2646140886bahan Kuliah Teori Ekonomi Mikro PDF

TEORI EKONOMI MIKRO
DOSEN:
DR. ARDITO BHINADI, SE., M.SI
JURUSAN ILMU EKONOMI, FAKULTAS EKONOMI,

UPN VETERAN YOGYAKARTA
2013
RANCANGAN PEMBELAJARAN SEMESTER ( RPS)
Program Studi /Jurusan : EKONOMI PEMBANGUNAN/ILMU EKONOMI

Matakuliah / Kode : TEORI EKONOMI MIKRO /
SKS / Semester : 3 (tiga x 50 menit)/ II (dua)
Mata Kuliah Prasyarat : Ekonomi Mikro Pengantar
Dosen : Dr. H. Ardito Bhinadi, M.Si
I.Deskripsi Mata Kuliah:

Matakuliah ini membahas sejumlah teori ekonomi mikro dari teori konsumen, teori produsen,
berbagai bentuk pasar dan eksternalitas.
II.Kompetensi Umum :
Pada akhir perkuliahan mahasiswa diharapkan mampu memahami dan menjelaskan model-model
ekonomi, pilihan dan permintaan, produksi dan penawaran, pasar kompetitif, kekuatan pasar,
penetapan harga di pasar input, dan kegagalan pasar.
III. Analisis Instruksional

Terlampir
IV. Strategi Pembelajaran :

Pembelajaran menggunakan metoda ceramah dan diskusi dengan harapan muncul sensitifitas
mahasiswa terhadap masalah mikro ekonomi. Materi perkuliahan didasarkan pada beberapa buku
dan studi kasus yang harus difahami oleh mahasiswa. Dosen menyampaikan materi dalam bentuk
dalam power point. Media yang digunakan adalah papan tulis, LCD, dan Laptop.
V. Rencana Pembelajaran Mingguan
Pertemuan Kompetensi Pokok/Sub-pokok Metoda Media Metoda Referensi

Ke Bahasan Pembelajaran Pembelajaran Evaluasi
Mahasiswa Model-Model Ceramah dan Papan tulis, Pertanyaan Ch1
1 mampu Ekonomi diskusi LCD, Laptop, kuis/umpan
(Satu) memahami balik
berbagai model
ekonomi.
Mahasiswa Preferensi dan Mahasiswa Papan tulis, Pertanyaan Ch 3
2 mampu Utilitas Presentasi, LCD, Laptop, kuis/umpan
(Dua) memahami Ceramah dan balik
preferensi dan diskusi
utilitas
konsumen.
Mahasiswa Efek Substitusi dan Mahasiswa Papan tulis, Pertanyaan Ch 5
3 mampu efek Pendapatan Presentasi, LCD, Laptop, kuis/umpan
(Tiga) substitusi dan Ceramah dan balik
pendapatan. diskusi
Mahasiswa Hubungan Mahasiswa Papan tulis, Pertanyaan Ch 6

4 mampu Permintaan Antar Presentasi, LCD, Laptop, kuis/umpan
(Empat) memahami Barang Ceramah dan balik
hubungan diskusi
permintaan antar
barang.
1
Mahasiswa Fungsi-Fungsi Mahasiswa Papan tulis, Pertanyaan Ch 9
5 mampu Produksi Presentasi, LCD, Laptop, kuis/umpan
(Lima) memahami Ceramah dan balik
fungsi-fungsi diskusi
produksi
Mahasiswa Fungsi-Fungsi Mahasiswa Papan tulis, Pertanyaan Ch 10
6 mampu Biaya. Presentasi, LCD, Laptop, kuis/umpan
(Enam) memahami Ceramah dan balik
fungsi-fungsi diskusi
biaya.
Mahasiwa Maksimisasi Laba Mahasiswa Papan tulis, Pertanyaan Ch 11
7 mampu Presentasi, LCD, Laptop umpan balik
(Tujuh) menghitung Ceramah dan
maksimisasi Diskusi
laba.
Ujian Tengah Semester
Pertemuan Kompetensi Pokok/Sub-pokok Metoda Media Metoda Referensi
Ke Bahasan Pembelajaran Pembelajaran Evaluasi
Mahasiwa Model Persaingan Diskusi dan Papan tulis, Pertanyaan Ch 12
8 mampu Keseimbangan Kuis LCD, Laptop umpan balik
(Delapan) memahami Parsial
model
persaingan
keseimbangan
parsial.
Mahasiwa Keseimbangan Diskusi dan Papan tulis, Pertanyaan Ch 13
9 mampu Umum dan Kuis LCD, Laptop umpan balik
(Sembilan) memahami Kesejahteraan
keseimbangan
umum dan
kesejahteraan.
Mahasiwa Monopoli Diskusi dan Papan tulis, Pertanyaan Ch 14
10 mampu Kuis LCD, Laptop umpan balik
(Sepuluh) memahami
monopoli.
Mahasiwa Persaingan Tidak Diskusi dan Papan tulis, Pertanyaan Ch 15
11 mampu Sempurna Kuis LCD, Laptop umpan balik
(Sebelas) memahami
persaingan tidak
sempurna.
Mahasiwa Pasar Tenaga Kerja Diskusi dan Papan tulis, Pertanyaan Ch 16
(Dua Belas) memahami pasar
tenaga kerja
Mahasiwa Asimetris Informasi Diskusi dan Papan tulis, Pertanyaan Ch 18
(Tiga Belas) memahami
informasi
asimetris.
2
Mahasiwa Eksternalitas dan Diskusi dan Papan tulis, Pertanyaan Ch 19
14 mampu Barang Publik Kuis LCD, Laptop umpan balik
(Empat memahami
Belas) eksternalitas dan
barang publik.
Ujian Akhir Semester
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
1.Ujian Tengah Semester = 30%

2.Ujian Akhir Semester = 30%
3.Partisipasi Kelas = 20%
4.Tugas-Tugas = 20%
3
Microeconomic Theory Chapter 1
Basic Principles and Extensions, 9e
By ECONOMIC MODELS
WALTER NICHOLSON
Slides prepared by
Linda Ghent
Eastern Illinois University
Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2
Theoretical Models Verification of Economic Models

Economists use models to describe There are two general methods used to
economic activities verify economic models:
direct approach
While most economic models are establishes the validity of the models
assumptions
abstractions from reality, they provide
aid in understanding economic behavior indirect approach
shows that the model correctly predicts real-
world events
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
Ceteris Paribus Assumption Optimization Assumptions

Ceteris Paribus means other things the Many economic models begin with the
same assumption that economic actors are
Economic models attempt to explain rationally pursuing some goal
simple relationships consumers seek to maximize their utility
focus on the effects of only a few forces at a firms seek to maximize profits (or minimize
time costs)
other variables are assumed to be unchanged government regulators seek to maximize
during the period of study public welfare
7 8
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
The Economic Theory of Value The Economic Theory of Value

Early Economic Thought The Founding of Modern Economics
value was considered to be synonymous the publication of Adam Smiths The Wealth of
with importance Nations is considered the beginning of modern
since prices were determined by humans, economics
it was possible for the price of an item to distinguishing between value and price
differ from its value continued (illustrated by the diamond-water
prices > value were judged to be unjust paradox)
the value of an item meant its value in use
the price of an item meant its value in exchange
11 12
3
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
The Economic Theory of Value Supply-Demand Equilibrium

Marshallian Supply-Demand Synthesis Price
Alfred Marshall showed that supply and demand Equilibrium

QD = Qs
S
The supply curve has a positive
simultaneously operate to determine price slope because marginal cost
rises as quantity increases
prices reflect both the marginal evaluation that
P*
consumers place on goods and the marginal
The demand curve has a
costs of producing the goods negative slope because
water has a low marginal value and a low marginal D
the marginal value falls as
cost of production Low price quantity increases
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
1000 - 100p = -125 + 125p Equilibrium qD = qS

225p = 1125
a + bp = c + dp
p* = 5
q* = 500 ac
p*
17 d b 18
Supply-Demand Equilibrium Supply-Demand Equilibrium

An increase in demand...
A shift in demand will lead to a new equilibrium: Price
S
leads to a rise in the
QD = 1450 - 100P equilibrium price and
7 quantity.
QD = 1450 - 100P = QS = -125 + 125P
5
225P = 1575
P* = 7 D
Q* = 750 D
500 750 Quantity per period

19 20
5
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
A Production Possibility Frontier A Production Possibility Frontier

Quantity of food
(weekly)
Opportunity cost of The production possibility frontier
clothing = 1/2 pound of food
reminds us that resources are scarce
10
9.5 Scarcity means that we must make
Opportunity cost of choices
clothing = 2 pounds of food
each choice has opportunity costs
4
2
the opportunity costs depend on how much

of each good is produced
3 4 12 13 Quantity of clothing
(weekly)
23 24
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
The Economic Theory of Value Modern Tools

Welfare Economics Clarification of the basic behavioral
tools used in general equilibrium analysis have
assumptions about individual and firm
been used for normative analysis concerning behavior
the desirability of various economic outcomes Creation of new tools to study markets
economists Francis Edgeworth and Vilfredo Pareto Incorporation of uncertainty and imperfect
helped to provide a precise definition of economic
information into economic models
efficiency and demonstrated the conditions under
which markets can attain that goal Increasing use of computers to analyze
data
27 28
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

The supply-demand model is only a Testing the validity of a model is a
partial-equilibrium model difficult task
a general equilibrium model is needed to are the models assumptions
look at many markets together reasonable?
does the model explain real-world
events?
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
Axioms of Rational Choice Axioms of Rational Choice

Transitivity Continuity
if A is preferred to B, and B is preferred to if A is preferred to B, then situations suitably
C, then A is preferred to C close to A must also be preferred to B
assumes that the individuals choices are used to analyze individuals responses to
internally consistent relatively small changes in income and
prices
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
Marginal Rate of Substitution Marginal Rate of Substitution

The negative of the slope of the MRS changes as x and y change
indifference curve at any point is called reflects the individuals willingness to trade y
the marginal rate of substitution (MRS) for x
Quantity of y Quantity of y At (x1, y1), the indifference curve is steeper.
The person would be willing to give up more
dy y to gain additional units of x
MRS
dx U U1 At (x2, y2), the indifference curve
is flatter. The person would be
y1 y1 willing to give up less y to gain
additional units of x
y2 U1 y2 U1
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
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)
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
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
Solving for MRS = -dy/dx:

MRS = -dy/dx = 100/x2
17 18
Marginal Utility Deriving the MRS

Suppose that an individual has a utility Therefore, we get:
function of the form
U
utility = U(x,y)
x
dy
MRS
The total differential of U is dx Uconstant
U
U U y
dU dx dy
x y MRS is the ratio of the marginal utility of
x to the marginal utility of y
Along any indifference curve, utility is
constant (dU = 0)
19 20
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
Convexity of Indifference Convexity of Indifference

Curves Curves
If the utility function is
Thus,
U(x,y) = x + xy + y
U * 0.5 There is no advantage to transforming
this utility function, so
MRS x x
y
U * 0.5 x
U
y y 1 y
MRS x
U 1 x
y
23 24
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
Examples of Utility Functions Examples of Utility Functions

Cobb-Douglas Utility Perfect Substitutes
utility = U(x,y) = xy utility = U(x,y) = x + y
where and are positive constants Quantity of y
The indifference curves will be linear.
The relative sizes of and indicate the The MRS will be constant along the
indifference curve.
relative importance of the goods
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
Examples of Utility Functions Homothetic Preferences

CES Utility (Constant elasticity of If the MRS depends only on the ratio of
substitution) the amounts of the two goods, not on
The elasticity of substitution () is equal to the quantities of the goods, the utility
1/(1 - ) function is homothetic
Perfect substitutes = Perfect substitutes MRS is the same at
Fixed proportions = 0 every point
Perfect complements MRS = if y/x >
/, undefined if y/x = /, and MRS = 0 if
y/x < /
31 32
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
The Many-Good Case The Many-Good Case

Suppose utility is a function of n goods We can find the MRS between any two
given by goods by setting dU = 0
utility = U(x1, x2,, xn) U U
dU 0 dxi dx j
The total differential of U is xi x j
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

If individuals obey certain behavioral The negative of the slope of the
postulates, they will be able to rank all indifference curve measures the marginal
commodity bundles rate of substitution (MRS)
the ranking can be represented by a utility the rate at which an individual would trade
function an amount of one good (y) for one more unit
in making choices, individuals will act as if of another good (x)
they were maximizing this function MRS decreases as x is substituted for y
Utility functions for two goods can be individuals prefer some balance in their
illustrated by an indifference curve map consumption choices
39 40
10
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)
Demand Functions Homogeneity

If there are only two goods (x and y), we If we were to double all prices and
can simplify the notation income, the optimal quantities demanded
will not change
x* = x(px,py,I)
the budget constraint is unchanged
y* = y(px,py,I)
xi* = di(p1,p2,,pn,I) = di(tp1,tp2,,tpn,tI)
Prices and income are exogenous
Individual demand functions are
the individual has no control over these homogeneous of degree zero in all prices
parameters
and income
3 4
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
Changes in Income Increase in Income

If both x and y increase as income rises,
An increase in income will cause the x and y are normal goods
budget constraint out in a parallel
fashion
Quantity of y
Since px/py does not change, the MRS As income rises, the individual chooses
to consume more x and y
will stay constant as the worker moves
to higher levels of satisfaction C
B
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
Note that the indifference

C
curves do not have to be
oddly shaped. The A good xi for which xi/I < 0 over some
B U3 assumption of a diminishing
MRS is obeyed. range of income is an inferior good in
A
U2
that range
U1
Quantity of x
9 10
Changes in a Goods Price Changes in a Goods Price

A change in the price of a good alters Even if the individual remained on the same
the slope of the budget constraint indifference curve when the price changes,
it also changes the MRS at the consumers
his optimal choice will change because the
utility-maximizing choices
MRS must equal the new price ratio
the substitution effect
When the price changes, two effects
come into play The price change alters the individuals
real income and therefore he must move
substitution effect
to a new indifference curve
income effect
the income effect
11 12
3
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

Quantity of y The income effect occurs because the Quantity of y
An increase in the price of good x means that
individuals real income changes when
the budget constraint gets steeper
the price of good x changes
The income effect is the movement The substitution effect is the
C
from point C to point B movement from point A to point C
B A
If x is a normal good, The income effect is the
A C B
U2 the individual will buy U1 movement from point C
more because real to point B
U1 U2
income increased
Substitution effect
Income effect
Income effect
15 16
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
Giffens Paradox A Summary

