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Chapter 5
Uncertainty and Consumer
Behavior
Introduction
• Choice with certainty is reasonably
straightforward
• How do we make choices when certain
variables such as income and prices are
uncertain (making choices with risk)?
Describing Risk
•
To measure risk we must know:
1. All of the possible outcomes
2. The probability or likelihood that each
outcome will occur
Describing Risk
•
Interpreting Probability
1. Objective Interpretation
•
Based on the observed frequency of past events
2. Subjective Interpretation
•
Based on perception that an outcome will occur
Interpreting Probability
• Subjective Probability
– Different information or different abilities to
process the same information can influence
the subjective probability
– Based on judgment or experience
Describing Risk
•
With an interpretation of probability, must
determine 2 measures to help describe
and compare risky choices
1. Expected value
2. Variability
Describing Risk
• Expected Value
– The weighted average of the payoffs or values
resulting from all possible outcomes
• Expected value measures the central tendency;
the payoff or value expected on average
Expected Value – An Example
• Investment in offshore drilling exploration:
• Two outcomes are possible
– Success – the stock price increases from $30
to $40/share
– Failure – the stock price falls from $30 to
$20/share
Expected Value – An Example
• Objective Probability
– 100 explorations, 25 successes and 75
failures
– Probability (Pr) of success = 1/4 and the
probability of failure = 3/4
Expected Value – An Example
EV  Pr(success
)(value
 Pr(failure )(value
EV  1 4 ($40/share
EV  $25/share
of success)
of failure)
)  3 4 ($20/share
)
Expected Value
• In general, for n possible outcomes:
– Possible outcomes having payoffs X1, X2, …,
Xn
– Probabilities of each outcome is given by Pr1,
Pr2, …, Prn
E(X)  Pr 1 X 1  Pr 2 X 2  ...  Pr n X n
Describing Risk
• Variability
– The extent to which possible outcomes of an
uncertain event may differ
– How much variation exists in the possible
choice
Variability – An Example
• Suppose you are choosing between two
part-time sales jobs that have the same
expected income ($1,500)
• The first job is based entirely on
commission
• The second is a salaried position
Variability – An Example
• There are two equally likely outcomes in
the first job: $2,000 for a good sales job
and $1,000 for a modestly successful one
• The second pays $1,510 most of the time
(.99 probability), but you will earn $510 if
the company goes out of business (.01
probability)
Variability – An Example
Outcome 1
Outcome 2
Prob.
Income
Prob.
Income
Job 1:
Commission
.5
2000
.5
1000
Job 2: Fixed
Salary
.99
1510
.01
510
Variability – An Example
• Income from Possible Sales Job
Job 1 Expected Income
E(X 1 )  .5($2000)  .5($1000)
 $ 1500
Job 2 Expected Income
E(X 2 )  .99($1510)
 .01($510)
 $1500
Variability
• While the expected values are the same,
the variability is not
• Greater variability from expected values
signals greater risk
• Variability comes from deviations in
payoffs
– Difference between expected payoff and
actual payoff
Variability – An Example
Deviations from Expected Income ($)
Outcome Deviation Outcome Deviation
1
2
Job
1
$2000
$500
$1000
-$500
Job
2
1510
10
510
-900
Variability
• Average deviations are always zero so we
must adjust for negative numbers
• We can measure variability with standard
deviation
– The square root of the average of the squares
of the deviations of the payoffs associated
with each outcome from their expected value
Variability
• Standard deviation is a measure of risk
– Measures how variable your payoff will be
– More variability means more risk
– Individuals generally prefer less variability –
less risk
Variability
• The standard deviation is written:
 
Pr 1  X 1  E ( X )   Pr 2  X 2  E ( X ) 
2
2
Standard Deviation – Example 1
Deviations from Expected
Income ($)
Outcom Deviatio Outcom Deviatio
e1
n
e2
n
Job
1
$2000
$500
$1000
-$500
Job
2
1510
10
510
-900
Standard Deviation – Example 1
• Standard deviations of the two jobs are:
 
Pr 1  X 1  E ( X )   Pr 2  X 2  E ( X ) 
2
1 
0 . 5 ($ 250 , 000 )  0 . 5 ($ 250 , 000 )
1 
250 , 000  500
2 
0 . 99 ($ 100 )  0 . 01 ($ 980 ,100 )
2 
9 ,900  99 . 50
2
Standard Deviation – Example 1
• Job 1 has a larger standard deviation and
therefore it is the riskier alternative
• The standard deviation also can be used
when there are many outcomes instead of
only two
Standard Deviation – Example 2
• Job 1 is a job in which the income ranges
from $1000 to $2000 in increments of
$100 that are all equally likely
• Job 2 is a job in which the income ranges
from $1300 to $1700 in increments of
$100 that, also, are all equally likely
Outcome Probabilities - Two
Jobs
Job 1 has greater
spread: greater
standard deviation
and greater risk
than Job 2.
Probability
0.2
Job 2
0.1
Job 1
$1000
$1500
$2000
Income
Decision Making – Example 1
• What if the outcome probabilities of two
jobs have unequal probability of
outcomes?
– Job 1: greater spread and standard deviation
– Peaked distribution: extreme payoffs are less
likely that those in the middle of the
distribution
– You will choose job 2 again
Unequal Probability Outcomes
The distribution of payoffs
associated with Job 1 has a
greater spread and standard
deviation than those with Job 2.
