ECON 111 Template PDF

3.1 Consumer Preferences Market Basket List with specific quantities of one or more goods. Affordable is not part of the examination, it is whether or not you prefer and it is part of your consumption set. To explain and utilize the theory of consumer behavior we will ask whether consumers prefer on...

3.1 Consumer Preferences Market Basket List with specific quantities of one or more goods. Affordable is not part of the examination, it is whether or not you prefer and it is part of your consumption set. To explain and utilize the theory of consumer behavior we will ask whether consumers prefer one market basket to another. Some basic assumptions: 1. Completeness: Preferences are assumed to be complete. In other words, consumers can compare and rank all possible baskets. Thus for any two market baskets A and B, a consumer will prefer A over B and B over or will be indifferent. By that, they are equally satisfied by both. 2. Transitivity: Preferences are transitive. If they like A more than B and B more than C, they like A more than C. Necessary for consumer consistency. 3. More is better than less: Goods are assumed to be desirable (in order to be good…) Consequently, consumers always prefer more than less. Consumers are never satiated; more is always better, even if just a little better. Indifference Curve Represents all combinations of market baskets that provide a consumer with the came satisfaction. They can: A. Never cross B. Farther it lies, the higher the utility C. Always slopes downwards D. Indifference curves are convex Describing Preferences: D is preferred over C. We cannot rank A and B without additional information. Any basket in U3 is preferred over any basket in U2 or U1. The closer the curve is to the point of origin, the less preferred it is. Marginal Rate of Substitution: Magnitude of the slope of an indifference curve measures the consumers’ marginal rate of substitution (MRS) between two goods. Ford Mustang Coupes are willing to give up considerable interior space for additional acceleration while Ford Explorers prefer interior space to acceleration. Here, MRS between Clothing (C) and Food (F) falls from 6 (between A and B) to 4 (between B and D) to 2 (between D and E) to 1 (between E and G). The satisfaction from switching gets increasingly lower Diminishing Marginal Rate of Substitution. Perfect Substitutes: Two goods for which the marginal rate of substitution of one for the other is constant. Perfect Complements: Two goods for which the MRS is zero or infinite; the indifference curves are shaped as right angles. Bads: Good for which the less is preferred rather than more. Ordinal vs. Cardinal Utility Ordinal: Utility function that generates a ranking of market baskets in order of most to least preferred. Cannot be measured numerically. Used when only relative position matters. Cardinal: Utility function describing by how much one market basket is preferred to another. Enables consumers to rank the magnitude of how much they prefer one good to another. Can be measured numerically. The numbers are arbitrary but at least it tells us which is more preferred. A tad restrictive and used for more advanced models. 3.2 Budget Constraints Constraints that consumers face as a result of limited incomes. The Budget Line is all combinations of goods for which the total amount of money spent is equal to income. Examples: Automobiles: Speed and Interior Space I = 𝑃𝐹𝐹 + 𝑃𝐶𝐶 Market Basket Food (F) Clothing (C) Total Spend A 0 40 80 B 20 30 80 D 40 20 80 E 60 10 80 G 80 0 80 A Budget Line Describe the combination of goods that can be purchased given the consumer’s income and the prices of the goods. clothing. The product whose price changes will have their intercept changed and the slope of the curve changes. 3.3 Consumer Choice Maximizing the market basket must satisfy two conditions: 1. Must be located on the budget line 2. Must give the consumer the most preferred combination of goods and services The slope of the budget line is ½. This is our base curve imposed by the market and not preference for MRS. The first is based on the assumption that more is better than less and the second assumes that the consumer is reaching the greatest level of utility. Income Effect As denoted by intercepts, more income = more food and more clothes. Assuming prices don’t change, a total shift to the right for the curve. Change in Price While Point W has more utility than Point X, consumers do not have the budget for any point on I4. Therefore, Point X offers the maximum utility for the budget of consumers. Satisfaction is maximized at the point where MRS = 𝑃𝐹 | 𝑃𝐶 If the price of food gets lower, you can buy more food without sacrificing units of Where the budget line is perpendicular to the indifference curve. Marginal Benefit: Benefit from consumption of one additional unit of good Marginal Cost: Cost of one additional unit of a good. So we can then say that satisfaction is maximized when the marginal benefit is equal to the marginal cost. The marginal benefit is measured by the MRS. If you buy more food, the marginal utility for food gets lower, the marginal rate of substitution gets lower. As you buy more of a certain good, the utility of each unit decreases. Diminishing Marginal Utility. (Convexity) The consumer maximizes satisfaction by consuming only one of the two goods. Since the budget line is closest tangentially to the indifference curve at point B, you buy only ice cream and no more yogurt to maximize utility. 