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1
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1. Sumber Referensi
Nicholson, Walter and Christopher Snyder, 2008. Microeconomic Theory, Basic Principles and
Extensions, Tenth Edition, Thomson South-Western, United Stated of America.
2. Komponen Penilaian
3
Microeconomic Theory Chapter 1
Basic Principles and Extensions, 9e
By ECONOMIC MODELS
WALTER NICHOLSON
Slides prepared by
Linda Ghent
Eastern Illinois University
3 4
1
Verification of Economic Models Features of Economic Models
We can use the profit-maximization model Ceteris Paribus assumption
to examine these approaches
is the basic assumption valid? do firms really Optimization assumption
seek to maximize profits?
Distinction between positive and
can the model predict the behavior of real-world
normative analysis
firms?
5 6
2
Optimization Assumptions Positive-Normative Distinction
Optimization assumptions generate Positive economic theories seek to
precise, solvable models explain the economic phenomena that
is observed
Optimization models appear to be Normative economic theories focus on
perform fairly well in explaining reality what should be done
9 10
3
The Economic Theory of Value The Economic Theory of Value
Labor Theory of Exchange Value The Marginalist Revolution
the exchange values of goods are determined by the exchange value of an item is not determined
what it costs to produce them by the total usefulness of the item, but rather
these costs of production were primarily affected by the usefulness of the last unit consumed
labor costs because water is plentiful, consuming an additional
therefore, the exchange values of goods were unit has a relatively low value to individuals
determined by the quantities of labor used to produce
them
producing diamonds requires more labor than
producing water
13 14
diamonds have a high marginal value and a high Quantity per period
Q*
marginal cost of production High price
15 16
4
Supply-Demand Equilibrium Supply-Demand Equilibrium
qD = 1000 - 100p A more general model is
qS = -125 + 125p qD = a + bp
Equilibrium qD = qS qS = c + dp
Q* = 750 D
5
The Economic Theory of Value The Economic Theory of Value
General Equilibrium Models The production possibilities frontier can
the Marshallian model is a partial be used as a basic building block for
equilibrium model general equilibrium models
focuses only on one market at a time A production possibilities frontier shows
to answer more general questions, we the combinations of two outputs that
need a model of the entire economy can be produced with an economys
need to include the interrelationships between resources
markets and economic agents
21 22
6
A Production Possibility Frontier A Production Possibility Frontier
Suppose that the production possibility dy 1 4 x 2x
(225 2x 2 )1/ 2 ( 4 x )
frontier can be represented by dx 2 2y y
2x 2 y 2 225 when x=5, y=13.2, the slope= -2(5)/13.2= -0.76
To find the slope, we can solve for Y when x=10, y=5, the slope= -2(10)/5= -4
y 225 2x 2
the slope rises as y rises
If we differentiate
dy 1 4 x 2x
(225 2x 2 )1/ 2 ( 4 x )
dx 2 2y y 25 26
7
Important Points to Note: Important Points to Note:
Economics is the study of how scarce The most commonly used economic
resources are allocated among model is the supply-demand model
alternative uses shows how prices serve to balance
economists use simple models to production costs and the willingness of
understand the process buyers to pay for these costs
29 30
31 32
8
Axioms of Rational Choice
Completeness
Chapter 3 if A and B are any two situations, an
individual can always specify exactly one of
PREFERENCES AND UTILITY these possibilities:
A is preferred to B
B is preferred to A
A and B are equally attractive
3 4
1
Utility Utility
Given these assumptions, it is possible to Utility rankings are ordinal in nature
show that people are able to rank in order they record the relative desirability of
all possible situations from least desirable commodity bundles
to most Because utility measures are not unique,
Economists call this ranking utility it makes no sense to consider how much
if A is preferred to B, then the utility assigned more utility is gained from A than from B
to A exceeds the utility assigned to B It is also impossible to compare utilities
U(A) > U(B) between people
5 6
Utility Utility
Utility is affected by the consumption of Assume that an individual must choose
physical commodities, psychological among consumption goods x1, x2,, xn
attitudes, peer group pressures, personal
The individuals rankings can be shown
experiences, and the general cultural
by a utility function of the form:
environment
utility = U(x1, x2,, xn; other things)
Economists generally devote attention to
quantifiable options while holding this function is unique up to an order-
constant the other things that affect utility preserving transformation
ceteris paribus assumption
7 8
2
Economic Goods Indifference Curves
In the utility function, the xs are assumed An indifference curve shows a set of
to be goods consumption bundles among which the
more is preferred to less individual is indifferent
Quantity of y Quantity of y
Preferred to x*, y* Combinations (x1, y1) and (x2, y2)
provide the same level of utility
?
y* y1
? y2 U1
Worse
than
x*, y* Quantity of x Quantity of x
x* 9 x1 x2 10
Quantity of x Quantity of x
x1 x2 11 x1 x2 12
3
Indifference Curve Map Transitivity
Each point must have an indifference Can any two of an individuals indifference
curve through it curves intersect?
The individual is indifferent between A and C.
Quantity of y Quantity of y The individual is indifferent between B and C.
Transitivity suggests that the individual
should be indifferent between A and B
Increasing utility
But B is preferred to A
C
because B contains more
B
U3 U1 < U2 < U3 U2 x and y than A
U2
A U1
U1
Quantity of x Quantity of x
13 14
Convexity Convexity
A set of points is convex if any two points If the indifference curve is convex, then
can be joined by a straight line that is the combination (x1 + x2)/2, (y1 + y2)/2 will
contained completely within the set be preferred to either (x1,y1) or (x2,y2)
Quantity of y Quantity of y
The assumption of a diminishing MRS is This implies that well-balanced bundles are preferred
equivalent to the assumption that all to bundles that are heavily weighted toward one
combinations of x and y which are commodity
preferred to x* and y* form a convex set
y1
(y1 + y2)/2
y*
U1 y2 U1
Quantity of x Quantity of x
x* 15 x1 (x1 + x2)/2 x2 16
4
Utility and the MRS Utility and the MRS
Suppose an individuals preferences for MRS = -dy/dx = 100/x2
hamburgers (y) and soft drinks (x) can
be represented by Note that as x rises, MRS falls
utility 10 x y when x = 5, MRS = 4
when x = 20, MRS = 0.25
Solving for y, we get
y = 100/x
5
Diminishing Marginal Utility Convexity of Indifference
and the MRS Curves
Intuitively, it seems that the assumption Suppose that the utility function is
of decreasing marginal utility is related to
the concept of a diminishing MRS utility x y
diminishing MRS requires that the utility We can simplify the algebra by taking the
function be quasi-concave
this is independent of how utility is measured
logarithm of this function
diminishing marginal utility depends on how U*(x,y) = ln[U(x,y)] = 0.5 ln x + 0.5 ln y
utility is measured
Thus, these two concepts are different
21 22
6
Convexity of Indifference Convexity of Indifference
Curves Curves
Suppose that the utility function is Thus,
utility x 2 y 2
U *
For this example, it is easier to use the
MRS x
2x x
transformation U * 2y y
U*(x,y) = [U(x,y)]2 = x2 + y2 y
25 26
U3
U2
U1
Quantity of x
27 28
7
Examples of Utility Functions Examples of Utility Functions
Perfect Complements CES Utility (Constant elasticity of
substitution)
utility = U(x,y) = min (x, y)
utility = U(x,y) = x/ + y/
Quantity of y
The indifference curves will be when 0 and
L-shaped. Only by choosing more
of the two goods together can utility utility = U(x,y) = ln x + ln y
be increased.
when = 0
U3 Perfect substitutes = 1
U2 Cobb-Douglas = 0
Perfect complements = -
U1
Quantity of x
29 30
8
Homothetic Preferences Nonhomothetic Preferences
For the general Cobb-Douglas function, Some utility functions do not exhibit
the MRS can be found as homothetic preferences
utility = U(x,y) = x + ln y
U
x 1y y
MRS x U
U x y 1 x
MRS x y
1
y U 1
y y
33 34
U U U Rearranging, we get
dU dx1 dx2 ... dxn U
x1 x2 xn
dx j x i
MRS( x i for x j )
dx i U
35 x j 36
9
Multigood Indifference Multigood Indifference
Surfaces Surfaces
We will define an indifference surface If the utility function is quasi-concave,
as being the set of points in n the set of points for which U k will be
dimensions that satisfy the equation convex
U(x1,x2,xn) = k all of the points on a line joining any two
points on the U = k indifference surface will
where k is any preassigned constant also have U k
37 38
10
Important Points to Note: Important Points to Note:
A few simple functional forms can capture It is a simple matter to generalize from
important differences in individuals two-good examples to many goods
preferences for two (or more) goods studying peoples choices among many
Cobb-Douglas function goods can yield many insights
linear function (perfect substitutes) the mathematics of many goods is not
fixed proportions function (perfect especially intuitive, so we will rely on two-
complements) good cases to build intuition
CES function
includes the other three as special cases
41 42
11
Demand Functions
The optimal levels of x1,x2,,xn can be
expressed as functions of all prices and
Chapter 5 income
INCOME AND SUBSTITUTION These can be expressed as n demand
EFFECTS functions of the form:
x1* = d1(p1,p2,,pn,I)
x2* = d2(p1,p2,,pn,I)
xn* = dn(p1,p2,,pn,I)
Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2
1
Homogeneity Homogeneity
With a Cobb-Douglas utility function With a CES utility function
utility = U(x,y) = x0.3y0.7 utility = U(x,y) = x0.5 + y0.5
the demand functions are the demand functions are
0 .3 I 0.7 I 1 I 1 I
x* y* x* y*
px py 1 px / py px 1 py / px py
Note that a doubling of both prices and Note that a doubling of both prices and
income would leave x* and y* income would leave x* and y*
unaffected unaffected
5 6
A U3
U2
U1
Quantity of x
7 8
2
Increase in Income Normal and Inferior Goods
If x decreases as income rises, x is an
inferior good A good xi for which xi/I 0 over some
As income rises, the individual chooses range of income is a normal good in that
to consume less x and more y range
Quantity of y
3
Changes in a Goods Price Changes in a Goods Price
Suppose the consumer is maximizing Quantity of y To isolate the substitution effect, we hold
Quantity of y
utility at point A. real income constant but allow the
relative price of good x to change
If the price of good x falls, the consumer
will maximize utility at point B. The substitution effect is the movement
from point A to point C
B
A C The individual substitutes
A good x for good y
U2 because it is now
U1
U1
relatively cheaper
Quantity of x
Quantity of x Substitution effect
Total increase in x
13 14
4
Price Changes for Price Changes for
Normal Goods Inferior Goods
If a good is normal, substitution and If a good is inferior, substitution and
income effects reinforce one another income effects move in opposite directions
when price falls, both effects lead to a rise in The combined effect is indeterminate
quantity demanded when price rises, the substitution effect leads
to a drop in quantity demanded, but the
when price rises, both effects lead to a drop
in quantity demanded income effect is opposite
when price falls, the substitution effect leads
to a rise in quantity demanded, but the
17
income effect is opposite 18
5
A Summary A Summary
Utility maximization implies that (for normal Utility maximization implies that (for inferior
goods) a rise in price leads to a decline in goods) no definite prediction can be made
quantity demanded for changes in price
the substitution effect causes less to be the substitution effect and income effect move
purchased as the individual moves along an in opposite directions
indifference curve
if the income effect outweighs the substitution
the income effect causes less to be purchased effect, we have a case of Giffens paradox
because the resulting drop in purchasing
power moves the individual to a lower
indifference curve 21 22
6
The Individuals Demand Curve Shifts in the Demand Curve
An individual demand curve shows the Three factors are held constant when a
relationship between the price of a good demand curve is derived
and the quantity of that good purchased by income
an individual assuming that all other prices of other goods (py)
determinants of demand are held constant the individuals preferences
If any of these factors change, the
demand curve will shift to a new position
25 26
7
Demand Functions and Curves Compensated Demand Curves
The actual level of utility varies along
Any change in income will shift these the demand curve
demand curves
As the price of x falls, the individual
moves to higher indifference curves
it is assumed that nominal income is held
constant as the demand curve is derived
this means that real income rises as the
price of x falls
29 30
8
Compensated Demand Curves Compensated &
Holding utility constant, as price falls... Uncompensated Demand
Quantity of y
px px
slope
px ' At px, the curves intersect because
py quantity demanded the individuals income is just sufficient
rises. to attain utility level U2
px ' ' px
slope
py
px px
px ' ' '
slope px x
py
xc
xc
U2
x Quantity of x
x x x x x x
Quantity of x Quantity of x
33 34
x px x
xc xc
35 36
9
Compensated & Compensated Demand
Uncompensated Demand Functions
For a normal good, the compensated Suppose that utility is given by
demand curve is less responsive to price utility = U(x,y) = x0.5y0.5
changes than is the uncompensated
The Marshallian demand functions are
demand curve
x = I/2px y = I/2py
the uncompensated demand curve reflects
both income and substitution effects The indirect utility function is
the compensated demand curve reflects only I
utility V ( I, px , py )
substitution effects 2p py0.5
0.5
x
37 38
10
A Mathematical Examination A Mathematical Examination
of a Change in Price of a Change in Price
Our goal is to examine how purchases of Instead, we will use an indirect approach
good x change when px changes Remember the expenditure function
x/px minimum expenditure = E(px,py,U)
Differentiation of the first-order conditions Then, by definition
from utility maximization can be performed xc (px,py,U) = x [px,py,E(px,py,U)]
to solve for this derivative
quantity demanded is equal for both demand
However, this approach is cumbersome functions when income is exactly what is
and provides little economic insight 41 needed to attain the required utility level 42
11
A Mathematical Examination The Slutsky Equation
of a Change in Price
The substitution effect can be written as
x x c x E
px px E px x c x
substituti on effect
px px
The second term measures the way in U constant
which changes in px affect the demand The income effect can be written as
for x through changes in purchasing
x E x E
power income effect
E px I px
the mathematical representation of the
income effect
45 46
12
The Slutsky Equation The Slutsky Equation
x x x x x x
x x
px px U constant
I px px I
U constant
The first term is the substitution effect The second term is the income effect
always negative as long as MRS is if x is a normal good, then x/I > 0
diminishing the entire income effect is negative
the slope of the compensated demand curve if x is an inferior good, then x/I < 0
must be negative the entire income effect is positive
49 50
13
A Slutsky Decomposition A Slutsky Decomposition
This total effect is the sum of the two We can substitute in for the indirect utility
effects that Slutsky identified function (V)
The substitution effect is found by 0.5(0.5 Ipx0.5 py0.5 )py0.5 0.25I
differentiating the compensated demand substituti on effect 1.5
p x px2
function
x c 0.5Vpy
0. 5
substituti on effect
px p1x.5
53 54
55 56
14
Marshallian Demand Price Elasticity of Demand
Elasticities
Income elasticity of demand (ex,I) The own price elasticity of demand is
always negative
x / x x I the only exception is Giffens paradox
e x ,I
I / I I x
The size of the elasticity is important
Cross-price elasticity of demand (ex,py) if ex,px < -1, demand is elastic
x / x x py if ex,px > -1, demand is inelastic
ex ,py if ex,px = -1, demand is unit elastic
py / py py x
57 58
15
Compensated Price Elasticities Compensated Price Elasticities
It is also useful to define elasticities If the compensated demand function is
based on the compensated demand xc = xc(px,py,U)
function
we can calculate
compensated own price elasticity of
demand (exc,px)
compensated cross-price elasticity of
demand (exc,py)
61 62
16
Compensated Price Elasticities Homogeneity
The Slutsky equation shows that the Demand functions are homogeneous of
compensated and uncompensated price degree zero in all prices and income
elasticities will be similar if Eulers theorem for homogenous
the share of income devoted to x is small functions shows that
the income elasticity of x is small
x x x
0 px py I
px py I
65 66
67 68
17
Engel Aggregation Cournot Aggregation
We can see this by differentiating the The size of the cross-price effect of a
budget constraint with respect to change in the price of x on the quantity
income (treating prices as constant) of y consumed is restricted because of
x y the budget constraint
1 px py
I I We can demonstrate this by
differentiating the budget constraint with
x xI y yI
1 px py s x e x , I s y ey , I respect to px
I xI I yI
69 70
s x ex,px sy ey ,px s x
71 72
18
Demand Elasticities Demand Elasticities
Calculating the elasticities, we get We can also show
x px I p homogeneity
ex ,px 2 x 1
px x p x I ex,px ex,py ex,I 1 0 1 0
px
Engel aggregation
x py p
e x , py 0 y 0 s x e x , I s y ey , I 1 1 1
py x x
Cournot aggregation
x I I
e x ,I 1 s x ex,px sy ey ,px ( 1) 0 s x
I x px I
px
73 74
75 76
19
Demand Elasticities Demand Elasticities
We will use the share elasticity to Thus, the share elasticity is given by
derive the own price elasticity
s x px py1 px px py1
s x px esx ,px
es x ,px 1 ex,px px s x (1 px py1 )2 (1 px py1 )1 1 px py1
px s x
In this case, Therefore, if we let px = py
px x 1 1
sx ex,px es x ,px 1 1 1.5
I 1 px py1 1 1
77 78
20
Consumer Surplus Consumer Welfare
One way to evaluate the welfare cost of a
An important problem in welfare price increase (from px0 to px1) would be
economics is to devise a monetary to compare the expenditures required to
measure of the gains and losses that achieve U0 under these two situations
individuals experience when prices
change expenditure at px0 = E0 = E(px0,py,U0)
81 82
U2
Quantity of x
83 84
21
Consumer Welfare Consumer Welfare
Quantity of y The consumer could be compensated so
that he can afford to remain on U1 The derivative of the expenditure function
with respect to px is the compensated
C CV is the amount that the demand function
individual would need to be
A
compensated E ( px , py ,U0 )
B x c ( px , py ,U0 )
U1
px
U2
Quantity of x
85 86
px0 px0
xc(pxU0)
22
The Consumer Surplus
Consumer Welfare Concept
Because a price change generally
involves both income and substitution Another way to look at this issue is to
effects, it is unclear which compensated ask how much the person would be
demand curve should be used willing to pay for the right to consume all
of this good that he wanted at the
Do we use the compensated demand
market price of px0
curve for the original target utility (U0) or
the new level of utility after the price
change (U1)?