Probability
0.2
Job 2
0.1
Job 1
$1000
$1500
$2000
Income
Decision Making – Example 2
• Suppose we add $100 to each payoff in
Job 1 which makes the expected payoff =
$1600
– Job 1: expected income $1,600 and a
standard deviation of $500
– Job 2: expected income of $1,500 and a
standard deviation of $99.50
Decision Making – Example 2
• Which job should be chosen?
– Depends on the individual
– Some may be willing to take risk with higher
expected income
– Some will prefer less risk even with lower
expected income
Risk and Crime Deterrence
• Attitudes toward risk affect willingness to
break the law
• Suppose a city wants to deter people from
double parking
• Monetary fines may be better than jail time
Risk and Crime Deterrence
• Costs of apprehending criminals are not
zero, therefore
– Fines must be higher than the costs to society
– Probability of apprehension is actually less
than one
Risk and Crime Deterrence Example
•
Assumptions:
1. Double-parking saves a person $5 in terms
of time spent searching for a parking space
2. The driver is risk neutral
3. Cost of apprehension is zero
Risk and Crime Deterrence Example
• A fine greater than $5.00 would deter the
driver from double parking
– Benefit of double parking ($5) is less than the
cost ($6.00) equals a net benefit that is
negative
– If the value of double parking is greater than
$5.00, then the person would still break the
law
Risk and Crime Deterrence Example
• The same deterrence effect is obtained by
either
– A $50 fine with a 0.1 probability of being
caught resulting in an expected penalty of $5
or
– A $500 fine with a 0.01 probability of being
caught resulting in an expected penalty of $5
Risk and Crime Deterrence Example
• Enforcement costs are reduced with high
fine and low probability
• Most effective if drivers don’t like to take
risks
Preferences Toward Risk
• Can expand evaluation of risky alternative
by considering utility that is obtained by
risk
– A consumer gets utility from income
– Payoff measured in terms of utility
Preferences Toward Risk Example
• A person is earning $15,000 and receiving
13.5 units of utility from the job
• She is considering a new, but risky job
– 0.50 chance of $30,000
– 0.50 chance of $10,000
Preferences Toward Risk Example
• Utility at $30,000 is 18
• Utility at $10,000 is 10
• Must compare utility from the risky job with
current utility of 13.5
• To evaluate the new job, we must
calculate the expected utility of the risky
job
Preferences Toward Risk
• The expected utility of the risky option is
the sum of the utilities associated with all
her possible incomes weighted by the
probability that each income will occur
E(u) = (Prob. of Utility 1) *(Utility 1)
+ (Prob. of Utility 2)*(Utility 2)
Preferences Toward Risk –
Example
• The expected is:
E(u) = (1/2)u($10,000) + (1/2)u($30,000)
= 0.5(10) + 0.5(18)
= 14
– E(u) of new job is 14, which is greater than
the current utility of 13.5 and therefore
preferred
Preferences Toward Risk
• People differ in their preference toward
risk
• People can be risk averse, risk neutral, or
risk loving
Preferences Toward Risk
• Risk Averse
– A person who prefers a certain given income
to a risky income with the same expected
value
– The person has a diminishing marginal utility
of income
– Most common attitude towards risk
• Ex: Market for insurance
Risk Averse - Example
• A person can have a $20,000 job with
100% probability and receive a utility level
of 16
• The person could have a job with a 0.5
chance of earning $30,000 and a 0.5
chance of earning $10,000
Risk Averse – Example
• Expected Income of Risky Job
E(I) = (0.5)($30,000) + (0.5)($10,000)
E(I) = $20,000
• Expected Utility of Risky Job
E(u) = (0.5)(10) + (0.5)(18)
E(u) = 14
Risk Averse – Example
• Expected income from both jobs is the
same – risk averse may choose current
job
• Expected utility is greater for certain job
– Would keep certain job
• Risk averse person’s losses (decreased
utility) are more important than risky gains
Risk Averse
• Can see risk averse choices graphically
• Risky job has expected income = $20,000
with expected utility = 14
– Point F
• Certain job has expected income =
$20,000 with utility = 16
– Point D
Risk Averse Utility Function
Utility
E
18
D
16
The consumer is risk
averse because she would
prefer a certain income of
$20,000 to an uncertain
expected income =
$20,000
C
14
F
A
10
0
10
16 20
30
Income ($1,000)
Preferences Toward Risk
• A person is said to be risk neutral if they
show no preference between a certain
income, and an uncertain income with the
same expected value
• Constant marginal utility of income
Risk Neutral
• Expected value for risky option is the
same as utility for certain outcome
E(I) = (0.5)($10,000) + (0.5)($30,000)
= $20,000
E(u) = (0.5)(6) + (0.5)(18) = 12
• This is the same as the certain income of
$20,000 with utility of 12
Risk Neutral
E
Utility 18
The consumer is risk
neutral and is indifferent
between certain events
and uncertain events
with the same
expected income.