If the income effect of a price change is Utility maximization implies that (for normal
strong enough, there could be a positive goods) a fall in price leads to an increase in
relationship between price and quantity quantity demanded
demanded the substitution effect causes more to be
purchased as the individual moves along an
an increase in price leads to a drop in real indifference curve
income
the income effect causes more to be purchased
since the good is inferior, a drop in income because the resulting rise in purchasing power
causes quantity demanded to rise allows the individual to move to a higher
indifference curve
19 20
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
The Individuals Demand Curve The Individuals Demand Curve

An individuals demand for x depends Quantity of y As the price px
on preferences, all prices, and income: of x falls...
quantity of x
x* = x(px,py,I) demanded rises.
px
It may be convenient to graph the px
individuals demand for x assuming that px
income and the price of y (py) are held U2

U3
x
U1
constant
x1 x2 x3 x x x
23 I = px + py I = px + py I = px + py 24
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
Shifts in the Demand Curve Demand Functions and Curves

A movement along a given demand We discovered earlier that
curve is caused by a change in the price
of the good 0 .3 I 0.7 I
x* y*
a change in quantity demanded px py
A shift in the demand curve is caused by If the individuals income is $100, these
changes in income, prices of other functions become
goods, or preferences 30 70
x* y*
a change in demand px py
27 28
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
Compensated Demand Curves Compensated Demand Curves

An alternative approach holds real income A compensated (Hicksian) demand curve
(or utility) constant while examining shows the relationship between the price
reactions to changes in px of a good and the quantity purchased
the effects of the price change are
assuming that other prices and utility are
compensated so as to constrain the held constant
individual to remain on the same indifference The compensated demand curve is a two-
curve dimensional representation of the
reactions to price changes include only compensated demand function
substitution effects
x* = xc(px,py,U)
31 32
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
33 34
Compensated & Compensated &

Uncompensated Demand Uncompensated Demand
At prices above px2, income
px px
compensation is positive because the
individual needs some help to remain
on U2 At prices below px2, income
compensation is negative to prevent an
px increase in utility from a lower price
px px
x px x
xc xc
x x* Quantity of x x*** x Quantity of x
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
Compensated Demand Compensated Demand

Functions Functions
To obtain the compensated demand Vpy0.5 Vpx0.5
x y
functions, we can solve the indirect px0.5 py0.5
utility function for I and then substitute Demand now depends on utility (V)
into the Marshallian demand functions rather than income
Vpy0.5 Vpx0.5 Increases in px reduce the amount of x
x y
px0.5 py0.5 demanded
only a substitution effect
39 40
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
A Mathematical Examination A Mathematical Examination

of a Change in Price of a Change in Price
xc (px,py,U) = x[px,py,E(px,py,U)] x x c x E

px px E px
We can differentiate the compensated
demand function and get The first term is the slope of the
xc
x x E compensated demand curve
the mathematical representation of the
px px E px
substitution effect
x x c x E

px px E px 43 44
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
The Slutsky Equation The Slutsky Equation

The utility-maximization hypothesis
Note that E/px = x shows that the substitution and income
a $1 increase in px raises necessary effects arising from a price change can be
expenditures by x dollars
represented by
$1 extra must be paid for each unit of x
purchased x
substituti on effect income effect
px
x x x
x
px px U constant
I
47 48
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
A Slutsky Decomposition A Slutsky Decomposition

We can demonstrate the decomposition The Hicksian (compensated) demand
of a price effect using the Cobb-Douglas function for good x was
example studied earlier Vpy0.5
x c ( px , py ,V )
The Marshallian demand function for px0.5
good x was
The overall effect of a price change on
0 .5 I the demand for x is
x ( p x , py , I )
px
x 0 .5 I

px px2
51 52
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
A Slutsky Decomposition Marshallian Demand

Elasticities
Calculation of the income effect is easier
Most of the commonly used demand
x 0.5I 0.5 0.25I
elasticities are derived from the
income effect x Marshallian demand function x(px,py,I)
I px px px2
Price elasticity of demand (ex,px)
Interestingly, the substitution and income
x / x x px
effects are exactly the same size ex ,px
px / px px x
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
Price Elasticity and Total Price Elasticity and Total

Spending Spending
Total spending on x is equal to ( p x x ) x
px x x[ex,px 1]
total spending =pxx px px
Using elasticity, we can determine how The sign of this derivative depends on
total spending changes when the price of whether ex,px is greater or less than -1
x changes if ex,px > -1, demand is inelastic and price and
total spending move in the same direction
( p x x ) x
px x x[ex,px 1] if ex,px < -1, demand is elastic and price and
px px total spending move in opposite directions
59 60
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
Compensated Price Elasticities Compensated Price Elasticities

The compensated own price elasticity of The relationship between Marshallian
demand (exc,px) is and compensated price elasticities can
x c / x c x c px be shown using the Slutsky equation
exc,px
px / px px x c px x p x c px x
ex,px xc x
x px x px x I
The compensated cross-price elasticity
of demand (exc,py) is If sx = pxx/I, then
x c / x c x c py ex,px exc,px sx ex,I
e c

py / py py x c
x ,py
63 64
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
Homogeneity Engel Aggregation

Dividing by x, we get Engels law suggests that the income
elasticity of demand for food items is
0 ex,px ex,py ex,I
less than one
Any proportional change in all prices this implies that the income elasticity of
and income will leave the quantity of x demand for all nonfood items must be
demanded unchanged greater than one
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
Cournot Aggregation Demand Elasticities

I x y The Cobb-Douglas utility function is
0 px x py
px px px U(x,y) = xy (+=1)
x px x p y px y The demand functions for x and y are

0 px x x py
px I x I px I y
I I
x y
px py
0 s x ex,px s x sy ey ,px
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

We can also use the Slutsky equation to The CES utility function (with = 2,
derive the compensated price elasticity = 5) is
exc,px ex,px sx ex,I 1 (1) 1 U(x,y) = x0.5 + y0.5
The demand functions for x and y are
The compensated price elasticity
depends on how important other goods I I
(y) are in the utility function x y
px (1 px py1 ) py (1 px1py )
75 76
19
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

The CES utility function (with = 0.5, Thus, the share elasticity is given by
= -1) is s x px 0.5 py0.5 px1.5 px
es x ,px 0.5 0.5 2
0.5 0.5 1
U(x,y) = -x -1 - y -1 px s x (1 py px ) (1 py px )
The share of good x is 0.5 py0.5 px0.5

px x 1 1 py0.5 px0.5
sx 0.5 0.5
I 1 py px Again, if we let px = py
0.5
ex,px esx ,px 1 1 0.75
79 2 80
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)
expenditure at px1 = E1 = E(px1,py,U0)
81 82
Consumer Welfare Consumer Welfare

Suppose the consumer is maximizing
Quantity of y
utility at point A.
In order to compensate for the price rise,
this person would require a If the price of good x rises, the consumer
will maximize utility at point B.
compensating variation (CV) of
A
CV = E(px1,py,U0) - E(px0,py,U0) The consumers utility
B
U1
falls from U1 to U2
U2
Quantity of x
83 84
21
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

px
The amount of CV required can be found When the price rises from px0 to px1,
the consumer suffers a loss in welfare
by integrating across a sequence of
small increments to price from px0 to px1
welfare loss
px1
p1x p1x
CV dE x c ( px , py ,U0 )dpx px0
px0 px0
xc(pxU0)
this integral is the area to the left of the

compensated demand curve between px0 x1 x0
Quantity of x
and px1
87 88
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
The Consumer Surplus Consumer Welfare

Concept px When the price rises from px0 to px1, the actual
market reaction will be to move from A to C
The area below the compensated
demand curve and above the market The consumers utility falls from U0 to U1
price is called consumer surplus px1
C
the extra benefit the person receives by px 0

A
being able to make market transactions at x(px)
the prevailing market price xc(...U0)
xc(...U1)
x1 x0
Quantity of x
91 92
23
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
93 94
Consumer Surplus Welfare Loss from a Price

Increase
We will define consumer surplus as the Suppose that the compensated demand
area below the Marshallian demand function for x is given by
curve and above price Vpy0.5
x c ( px , py ,V )
shows what an individual would pay for the px0.5
right to make voluntary transactions at this The welfare cost of a price increase
price
from px = 1 to px = 4 is given by
changes in consumer surplus measure the
4
welfare effects of price changes px 4
CV Vpy0.5 px0.5 2Vpy0.5 px0.5
p X 1
95
1 96
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
Welfare Loss from a Price Revealed Preference and

Increase the Substitution Effect
If income (I) is equal to 8,
The theory of revealed preference was
loss = 4 ln(4) - 4 ln(1) = 4 ln(4) = 4(1.39) = 5.55 proposed by Paul Samuelson in the late
1940s
this computed loss from the Marshallian The theory defines a principle of
demand function is a compromise between rationality based on observed behavior
the two amounts computed using the
compensated demand functions
and then uses it to approximate an
individuals utility function
99 100
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
101 Quantity of x 102
Negativity of the Negativity of the

Substitution Effect Substitution Effect
Suppose that an individual is indifferent Since the individual is indifferent between
between two bundles: C and D C and D
Let pxC,pyC be the prices at which When C is chosen, D must cost at least as
much as C
bundle C is chosen pxCxC + pyCyC pxCxD + pyCyD
Let pxD,pyD be the prices at which When D is chosen, C must cost at least as
bundle D is chosen much as D
pxDxD + pyDyD pxDxC + pyDyC
103 104
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
Mathematical Generalization Mathematical Generalization

If, at prices pi0 bundle xi0 is chosen Consequently, at prices that prevail
instead of bundle xi1 (and bundle xi1 is when bundle 1 is chosen (pi1), then
affordable), then
n n
n n
p x 1 0
pi1xi1
p x pi0 xi1
0 0 i i
i i i 1 i 1
i 1 i 1
Bundle 0 must be more expensive than
Bundle 0 has been revealed preferred bundle 1
to bundle 1
107 108
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

When purchasing power changes A fall in the price of a good causes
(income changes but prices remain the substitution and income effects
same), budget constraints shift for a normal good, both effects cause more
for normal goods, an increase in income of the good to be purchased
means that more is purchased for inferior goods, substitution and income
for inferior goods, an increase in income effects work in opposite directions
means that less is purchased no unambiguous prediction is possible
111 112
28
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

Compensated demand curves illustrate Demand elasticities are often used in
movements along a given indifference empirical work to summarize how
curve for alternative prices individuals react to changes in prices
they are constructed by holding utility and income
constant and exhibit only the substitution the most important is the price elasticity of
effects from a price change demand
their slope is unambiguously negative (or measures the proportionate change in quantity
zero) in response to a 1 percent change in price
115 116
29
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
Important Points to Note:

The negativity of the substitution effect
is one of the most basic findings of
demand theory
this result can be shown using revealed
preference theory and does not
necessarily require assuming the
existence of a utility function
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
Gross Complements Gross Substitutes

Quantity of y When the price of y falls, the substitution Quantity of y When the price of y falls, the substitution
effect may be so small that the consumer effect may be so large that the consumer
purchases more x and more y purchases less x and more y
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
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
Substitutes and Complements Gross Substitutes and

Complements
Two goods are substitutes if one good
may replace the other in use The concepts of gross substitutes and
complements include both substitution
examples: tea & coffee, butter & margarine
and income effects
Two goods are complements if they are
two goods are gross substitutes if
used together
xi /pj > 0
examples: coffee & cream, fish & chips
two goods are gross complements if
xi /pj < 0
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
Asymmetry of the Gross Asymmetry of the Gross

Definitions Definitions
gives us the following first-order conditions: Inserting this into the budget constraint, we
L/x = 1/x - px = 0
can find the Marshallian demand for y
pyy = I py
L/y = 1 - py = 0
an increase in py causes a decline in spending
L/ = I - pxx - pyy = 0 on y
Manipulating the first two equations, we get since px and I are unchanged, spending on x must
rise ( x and y are gross substitutes)
pxx = py
but spending on y is independent of px ( x and y
are independent of one another)
11 12
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
Gross Complements Substitutability with Many

Quantity of y Even though x and y are gross Goods
complements, they are net substitutes
Once the utility-maximizing model is
Since MRS is diminishing,
extended to may goods, a wide variety
the own-price substitution of demand patterns become possible
y1
effect must be negative so
According to Hicks second law of
y0 the cross-price substitution
U1 effect must be positive demand, most goods must be
U0
substitutes
x0 x1
Quantity of x
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
Composite Commodities Composite Commodity Theorem

In the most general case, an individual Suppose that consumers choose among n
who consumes n goods will have goods
demand functions that reflect n(n+1)/2 The demand for x1 will depend on the
different substitution effects prices of the other n-1 commodities
It is often convenient to group goods If all of these prices move together, it may
into larger aggregates make sense to lump them into a single
examples: food, clothing, all other goods composite commodity (y)
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
y = p20x2 + p30x3 ++ pn0xn changes in p1 or t induce substitution effects

21 22
Composite Commodity Theorem Composite Commodity

As long as p20pn0move together, we can A composite commodity is a group of
confine our examination of demand to goods for which all prices move together
choices between buying x1 and These goods can be treated as a single
everything else commodity
The theorem makes no prediction about the individual behaves as if he is choosing
between other goods and spending on this
how choices of x2xn behave
entire composite group
only focuses on total spending on x2xn
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

Commodity Commodity
If initially I = 100, px = 1, py = 4, and If we assume that the prices of housing
pz = 1, then services (py) and electricity (pz) move
together, we can use their initial prices to
x* = 25, y* = 12.5, z* = 25
define the composite commodity
$25 is spent on food and $75 is spent on housing (h)
housing-related needs
h = 4y + 1z
The initial quantity of housing is the total
spent on housing (75)
27 28
7
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
Example: Composite Household Production Model

Commodity Assume that individuals do not receive
Since ph = 4, h* = 150/7 utility directly from the goods they
If I = 100, px = 1, py = 16, and pz = 4, the purchase in the market
individual demand functions show that Utility is received when the individual
produces goods by combining market
x* = 100/7, y* = 100/28, z* = 100/14 goods with time inputs
This means that the amount of h that is raw beef and uncooked potatoes yield no
consumed can also be computed as utility until they are cooked together to
produce stew
h* = 4y* + 1z* = 150/7
31 32
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
Household Production Model The Linear Attributes Model

Two important insights from this general In this model, it is the attributes of
model can be drawn goods that provide utility to individuals
because the production functions are Each good has a fixed set of attributes
measurable, households can be treated as
multi-product firms The model assumes that the production
because consuming more a1 requires more equations for a1 and a2 have the form
use of x, y, and z, this activity has an a1 = ax1x + ay1y + az1z
opportunity cost in terms of the amount of a2
that can be produced a2 = ax2x + ay2y + az2z
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

x* is the combination of a1 and a2 that would be
obtained if all income was spent on x All possible combinations from mixing the
a2 a2
x x three market goods are represented by
the shaded triangular area x*y*z*
y* is the combination of a1 and a2 that
y would be obtained if all income was y
x* spent on y x*
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
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

