microfoundations of supply & demand chap 8,9, and 11
TRANSCRIPT
MICROFOUNDATIONS OF SUPPLY &
DEMAND Chap 8,9, and 11.
PREFERENCES & BUDGET
CONSTRAINTSChap 8,9
FRUIT SALAD
Bananas cost $5 and Apples cost $10. What is the best fruit salad you can make with $60.
BUDGET CONSTRAINT
Income creates limits on how much of each good can be purchased.
Deciding to purchase an amount of one, one is a decision not to purchase the other.
0 1 2 3 4 5 60
2
4
6
8
10
12
14
Apples
Bananas
Apple Banana
0 12
1 10
2 8
3 6
4 4
5 2
6 0
UTILITY AND CHOICE
Many possible choices which is best.
We hypothesize another, more theoretical measure of overall happiness, called utility, which consumers are attempting to maximize.
Given their income, consumers choose a shopping basket of goods to get the most utility.
MARGINAL UTILITY: DIMINISHING RETURNS
The marginal utility of a good is the amount of extra utility that a consumer can get from consuming a bit more of the good (or the amount of utility they would lose by consuming a bit less of the good).
Marginal utility is not constant for any good. Utility is diminishing, meaning that the more of a good you consume, the less extra utility that you get from consuming a bit more of it.
0 1 2 3 4 5 6 7 8 9 10 11 120
200
400
600
800
1000
1200
1400
1600
1800
AppleΔUtilityΔapple
240
220
200
180
160
140
Apple Utility
0 0
1 240
2 460
3 660
4 840
5 1000
6 1140
1 2 3 4 5 6 7 8 9 10 11 120
50
100
150
200
250
300
ΔUtilityΔApple
Apples
Mar
gina
l Util
ity
Δapple
ΔUtility
UTILITY CURVE: FRUIT SALAD
Apples BananasΔUtility ΔUtilityApple Utility Δapple Banana Utility Δbanana
0 0 0 01 240 240 1 122 1222 460 220 2 242 1203 660 200 3 350 1084 840 180 4 456 1065 1000 160 5 559 1036 1140 140 6 659 100
7 756 978 850 949 940 90
10 1028 8811 1112 8412 1192 8013 1268 7614 1340 7215 1408 68
MARGINAL UTILITY AS A GUIDE LINE FOR MAXIMIZATION. As consumers choose goods to maximize utility, they must ask how much goods add to their utility relative to how much they cost.
Choose to buy those goods for which you get the most bang for the buck (i.e. the most extra utility per $ cost).
If put more of good A into your market basket and take good B out of your market basket.
If put more of good B into your market basket and take good A out of your market basket.
A B
A B
U UP P
A B
A B
U UP P
EQUILIBRIUM
A B
A B
U UP P
As you choose more goods with high bang-for-buck, their bang will diminish (diminishing marginal utility).
As you put low bang-for-buck goods back, their marginal utility will increase.
Eventually, will come to chose a market basket such that
MUB
808894
100106120
MUB/PB
1617.618.8
2021.2
2416
Utility11921028
850659456242
0
Total1192126813101319129612421140
Utility0
240460660840
10001140
Banana
1210
86420
Apple0123456
MUA
240220200180160140
MUA/PA
242220181614
Apples Bananas Total# Utility MUA MUA/PA # Utility MUB MUB/PB Utility
0 0 12 1192 80 16 11921 240 240 24 10 1028 88 17.6 12682 460 220 22 8 850 94 18.8 13103 660 200 20 6 659 100 20 13194 840 180 18 4 456 106 21.2 12965 1000 160 16 2 242 120 24 12426 1140 140 14 0 1140
A
B
PB
PA
B
YP
A
YP
B
YB P
Budget Constraint
B
A
P
P
If B = 0A
YA P B
A
PB
P 0B
A
P
P
If B = PA
PA
BA
A
PP
P
A
YA PB
A
PB
P
BP
PB
For every extra PA of Bananas that you eat
you must give up PB Apples.
If A = 0
Slope:
A
B
PB
PA
B
YP
A
YP
Budget Constraint
B
A
P
P
A
YA P B
A
PB
P
For every extra PA of Bananas that you eat
you must give up PB Apples.
Slope:
INDIFFERENCE CURVES
Indifference Curves are a tool for describing trade-offsOften used to study trade-offs of risk and return.
Compare all possible combinations of goods and rank them according to the utility generated by a particular combo.In particular, find those combos which produce an identical level of welfare.