3.4 Revealed Preference 0 = 𝑀𝑈𝐹(∆𝐹) + 𝑀𝑈𝐶(∆𝐶) 𝑀𝑅𝑆 = 𝑀𝑈𝐹 𝑀𝑈𝐶 𝑀𝑈𝐹/𝑃𝐹 = 𝑀𝑈𝐶/𝑃𝐶 *In English, this is the Equal Marginal Principle Equal Marginal Principle: Utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across all goods. Corner Solutions Situation in which the marginal rate of substitution for one good in a chosen market basket is not equal to the slope of the budget line. A is preferred over B and D. Individual 1 can purchase A so they get A. But for Individual 2 who has a flatter budget line, they get the second best basket of B which is preferred to D. SUMMARY #2 1. The theory of consumer choice rests on the assumption that people behave rationally in an attempt to maximize the satisfaction that they can obtain by purchasing a particular combination of goods and services. 2. Consumer choice has two related parts: the study of the consumer’s preferences and the analysis of the budget line that constrains consumer choices. 3. Consumers make choices by comparing market baskets or bundles of commodities. Preferences are assumed to be complete (consumers can compare all possible market baskets) and transitive (if they prefer basket A to B, and B to C, then they prefer A to C). In addition, economists assume that more of each good is always preferred to less. 4. Indifference curves, which represent all combinations of goods and services that give the same level of satisfaction, are downward-sloping and cannot intersect one another. 5. Consumer preferences can be completely described by a set of indifference curves known as an indifference map. An indifference map provides an ordinal ranking of all choices that the consumer might make. 6. The marginal rate of substitution (MRS) of F for C is the maximum amount of C that a person is willing to give up to obtain 1 additional unit of F. The MRS diminishes as we move down along an indifference curve. When there is a diminishing MRS, indifference curves are convex. 7. Budget lines represent all combinations of goods for which consumers expend all their income. Budget lines shift outward in response to an increase in consumer income. When the price of one good (on the horizontal axis) changes while income and the price of the other good do not, budget lines pivot and rotate about a fixed point (on the vertical axis) - the intercept changes. 8. Consumers maximize satisfaction subject to budget constraints. When a consumer maximizes satisfaction by consuming some of each of two goods, the marginal rate of substitution is equal to the ratio of the prices of the two goods being purchased. 9. Maximization is sometimes achieved at a corner solution in which one good is not consumed. In such cases, the marginal rate of substitution need not equal the ratio of the prices. 10. The theory of revealed preference shows how the choices that individuals make when prices and income vary can be used to determine their preferences. When an individual chooses basket A even though he or she could afford B, we know that A is preferred to B. 11. The theory of the consumer can be presented by two different approaches. The indifference curve approach uses the ordinal properties of utility (that is, it allows for the ranking of alternatives). The utility function approach obtains a utility function by attaching a number to each market basket; if basket A is preferred to basket B, A generates more utility than B. 12. When risky choices are analyzed or when comparisons must be made among individuals, the cardinal properties of the utility function can be important. Usually the utility function will show diminishing marginal utility: As more and more of a good is consumed, the consumer obtains smaller and smaller increments of utility. 13. Equal Marginal Principle - When the utility function approach is used and both goods are consumed, utility maximization occurs when the ratio of the marginal utilities of the two goods (which is the marginal rate of substitution) is equal to the ratio of the prices. 14. In times of war and other crises, governments sometimes ration food, gasoline, and other products, rather than allow prices to increase to competitive levels. Some consider nonprice rationing to be more equitable than relying on uncontested market forces. 4.1 Individual Demand Individual demand curve Curve relating the quantity of a good that a single consumer will buy to its price. Effect of income changes An increase in income with the prices of goods fixed causes consumers to alter their choice of market basket Income Consumption Curve Curve tracing the utility-maximizing combinations of two goods as a consumer’s income changes A reduction in price changes the intercept of the budget line, causing the consumer to choose a better basket - changing the equilibrium points. The Price-Consumption Curve Curve Tracing the utility maximizing combinations of two as the price of one changes An Inferior Good An increase in a person’s income can lead to less consumption of one of the two goods being purchased. Engel Curve Engel curves relate the quantity of a