When there are only two goods, the In cases of more than two goods,
income and substitution effects from the demand relationships can be specified
change in the price of one good (py) on in two ways
the demand for another good (x) usually two goods are gross substitutes if xi /pj
work in opposite directions > 0 and gross complements if xi /pj < 0
the sign of x/py is ambiguous because these price effects include
the substitution effect is positive income effects, they may not be
the income effect is negative symmetric
it is possible that xi /pj xj /pi
43 44
11
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

An alternative way to develop the
theory of choice among market goods
is to focus on the ways in which
market goods are used in household
production to yield utility-providing
attributes
this may provide additional insights into
relationships among goods
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
A Two-Input Production A Two-Input Production

Function Function
Suppose the production function for The marginal productivity function is
flyswatters can be represented by MPl = q/l = 120,000l - 3000l2
q = f(k,l) = 600k 2l2 - k 3l3 which diminishes as l increases
To construct MPl and APl, we must This implies that q has a maximum value:
assume a value for k 120,000l - 3000l2 = 0
let k = 10 40l = l2
The production function becomes l = 40
q = 60,000l2 - 1000l3 7
Labor input beyond l = 40 reduces output8
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
Isoquant Maps Isoquant Map

Each isoquant represents a different level
To illustrate the possible substitution of
of output
one input for another, we use an
output rises as we move northeast
isoquant map k per period
An isoquant shows those combinations

of k and l that can produce a given level
of output (q0)
q = 30
f(k,l) = q0 q = 20
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
RTS and Marginal Productivities RTS and Marginal Productivities

Take the total differential of the production
function: Because MPl and MPk will both be
f f nonnegative, RTS will be positive (or zero)
dq dl dk MPl dl MPk dk
l k
Along an isoquant dq = 0, so However, it is generally not possible to
derive a diminishing RTS from the
MPl dl MPk dk assumption of diminishing marginal
dk MPl productivity alone
RTS (l for k )
dl q q0 MPk
15 16
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
RTS and Marginal Productivities A Diminishing RTS

Intuitively, it seems reasonable that fkl = flk Suppose the production function is
should be positive q = f(k,l) = 600k 2l 2 - k 3l 3
if workers have more capital, they will be For this production function
more productive
MPl = fl = 1200k 2l - 3k 3l 2
But some production functions have fkl < 0 MPk = fk = 1200kl 2 - 3k 2l 3
over some input ranges
these marginal productivities will be
when we assume diminishing RTS we are positive for values of k and l for which
assuming that MPl and MPk diminish quickly kl < 400
enough to compensate for any possible
negative cross-productivity effects 19 20
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
A Diminishing RTS Returns to Scale

Thus, for this production function, RTS is
How does output respond to increases
diminishing throughout the range of k and l
in all inputs together?
where marginal productivities are positive
suppose that all inputs are doubled, would
for higher values of k and l, the diminishing output double?
marginal productivities are sufficient to
overcome the influence of a negative value for Returns to scale have been of interest
fkl to ensure convexity of the isoquants to economists since the days of Adam
Smith
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
Returns to Scale Constant Returns to Scale

It is possible for a production function to Constant returns-to-scale production
exhibit constant returns to scale for some functions are homogeneous of degree
levels of input usage and increasing or one in inputs
decreasing returns for other levels f(tk,tl) = t1f(k,l) = tq
economists refer to the degree of returns to This implies that the marginal
scale with the implicit notion that only a productivity functions are homogeneous
fairly narrow range of variation in input of degree zero
usage and the related level of output is
if a function is homogeneous of degree k,
being considered
its derivatives are homogeneous of degree
27 k-1 28
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
Constant Returns to Scale Returns to Scale

Along a ray from the origin (constant k/l), Returns to scale can be generalized to a
the RTS will be the same on all isoquants production function with n inputs
q = f(x1,x2,,xn)
k per period
If all inputs are multiplied by a positive
The isoquants are equally
spaced as output expands constant t, we have
f(tx1,tx2,,txn) = tkf(x1,x2,,xn)=tkq
q=3 If k = 1, we have constant returns to scale
q=2
q=1 If k < 1, we have decreasing returns to scale
l per period If k > 1, we have increasing returns to scale
31 32
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
Elasticity of Substitution Elasticity of Substitution

If is high, the RTS will not change Generalizing the elasticity of substitution
much relative to k/l to the many-input case raises several
the isoquant will be relatively flat complications
If is low, the RTS will change by a if we define the elasticity of substitution
substantial amount as k/l changes between two inputs to be the proportionate
change in the ratio of the two inputs to the
the isoquant will be sharply curved
proportionate change in RTS, we need to
It is possible for to change along an hold output and the levels of other inputs
isoquant or as the scale of production constant
changes
35 36
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
Fixed Proportions Fixed Proportions

No substitution between labor and capital
Suppose that the production function is
is possible
q = min (ak,bl) a,b > 0
Capital and labor must always be used
k per period k/l is fixed at b/a
in a fixed ratio
the firm will always operate along a ray =0
where k/l is constant q3/a q3
Because k/l is constant, = 0 q2
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
CES Production Function A Generalized Leontief

Suppose that the production function is Production Function
q = f(k,l) = [k + l] / 1, 0, > 0 Suppose that the production function is
> 1 increasing returns to scale q = f(k,l) = k + l + 2(kl)0.5
< 1 decreasing returns to scale Marginal productivities are
For this production function fk = 1 + (k/l)-0.5
= 1/(1-) fl = 1 + (k/l)0.5
= 1 linear production function Thus,
= - fixed proportions production function fl 1 (k / l )0.5
RTS
= 0 Cobb-Douglas production function fk 1 (k / l )0.5
43 44
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

Differentiating the production function Dividing by q gives us
with respect to time we get
dq / dt dA / dt f / k dk f / l dl
dq dA df (k, l )
f (k, l ) A q A f (k, l ) dt f (k, l ) dt
dt dt dt
dq / dt dA / dt f k dk / dt f l dl / dt
dq dA q q f dk f dl
q A k f (k, l ) k l f (k, l ) l
dt dt A f (k, l) k dt l dt
47 48
12
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
Technical Progress in the Technical Progress in the

Cobb-Douglas Function Cobb-Douglas Function
Suppose that the production function is Taking logarithms and differentiating
q = A(t)f(k,l) = A(t)k l 1- with respect to t gives the growth
If we assume that technical progress equation
occurs at a constant exponential () then
ln q ln q q q / t
A(t) = Ae-t Gq
t q t q
q = Ae-tk l 1-
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

The entire production function can be Isoquants are usually assumed to be
illustrated by an isoquant map convex
the slope of an isoquant is the marginal they obey the assumption of a diminishing
rate of technical substitution (RTS) RTS
it shows how one input can be substituted for this assumption cannot be derived exclusively
another while holding output constant from the assumption of diminishing marginal
it is the ratio of the marginal physical productivity
productivities of the two inputs one must be concerned with the effect of
changes in one input on the marginal
productivity of other inputs
55 56
14
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

Technical progress shifts the entire
production function and isoquant map
technical improvements may arise from the
use of more productive inputs or better
methods of economic organization
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
Copyright 2005 by South-western, a division of Thomson learning. All rights reserved. 1 2
Definitions of Costs Definitions of Costs

Capital Costs
Labor Costs
accountants use the historical price of the
to accountants, expenditures on labor are
capital and apply some depreciation rule to
current expenses and hence costs of
determine current costs
production
economists refer to the capitals original price
to economists, labor is an explicit cost
as a sunk cost and instead regard the
labor services are contracted at some hourly
implicit cost of the capital to be what
wage (w) and it is assumed that this is also
what the labor could earn in alternative someone else would be willing to pay for its
employment use
we will use v to denote the rental rate for capital
3 4
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
Two Simplifying Assumptions Economic Profits

There are only two inputs Total costs for the firm are given by
homogeneous labor (l), measured in labor- total costs = C = wl + vk
hours Total revenue for the firm is given by
homogeneous capital (k), measured in total revenue = pq = pf(k,l)
machine-hours
entrepreneurial costs are included in capital costs Economic profits () are equal to
= total revenue - total cost
Inputs are hired in perfectly competitive
markets = pq - wl - vk
firms are price takers in input markets = pf(k,l) - wl - vk
7 8
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
Cost-Minimizing Input Choices Cost-Minimizing Input Choices

Mathematically, we seek to minimize Dividing the first two conditions we get
total costs given q = f(k,l) = q0
w f / l
Setting up the Lagrangian: RTS (l for k )
v f / k
L = wl + vk + [q0 - f(k,l)]
The cost-minimizing firm should equate
First order conditions are
the RTS for the two inputs to the ratio of
L/l = w - (f/l) = 0 their prices
L/k = v - (f/k) = 0
L/ = q0 - f(k,l) = 0
11 12
3
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

Given output q0, we wish to find the least costly The minimum cost of producing q0 is C2
point on the isoquant
k per period
Costs are represented by k per period This occurs at the
parallel lines with a slope of - tangency between the
C1 C1
C3 w/v C3
isoquant and the total cost
curve
C2 C2
C1 < C2 < C3 k* The optimal choice

q0 q0 is l*, k*
l per period l per period

15 l* 16
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
The Firms Expansion Path The Firms Expansion Path

The expansion path is the locus of cost-
The firm can determine the cost-
minimizing tangencies
minimizing combinations of k and l for
k per period The curve shows
every level of output
how inputs increase
If input costs remain constant for all E
as output increases
amounts of k and l the firm may
demand, we can trace the locus of cost-
minimizing choices q1
called the firms expansion path q0
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
Cost Minimization Cost Minimization

The first-order conditions for a minimum Dividing the first equation by the second
are gives us
L/k = v - k -1l = 0 w k l 1 k
RTS
L/l = w - k l -1 = 0 v k 1l l
L/ = q0 - k l = 0 This production function is homothetic
the RTS depends only on the ratio of the two
inputs
the expansion path is a straight line
23 24
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
Cost Minimization Total Cost Function

Dividing the first equation by the second The total cost function shows that for
gives us any set of input costs and for any output
1 1 1/
w 1 k k level, the minimum cost incurred by the

v k l l firm is
C = C(v,w,q)
This production function is also
homothetic As output (q) increases, total costs
increase
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
Graphical Analysis of Graphical Analysis of

Total Costs Total Costs
Suppose that k1 units of capital and l1 Total With constant returns to scale, total costs
costs are proportional to output
units of labor input are required to
produce one unit of output AC = MC
C
C(q=1) = vk1 + wl1
Both AC and
To produce m units of output (assuming MC will be
constant returns to scale) constant
C(q=m) = vmk1 + wml1 = m(vk1 + wl1)
C(q=m) = m C(q=1) Output
31 32
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
Some Illustrative Cost Some Illustrative Cost

Functions Functions
If we substitute into the production Now we can derive total costs as
function and solve for l, we will get
/ C(v,w, q ) vk wl q1/ Bv / w /
1/ / /
l q w v
where
A similar method will yield B ( ) / /
/
1 / which is a constant that involves only
k q w / v /
the parameters and
39 40
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
Properties of Cost Functions Properties of Cost Functions

Nondecreasing in q, v, and w Concave in input prices
cost functions are derived from a cost- costs will be lower when a firm faces input
minimization process prices that fluctuate around a given level
any decline in costs from an increase in one of than when they remain constant at that
the functions arguments would lead to a level
contradiction the firm can adapt its input mix to take
advantage of such fluctuations
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)
C(v,w 1,q1) Since the firms input mix

will likely change, actual
costs will be less than
Cpseudo such as C(v,w,q1)
w1 w 45 46
Input Substitution Input Substitution

A change in the price of an input will Putting this in proportional terms as
cause the firm to alter its input mix (k / l ) w / v ln( k / l )
s
We wish to see how k/l changes in (w / v ) k / l ln( w / v )
response to a change in w/v, while gives an alternative definition of the
holding q constant elasticity of substitution
k in the two-input case, s must be nonnegative

l large values of s indicate that firms change
w their input mix significantly if input prices

v change
47 48
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

Improvements in technology also lower Because the same inputs that produced
cost curves one unit of output in period zero will
Suppose that total costs (with constant produce A(t) units in period t
returns to scale) are Ct(v,w,A(t)) = A(t)Ct(v,w,1)= C0(v,w,1)
C0 = C0(q,v,w) = qC0(v,w,1) Total costs are given by
Ct(v,w,q) = qCt(v,w,1) = qC0(v,w,1)/A(t)
= C0(v,w,q)/A(t)
51 52
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
Shifting the Cobb-Douglas

Cost Function Contingent Demand for Inputs
If v = 3 and w = 27, the relationship is Contingent demand functions for all of
C(3,27, q ) 2q 81 18q the firms inputs can be derived from the
cost function
C = 720 to produce q =40 Shephards lemma
AC = C/q = 18 the contingent demand function for any input is
MC = C/q = 18 given by the partial derivative of the total-cost
function with respect to that inputs price
55 56
14
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

Suppose we have a Cobb-Douglas For this cost function, the derivation is
technology messier:
The cost function is C
k c (v ,w , q ) q 1/ Bv / w /
v
C(v,w, q ) vk wl q1/ Bv / w / w
/
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
Short-Run Total Costs Short-Run Total Costs

Short-run total cost for the firm is Short-run costs are not minimal costs
SC = vk1 + wl for producing the various output levels
There are two types of short-run costs: the firm does not have the flexibility of input
choice
short-run fixed costs are costs associated
with fixed inputs (vk1) to vary its output in the short run, the firm
must use nonoptimal input combinations
short-run variable costs are costs
associated with variable inputs (wl) the RTS will not be equal to the ratio of
input prices
63 64
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
Relationship between Short- Relationship between Short-

Run and Long-Run Costs Run and Long-Run Costs
SC (k2)
Total SC (k1) Costs
costs C
SMC (k0) SAC (k0) MC The geometric
AC relationship
SC (k0) The long-run SMC (k1) SAC (k1)
between short-
C curve can
run and long-run
be derived by
varying the
AC and MC can
also be shown
level of k
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

Repeated application of this The firms average cost (AC = C/q)
minimization procedure yields the and marginal cost (MC = C/q) can
firms expansion path be derived directly from the total-cost
the expansion path shows how input function
usage expands with the level of output if the total cost curve has a general cubic
it also shows the relationship between output shape, the AC and MC curves will be u-
level and total cost shaped
this relationship is summarized by the total
cost function, C(v,w,q)
71 72
18
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