89 90
xc(...U1)
x1 x0
Quantity of x
91 92
23
Consumer Welfare Consumer Welfare
px px
Is the consumers loss in welfare We can use the Marshallian demand
best described by area px1BApx0 curve as a compromise
[using xc(...U0)] or by area px1CDpx0
[using xc(...U1)]? The area px1CApx0
px1
C B px1
C B falls between the
px0
A Is U0 or U1 the px0
A sizes of the welfare
D appropriate utility D
x(px)
losses defined by
target? xc(...U0) and
xc(...U0) xc(...U0)
xc(...U1)
xc(...U1) xc(...U1)
x1 x0 x1 x0
Quantity of x Quantity of x
93 94
24
Welfare Loss from a Price Welfare Loss from Price
Increase Increase
If we assume that V = 2 and py = 2, Suppose that we use the Marshallian
demand function instead
CV = 222(4)0.5 222(1)0.5 = 8
If we assume that the utility level (V) x( px , py , I ) 0.5Ipx-1
falls to 1 after the price increase (and
used this level to calculate welfare loss), The welfare loss from a price increase
from px = 1 to px = 4 is given by
CV = 122(4)0.5 122(1)0.5 = 4
4
px 4
Loss 0.5 Ipx-1dpx 0.5 I ln px
px 1
97 1 98
25
Revealed Preference and Revealed Preference and
the Substitution Effect the Substitution Effect
Quantity of y Suppose that, when the budget constraint is
Consider two bundles of goods: A and B given by I1, A is chosen
If the individual can afford to purchase A must still be preferred to B when income
is I3 (because both A and B are available)
either bundle but chooses A, we say that
A
A had been revealed preferred to B If B is chosen, the budget
B constraint must be similar to
Under any other price-income that given by I2 where A is not
arrangement, B can never be revealed available
I2
preferred to A I3
I1
26
Negativity of the Negativity of the
Substitution Effect Substitution Effect
Rearranging, we get Suppose that only the price of x changes
pxC(xC - xD) + pyC(yC -yD) 0 (pyC = pyD)
pxD(xD - xC) + pyD(yD -yC) 0 (pxC pxD)(xC - xD) 0
This implies that price and quantity move
Adding these together, we get in opposite direction when utility is held
(pxC pxD)(xC - xD) + (pyC pyD)(yC - yD) 0 constant
the substitution effect is negative
105 106
27
Strong Axiom of Revealed Important Points to Note:
Preference
If commodity bundle 0 is revealed Proportional changes in all prices and
preferred to bundle 1, and if bundle 1 is income do not shift the individuals
revealed preferred to bundle 2, and if budget constraint and therefore do not
bundle 2 is revealed preferred to bundle alter the quantities of goods chosen
3,,and if bundle K-1 is revealed demand functions are homogeneous of
degree zero in all prices and income
preferred to bundle K, then bundle K
cannot be revealed preferred to bundle 0
109 110
111 112
28
Important Points to Note: Important Points to Note:
A rise in the price of a good also The Marshallian demand curve
causes income and substitution effects summarizes the total quantity of a good
for normal goods, less will be demanded demanded at each possible price
for inferior goods, the net result is changes in price prompt movements
ambiguous along the curve
changes in income, prices of other goods,
or preferences may cause the demand
curve to shift
113 114
115 116
29
Important Points to Note: Important Points to Note:
There are many relationships among Welfare effects of price changes can
demand elasticities be measured by changing areas below
own-price elasticities determine how a either compensated or ordinary
price change affects total spending on a demand curves
good such changes affect the size of the
substitution and income effects can be consumer surplus that individuals receive
summarized by the Slutsky equation by being able to make market transactions
various aggregation results hold among
elasticities
117 118
119
30
The Two-Good Case
The types of relationships that can
Chapter 6 occur when there are only two goods
DEMAND RELATIONSHIPS are limited
AMONG GOODS But this case can be illustrated with two-
dimensional graphs
y1
In this case, we call x and y gross y1 In this case, we call x and y gross
complements substitutes
y0
y0 U1
U1
U0 x/py < 0 x/py > 0
U0
x0 x1 x1 x0
Quantity of x Quantity of x
3 4
1
A Mathematical Treatment Substitutes and Complements
The change in x caused by changes in py For the case of many goods, we can
can be shown by a Slutsky-type equation generalize the Slutsky analysis
x x x xi xi xi
y xj
py py U constant
I p j p j U constant
I
for any i or j
substitution income effect
effect (+) (-) if x is normal this implies that the change in the price of
any good induces income and substitution
combined effect effects that may change the quantity of
(ambiguous) every good demanded
5 6
7 8
2
Asymmetry of the Gross Asymmetry of the Gross
Definitions Definitions
One undesirable characteristic of the gross Suppose that the utility function for two
definitions of substitutes and complements goods is given by
is that they are not symmetric
U(x,y) = ln x + y
It is possible for x1 to be a substitute for x2
and at the same time for x2 to be a Setting up the Lagrangian
complement of x1 L = ln x + y + (I pxx pyy)
9 10
3
Net Substitutes and Net Substitutes and
Complements Complements
The concepts of net substitutes and This definition looks only at the shape of
complements focuses solely on substitution
effects the indifference curve
two goods are net substitutes if This definition is unambiguous because
xi
the definitions are perfectly symmetric
0
p j U constant
xi x j
two goods are net complements if
p j U constant
pi U constant
xi
0
p j U constant 13 14
15 16
4
Substitutability with Many Substitutability with Many
Goods Goods
To prove this, we can start with the In elasticity terms, we get
compensated demand function
eic1 eic2 ... einc 0
xc(p1,pn,V)
Since the negativity of the substitution
Applying Eulers theorem yields
effect implies that eiic 0, it must be the
xic x c x c case that
p1 p2 i ... pn i 0
p1 p2 pn
e
j i
c
ij 0
17 18
19 20
5
Composite Commodity Theorem Composite Commodity Theorem
Let p20pn0 represent the initial prices of The individuals budget constraint is
these other commodities I = p1x1 + p20x2 ++ pn0xn = p1x1 + y
assume that they all vary together (so that the
relative prices of x2xn do not change) If we assume that all of the prices p20pn0
change by the same factor (t > 0) then the
Define the composite commodity y to be
budget constraint becomes
total expenditures on x2xn at the initial
prices I = p1x1 + tp20x2 ++ tpn0xn = p1x1 + ty
23 24
6
Example: Composite Example: Composite
Commodity Commodity
Suppose that an individual receives utility U ( x, y , z )
1 1 1
utility from three goods: x y z
food (x) The Lagrangian technique can be used
housing services (y), measured in to derive demand functions
hundreds of square feet I I
x y
household operations (z), measured by p x p x p y p x pz py py px py pz
electricity use
I
Assume a CES utility function z
pz pz px pz py
25 26
7
Example: Composite Example: Composite
Commodity Commodity
Now x can be shown as a function of I, If py rises to 16 and pz rises to 4 (with px
px, and ph remaining at 1), ph would also rise to 4
I The demand for x would fall to
x
py 3 px ph 100 100
x*
If I = 100, px = 1, py = 4, and ph = 1, then 1 3 4 7
x* = 25 and spending on housing (h*) = Housing purchases would be given by
75 100 600
Ph h* 100
29 7 7 30
8
Household Production Model Household Production Model
Assume that there are three goods that The individuals goal is to choose x,y,
a person might want to purchase in the and z so as to maximize utility
market: x, y, and z utility = U(a1,a2)
these goods provide no direct utility subject to the production functions
these goods can be combined by the
a1 = f1(x,y,z)
individual to produce either of two home-
produced goods: a1 or a2 a2 = f2(x,y,z)
the technology of this household production and a financial budget constraint
can be represented by a production function
pxx + pyy + pzz = I
33 34
35 36
9
The Linear Attributes Model The Linear Attributes Model
The ray 0x shows the combinations of a1 and a2
a2 available from successively larger amounts of good x If the individual spends all of his or her
x
income on good x
The ray 0y shows the combinations of
y a1 and a2 available from successively x* = I/px
larger amounts of good y
That will yield
The ray 0z shows the
combinations of a1 and
a1* = ax1x* = (ax1I)/px
z
a2 available from
successively larger
a2* = ax2x* = (ax2I)/px
amounts of good z
0 a1
37 38
y* y*
z* is the combination of
z a1 and a2 that would be z
obtained if all income was
spent on z
Z* z*
0 a1 0 a1
39 40
10
The Linear Attributes Model The Linear Attributes Model
A utility-maximizing individual would never The model predicts that corner solutions
a2 consume positive quantities of all three
x goods
(where individuals consume zero amounts
Individuals with a preference toward
of some commodities) will be relatively
y
a1 will have indifference curves similar common
U1 to U0 and will consume only y and z
especially in cases where individuals attach
Individuals with a preference value to fewer attributes than there are
toward a0 will have
U0
z
indifference curves similar
market goods to choose from
to U1 and will consume only
x and y
Consumption patterns may change
abruptly if income, prices, or preferences
a1
0
41
change 42
11
Important Points to Note: Important Points to Note:
Focusing only on the substitution If a group of goods has prices that
effects from price changes does always move in unison, expenditures
provide a symmetric definition on these goods can be treated as a
two goods are net substitutes if xi c/pj > composite commodity whose price
0 and net complements if xi c/pj < 0 is given by the size of the proportional
because xic /pj = xjc /pi, there is no change in the composite goods prices
ambiguity
Hicks second law of demand shows that
net substitutes are more prevalent
45 46
47
12
Production Function
The firms production function for a
Chapter 9 particular good (q) shows the maximum
amount of the good that can be produced
PRODUCTION FUNCTIONS
using alternative combinations of capital
(k) and labor (l)
q = f(k,l)
Diminishing Marginal
Marginal Physical Product
Productivity
To study variation in a single input, we
The marginal physical product of an input
define marginal physical product as the
depends on how much of that input is
additional output that can be produced by
used
employing one more unit of that input
while holding other inputs constant In general, we assume diminishing
marginal productivity
q
marginal physical product of capital MPk fk
k MPk 2f MPl 2f
q 2 fkk f11 0 2 fll f22 0
marginal physical product of labor MPl fl k k l l
l 3 4
1
Diminishing Marginal
Productivity Average Physical Product
Because of diminishing marginal Labor productivity is often measured by
productivity, 19th century economist average productivity
Thomas Malthus worried about the effect
output q f (k, l )
of population growth on labor productivity APl
labor input l l
But changes in the marginal productivity of
labor over time also depend on changes in Note that APl also depends on the
other inputs such as capital amount of capital employed
we need to consider flk which is often > 0
5 6
2
A Two-Input Production A Two-Input Production
Function Function
To find average productivity, we hold In fact, when l = 30, both APl and MPl are
k=10 and solve equal to 900,000
APl = q/l = 60,000l - 1000l2
APl reaches its maximum where Thus, when APl is at its maximum, APl
APl/l = 60,000 - 2000l = 0 and MPl are equal
l = 30
9 10
l per period
11 12
3
Marginal Rate of Technical Marginal Rate of Technical
Substitution (RTS) Substitution (RTS)
The slope of an isoquant shows the rate
at which l can be substituted for k The marginal rate of technical
k per period substitution (RTS) shows the rate at
- slope = marginal rate of technical
substitution (RTS) which labor can be substituted for
capital while holding output constant
RTS > 0 and is diminishing for along an isoquant
A increasing inputs of labor
kA
dk
kB
B RTS (l for k )
q = 20 dl q q0
l per period
lA lB 13 14
4
RTS and Marginal Productivities RTS and Marginal Productivities
Using the fact that dk/dl = -fl/fk along an
To show that isoquants are convex, we isoquant and Youngs theorem (fkl = flk)
would like to show that d(RTS)/dl < 0
dRTS (fk2fll 2fk fl fkl fl 2fkk )
Since RTS = fl/fk
dl (fk )3
dRTS d (fl / fk )
Because we have assumed fk > 0, the
dl dl denominator is positive
dRTS [fk (fll flk dk / dl ) fl (fkl fkk dk / dl )] Because fll and fkk are both assumed to be
negative, the ratio will be negative if fkl is
dl (fk )2
17
positive 18
5
A Diminishing RTS A Diminishing RTS
Because Cross differentiation of either of the
2
fll = 1200k - 6k 3l marginal productivity functions yields
fkk = 1200l 2 - 6kl 3 fkl = flk = 2400kl - 9k 2l 2
this production function exhibits which is positive only for kl < 266
diminishing marginal productivities for
sufficiently large values of k and l
fll and fkk < 0 if kl > 200
21 22
23 24
6
Returns to Scale Returns to Scale
If the production function is given by q =
Smith identified two forces that come
f(k,l) and all inputs are multiplied by the
into operation as inputs are doubled
same positive constant (t >1), then
greater division of labor and specialization
of function Effect on Output Returns to Scale
loss in efficiency because management
f(tk,tl) = tf(k,l) Constant
may become more difficult given the larger
scale of the firm f(tk,tl) < tf(k,l) Decreasing
f(tk,tl) > tf(k,l) Increasing
25 26
7
Constant Returns to Scale Constant Returns to Scale
The marginal productivity of any input The production function will be
depends on the ratio of capital and labor homothetic
(not on the absolute levels of these Geometrically, all of the isoquants are
inputs) radial expansions of one another
The RTS between k and l depends only
on the ratio of k to l, not the scale of
operation
29 30
8
Elasticity of Substitution Elasticity of Substitution
The elasticity of substitution () measures Both RTS and k/l will change as we
the proportionate change in k/l relative to move from point A to point B
the proportionate change in the RTS along
k per period is the ratio of these
an isoquant proportional changes
%(k / l ) d (k / l ) RTS ln( k / l )
measures the
%RTS dRTS k / l ln RTS RTSA
A
RTSB
curvature of the
The value of will always be positive isoquant
because k/l and RTS move in the same (k/l)A B q = q0
(k/l)B
direction 33
l per period
34
9
The Linear Production Function The Linear Production Function
Suppose that the production function is Capital and labor are perfect substitutes
q = f(k,l) = ak + bl
This production function exhibits constant k per period
RTS is constant as k/l changes
returns to scale
f(tk,tl) = atk + btl = t(ak + bl) = tf(k,l)
All isoquants are straight lines
slope = -b/a
=
RTS is constant
= q2 q3
q1
l per period
37 38
q1
l per period
39 q3/b 40
10
Cobb-Douglas Production Cobb-Douglas Production
Function Function
Suppose that the production function is The Cobb-Douglas production function is
q = f(k,l) = Akalb A,a,b > 0 linear in logarithms
This production function can exhibit any ln q = ln A + a ln k + b ln l
returns to scale a is the elasticity of output with respect to k
f(tk,tl) = A(tk)a(tl)b = Ata+b kalb = ta+bf(k,l) b is the elasticity of output with respect to l
if a + b = 1 constant returns to scale
if a + b > 1 increasing returns to scale
if a + b < 1 decreasing returns to scale
41 42
11
Technical Progress Technical Progress
Methods of production change over time Suppose that the production function is
Following the development of superior q = A(t)f(k,l)
production techniques, the same level where A(t) represents all influences that
of output can be produced with fewer go into determining q other than k and l
inputs changes in A over time represent technical
