agec 340 – international economic development course slides for week 6 (feb. 16 & 18) the...

AGEC 340 – International Economic Development

Course slides for week 6 (Feb. 16 & 18)

The Microeconomics of Development: Are low-income people “poor but efficient”?*

–This starts proper microeconomics: a powerful way to explain peoples’ choices, particularly useful when looking over large

numbers of people and long time periods

* If you’re following the textbook, this is in chapter 5, pages 87-102.

Are low-income people “inefficient”?

• Why do the poor have low incomes? –Do they use what they have “inefficiently”?

• Modern economics answers these questions in a very specific way!

For example,

• Why do farmers in a given place often use similar farming practices?

• Why do farmers in different places use such different farming practices?

How can we explain & predict production decisions?

• We can start by describing what is possible, – then ask what is technically efficient, and– finally ask what is economically efficient.

• With this approach we can understand differences and predict changes.

As a farmer turns labor into crops, what levels of effort and yield

might we see?

labor use (hrs/acre)

crop yields(bu/acre)

This is our textbook “production function”or “input response curve” (IRC)

The IRC defines a frontier of technical efficiency



to produce below the curve

would be inefficient

to produce above thethe curve would be technologically impossible

Qoutput

Qinput

But what point along the IRC will people choose?



point of maximum yields?

segment withsteepest slope?

Qoutput

Qinput

Every point along the curve is technologically efficient, but not all are economically efficient

• If producers want to maximize profit:

= PoQo - PiQi (equation #1)

• and then some algebra, to solve for Qo so we can draw a line like Y = mX+b:

Subtract PoQo and from both sides

-PoQo = - - PiQi

and then divide both sides by –Po:

Qo = /Po + (Pi/Po)Qi (equation #2)

We can graph this equation...



/Po The formula for this line isQo = /Po + (Pi/Po)Qi

Qo

Qi

… but there are there are as many of these lines as there are levels of profit.



2/Po

1/Po

3/Po

Each line isQo = /Po + (Pi/Po)Qiwith the same slope (Pi/Po), but a different intercept (/Po)

Qo

Qi

These lines are called “iso-profit” lines

2/Po

1/Po

3/Po

Slope = Pi/Po

Qo

Qilabor use (hrs/acre)


…and we expect farmers will choose the point on IRC with the highest profit level

Slope = Pi/Po*/Po

This is the highest-possiblelevel of profit

Because of diminishing returns, only one point can be economically optimal.

*/Po

Profits below* are economicallyinefficient

Profits above * aretechnically impossible

At the optimal point, the isoprofit line crosses the IRC only once:the isoprofit line is “tangent” to the IRC

We can do a similar analysis for farmer’s choice among outputs.

Qty. ofCorn perfarm

Qty. of Beansper farm

Holding all else constant!

Qty. ofCorn perfarm


What combinations of outputs do we expect to see?

Qty. ofCorn perfarm


A “production possibilitiesfrontier” (PPF)

What combinations of outputs do we expect to see?

We have a similar picture as before...

Qty. ofCorn perfarm


Technicallyinefficient

Technicallyimpossible

What is the economically efficient choice?

• First the assumption that producers will maximize profit:

= PcQc + PbQb (equation #1)

• and then some algebra, to turn equation #1 into the equation for a line on our graph:

Qc = /Pc - (Pb/Pc)Qb (equation #2)

Qty. ofCorn perfarm


Graphing this equation we get:

Iso-revenue lines,of slope = -Pb/Pc

which we can use to find the efficient point:

Qty. ofCorn perfarm


Revenue (& profits) are highest;the iso-revenue line is tangent to the PPF

To apply this to choice among inputs… we can again hold all other things constant

(both outputs and other inputs)tractor oranimal use(hp-hrs)

labor use(person-hours)

possible techniques to produce two tons of corn, using one acre of land, etc.

To apply this to choice among inputs… we can again hold all other things constant

(both outputs and other inputs)tractor oranimal use(hp-hrs)


An “iso-quant”

technicallyimpossible

technicallyinefficient

All points along the isoquant are “technically efficient”, but which is

economically efficient?