In the short run, the firm may not be
able to vary some inputs
it can then alter its level of production
only by changing the employment of its
variable inputs
it may have to use nonoptimal, higher-
cost input combinations than it would
choose if it were possible to vary all
inputs
75
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
Contractual Relationships Modeling Firms Behavior

Some contracts between providers of Most economists treat the firm as a
inputs may be explicit single decision-making unit
may specify hours, work details, or the decisions are made by a single
compensation dictatorial manager who rationally pursues
Other arrangements will be more some goal
implicit in nature usually profit-maximization
decision-making authority or sharing of

tasks
3 4
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
Output Choice Output Choice

Total revenue for a firm is given by The necessary condition for choosing the
R(q) = p(q)q level of q that maximizes profits can be
In the production of q, certain economic found by setting the derivative of the
costs are incurred [C(q)] function with respect to q equal to zero
Economic profits () are the difference d
' (q )
dR dC
0
between total revenue and total costs dq dq dq
(q) = R(q) C(q) = p(q)q C(q) dR dC

dq dq
7 8
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
Profit Maximization Marginal Revenue

Profits are maximized when the slope of
revenues & costs
the revenue function is equal to the slope of
If a firm can sell all it wishes without
the cost function having any effect on market price,
C
R marginal revenue will be equal to price
The second-order
condition prevents us
If a firm faces a downward-sloping
from mistaking q0 as demand curve, more output can only be
a maximum sold if the firm reduces the goods price
dR d [ p(q ) q ] dp
marginal revenue MR(q ) pq
dq dq dq
output
q0 q*
11 12
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
Profit Maximization Marginal Revenue and

Elasticity
To determine the profit-maximizing The concept of marginal revenue is
output, we must know the firms costs directly related to the elasticity of the
If subs can be produced at a constant demand curve facing the firm
average and marginal cost of $4, then The price elasticity of demand is equal
MR = MC to the percentage change in quantity
-q/5 + 10 = 4 that results from a one percent change
q = 30 in price
dq / q dq p
eq,p
15
dp / p dp q 16
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
The Inverse Elasticity Rule The Inverse Elasticity Rule

Because MR = MC when the firm p MC 1

maximizes profit, we can see that p eq,p
1 p MC 1 If eq,p > -1, MC < 0
MC p1
e
q ,p p eq,p This means that firms will choose to
operate only at points on the demand
The gap between price and marginal curve where demand is elastic
cost will fall as the demand curve facing
the firm becomes more elastic
19 20
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
Marginal Revenue Curve Marginal Revenue Curve

As output increases from 0 to q1, total
price revenue increases so MR > 0 When the demand curve shifts, its
As output increases beyond q1, total
associated marginal revenue curve
revenue decreases so MR < 0 shifts as well
a marginal revenue curve cannot be
p1
calculated without referring to a specific
demand curve
D (average revenue)
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
Short-Run Supply by a Short-Run Supply by a

Price-Taking Firm Price-Taking Firm
price SMC price SMC
p* = MR SAC p* = MR SAC
SAVC SAVC
Maximum profit Since p > SAC,

occurs where profit > 0
p = SMC
output output
q* q*
27 28
7
price price SMC
If the price falls to
SMC
p***, the firm will
p**
produce q***
p* = MR SAC p* = MR SAC
SAVC SAVC
If the price rises p***

Profit maximization
to p**, the firm requires that p =
will produce q** SMC and that SMC
and > 0 is upward-sloping
output output
q* q** q*** q*
<0
29 30

The positively-sloped portion of the Thus, the price-taking firms short-run
short-run marginal cost curve is the supply curve is the positively-sloped
short-run supply curve for a price-taking portion of the firms short-run marginal
firm cost curve above the point of minimum
it shows how much the firm will produce at average variable cost
every possible market price for prices below this level, the firms profit-
firms will only operate in the short run as maximizing decision is to shut down and
long as total revenue covers variable cost produce no output
the firm will produce no output if p < SAVC
31 32
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
Short-Run Supply Short-Run Supply

The price-taking firm will maximize profit To find the firms shut-down price, we
where p = SMC need to solve for SAVC
SMC
w (1 ) / /
q k1 p
SVC = wq1/k1-/
SAVC = SVC/q = wq(1-)/k1-/
Therefore, quantity supplied will be SAVC < SMC for all values of < 1
there is no price low enough that the firm will
/(1 )
w /(1 ) /(1 ) want to shut down
q k p

1
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
Properties of the Profit Properties of the Profit

Function Function
Homogeneity Nondecreasing in output price
the profit function is homogeneous of a firm could always respond to a rise in the
degree one in all prices price of its output by not changing its input
with pure inflation, a firm will not change its or output plans
production plans and its level of profits will keep profits must rise
up with that inflation
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
Envelope Results Producer Surplus in the

Short Run
We can apply the envelope theorem to Because the profit function is
see how profits respond to changes in nondecreasing in output prices, we know
output and input prices that if p2 > p1
( p,v ,w ) (p2,) (p1,)
q( p,v ,w )
p
The welfare gain to the firm of this price
( p,v ,w ) increase can be measured by
k ( p,v ,w )
v
welfare gain = (p2,) - (p1,)
( p,v ,w )
l ( p,v ,w )
w 43 44
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

Short Run Short Run
Mathematically, we can use the We can measure how much the firm
envelope theorem results values the right to produce at the
p2 p2 prevailing price relative to a situation
welfare gain q( p)dp ( / p)dp
p1 p1 where it would produce no output
( p2 ,...) ( p1,...)
47 48
12
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

Short Run Short Run
price SMC
Producer surplus is the extra return that
Producer surplus producers make by making transactions
at a market price at the market price over and above what
of p1 is the they would earn if nothing was
p1
shaded area produced
p
0
the area below the market price and above
the supply curve
output
q1
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
Profit Maximization and Profit Maximization and

Input Demand Input Demand
The first-order conditions for a maximum These first-order conditions for profit
are maximization also imply cost
/k = p[f/k] v = 0 minimization
/l = p[f/l] w = 0 they imply that RTS = w/v
A profit-maximizing firm should hire any
input up to the point at which its marginal
contribution to revenues is equal to the
marginal cost of hiring the input
55 56
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
Single-Input Case Single-Input Case

We expect l/w 0 This reduces to
diminishing marginal productivity of labor l
1 p fll
The first order condition for profit w
maximization was Solving further, we get
/l = p[f/l] w = 0 l 1

Taking the total differential, we get w p fll
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
Substitution Effect Output Effect

If output is held constant at q0 and w A decline in w will lower the firms MC
falls, the firm will substitute l for k in
k per period the production process Price MC
MC
Consequently, the firm
Because of diminishing will choose a new level
RTS along an isoquant, of output that is higher
the substitution effect will P
always be negative
q0
l per period Output

63 q0 q1 64
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
Substitution and Output Substitution and Output

Effects Effects
We have two concepts of demand for Differentiation with respect to w yields
any input l( p,v ,w ) l c (v ,w, q ) l c (v ,w, q ) q
the conditional demand for labor, lc(v,w,q)
w w q w
the unconditional demand for labor, l(p,v,w)
At the profit-maximizing level of output substitution output
effect effect
lc(v,w,q) = l(p,v,w)
total effect
67 68
17
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

Marginal revenue and the price The supply curve for a price-taking,
elasticity of demand are related by the profit-maximizing firm is given by the
formula positively sloped portion of its marginal
cost curve above the point of minimum
1
MR p1 average variable cost (AVC)
e
q ,p
if price falls below minimum AVC, the
firms profit-maximizing choice is to shut
down and produce nothing
71 72
18
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

Short-run changes in market price Profit maximization provides a theory
result in changes in the firms short-run of the firms derived demand for inputs
profitability the firm will hire any input up to the point
these can be measured graphically by at which the value of its marginal product
changes in the size of producer surplus is just equal to its per-unit market price
the profit function can also be used to increases in the price of an input will
calculate changes in producer surplus induce substitution and output effects that
cause the firm to reduce hiring of that
input
75 76
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
Market Demand Market Demand

To derive the market demand curve, we sum the
To construct the market demand curve, quantities demanded at every price
PX is allowed to vary while Py and the
px px
income of each individual are held Individual 1s
demand curve
Individual 2s
demand curve
px Market demand
curve
constant
px*
If each individuals demand for x is
X
downward sloping, the market demand x1 x2
curve will also be downward sloping x1 * x x2 * x X* x
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
Shifts in Market Demand Shifts in Market Demand

To graph the demand curve, we must If py rises to 6, the market demand curve
assume values for py, I1, and I2 shifts outward to
X = 27 3px + 4 + 1 + 6 = 38 3px
If py = 4, I1 = 40, and I2 = 20, the market note that X and Y are substitutes
demand curve becomes If I1 fell to 30 while I2 rose to 30, the
X = 27 3px + 4 + 1 + 4 = 36 3px market demand would shift inward to
X = 27 3px + 3 + 1.5 + 4 = 35.5 3px
note that X is a normal good for both buyers
7 8
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
depend on all prices and on Ij The market demand function depends on

the prices of all goods and the incomes
xij = xij(p1,,pn, Ij)
and preferences of all buyers
9 10
Elasticity of Market Demand Elasticity of Market Demand

The price elasticity of market demand is The cross-price elasticity of market
measured by demand is measured by
QD (P, P ' , I ) P QD (P, P ' , I ) P '
eQ,P eQ,P
P QD P ' QD
The income elasticity of market demand is
Market demand is characterized by
measured by
whether demand is elastic (eQ,P <-1) or
inelastic (0> eQ,P > -1) QD (P, P ' , I ) I
eQ,I
I QD
11 12
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
Pricing in the Very Short Run Short-Run Price Determination

When quantity is fixed in the
Price
very short run, price will rise
The number of firms in an industry is
S
from P1 to P2 when the demand fixed
rises from D to D
These firms are able to adjust the
P2 quantity they are producing
they can do this by altering the levels of the
P1
D variable inputs they employ
D
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
Short-Run Market Supply Curve Short-Run Market Supply

Function
To derive the market supply curve, we sum the
quantities supplied at every price The short-run market supply function
Firm As shows total quantity supplied by each
P supply curve P P
sA
sB
Firm Bs Market supply S
firm to a market
supply curve curve n
P1 Qs (P,v ,w ) qi (P,v ,w )
i 1
Firms are assumed to face the same

quantity q1B quantity Q1 Quantity
q1A
market price and the same prices for
q1A + q1B = Q1 inputs
19 20
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
A Short-Run Supply Function Equilibrium Price

Determination
In this case, computation of the An equilibrium price is one at which
elasticity of supply shows that it is unit quantity demanded is equal to quantity
elastic supplied
QS (P,v ,w ) P 1000 P neither suppliers nor demanders have an
eS,P 1 incentive to alter their economic decisions
P QS 3 1000P / 3
An equilibrium price (P*) solves the
equation:
QD (P *, P ' , I ) QS (P *,v,w )
23 24
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
Market Reaction to a Market Reaction to a

Shift in Demand Shift in Demand
If many buyers experience
an increase in their demands, If the market price rises,
Price Price
the market demand curve SMC firms will increase their
S
will shift to the right level of output
SAC
P2 Equilibrium price and P2 This is the short-run
P1 equilibrium quantity will P1
supply response to an
D both rise increase in market price
D
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
Shifts in Supply Shifts in Demand

Small increase in price, Large increase in price, Small increase in price, Large increase in price,
large drop in quantity small drop in quantity large rise in quantity small rise in quantity
Price S Price S Price Price S
S S
P
P P P
P
P P
P
D D D
D D D
Q Q Quantity Q Q Quantity Q Q Quantity Q Q Quantity

Elastic Demand Inelastic Demand 31 Elastic Supply Inelastic Supply 32
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
Changing Short-Run Equilibria Mathematical Model of

Supply and Demand
Suppose that the wage of towel cutters
rises so that the short-run market supply Suppose that the demand function is
becomes represented by
QS = 800P/3 QD = D(P,)
Solving for the new equilibrium, we find is a parameter that shifts the demand curve
P* = $13.04 D/ = D can have any sign
Q* = 3,480 D/P = DP < 0
Equilibrium price rises and quantity falls
35 36
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
Mathematical Model of Mathematical Model of

Supply and Demand Supply and Demand
Suppose that the demand parameter () We can convert our analysis to elasticities
changed while remains constant
P D
The equilibrium condition requires that eP ,
P SP DP P
DPdP + Dd = SPdP

P D D
eQ,
eP ,
Q

SP DP
(SP DP )
P eS,P eQ,P
Because SP - DP > 0, P/ will have the Q
same sign as D 39 40
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
Long-Run Analysis Long-Run Competitive

Equilibrium
Existing firms will leave any industry for
which economic profits are negative A perfectly competitive industry is in
long-run equilibrium if there are no
exit of firms will cause the short-run industry
supply curve to shift inward incentives for profit-maximizing firms to
market price will rise and losses will fall
enter or to leave the industry
the process will continue until economic this will occur when the number of firms is
profits are zero such that P = MC = AC and each firm
operates at minimum AC
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
Long-Run Equilibrium: Long-Run Equilibrium:

Constant-Cost Case Constant-Cost Case
This is a long-run equilibrium for this industry Suppose that market demand rises to D
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
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
Long-Run Equilibrium: Infinitely Elastic Long-Run

Constant-Cost Case Supply
The long-run supply curve will be a horizontal line
(infinitely elastic) at p1 Suppose that the total cost curve for a
Price
SMC MC Price typical firm in the bicycle industry is
S
S
TC = q3 20q2 + 100q + 8,000
AC
Demand for bicycles is given by

P1 LS QD = 2,500 3P
D
D
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

Increasing-Cost Industry Increasing-Cost Industry
The entry of new firms may cause the Suppose that we are in long-run equilibrium in this industry
average costs of all firms to rise Price P = MC = AC
SMC MC Price
prices of scarce inputs may rise S
new firms may impose external costs on AC
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
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

Increasing-Cost Industry Decreasing-Cost Industry
The long-run supply curve will be upward-sloping The entry of new firms may cause the
Price SMC MC Price average costs of all firms to fall
S
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
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

Decreasing-Cost Industry Decreasing-Cost Industry
Positive profits attract new firms and supply shifts out The long-run industry supply curve will be downward-sloping
Entry of firms causes costs for each firm to fall
Price Price Price
Price
SMC S SMC S
MC MC
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
Long-Run Elasticity of Supply Comparative Statics Analysis

of Long-Run Equilibrium
The long-run elasticity of supply (eLS,P)
records the proportionate change in long- Comparative statics analysis of long-run
run industry output to a proportionate equilibria can be conducted using
change in price estimates of long-run elasticities of
supply and demand
% change in Q QLS P
eLS ,P Remember that, in the long run, the
% change in P P QLS
number of firms in the industry will vary
eLS,P can be positive or negative
from one long-run equilibrium to another
the sign depends on whether the industry
exhibits increasing or decreasing costs 67 68
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
Comparative Statics Analysis Comparative Statics Analysis

of Long-Run Equilibrium of Long-Run Equilibrium
The effect of a change in input prices is The optimal level of output for each firm
more complicated may also be affected
we need to know how much minimum Therefore, the change in the number of
average cost is affected firms becomes
we need to know how an increase in long-
Q Q
run equilibrium price will affect quantity n1 n0 *1 *0
demanded q1 q0
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
TC = q3 20q2 + 100q + 11,616 then QD = 484