C
12
A
6
0
10
20
30
Income ($1,000)
Preferences Toward Risk
• A person is said to be risk loving if they
show a preference toward an uncertain
income over a certain income with the
same expected value
– Examples: Gambling, some criminal activities
• Increasing marginal utility of income
Risk Loving
• Expected value for risky option – point F
E(I) = (0.5)($10,000) + (0.5)($30,000)
= $20,000
E(u) = (0.5)(3) + (0.5)(18) = 10.5
• Certain income is $20,000 with utility of 8
– point C
• Risky alternative is preferred
Risk Loving
Utility
E
18
The consumer is risk
loving because she
would prefer the gamble
to a certain income.
F
10.5
C
8
A
3
0
10
20
30
Income ($1,000)
Preferences Toward Risk
• The risk premium is the maximum
amount of money that a risk-averse
person would pay to avoid taking a risk
• The risk premium depends on the risky
alternatives the person faces
Risk Premium – Example
• From the previous example
– A person has a .5 probability of earning
$30,000 and a .5 probability of earning
$10,000
– The expected income is $20,000 with
expected utility of 14
Risk Premium – Example
• Point F shows the risky scenario – the
utility of 14 can also be obtained with
certain income of $16,000
• This person would be willing to pay up to
$4000 (20 – 16) to avoid the risk of
uncertain income
• Can show this graphically by drawing a
straight line between the two points – line
CF
Risk Premium – Example
Risk Premium
Utility
G
20
18
E
C
14
Here, the risk
premium is $4,000
because a certain
income of $16,000
gives the person
the same expected
utility as the
uncertain income
with expected value
of $20,000.
F
A
10
0
10
16
20
30
40
Income ($1,000)
Risk Aversion and Indifference
Curves
• Can describe a person’s risk aversion
using indifference curves that relate
expected income to variability of income
(standard deviation)
• Since risk is undesirable, greater risk
requires greater expected income to make
the person equally well off
• Indifference curves are therefore upward
sloping
Risk Aversion and Indifference
Curves
Expected
Income
U3
U2
U1
Standard Deviation of Income
Highly Risk Averse: An
increase in standard
deviation requires a
large increase in
income to maintain
satisfaction.
Risk Aversion and Indifference
Curves
Expected
Income
Slightly Risk Averse:
A large increase in standard
deviation requires only a
small increase in income
to maintain satisfaction.
U3
U2
U1
Standard Deviation of Income
Reducing Risk
•
•
Consumers are generally risk averse and
therefore want to reduce risk
Three ways consumers attempt to reduce
risk are:
1. Diversification
2. Insurance
3. Obtaining more information
Reducing Risk
• Diversification
– Reducing risk by allocating resources to a
variety of activities whose outcomes are not
closely related
• Example:
– Suppose a firm has a choice of selling air
conditioners, heaters, or both
– The probability of it being hot or cold is 0.5
– How does a firm decide what to sell?
Income from Sales of
Appliances
Hot Weather
Cold
Weather
Air
conditioner
sales
$30,000
$12,000
Heater sales
12,000
30,000
Diversification – Example
• If the firm sells only heaters or air
conditioners their income will be either
$12,000 or $30,000
• Their expected income would be:
– 1/2($12,000) + 1/2($30,000) = $21,000
Diversification – Example
• If the firm divides their time evenly between
appliances, their air conditioning and heating
sales would be half their original values
• If it were hot, their expected income would be
$15,000 from air conditioners and $6,000 from
heaters, or $21,000
• If it were cold, their expected income would be
$6,000 from air conditioners and $15,000 from
heaters, or $21,000
Diversification – Example
• With diversification, expected income is
$21,000 with no risk
• Better off diversifying to minimize risk
• Firms can reduce risk by diversifying
among a variety of activities that are not
closely related
Reducing Risk – The Stock
Market
• If invest all money in one stock, then take
on a lot of risk
– If that stock loses value, you lose all your
investment value
• Can spread risk out by investing in many
different stocks or investments
– Ex: Mutual funds
Reducing Risk – Insurance
• Risk averse are willing to pay to avoid risk
• If the cost of insurance equals the
expected loss, risk averse people will buy
enough insurance to recover fully from a
potential financial loss
The Law of Large Numbers
• Insurance companies know that although
single events are random and largely
unpredictable, the average outcome of
many similar events can be predicted
• When insurance companies sell many
policies, they face relatively little risk
Reducing Risk – Actuarially Fair
• Insurance companies can be sure total
premiums paid will equal total money paid
out
• Companies set the premiums so money
received will be enough to pay expected
losses
The Value of Information
• Risk often exists because we don’t know
all the information surrounding a decision
• Because of this, information is valuable
and people are willing to pay for it
The Value of Information
• The value of complete information
– The difference between the expected value of
a choice with complete information and the
expected value when information is
incomplete
The Value of Information –
Example
• Per capita milk consumption has fallen
over the years
• The milk producers engaged in market
research to develop new sales strategies
to encourage the consumption of milk
The Value of Information –
Example
• Findings
– Milk demand is seasonal with the greatest
demand in the spring
– Price elasticity of demand is negative and
small
– Income elasticity is positive and large
The Value of Information –
Example
• Milk advertising increases sales most in
the spring
• Allocating advertising based on this
information in New York increased profits
by 9% or $14 million
• The cost of the information was relatively
low, while the value was substantial
(increased profits)
Behavioral Economics
• Sometimes individuals’ behavior
contradicts basic assumptions of
consumer choice
– More information about human behavior might
lead to better understanding
– This is the objective of behavioral
economics
• Improving understanding of consumer choice by
incorporating more realistic and detailed
assumptions regarding human behavior
Behavioral Economics
• There are a number of examples of
consumer choice contradictions
– You take at trip and stop at a restaurant that
you will most likely never stop at again. You
still think it fair to leave a 15% tip rewarding
the good service.
