copyright © 2002 by thomson learning, inc. chapter 1 appendix copyright © 2002 thomson learning,...

Copyright © 2002 by Thomson Learning, Inc.

Chapter 1 Appendix

Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license.

ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom

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ISBN 0-03-033652-X


Indifference Curve Analysis

Market Baskets are combinations of various goods.

Indifference Curves are curves connecting various market basket combinations of goods that make an individual equally happy.


Assumptions about Preferences

Persons can rank market baskets. Rankings are transitive. More is preferred to less. The marginal rate of substitution is

diminishing.


Indifference Curves and Indifference Maps


Figure 1A.1 Indifference Curves

Exp

end

itu

re o

n O

ther

Go

od

s p

er M

on

th (

Do

llar

s)

60

50

0 40 50Gasoline per Month (Gallons)

Qx

U3 U2 U1

B2

B1


The amount of expenditure on other goods that a person will give up in order to get an additional unit of another good is called the marginal rate of substitution.

The Marginal Rate of Substitution


The Budget Constraint

The budget constraint is the combination of goods that can be afforded by a person.


The Budget Constraint in Algebraic Terms

I = PxQx + PiQi

Where: I is income

Pi is the price of good i

Qi is the amount of good i purchased


Figure 1A.2 The Budget ConstraintE

xpen

dit

ure

on

Oth

er G

oo

ds

per

Mo

nth

(D

olla

rs)

Exp

endi

ture

on

Gas

olin

e pe

r M

onth

Exp

endi

ture

on

All

O

ther

Goo

ds E

xcep

t G

asol

ine

per

Mon

th

Gasoline per Month (Gallons)

100

60

0 40 100

A

F D

C

B

Qx


Figure 1A.3 Consumer EquilibriumE

xpen

dit

ure

on

Oth

er G

oo

ds

per

Mo

nth

(D

oll

ars)

Gasoline per Month (Gallons)

A

E

BU1

U3 U2

40

0 60 Qx


Equilibrium Condition

PX = MBX


Figure 1A.4 Changes in Income

Exp

end

itu

re o

n O

ther

Go

od

s p

er M

on

th (

Do

llars

)

A

A'

B

Qx per Month 0 B'


Figure 1A.5 Changes in the Price of Good X

Exp

end

itu

re o

n O

ther

Go

od

s p

er M

on

th (

Do

llars

) A

B'' B' B 0

Qx per Month


Figure 1A.6 Income and Substitution Effects

The Income Effect Qx

E'

E1

150

50

100

60 40

20

Exp

end

itu

re o

n O

ther

Go

od

s p

er M

on

th (

Do

llar

s)

The Substitution Effect

Gasoline per Month

(Gallons)

U2

U1

E2

45


The Law of Demand

The demand curve is downward sloping.

As the price rises the quantity demanded falls.


Figure 1A.7 The Law of Demand

D = MB

Pri

ce

Qx per Month 0


Price Elasticity of Demand

% Change in Quantity Demanded

% Change in PriceED =

QD/QD

P/P=


Consumer Surplus

Net benefit that consumers obtain from a good. Total benefit to consumers from obtaining

a good, less the money they give up to get the good.


Figure 1A.8 Consumer Surplus

Pri

ce

Q 1

A

P B

D = MB

Market Price

Consumer Surplus

Gasoline per Month 0


Figure 1A.9 The Work Leisure Choice

U3

A

E

B

Leisure Hours per Day

40 U2

U1

Inco

me

per

Day

16 240


Budget line for time allocation

I = w(24 – L)

Where: I is income

W is wage

L is the amount of time devoted to leisure


Analysis of Production and Cost

The Production Function is the expression of the maximum output obtainable from any combination of inputs.

The Short Run is the period of time in which some inputs cannot be changed.

The Long Run is the period of time in which all inputs can be changed.


Marginal Product

The increase in output associated with a one unit increase in an input is called the Marginal Product.


Isoquants Isoquants are curves that show alternative

combinations of variable inputs that can be used to produce a given amount of output.

The Marginal Technical Rate of Substitution is the amount of one input that can be given up with one additional unit of another input while keeping output constant. It is the slope of the isoquant.


Isocost Lines

Lines that show combinations of variable inputs that are of equal cost are called Isocost Lines

C = PLL + PKK

Where: C is the total cost

PL is the price of labor (typically the wage)

L is the units of labor employed

PK is the price of capital (typically a rental price or an interest rate to reflect the opportunity cost of that capital)

K is the units of capital employed


Figure 1A.10 Isoquant Analysis

Lab

or

Ho

urs

per

Mo

nth

Monthly Output = Q1

Machine Hours per Month

Isocost Lines

L* E

K* 0


Cost Minimization

Costs are minimized for every level of output where:

MRTSKL = PK/PL


Cost Functions

Total Cost Variable Cost Average Cost Average Variable Cost Average Fixed Cost Marginal Cost


Returns to Scale

Constant Returns to Scale AC = MC AC and MC are constant

Increasing Returns to Scale AC < MC AC is diminishing

Decreasing Returns to Scale AC > MC AC is increasing


Profit Maximization

Assumption: All firms seek to maximize profits.

Operationally that means that firms will set production where Marginal Revenue equals Marginal Cost; MC = MR.


Perfect CompetitionThe situation where: There are many buyers and sellers such that

no one has market power. The product being sold is homogenous. There are no legal or economic barriers to

entry. Information is freely available.

In such a case the market price is the MarginalRevenue to the firm and that firm will maximize profits where P = MC.


Figure 1A.11 Short-Run Cost Curves and Profit Maximization under Perfect Competition

Pri

ce a

nd

Co

st

Output per Month

AVC min = F

D = MR P

E

MC

AC

0

Producer Surplus

Q*


Short-Run Supply

Under perfect competition, Supply is the Marginal Cost curve emanating from the minimum of average variable cost


Producer Surplus

Producer Surplus is the difference between the market price and the minimum price for which the firm would sell the product. It is the area under the price line and above the marginal cost curve. It also represents the profit less fixed costs to the firm.


Normal and Economic Profit

Normal Profit is the opportunity cost of resources of owner-supplied inputs. The value of the firm owners’ time (typically measured by their next job opportunity) plus any other inputs provided by the owner(s).

Economic Profit is any profit to the firm that is above normal profit.


Long Run Supply

In the long run, economic profit is driven to zero under competition.

P = LRMC = LRACmin


Figure 1A.12 Long-Run Competitive Equilibrium P

rice

LRAC min = P

LRMC

LRAC

D = MR

Q*

Output per Month

0


Figure 1A.13 Long-Run Supply: The Case of A Constant-Costs Competitive Industry

LRACmin = P Long-Run Supply

Price

Output per Year 0


Figure 1A.14 A Perfectly Inelastic Supply Curve

Supply P

ric

e

Output per Year 0 Q1


Price Elasticity of Supply

% Change in Quantity Supplied

% Change in PriceES = =

QS/QS

P/P

copyright © 2002 by thomson learning, inc. chapter 1 appendix copyright © 2002 thomson learning,...

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