This means that the industry will have
The optimal scale of each firm rises
22 firms (484 22)
from 20 to 22 (where MC = AC)
73 74

Long Run Long Run
In the long-run, all profits are zero and
Short-run producer surplus represents
there are no fixed costs
the return to a firms owners in excess
owners are indifferent about whether they
of what would be earned if output was
are in a particular market
zero they could earn identical returns on their
the sum of short-run profits and fixed costs investments elsewhere
Suppliers of inputs may not be indifferent
about the level of production in an
75
industry 76
19
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
Ricardian Rent Ricardian Rent

Long-run producer surplus can be most At low prices only the best land is used
easily illustrated with a situation first Higher prices lead to an increase in
described by economist David Ricardo output through the use of higher-cost
assume that there are many parcels of land land
on which a particular crop may be grown the long-run supply curve is upward-sloping
the land ranges from very fertile land (low costs because of the increased costs of using less
of production) to very poor, dry land (high costs
of production)
fertile land
79 80
20
The owners of low-cost firms will earn positive profits The owners of the marginal firm will earn zero profit
Price Price Price

MC Price
MC
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

Each point on the supply curve represents minimum
Firms with higher costs (than the average cost for some firm
marginal firm) will stay out of the market Price
For each firm, P AC represents
would incur losses at a price of P* profit per unit of output
Profits earned by intramarginal firms
can persist in the long run S
Total long-run profits can be
computed by summing over all
they reflect a return to a unique resource P*
units of output
The sum of these long-run profits D
constitutes long-run producer surplus Q* Quantity

83 Total Market 84
21
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

In the short run, equilibrium prices are A shift in either demand or supply will
established by the intersection of what cause the equilibrium price to change
demanders are willing to pay (as reflected the extent of such a change will depend on
by the demand curve) and what firms are the slopes of the various curves
willing to produce (as reflected by the Firms may earn positive profits in the
short-run supply curve) short run
these prices are treated as fixed in both because fixed costs must always be paid,
demanders and suppliers decision-making firms will choose a positive output as long as
processes revenues exceed variable costs
87 88
22
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

Changes in long-run market equilibrium If changes in the long-run equilibrium in a
will also change the number of firms market change the prices of inputs to that
precise predictions about the extent of these market, the welfare of the suppliers of
changes is made difficult by the possibility these inputs will be affected
that the minimum average cost level of such changes can be measured by changes
output may be affected by changes in input in the value of long-run producer surplus
costs or by technical progress
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
Law of One Price Assumptions of Perfect

Competition
A homogeneous good trades at the
There are a large number of people
same price no matter who buys it or
buying any one good
who sells it
each person takes all prices as given and
if one good traded at two different prices, seeks to maximize utility given his budget
demanders would rush to buy the good constraint
where it was cheaper and firms would try
to sell their output where the price was There are a large number of firms
higher producing each good
these actions would tend to equalize the price each firm takes all prices as given and
of the good attempts to maximize profits
3 4
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
Edgeworth Box Diagram Edgeworth Box Diagram

Labor in y production
Labor for x Labor for y
Oy in y
Capital
Many of the allocations in the Edgeworth
production box are technically inefficient
it is possible to produce more x and more y by
Capital for y
shifting capital and labor around

Total Capital
We will assume that competitive markets

will not exhibit inefficient input choices

A
We want to find the efficient allocations
Capital
for x
Capital
in x they illustrate the actual production outcomes
production
Ox
Total Labor 7 8
Labor in x production
2
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
the isoquants are tangent to one another

Ox
9 Total Labor 10

We could also increase y from y1 to y2 while holding x constant At each efficient point, the RTS (of k for l) is equal in both
by moving along x1 x and y production
Oy Oy
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
Rate of Product Transformation Rate of Product Transformation

The rate of product transformation (RPT) The rate of product transformation shows
between two outputs is the negative of how x can be technically traded for y
the slope of the production possibility while continuing to keep the available
frontier productive inputs efficiently employed
RPT (of x for y ) slope of production
possibility frontier
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
Shape of the Production Shape of the Production

Possibility Frontier Possibility Frontier
Rewriting, we get As production of x rises and production
dy C / x MCx of y falls, the ratio of MCx to MCy rises
RPT (along OxOy )
dx C / y MCy this occurs if both goods are produced
under diminishing returns
The RPT is a measure of the relative increasing the production of x raises MCx, while
reducing the production of y lowers MCy
marginal costs of the two goods
this could also occur if some inputs were
more suited for x production than for y
production
19 20
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
Opportunity Cost Concavity of the Production

Possibility Frontier
The opportunity cost of one more unit of Suppose that the production of x and y
x is the reduction in y that this entails depends only on labor and the production
Thus, the opportunity cost is best functions are
measured as the RPT (of x for y) at the
x f (lx ) lx0.5 y f (ly ) ly0.5
prevailing point on the production
possibility frontier If labor supply is fixed at 100, then
this opportunity cost rises as more x is lx + ly = 100
produced The production possibility frontier is
x2 + y2 = 100 for x,y 0
23 24
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
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*
Comparative Statics Analysis Technical Progress in the

Production of x
Technical progress in the production of Technical progress in the production
Quantity of y
good x will shift the production of x will shift the production possibility
possibility curve outward curve out
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
General Equilibrium Pricing The Corn Laws Debate

Equilibrium requires that firms and
individuals face the same price ratio High tariffs on grain imports were
imposed by the British government after
x px y
RPT MRS the Napoleonic wars
y py x
Economists debated the effects of these
or corn laws between 1829 and 1845
x* = y* what effect would the elimination of these
tariffs have on factor prices?
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

Quantity of
manufactured Grain imports will be x1 x1
goods (y) We can use an Edgeworth box diagram
These imports will be financed by to see the effects of tariff reduction on
the export of manufactured goods
exports
y1
equal to y1 y1
the use of labor and capital
of
goods
y0 If the corn laws were repealed, there
y1
would be an increase in the production
U2
U1 of manufactured goods and a decline in
slope
px '
py '
the production of grain
Quantity of Grain (x)
x1 x0 x1
39 40
imports of grain
10
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
Political Support for Existence of General

Trade Policies Equilibrium Prices
Trade policies may affect the relative Beginning with 19th century investigations
incomes of various factors of production by Leon Walras, economists have
In the United States, exports tend to be examined whether there exists a set of
intensive in their use of skilled labor prices that equilibrates all markets
whereas imports tend to be intensive in simultaneously
their use of unskilled labor if this set of prices exists, how can it be
free trade policies will result in rising relative found?
wages for skilled workers and in falling
relative wages for unskilled workers 43 44
11
Existence of General Existence of General
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
Excess Demand Functions Excess Demand Functions

The excess demand function for any Demand functions are homogeneous of
good i at any set of prices (P) is defined degree zero
to be this implies that we can only establish
EDi (P) = Di (P) Si equilibrium relative prices in a Walrasian-
type model
This means that the equilibrium
Walras also assumed that demand
condition can be rewritten as
functions are continuous
EDi (P*) = Di (P*) Si = 0 small changes in price lead to small changes
in quantity demanded
47 48
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
Walras Proof of the Existence Walras Proof of the Existence

of Equilibrium Prices of Equilibrium Prices
The market equilibrium conditions Start with an arbitrary set of prices
provide (n-1) independent equations in Holding the other n-1 prices constant,
(n-1) unknown relative prices find the equilibrium price for good 1 (p1)
can we solve the system for an equilibrium Holding p1 and the other n-2 prices
condition?
constant, solve for the equilibrium price
the equations are not necessarily linear
all prices must be nonnegative
of good 2 (p2)
in changing p2 from its initial position to p2,
To attack these difficulties, Walras set up
the price calculated for good 1 does not
a complicated proof 51 need to remain an equilibrium price 52
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
Brouwers Fixed-Point Theorem Brouwers Fixed-Point Theorem

f (X)
Suppose that f(X) is a continuous function defined
on the interval [0,1] and that f(X) takes on the
Any continuous mapping [F(X)] of a values also on the interval [0,1]
closed, bounded, convex set into itself
Any continuous function must
has at least one fixed point (X*) such 1 cross the 45 line
that F(X*) = X*
This point of crossing is a
fixed point because f maps
f (X*) this point (X*) into itself
45
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
Proof of the Existence of Proof of the Existence of

Because only relative prices matter, it is These new prices will retain their original
convenient to assume that prices have relative values and will sum to 1
been defined so that the sum of all prices pi ' pi
is equal to 1
pj ' pj
Thus, for any arbitrary set of prices
These new prices will sum to 1
(p1,,pn), we can use normalized prices
n
of the form
pi p ' 1i
pi ' n
i 1
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
Free Goods Mapping the Set of Prices

Into Itself
The equilibrium conditions are
In order to achieve equilibrium, prices of
EDi (P*) = 0 for pi* > 0
goods in excess demand should be
EDi (P*) 0 for pi* = 0 raised, whereas those in excess supply
Note that this set of equilibrium prices should have their prices lowered
continues to obey Walras law
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
Mapping the Set of Prices Application of Brouwers

Into Itself Theorem
Second, the recalculated prices are not Thus, F satisfies the conditions of the
necessarily normalized Brouwer fixed-point theorem
they will not sum to 1 it is a continuous mapping of the set S into
it will be simple to normalize such that itself
n
There exists a point (P*) that is mapped
F (P ) 1
i 1
i
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
A General Equilibrium with A General Equilibrium with

Three Goods Three Goods
Equilibrium in the gold and platinum This system of simultaneous equations
markets requires that demand equal can be solved as
supply in both markets simultaneously p2/p1 = 2 p3/p1 = 3
In equilibrium:
p2 p3
2 11 10 gold will have a price twice that of silver
p1 p1
platinum will have a price three times that
of silver
p2 p
2 3 18 10 the price of platinum will be 1.5 times that
p1 p1 of gold
71 72
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
Smiths Invisible Hand Pareto Efficiency

Hypothesis
An allocation of resources is Pareto
Smiths insights gave rise to modern efficient if it is not possible (through
welfare economics further reallocations) to make one person
The First Theorem of Welfare better off without making someone else
Economics suggests that there is an worse off
exact correspondence between the The Pareto definition identifies allocations
efficient allocation of resources and the as being inefficient if unambiguous
competitive pricing of these resources improvements are possible
75 76
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
Efficient Choice of Inputs for a Efficient Choice of Inputs for a

Single Firm Single Firm
Assume that the firm produces two Technical efficiency requires that x
goods (x and y) and that the available output be as large as possible for any
levels of capital and labor are k and l value of y (y)
The production function for x is given by Setting up the Lagrangian and solving for
x = f (kx, lx) the first-order conditions:
L = f (kx, lx) + [y g (k - kx, l - lx)]
If we assume full employment, the
production function for y is L/kx = fk + gk = 0
y = g (ky, ly) = g (k - kx, l - lx) L/lx = fl + gl = 0
79
L/ = y g (k - kx, l - lx) = 0 80
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
Efficient Allocation of Efficient Allocation of

Resources among Firms Resources among Firms
The allocational problem is to maximize
Suppose that there are two firms
producing x and their production x = f1(k1, l1) + f2(k2, l2)
functions are subject to the constraints
f1(k1, l1) k1 + k2 = k
f2(k2, l2) l1 + l2 = l
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
x f1 f2 f1 f2 The marginal physical product of each

0
l1 l1 l1 l1 l2 input should be equal across the two
85
firms 86
Efficient Choice of Output Efficient Choice of Output

by Firms by Firms
Suppose that there are two outputs (x The Lagrangian for this problem is
and y) each produced by two firms L = x1 + x2 + [y* - f1(x1) - f2(x2)]
The production possibility frontiers for and yields the first-order condition:
these two firms are
f1/x1 = f2/x2
yi = fi (xi ) for i=1,2
The rate of product transformation
The overall optimization problem is to (RPT) should be the same for all firms
produce the maximum amount of x for
producing these goods
any given level of y (y*)
87 88
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
50 Trucks 50 Trucks 50 Trucks 50 Trucks

Firm A Firm B 89 Firm A Firm B 90
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

Only one point on PP will maximize
Output of y
Crusoes utility
Assume that there are only two goods
(x and y) and one individual in society
At the point of
P
(Robinson Crusoe)
tangency, Crusoes
MRS will be equal to Crusoes utility function is
the technical RPT
U3 U = U(x,y)
U2
The production possibility frontier is
U1
Output of x
T(x,y) = 0
P
95 96
24
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
Efficiency in Product Mix Competitive Prices and

Efficiency
Combining the first two, we get
Attaining a Pareto efficient allocation of
U / x T / x resources requires that the rate of

U / y T / y trade-off between any two goods be the
same for all economic agents
or
In a perfectly competitive economy, the
dy ratio of the prices of the two goods
MRS ( x for y ) (along T ) RPT ( x for y )
dx provides the common rate of trade-off to
which all agents will adjust
99 100
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
Efficiency in Production Efficiency in Production

A profit-maximizing firm will hire If this is true for every firm, then with a
additional units of an input (l) up to the competitive labor market
point at which its marginal contribution pxfl1 = w = pxfl2
to revenues is equal to the marginal fl1 = fl2
cost of hiring the input (w) Every firm that produces x has identical
pxfl = w marginal productivities of every input in
the production of x
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

The price ratios quoted to consumers Output of y x* and y* represent the efficient output mix
are the same ratios the market presents slope
px*
py*
to firms P
Only with a price ratio of
px*/py* will supply and
This implies that the MRS shared by all y* demand be in equilibrium
individuals will be equal to the RPT
shared by all the firms U0
An efficient mix of goods will therefore

be produced x* P
Output of x
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
Imperfect Competition Externalities

Imperfect competition includes all An externality occurs when there are
situations in which economic agents interactions among firms and individuals
exert some market power in determining that are not adequately reflected in
market prices market prices
these agents will take these effects into With externalities, market prices no
account in their decisions longer reflect all of a goods costs of
Market prices no longer carry the production
informational content required to achieve there is a divergence between private and
Pareto efficiency social marginal cost
111 112
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
Any point within the Edgeworth box in