– You choose to buy a lottery ticket even though
the expected value is less than the price of
the ticket
Behavioral Economics
• Reference Points
– Economists assume that consumers place a
unique value on the goods/services
purchased
– Psychologists have found that perceived
value can depend on circumstances
• You are able to buy a ticket to the sold out Cher
concert for the published price of $125. You find
out you can sell the ticket for $500 but you choose
not to, even though you would never have paid
more than $250 for the ticket.
Behavioral Economics
• Reference Points (cont.)
– The point from which an individual makes a
consumption decision
– From the example, owning the Cher ticket is
the reference point
• Individuals dislike losing things they own
• They value items more when they own them than
when they do not
• Losses are valued more than gains
• Utility loss from selling the ticket is greater than
original utility gain from purchasing it
Behavioral Economics
• Experimental Economics
– Students were divided into two groups
– Group one was given a mug with a market
value of $5.00
– Group two received nothing
– Students with mugs were asked how much
they would take to sell the mug back
• Lowest price for mugs, on average, was $7.00
Behavioral Economics
• Experimental Economics (cont.)
– Group without mugs was asked minimum
amount of cash they would except in lieu of
the mug
• On average willing to accept $3.50 instead of
getting the mug
– Group one had reference point of owning the
mug
– Group two had reference point of no mug
Behavioral Economics
• Fairness
– Individuals often make choices because they
think they are fair and appropriate
• Charitable giving, tipping in restaurants
– Some consumers will go out of their way to
punish a store they think is “unfair” in their
pricing
– Manager might offer higher than market
wages to make for happier working
environment or more productive worker
Chapter 6
Production
Introduction
• Our study of consumer behavior was
broken down into 3 steps:
– Describing consumer preferences
– Consumers face budget constraints
– Consumers choose to maximize utility
• Production decisions of a firm are similar
to consumer decisions
– Can also be broken down into three steps
Production Decisions of a Firm
1. Production Technology
– Describe how inputs can be transformed into
outputs
•
•
Inputs: land, labor, capital and raw materials
Outputs: cars, desks, books, etc.
– Firms can produce different amounts of
outputs using different combinations of
inputs
Production Decisions of a Firm
2. Cost Constraints
– Firms must consider prices of labor, capital
and other inputs
– Firms want to minimize total production costs
partly determined by input prices
– As consumers must consider budget
constraints, firms must be concerned about
costs of production
Production Decisions of a Firm
3. Input Choices
– Given input prices and production
technology, the firm must choose how much
of each input to use in producing output
– Given prices of different inputs, the firm may
choose different combinations of inputs to
minimize costs
•
If labor is cheap, firm may choose to produce with
more labor and less capital
Production Decisions of a Firm
• If a firm is a cost minimizer, we can also
study
– How total costs of production vary with output
– How the firm chooses the quantity to
maximize its profits
• We can represent the firm’s production
technology in the form of a production
function
The Technology of Production
• Production Function:
– Indicates the highest output (q) that a firm can
produce for every specified combination of
inputs
– For simplicity, we will consider only labor (L)
and capital (K)
– Shows what is technically feasible when the
firm operates efficiently
The Technology of Production
• The production function for two inputs:
q = F(K,L)
– Output (q) is a function of capital (K) and labor
(L)
– The production function is true for a given
technology
• If technology increases, more output can be
produced for a given level of inputs
The Technology of Production
• Short Run versus Long Run
– It takes time for a firm to adjust production
from one set of inputs to another
– Firms must consider not only what inputs can
be varied but over what period of time that
can occur
– We must distinguish between long run and
short run
The Technology of Production
• Short Run
– Period of time in which quantities of one or
more production factors cannot be changed
– These inputs are called fixed inputs
• Long Run
– Amount of time needed to make all production
inputs variable
• Short run and long run are not time
specific
Production: One Variable Input
• We will begin looking at the short run
when only one input can be varied
• We assume capital is fixed and labor is
variable
– Output can only be increased by increasing
labor
– Must know how output changes as the
amount of labor is changed (Table 6.1)
Production: One Variable Input
Production: One Variable Input
•
Observations:
1. When labor is zero, output is zero as well
2. With additional workers, output (q) increases
up to 8 units of labor
3. Beyond this point, output declines
•
•
Increasing labor can make better use of existing
capital initially
After a point, more labor is not useful and can be
counterproductive
Production: One Variable Input
• Firms make decisions based on the
benefits and costs of production
• Sometimes useful to look at benefits and
costs on an incremental basis
– How much more can be produced when at
incremental units of an input?
