Drexel University
Spring Quarter 2009

• Socialists are humanists and rationalists, and agree that production should be rationally directed to improve the conditions of human life.
• It is embarrassing, then, that a case can be made that the allocation of resources under market capitalism tends to be efficient.

• land
– the "original and indestructible powers of the soil" and
– natural resources, such as coal, oil, and metallic ores
• labor
• and capital
– machinery
– houses and other buildings
– grapevines, fruit trees and hogs on the hoof
– and human capital

• There are, of course, some important differences between land and some other natural resources.
Coal and oil, once they are dug out or the ground and burned, are gone for ever. In other words, they are "wasting resources." On the other hand, the fertility of the soil does not have to be a wasting resource, if the farmer uses farming methods which maintain fertility. But this difference is not absolute. Copper ores, for example, may be used and then recycled.

• Capital consists of all goods produced by human labor (with other resources) and used in the production of still more goods and services; in other words, produced means of production. Some examples are
– machinery
– houses and other buildings
– grapevines, fruit trees and hogs on the hoof
– and human capital

• For neoclassical economics, economics is the study of the allocation of resources. In this school of thought, economics is defined as "The study that considers human behavior as a relation between scarce means and alternative ends.” (Robbins)
• Neoclassical economists regard the study of the allocation of resources as essentially a scientific, not a normative, study.
Lionel Robbins

• Resources of all kinds are scarce. That simply means that we do not have enough resources to produce all of the goods and services that anybody might like to have. It means that we, as a society, must somehow answer some basic questions: What resources will be used to produce which goods and services, and for whom ? To answer these questions, and get the resources to the users, is to
"allocate" resources. We would, of course, like to organize things so that the resources are used for the most urgent and rewarding kinds of production --that is, we would like to allocate resources "efficiently."

A Model Illustrating Scarcity
For our model, let us think of an economy that produces just two kinds of goods: "machines" and food. At any given time, a country cannot produce more machines without producing less of something else. (In this case, the country produces less food).
Table 1 on the next slide shows, for the model country, how much food they can produce given each respective output of machines. For example, to increase machine output from 7000 to 8000, they would have to cut food output from 1020 to 720.

machines food
0 2000
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000 0
1280
1020
720
380
1980
1920
1820
1680
1500

A key point here is the trade-off between machines and food. Whenever we increase the output of machines we must decrease the output of food.
This is a cost: it is the "opportunity cost" of the increase in production of machines.
In general, economists define the "opportunity cost" of any good or service as the value of all the other goods or services that we must give up in order to produce it.

The idea is that, in order to increase the production of machines, we must use up resources that could otherwise be used to produce food. We give up the opportunity to produce a relatively large amount of food. The opportunity cost of any decision consists of everything we must give up in order to carry out that decision (as, the opportunity cost of the decision to increase the output of gadgets in the model economy consists of the food the model economy must give up as a result).

• For example, going from 3000 to 4000 machines, we give up 1820-1680 = 140 carloads of food. This is the opportunity cost of the 1000 machines.
• Thus, the opportunity cost of one machine averages about 0.14 carloads of food over this range.

Here is the Production Possibility Frontier for capital
(vertical) and consumption goods (horizontal) for the
United States in 1996.

The "production function." is a relationship between quantities of input and quantities of output (of one particular good) that tells us, for each quantity of input, the greatest output that can be produced with those inputs.
Here is an example in the form of a table, with labor as the only input.
Labor Output
0 0
100 945
200 1780
300 2505
400 3120
500 3625
600 4020
700 4305
800 4480
900 4545
1000 4500

• This production function provides an example of
“diminishing returns,” and important principle for our understanding of production.
• With labor as the only variable input -- with other inputs, such as land and capital, fixed, even if only for the short run -- the “law of diminishing returns” will be applicable.
• This “law” was originally proposed by the first professor of economics in history -- Thomas
Malthus.

