AGEC 340 – International Economic Development
Course slides for week 6 (Feb. 16 & 18)
The Microeconomics of Development:
Are low-income people “poor but efficient”?*
– This starts proper microeconomics:
a powerful way to explain peoples’ choices,
 particularly useful when looking over large
numbers of people and long time periods

* If you’re following the textbook, this is in chapter 5, pages 87-102.
Are low-income people “inefficient”?
• Why do the poor have low incomes?
– Do they use what they have “inefficiently”?
…or just have few resources?
…or is something else holding them back?
• Modern economics answers these questions in a
very specific way!
– Here we will use farming as an example,
but same logic applies to any kind of production
For example,
• Why do farmers in a given place often use
similar farming practices?
• Why do farmers in different places use such
different farming practices?
How can we explain & predict
production decisions?
• We can start by describing what is possible,
– then ask what is technically efficient, and
– finally ask what is economically efficient.
• With this approach we can understand
differences and predict changes.
As a farmer turns labor into crops,
what levels of effort and yield
might we see?
crop
yields
(bu/acre)
labor use (hrs/acre)
This is our textbook “production function”
or “input response curve” (IRC)
The IRC defines a frontier of
technical efficiency
Qoutput
crop
to produce above the
yields
(bu/acre) the curve would be
technologically
impossible
to produce
below the curve
would be inefficient
labor use (hrs/acre) Qinput
But what point along the IRC
will people choose?
Qoutput
crop
yields
(bu/acre)
point of maximum yields?
segment with
steepest slope?
labor use (hrs/acre) Qinput
Every point along the curve is technologically
efficient, but not all are economically efficient
• If producers want to maximize profit:
 = PoQo - PiQi
(equation #1)
• and then some algebra, to solve for Qo so
we can draw a line like Y = mX+b:
Subtract PoQo and  from both sides
-PoQo = - - PiQi
and then divide both sides by –Po:
Qo = /Po + (Pi/Po)Qi
(equation #2)
We can graph this equation...
Qo
crop
yields
(bu/acre)
/Po
The formula for this line is
Qo = /Po + (Pi/Po)Qi
labor use (hrs/acre) Qi
… but there are there are as many of
these lines as there are levels of profit.
Qo
crop
yields
(bu/acre)
3/Po
2/Po
1/Po
Each line is
Qo = /Po + (Pi/Po)Qi
with the same slope (Pi/Po),
but a different intercept (/Po)
labor use (hrs/acre) Qi
These lines are called “iso-profit” lines
Qo
crop
yields
(bu/acre)
3/Po
2/Po
Slope = Pi/Po
1/Po
labor use (hrs/acre) Qi
…and we expect farmers will choose the
point on IRC with the highest profit level
This is the
highest-possible
level of profit
*/Po
Slope = Pi/Po
Because of diminishing returns,
only one point can be economically optimal.
Profits above
* are
technically
impossible
*/Po
Profits below
* are
economically
inefficient
At the optimal point, the
isoprofit line crosses
the IRC only once:
the isoprofit line is
“tangent” to the IRC
We can do a similar analysis for farmer’s
choice among outputs.
Qty. of
Corn per
farm
Holding all else constant!
Qty. of Beans
per farm
What combinations of outputs
do we expect to see?
Qty. of
Corn per
farm
Qty. of Beans
per farm
What combinations of outputs
do we expect to see?
Qty. of
Corn per
farm
A “production
possibilities
frontier” (PPF)
Qty. of Beans
per farm
We have a similar picture as before...
Qty. of
Corn per
farm
Technically
impossible
Technically
inefficient
Qty. of Beans
per farm
What is the economically efficient choice?
• First the assumption that producers will
maximize profit:
 = PcQc + PbQb
(equation #1)
• and then some algebra, to turn equation #1
into the equation for a line on our graph:
Qc = /Pc - (Pb/Pc)Qb
(equation #2)
Graphing this equation we get:
Qty. of
Corn per
farm
Iso-revenue lines,
of slope = -Pb/Pc
Qty. of Beans
per farm
which we can use to find the efficient point:
Qty. of
Corn per
farm
Revenue (& profits) are highest;
the iso-revenue line is tangent to the PPF
Qty. of Beans
per farm
To apply this to choice among inputs…
we can again hold all other things constant
(both outputs and other inputs)
tractor or
animal use
(hp-hrs)
possible techniques to
produce two tons of corn,
using one acre of land, etc.
labor use
(person-hours)
To apply this to choice among inputs…
we can again hold all other things constant
(both outputs and other inputs)
tractor or
animal use
(hp-hrs)
An “iso-quant”
technically
inefficient
technically
impossible
labor use
(person-hours)
All points along the isoquant are
“technically efficient”, but which is
economically efficient?
• In this case the assumption that producers
maximize profit means minimizing costs:
C = PlabQlab + PtracQtrac
(equation #1)
• and then some algebra, to turn equation #1 into the
equation for a line on our graph:
Qtrac = C/Ptrac - (Plab/Ptrac)Qlab
(equation #2)
Graphing this equation we get:
tractor or
animal use
(hp-hrs)
Iso-cost lines,
of slope = -Plabor/Ptractor
labor use
(person-hours)
and again only one choice can
minimize costs (or maximize profits)
Qtractors
“iso-quant”
iso-cost line
(slope = -Plab/Ptrac)
Qlabor
So we have three kinds of diagrams...
