is larger than TU of
diamond.
Opportunity Cost and The Value of Time
• Time is a valuable economic commodity. There are 2
components to the cost of consumption.
1.The money price of the good. 2. The time price
of the good.
• Your willingness to pay a higher price for time-saving
depends on the opportunity cost of your time.
• Example a retired couple = clip coupon and search
the newspaper for bargains ,whereas a working
couple = ignore coupons and sales , eat out more
often , pay extra for the convenience.
Medical Care Purchases
• Method of payment affect price that we pay at the
time and amount of purchased.
• Example : Medical care and Health insurance = pay
only 20% of full price = willing to buy more.
Cash and Noncash Gifts
• Why people prefer cash gifts to noncash gift costing
the same amount?
• The reason is noncash gifts may not match
recipient’s preferences, so yields less utility than
does the cash gifts.
• 3 actions that individuals act to maximize their total
utility
1.Set up gift registries 2. Obtain cash refund or
exchange gifts 3. Recycle gifts.
Prospect Theory
• How people actually deal with life’s ups and downs
• Prospect theory discovered 3 interesting facts
1.People judge things relative to the status quo(current
situation)
2.People experience:
• Diminishing marginal utility for gains
• Diminishing marginal disutility for losses
3.People are loss averse: losses are felt much more
intensely than gains. (about 2.5 times more intensely)
• 3 explanations how people deal with good and bad
1.Losses and Shrinking Packages
• Consumers see any price increase as a loss
relative to the status quo.
• Producers are reducing package size instead of
raising prices.
2.Framing Effects and Advertising
• Consumers evaluate events in a particular mental
frame.
• New information alters the frame in which the
consumer defines whether situations are gains or
losses.
• Example: (a) get 10% raise in salary.
(b) but others get 15% raise in salary.
3. Anchoring Effects and Credit Card Bills
• Anchoring Effect= Irrelevant information or recently
consideration can unconsciously influence people’s
feeling about the status quo.
• Many credit card customers become fixated on the
level of minimum payments given on credit card
bills. The mere presence of a minimum payment is
enough to reduce the actual amount many people
choose to pay on their bills, leading to further
interest payments.(increase profits to credit card
company)
4.Mental Accounting and Overpriced Warranties
• Mental Accounting explain that people sometimes
look at consumption options in isolation or put
options into totally separate “Mental Accounting”, so
irrationally failing to look at all their options
simultaneously.
• Example: Electronic stores, they sell “Overpriced
Warranties” of hardly break down electronic
appliances.
5. The Endowment Effect
• Endowment Effect caused by once a person’s
something, the thought of parting with it seems like
a potential loss. Therefore, the owners of items end
up demanding a lot of money as compensation.
• This effect can make market transactions between
buyers and sellers harder.
• The seller has a tendency to demand a higher
price.
• The buyer has a tendency to offer a lower
price.
Chapter 10 Bussinesses and the Cost of
Production
Economic Costs : Explicit and Implicit Costs
- Explicit Cost ( Accounting Costs) - Opportunity cost of
resources employed by firm that takes in from of cash
payment
- Implicit Costs - Opportunity costs for the use of selfowned and self-employed resources
Economic Costs = Explicit costs + Implicit costs
- Accounting Profit - the profit that accountants
calculate by subtracting explicit costs from total
revenue.
Accounting Profit = Total revenue - Explicit costs
- Normal Profit - The typical or normal amount of
payment you could have received for performing
entrepreneurial functions.(It is one of implicit cost)
Economic Profit
Economic profit = Total revenue - Economic costs
Short Run and Long Run
Short Run : Fixed Plant
- The short run is period too brief for a firm to change
its plant capacity, yet long enough to permit a change
in the degree to which the fixed plant is used
Long Run : Variable Plant
- A period long enough for that firm to adjust the
quantities of all the resources it employs including
plant capacity
- Enough time for existing firms to leave the industry or
for new firms to and enter the industry
Note : While the short run is a “fixed-plant” period, the
long run is a “variable-plant” period.
Short-Run Production Relationships
1. Total product (TP) - the total quantity, or total
output, of a particular good product.
2. Marginal product (MP) - the extra output resulted
from adding a unit of a variable resource (labor)
Marginal Product = Change in total product/ Change in
labor input
3. Average product (AP) - also called labor
productivity, is output per unit of labor input
Average Product = Total product/Unit of labor
Law of Diminishing Returns
It states that as successive units of variable
resources (VR ex.labor) are added to a fixed resource (FR
ex.capital,land), beyond some point,the marginal
product of each additional unit of the variable resource
will decline.
- Relationship between MP and AP
- Average always follow Marginal
- Where marginal product exceeds average product,
average product rises.
- Where marginal product is less than average
product, average product declines.
- AP intersects MP when AP is at maximum.