UJ2
which the MRS for Smith is unequal to
US4
UJ3 that for Jones offers an opportunity for
Total Y
Pareto improvements
UJ4 US3
both can move to higher levels of utility
US2
through trade
US1
OS Total X
117 118
Distribution Contract Curve

OJ
UJ1
In an exchange economy, all efficient
UJ2 allocations lie along a contract curve
UJ3
US4 points off the curve are necessarily
inefficient
UJ4 US3 individuals can be made better off by moving to
the curve
US2
Along the contract curve, individuals
A

US1
preferences are rivals
one may be made better off only by making
OS Any trade in this area is
an improvement over A 119 the other worse off 120
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
Exchange with Initial Exchange with Initial

Endowments Endowments OJ
Neither person would engage in a trade Suppose that A represents
that would leave him worse off the initial endowments
Only a portion of the contract curve UJA
shows allocations that may result from

voluntary exchange
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
The Distributional Dilemma The Distributional Dilemma

If the initial endowments are skewed in These thoughts lead to the Second
favor of some economic actors, the Theorem of Welfare Economics
Pareto efficient allocations promised by any desired distribution of welfare among
the competitive price system will also individuals in an economy can be achieved
tend to favor those actors in an efficient manner through competitive
pricing if initial endowments are adjusted
voluntary transactions cannot overcome
appropriately
large differences in initial endowments
some sort of transfers will be needed to
attain more equal results
127 128
32
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

Competitive prices will result in a Factors that will interfere with
Pareto-efficient allocation of resources competitive markets abilities to
this is the First Theorem of Welfare achieve efficiency include
Economics market power
externalities
existence of public goods
imperfect information
131 132
33
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
Chapter 14 A monopoly is a single supplier to a

market
MODELS OF MONOPOLY This firm may choose to produce at any
point on the market demand curve
Barriers to Entry Technical Barriers to Entry

The reason a monopoly exists is that The production of a good may exhibit
other firms find it unprofitable or decreasing marginal and average costs
impossible to enter the market over a wide range of output levels
Barriers to entry are the source of all in this situation, relatively large-scale firms
monopoly power are low-cost producers
there are two general types of barriers to firms may find it profitable to drive others out of
the industry by cutting prices
entry
this situation is known as natural monopoly
technical barriers
once the monopoly is established, entry of new
legal barriers
firms will be difficult
3 4
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
Creation of Barriers to Entry Profit Maximization

Some barriers to entry result from actions To maximize profits, a monopolist will
taken by the firm choose to produce that output level for
research and development of new products which marginal revenue is equal to
or technologies marginal cost
purchase of unique resources marginal revenue is less than price because
lobbying efforts to gain monopoly power the monopolist faces a downward-sloping
demand curve
The attempt by a monopolist to erect
he must lower its price on all units to be sold if it
barriers to entry may involve real is to generate the extra demand for this unit
resource costs 7 8
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
monopolist will set a price greater than AC

P* The firm will charge a price
marginal cost of P*
C
Profits can be found in

the shaded rectangle
D
MR
Quantity
Q*
9 10
The Inverse Elasticity Rule The Inverse Elasticity Rule

The gap between a firms price and its Two general conclusions about monopoly
marginal cost is inversely related to the pricing can be drawn:
price elasticity of demand facing the firm a monopoly will choose to operate only in
regions where the market demand curve is
P MC 1
elastic
P eQ,P eQ,P < -1
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
Monopoly Profits No Monopoly Supply Curve

Price
Price
MC MC
AC
With a fixed market demand curve, the
supply curve for a monopolist will only
AC
P*=AC
be one point
P*
the price-output combination where MR =
C
MC
If the demand curve shifts, the marginal
D MR
D revenue curve shifts and a new profit-
MR
Q* Quantity Q* Quantity maximizing output will be chosen

Positive profits Zero profit
15 16
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
Monopoly with Linear Demand Monopoly with Linear Demand

Thus, MR = MC where To see that the inverse elasticity rule
100 - Q/10 = 0.01Q holds, we can calculate the elasticity of
Q* = 500 P* = 75 demand at the monopolys profit-
At the profit-maximizing output, maximizing level of output
C(Q) = 0.05(500)2 + 10,000 = 22,500
Q P 75
AC = 22,500/500 = 45 eQ,P 20 3
P Q 500
= (P* - AC)Q = (75 - 45)500 = 15,000
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
Monopoly and Resource Monopoly and Resource

Allocation Allocation
Price Price Consumer surplus would fall
If this market was competitive, output would
be Q* and price would be P*
Producer surplus will rise
Under a monopoly, output would be Q**
P**
and price would rise to P**
P** Consumer surplus falls by more
than producer surplus rises.
MC=AC MC=AC
P* P* There is a deadweight
loss from monopoly
D D
MR MR
Q** Q* Quantity Q** Q* Quantity

23 24
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

The consumer surplus associated with Therefore, under perfect competition
any price (P0) can be computed as c e 1
CSc

e 1
CS Q(P )dP P edP and under monopoly
P0 P0
e 1

Pe 1
P e 1 c
CS 0

e 1P e 1 1 1
0

CSm e
27 e 1 28
7
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
Welfare Losses and Elasticity Monopoly and Product Quality

To find the transfer from consumer The market power enjoyed by a monopoly
surplus into monopoly profits we can may be exercised along dimensions other
divide monopoly profits by the competitive than the market price of its product
consumer surplus type, quality, or diversity of goods
e 1
Whether a monopoly will produce a
m e
e 1 1 e higher-quality or lower-quality good than

CSc e 1 1 1 e would be produced under competition

e depends on demand and the firms costs
If e = -2, this ratio is 31 32
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
Monopoly and Product Quality Monopoly and Product Quality

The level of product quality that will be The difference between the quality choice
opted for under competitive conditions is of a competitive industry and the
the one that maximizes net social welfare monopolist is:
the monopolist looks at the marginal
Q*
SW P(Q, X )dQ C(Q, X ) valuation of one more unit of quality
0
assuming that Q is at its profit-maximizing
Maximizing with respect to X yields level
the competitve industry looks at the marginal
SW Q*
PX (Q, X )dQ C X 0 value of quality averaged across all output
X 0
35 levels 36
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
Perfect Price Discrimination Perfect Price Discrimination

Under perfect price discrimination, the monopolist
If each buyer can be separately Price charges a different price to each buyer
identified by the monopolist, it may be The first buyer pays P1 for Q1 units
P1
possible to charge each buyer the P2 The second buyer pays P2 for Q2-Q1 units
maximum price he would be willing to
MC
pay for the good The monopolist will
continue this way until the
perfect or first-degree price discrimination marginal buyer is no
extracts all consumer surplus D longer willing to pay the
no deadweight loss goods marginal cost
Quantity
Q1 Q2
39 40
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
R P (Q )dQ 100Q 55,511

marginal buyer pays a price exactly 0 40 0
equal to the marginal cost
c(Q) 0.05Q 2 10,000 32,178
41 Profit is much larger (23,333 > 15,000) 42
Market Separation Market Separation

Perfect price discrimination requires the All the monopolist needs to know in this
monopolist to know the demand function case is the price elasticities of demand
for each potential buyer for each market
A less stringent requirement would be to set price according to the inverse elasticity
assume that the monopoly can separate its rule
buyers into a few identifiable markets If the marginal cost is the same in all
can follow a different pricing policy in each markets,
market
1 1
third-degree price discrimination Pi (1 ) Pj (1 )
43
ei ej 44
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
higher in markets where demand is less D

D
elastic MR MR
Quantity in Market 1 Q1* 0 Q2* Quantity in Market 2

45 46
Third-Degree Price Third-Degree Price

Discrimination Discrimination
Suppose that the demand curves in two Optimal choices and prices are
separated markets are given by Q1 = 9 P1 = 15
Q1 = 24 P1 Q2 = 6 P2 = 9
Q2 = 24 2P2 Profits for the monopoly are
Suppose that MC = 6 = (P1 - 6)Q1 + (P2 - 6)Q2 = 81 + 18 = 99
Profit maximization requires that
MR1 = 24 2Q1 = 6 = MR2 = 12 Q2
47 48
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
Third-Degree Price Two-Part Tariffs

Discrimination
A linear two-part tariff occurs when
The deadweight loss is smaller with one buyers must pay a fixed fee for the right
price than with two: to consume a good and a uniform price
DW = 0.5(P-MC)(30-Q) = 0.5(11-6)(15) = 37.5 for each unit consumed
T(q) = a + pq
The monopolists goal is to choose a
and p to maximize profits, given the
demand for the product
51 52
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
Two-Part Tariffs Two-Part Tariffs

Suppose there are two different buyers With this marginal price, demander 2
with the demand functions obtains consumer surplus of 36
q1 = 24 - p1 this would be the maximum entry fee that
q2 = 24 - 2p2 can be charged without causing this buyer
to leave the market
If MC = 6, one way for the monopolist to
implement a two-part tariff would be to This means that the two-part tariff in this
set p1 = p2 = MC = 6 case would be
T(q) = 36 + 6q
q1 = 18 q2 = 12
55 56
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

Because natural monopolies exhibit Suppose that the regulatory commission allows the
Price decreasing costs, MC falls below AC Price monopoly to charge a price of P1 to some users
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
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

Suppose that s is constrained by If =0, regulation is ineffective and the
regulation to be equal to s0, then the monopoly behaves like any profit-
firms problem is to maximize profits maximizing firm
= pf (k,l) wl vk If =1, the Lagrangian reduces to
subject to this constraint L = (s0 v)k
The Lagrangian for this problem is which (assuming s0>v), will mean that
L = pf (k,l) wl vk + [wl + s0k pf (k,l)]
the monopoly will hire infinite amounts
of capital an implausible result
63 64
16
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
Dynamic Views of Monopoly Important Points to Note:

Some economists have stressed the The most profitable level of output for
beneficial role that monopoly profits can the monopolist is the one for which
play in the process of economic marginal revenue is equal to marginal
development cost
these profits provide funds that can be at this output level, price will exceed
invested in research and development marginal cost
the possibility of attaining or maintaining a the profitability of the monopolist will
monopoly position provides an incentive to depend on the relationship between price
keep one step ahead of potential competitors and average cost
67 68
17
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

A monopoly may be able to increase its Governments often choose to regulate
profits further through price natural monopolies (firms with
discrimination charging different diminishing average costs over a broad
prices to different categories of buyers range of output levels)
the ability of the monopoly to practice the type of regulatory mechanisms
price discrimination depends on its ability adopted can affect the behavior of the
to prevent arbitrage among buyers regulated firm
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
Pricing Under Pricing Under

Homogeneous Oligopoly Homogeneous Oligopoly
We will assume that there is a relatively The inverse demand function for the
small number of identical firms (n) good shows the price that buyers are
we will initially start with n fixed, but later willing to pay for any particular level of
allow n to vary through entry and exit in industry output
response to firms profitability P = f(Q) = f(q1+q2++qn)
The output of each firm is qi (i=1,,n) Each firms goal is to maximize profits
symmetry in costs across firms will usually i = f(Q)qi Ci(qi)
require that these outputs are equal
i = f(q1+q2+qn)qi Ci
3 4
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
Quasi-Competitive Model Quasi-Competitive Model

Each firm is assumed to be a price taker If each firm acts as a price taker, P = MCi
Price
so QC output is produced and sold at a
The first-order condition for profit- price of PC
maximization is
i /qi = P (Ci /qi) = 0
P = MCi (qi) (i=1,,n) PC MC
Along with market demand, these n

supply equations will ensure that this D
MR
market ends up at the short-run Quantity
QC
competitive solution 7 8
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
Cartel Model Cartel Model

The first-order conditions for a maximum If the firms form a group and act as a
Price
are that monopoly, MR = MCi so QM output is
produced and sold at a price of PM
P
P (q1 q2 ... qn ) MC(qi ) 0 PM
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
Cournot Model Cournot Model

The first-order conditions for a profit Each firms output will exceed the cartel
maximization are output
i P the firm-specific marginal revenue is larger
P qi MCi (qi ) 0
qi qi than the market-marginal revenue
The firm maximizes profit where MRi = Each firms output will fall short of the
MCi competitive output
the firm assumes that changes in qi affect qi P/qi < 0
its total revenue only through their direct
effect on market price
15 16
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
Cournots Natural Springs Cournots Natural Springs

Duopoly Duopoly
Because each firm has zero marginal The cartel solution to this problem can
costs, the quasi-competitive solution be found by maximizing industry
will result in a market price of zero revenue (and profits)
total demand will be 120 = PQ = 120Q - Q2
the division of output between the two
firms is indeterminate
The first-order condition is
each firm has zero marginal cost over all /Q = 120 - 2Q = 0
output ranges
19 20
5
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

Duopoly Duopoly
These first-order equations are called We can solve the reaction functions
reaction functions simultaneously to find that
show how each firm reacts to the others q1 = q2 = 40
output level P = 120 - (q1 + q2) = 40
In equilibrium, each firm must produce 1 = 2 = Pq1 = Pq2 = 1,600
what the other firm thinks it will
Note that the Cournot equilibrium falls
between the quasi-competitive model
23
and the cartel model 24
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
Conjectural Variations Model Price Leadership Model

The first-order condition for profit Suppose that the market is composed
maximization becomes of a single price leader (firm 1) and a
i P P q j fringe of quasi-competitors
P qi MCi (qi ) 0
qi qi j i q j qi firms 2,,n would be price takers
The firm must consider how its output firm 1 would have a more complex reaction
function, taking other firms actions into
decisions will affect price in two ways
account
directly
indirectly through its effect on the output
decisions of other firms 27 28
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
For a price of P1 or above, the

SC represents the supply leader will sell nothing
P1
decisions of all of the n-1 firms in
the competitive fringe For a price of P2 or below, the
P2 leader has the market to itself
D D
Quantity Quantity
29 30
Price Leadership Model Price Leadership Model

Between P2 and P1, the
Price demand for the leader (D) Price
SC is constructed by SC
Market price will then be PL
subtracting what the fringe
will supply from total
P1 P1
market demand
The competitive fringe will
PL PL
D
The leader would then set D
produce QC and total
P2 P2
MC
MR = MC and produce QL MC
industry output will be QT
at a price of PL (= QC + QL)
MR D MR D
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
Stackelberg Leadership Model Stackelberg Leadership Model

There is the possibility of a different This means that firm 2 reduces its output
type of strategic leadership by unit for each unit increase in q1
Assume that firm 1 knows that firm 2 Firm 1s profit-maximization problem can
chooses q2 so that be rewritten as
q2 = (120 q1)/2 1 = Pq1 = 120q1 q12 q1q2
Firm 1 can now calculate the conjectural 1/q1 = 120 2q1 q1(q2/q1) q2 = 0
variation 1/q1 = 120 (3/2)q1 q2 = 0
q2/q1 = -1/2
35 36
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
Product Differentiation Product Differentiation