Qo
Qo2
IRC
Qi2
PPF
Qi
Isoquant
Qo1
Qi1
The curves are fixed by nature and technology;
they show the “frontier” of what is
technologically possible to produce
Qo
Qo2
impossible
Qi2
impossible
inefficient
inefficient
inefficient
impossible
Qi
Qo1
Qi1
The lines’ slopes are fixed by market values;
they show the “relative prices” or what is
economically desirable to produce
Qo
iso-profit lines Qo2 iso-revenue linesQi2
(slope = Pi/Po)
(slope = -Po1/Po2)
Qi
Qo1
iso-cost lines
(slope = -Pi1/Pi2)
Qi1
The combination gives us the profit-maximizing
combination of all inputs & all outputs
Qo
highest
profit Qo2
Qi2
highest
revenue
Qi
Qo1
lowest
cost
Qi1
Does profit maximization apply only to
“modern” farmers?
• No! We can do the same analysis using “values”
(in any units) instead of prices.
– the “values” cancel out, and the “price ratios” become
a barter ratio at which the goods would be traded
– For example, if the value of labor is $5/hr and the
value of corn is $2.50/bushel, then the barter exchange
ratio between them is 2 bushels/hour.
– The “price ratio” or relative scarcity of two things
does not depend on whether they are sold for cash.
Profit-maximizing production choices depend
only on relative prices or exchange ratios
Qty. of corn
(bu/acre)
Qty. of corn
(bu/acre)
iso-profit line
slope = Pl/Pc
(corn exchanged
for labor)
Qty. of labor
(hours/acre)
Qty. of machinery
(hp/acre)
iso-revenue line
slope = -Pb/Pc
(corn exchanged
for beans)
Qty. of beans
(bushels/acre)
iso-cost line
slope = -Pl/Pm
(machines
exchanged
for labor)
Qty. of labor
(hours/acre)
With relative price lines and
technological-possibilities curves
we can predict the profit-maximizing
combination of all inputs & all outputs.
Qty. of corn
(bu/acre)
Qty. of labor
(hours/acre)
Qty. of corn
(bu/acre)
Qty. of machinery
(hp/acre)
Qty. of beans
(bushels/acre)
Qty. of labor
(hours/acre)
We expect that farmers will try to be...
• technically efficient
on the curves
• economically efficient
at the point of highest profit:
– highest profit along the IRC,
– highest revenue along the PPF,
– lowest cost along the isoquant.
Putting the two ideas together...
• with “technical efficiency”
– a curve, representing what’s physically
possible for a producer to do
• and “economic efficiency”
– a line, representing relative values
• we get a specific prediction about what
people are likely to choose
What happens when prices change?
• In developing countries, rapid population
growth and few nonfarm job opportunities
means that the number of people needing to
work on farms rises;
• If nothing else changes, labor becomes
more abundant and its price goes down...
…which graph(s) change?
Qty. of corn
(bu/acre)
Qty. of labor
(hours/acre)
Qty. of corn
(bu/acre)
Qty. of machinery
(hp/acre)
Qty. of beans
(bushels/acre)
Qty. of labor
(hours/acre)
We need to see where labor enters the picture...
Qty. of corn
Qty. of corn
Qty. of machinery
(bu/acre)
(bu/acre)
(hp/acre)
iso-profit
iso-revenue
(slope=Pl/Pc)
(-Pb/Pc)
iso-cost
(-Pl/Pm)
Qty. of labor
(hours/acre)
Qty. of beans
(bushels/acre)
Qty. of labor
(hours/acre)
and ask what would be changed by
more abundant (lower-priced) labor
Qty. of corn
(bu/acre)
slope of isoprofit line
= Plabor/Pcorn
Qty. of labor
(hours/acre)
Qty. of machinery
(hp/acre)
slope of isocost line
= -Plabor/Ptractors
Qty. of labor
(hours/acre)
…in both cases the lines become less steep
(a lower ratio, so a smaller slope)
At the new prices, is the old choice still optimal?
Qty. of corn
(bu/acre)
old slope = Pl/Pc
new slope = Pl’/Pc
Qty. of machinery
(hp/acre)
old slope = Pl/Pt
new slope=Pl’/Pt
Qty. of labor
(hours/acre)
Qty. of labor
(hours/acre)
Now, higher profits & lower costs could be
reached if farmers move along the IRC & isoquant
to a different technique, that was not optimal before.
Qty. of corn
(bu/acre)
Qty. of machinery
(hp/acre)
higher profits
more labor use,
more corn production
lower
costs
more labor use,
less machinery
Qty. of labor
(hours/acre)
Qty. of labor
(hours/acre)
In this way we can explain (and predict)
how farmers respond to changing prices:
Qty. of corn
(bu/acre)
a new
price ratio
a new optimum
old optimum
Qty. of labor
(hours/acre)
Qty. of machinery
(hp/acre)
a new
price ratio
old optimum
a new optimum
Qty. of labor
(hours/acre)
In summary…
• Using these three simple diagrams helps you do
the math on how an optimizing person would
respond to change
• Many studies find that real farmers do usually
respond in these ways
• Next week… if everyone’s already maximizing
their profits, how can things improve?