• Sometimes useful to make comparison on
an average basis
Production: One Variable Input
• Average product of Labor - Output per unit
of a particular product
• Measures the productivity of a firm’s labor
in terms of how much, on average, each
worker can produce
AP L 
Output
Labor Input

q
L
Production: One Variable Input
• Marginal Product of Labor – additional
output produced when labor increases by
one unit
• Change in output divided by the change in
labor
MP L 
 Output
 Labor Input

q
L
Production: One Variable Input
Production: One Variable Input
• We can graph the information in Table 6.1
to show
– How output varies with changes in labor
• Output is maximized at 112 units
– Average and Marginal Products
• Marginal Product is positive as long as total output
is increasing
• Marginal Product crosses Average Product at its
maximum
Production: One Variable Input
Output
per
Month
D
112
Total Product
C
60
At point D, output is
maximized.
B
A
0 1
2 3
4
5 6
7 8
9
10 Labor per Month
Production: One Variable Input
Output
per
Worker
•Left of E: MP > AP & AP is increasing
•Right of E: MP < AP & AP is decreasing
•At E: MP = AP & AP is at its maximum
•At 8 units, MP is zero and output is at max
30
Marginal Product
E
20
Average Product
10
0 1
2 3
4
5 6
7 8
9
10 Labor per Month
Marginal and Average Product
• When marginal product is greater than the
average product, the average product is
increasing
• When marginal product is less than the average
product, the average product is decreasing
• When marginal product is zero, total product
(output) is at its maximum
• Marginal product crosses average product at its
maximum
Product Curves
• We can show a geometric relationship
between the total product and the average
and marginal product curves
– Slope of line from origin to any point on the
total product curve is the average product
– At point B, AP = 60/3 = 20 which is the same
as the slope of the line from the origin to point
B on the total product curve
Product Curves
q
AP is slope of line from
origin to point on TP
curve
q/L
112
TP
C
60
30
20
B
AP
10
MP
0 1 2 3 4 5 6 7 8 9 10
Labor
0 1 2 3 4 5 6 7 8 9 10
Labor
Product Curves
• Geometric relationship between total
product and marginal product
– The marginal product is the slope of the line
tangent to any corresponding point on the
total product curve
– For 2 units of labor, MP = 30/2 = 15 which is
slope of total product curve at point A
Product Curves
q
q
MP is slope of line tangent to
corresponding point on TP
curve
112
TP 30
15
60
30
10
A
0 1 2 3 4 5 6 7 8 9 10
Labor
AP
MP
0 1 2 3 4 5 6 7 8 9 10
Labor
Production: One Variable Input
• From the previous example, we can see
that as we increase labor the additional
output produced declines
• Law of Diminishing Marginal Returns:
As the use of an input increases with other
inputs fixed, the resulting additions to
output will eventually decrease
Law of Diminishing Marginal
Returns
• When the use of labor input is small and
capital is fixed, output increases
considerably since workers can begin to
specialize and MP of labor increases
• When the use of labor input is large, some
workers become less efficient and MP of
labor decreases
Law of Diminishing Marginal
Returns
• Typically applies only for the short run
when one variable input is fixed
• Can be used for long-run decisions to
evaluate the trade-offs of different plant
configurations
• Assumes the quality of the variable input is
constant
Law of Diminishing Marginal
Returns
• Easily confused with negative returns –
decreases in output
• Explains a declining marginal product, not
necessarily a negative one
– Additional output can be declining while total
output is increasing
Law of Diminishing Marginal
Returns
• Assumes a constant technology
– Changes in technology will cause shifts in the
total product curve
– More output can be produced with same
inputs
– Labor productivity can increase if there are
improvements in technology, even though any
given production process exhibits diminishing
returns to labor
The Effect of Technological
Improvement
Output
Moving from A to B to
C, labor productivity is
increasing over time
C
100
O3
B
A
O2
50
O1
0 1
2 3
4
5 6
7 8
9
10
Labor per
time period
Production: Two Variable Inputs
• Firm can produce output by combining
different amounts of labor and capital
• In the long run, capital and labor are both
variable
• We can look at the output we can achieve
with different combinations of capital and
labor – Table 6.4
Production: Two Variable Inputs
Production: Two Variable Inputs
• The information can be represented
graphically using isoquants
– Curves showing all possible combinations of
inputs that yield the same output
• Curves are smooth to allow for use of
fractional inputs
– Curve 1 shows all possible combinations of
labor and capital that will produce 55 units of
output
Isoquant Map
E
Capital 5
per year
Ex: 55 units of output
can be produced with
3K & 1L (pt. A)
OR
1K & 3L (pt. D)
4
3
A
B
C
2
q3 = 90
D
1
q2 = 75
q1 = 55
1
2
3
4
5
Labor per year
Production: Two Variable Inputs
• Diminishing Returns to Labor with
Isoquants
• Holding capital at 3 and increasing labor
from 0 to 1 to 2 to 3
– Output increases at a decreasing rate (0, 55,
20, 15) illustrating diminishing marginal
returns from labor in the short run and long
run
Production: Two Variable Inputs
• Diminishing Returns to Capital with
Isoquants
• Holding labor constant at 3 increasing
capital from 0 to 1 to 2 to 3
– Output increases at a decreasing rate (0, 55,
20, 15) due to diminishing returns from capital
in short run and long run