the isoquant shifts in progress
A is shown as a function of time (t)
dA/dt > 0
45 46
47 48
12
Technical Progress Technical Progress
For any variable x, [(dx/dt)/x] is the Since
proportional growth rate in x f k q k
denote this by Gx eq,k
k f (k, l ) k q
Then, we can write the equation in terms
of growth rates f l q l
eq,l
l f (k, l ) l q
f k f l
Gq GA Gk Gl
k f (k, l ) l f (k, l )
Gq GA eq,kGk eq,lGl
49 50
51 52
13
Technical Progress in the Important Points to Note:
Cobb-Douglas Function
If all but one of the inputs are held
(ln A t ln k (1 ) ln l ) constant, a relationship between the
Gq
t single variable input and output can be
ln k ln l derived
(1 ) Gk (1 )Gl
t t the marginal physical productivity is the
change in output resulting from a one-unit
increase in the use of the input
assumed to decline as use of the input
increases
53 54
14
Important Points to Note: Important Points to Note:
The returns to scale exhibited by a The elasticity of substitution ()
production function record how output provides a measure of how easy it is to
responds to proportionate increases in substitute one input for another in
all inputs production
if output increases proportionately with input a high implies nearly straight isoquants
use, there are constant returns to scale a low implies that isoquants are nearly
L-shaped
57 58
59
15
Definitions of Costs
It is important to differentiate between
Chapter 10 accounting cost and economic cost
the accountants view of cost stresses out-
COST FUNCTIONS of-pocket expenses, historical costs,
depreciation, and other bookkeeping
entries
economists focus more on opportunity cost
1
Definitions of Costs Economic Cost
Costs of Entrepreneurial Services
accountants believe that the owner of a firm The economic cost of any input is the
is entitled to all profits payment required to keep that input in
revenues or losses left over after paying all input its present employment
costs the remuneration the input would receive in
economists consider the opportunity costs of its best alternative employment
time and funds that owners devote to the
operation of their firms
part of accounting profits would be considered as
entrepreneurial costs by economists
5 6
2
Economic Profits Cost-Minimizing Input Choices
Economic profits are a function of the To minimize the cost of producing a
amount of capital and labor employed given level of output, a firm should
we could examine how a firm would choose choose a point on the isoquant at which
k and l to maximize profit the RTS is equal to the ratio w/v
derived demand theory of labor and capital
it should equate the rate at which k can be
inputs
traded for l in the productive process to the
for now, we will assume that the firm has rate at which they can be traded in the
already chosen its output level (q0) and marketplace
wants to minimize its costs
9 10
3
Cost-Minimizing Input Choices Cost-Minimizing Input Choices
Cross-multiplying, we get Note that this equations inverse is also
fk fl of interest
v w w v
fl fk
For costs to be minimized, the marginal
productivity per dollar spent should be The Lagrangian multiplier shows how
the same for all inputs much in extra costs would be incurred
by increasing the output constraint
slightly
13 14
C3 w/v C3
isoquant and the total cost
curve
C2 C2
4
Contingent Demand for Inputs Contingent Demand for Inputs
In Chapter 4, we considered an In the present case, cost minimization
individuals expenditure-minimization leads to a demand for capital and labor
problem that is contingent on the level of output
we used this technique to develop the being produced
compensated demand for a good The demand for an input is a derived
Can we develop a firms demand for an demand
input in the same way? it is based on the level of the firms output
17 18
q00
l per period
19 20
5
The Firms Expansion Path Cost Minimization
The expansion path does not have to be Suppose that the production function is
a straight line Cobb-Douglas:
the use of some inputs may increase faster q = kl
than others as output expands
depends on the shape of the isoquants The Lagrangian expression for cost
The expansion path does not have to be minimization of producing q0 is
upward sloping L = vk + wl + (q0 - k l )
if the use of an input falls as output expands,
that input is an inferior input
21 22
6
Cost Minimization Cost Minimization
Suppose that the production function is The first-order conditions for a minimum
CES: are
q = (k + l )/ L/k = v - (/)(k + l)(-)/()k-1 = 0
The Lagrangian expression for cost L/l = w - (/)(k + l)(-)/()l-1 = 0
minimization of producing q0 is L/ = q0 - (k + l )/ = 0
L = vk + wl + [q0 - (k + l )/]
25 26
27 28
7
Average Cost Function Marginal Cost Function
The average cost function (AC) is found The marginal cost function (MC) is
by computing total costs per unit of found by computing the change in total
output costs for a change in output produced
C(v ,w, q )
average cost AC(v ,w, q ) C(v ,w, q )
q marginal cost MC(v ,w, q )
q
29 30
8
Graphical Analysis of Graphical Analysis of
Total Costs Total Costs
Suppose instead that total costs start Total C
costs
out as concave and then becomes
convex as output increases Total costs rise
one possible explanation for this is that dramatically as
there is a third factor of production that is output increases
fixed as capital and labor usage expands after diminishing
returns set in
total costs begin rising rapidly after
diminishing returns set in
Output
33 34
Graphical Analysis of
Total Costs Shifts in Cost Curves
Average
and MC is the slope of the C curve The cost curves are drawn under the
marginal
costs MC
If AC > MC, assumption that input prices and the
AC AC must be level of technology are held constant
falling any change in these factors will cause the
If AC < MC, cost curves to shift
min AC
AC must be
rising
Output
35 36
9
Some Illustrative Cost Some Illustrative Cost
Functions Functions
Suppose we have a fixed proportions Suppose we have a Cobb-Douglas
technology such that technology such that
q = f(k,l) = min(ak,bl) q = f(k,l) = k l
Production will occur at the vertex of the Cost minimization requires that
L-shaped isoquants (q = ak = bl) w k
C(w,v,q) = vk + wl = v(q/a) + w(q/b) v l
v w w
C(w ,v , q ) a k l
a b v
37 38
10
Some Illustrative Cost Properties of Cost Functions
Functions
Suppose we have a CES technology Homogeneity
such that cost functions are all homogeneous of
q = f(k,l) = (k + l )/ degree one in the input prices
cost minimization requires that the ratio of input
To derive the total cost, we would use prices be set equal to RTS, a doubling of all
the same method and eventually get input prices will not change the levels of inputs
purchased
C(v,w, q ) vk wl q1/ (v / 1 w / 1 )( 1) / pure, uniform inflation will not change a firms
input decisions but will shift the cost curves up
C(v,w, q ) q1/ (v 1 w 1 )1/ 1
41 42
43 44
11
Concavity of Cost Function Properties of Cost Functions
At w1, the firms costs are C(v,w1,q1) Some of these properties carry over to
If the firm continues to average and marginal costs
buy the same input mix
as w changes, its cost
homogeneity
Costs Cpseudo
function would be Cpseudo effects of v, w, and q are ambiguous
C(v,w,q1)
w1 w 45 46
12
Partial Elasticity of Substitution Size of Shifts in Costs Curves
The partial elasticity of substitution
between two inputs (xi and xj) with The increase in costs will be largely
prices wi and wj is given by influenced by the relative significance of
( x i / x j ) w j / w i ln( xi / x j ) the input in the production process
sij If firms can easily substitute another
(w j / w i ) xi / x j ln( w j / w i )
input for the one that has risen in price,
Sij is a more flexible concept than
there may be little increase in costs
because it allows the firm to alter the
usage of inputs other than xi and xj
when input prices change
49 50
13
Shifting the Cobb-Douglas Shifting the Cobb-Douglas
Cost Function Cost Function
The Cobb-Douglas cost function is If v = 3 and w = 12, the relationship is
C(v,w, q ) vk wl q1/ Bv / w / C(3,12, q ) 2q 36 12q
where C = 480 to produce q =40
/ /
B ( ) AC = C/q = 12
If we assume = = 0.5, the total cost MC = C/q = 12
curve is greatly simplified:
C(v,w, q ) vk wl 2qv 0.5w 0.5
53 54
55 56
14
Contingent Demand for Inputs Contingent Demand for Inputs
Suppose we have a fixed proportions For this cost function, contingent
technology demand functions are quite simple:
The cost function is C(v ,w , q ) q
k c (v ,w , q )
v w v a
C(w ,v , q ) a
a b C(v ,w , q ) q
l c (v ,w , q )
w b
57 58
q 1/ B
v
59 60
15
Contingent Demand for Inputs Short-Run, Long-Run
Distinction
C
l c (v ,w , q ) q 1/ Bv / w / In the short run, economic actors have
w
/
only limited flexibility in their actions
w
q 1/ B Assume that the capital input is held
v constant at k1 and the firm is free to
The contingent demands for inputs vary only its labor input
depend on both inputs prices The production function becomes
q = f(k1,l)
61 62
16
Short-Run Total Costs Short-Run Marginal and
k per period Average Costs
Because capital is fixed at k1,
the firm cannot equate RTS The short-run average total cost (SAC)
with the ratio of input prices function is
SAC = total costs/total output = SC/q
The short-run marginal cost (SMC) function
k1
is
q2
q1
SMC = change in SC/change in output = SC/q
q0
l per period
l1 l2 l3
65 66
Output Output
q0 q1 q2 67 q0 q1 68
17
Relationship between Short- Important Points to Note:
Run and Long-Run Costs
A firm that wishes to minimize the
At the minimum point of the AC curve: economic costs of producing a
the MC curve crosses the AC curve particular level of output should
MC = AC at this point choose that input combination for
the SAC curve is tangent to the AC curve which the rate of technical substitution
SAC (for this level of k) is minimized at the same (RTS) is equal to the ratio of the
level of output as AC
inputs rental prices
SMC intersects SAC also at this point
AC = MC = SAC = SMC
69 70
18
Important Points to Note: Important Points to Note:
All cost curves are drawn on the Input demand functions can be derived
assumption that the input prices are from the firms total-cost function
held constant through partial differentiation
when an input price changes, cost curves these input demands will depend on the
shift to new positions quantity of output the firm chooses to
the size of the shifts will be determined by the produce
overall importance of the input and the are called contingent demand functions
substitution abilities of the firm
technical progress will also shift cost
curves 73 74
19
The Nature of Firms
A firm is an association of individuals
Chapter 11 who have organized themselves for the
purpose of turning inputs into outputs
PROFIT MAXIMIZATION
Different individuals will provide different
types of inputs
the nature of the contractual relationship
between the providers of inputs to a firm
may be quite complicated
Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2
1
Profit Maximization Profit Maximization
A profit-maximizing firm chooses both If firms are strictly profit maximizers,
its inputs and its outputs with the sole they will make decisions in a marginal
goal of achieving maximum economic way
profits examine the marginal profit obtainable
seeks to maximize the difference between from producing one more unit of hiring one
total revenue and total economic costs additional laborer
5 6
2
Output Choice Second-Order Conditions
To maximize economic profits, the firm MR = MC is only a necessary condition
should choose the output for which for profit maximization
marginal revenue is equal to marginal For sufficiency, it is also required that
cost
d 2 d' (q )
dR dC 0
MR MC
2
dq q q * dq q q *
dq dq
marginal profit must be decreasing at
the optimal level of q
9 10
3
Marginal Revenue Marginal Revenue
If a firm faces a downward-sloping Suppose that the demand curve for a sub
demand curve, marginal revenue will be sandwich is
q = 100 10p
a function of output
Solving for price, we get
If price falls as a firm increases output,
marginal revenue will be less than price p = -q/10 + 10
This means that total revenue is
R = pq = -q2/10 + 10q
Marginal revenue will be given by
13
MR = dR/dq = -q/5 + 10 14
4
Marginal Revenue and Marginal Revenue and
Elasticity Elasticity
This means that
q dp q dp 1
MR p p1 p1
dq p dq eq,p < -1 MR > 0
eq,p
if the demand curve slopes downward,
eq,p = -1 MR = 0
eq,p < 0 and MR < p
if the demand is elastic, eq,p < -1 and
eq,p > -1 MR < 0
marginal revenue will be positive
if the demand is infinitely elastic, eq,p = - and
marginal revenue will equal price
17 18
5
Average Revenue Curve Marginal Revenue Curve
If we assume that the firm must sell all The marginal revenue curve shows the
its output at one price, we can think of extra revenue provided by the last unit
the demand curve facing the firm as its sold
average revenue curve In the case of a downward-sloping
shows the revenue per unit yielded by demand curve, the marginal revenue
alternative output choices
curve will lie below the demand curve
21 22
output
q1
MR 23 24
6
The Constant Elasticity Case The Constant Elasticity Case
We showed (in Chapter 5) that a This means that
demand function of the form R = pq = kq(1+b)/b
q = apb and
has a constant price elasticity of MR = dr/dq = [(1+b)/b]kq1/b = [(1+b)/b]p
demand equal to b
This implies that MR is proportional to
Solving this equation for p, we get price
p = (1/a)1/bq1/b = kq1/b where k = (1/a)1/b
25 26
p* = MR SAC p* = MR SAC
SAVC SAVC
output output
q* q*
27 28
7
Short-Run Supply by a Short-Run Supply by a
Price-Taking Firm Price-Taking Firm
price price SMC
If the price falls to
SMC
p***, the firm will
p**
produce q***
p* = MR SAC p* = MR SAC
SAVC SAVC
8
Short-Run Supply by a Short-Run Supply
Price-Taking Firm
price SMC
Suppose that the firms short-run total cost
curve is
SAC SC(v,w,q,k) = vk1 + wq1/k1-/
SAVC
where k1 is the level of capital held
The firms short-run constant in the short run
supply curve is the
SMC curve that is Short-run marginal cost is
above SAVC
SC w (1 ) / /
output SMC(v ,w, q, k1 ) q k1
q
33 34
35 36
9
Profit Functions Profit Functions
A firms economic profit can be A firms profit function shows its
expressed as a function of inputs maximal profits as a function of the
= pq - C(q) = pf(k,l) - vk - wl prices that the firm faces
Only the variables k and l are under the ( p,v,w ) Max (k, l ) Max[ pf (k, l ) vk wl ]
k ,l k ,l
firms control
the firm chooses levels of these inputs in
order to maximize profits
treats p, v, and w as fixed parameters in its
decisions
37 38
39 40
10
Properties of the Profit Properties of the Profit
Function Function
Nonincreasing in input prices Convex in output prices
if the firm responded to an increase in an the profits obtainable by averaging those
input price by not changing the level of that from two different output prices will be at
input, its costs would rise least as large as those obtainable from the
profits would fall average of the two prices
( p1,v ,w ) ( p2 ,v ,w ) p p2
1 ,v ,w
2 2
41 42
11
Producer Surplus in the Producer Surplus in the
Short Run Short Run
SMC SMC
price price
If the market price The firms profits
is p1, the firm will rise by the shaded
p2 p2
produce q1 area
p1 p1
If the market price
rises to p2, the firm
will produce q2
output output
q1 q2 q1 q2
45 46
47 48
12
Producer Surplus in the Producer Surplus in the
Short Run Short Run
SMC
price
Suppose that the The extra profits available from facing a
firms shutdown price of p1 are defined to be producer
price is p0 surplus
p1 p1
p producer surplus ( p1,...) ( p0 ,...) q( p)dp
0
p0
output
q1
49 50
51 52
13
Producer Surplus in the Profit Maximization and
Short Run Input Demand