A
BI1
I2
I3
Shape of Indifference Curves Indicate Properties of Consumer Demand
More is better – Higher indifference curves generate more utility. Indifference curves don’t cross
Goods are substitutes- To make you just as happy to give up one good you need to get more of the other. Indifference curves have negative slope.
Each good has diminishing marginal utility. To make you just as happy to give up increasing amounts of one good, you need to get an increasing amount of the other good. Indifference
curves are steep toward the left and flatter toward the right.
• (Negative) Slope of the Indifference Curve is the amount of A you need to
compensate you for giving up a unit of B. • (Negative) Slope is called the marginal
rate of substitution.
Income Good Time
I2
Income Bad Time
Risk Aversion
Return
I2
Risk
I1
I2
Risk Return Tradeoff
A
BI1
I2
I3
Can Do Better
UnobtainableF
CD
E
COMPARE INDIFFERENCE CURVES
Indifference Curve 3 does not cross the budget constraint. No point is affordable.
Indifference Curve 1 crosses the budget constraint, points C and E are affordable.
However, by definition, these points are no better than point D and other points directly
below the budget constraint which are worse (in utility terms) than points on the
budget constraint directly above them.
Only an indifference curve that touches but does not cross the budget curve can contain the optimum combo at the tangency point, F.
F maximizes Utility
OPTIMAL CHOICE
The consumer can maximize utility by being on the highest indifference curve that is in the budget curve set.
Best choice is to choose the point on an indifference curve that is tangent to the budget line.
At a point of tangency, two lines have the same slope.
B B
A A
U PMRS U P
PRICE CHANGES AND DEMAND
A B B B
A B A A
U U U PP P U P
Assume we are at the optimal market basket, Now, assume that the price of bananas goes down, then either the marginal utility of apples must fall or the marginal utility of banana’s must fall. Either banana purchases must rise or apple purchases must fall or both. Substitution Effect Consumers buy two goods and have a limited amount of income Y. Price of apples goes up and this will reduce the spending power of Y. Either the consumer must drop demand for Apples or Bananas or both. Income Effect
A BP A P B Y
PRICE OF B GOES DOWN
If Good B becomes cheaper, the amount of good A you can buy if you buy B = 0 is unchanged, but each extra unit of B costs more in relative terms.
The budget curve flattens and rotates around the vertical axis.
The new tangent point implies an optimum with more B. (Consumption of Good A may go up or down depending on complementarity).
A
BI1
I2
FG
Equilibrium at point G
Price of B drops.
A
YP
𝑃𝐵
𝑃 𝐴
Becomes larger
B
YP
B
YP
Becomes flatter
Budget Curve Rotates
New Optimum with Higher B
MUB
687888
95.5103114
Utility140812301028
803559303
0
Banana
1210
86420
Utility0
240460660840
10001140
Banana15
12.510
7.55
2.50
Apple0123456
MUA
240220200180160140
MUB/PB
1719.5
2223.875
25.7528.25
MUA/PA
242220181614
Price of Bananas Goes to 4
Optimal Banana’s Rise, Optimal Apple’s Fall
Apples Bananas Total# Utility MUA MUA/PA # Utility MUB MUB/PB Utility
0 0 15 1408 68 17 14081 240 240 24 12.5 1230 78 19.5 14702 460 220 22 10 1028 88 22 14883 660 200 20 7.5 803 95.5 23.875 14634 840 180 18 5 559 103 25.75 13995 1000 160 16 2.5 303 114 28.5 13036 1140 140 14 0 1140
Apples
BananasI1
I2
H
G
Decompose into two parts
1. Move to a combination with a lower MRS
Pure Substitution Effect
F
2. Move to a higher indifference curve
Pure Income Effect
A
D
I1
I2
I3
PB
P1
1
YP2
YP
3
YP4
YP
P2
P3
P4
I4
B
B
Foundation of Demand Curve
A
B
I1
I2
F
D
B
YP
B
YP
Income Declines
A
YP
A
YP & Fall
Both Apples and Bananas fall
Consumer moves to lower indifference curve
Utility0
240460660840
10001140
Banana
1210
86420
Apple0123456
Utility11721008
830639436222
0
Total1172124812901299127612221140
MUB
808893
100109120
80
MUA
240220200180160140
MUB/PB
1617.618.6
2021.8
2416
MUA/PA
242220181614
Banana
420
Apple012
Utility0
240460
Utility436
2220
Total436
462460
MUA
240220
MUB
106120
MUA/PA
2422
MUB/PB
21.824
Apple0123456
Banana
1210
86420
Income falls to 20
Apple Banana Total# Utility MUA MUA/PA # Utility MUB MUB/PB Utility
0 0 4 456 106 21.2 4561 240 240 24 2 242 120 24 4822 460 220 22 0 0 460
COSTS OF PRODUCTIONChapters 11
Costs: Explicit vs. Implicit
• Explicit Costs of Production: Direct payments for resources not owned by a firm (raw materials, wages, energy payments, interest payments).