The Law of Diminishing Returns: when a fixed input is combined in production with a variable input, using a given technology, increases in the quantity of the variable input will eventually lead to decreasing productivity of the variable input.
Malthus argued that land is the fixed input, labor the variable input, and that decreasing productivity of labor would depress incomes. Malthus knew that technological progress could reverse this prediction, but probably underestimated the real impact of technology.

• In most statistical discussions of productivity, we refer to the average productivity of labor:
 output
Average Productivity = labor input
• In microeconomics, however, we will focus more on the marginal productivity.
Marginal Productivity = MP =
 Output
 Input

• marginal productivity of labor is
– the additional output as a result of adding one unit of labor, with all other inputs held steady and ceteris paribus.
Marginal Productivity = MP =
 Output
 Input is an approximation to this.


When 300 labor-days per week are employed the firm produces 2505 units of output per week.

When 400 labor-days per week are employed the firm produces 3120 units of output per week.

It follows that the change in labor input,

Labor, is 100.

It also follows that the change in output,

Output, is 615.
Labor Output
0 0
100 945
200 1780
300 2505
400 3120
500 3625
600 4020
700 4305
800 4480
900 4545
1000 4500


Applying the formula above, we approximate the marginal productivity of labor by the quotient 615/100 = 6.15.

We can interpret this result as follows: over the range of 300 to 400 man-days of labor per week, each additional worker adds approximately 6.15 units to output.
Labor Output
0 0
100 945
200 1780
300 2505
400 3120
500 3625
600 4020
700 4305
800 4480
900 4545
1000 4500

• Law of Diminishing Returns (Modern
Statement):

When the technology of production and some of the inputs are held constant and the quantity of a variable input increases continually, the marginal productivity of the variable input will eventually decline.
• The inputs that are held steady are called the
"fixed inputs." We are treating land and capital as fixed inputs. Labor is the “variable input.”

0
Labor Output Ave rage
Productivit y
Marginal
Productivit y
0 0
9.45
100 945 9.45
8.35
200 1780 8.90
7.25
300 2505 8.35
6.15
400 3120 7.80
5.05
500 3625 7.25
3.95
600 4020 6.70
2.85
700 4305 6.15
1.75
800 4480 5.60
0.65
900 4545 5.05
-0.45
1000 4500 4.50

• Ajit is a farmer who grows lentils on two fields in North
India.
• He has a field on a hill and a field beside a small river.
• The riverside field is more fertile than the hilltop field.
• Ajit has only a limited amount of labor to divide between the two fields.
– He can work at most 300 days, total, on both fields.
– He wants to get the largest possible crop of lentils from his two fields.
– How should he 'allocate his labor' between the hilltop field and the riverside field?

100
125
150
175
200
225
250
275
300 input on river field input on hill field total output
0
25
50
75
300
275
250
225
3300
3959.38
4537.5
5034.38
200
175
150
125
100
75
50
25
0
5450
5784.38
6037.5
6209.38
6300
6309.38
6237.5
6084.38
5850
What happens is: when Ajit allocates more labor to the river field, marginal productivity on that field decreases, and eventually it is less productive at the margin.

We can visualize the efficient allocation of resources with a graph like this one.
QuickTime™ and a
Graphics decompressor are needed to see this picture.
Labor on the more fertile field

• Allocating 215 to the river field produces the largest output.
• If you start from any other quantity, moving toward 215 increases output “at the margin.”
• Rule -- “equimarginal principle”
When the same product or service is being produced in two or more units of production, in order to get the maximum total output, resources should be allocated among the units of production in such a way that the marginal productivity of each resource is the same in each unit of production.

• Output depends on productivity
• For many economic applications, it is marginal productivity that is more important.
• When there is a single variable resource, it is subject to diminishing marginal productivity.
• This leads to and important principle of resource allocation:
• Make MP equal in every use of the resource.