Because the firm produces no output at A firms output is determined by the
the shutdown price, (p0,) = -vk1 amount of inputs it chooses to employ
profits at the shutdown price are equal to the the relationship between inputs and
firms fixed costs outputs is summarized by the production
This implies that function
producer surplus = (p1,) - (p0,) A firms economic profit can also be
= (p1,) (-vk1) = (p1,) + vk1 expressed as a function of inputs
producer surplus is equal to current profits (k,l) = pq C(q) = pf(k,l) (vk + wl)
plus short-run fixed costs 53 54
14
Profit Maximization and Input Demand Functions
Input Demand
To ensure a true maximum, second- In principle, the first-order conditions can
order conditions require that be solved to yield input demand functions
kk = fkk < 0 Capital Demand = k(p,v,w)
Labor Demand = l(p,v,w)
ll = fll < 0
kk ll - kl2 = fkkfll fkl2 > 0
These demand functions are
unconditional
capital and labor must exhibit sufficiently they implicitly allow the firm to adjust its
diminishing marginal productivities so that output to changing prices
marginal costs rise as output expands
57 58
dw p
fl l
dw
Since fll 0, l/w 0
l w
59 60
15
Two-Input Case Two-Input Case
For the case of two (or more inputs), the When w falls, two effects occur
story is more complex substitution effect
if there is a decrease in w, there will not if output is held constant, there will be a
only be a change in l but also a change in tendency for the firm to want to substitute l for k
in the production process
k as a new cost-minimizing combination of
inputs is chosen output effect
when k changes, the entire fl function changes a change in w will shift the firms expansion
path
But, even in this case, l/w 0 the firms cost curves will shift and a different
output level will be chosen
61 62
16
Output Effect Cross-Price Effects
Output will rise to q1 No definite statement can be made
k per period about how capital usage responds to a
Thus, the output effect
wage change
also implies a negative
relationship between l a fall in the wage will lead the firm to
and w substitute away from capital
the output effect will cause more capital to
be demanded as the firm expands
q1
q0 production
l per period
65 66
17
Important Points to Note: Important Points to Note:
In order to maximize profits, the firm If a firm is a price taker, its output
should choose to produce that output decisions do not affect the price of its
level for which the marginal revenue is output
equal to the marginal cost marginal revenue is equal to price
If the firm faces a downward-sloping
demand for its output, marginal
revenue will be less than price
69 70
71 72
18
Important Points to Note: Important Points to Note:
The firms reactions to the various The firms profit function yields
prices it faces can be judged through particularly useful envelope results
use of its profit function differentiation with respect to market price
shows maximum profits for the firm given yields the supply function
the price of its output, the prices of its differentiation with respect to any input
inputs, and the production technology price yields the (inverse of) the demand
function for that input
73 74
19
Market Demand
Assume that there are only two goods
Chapter 12 (x and y)
THE PARTIAL EQUILIBRIUM An individuals demand for x is
COMPETITIVE MODEL Quantity of x demanded = x(px,py,I)
If we use i to reflect each individual in the
market, then the market demand curve is
n
Market demand for X xi ( px , py , Ii )
Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 i 1 2
x1* + x2* = X*
3 4
1
Shifts in the Market Shifts in Market Demand
Demand Curve
The market demand summarizes the Suppose that individual 1s demand for
ceteris paribus relationship between X oranges is given by
and px x1 = 10 2px + 0.1I1 + 0.5py
changes in px result in movements along the and individual 2s demand is
curve (change in quantity demanded) x2 = 17 px + 0.05I2 + 0.5py
changes in other determinants of the
The market demand curve is
demand for X cause the demand curve to
X = x1 + x2 = 27 3px + 0.1I1 + 0.05I2 + py
shift to a new position (change in demand)
5 6
2
Generalizations Generalizations
Suppose that there are n goods (xi, i = 1,n) The market demand function for xi is the
with prices pi, i = 1,n. sum of each individuals demand for that
Assume that there are m individuals in the good
m
economy X i xij ( p1,..., pn , I j )
The j ths demand for the i th good will j 1
3
Timing of the Supply Response Pricing in the Very Short Run
In the analysis of competitive pricing, the
In the very short run (or the market
time period under consideration is
period), there is no supply response to
important
changing market conditions
very short run
price acts only as a device to ration demand
no supply response (quantity supplied is fixed)
price will adjust to clear the market
short run
the supply curve is a vertical line
existing firms can alter their quantity supplied, but
no new firms can enter the industry
long run
new firms may enter an industry 13 14
Quantity
Q*
15 16
4
Perfect Competition Short-Run Market Supply
A perfectly competitive industry is one The quantity of output supplied to the
that obeys the following assumptions: entire market in the short run is the sum
there are a large number of firms, each of the quantities supplied by each firm
producing the same homogeneous product the amount supplied by each firm depends
each firm attempts to maximize profits on price
each firm is a price taker The short-run market supply curve will
its actions have no effect on the market price be upward-sloping because each firms
information is perfect short-run supply curve has a positive
transactions are costless slope
17 18
5
Short-Run Supply Elasticity A Short-Run Supply Function
The short-run supply elasticity describes Suppose that there are 100 identical
the responsiveness of quantity supplied firms each with the following short-run
to changes in market price supply curve
% change in Q supplied QS P qi (P,v,w) = 10P/3 (i = 1,2,,100)
eS,P
% change in P P QS This means that the market supply
Because price and quantity supplied are function is given by
positively related, eS,P > 0 100 100
10P 1000P
Qs qi
i 1 i 1 3 3
21 22
6
Equilibrium Price Equilibrium Price
Determination Determination
The equilibrium price depends on many The interaction between
exogenous factors Price market demand and market
S supply determines the
changes in any of these factors will likely equilibrium price
result in a new equilibrium price
P1
Q1 Quantity
25 26
Q1 Q2 Quantity q1 q2 Quantity
27 28
7
Shifts in Supply and Shifts in Supply and
Demand Curves Demand Curves
Demand curves shift because When either a supply curve or a
incomes change demand curve shift, equilibrium price
prices of substitutes or complements change and quantity will change
preferences change The relative magnitudes of these
Supply curves shift because changes depends on the shapes of the
input prices change supply and demand curves
technology changes
number of producers change
29 30
P
P P P
P
P P
P
D D D
D D D
8
Changing Short-Run Equilibria Changing Short-Run Equilibria
Suppose that the market demand for Suppose instead that the demand for
luxury beach towels is luxury towels rises to
QD = 10,000 500P QD = 12,500 500P
and the short-run market supply is Solving for the new equilibrium, we find
QS = 1,000P/3 P* = $15
Setting these equal, we find Q* = 5,000
P* = $12 Equilibrium price and quantity both rise
Q* = 4,000
33 34
9
Mathematical Model of Mathematical Model of
Supply and Demand Supply and Demand
The supply relationship can be shown as To analyze the comparative statics of
QS = S(P,) this model, we need to use the total
differentials of the supply and demand
is a parameter that shifts the supply curve
functions:
S/ = S can have any sign
dQD = DPdP + Dd
S/P = SP > 0 dQS = SPdP + Sd
Equilibrium requires that QD = QS Maintenance of equilibrium requires that
dQD = dQS
37 38
10
Long-Run Analysis Long-Run Analysis
In the long run, a firm may adapt all of its New firms will be lured into any market
inputs to fit market conditions for which economic profits are greater
profit-maximization for a price-taking firm than zero
implies that price is equal to long-run MC entry of firms will cause the short-run
Firms can also enter and exit an industry industry supply curve to shift outward
in the long run market price and profits will fall
perfect competition assumes that there are the process will continue until economic
no special costs of entering or exiting an profits are zero
industry
41 42
43 44
11
Long-Run Competitive Long-Run Equilibrium:
Equilibrium Constant-Cost Case
We will assume that all firms in an Assume that the entry of new firms in an
industry have identical cost curves industry has no effect on the cost of
no firm controls any special resources or inputs
technology no matter how many firms enter or leave
The equilibrium long-run position an industry, a firms cost curves will remain
requires that each firm earn zero unchanged
economic profit This is referred to as a constant-cost
industry
45 46
Price Price
P = MC = AC Price Price Market price rises to P2
SMC MC SMC MC
S S
AC AC
P2
P1 P1
D
D D
q1 Quantity
47 q1 Quantity
48
Quantity Q1 Quantity Q1 Q2
A Typical Firm Total Market A Typical Firm Total Market
12
Long-Run Equilibrium: Long-Run Equilibrium:
Constant-Cost Case Constant-Cost Case
In the short run, each firm increases output to q2 In the long run, new firms will enter the industry
Economic profit > 0 Economic profit will return to 0
Price Price Price
SMC MC SMC MC Price
S S
S
AC AC
P2
P1 P1
D D
D D
q1 q2 Quantity
49 q1 Quantity
50
Quantity Q1 Q2 Quantity Q1 Q3
A Typical Firm Total Market A Typical Firm Total Market
q1 Quantity
51 52
Quantity Q1 Q3
A Typical Firm Total Market
13
Infinitely Elastic Long-Run Shape of the Long-Run
Supply Supply Curve
To find the long-run equilibrium for this The zero-profit condition is the factor that
market, we must find the low point on the determines the shape of the long-run cost
typical firms average cost curve curve
where AC = MC if average costs are constant as firms enter,
AC = q2 20q + 100 + 8,000/q long-run supply will be horizontal
MC = 3q2 40q + 100 if average costs rise as firms enter, long-run
this occurs where q = 20 supply will have an upward slope
If q = 20, AC = MC = $500 if average costs fall as firms enter, long-run
supply will be negatively sloped
this will be the long-run equilibrium price 53 54
existing firms
new firms may increase the demand for
tax-financed services P1
55 q1 Quantity
56
Quantity Q1
A Typical Firm (before entry) Total Market
14
Long-Run Equilibrium: Long-Run Equilibrium:
Increasing-Cost Industry Increasing-Cost Industry
Suppose that market demand rises to D Positive profits attract new firms and supply shifts out
Market price rises to P2 and firms increase output to q2 Entry of firms causes costs for each firm to rise
Price MC Price SMC MC
SMC Price Price
S S
S
AC
AC
P2
P3
P1 P1
D D
D D
q1 q2 Quantity
57 q3 Quantity
58
Quantity Q1 Q2 Quantity Q1 Q3
A Typical Firm (before entry) Total Market A Typical Firm (after entry) Total Market
AC
S new firms may attract a larger pool of
LS trained labor
entry of new firms may provide a critical
p3 mass of industrialization
p1 permits the development of more efficient
D transportation and communications networks
D
q3 Q1 Q3 59
Quantity 60
Quantity
A Typical Firm (after entry) Total Market
15
Long-Run Equilibrium: Long-Run Equilibrium:
Decreasing-Cost Case Decreasing-Cost Industry
Suppose that we are in long-run equilibrium in this industry Suppose that market demand rises to D
P = MC = AC Market price rises to P2 and firms increase output to q2
Price Price Price
SMC MC SMC MC Price
S S
AC AC
P2
P1 P1
D
D D
q1 Quantity
61 q1 q2 Quantity
62
Quantity Q1 Quantity Q1 Q2
A Typical Firm (before entry) Total Market A Typical Firm (before entry) Total Market
S S
AC AC
P1 P1
P3 D P3
D D D LS
q1 q3 Quantity
63 q1 q3 64
Q3 Quantity
Quantity Q1 Q3 Quantity Q1
A Typical Firm (before entry) Total Market A Typical Firm (before entry) Total Market
16
Classification of Long-Run Classification of Long-Run
Supply Curves Supply Curves
Constant Cost Decreasing Cost
entry does not affect input costs entry reduces input costs
the long-run supply curve is horizontal at the long-run supply curve is negatively
the long-run equilibrium price sloped
Increasing Cost
entry increases inputs costs
the long-run supply curve is positively
sloped
65 66
17
Comparative Statics Analysis Comparative Statics Analysis
of Long-Run Equilibrium of Long-Run Equilibrium
Assume that we are examining a A shift in demand that changes the
constant-cost industry equilibrium industry output to Q1 will
Suppose that the initial long-run change the equilibrium number of firms to
equilibrium industry output is Q0 and the n1 = Q1/q*
typical firms output is q* (where AC is The change in the number of firms is
minimized) Q1 Q0
n1 n0
q*
The equilibrium number of firms in the
completely determined by the extent of the
industry (n0) is Q0/q* demand shift and the optimal output level for
69 70
the typical firm
71 72
18
Rising Input Costs and Rising Input Costs and
Industry Structure Industry Structure
Suppose that the total cost curve for a
At q = 22, MC = AC = $672 so the long-
typical firm in the bicycle industry is
run equilibrium price will be $672
TC = q3 20q2 + 100q + 8,000
If demand can be represented by
and then rises to QD = 2,500 3P
19
Producer Surplus in the Producer Surplus in the
Long Run Long Run
In the constant-cost case, input prices Long-run producer surplus represents
are assumed to be independent of the the additional returns to the inputs in an
level of production industry in excess of what these inputs
inputs can earn the same amount in would earn if industry output was zero
alternative occupations
the area above the long-run supply curve
In the increasing-cost case, entry will bid and below the market price
up some input prices this would equal zero in the case of constant
suppliers of these inputs will be made better costs
off 77 78
79 80
20
Ricardian Rent Ricardian Rent
The owners of low-cost firms will earn positive profits The owners of the marginal firm will earn zero profit
AC
AC
S S
P* P*
D D
q* Quantity Q* Quantity
81 q* Quantity Q* 82
Quantity
Low-Cost Firm Total Market Marginal Firm Total Market
21
Ricardian Rent Ricardian Rent
The long-run profits for the low-cost firms It is the scarcity of low-cost inputs that
will often be reflected in the prices of the creates the possibility of Ricardian rent
unique resources owned by those firms
In industries with upward-sloping long-
the more fertile the land is, the higher its
run supply curves, increases in output
price
not only raise firms costs but also
Thus, profits are said to be capitalized generate factor rents for inputs
inputs prices
reflect the present value of all future profits
85 86
22
Important Points to Note: Important Points to Note:
In the long run, the number of firms is The shape of the long-run supply curve
variable in response to profit opportunities depends on how entry and exit affect
the assumption of free entry and exit implies firms input costs
that firms in a competitive industry will earn in the constant-cost case, input prices do not
zero economic profits in the long run (P = AC) change and the long-run supply curve is
because firms also seek maximum profits, the horizontal
equality P = AC = MC implies that firms will if entry raises input costs, the long-run supply
operate at the low points of their long-run curve will have a positive slope
average cost curves
89 90
91 92
23
Perfectly Competitive
Price System
We will assume that all markets are
Chapter 13 perfectly competitive