Diminishing Returns
Capital 5
per year
Increasing labor
holding capital
constant (A, B, C)
OR
Increasing capital
holding labor constant
(E, D, C
4
3
A
B
C
D
2
q3 = 90
E
1
q2 = 75
q1 = 55
1
2
3
4
5
Labor per year
Production: Two Variable Inputs
• Substituting Among Inputs
– Companies must decide what combination of
inputs to use to produce a certain quantity of
output
– There is a trade-off between inputs, allowing
them to use more of one input and less of
another for the same level of output
Production: Two Variable Inputs
• Substituting Among Inputs
– Slope of the isoquant shows how one input
can be substituted for the other and keep the
level of output the same
– The negative of the slope is the marginal rate
of technical substitution (MRTS)
• Amount by which the quantity of one input can be
reduced when one extra unit of another input is
used, so that output remains constant
Production: Two Variable Inputs
• The marginal rate of technical substitution
equals:
MRTS  
Change in Capital Input
Change in Labor Input
MRTS    K
L
( for a fixed level of q )
Production: Two Variable Inputs
• As labor increases to replace capital
– Labor becomes relatively less productive
– Capital becomes relatively more productive
– Need less capital to keep output constant
– Isoquant becomes flatter
Marginal Rate of
Technical Substitution
Capital
per year
5
4
Negative Slope measures
MRTS;
MRTS decreases as move down
the indifference curve
2
1
3
1
1
2
2/3
Q3 =90
1
1/3
1
Q2 =75
1
Q1 =55
1
2
3
4
5
Labor per month
MRTS and Isoquants
• We assume there is diminishing MRTS
– Increasing labor in one unit increments from 1 to 5
results in a decreasing MRTS from 1 to 1/2
– Productivity of any one input is limited
• Diminishing MRTS occurs because of
diminishing returns and implies isoquants are
convex
• There is a relationship between MRTS and
marginal products of inputs
MRTS and Marginal Products
• If we increase labor and decrease capital
to keep output constant, we can see how
much the increase in output is due to the
increased labor
– Amount of labor increased times the marginal
productivity of labor
 ( MP L )(  L )
MRTS and Marginal Products
• Similarly, the decrease in output from the
decrease in capital can be calculated
– Decrease in output from reduction of capital
times the marginal produce of capital
 ( MP K )(  K )
MRTS and Marginal Products
• If we are holding output constant, the net
effect of increasing labor and decreasing
capital must be zero
• Using changes in output from capital and
labor we can see
(MP L )(  L)  (MP K )(  K)  0
MRTS and Marginal Products
• Rearranging equation, we can see the
relationship between MRTS and MPs
(MP L )(  L)  (MP K )(  K)  0
(MP L )(  L )  - (MP K )(  K)
(MP L )
( MP
K
)

L
K
 MRTS
Isoquants: Special Cases
•
Two extreme cases show the possible
range of input substitution in production
1. Perfect substitutes
– MRTS is constant at all points on isoquant
– Same output can be produced with a lot of
capital or a lot of labor or a balanced mix
Perfect Substitutes
Capital
per
month
A
Same output can be
reached with mostly
capital or mostly labor
(A or C) or with equal
amount of both (B)
B
C
Q1
Q2
Q3
Labor
per month
Isoquants: Special Cases
2. Perfect Complements
– Fixed proportions production function
– There is no substitution available between
inputs
– The output can be made with only a specific
proportion of capital and labor
– Cannot increase output unless increase both
capital and labor in that specific proportion
Fixed-Proportions
Production Function
Capital
per
month
Same output can
only be produced
with one set of
inputs.
Q3
C
Q2
B
K1
A
Q1
Labor
per month
L1
Returns to Scale
• In addition to discussing the tradeoff
between inputs to keep production the
same
• How does a firm decide, in the long run,
the best way to increase output?
– Can change the scale of production by
increasing all inputs in proportion
– If double inputs, output will most likely
increase but by how much?
Returns to Scale
• Rate at which output increases as inputs
are increased proportionately
– Increasing returns to scale
– Constant returns to scale
– Decreasing returns to scale
Returns to Scale
• Increasing returns to scale: output more
than doubles when all inputs are doubled
– Larger output associated with lower cost
(cars)
– One firm is more efficient than many (utilities)
– The isoquants get closer together
Increasing Returns to Scale
Capital
(machine
hours)
A
The isoquants
move closer
together
4
30
20
2
10
5
10
Labor (hours)
Returns to Scale
• Constant returns to scale: output
doubles when all inputs are doubled
–
Size does not affect productivity
–
May have a large number of producers
–
Isoquants are equidistant apart
Returns to Scale
Capital
(machine
hours)
A
6
30
4
2
0
2
Constant
Returns:
Isoquants are
equally spaced
10
5
10
15
Labor (hours)
Returns to Scale
• Decreasing returns to scale: output less
than doubles when all inputs are doubled
–
Decreasing efficiency with large size
–
Reduction of entrepreneurial abilities
–
Isoquants become farther apart
Returns to Scale
Capital
(machine
hours)
A
Decreasing Returns:
Isoquants get further
apart
4
30
2
10
5
10
20
Labor (hours)
Chapter 7
The Cost of Production
Measuring Cost:
Which Costs Matter?
• For a firm to minimize costs, we must
clarify what is meant by costs and how to
measure them
– It is clear that if a firm has to rent equipment
or buildings, the rent they pay is a cost
– What if a firm owns its own equipment or
building?
• How are costs calculated here?
Measuring Cost:
Which Costs Matter?