- The law of diminishing returns is embodied in the
shapes of all three curves (from the effects of MP).
Short-Run Production Costs
Fixed Costs - those cost which in total do not vary with
changes in output, Fixed costs cannot be avoid in the
short run even if output in zero.
Variable Costs - those costs that change with the level of
output
Total Cost - the sum of fixed cost and variable cost at
each level of output. TC =TFC + TVC
Per-Unit, or Average Costs
Average Fixed Cost (AFC)
AFC = TFC/Q
Average Variable Cost (AVC)
AVC = TVC/Q
Average total Cost (ATC)
ATC = TC/Q = AFC + AVC
Marginal Cost (MC)
MC = Change in TC/Change in Q (or)
MC = Change in TVC/Change in Q
Relationship between MC and MP
- The shape of the MC curve is a consequence of the law
of diminishing return because the MC curve is a mirror
reflection of the MP curve.
- When marginal product is rising, marginal cost is
falling.
- Increasing marginal product return will be reflected in
a declining marginal cost.
- When marginal product is at its maximum, marginal
cost is at its minimum.
- Diminishing marginal return will be reflected in a
rising marginal cost.
- the AVC cure is also a mirror of the AP curve.
Relation of MC to AVC and ATC
- Average always follows Marginal.
- AVC and ATC followed by MC
- As long as MC lies below ATC, ATC will fall, and
whenever MC is above AVC,AVC will rise.
- The MC curve intersects the MC curve and the AFV
curve because they are not related.
Shifting the Coat Curves
- If fixed costs rose then the AFC curve would be shifted
upward, The ATC curve would also shift upward
because AFC is a component of ATC. But the position of
the AVC and MC curve would be unchanged.
- If the price of variable input rose, the AVC, ATC, and
MC curve would all shifts upward, but the position of
AFC would remain unchanged.
Long-Run Production Cost
- The long-run ATC curve show the lowest average total
cost at which any output level can be produced after
the firm has had time to make all adjustment in its
plant size.
- The long-run ATC curve for the enterprise is made up
of segment of the short-run ATC curves for the various
plant sizes that can be constructed.
- It is often called the firm’s planning curve.
- In many industries, the number of plant sizes is
virtually unlimited. Therefore, the long-run ATC curve
is made up of all point of tangency of the unlimited
number of short-run ATC curves.
- Each point on it tell us the minimum ATC of producing
the corresponding level of output.
Economies and Diseconomies of Scale
- The U-shaped of long-run ATC curve is caused by
economies and diseconomies of scale.
- The U-shaped of long-run ATC cannot be the result of
rising of rising resource prices or law of diminishing
returns because :
- We assume that the resource prices are constant.
- The law of diminishing returns does not apply in
long run since all resources are variable.
Economies of Scale (EOS)
- Economies of scale or economies of mass production,
explain the downward sloping part of long-run ATC
curve.
- As plant size increases, average costs of production
will be lower due to:
- Labor specialization
- Managerial specialization
- Efficient capital
- Other factor such as spreading the start-up,
learning by doing.
- Where economies of scale are operative, an increase
in all inputs of, say, 10 percent will cause a more thanproportionate increase in output of, say 15 percent.
Diseconomies of Scale (DEOS)
- As plant size increases, average costs of production
will be higher.
- The main cause diseconomies of scale is the difficulty
of efficiently controlling and coordinating operations
as the firm becomes a large-scale producer.
- Where diseconomies of scale happen, an increase in all
inputs of, say, 10 percent will cause a less thanproportionate in output of, say 5 percent.
Constant Return to Scale
- In some industries there may be a rather wide range of
output between the output at which economies of
scale end and the output at which diseconomies of
scale begin.
- Here a given percentage increase in all inputs of, say,
10 percent will cause a proportionate 10 percent
increase in output. Thus,in this range ATC is constant.
Minimum Efficient Scale and Industry Structure
- Minimum Efficient Scale (MES), which is the lowest
level of output at which a firm could minimize longrun average costs.
- The shape of the long-run ATC curve can be significant
in determining whether and industry is populated by a
relatively large number of small firm or dominated by
a few large producers, or is somewhere between the
two.
With an extended range of constant returns to scare
- Relatively large and relatively small firms could
coexists in an industry and be equally successful.
Where economies of scale occur over a wide range
of output and diseconomies of scale appear only at
very high levels of output.
- Given consumer demand, efficient production will be
achieved with a few large-scale producers.
- Small firm cannot realize the minimum efficient scale
and will not be able to complete.
- Natural Monopoly - a market situation in which
average total cost is minimized when only one firm
produces the particular goods and services.
Where economies of scale are few and
diseconomies happen quickly, the minimum
efficient size occurs at a low level of output.
- In such industries, consumer demand will support a
large number of relatively small producers.
- Fairly small firm are as efficient as, or more efficient
than large-scale producers.