there is some large number of homogeneous
GENERAL EQUILIBRIUM AND goods in the economy
WELFARE both consumption goods and factors of
production
each good has an equilibrium price
there are no transaction or transportation
costs
Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 individuals and firms have perfect information
2
1
General Equilibrium Edgeworth Box Diagram
Construction of the production possibility
Assume that there are only two goods, x
curve for x and y starts with the
and y
assumption that the amounts of k and l
All individuals are assumed to have are fixed
identical preferences
An Edgeworth box shows every possible
represented by an indifference map
way the existing k and l might be used to
The production possibility curve can be produce x and y
used to show how outputs and inputs are any point in the box represents a fully
related employed allocation of the available
5 resources to x and y 6
Capital
in x they illustrate the actual production outcomes
production
Ox
Total Labor 7 8
Labor in x production
2
Edgeworth Box Diagram Edgeworth Box Diagram
Point A is inefficient because, by moving along y1, we can increase
We will use isoquant maps for the two x from x1 to x2 while holding y constant
Oy
goods
the isoquant map for good x uses Ox as the y1
origin
Total Capital
the isoquant map for good y uses Oy as the y2
origin
x2
The efficient allocations will occur where A
x1
y1
y1
p4
y2
Total Capital
Total Capital
y2 p3
x4
y3
p2
x2 x3
y4 p1
A x1
x2
x1
Ox Ox
Total Labor 11 Total Labor 12
3
Production Possibility Frontier Production Possibility Frontier
Each efficient point of production
The locus of efficient points shows the Quantity of y
becomes a point on the production
maximum output of y that can be Ox p1
possibility frontier
y4
produced for any level of x y3
p2
The negative of the slope of
we can use this information to construct a y2
p3
the production possibility
production possibility frontier frontier is the rate of product
shows the alternative outputs of x and y that transformation (RPT)
p4
y1
can be produced with the fixed capital and
labor inputs that are employed efficiently
Quantity of x
x1 x2 x3 x4 Oy
13 14
dy
RPT (of x for y ) (along OxOy )
dx
15 16
4
Shape of the Production Shape of the Production
Possibility Frontier Possibility Frontier
The production possibility frontier shown Suppose that the costs of any output
earlier exhibited an increasing RPT combination are C(x,y)
this concave shape will characterize most along the production possibility frontier,
production situations C(x,y) is constant
RPT is equal to the ratio of MCx to MCy We can write the total differential of the
cost function as
C C
dC dx dy 0
x y
17 18
5
Shape of the Production Opportunity Cost
Possibility Frontier
The production possibility frontier
But we have assumed that inputs are demonstrates that there are many
homogeneous possible efficient combinations of two
We need an explanation that allows goods
homogeneous inputs and constant Producing more of one good
returns to scale necessitates lowering the production of
The production possibility frontier will be the other good
concave if goods x and y use inputs in this is what economists mean by opportunity
different proportions cost
21 22
6
Concavity of the Production Determination of
Possibility Frontier Equilibrium Prices
The RPT can be calculated by taking the
We can use the production possibility
total differential:
frontier along with a set of indifference
dy ( 2x ) x
2xdx 2ydy 0 or RPT curves to show how equilibrium prices
dx 2y y
are determined
The slope of the production possibility the indifference curves represent
frontier increases as x output increases individuals preferences for the two goods
the frontier is concave
25 26
Determination of Determination of
Equilibrium Prices Equilibrium Prices
If the prices of x and y are px and py, There is excess demand for x and
Quantity of y Quantity of y
societys budget constraint is C excess supply of y
C C
Output will be x1, y1 The price of x will rise and
y1 y1 the price of y will fall
Individuals will demand x1, y1 excess
supply
y1 y1
U3 U3
U2 C U2 C
px px
U1 slope U1 slope
py py
Quantity of x x1
Quantity of x
x1 x1 27 x 28
1 excess demand
7
Determination of Comparative Statics Analysis
Equilibrium Prices
The equilibrium price ratio will tend to
Quantity of y C* The equilibrium prices will
be px* and py*
persist until either preferences or
C
production technologies change
The equilibrium output will
y1
be x1* and y1* If preferences were to shift toward good
y1 *
x, px /py would rise and more x and less
y1
U3
y would be produced
U2 C we would move in a clockwise direction
px
U1 slope
py
along the production possibility frontier
C*
Quantity of x
x x1 * x1 px* 29 30
slope
1 py*
this will lower the relative price of x The relative price of x will fall
more x will be consumed More x will be consumed
if x is a normal good
U3
the effect on y is ambiguous U2
U1
31 x1 * x2 *
Quantity of x 32
8
General Equilibrium Pricing General Equilibrium Pricing
Suppose that the production possibility Profit-maximizing firms will equate RPT
frontier can be represented by and the ratio of px /py
x 2 + y 2 = 100 x px
RPT
Suppose also that the communitys y py
preferences can be represented by Utility maximization requires that
U(x,y) = x0.5y0.5
y px
MRS
x py
33 34
35 36
9
The Corn Laws Debate The Corn Laws Debate
Quantity of Quantity of
manufactured If the corn laws completely prevented manufactured Removal of the corn laws will change
goods (y)
trade, output would be x0 and y0 goods (y) the prices to px and py
Output will be x1 and y1
The equilibrium prices will be
y1
px* and py* Individuals will demand x1 and y1
y0 y0
y1
U2 U2
U1 U1
px '
px* slope
slope py '
py*
Quantity of Grain (x) Quantity of Grain (x)
x0 x1 x0 x1
37 38
39 40
imports of grain
10
The Corn Laws Debate The Corn Laws Debate
A repeal of the corn laws would result in a movement from p3 to
p1 where more y and less x is produced
Oy
If we assume that grain production is
relatively capital intensive, the movement
y1 from p3 to p1 causes the ratio of k to l to
p4
y2 rise in both industries
Total Capital
p3
x4 the relative price of capital will fall
y3
p2 the relative price of labor will rise
x3
y4 p1 The repeal of the corn laws will be
x2
x1 harmful to capital owners and helpful to
Ox
Total Labor 41
laborers 42
11
Existence of General Existence of General
Equilibrium Prices Equilibrium Prices
Suppose that there are n goods in fixed We will write this demand function as
supply in this economy dependent on the whole set of prices (P)
let Si (i =1,,n) be the total supply of good i Di (P)
available Walras problem: Does there exist an
let pi (i =1,n) be the price of good i equilibrium set of prices such that
The total demand for good i depends on Di (P*) = Si
all prices for all values of i ?
Di (p1,,pn) for i =1,,n
45 46
12
Walras Law Walras Law
A final observation that Walras made Walras law holds for any set of prices
was that the n excess demand equations (not just equilibrium prices)
are not independent of one another There can be neither excess demand for
Walras law shows that the total value of all goods together nor excess supply
excess demand is zero at any set of
prices
n
P ED (P ) 0
i 1
i i
49 50
13
Walras Proof of the Existence Walras Proof of the Existence
of Equilibrium Prices of Equilibrium Prices
Using the provisional prices p1 and p2, The importance of Walras proof is its
solve for p3 ability to demonstrate the simultaneous
proceed in this way until an entire set of nature of the problem of finding
provisional relative prices has been found equilibrium prices
In the 2nd iteration of Walras proof, Because it is cumbersome, it is not
p2,,pn are held constant while a new generally used today
equilibrium price is calculated for good 1
More recent work uses some relatively
proceed in this way until an entire new set of simple tools from advanced mathematics
prices is found 53 54
x
0 X* 1
55 56
14
Brouwers Fixed-Point Theorem Brouwers Fixed-Point Theorem
A mapping is a rule that associates the A mapping is continuous if points that are
points in one set with points in another set close to each other are mapped into other
let X be a point for which a mapping (F) is points that are close to each other
defined The Brouwer fixed-point theorem considers
the mapping associates X with some point Y = F(X)
mappings defined on certain kinds of sets
if a mapping is defined over a subset of n-
closed (they contain their boundaries)
dimensional space (S), and if every point in S
is associated (by the rule F) with some other bounded (none of their dimensions is infinitely
point in S, the mapping is said to map S into large)
itself 57
convex (they have no holes in them) 58
p
i 1
i 59 60
15
Proof of the Existence of Free Goods
Equilibrium Prices
Equilibrium does not really require that
We will assume that the feasible set of excess demand be zero for every market
prices (S) is composed of all
Goods may exist for which the markets
nonnegative numbers that sum to 1
are in equilibrium where supply exceeds
S is the set to which we will apply Brouwers demand (negative excess demand)
theorem
it is necessary for the prices of these goods
S is closed, bounded, and convex
to be equal to zero
we will need to define a continuous mapping
free goods
of S into itself
61 62
63 64
16
Mapping the Set of Prices Mapping the Set of Prices
Into Itself Into Itself
We define the mapping F(P) for any Two problems exist with this mapping
normalized set of prices (P), such that First, nothing ensures that the prices will
the ith component of F(P) is given by be nonnegative
F i(P) = pi + EDi (P) the mapping must be redefined to be
The mapping performs the necessary F i(P) = Max [pi + EDi (P),0]
task of appropriately raising or lowering the new prices defined by the mapping must
prices be positive or zero
65 66
into itself
we will assume that this normalization has For this point,
been done pi* = Max [pi* + EDi (P*),0] for all i
67 68
17
Application of Brouwers A General Equilibrium with
Theorem Three Goods
This says that P* is an equilibrium set of The economy of Oz is composed only of
prices three precious metals: (1) silver, (2)
for pi* > 0, gold, and (3) platinum
pi* = pi* + EDi (P*) there are 10 (thousand) ounces of each
EDi (P*) = 0 metal available
For pi* = 0,
The demands for gold and platinum are
pi* + EDi (P*) 0
EDi (P*) 0 p2 p3 p2 p
D2 2 11 D3 2 3 18
69
p1 p1 p1 p1 70
18
A General Equilibrium with Smiths Invisible Hand
Three Goods Hypothesis
Because Walras law must hold, we know Adam Smith believed that the
p1ED1 = p2ED2 p3ED3 competitive market system provided a
Substituting the excess demand functions powerful invisible hand that ensured
for gold and silver and substituting, we get resources would find their way to where
they were most valued
p22 p2 p3 pp p2
p1ED1 2 p2 2 3 2 3 8 p3 Reliance on the economic self-interest
p1 p1 p1 p1
of individuals and firms would result in a
p22 p2 p p desirable social outcome
ED1 2 2 32 2 8 3
p12
p1 p1 p1 73 74
19
Efficiency in Production Efficient Choice of Inputs for a
Single Firm
An allocation of resources is efficient in
production (or technically efficient) if no A single firm with fixed inputs of labor
further reallocation would permit more of and capital will have allocated these
one good to be produced without resources efficiently if they are fully
necessarily reducing the output of some employed and if the RTS between
other good capital and labor is the same for every
output the firm produces
Technical efficiency is a precondition for
Pareto efficiency but does not guarantee
Pareto efficiency 77 78
20
Efficient Choice of Inputs for a Efficient Allocation of
Single Firm Resources among Firms
From the first two conditions, we can see Resources should be allocated to those
that firms where they can be most efficiently
fk g k
used
fl gl the marginal physical product of any
This implies that resource in the production of a particular
good should be the same across all firms
RTSx (k for l) = RTSy (k for l)
that produce the good
81 82
Assume that the total supplies of capital Substituting, the maximization problem
and labor are k and l becomes
x = f1(k1, l1) + f2(k - k1, l - l1)
83 84
21
Efficient Allocation of Efficient Allocation of
Resources among Firms Resources among Firms
First-order conditions for a maximum These first-order conditions can be
are rewritten as
x f f f f f1 f f1 f2
1 2 1 2 0 2
k1 k1 k1 k1 k 2 k1 k 2 l1 l2
22
Efficient Choice of Output Efficient Choice of Output
by Firms by Firms
Firm A is relatively efficient at producing cars, while Firm B If each firm was to specialize in its efficient product, total
is relatively efficient at producing trucks output could be increased
Cars Cars 1 Cars Cars 1
2 RPT 2 RPT
RPT 1 RPT 1
1 1
100 100 100 100
Theory of Comparative
Advantage Efficiency in Product Mix
The theory of comparative advantage Technical efficiency is not a sufficient
was first proposed by Ricardo condition for Pareto efficiency
countries should specialize in producing demand must also be brought into the
those goods of which they are relatively picture
more efficient producers In order to ensure Pareto efficiency, we
these countries should then trade with the rest
of the world to obtain needed commodities
must be able to tie individuals
if countries do specialize this way, total
preferences and production possibilities
world production will be greater together
91 92
23
Efficiency in Product Mix Efficiency in Product Mix
The condition necessary to ensure that Output of y Suppose that we have a one-person (Robinson
Crusoe) economy and PP represents the
the right goods are produced is combinations of x and y that can be produced
P
MRS = RPT
the psychological rate of trade-off between Any point on PP represents a
the two goods in peoples preferences must point of technical efficiency
be equal to the rate at which they can be
traded off in production
Output of x
P
93 94
Output of x
T(x,y) = 0
P
95 96
24
Efficiency in Product Mix Efficiency in Product Mix
Crusoes problem is to maximize his First-order conditions for an interior
utility subject to the production maximum are
constraint L U T
0
x x x
Setting up the Lagrangian yields
L U T
L = U(x,y) + [T(x,y)] 0
y y y
L
T ( x, y ) 0
97
98
25
Competitive Prices and Efficiency in Production
Efficiency
Because all agents face the same In minimizing costs, a firm will equate
prices, all trade-off rates will be the RTS between any two inputs (k and
equalized and an efficient allocation will l) to the ratio of their competitive prices
be achieved (w/v)
this is true for all outputs the firm produces
This is the First Theorem of Welfare
RTS will be equal across all outputs
Economics
101 102
103 104
26
Efficiency in Production Efficiency in Production
Recall that the RPT (of x for y) is equal Thus, the profit-maximizing decisions
to MCx /MCy of many firms can achieve technical
In perfect competition, each profit- efficiency in production without any
maximizing firm will produce the output central direction
level for which marginal cost is equal to Competitive market prices act as
price signals to unify the multitude of
Since px = MCx and py = MCy for every decisions that firms make into one
firm, RTS = MCx /MCy = px /py coherent, efficient pattern
105 106
107 108
27
Departing from the
Laissez-Faire Policies Competitive Assumptions
The correspondence between
competitive equilibrium and Pareto The ability of competitive markets to
efficiency provides some support for the achieve efficiency may be impaired
laissez-faire position taken by many because of
economists imperfect competition
government intervention may only result in externalities