• In this case the assumption that producers maximize profit means minimizing costs:

C = PlabQlab + PtracQtrac (equation #1)

• and then some algebra, to turn equation #1 into the equation for a line on our graph:

Qtrac = C/Ptrac - (Plab/Ptrac)Qlab (equation #2)

Graphing this equation we get:

Iso-cost lines,of slope = -Plabor/Ptractor

tractor oranimal use(hp-hrs)


and again only one choice can minimize costs (or maximize profits)

Qtractors

Qlabor

“iso-quant”

iso-cost line(slope = -Plab/Ptrac)

So we have three kinds of diagrams...

Qo

Qi

Qo2

Qo1

Qi2

Qi1

IRC PPF Isoquant

The curves are fixed by nature and technology; they show the “frontier” of what is technologically possible to produce

Qo

Qi

Qo2

Qo1

Qi2

Qi1

inefficientinefficient

impossible impossible

impossible

inefficient

The lines’ slopes are fixed by market values;they show the “relative prices” or what is

economically desirable to produce

Qo

Qi

Qo2

Qo1

Qi2

Qi1

iso-profit lines(slope = Pi/Po)

iso-revenue lines(slope = -Po1/Po2)

iso-cost lines(slope = -Pi1/Pi2)

Qi

Qo2

Qo1

Qi2

Qi1

The combination gives us the profit-maximizing combination of all inputs & all outputs

Qo

Qi

Qo2

Qo1

Qi2

Qi1Qi

Qo2

Qo1

Qi2

Qi1

highest profit

highest revenue

lowest cost

Does profit maximization apply only to “modern” farmers?

• No! We can do the same analysis using “values” (in any units) instead of prices.– the “values” cancel out, and the “price ratios” become

a barter ratio at which the goods would be traded

Profit-maximizing production choices depend only on relative prices or exchange ratios

iso-profit lineslope = Pl/Pc

(corn exchanged for labor)

iso-revenue lineslope = -Pb/Pc

(corn exchanged for beans)

iso-cost lineslope = -Pl/Pm

(machinesexchanged for labor)

Qty. of corn(bu/acre)

Qty. of labor (hours/acre)


Qty. of beans(bushels/acre)

Qty. of machinery(hp/acre)


With relative price lines and technological-possibilities curves

we can predict the profit-maximizing combination of all inputs & all outputs.







We expect that farmers will try to be...

• technically efficient on the curves

• economically efficient

at the point of highest profit:–highest profit along the IRC,–highest revenue along the PPF,– lowest cost along the isoquant.

Putting the two ideas together...

• with “technical efficiency” – a curve, representing what’s physically

possible for a producer to do• and “economic efficiency”

– a line, representing relative values • we get a specific prediction about what

people are likely to choose

• In developing countries, rapid population growth and few nonfarm job opportunities means that the number of people needing to work on farms rises;

• If nothing else changes, labor becomes more abundant and its price goes down...

What happens when prices change?

…which graph(s) change?







We need to see where labor enters the picture...







iso-profit(slope=Pl/Pc) iso-revenue

(-Pb/Pc)

iso-cost (-Pl/Pm)

and ask what would be changed bymore abundant (lower-priced) labor





slope of isoprofit line= Plabor/Pcorn slope of isocost line

= -Plabor/Ptractors

…in both cases the lines become less steep (a lower ratio, so a smaller slope)

At the new prices, is the old choice still optimal?

new slope = Pl’/Pc

new slope=Pl’/Pt





old slope = Pl/Pc

old slope = Pl/Pt





more labor use, more corn production

more labor use,less machinery

higher profits

lowercosts

Now, higher profits & lower costs could be reached if farmers move along the IRC & isoquant

to a different technique, that was not optimal before.





In this way we can explain (and predict) how farmers respond to changing prices:

old optimuma new optimum

old optimum

a new optimum

a newprice ratio

a newprice ratio

In summary…

• Using these three simple diagrams helps you do the math on how an optimizing person would respond to change

• Many studies find that real farmers do usually respond in these ways

• Next week… if everyone’s already maximizing their profits, how can things improve?

agec 340 – international economic development course slides for week 6 (feb. 16 & 18) the...

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