• Opportunity Cost: Lost payment for best alternative use of input.
• Implicit Costs: Opportunity Costs of assets owned by firms• Ex. Owner of barbershop could earn $100 per hour working as a
barber. Implicit cost of the owners time is $100 per hour. • Opportunity cost of equity capital is return that could have been
earned elsewhere.
Accounting vs. Economic Profits
• Profits are revenues less costs.• Economic profits are revenues less explicit and implicit costs.• Economic profits attract competition so they typically
don’t last.
• Accountants do not fully incorporate all implicit costs including cost of equity capital or owner’s contribution of time or expertise. • Accountants do incorporate some implicit costs (such
as depreciation) into their profit& loss statements.
Short-Run vs. Long Run• Firms typically have several types of inputs that they can
adjust to adjust production.• Long-run - When firms are able to adjust all of their inputs
including physical plant.• Short-run – When firms are able to adjust only some of
their inputs (usually energy, labor, and raw material costs).
Productivity• Average Productivity of Labor is output per work unit.
• Marginal Productivity of Labor is the extra production that is obtained from an extra unit of labor.
Total ProductAPL
Labor
TPMPL
Labor
Short Run Production Function
TPMPL
Labor
ΔLabor
ΔTP
ΔLaborΔTP
Total
Product TP
Production in the Short-Run• Given a set of fixed inputs (like plant and capital equipment),
a firm can vary other inputs (typically labor) in order to vary production.
• Typically, as you add workers, you get more output.
• Up to a point, each additional worker adds synergy and adding more workers leads to more and more extra pay-off and marginal product may rise.
• But at some point, capacity constraints bind, diminishing returns sets in, and the addition of extra workers will generate less and less extra production.
Small Scale Schedule: Bakery
Average MarginalHours Loaves Product Product
0 00.10
2 0.20 0.100.32
4 0.83 0.210.58
6 2 0.331
8 4 0.53
10 10 1
Large Scale ScheduleAverage Marginal
Hours Output Product Product0 0
110 10 1
0.33333340 20 0.5
0.290 30 0.333333
0.142857160 40 0.25
0.111111250 50 0.2
0.090909360 60 0.166667
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
105
0
5
10
15
20
25
30
35
Bakery
Hours
Lo
av
es
Productivity• Labor productivity depends on the number of workers
• First, increasing, then, decreasing• Average product of labor begins decreasing when
marginal product of labor drops below average.
Note: Marginal Product crosses through average product at the peak of average product.
As long as the next worker adds more product than the average worker, they will increase the average.
Once diminishing returns set in, additional workers may add less to output than the average worker, reducing the overall average.
MPL, APL
L
MPLAPL
Fixed Costs vs. Variable Costs• In short-run, we distinguish between the costs that are
adjustable as production level is adjusted (variable costs) and costs that are unchanged regardless of scale of production (fixed costs).• Variable costs (Wages of production workers, supply and raw
materials costs)• Fixed costs (Depreciation costs, Financial costs, wages of non-
production workers).
Types of Costs• Total Fixed Costs – Invariant to the number of goods
produced (in the short-run)• Average Fixed Costs – Decreasing in the number of goods
produced.
• Total Variable Costs- Increasing in the number of goods produced (once synergy point is passed).
• Total Costs: Fixed Costs + Variable Costs
Bakery: Wages $10 per Worker, $5 Wheat per Loaf
Output Fixed Workers Bakers Wheat Variable Total(Loaves) Costs Wages Costs Costs
2.00 1000 6 60 10.00 70.00 1070.00
10.00 1000 10 100 50.00 150.00 1150.00
20.00 1000 40 400 100.00 500.00 1500.00
30.00 1000 90 900 150.00 1050.00 2050.00
40.00 1000 160 1600 200.00 1800.00 2800.00
50.00 1000 250 2500 250.00 2750.00 3750.00
60.00 1000 360 3600 300.00 3900.00 4900.00
Total Variable Costs are increasing at an accelerating rate.
Reason: Diminishing returns to variable inputs.
2.00 10.00 20.00 30.00 40.00 50.00 60.000
1000
2000
3000
4000
5000
6000
Cost Schedule
Fixed Costs Variable Costs Total Costs
Costs: Average vs. Marginal• Total Costs are the sum of all relevant costs for a firm.• Average Costs: Costs per unit of output.• Marginal Cost: Extra Cost per Extra Unit of Output.