a loss of Pareto efficiency public goods
imperfect information
109 110
28
Public Goods Imperfect Information
Public goods have two properties that If economic actors are uncertain about
make them unsuitable for production in prices or if markets cannot reach
markets equilibrium, there is no reason to expect
they are nonrival that the efficiency property of
additional people can consume the benefits of competitive pricing will be retained
these goods at zero cost
they are nonexclusive
extra individuals cannot be precluded from
consuming the good
113 114
Distribution Distribution
Although the First Theorem of Welfare Assume that there are only two people
Economics ensures that competitive in society (Smith and Jones)
markets will achieve efficient allocations, The quantities of two goods (x and y) to
there are no guarantees that these be distributed among these two people
allocations will exhibit desirable are fixed in supply
distributions of welfare among individuals We can use an Edgeworth box diagram
to show all possible allocations of these
goods between Smith and Jones
115 116
29
Distribution Distribution
OJ
UJ 1
US1
OS Total X
117 118
30
Contract Curve Exchange with Initial
UJ1
OJ
Endowments
UJ2
Suppose that the two individuals
US4
possess different quantities of the two
UJ3
goods at the start
UJ4 US3 it is possible that the two individuals could
both benefit from trade if the initial
US2 allocations were inefficient
A
US1
Contract curve
OS
121 122
A
USA
123 OS 124
31
Exchange with Initial Exchange with Initial
Endowments OJ
Endowments OJ
Neither individual would be Only allocations between M1
willing to accept a lower level and M2 will be acceptable to
of utility than A gives both
UJA UJA
M2
M1
A A
USA USA
OS 125 OS 126
32
Important Points to Note: Important Points to Note:
Preferences and production Competitive markets can establish
technologies provide the building equilibrium prices by making marginal
blocks upon which all general adjustments in prices in response to
equilibrium models are based information about the demand and
one particularly simple version of such a supply for individual goods
model uses individual preferences for two Walras law ties markets together so that
goods together with a concave production such a solution is assured (in most cases)
possibility frontier for those two goods
129 130
131 132
33
Important Points to Note:
Competitive markets need not yield
equitable distributions of resources,
especially when initial endowments are
very skewed
in theory any desired distribution can be
attained through competitive markets
accompanied by lump-sum transfers
there are many practical problems in
implementing such transfers
133
34
Monopoly
1
Technical Barriers to Entry Legal Barriers to Entry
Another technical basis of monopoly is Many pure monopolies are created as a
special knowledge of a low-cost matter of law
productive technique with a patent, the basic technology for a
it may be difficult to keep this knowledge product is assigned to one firm
out of the hands of other firms the government may also award a firm an
Ownership of unique resources may exclusive franchise to serve a market
also be a lasting basis for maintaining a
monopoly
5 6
2
Profit Maximization Profit Maximization
Since MR = MC at the profit-maximizing Price MC The monopolist will maximize
output and P > MR for a monopolist, the profits where MR = MC
9 10
where eQ,P is the elasticity of demand the firms markup over marginal cost
depends inversely on the elasticity of market
for the entire market
demand
11 12
3
Monopoly Profits Monopoly Profits
Monopoly profits will be positive as long The size of monopoly profits in the long
as P > AC run will depend on the relationship
Monopoly profits can continue into the between average costs and market
long run because entry is not possible demand for the product
some economists refer to the profits that a
monopoly earns in the long run as
monopoly rents
the return to the factor that forms the basis of
the monopoly
13 14
4
Monopoly with Linear Demand Monopoly with Linear Demand
Suppose that the market for frisbees To maximize profits, the monopolist
has a linear demand curve of the form chooses the output for which MR = MC
Q = 2,000 - 20P We need to find total revenue
or TR = PQ = 100Q - Q2/20
P = 100 - Q/20 Therefore, marginal revenue is
The total costs of the frisbee producer MR = 100 - Q/10
are given by
while marginal cost is
C(Q) = 0.05Q2 + 10,000
MC = 0.01Q
17 18
19 20
5
Monopoly with Linear Demand Monopoly and Resource
Allocation
The inverse elasticity rule specifies that To evaluate the allocational effect of a
P MC 1 1 monopoly, we will use a perfectly
competitive, constant-cost industry as a
P eQ,P 3
basis of comparison
Since P* = 75 and MC = 50, this the industrys long-run supply curve is
relationship holds infinitely elastic with a price equal to both
marginal and average cost
21 22
6
Welfare Losses and Elasticity Welfare Losses and Elasticity
Assume that the constant marginal (and The competitive price in this market will
average) costs for a monopolist are be
given by c and that the compensated Pc = c
demand curve has a constant elasticity:
and the monopoly price is given by
Q = Pe
where e is the price elasticity of demand c
Pm
(e < -1) 1
1
e
25 26
7
Welfare Losses and Elasticity Welfare Losses and Elasticity
Taking the ratio of these two surplus Monopoly profits are given by
measures yields
e 1 c
m PmQm cQm c Qm
CSm 1 1 1
CSc 1 1 e
e e e 1
c
If e = -2, this ratio is c c 1
m e
consumer surplus under monopoly is half 1 1 1 1 1 1 e
what it is under perfect competition 29 e e e 30
8
Monopoly and Product Quality Monopoly and Product Quality
Suppose that consumers willingness to First-order conditions for a maximum are
pay for quality (X) is given by the inverse P
demand function P(Q,X) where P (Q, X ) Q CQ 0
Q Q
P/Q < 0 and P/X > 0
MR = MC for output decisions
If costs are given by C(Q,X), the P
monopoly will choose Q and X to Q CX 0
X X
maximize
Marginal revenue from increasing quality by
= P(Q,X)Q - C(Q,X)
one unit is equal to the marginal cost of
33 making such an increase 34
9
Monopoly and Product Quality Price Discrimination
A monopoly engages in price
Even if a monopoly and a perfectly
discrimination if it is able to sell otherwise
competitive industry chose the same
identical units of output at different prices
output level, they might opt for diffferent
quality levels Whether a price discrimination strategy is
each is concerned with a different margin feasible depends on the inability of
in its decision making buyers to practice arbitrage
profit-seeking middlemen will destroy any
discriminatory pricing scheme if possible
price discrimination becomes possible if resale is
37 costly 38
Q2
10
Perfect Price Discrimination Perfect Price Discrimination
Therefore,
Recall the example of the frisbee
P = 100 - Q/20 = MC = 0.1Q
manufacturer
Q* = 666
If this monopolist wishes to practice
perfect price discrimination, he will want Total revenue and total costs will be
to produce the quantity for which the Q* Q2
666
11
Market Separation Market Separation
If two markets are separate, maximum profits occur by
This implies that setting different prices in the two markets
Price
1
(1 ) The market with the less
Pi ej P1 elastic demand will be
Pj (1 1 ) charged the higher price
P2
ei
The profit-maximizing price will be MC MC
12
Third-Degree Price Third-Degree Price
Discrimination Discrimination
The allocational impact of this policy can be If this monopoly was to pursue a single-
evaluated by calculating the deadweight price policy, it would use the demand
losses in the two markets function
the competitive output would be 18 in market 1 Q = Q1 + Q2 = 48 3P
and 12 in market 2 So marginal revenue would be
DW 1 = 0.5(P1-MC)(18-Q1) = 0.5(15-6)(18-9) = 40.5 MR = 16 2Q/3
DW 2 = 0.5(P2-MC)(12-Q2) = 0.5(9-6)(12-6) = 9 Profit-maximization occurs where
49
Q = 15 P = 11 50
13
Two-Part Tariffs Two-Part Tariffs
Because the average price paid by any One feasible approach for profit
demander is maximization would be for the firm to set
p = T/q = a/q + p p = MC and then set a equal to the
this tariff is only feasible if those who consumer surplus of the least eager
pay low average prices (those for whom buyer
q is large) cannot resell the good to this might not be the most profitable
approach
those who must pay high average
in general, optimal pricing schedules will
prices (those for whom q is small)
depend on a variety of contingencies
53 54
14
Regulation of Monopoly Regulation of Monopoly
Natural monopolies such as the utility, Many economists believe that it is
communications, and transportation important for the prices of regulated
industries are highly regulated in many monopolies to reflect marginal costs of
countries production accurately
An enforced policy of marginal cost
pricing will cause a natural monopoly to
operate at a loss
natural monopolies exhibit declining
average costs over a wide range of output
57 58
An unregulated monopoly will Other users are offered the lower price
maximize profit at Q1 and P1 of P2
P1
If regulators force the The profits on the sales to high-
P1 price customers are enough to
monopoly to charge a
C1
C1 price of P2, the firm will cover the losses on the sales to
suffer a loss because low-price customers
C2 C2
AC
P2 < C2 AC
P2 MR MC P2 MC
Quantity Quantity
Q1 Q2 D Q1 Q2 D
59 60
15
Regulation of Monopoly Regulation of Monopoly
Another approach followed in many Suppose that a regulated utility has a
regulatory situations is to allow the production function of the form
monopoly to charge a price above q = f (k,l)
marginal cost that is sufficient to earn a
The firms actual rate of return on
fair rate of return on investment
capital is defined as
if this rate of return is greater than that
which would occur in a competitive market, pf (k, l ) wl
s
there is an incentive to use relatively more k
capital than would truly minimize costs
61 62
16
Regulation of Monopoly Regulation of Monopoly
Therefore, 0<<1 and the first-order Because s0>v and <1, this means that
conditions for a maximum are: pfk < v
L The firm will hire more capital than it
pfl w (w pfl ) 0
l would under unregulated conditions
L it will also achieve a lower marginal
pfk v (s0 pfk ) 0
k productivity of capital
L
wl s0 pf (k, l ) 0
65 66
17
Important Points to Note: Important Points to Note:
Relative to perfect competition, Monopolies may opt for different levels
monopoly involves a loss of consumer of quality than would perfectly
surplus for demanders competitive firms
some of this is transferred into monopoly Durable good monopolists may be
profits, whereas some of the loss in
constrained by markets for used goods
consumer surplus represents a
deadweight loss of overall economic
welfare
it is a sign of Pareto inefficiency
69 70
71 72
18
Pricing Under
Homogeneous Oligopoly
We will assume that the market is
Chapter 15 perfectly competitive on the demand side
TRADITIONAL MODELS OF there are many buyers, each of whom is a
price taker
IMPERFECT COMPETITION
We will assume that the good obeys the
law of one price
this assumption will be relaxed when product
differentiation is discussed
Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2
1
Oligopoly Pricing Models Oligopoly Pricing Models
The quasi-competitive model assumes The Cournot model assumes that firm i
price-taking behavior by all firms treats firm js output as fixed in its
P is treated as fixed
decisions
qj/qi = 0
The cartel model assumes that firms The conjectural variations model
can collude perfectly in choosing assumes that firm js output will respond
industry output and P to variations in firm is output
qj/qi 0
5 6
2
Cartel Model Cartel Model
The assumption of price-taking behavior In this case, the cartel acts as a
may be inappropriate in oligopolistic multiplant monopoly and chooses qi for
industries each firm so as to maximize total
each firm can recognize that its output industry profits
decision will affect price = PQ [C1(q1) + C2(q2) ++ Cn(qn)]
An alternative assumption would be that n
firms act as a group and coordinate their f (q1 q2 ... qn )[q1 q2 ... qn ] Ci (qi )
decisions so as to achieve monopoly i 1
profits
9 10
qi qi
This implies that MC
MR(Q) = MCi(qi)
At the profit-maximizing point, marginal D
MR
revenue will be equal to each firms QM
Quantity
marginal cost 11 12
3
Cartel Model Cournot Model
There are three problems with the cartel Each firm recognizes that its own
solution decisions about qi affect price
these monopolistic decisions may be illegal P/qi 0
it requires that the directors of the cartel
However, each firm believes that its
know the market demand function and
each firms marginal cost function decisions do not affect those of any
the solution may be unstable other firm
each firm has an incentive to expand output qj /qi = 0 for all j i
because P > MCi
13 14
4
Cournot Model Cournots Natural Springs
Duopoly
Price will exceed marginal cost, but Assume that there are two owners of
industry profits will be lower than in the natural springs
cartel model each firm has no production costs
The greater the number of firms in the each firm has to decide how much water
industry, the closer the equilibrium point to supply to the market
will be to the competitive result The demand for spring water is given
by the linear demand function
Q = q1 + q2 = 120 - P
17 18
19 20
5
Cournots Natural Springs Cournots Natural Springs
Duopoly Duopoly
The profit-maximizing output, price, and The two firms revenues (and profits) are
level of profit are given by
Q = 60 1 = Pq1 = (120 - q1 - q2) q1 = 120q1 - q12 - q1q2
P = 60 2 = Pq2 = (120 - q1 - q2) q2 = 120q2 - q22 - q1q2
= 3,600 First-order conditions for a maximum are
The precise division of output and 1 2
profits is indeterminate 120 2q1 q2 0 120 2q2 q1 0
q1 q2
21 22
6
Conjectural Variations Model Conjectural Variations Model
In markets with only a few firms, we can For each firm i, we are concerned with
expect there to be strategic interaction the assumed value of qj /qi for ij
among firms because the value will be speculative,
One way to build strategic concerns into models based on various assumptions
about its value are termed conjectural
our model is to consider the
variations models
assumptions that might be made by one
they are concerned with firm is conjectures
firm about the other firms behavior about firm js output variations
25 26
7
Price Leadership Model Price Leadership Model
We can derive the demand curve facing
D represents the market demand curve
Price Price the industry leader
SC SC
D D
Quantity Quantity
29 30
QL Quantity QC QL QT Quantity
31 32
8
Price Leadership Model Stackelberg Leadership Model
This model does not explain how the The assumption of a constant marginal
price leader is chosen or what happens cost makes the price leadership model
if a member of the fringe decides to inappropriate for Cournots natural
challenge the leader spring problem
The model does illustrate one tractable the competitive fringe would take the entire
example of the conjectural variations market by pricing at marginal cost (= 0)
model that may explain pricing behavior there would be no room left in the market
in some instances for the price leader
33 34
9
Stackelberg Leadership Model Product Differentiation
Solving this simultaneously with firm 2s Firms often devote considerable
reaction function, we get resources to differentiating their
q1 = 60 products from those of their competitors
q2 = 30 quality and style variations
P = 120 (q1 + q2) = 30 warranties and guarantees
1 = Pq1 = 1,800 special service features
2 = Pq2 = 900 product advertising
Again, there is no theory on how the
leader is chosen 37 38
10
Product Differentiation Product Differentiation