good consumed to income. consumer consumption goes to Basket UB at point B as the intercept changes. As point A descends to Point C, this highlights the substitution effect given that income remains constant as a result of being on the same budget line. As C jumps to B, price is made relatively constant but purchasing power increases - thus the income effect. Price increases a bit because Basket UA is inferior to Basket UB. For example, a hamburger is a normal good for income less than x. But then it becomes an inferior food for incomes greater than x. The real income is from the price change. So what is left is a result of the substitution effect. The Engel Curve can be used as a measure for development as the more developed you are, the type of food and consumption changes. The convexity of the indifference curve is the cause for why the demand curve is downward sloping. 4.2 Income and Substitution Effects How much is the increase in demand explained by the substitution effect and income effect? Hicks’ Decomposition Decrease in the price of food has both an income and substitution effect. The consumer is initially at A on the budget line RA. When the price of food falls Giffen Good Goods that are necessary for survival and therefore usually have completely inelastic elasticity. All Giffen goods are inferior but not all inferior goods are Giffen goods. Giffen goods cannot be substituted easily and the negative income effect overrules the substitution. 7. Two goods are substitutes if an increase in the price of one leads to an increase in the quantity demanded of the other. In contrast, two goods are complements if an increase in the price of one leads to a decrease in the quantity demanded of the other. Veblen Good The same thing as the Giffen good except it is a luxury item. These goods have perceived status and power and therefore overrule the rationality of consumers. The demand increases as the price goes up. SUMMARY #3 1. The indifference curve where one commodity (such as work) is "bad" has a positive slope. 2. The fact that both products concerned are regarded as desirable is NOT a reason why most indifference curves are curved. 3. The shape and position of the consumer’s indifference curve does not affect the slope and position of a consumer’s budget line. 8. The effect of a price change on the quantity demanded of a good can be broken into two parts: a substitution effect, in which the level of utility remains constant while price changes, and an income effect, in which the price remains constant while the level of utility changes. Because the income effect can be positive or negative, a price change can have a small or a large effect on quantity demanded. In the unusual case of a so-called Giffen good, the quantity demanded may move in the same direction as the price change, thereby generating an upward-sloping individual demand curve. Production Theory 4. Indifference curves measure preference and thus earnings will not cause a shift. 1. Technological Assumptions 2. Resources of the Firm - Cost 3. of inputs - Profit Maximization 5. Individual consumers’ demand curves for a commodity can be derived from information about their tastes for all goods and services and from their budget constraints. Inputs 1. Capital 2. Labor 3. Intermediate Inputs (Other things you might need - Water, Electricity, Steel etc.) 6. Engel curves, which describe the relationship between the quantity of a good consumed and income, can be useful in showing how consumer expenditures vary with income. 𝑄 = 𝐹(𝐾, 𝐿) Short Run: The greater the size of the firm, the greater the need to have an organizational structure to minimize the cost of transactions Worker Capital Output Average Marginal 1 10 15 15 15 2 10 40 20 25 3 10 69 23 29 4 10 96 24 27 Marginal Product of Labor = ∆𝑄 ∆𝐿 where Q is quantity and L is labor Labor Productivity: Brought about by better technology and stock of capital Production with Two Variable Inputs As you increase your inputs, there will be diminishing marginal returns in both Isoquant Represents all the possible combinations of inputs that yield a constant level of output. Properties 1. Farther from origin means greater level of production 2. Do no cross 3. Slope downward *The convexity shows how readily a firm can substitute between inputs. Long Run ∆𝑄 = Fun Fact: Malthus, the man who first coined “diminishing” in economics, predicted famines but said famines never came to fruition because of the technology in the Industrial Revolution. Technology shifts the curve up. As a country develops, the opportunity cost of time gets higher. You wouldn’t want to spend time cooking or raising children when wages are up. Your goal then would be to make as much money as you can provided you are a rational person. Laws: MP > AP, then Average Product increases. MP < AP, then Average Product diminishes MP = AP, then Average Product is max δ𝑄 δ𝐾 ∆𝐾 = δ𝑄 δ𝐿 Marginal Product of Capital = ∆𝑄 ∆𝐾 0 = 𝑀𝑃𝑘∆𝐾 + 𝑀𝑃𝐿∆𝐿 MRTS = MRTS = 𝑀𝑃𝐿 𝑀𝑃𝑘 −∆𝐾 ∆𝐿 Marginal Rate of Technical Substitution refers to how much labor can be substituted with capital and remain at the same level of output. If it is very high, you can hire more workers than capital. But the lower it gets, the less utility is derived from labor and capital becomes more