The law of one price may not hold, The output of a set of firms constitute a
because demanders may now have product group if the substitutability in
preferences about which suppliers to demand among the products (as
purchase the product from measured by the cross-price elasticity) is
there are now many closely related, but not very high relative to the substitutability
identical, products to choose from between those firms outputs and other
We must be careful about which goods generally
products we assume are in the same
market
39 40
10
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

The ith firms profits are given by At the profit-maximizing level of output,
i = piqi Ci(qi,zi) marginal revenue is equal to marginal
In the simple case where zj/qi, zj/zi, cost
pj/qi, and pj/zi are all equal to zero, Additional differentiation activities should
the first-order conditions for a maximum be pursued up to the point at which the
are additional revenues they generate are
i p C
pi qi i i 0 equal to their marginal costs
qi qi qi
i p C
qi i i 0
zi zi zi 43 44
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
Spatial Differentiation Spatial Differentiation

L A person located at point E will be
Ice cream stands are located at points A indifferent between stands A and B if
and B along a linear beach of length L pA + cx = pB + cy
where pA and pB are the prices charged
by each stand, x is the distance from E

A E B to A, and y is the distance from E to B
Suppose that a person is standing at point E
47 48
12
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

Profits for the two firms are Each firm will choose its price so as to
maximize profits
1 p p pA2
A p A (a x ) (L a b ) p A A B
2 2c A 1 p p
(L a b ) B A 0
pA 2 2c c
1 p p pB2
B pB (b y ) (L a b)pB A B B 1 p p
2 2c (L a b ) A B 0
pB 2 2c c
51 52
13
These can be solved to yield:
L
ab
pA c L a x y b
3
ab Because A is somewhat more favorably located

pB c L
3 than B, pA will exceed pB

These prices depend on the precise A E B
locations of the stands and will differ

from one another
53 54
Spatial Differentiation Entry

If we allow the ice cream stands to In perfect competition, the possibility of
change their locations at zero cost, entry ensures that firms will earn zero
each stand has an incentive to move to profit in the long run
the center of the beach These conditions continue to operate
any stand that opts for an off-center under oligopoly
position is subject to its rival moving to the extent that entry is possible, long-run
between it and the center and taking a profits are constrained
larger share of the market
if entry is completely costless, long-run
this encourages a similarity of products
profits will be zero
55 56
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
Entry Monopolistic Competition

Firms will initially be maximizing
profits at q*. Since P > AC, > 0 The zero-profit equilibrium model just
Price MC
Since > 0, firms will
shown was developed by Chamberlin
AC enter and the demand who termed it monopolistic competition
facing the firm will shift each firm produces a slightly differentiated
P* left
product and entry is costless
P Entry will end when = 0 Suppose that there are n firms in a
d
Firms will exhibit excess market and that each firm has the total
capacity = qm - q cost schedule
mr mr d
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

This means that The equilibrium n is determined by the
0.5 p j zero-profit condition
j i 303
pi 2
n 1 0.02(n 1)n pi qi ci 0
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
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
Contestable Markets and Perfectly Contestable Market

Industry Structure
Several economists have challenged A market is perfectly contestable if entry
that this zero-profit equilibrium is and exit are absolutely free
sustainable in the long run no outside potential competitor can enter
the model ignores the effects of potential by cutting price and still make a profit
entry on market equilibrium by focusing if such profit opportunities existed, potential
only on actual entrants entrants would take advantage of them
need to distinguish between competition in

the market and competition for the market
67 68
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
Perfectly Contestable Market Perfectly Contestable Market

In a perfectly contestable market, equilibrium
If we let q* represent the output level for requires that P = MC = AC
Price
which average costs are minimized and The number of firms is
Q* represent the total market demand completely determined by
when price equals average cost, then market demand (Q*) and
by the output level that
the equilibrium number of firms in the AC1 AC2 AC3 AC4 minimizes AC (q*)
industry is given by P*
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
A Contestable Natural A Contestable Natural

Monopoly Monopoly
Suppose that the total cost of producing If the producer behaves as a monopolist,
electric power is given by it will maximize profits by
C(Q) = 100Q + 8,000 MR = 200 - (2Q)/5 = MC = 100
since AC declines over all output ranges, Qm = 250
this is a natural monopoly Pm = 150
The demand for electricity is given by m = R - C = 37,500 - 33,000 = 4,500
QD = 1,000 - 5P These profits will be tempting to would-be
75
entrants 76
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
A Contestable Natural Important Points to Note:

Monopoly
Markets with few firms offer potential
Only Q = 400 is a sustainable entry
profits through the formation of a
deterrent
monopoly cartel
Under contestability, the market equilibrium such cartels may, however, be unstable
is and costly to maintain because each
Qc = 400 member has an incentive to chisel on
Pc = 120 price
Contestability increased consumer welfare
from what it was under the monopoly
situation 79 80
20
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

Product differentiation can be Entry conditions are important
analyzed in a standard profit- determinants of the long-run
maximization framework sustainability of various market
with differentiated products, the law of equilibria
one price no longer holds and firms may with perfect contestability, equilibria may
have somewhat more leeway in their resemble perfectly competitive ones
pricing decisions even though there are relatively few
firms in the market
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)
Allocation of Time Allocation of Time

Assume that an individuals utility Combining the two constraints, we get
depends on consumption (c) and hours c = w(24 h)
of leisure (h) c + wh = 24w
utility = U(c,h)
An individual has a full income of 24w
In seeking to maximize utility, the may spend the full income either by
individual is bound by two constraints working (for real income and consumption)
l + h = 24 or by not working (enjoying leisure)
c = wl The opportunity cost of leisure is w
3 4
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
Income and Income and

Substitution Effects Consumption Substitution Effects
The substitution effect is the movement
Both a substitution effect and an income from point A to point C
effect occur when w changes
The income effect is the movement
when w rises, the price of leisure becomes B
from point C to point B
higher and the individual will choose less C
leisure A U2 The individual chooses

less leisure as a result
because leisure is a normal good, an U1
of the increase in w
increase in w leads to an increase in leisure Leisure
The income and substitution effects move
in opposite directions 7
substitution effect > income effect 8
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
A Mathematical Analysis Dual Statement of the Problem

of Labor Supply
The dual problem can be phrased as
The only effect of introducing nonlabor
choosing levels of c and h so that the
income is that the budget constraint
amount of expenditure (E = c wl)
shifts out (or in) in a parallel fashion
required to obtain a given utility level
We can now write the individuals labor (U0) is as small as possible
supply function as l(w,n) solving this minimization problem will yield
hours worked will depend on both the exactly the same solution as the utility
wage and the amount of nonlabor income maximization problem
since leisure is a normal good, l/n < 0
11 12
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
Slutsky Equation of Slutsky Equation of

Labor Supply Labor Supply
The expenditures being minimized in the Substituting for E/w, we get
dual expenditure-minimization problem l c l l l l
play the role of nonlabor income in the l l
w w E w n
primary utility-maximization problem
Introducing a different notation for lc ,
lc(w,U) = l[w,E(w,U)] = l(w,N) and rearranging terms gives us the
Partial differentiation of both sides with Slutsky equation for labor supply:
respect to w gives us
l l l
l c l l E l
w w U U 0 n
w w E w 15 16
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

Dividing the first by the second yields Substitution into the full income
h h 1 constraint yields
c = (w + n)
c (1 )c w
h = (w + n)/w
1 the person spends of his income on
wh c consumption and = 1- on leisure

the labor supply function is
n
l (w , n ) 1 h (1 )
w
19 20
5
Note that if n = 0, the person will work If n > 0, l/w > 0

(1-) of each hour no matter what the the individual will always choose to spend
wage is n on leisure
the substitution and income effects of a Since leisure costs w per hour, an increase
change in w offset each other and leave l in w means that less leisure can be bought
unaffected with n
21 22
Cobb-Douglas Labor Supply CES Labor Supply

Suppose that the utility function is
Note that l/n < 0
c h
an increase in nonlabor income allows this U (c, h )

person to buy more leisure
income transfer programs are likely to reduce
Budget share equations are given by
labor supply c 1
sc
lump-sum taxes will increase labor supply w n (1 w )
wh 1
sh
w n (1 w )
23 where = /(-1) 24
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
Market Supply Curve for Labor Labor Market Equilibrium

Note that at w0, individual B would choose to remain
out of the labor force Equilibrium in the labor market is
w
Individual As
w Individual Bs
established through the interactions of
supply curve w
sA supply curve
sB
Total labor S individuals labor supply decisions with
supply curve
firms decisions about how much labor
w0
to hire
l l l
As w rises, l rises for two reasons: increased hours

of work and increased labor force participation 27 28
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
Mandated Benefits Mandated Benefits

Suppose that, prior to the mandate, the Suppose that the government mandates
supply and demand for labor are that all firms provide a benefit to their
lS = a + bw workers that costs t per unit of labor
lD = c dw hired
Setting lS = lD yields an equilibrium wage unit labor costs become w + t
of Suppose also that the benefit has a
w* = (c a)/(b + d) value of k per unit supplied
the net return from employment rises to
31
w+k 32
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
Mandated Benefits Wage Variation

If k > t, the new wage falls by more than It is impossible to explain the variation
the cost of the benefit and the in wages across workers with the tools
equilibrium level of employment rises developed so far
we must consider the heterogeneity that
exists across workers and the types of jobs
they take
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
Monopsony in the Monopsony in the

Labor Market Labor Market
In many situations, the supply curve for The marginal expense (ME) associated
an input (l) is not perfectly elastic with any input is the increase in total
We will examine the polar case of costs of that input that results from hiring
monopsony, where the firm is the single one more unit
buyer of the input in question if the firm faces an upward-sloping supply
the firm faces the entire market supply curve curve for that input, the marginal expense will
exceed the market price of the input
to increase its hiring of labor, the firm must
pay a higher wage
39 40
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
Monopsonistic Hiring Monopsonistic Hiring

The firms wage bill is
Suppose that a coal mines workers can
wl = l2/50
dig 2 tons per hour and coal sells for
$10 per ton The marginal expense associated with
this implies that MRPl = $20 per hour hiring miners is
If the coal mine is the only hirer of MEl = wl/l = l/25
miners in the local area, it faces a labor Setting MEl = MRPl, we find that the
supply curve of the form optimal quantity of labor is 500 and the
l = 50w optimal wage is $10
43 44
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
Labor Unions Labor Unions

The union may wish to maximize the total The union may wish to maximize the total
Wage Wage
wage bill (wl). economic rent of its employed members
This occurs where This occurs where
S MR = 0 S MR = S
w2
w1 l1 workers will be l2 workers will be

hired and paid a hired and paid a
wage of w1 wage of w2
D D
This choice will Again, this will
MR create an excess MR cause an excess
Labor supply of labor Labor
l1 l2 supply of labor
47 48
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
Modeling a Union A Union Bargaining Model

If a union can establish control over Suppose a firm and a union engage in a
labor supply, other options become two-stage game
possible first stage: union sets the wage rate its
competitive solution where l = 583 and workers will accept
w = $11.66 second stage: firm chooses its employment
monopoly solution where l = 318 and level
w = $38.20
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
A Union Bargaining Model Important Points to Note:

This implies that the union should choose A utility-maximizing individual will
w so that its MRS is equal to the slope of choose to supply an amount of labor at
the firms labor demand function which the MRS of leisure for
consumption is equal to the real wage
The result from this game is a Nash
rate
equilibrium
55 56
14
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

Monopsony power by firms on the Labor unions can be treated
demand side of the market will analytically as monopoly suppliers of
reduce both the quantity of labor labor
hired and the real wage rate the nature of labor market equilibrium in
as in the monopoly case, there will be a the presence of unions will depend
welfare loss importantly on the goals the union
chooses to pursue
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
Properties of Information The Value of Information

Studying information also becomes In many respects, lack of information
difficult due to some technical properties does represent a problem involving
of information uncertainty for a decision maker
it is durable and retains value after its use the individual may not know exactly what the
it can be nonrival and nonexclusive consequences of a particular action will be
in this manner it can be considered a public Better information can reduce uncertainty
good and lead to better decisions and higher
utility
3 4
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

The individuals goal will be to maximize First-order conditions for a constrained
E(U) = gU(W g) + bU(W b)
maximum are:
L
subject to gU ' (Wg ) pg 0
Wg
I = pgW g + pbW b + pmm
L
We need to set up the Lagrangian bU ' (Wb ) pb 0
Wb
L = gU(W g) + bU(W b) + (I-pgW g-pbW b-pmm)
L
I pgWg pbWb pm m 0
7
8
2
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
Asymmetry of Information Information and Insurance

The level of information that a person buys There are a number of information
will depend on the price per unit asymmetries in the market for insurance
Information costs may differ significantly Buyers are often in a better position to
across individuals know the likelihood of uncertain events
some may possess specific skills for acquiring may also be able to take actions that
information impact these probabilities
some may have experience that is relevant
some may have made different former
investments in information services 11 12
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
Moral Hazard Moral Hazard

The first-order condition for a maximum is
Wealth in the two states is given by
W1 = W 0 - a E
U (W1 ) (1 )U ' (W1 ) U (W2 ) U ' (W2 ) 0
W2 = W 0 - a - l a a a

U ' (W2 ) (1 )U ' (W1 ) [U (W2 ) U (W1 )]
a
The individual chooses a to maximize the optimal point is where the expected
E(U) = E = (1-)U(W 1) + U(W 2) marginal utility cost from spending one
additional dollar on prevention is equal to the
reduction in the expected value of the utility loss
15
that may be encountered in bad times 16
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
Behavior with Insurance Moral Hazard

and Perfect Monitoring
So far, we have assumed that insurance
Since W 1 = W 2, this condition becomes
providers know the probability of a loss

1 l and can charge the actuarially fair premium
a
this is doubtful when individuals can undertake
at the utility maximizing choice, the marginal
precautionary activities
cost of an extra unit of prevention should
equal the marginal reduction in the expected the insurance provider would have to
loss provided by the extra spending constantly monitor each persons activities to
determine the correct probability of loss
with full insurance and actuarially fair
premiums, precautionary purchases still occur
19 20
at the optimal level
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
Adverse Selection Adverse Selection

Suppose that one person has a probability of loss
equal to H, while the other has a probability of loss
W2 W2 equal to l
certainty line
certainty line
Assume that two individuals F
have the same initial wealth Both individuals would
(W*) and each face a G
prefer to move to the
potential loss of l certainty line if premiums
W *- l E W*- l E are actuarially fair
W* W1 W* W1
23 24
6
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