We will assume that there are n firms Because there are n firms competing in
competing in a particular product group the product group, we must allow for
each firm can choose the amount it spends different market prices for each (p1,...,pn)
on attempting to differentiate its product The demand facing the ith firm is
from its competitors (zi)
pi = g(qi,pj,zi,zj)
The firms costs are now given by
total costs = Ci (qi,zi)
Presumably, pi/qi 0, pi/pj 0,
pi/zi 0, and pi/zj 0
41 42
11
Product Differentiation Spatial Differentiation
The demand curve facing any one firm Suppose we are examining the case of
may shift often ice cream stands located on a beach
it depends on the prices and product assume that demanders are located
differentiation activities of its competitors uniformly along the beach
one at each unit of beach
The firm must make some assumptions each buyer purchases exactly one ice cream
in order to make its decisions cone per period
The firm must realize that its own actions ice cream cones are costless to produce but
may influence its competitors actions carrying them back to ones place on the
beach results in a cost of c per unit traveled
45 46
12
Spatial Differentiation Spatial Differentiation
The coordinate of point E is
L
pB pA cy
a x y b
x
c
pB pA
a+x+y+b=L x Lab x
c
1 p pA
x L a b B
A E B 2 c
1 p pB
y L a b A
2 c
49 50
51 52
13
Spatial Differentiation Spatial Differentiation
These can be solved to yield:
L
ab
pA c L a x y b
3
14
Entry Entry
Whether firms in an oligopolistic If firms are price takers:
industry with free entry will be directed P = MR = MC for profit maximization, P =
to the point of minimum average cost AC for zero profits, so production takes
place at MC = AC
depends on the nature of the demand
facing them If firms have some control over price:
each firm will face a downward-sloping
demand curve
entry may reduce profits to zero, but
production at minimum average cost is not
57 ensured 58
q q* qm Quantity ci = 9 + 4qi
59 60
15
Monopolistic Competition Monopolistic Competition
Each firm also faces a demand curve To find the equilibrium n, we must
for its product of the form: examine each firms profit-maximizing
303 choice of pi
qi 0.01(n 1)pi 0.01 p j
j i n Because
We will define an equilibrium for this i = piqi ci
industry to be a situation in which prices the first-order condition for a maximum is
must be equal i 303
0.02(n 1)pi 0.01 p j 0.04(n 1) 0
pi = pj for all i and j pi j i n
61 62
Applying the equilibrium condition that pi Substituting in the expression for pi, we
= pj yields find that
pi
30,300
4 30,300 303 4(303) 4(303)
9
(n 1)n n 2 (n 1) n n
P approaches MC (4) as n gets larger 63
n 101 64
16
Monopolistic Competition Monopolistic Competition
The final equilibrium is If each firm faces a similar demand
pi = pj = 7 function, this equilibrium is sustainable
qi = 3 no firm would find it profitable to enter this
i = 0 industry
In this equilibrium, each firm has pi = ACi, But what if a potential entrant adopted a
but pi > MCi = 4 large-scale production plan?
Because ACi = 4 + 9/qi, each firm has the low average cost may give the potential
entrant considerable leeway in pricing so as
diminishing AC throughout all output to tempt customers of existing firms to
ranges 65 switch allegiances 66
17
Perfectly Contestable Market Perfectly Contestable Market
This market would be unsustainable
in a perfectly contestable market
Therefore, to be perfectly contestable,
Price MC
Because P > MC, a the market must be such that firms earn
AC potential entrant can take zero profits and price at marginal costs
one zero-profit firms
P* market away and firms will produce at minimum average cost
encroach a bit on other P = AC = MC
P
firms markets where, at
the margin, profits are Perfect contestability guides market
d
attainable equilibrium to a competitive-type result
mr mr d
q q* q Quantity
69 70
n = Q*/q*
D
this number may be relatively small (unlike
Quantity
the perfectly competitive case) q* 2q* 3q* Q*=4q*
71 72
18
Barriers to Entry Barriers to Entry
If barriers to entry prevent free entry and The completely flexible type of hit-and-
exit, the results of this model must be run behavior assumed in the contestable
modified markets theory may be subject to barriers
barriers to entry can be the same as those to entry
that lead to monopolies or can be the result some types of capital investments may not
of some of the features of oligopolistic be reversible
markets demanders may not respond to price
product differentiation differentials quickly
strategic pricing decisions
73 74
19
A Contestable Natural A Contestable Natural
Monopoly Monopoly
If there are no entry barriers, a potential If electricity production is fully
entrant can offer electricity customers a contestable, the only price viable under
lower price and still cover costs threat of potential entry is average cost
this monopoly solution might not represent Q = 1,000 - 5P = 1,000 5(AC)
a viable equilibrium
Q = 1,000 - 5[100 + (8,000/Q)]
Q2 - 500Q + 40,000 = 0
(Q - 400)(Q - 100) = 0
77 78
20
Important Points to Note: Important Points to Note:
In markets with few firms, output and The Cournot model provides a
price decisions are interdependent tractable approach to oligopoly
each firm must consider its rivals markets, but neglects important
decisions strategic issues
modeling such interdependence is
difficult because of the need to consider
conjectural variations
81 82
83 84
21
Allocation of Time
Individuals must decide how to allocate
Chapter 16 the fixed amount of time they have
We will initially assume that there are
LABOR MARKETS only two uses of an individuals time
engaging in market work at a real wage
rate of w
leisure (nonwork)
1
Utility Maximization Utility Maximization
The individuals problem is to maximize Dividing the two, we get
utility subject to the full income constraint
U / c
Setting up the Lagrangian w MRS (h for c )
U / h
L = U(c,h) + (24w c wh)
To maximize utility, the individual should
The first-order conditions are choose to work that number of hours for
L/c = U/c - = 0 which the MRS (of h for c) is equal to w
L/h = U/h - = 0 to be a true maximum, the MRS (of h for c)
must be diminishing
5 6
2
Income and A Mathematical Analysis
Consumption Substitution Effects of Labor Supply
The substitution effect is the movement
from point A to point C We will start by amending the budget
The income effect is the movement constraint to allow for the possibility of
from point C to point B nonlabor income
B The individual c = wl + n
C
A chooses more
U2
leisure as a result Maximization of utility subject to this
U1
of the increase in constraint yields identical results
w
Leisure
as long as n is unaffected by the labor-
leisure choice
substitution effect < income effect 9 10
3
Dual Statement of the Problem Dual Statement of the Problem
A small change in w will change the This means that a labor supply
minimum expenditures required by function can be calculated by partially
E/w = -l differentiating the expenditure function
this is the extent to which labor earnings because utility is held constant, this
are increased by the wage change function should be interpreted as a
compensated (constant utility) labor
supply function
lc(w,U)
13 14
4
Cobb-Douglas Labor Supply Cobb-Douglas Labor Supply
Suppose that utility is of the form The Lagrangian expression for utility
maximization is
U c h
L = ch + (w + n - wh - c)
The budget constraint is
First-order conditions are
c = wl + n
L/c = c-h - = 0
and the time constraint is
L/h = ch- - w = 0
l+h=1
note that we have set maximum work time L/ = w + n - wh - c = 0
to 1 hour for convenience 17 18
5
Cobb-Douglas Labor Supply Cobb-Douglas Labor Supply
21 22
6
CES Labor Supply Market Supply Curve for Labor
To derive the market supply curve for labor, we sum
Solving for leisure gives the quantities of labor offered at every wage
w n
h Individual As
w w 1 w supply curve w Individual Bs w
sA supply curve Total labor S
and sB supply curve
w*
w 1 n
l(w, n ) 1 h
w w 1
lA* l lB* l l* l
lA* + lB* = l*
25 26
l l l
7
Labor Market Equilibrium Mandated Benefits
At w*, the quantity of labor demanded is
equal to the quantity of labor supplied A number of new laws have mandated
real wage
At any wage above w*, the quantity
that employers provide special benefits
S
of labor demanded will be less to their workers
than the quantity of labor supplied health insurance
At any wage below w*, the quantity paid time off
w*
of labor demanded will be greater minimum severance packages
than the quantity of labor supplied
D
The effects of these mandates depend
l* quantity of labor on how much the employee values the
29 benefit 30
8
Mandated Benefits Mandated Benefits
Equilibrium in the labor market then If workers derive no value from the
requires that mandated benefits (k = 0), the mandate
a + b(w + k) = c d(w + t) is just like a tax on employment
This means that the net wage is similar results will occur as long as k < t
c a bk dt bk dt If k = t, the new wage falls precisely by
w ** w * the amount of the cost and the
bd bd bd
equilibrium level of employment does not
change
33 34
35 36
9
Wage Variation Wage Variation
Human Capital Compensating Differentials
differences in human capital translate into individuals prefer some jobs to others
differences in worker productivities desirable job characteristics may make a
workers with greater productivities would be person willing to take a job that pays less
expected to earn higher wages than others
while the investment in human capital is jobs that are unpleasant or dangerous will
similar to that in physical capital, there are require higher wages to attract workers
two differences these differences in wages are termed
investments are sunk costs compensating differentials
opportunity costs are related to past investments
37 38
10
Monopsony in the Monopsony in the
Labor Market Labor Market
Note that the quantity of
If the total cost of labor is wl, then Wage
MEl
labor demanded by this
firm falls short of the
wl w level that would be hired
MEl w l S
in a competitive labor
l l market (l*)
In the competitive case, w/l = 0 and w*
The wage paid by the
MEl = w w1 firm will also be lower
than the competitive
If w/l > 0, MEl > w D
level (w*)
Labor
l1 l*
41 42
11
Labor Unions Labor Unions
If association with a union was wholly We will assume that the goals of the
voluntary, we can assume that every union are representative of the goals of
member derives a positive benefit its members
With compulsory membership, we In some ways, we can use a monopoly
cannot make the same claim model to examine unions
even if workers would benefit from the the union faces a demand curve for labor
union, they may choose to be free riders as the sole supplier, it can choose at which
point it will operate
this point depends on the unions goals
45 46
12
Labor Unions Modeling a Union
The union may wish to maximize the total
Wage
employment of its members A monopsonistic hirer of coal miners
This occurs where faces a supply curve of
S D=S l = 50w
l3 workers will be
w3
hired and paid a
Assume that the monopsony has a
wage of w3 MRPL curve of the form
D MRPl = 70 0.1l
MR
Labor The monopsonist will choose to hire 500
l3
workers at a wage of $10
49 50
51 52
13
A Union Bargaining Model A Union Bargaining Model
This two-stage game can be solved by Assuming that l* solves the firms
backward induction problem, the unions goal is to choose w
The firms second-stage problem is to to maximize utility
maximize its profits: U(w,l) = U[w,l*(w)]
= R(l) wl and the first-order condition for a
The first-order condition for a maximum is maximum is
U1 + U2l = 0
R(l) = w
U1/U2 = l
53 54
55 56
14
Important Points to Note: Important Points to Note:
An increase in the real wage rate A competitive labor market will
creates income and substitution establish an equilibrium real wage
effects that operate in different rate at which the quantity of labor
directions in affecting the quantity of supplied by individuals is equal to the
labor supplied quantity demanded by firms
this result can be summarized by a
Slutsky-type equation much like the
one already derived in consumer
theory
57 58
59 60
15
Properties of Information
Information is not easy to define
Chapter 18 it is difficult to measure the quantity of
information obtainable from different
THE ECONOMICS OF actions
INFORMATION there are too many forms of useful
information to permit the standard price-
quantity characterization used in supply
and demand analysis
1
The Value of Information The Value of Information
Assume an individual forms subjective Assume that information can be
opinions about the probabilities of two measured by the number of messages
states of the world (m) purchased
good times (probability = g) and bad g and b will be functions of m
times (probability = b)
Information is valuable because it helps
the individual revise his estimates of
these probabilities
5 6
2
The Value of Information The Value of Information
First-order conditions for a constrained
maximum are: The first two equations show that the
individual will maximize utility at a point
L dWg dWb where the subjective ratio of expected
gU ' (Wg ) bU ' (Wb )
m dm dm marginal utilities is equal to the price
d g d b dWg ratio (pg /pb)
U (Wg ) U (Wb ) pg
dm dm dm The last equation shows the utility-
dWb
pb pm 0 maximizing level of information to buy
dm
9 10
3
Moral Hazard Moral Hazard
Moral hazard is the effect of insurance Suppose a risk-averse individual faces
coverage on individuals decisions to the risk of a loss (l) that will lower
take activities that may change the wealth
likelihood or size of losses the probability of a loss is
parking an insured car in an unsafe area this probability can be lowered by the
choosing not to install a sprinkler system in amount the person spends on preventive
an insured home measures (a)
13 14
4
Behavior with Insurance Behavior with Insurance
and Perfect Monitoring and Perfect Monitoring
Suppose that the individual may purchase The person can maximize expected utility
insurance (premium = p) that pays x if a by choosing x such that W 1 = W 2
loss occurs The first-order condition is
Wealth in each state becomes
E
W1 = W 0 - a - p (1 )U ' (W1 )1 l U (W1 )
a a a
W2 = W 0 - a - p - l + x
A fair premium would be equal to U ' (W2 )1 l U (W2 ) 0
a a
p = x 17 18
5
Moral Hazard Adverse Selection
In the simplest case, the insurer might set Individuals may have different probabilities
a premium based on the average of experiencing a loss
probability of loss experienced by some If individuals know the probabilities more
group of people accurately than insurers, insurance
no variation in premiums allowed for specific markets may not function properly
precautionary activities
it will be difficult for insurers to set premiums
each individual would have an incentive to reduce
his level of precautionary activities
based on accurate measures of expected loss
21 22
W* W1 W* W1
23 24
6
Adverse Selection Adverse Selection
The lines show the market opportunities for each If insurers have imperfect information
person to trade W 1 for W2 by buying fair insurance
W2 about which individuals fall into low- and
certainty line
high-risk categories, this solution is
F
slope
(1 l ) unstable
l
G point F provides more wealth in both states
The low-risk person will
W*- l E
high-risk individuals will want to buy
maximize utility at point
slope
(1 H )
F, while the high-risk insurance that is intended for low-risk
H
person will choose G individuals
W* W1 insurers will lose money on each policy sold
25 26
W* W1 W* W1
27 28
7
Adverse Selection Adverse Selection
Suppose that insurers offer policy G. High-risk
individuals will opt for full insurance.