important. Isoquants when inputs are: Perfect Substitutes: Straight Increase Situation in which output more than doubles when all inputs are doubled. Basically you are increasing the size of your firm. Constant Output doubles when all inputs are doubled Fixed Proportions: L Shaped Convex Decreasing Output less than doubles when all inputs are doubled. The reason there is a decrease in output (q) is because of inefficiencies whether that stems from technological, educational, or diseconomies of scale. The goal is to have constant returns of scales to maximize output. SUMMARY #4 1. A production function describes the maximum output that a firm can produce for each specified combination of inputs. Returns to Scale Refers to the rate at which output increases as inputs are increased proportionately. 2. In the short run, one or more inputs to the production process are fixed. In the long run, all inputs are potentially variable. 3. Production with one variable input, labor, can be usefully described in terms of the average product of labor (which measures output per unit of labor input) and the marginal product of labor (which measures the additional output as labor is increased by 1 unit). 4. According to the law of diminishing marginal returns, when one or more inputs are fixed, a variable input (usually labor) is likely to have a marginal product that eventually diminishes as the level of input increases. 5. An isoquant is a curve that shows all combinations of inputs that yield a given level of output. A firm’s production function can be represented by a series of isoquants associated with different levels of output. 6. Isoquants always slope downward because the marginal product of all inputs is positive. The shape of each isoquant can be described by the marginal rate of technical substitution at each point on the isoquant. The marginal rate of technical substitution of labor for capital (MRTS) is the amount by which the input of capital can be reduced when one extra unit of labor is used so that output remains constant. 7. The standard of living that a country can attain for its citizens is closely related to its level of labor productivity. Decreases in the rate of productivity growth in developed countries are due in part to the lack of growth of capital investment. 8. The possibilities for substitution among inputs in the production process range from a production function in which inputs are perfect substitutes to one in which the proportions of inputs to be used are fixed (a fixed- proportions production function). 9. In long-run analysis, we tend to focus on the firm’s choice of its scale or size of operation. Constant returns to scale means that doubling all inputs leads to doubling output. Increasing returns to scale occurs when output more than doubles when inputs are doubled; decreasing returns to scale applies when output less than doubles. 7.1 Measuring Cost: Which Costs Matter? Types of Costs Accounting Cost: Actual expenses plus depreciation charges for capital equipment Economic Cost: Cost to a firm of utilizing economic resources in production Opportunity Cost: Cost associated with opportunities forgone when a firm’s resources are not put to their best alternative use. Particularly useful in situations where alternatives that are foregone do not reflect monetary outlays Economic Cost = Opportunity Cost Sunk Costs: Expenditure that has been made and cannot be recovered. Has no influence on the firm’s decision and therefore not an economic cost. Its opportunity cost might be lower than the financial cost. Think of breaking up with your partner. The opportunity cost to prolong it is so much higher and more painful than ending it moving on even if there was so much investment of time and resources placed into it. Fixed Costs and Variable Costs O FC VC TC MC AF AV AT TC(Q) = FC + VC(Q) 0 50 0 50 - - - - Fixed costs will make it so the y-intercept can never be zero. The only way to remove fixed costs is the shut down the business. In the long-run, everything is variable. 1 50 50 100 50 50 50 100 2 50 78 128 28 25 39 64 3 50 98 148 20 17 38 49 7 50 175 225 25 7.1 25 32 0 𝐶 = 𝑤𝐿 + 𝑟𝐾 Cost is wage times labor plus the user cost of capital (interest rate + depreciation) times the existing the capital (human and physical). Fixed cost is not sunk cost as you can recover or avoid fixed costs, sunk costs just happen. Amortizing Sunk Costs Amortization Policy of treating a one-time expenditure as an annual cost spread out over some number of years. Your marginal cost will decrease as output increases up to a certain point due to increasing returns to scale but MC will start to increase once more due to the increase in labor as you increase your output. Marginal Cost LR = 𝑤 ∆𝑄/∆𝐿 In the long run, wage is subject to diminishing marginal productivity of labor which causes your marginal cost to increase due to decreasing returns to scale. Repurposing sunk costs into something else could be an effective way of liquidating and not making it a loss entirety. Examples: Computers: Fixed Cost = Initial Variable: Many parts and different manufacturers Pizza: Variable Cost (ingredients and labor) is not that high but there is a lot of fixed cost for the restaurant, machinery, etc. Book: Plenty of sunk costs as drafts are foregone and deleted revision after revision after revision. Marginal Cost SR = ∆𝑇𝐶 ∆𝑄 MC < AC | AC is falling MC > AC | AC is rising MC = AC | Minimum Cost/Constant Returns to Scale SUMMARY #5 1. Managers, investors, and economists must take into account the opportunity cost associated with the use of a firm’s resources: the cost associated with the opportunities forgone when the firm uses its resources in its next best alternative. 