• Accountants tend to take a retrospective
view of firms’ costs, whereas economists
tend to take a forward-looking view
• Accounting Cost
– Actual expenses plus depreciation charges for
capital equipment
• Economic Cost
– Cost to a firm of utilizing economic resources
in production, including opportunity cost
Measuring Cost:
Which Costs Matter?
• Economic costs distinguish between costs
the firm can control and those it cannot
– Concept of opportunity cost plays an
important role
• Opportunity cost
– Cost associated with opportunities that are
foregone when a firm’s resources are not put
to their highest-value use
Opportunity Cost
• An Example
– A firm owns its own building and pays no rent
for office space
– Does this mean the cost of office space is
zero?
– The building could have been rented instead
– Foregone rent is the opportunity cost of using
the building for production and should be
included in the economic costs of doing
business
Opportunity Cost
• A person starting their own business must
take into account the opportunity cost of
their time
– Could have worked elsewhere making a
competitive salary
Measuring Cost:
Which Costs Matter?
• Although opportunity costs are hidden and
should be taken into account, sunk costs
should not
• Sunk Cost
– Expenditure that has been made and cannot
be recovered
– Should not influence a firm’s future economic
decisions
Sunk Cost
• Firm buys a piece of equipment that
cannot be converted to another use
• Expenditure on the equipment is a sunk
cost
– Has no alternative use so cost cannot be
recovered – opportunity cost is zero
– Decision to buy the equipment might have
been good or bad, but now does not matter
Prospective Sunk Cost
• An Example
– Firm is considering moving its headquarters
– A firm paid $500,000 for an option to buy a
building
– The cost of the building is $5 million for a total
of $5.5 million
– The firm finds another building for $5.25
million
– Which building should the firm buy?
Prospective Sunk Cost
The first building should be purchased
• The $500,000 is a sunk cost and should
not be considered in the decision to buy
• What should be considered is
– Spending an additional $5,250,000 or
– Spending an additional $5,000,000
Measuring Cost:
Which Costs Matter?
•
Some costs vary with output, while some
remain the same no matter the amount of
output
• Total cost can be divided into:
1. Fixed Cost
– Does not vary with the level of output
2. Variable Cost
– Cost that varies as output varies
Fixed and Variable Costs
• Total output is a function of variable inputs
and fixed inputs
• Therefore, the total cost of production
equals the fixed cost (the cost of the fixed
inputs) plus the variable cost (the cost of
the variable inputs), or…
TC  FC  VC
Fixed and Variable Costs
• Which costs are variable and which are
fixed depends on the time horizon
• Short time horizon – most costs are fixed
• Long time horizon – many costs become
variable
• In determining how changes in production
will affect costs, must consider if fixed or
variable costs are affected.
Fixed Cost Versus Sunk Cost
• Fixed cost and sunk cost are often
confused
• Fixed Cost
– Cost paid by a firm that is in business
regardless of the level of output
• Sunk Cost
– Cost that has been incurred and cannot be
recovered
Measuring Cost:
Which Costs Matter?
• Personal Computers
– Most costs are variable
– Largest component: labor
• Software
– Most costs are sunk
– Initial cost of developing the software
Measuring Costs
• Marginal Cost (MC):
– The cost of expanding output by one unit
– Fixed costs have no impact on marginal cost,
so it can be written as:
MC 
ΔVC
Δq

ΔTC
Δq
Measuring Costs
• Average Total Cost (ATC)
– Cost per unit of output
– Also equals average fixed cost (AFC) plus
average variable cost (AVC)
ATC 
TC
 AFC  AVC
q
ATC 
TC
q

TFC
q

TVC
q
A Firm’s Short Run Costs
A Firm’s Short Run Costs
Determinants of Short Run Costs
• The rate at which these costs increase
depends on the nature of the production
process
– The extent to which production involves
diminishing returns to variable factors
• Diminishing returns to labor
– When marginal product of labor is decreasing
Determinants of Short Run Costs
• If marginal product of labor decreases
significantly as more labor is hired
– Costs of production increase rapidly
– Greater and greater expenditures must be made to
produce more output
• If marginal product of labor decreases only
slightly as increase labor
– Costs will not rise very fast when output is increased
Determinants of Short Run
Costs – An Example
• Assume the wage rate (w) is fixed relative
to the number of workers hired
• Variable costs is the per unit cost of extra
labor times the amount of extra labor: wL
MC 
 VC
q

wL
q
Determinants of Short Run
Costs – An Example
• Remembering that
 MP L 
Q
L
 And rearranging
 L for a 1 unit  Q 
L
Q

1
 MP L
Determinants of Short Run
Costs – An Example
• We can conclude:
MC 
w
MP L
 …and a low marginal product (MPL) leads
to a high marginal cost (MC) and vice
versa
Determinants of Short Run Costs
• Consequently
– MC decreases initially with increasing returns
• 0 through 4 units of output
– MC increases with decreasing returns
• 5 through 11 units of output
Cost Curves for a Firm
TC
Cost 400
($ per
year)
Total cost
is the vertical
sum of FC
and VC.
300
VC
Variable cost
increases with
production and
the rate varies with
increasing and
decreasing returns.