One possible solution would be for the insurer to
Point M is not an equilibrium because further trading
offer premiums based on the average probability of
opportunities exist for low-risk individuals
W2 loss W2
certainty line certainty line
An insurance policy
F F
Since EH does not such as N would be
H H
M accurately reflect the true M unattractive to high-
G G UH
probabilities of each buyer, N risk individuals, but
W*- l E they may not fully insure W*- l E UL attractive to low-risk
and may choose a point individuals and
such as M profitable for insurers
W* W1 W* W1
27 28
7
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

The best policy that low-risk individuals can obtain is
one such as J Low-risk individuals could try to signal
W2 insurers their true probabilities of loss
certainty line
insurers must be able to determine if the
F
signals are believable
The policies G and J
UH insurers may be able to infer accurate
G J represent a
W*- l separating equilibrium probabilities by observing their clients
E
market behavior
the separating equilibrium identifies an
W1
individuals risk category
W*
31 32
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
The Principal-Agent The Principal-Agent

Relationship Relationship
In each of these cases, a person with less Assume that we can show a graph of the
information (the principal) is hiring a more owners (or managers) preferences in
informed person (the agent) to make terms of profits and various benefits (such
decisions that will directly affect the as fancy offices or use of the corporate
principals own well-being jet)
The owners budget constraint will have a
slope of -1
each $1 of benefits reduces profit by $1
35 36
9
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

Suppose that the manager is not the The new budget constraint continues to
sole owner of the firm include the point b*, *
suppose there are two other owners who the manager could still make the same
play no role in operating the firm decision that a sole owner could)
$1 in benefits only costs the manager For benefits greater than b*, the slope
$0.33 in profits of the budget constraint is only -1/3
the other $0.67 is effectively paid by the
other owners in terms of reduced profits
39 40
10
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
Using the Corporate Jet Using the Corporate Jet

A firm owns a fleet of corporate jets Suppose that all would-be applicants
used mainly for business purposes have the same utility function
the firm has just fired a CEO for misusing U(s,j) = 0.1s0.5 + j
the corporate fleet
where s is salary and j is jet use (0 or 1)
The firm wants to structure a
management contract that provides All applicants have job offers from other
better incentives for cost control firms promising them a utility level of at
most 2.0
43 44
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
The Owner-Manager The Owner-Manager

Suppose that the gross profits of the firm The owners face two issues
depend on some specific action that a they must know the agents utility function
hired manager might take (a) which depends on net income (IM)
net profits = = (a) s[(a)] IM = s[(a)] = c(a) = c0
where c(a) represents the cost to the manager of
Both gross and net profits are maximized
undertaking a
when /a = 0
they must design the compensation system
the owners problem is to design a salary so that the agent is willing to take the job
structure that provides an incentive for the this requires that IM 0
manager to choose a that maximizes 47 48
12
The Owner-Manager The Owner-Manager
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
Asymmetric Information Hidden Action

Models of the principal-agent relationship The primary reason that the managers
have introduced asymmetric information action may be hidden is that profits
into this problem in two ways depend on random factors that cannot be
it is assumed that a managers action is not observed by the firms owner
directly observed and cannot be perfectly Suppose that profits depend on both the
inferred from the firms profits
managers action and on a random
referred to as hidden action
variable (u)
the agent-managers objective function is not
directly observed (a) = (a) + u
referred to as hidden information 51 where represents expected profits 52
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

Information is valuable because it Information has a number of special
permits individuals to increase the properties that suggest that
expected utility of their decisions inefficiencies associated with
individuals might be willing to pay imperfect and asymmetric information
something to acquire additional may be quite prevalent
information differing costs of acquisition
some aspects of a public good
55 56
14
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

Informational asymmetries can also Asymmetric information may also
lead to adverse selection in insurance cause some (principal) economic
markets actors to hire others (agents) to make
the resulting equilibria may often be decisions for them
inefficient because low-risk individuals will providing the correct incentives to the
be worse off than in the full information agent is a difficult problem
case
market signaling may be able to reduce
these inefficiencies
59 60
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
Interfirm Externalities Beneficial Externalities

Consider two firms, one producing good
x and the other producing good y The relationship between the two firms
can be beneficial
The production of x will have an external
two firms, one producing honey and the
effect on the production of y if the output other producing apples
of y depends not only on the level of
inputs chosen by the firm but on the level
at which x is produced
y = f(k,l;x)
3 4
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
Externalities and Allocative Externalities and Allocative

Inefficiency Inefficiency
Externalities lead to inefficient Suppose that the individuals utility
allocations of resources because function is given by
market prices do not accurately reflect utility = U(xc,yc)
the additional costs imposed on or the where xc and yc are the levels of x and y
benefits provided to third parties consumed
We can show this by using a general The individual has initial stocks of x* and
equilibrium model with only one y*
individual
can consume them or use them in
7 8
production
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
Externalities and Allocative Finding the Efficient Allocation

Inefficiency
The economic problem is to maximize
The quantities of each good in this
utility subject to the four constraints
economy are constrained by the initial
listed earlier
stocks available and by the additional
production that takes place The Lagrangian for this problem is
xc + xi = xo + x* L = U(xc,yc) + 1[f(yi) - xo] + 2[g(xi,xo) - yo] +
yc + yi = xo + y* 3(xc + xi - xo - x*) + 4(yc + yi - yo - y*)
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
Finding the Efficient Allocation Finding the Efficient Allocation

To achieve efficiency in x production, This equation requires the individuals
we must also consider the externality MRS to equal dy/dx obtained through x
this production poses to y production
Combining the last three equations 1/fy represents the reciprocal of the
gives marginal productivity of y in x production
MRS = 3/4 = (-1 + 2g2)/4 = -1/4 + 2g2/4 g2 represents the negative impact that
added x production has on y output
MRS = 1/fy - g2 allows us to consider the externality from x
production
15 16
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
Production Externalities Production Externalities

Suppose that two newsprint producers The downstream firm has a similar
are located along a river production function but its output may
be affected by chemicals that firm x
pours in the river
The upstream firm has a production
function of the form y = 2,000ly0.5(x - x0) (for x > x0)
x = 2,000lx0.5 y = 2,000ly0.5 (for x x0)

where x0 represents the rivers natural
capacity for pollutants
19 20
5
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

Suppose that these two firms merge
If = -0.1 and x0 = 38,000, firm y will
and the manager must now decide how
maximize profits by
to allocate the combined workforce
y
50 p 1,000ly0.5 ( 40,000 38,000)0.1 If one worker is transferred from x to y,
ly
output of x becomes
50 468ly0.5 x = 2,000(399)0.5 = 39,950
Because of the externality, ly* = 87 and and output of y becomes
y output will be 8,723 y = 2,000(88)0.5(1,950)-0.1 = 8,796
23 24
6
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
Solutions to the Solutions to the

Externality Problem Externality Problem
Price MC
Market equilibrium
The output of the externality-producing will occur at p1, x1
activity is too high under a market- S = MC
If there are external
determined equilibrium
costs in the
Incentive-based solutions to the production of x,
externality problem originated with p1 social marginal costs
are represented by
Pigou, who suggested that the most MC
direct solution would be to tax the D
externality-creating entity Quantity of x

x1
27 28
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
A Pigouvian Tax on Newsprint Taxation in the General

Equilibrium Model
Output of x will be 38,000 if lx = 361
The optimal Pigouvian tax in our
Thus, we can calculate t from the labor
general equilibrium model is to set
demand condition
t = -pyg2
(1 - t)MPl = (1 - t)1,000(361)-0.5 = 50
the per-unit tax on x should reflect the
t = 0.05 marginal harm that x does in reducing y
Therefore, a 5 percent tax on the price output, valued at the price of good y
firm x receives would eliminate the
externality
31 32
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
Pollution Rights Pollution Rights

An innovation that would mitigate the The net revenue that x receives per unit
informational requirements involved with is given by px - r, where r is the payment
Pigouvian taxation is the creation of a the firm must make to firm y for each
market for pollution rights unit of x it produces
Suppose that firm x must purchase from Firm y must decide how many rights to
firm y the rights to pollute the river they sell firm x by choosing x output to
share maximize its profits
xs choice to purchase these rights is y = pyg(xi,xo) + rxo
identical to its output choice
35 36
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
The Coase Theorem The Coase Theorem

Suppose that firm x is initially given xT Profits for firm y are given by
rights to produce (and to pollute)
y = pyg(xi,xo) - r(xT - xo)
it can choose to use these for its own
production or it may sell some to firm y Profit maximization in this case will lead
Profits for firm x are given by to precisely the same solution as in the
x = pxxo + r(xT - xo) = (px - r)xo + rxT case where firm y was assigned the
rights
x = (px - r)f(yi) + rxT
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
Attributes of Public Goods Attributes of Public Goods

Some examples of these types of goods
A good is nonrival if consumption of
include:
additional units of the good involves
zero social marginal costs of production Exclusive
Yes No
Hot dogs, Fishing
Yes cars, grounds,
houses clean air
Rival National
Bridges,
defense,
No swimming
mosquito
pools
control
43 44
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
Public Goods and Public Goods and

Resource Allocation Resource Allocation
Resulting utilities for these individuals are The necessary conditions for efficient
UA[x,(yA* - ysA)] resource allocation consist of choosing
UB[x,(yB* - ysB)] the levels of ysA and ysB that maximize
The level of x enters identically into each one persons (As) utility for any given
persons utility curve level of the others (Bs) utility
it is nonexclusive and nonrival The Lagrangian expression is
each persons consumption is unrelated to what L = UA(x, yA* - ysA) + [UB(x, yB* - ysB) - K]
he contributes to production
each consumes the total amount produced 47 48
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
The Roommates Dilemma The Roommates Dilemma

Suppose two roommates with identical We know from our earlier analysis of
preferences derive utility from the number Cobb-Douglas utility functions that if each
of paintings hung on their walls (x) and the individual lived alone, he would spend 1/3
number of granola bars they eat (y) with a of his income on paintings (x = 1) and 2/3
utility function of on granola bars (y = 1,000)
Ui(x,yi) = x1/3yi2/3 (for i=1,2) When the roommates live together, each
Assume each roommate has $300 to must consider what the other will do
spend and that px = $100 and py = $0.20 if each assumed the other would buy
paintings, x = 0 and utility = 0
55 56
14
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

Since MRS1 + MRS2 = 1,250, the To calculate the efficient level of x, we
roommates would be willing to sacrifice must set the sum of each persons MRS
1,250 granola bars to have one additional equal to the price ratio
painting y1 y 2 y1 y 2 px 100
MRS1 MRS2
an additional painting would only cost them 2x 2x 2x py 0.20
500 granola bars
too few paintings are bought This means that
y1 + y2 = 1,000x
59 60
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
Lindahl Pricing of Lindahl Pricing of

Public Goods Public Goods
Suppose that individual A would be The first-order condition is given by
quoted a specific percentage (A) and U1A - AU2B(1/f)=0
asked the level of a public good (x) he MRSA = A/f
would want given the knowledge that this
fraction of total cost would have to be Faced by the same choice, individual B
paid would opt for the level of x which satisfies
MRSB = B/f
The person would choose the level of x
which maximizes
utility = UA[x,yA*- Af -1(x)] 63 64
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

Externalities may cause a If transactions costs are small, private
misallocation of resources because of bargaining among the parties
a divergence between private and affected by an externality may bring
social marginal cost social and private costs into line
traditional solutions to this divergence the proof that resources will be
includes mergers among the affected efficiently allocated under such
parties and adoption of suitable circumstances is sometimes called the
Pigouvian taxes or subsidies Coase theorem
67 68
17
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

A Lindahl optimal tax-sharing scheme
can result in an efficient allocation of
resources to the production of public
goods
computation of these tax shares
requires substantial information that
individuals have incentives to hide
71
18

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TEORI EKONOMI MIKRO

JURUSAN ILMU EKONOMI, FAKULTAS EKONOMI,

Program Studi /Jurusan : EKONOMI PEMBANGUNAN/ILMU EKONOMI

I.Deskripsi Mata Kuliah:

III. Analisis Instruksional

IV. Strategi Pembelajaran :

V. Rencana Pembelajaran Mingguan

Pertemuan Kompetensi Pokok/Sub-pokok Metoda Media Metoda Referensi

Mahasiswa Hubungan Mahasiswa Papan tulis, Pertanyaan Ch 6

Ujian Akhir Semester

1.Ujian Tengah Semester = 30%

Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2

Theoretical Models Verification of Economic Models

Ceteris Paribus Assumption Optimization Assumptions

The Economic Theory of Value The Economic Theory of Value

The Economic Theory of Value Supply-Demand Equilibrium

Alfred Marshall showed that supply and demand Equilibrium

1000 - 100p = -125 + 125p Equilibrium qD = qS

Supply-Demand Equilibrium Supply-Demand Equilibrium

500 750 Quantity per period

A Production Possibility Frontier A Production Possibility Frontier

the opportunity costs depend on how much

The Economic Theory of Value Modern Tools

Important Points to Note: Important Points to Note:

Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2

Axioms of Rational Choice Axioms of Rational Choice

Marginal Rate of Substitution Marginal Rate of Substitution

Solving for MRS = -dy/dx:

Marginal Utility Deriving the MRS

Convexity of Indifference Convexity of Indifference

Examples of Utility Functions Examples of Utility Functions

Examples of Utility Functions Homothetic Preferences

The Many-Good Case The Many-Good Case

Important Points to Note: Important Points to Note:

Demand Functions Homogeneity

Changes in Income Increase in Income

Note that the indifference

Changes in a Goods Price Changes in a Goods Price

Changes in a Goods Price Changes in a Goods Price

Giffens Paradox A Summary

The Individuals Demand Curve The Individuals Demand Curve

income and the price of y (py) are held U2

Shifts in the Demand Curve Demand Functions and Curves

Compensated Demand Curves Compensated Demand Curves

Compensated & Compensated &

x x* Quantity of x x*** x Quantity of x

Compensated Demand Compensated Demand

A Mathematical Examination A Mathematical Examination

The Slutsky Equation The Slutsky Equation

A Slutsky Decomposition A Slutsky Decomposition

A Slutsky Decomposition Marshallian Demand

Price Elasticity and Total Price Elasticity and Total

Compensated Price Elasticities Compensated Price Elasticities

Homogeneity Engel Aggregation

Cournot Aggregation Demand Elasticities

x px x p y px y The demand functions for x and y are

Demand Elasticities Demand Elasticities

Demand Elasticities Demand Elasticities

expenditure at px1 = E1 = E(px1,py,U0)

Consumer Welfare Consumer Welfare

Consumer Welfare Consumer Welfare

CV dE x c ( px , py ,U0 )dpx px0

this integral is the area to the left of the