2. Economic cost is the cost to a firm of utilizing economic resources in production. While economic cost and opportunity cost are identical concepts, opportunity cost is particularly useful in situations when alternatives that are forgone do not reflect monetary outlays. 3. A sunk cost is an expenditure that has been made and cannot be recovered. After it has been incurred, it should be ignored when making future economic decisions. Because an expenditure that is sunk has no alternative use, its opportunity cost is zero. 4. In the short run, one or more of a firm’s inputs are fixed. Total cost can be divided into fixed cost and variable cost. A firm’s marginal cost is the additional variable cost associated with each additional unit of output. The average variable cost is the total variable cost divided by the number of units of output. 5. In the short run, when not all inputs are variable, the presence of diminishing returns determines the shape of the cost curves. In particular, there is an inverse relationship between the marginal product of a single variable input and the marginal cost of production. The average variable cost and average total cost curves are (AVC and ATC) U-shaped. The short-run marginal cost curve increases beyond a certain point, and cuts both average cost curves from below at their minimum points. 6. In the long run, all inputs to the production process are variable. As a result, the choice of inputs depends both on the relative costs of the factors of production and on the extent to which the firm can substitute among inputs in its production process. The cost-minimizing input choice is made by finding the point of tangency between the isoquant representing the level of desired output and an isocost line. 7. The firm’s expansion path shows how its cost-minimizing input choices vary as the scale or output of its operation increases. As a result, the expansion path provides useful information relevant for long-run planning decisions. 8. The long-run average cost curve is the envelope of the firm’s short-run average cost curves, and it reflects the presence or absence of returns to scale. When there are increasing returns to scale initially and then decreasing returns to scale, the long-run average cost curve is U-shaped, and the envelope does not include all points of minimum short-run average cost. 9. A firm enjoys economies of scale when it can double its output at less than twice the cost. Correspondingly, there are diseconomies of scale when a doubling of output requires more than twice the cost. Scale economies and diseconomies apply even when input pro- portions are variable; returns to scale apply only when input proportions are fixed. 10. Economies of scope arise when the firm can produce any combination of the two outputs more cheaply than could two independent firms that each produced a single output. The degree of economies of scope is measured by the percentage reduction in cost when one firm produces two products relative to the cost of producing them individually. 11. A firm’s average cost of production can fall over time if the firm “learns” how to produce more effectively. The learning curve shows how much the input needed to produce a given output falls as the cumulative output of the firm increases. 12. Cost functions relate the cost of production to the firm’s level of output. The functions can be measured in both the short run and the long run by using either data for firms in an industry at a given time or data for an industry over time. A number of functional relationships, including linear, quadratic, and cubic, can be used to represent cost functions. wages go down, you are less willing to give up your capital. If the marginal product of labor is relatively higher than the marginal product of capital, you can hire more labor. Vice versa. When a price changes (whether capital or labor), your isocost line becomes steeper. Isocost Line Graph showing all possible combinations of labor and capital that can be purchased for a given total cost. 0 𝐾 = 𝐶 𝑟 − 𝑤𝐿 𝑟 0 Where 𝐶 is the total cost of producing any output and (w/r) is the ratio of the wage rate to the rental cost of capital. When it is equal to your marginal rate of technical substitution, you minimize costs, maximize profits. In trying to solve how much to produce to maximize profit, the firm also tries to minimize cost as much as possible. If wages go up, more capital will be given up to gain one more unit of labor. If This changes the equilibrium point and moves it to point B. In this example, minimum wage is increased, incentivizing firms to hire less workers. In the long-run, if you are able to accumulate more capital, you can generate other ways to minimize costs. As you gain more capital, you can produce at the $3000 isocost line, shifting from point A to C.