Cost SchedulesOutput Average Average Average
Total Fixed Variable Total Marginal(Loaves) Costs Costs Costs Costs Costs
2.00 1070.00 500 35 53510.00
10.00 1150.00 100 15 11535.00
20.00 1500.00 50 25 7555.00
30.00 2050.00 33.33333 35 6875.00
40.00 2800.00 25 45 7095.00
50.00 3750.00 20 55 75115.00
60.00 4900.00 16.66667 65 82
Average and Marginal CostsAverage Fixed Costs decreases as production increases
AVC, ATC, MC all increase as diminishing returns kick in
2.00 10.00 20.00 30.00 40.00 50.00 60.00
AFC NaN 100 50 33.33333333333
33
25 20 16.66666666666
67
AVC 35 15 25 35 45 55 65
ATC NaN 115 75 68.33333333333
33
70 75 81.66666666666
67
MC 35 10 35 55 75 95 115
10
30
50
70
90
110
130
Cost Curve
$
MC equals AVC and ATC when each of the latter are at their minimum level.
Long Run Costs• In the short-run, the size of a firms physical plant is a fixed
factor. • Over-time, the plant size can adjust. • In the bakery example, extra ovens can be added.
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208 1 Oven
1 Oven
Output
Average Total Cost Schedules at Different Scales of Production
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208
1 Oven
2 Ovens
Output
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208
1 Oven
2 Ovens
3 Ovens
Output
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208
1 Oven
2 Ovens
3 Ovens
4 Ovens
Output
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208
1 Oven
2 Ovens
3 Ovens
4 Ovens
5 Ovens
Output
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208
1 Oven
2 Ovens
3 Ovens
4 Ovens
5 Ovens
6 Ovens
Output
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208
1 Oven
2 Ovens
3 Ovens
4 Ovens
5 Ovens
6 Ovens
7 Ovens
Output
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208
228
1 Oven
2 Ovens
3 Ovens
4 Ovens
5 Ovens
6 Ovens
7 Ovens
8 Ovens
Output
Minimizing Costs in the Long Run• Consider average total cost schedules at different
numbers of ovens. • Each oven will have a production level that generates the
minimum average total cost. • To minimize average costs in the long-run, choose the
number of ovens which will have the lowest, minimum average total cost.
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208
228
1 Oven
2 Ovens
3 Ovens
4 Ovens
5 Ovens
6 Ovens
7 Ovens
8 Ovens
Output
Average Total Cost Schedules at Different Scales of Production
Minimum of the different cost Schedules
Connect the DotsLong Run Average Total Costs
If we adjust capital scale continuously, the collection of minimum points is the Long Run Average Total cost curve
LR ATC
Short-run ATC
Output
Cost
MC
MC MC MC
MC
Economies of Scale• When firms are able to adjust all of their inputs, they can choose a size that will minimize costs.
• If a firm is able to achieve some economies of scale, increasing size will reduce the average total cost.
• Sources of Economies of Scale• Production requires major expenditure on items needed to
produce even zero products• Ex. Software, pharmaceuticals
• Production requires many specific steps which can be most efficiently done through specialization• Ex. Airplanes, automobiles
Long Run ATC increasing returns to scale.
Output
Costs
LR ATC
Economies of Scale
Returns to Scale• Scale Economies is not always likely to characterize production.
• If each production unit can act autonomously with identical costs then we may experience constant returns to scale.
• Firms at some point experience diseconomies of scale or increasing long run average total costs.
• Sources of diseconomies of scale• Limits of managerial attention. • Limits of some other fixed resource.
Long Run ATC decreasing returns to scale.
Output
Costs
LR ATC
Constant Returns
Scale Diseconomies
Overall Cost Function
LR ATC
Minimum Efficient Scale
Costs
Output
MES is smallest production level at which the firm can reach the lowest ATC
MES and Market Structure• If MES is relatively large in comparison with the market
demand:
$
Q
D
LRAC
The market is most efficiently served by a single firm---natural monopoly!
MES and Market Structure• If MES is relatively small in comparison with market
demand:
$
Q
Many “small” firms in the market.
Learning OutcomesStudents should be able to: • Examine an indifference curve and budget curve and explain which point maximizes utility and why.
• Define and calculate various types of economic costs.• Fixed, variable, total, average, marginal.
• Describe the shape of various relevant cost curves• Average Total (in LR and SR), Average Fixed, Marginal Costs
• Describe the relationship between production, productivity (marginal and average) and the law of diminishing returns.