If a market has asymmetric information,
W2
the equilibria must be separated in certainty line
Insurers cannot offer
some way F
any policy that lies
high-risk individuals must have an above UH because
UH
incentive to purchase one type of G they cannot prevent
insurance, while low-risk purchase another W*- l E
high-risk individuals
from taking advantage
of it
W* W1
29 30
8
Adverse Selection The Principal-Agent
Relationship
Market signals can be drawn from a
number of sources One important way in which asymmetric
the economic behavior must accurately information may affect the allocation of
reflect risk categories resources is when one person hires
the costs to individuals of taking the another person to make decisions
signaling action must be related to the patients hiring physicians
probability of loss investors hiring financial advisors
car owners hiring mechanics
stockholders hiring managers
33 34
9
The Principal-Agent The Principal-Agent
Relationship Relationship
Profits Profits
If the manager is also the The owner-manager maximizes
owner of the firm, he will profit because any other owner-
maximize his utility at manager will also want b* in
profits of * and benefits of benefits
b*
* * b* represents a true
cost of doing business
U1 U1
Owners constraint Owners constraint
Benefits Benefits
b* b*
37 38
10
The Principal-Agent The Principal-Agent
Relationship Relationship
Profits
Given the managers budget
The firms owners are harmed by having
constraint, he will maximize
utility at benefits of b** to rely on an agency relationship with
Agents constraint
the firms manager
*
Profits for the The smaller the fraction of the firm that
**
U2 firm will be *** is owned by the manager, the greater
***
U1
the distortions that will be induced by
Owners constraint
Benefits
this relationship
b* b**
41 42
11
Using the Corporate Jet Using the Corporate Jet
Because jet use is expensive, = 800 If the directors find it difficult to monitor
(thousand) if j =0 and = 162 if j =1 the CEOs jet usage, this could mean
the directors will be willing to pay the new that the firm ends up with < 0
CEO up to 638 providing that they can The owners may therefore want to
guarantee that he will not use the
create a contract where the
corporate jet for personal use
compensation of the new CEO is tied to
a salary of more than 400 will just be
profit
sufficient to get a potential candidate to
accept the job without jet usage
45 46
12
The Owner-Manager The Owner-Manager
Relationship Relationship
One option would be to pay no The manager will choose a* and receive
compensation unless the manager an income that just covers costs
chooses a* and to pay an amount equal to IM = s(a*) c(a*) c0 = (a*) f c(a*) c0 = 0
c(a*) + c0 if a* is chosen
This compensation plan makes the agent
Another possible scheme is s(a) = (a) f, the residual claimant to the firms profits
where f = (a) c(a*) c0
with this compensation package, the
managers income is maximized by setting
s(a)/a = /a = 0 49 50
13
Hidden Action Hidden Information
Because owners observe only and not When the principal does not know the
, they can only use actual profits in their incentive structure of the agent, the
compensation function incentive scheme must be designed
a risk averse manager will be concerned that using some initial assumptions about the
actual profits will turn out badly and may agents motivation
decline the job will be adapted as new information becomes
The owner might need to design a available
compensation scheme that allows for
profit-sharing
53 54
55 56
14
Important Points to Note: Important Points to Note:
The presence of asymmetric If insurers are unable to monitor the
information may affect a variety of behavior of insured individuals
market outcomes, many of which are accurately, moral hazard may arise
illustrated in the context of insurance being insured will affect the willingness to
theory make precautionary expenditures
insurers may have less information such behavioral effects can arise in any
about potential risks than do insurance contractual situation in which monitoring
purchasers costs are high
57 58
15
Externality
An externality occurs whenever the
Chapter 19 activities of one economic agent affect
the activities of another economic agent
EXTERNALITIES AND in ways that are not reflected in market
PUBLIC GOODS transactions
chemical manufacturers releasing toxic
fumes
noise from airplanes
motorists littering roadways
Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2
1
Externalities in Utility Public Goods Externalities
Externalities can also occur if the Public goods are nonexclusive
activities of an economic agent directly once they are produced, they provide
affect an individuals utility benefits to an entire group
externalities can decrease or increase it is impossible to restrict these benefits to
utility the specific groups of individuals who pay
It is also possible for someones utility to for them
be dependent on the utility of another
utility = US(x1,,xn;UJ)
5 6
2
Externalities and Allocative Externalities and Allocative
Inefficiency Inefficiency
Assume that good x is produced using For example, y could be produced
only good y according to downriver from x and thus firm y must
xo = f(yi) cope with any pollution that production of
Assume that the output of good y x creates
depends on both the amount of x used in This implies that g1 > 0 and g2 < 0
the production process and the amount
of x produced
yo = g(xi,xo)
9 10
11 12
3
Finding the Efficient Allocation Finding the Efficient Allocation
The six first-order conditions are Taking the ratio of the first two, we find
L/xc = U1 + 3 = 0 MRS = U1/U2 = 3/4
The third and sixth equation also imply
L/yc = U2 + 4 = 0
that
L/xi = 2g1 + 3 = 0 MRS = 3/4 = 2g1/2 = g1
L/yi = 1fy + 4 = 0 Optimality in y production requires that
L/xo = -1 + 2g2 - 3 = 0
the individuals MRS in consumption
equals the marginal productivity of x in
L/yo = -2 - 4 = 0 13 the production of y 14
4
Inefficiency of the Inefficiency of the
Competitive Allocation Competitive Allocation
Reliance on competitive pricing will result But the producer of x would choose y
in an inefficient allocation of resources input so that
A utility-maximizing individual will opt for Py = Pxfy
MRS = Px/Py Px/Py = 1/fy
and the profit-maximizing producer of y This means that the producer of x would
would choose x input according to disregard the externality that its
Px = Pyg1 production poses for y and will
17
overproduce x 18
5
Production Externalities Production Externalities
Assuming that newsprint sells for $1 per
foot and workers earn $50 per day, firm When firm x does have a negative
x will maximize profits by setting this externality ( < 0), its profit-maximizing
wage equal to the labors marginal decision will be unaffected (lx* = 400
product and x* = 40,000)
x But the marginal product of labor will be
50 p 1,000lx0.5
lx lower in firm y because of the externality
lx* = 400
If = 0 (no externalities), ly* = 400 21 22
6
Production Externalities Production Externalities
Total output increased with no change If firm x was to hire one more worker, its
in total labor input own output would rise to
The earlier market-based allocation x = 2,000(401)0.5 = 40,050
was inefficient because firm x did not the private marginal value product of the
take into account the effect of its hiring 401st worker is equal to the wage
decisions on firm y But, increasing the output of x causes
the output of y to fall (by about 21 units)
The social marginal value product of the
25
additional worker is only $29 26
7
Solutions to the A Pigouvian Tax on Newsprint
Externality Problem
Price MC
A tax equal to these A suitably chosen tax on firm x can
additional marginal cause it to reduce its hiring to a level at
S = MC costs will reduce
output to the socially which the externality vanishes
p2
optimal level (x2) Because the river can handle pollutants
tax The price paid for the with an output of x = 38,000, we might
good (p2) now consider a tax that encourages the firm
reflects all costs to produce at that level
D
Quantity of x
x2
29 30
8
Taxation in the General Taxation in the General
Equilibrium Model Equilibrium Model
With the optimal tax, firm x now faces a The Pigouvian tax scheme requires that
net price of (px - t) and will choose y regulators have enough information to
input according to set the tax properly
py = (px - t)fy in this case, they would need to know firm
ys production function
The resulting allocation of resources will
achieve
MRS = px/py = (1/fy) + t/py = (1/fy) - g2
33 34
9
Pollution Rights The Coase Theorem
The first-order condition for a maximum The key feature of the pollution rights
is equilibrium is that the rights are well-
y/xo = pyg2 + r = 0
defined and tradable with zero
r = -pyg2 transactions costs
The equilibrium solution is identical to The initial assignment of rights is
that for the Pigouvian tax irrelevant
from firm xs point of view, it makes no subsequent trading will always achieve the
difference whether it pays the fee to the same, efficient equilibrium
government or to firm y 37 38
39 40
10
The Coase Theorem Attributes of Public Goods
The independence of initial rights A good is exclusive if it is relatively easy
assignment is usually referred to as the to exclude individuals from benefiting
Coase Theorem from the good once it is produced
in the absence of impediments to making
A good is nonexclusive if it is
bargains, all mutually beneficial
transactions will be completed impossible, or very costly, to exclude
if transactions costs are involved or if individuals from benefiting from the
information is asymmetric, initial rights good
assignments will matter
41 42
11
Public Good Public Goods and
Resource Allocation
A good is a pure public good if, once We will use a simple general equilibrium
produced, no one can be excluded from model with two individuals (A and B)
benefiting from its availability and if the There are only two goods
good is nonrival -- the marginal cost of good y is an ordinary private good
an additional consumer is zero each person begins with an allocation (yA* and
yB*)
good x is a public good that is produced
using y
x = f(ysA + ysB)
45 46
12
Public Goods and Public Goods and
Resource Allocation Resource Allocation
The first-order conditions for a maximum We can now derive the optimality
are condition for the production of x
L/ysA = U1Af - U2A + U1Bf = 0 From the initial first-order condition we
know that
L/ysB = U1Af - U2B + U1Bf = 0
U1A/U2A + U1B/U2B = 1/f
Comparing the two equations, we find
MRSA + MRSB = 1/f
U2B = U2A
The MRS must reflect all consumers
49
because all will get the same benefits 50
Failure of a Failure of a
Competitive Market Competitive Market
Production of x and y in competitive For public goods, the value of producing
markets will fail to achieve this allocation one more unit is the sum of each
with perfectly competitive prices px and py, consumers valuation of that output
each individual will equate his MRS to px/py individual demand curves should be added
the producer will also set 1/f equal to px/py vertically rather than horizontally
to maximize profits Thus, the usual market demand curve
the price ratio px/py will be too low will not reflect the full marginal valuation
it would provide too little incentive to produce x
51 52
13
Inefficiency of a Inefficiency of a
Nash Equilibrium Nash Equilibrium
Suppose that individual A is thinking The first-order condition for a maximum
about contributing sA of his initial y is
endowment to the production of x U1Af - U2A = 0
The utility maximization problem for A is U1A/U2A = MRSA = 1/f
then Because a similar argument can be
choose sA to maximize UA[f(sA + sB),yA - sA] applied to B, the efficiency condition will
fail to be achieved
each person considers only his own benefit
53 54
14
The Roommates Dilemma The Roommates Dilemma
If person 1 believes that person 2 will We can show that this solution is
not buy any paintings, he could choose inefficient by calculating each persons
to purchase one and receive utility of MRS
U1(x,y1) = 11/3(1,000)2/3 = 100 U i / x y
MRSi i
while person 2s utility will be U i / y i 2 x
U2(x,y2) = 11/3(1,500)2/3 = 131 At the allocations described,
Person 2 has gained from his free-riding MRS1 = 1,000/2 = 500
position MRS2 = 1,500/2 = 750
57 58
15
The Roommates Dilemma Lindahl Pricing of
Public Goods
Substituting into the budget constraint, Swedish economist E. Lindahl
we get suggested that individuals might be
0.20(y1 + y2) + 100x = 600 willing to be taxed for public goods if they
x=2 knew that others were being taxed
y1 + y2 = 2,000 Lindahl assumed that each individual would
The allocation of the cost of the be presented by the government with the
proportion of a public goods cost he was
paintings depends on how each expected to pay and then reply with the
roommate plays the strategic financing level of public good he would prefer
game 61 62
16
Lindahl Pricing of Shortcomings of the
Public Goods Lindahl Solution
An equilibrium would occur when The incentive to be a free rider is very
A+B = 1 strong
the level of public goods expenditure this makes it difficult to envision how the
favored by the two individuals precisely information necessary to compute
generates enough tax contributions to pay equilibrium Lindahl shares might be
for it computed
MRSA + MRSB = (A + B)/f = 1/f individuals have a clear incentive to understate
their true preferences
65 66
67 68
17
Important Points to Note: Important Points to Note:
Public goods provide benefits to Private markets will tend to
individuals on a nonexclusive basis - underallocate resources to public
no one can be prevented from goods because no single buyer can
consuming such goods appropriate all of the benefits that
such goods are usually nonrival in that such goods provide
the marginal cost of serving another
user is zero
69 70
71
18