• Ragnar Ohlsson, Morals Based on Needs, Ch. 5, handout.
• The Preference Approach to Marginal Benefit and
Consumer Demand
, McCain’s website,
• http://faculty.lebow.drexel.edu/mccainr/top/prin/ txt/MUch/pref1.html

• We want to allow for production of more than one kind of output.
• So return to the Production
Possibility
Frontier model:

Suppose we ask ourselves: how many machines (of a specific kind) would it be efficient to produce?
Define "net benefits" as "benefits minus costs." One concept of "efficient output" is "the output that maximizes the net benefit from machines." That is the concept of efficiency we will use. It is approximative, of course -- since "benefits" and "costs" are money approximations to nonmonetary utility and opportunity costs -- but it will give the right answers all the same.

• That sounds like a criterion for a planner to use -- and it could be. But we are interested in market economies.
• Proposition: A planner could do no better than the equilibrium of supply and demand.

We will -- as usual -- think in terms of a model economy (Economia) that produces only 2 goods, with the production possibility frontier shown.

• In Economia, as always, cost is the opportunity given up.
• In Economia, that means the cost of machines is a quantity of food.
• We can construct a total cost curve rather simply: invert the possibility frontier!

Marginal cost is always the concept of cost most important for the allocation of resources.

Marginal Cost of Machines

We can measure the total benefit from machine production in terms of food. The measure of benefit is the amount of food that the citizens would be willing to trade for the given quantity of machines.
Perhaps we could do a questionnaire survey.

benefits
1400
1200
1000
800
600
400
200
0
0 200 400 600 production of machines
800 1000
Assumed total benefits of machines in Economia

As before, it is the marginal benefits that are relevant to the efficient allocation of resources.

Here is the relationship between machine production and marginal benefit expressed in a diagram.

RULE : The output at which marginal benefit is equal to marginal cost is the output at which the net benefit of output is at its greatest. This is the optimal output, and when each industry has just enough resources to produce the optimal output (and the industries use the resources efficiently), that is the optimal allocation of resources.

Remember: Reason backward!

• In a perfectly competitive market,
– demand is the same as marginal benefit and
– supply is the same as marginal cost.
• Therefore, to say that quantity supplied equals quantity demanded is to say that marginal benefit equals marginal cost

A consumer will always maximize her net benefit (or consumer’s surplus, as it is called) by buying a quantity like B, at which price=MB.
Therefore, the MB curve is the demand curve.

A firm will always maximize its profits by selling the quantity that corresponds to price=MC. Therefore, the MC curve is the supply curve.

FUNDAMENTAL PRINCIPLE OF
MICROECONOMICS : If
• All goods, services and resources are paid for by those who benefit from them, and
• the payment is at supply-and-demand equilibrium prices, then
• output quantities are efficient.

• First, markets may not be Perfectly
Competitive. Prices may not be determined by supply and demand, and outputs may deviate from the perfectly competitive norm.

• Second, people may not pay for the goods, services, and resources they use. for example, in Equador, the loggers pollute water and thus destroy the businesses of the fish-farmers downstream. The loggers are using a resource they do not pay for -- fresh water -- and thus depriving the fish-farmers of it, even though (probably) the fish-farmers can make more effective use of it. In economics this sort of problem is called an
"externality."

• Finally, even if the Perfectly Competitive equilibrium is efficient, there may be other objectives besides efficiency. For example, efficiency can coexist with great inequality. A slave economy could be efficient.
Most of us wouldn't want to adopt a slave system even so, I suspect.

• The efficient market economy, with marginal cost equal to marginal benefit in every market, defines the potential of a complex economy, even if it is not perfectly realized.
• Thus, in microeconomics, it defines the benchmark against which the performance of the actual economic system is measured.
• It also provides a challenge and a high standard for advocates of economic planning to meet.
• One thing that is missing is any consideration of need.
• We will address that next week, and planning the following week.