200
Fixed cost does not
vary with output
100
FC
50
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Output
Cost Curves
120
Cost ($/unit)
100
MC
80
60
ATC
40
AVC
20
AFC
0
0
2
4
6
Output (units/yr)
8
10
12
Cost Curves
•
•
•
•
•
When MC is below AVC, AVC is falling
When MC is above AVC, AVC is rising
When MC is below ATC, ATC is falling
When MC is above ATC, ATC is rising
Therefore, MC crosses AVC and ATC at the
minimums
– The Average – Marginal relationship
Cost Curves for a Firm
• The line drawn
from the origin to
the variable cost
curve:
– Its slope equals
AVC
– The slope of a
point on VC or TC
equals MC
– Therefore, MC =
AVC at 7 units of
output (point A)
TC
P
400
VC
300
200
A
100
FC
1
2
3
4
5
6
7
8
9
10
11
12
13
Output
Cost in the Long Run
• In the long run a firm can change all of its
inputs
• In making cost minimizing choices, must
look at the cost of using capital and labor
in production decisions
Cost Minimizing Input Choice
• How do we put all this together to select inputs to
produce a given output at minimum cost?
• Assumptions
– Two Inputs: Labor (L) and capital (K)
– Price of labor: wage rate (w)
– The price of capital
• r = depreciation rate + interest rate
• Or rental rate if not purchasing
• These are equal in a competitive capital
market
Cost in the Long Run
• The Isocost Line
– A line showing all combinations of L & K that
can be purchased for the same cost
– Total cost of production is sum of firm’s labor
cost, wL, and its capital cost, rK:
C = wL + rK
– For each different level of cost, the equation
shows another isocost line
Cost in the Long Run
• Rewriting C as an equation for a straight
line:
– K = C/r - (w/r)L
– Slope of the isocost:
K
L
 r
  w
• -(w/r) is the ratio of the wage rate to rental cost of
capital.
• This shows the rate at which capital can be
substituted for labor with no change in cost
Choosing Inputs
• We will address how to minimize cost for a
given level of output by combining isocosts
with isoquants
• We choose the output we wish to produce
and then determine how to do that at
minimum cost
– Isoquant is the quantity we wish to produce
– Isocost is the combination of K and L that
gives a set cost
Producing a Given Output at
Minimum Cost
Capital
per
year
Q1 is an isoquant for output Q1.
There are three isocost lines, of
which 2 are possible choices in
which to produce Q1.
K2
Isocost C2 shows quantity
Q1 can be produced with
combination K2,L2 or K3,L3.
However, both of these
are higher cost combinations
than K1,L1.
A
K1
Q1
K3
C0
L2
L1
C1
L3
C2
Labor per year
Input Substitution When an
Input Price Change
• If the price of labor changes, then the
slope of the isocost line changes, -(w/r)
• It now takes a new quantity of labor and
capital to produce the output
• If price of labor increases relative to price
of capital, and capital is substituted for
labor
Input Substitution When an
Input Price Change
Capital
per
year
If the price of labor
rises, the isocost curve
becomes steeper due to
the change in the slope -(w/L).
The new combination of K
and L is used to produce Q1.
Combination B is used in
place of combination A.
B
K2
A
K1
Q1
C2
L2
L1
C1
Labor per year
Cost in the Long Run
• How does the isocost line relate to the
firm’s production process?
MRTS  -  K
Slope of isocost
MP L
MP K
w
r
L

MP L
line   K
MP K
L
 w
when firm minimizes
r
cost
Cost in the Long Run
• The minimum cost combination can then
be written as:
MP L
w
–

MP K
r
Minimum cost for a given output will occur
when each dollar of input added to the
production process will add an equivalent
amount of output.
Cost in the Long Run
• If w = $10, r = $2, and MPL = MPK, which
input would the producer use more of?
– Labor because it is cheaper
– Increasing labor lowers MPL
– Decreasing capital raises MPK
– Substitute labor for capital until
MP L
w

MP K
r
Cost in the Long Run
• Cost minimization with Varying Output
Levels
– For each level of output, there is an isocost
curve showing minimum cost for that output
level
– A firm’s expansion path shows the minimum
cost combinations of labor and capital at each
level of output
– Slope equals K/L
A Firm’s Expansion Path
Capital
per
year
The expansion path illustrates
the least-cost combinations of
labor and capital that can be
used to produce each level of
output in the long-run.
150 $3000
Expansion Path
$200
100 0
C
75
B
50
300 Units
A
25
200 Units
50
100
150
200
300
Labor per year
Expansion Path and Long Run
Costs
• Firm’s expansion path has same
information as long-run total cost curve
• To move from expansion path to LR cost
curve
– Find tangency with isoquant and isocost
– Determine min cost of producing the output
level selected
– Graph output-cost combination
A Firm’s Long Run Total Cost
Curve
Cost/
Year
Long Run Total Cost
F
3000
E
2000
D
1000
100
200
300
Output, Units/yr
Long Run Versus Short Run
Cost Curves
• In the short run, some costs are fixed
• In the long run, firm can change anything
including plant size
– Can produce at a lower average cost in long
run than in short run
– Capital and labor are both flexible
• We can show this by holding capital fixed
in the short run and flexible in long run
The Inflexibility of Short Run
Production
Capital E
per
year
Capital is fixed at K1.
To produce q1, min cost at K1,L1.
If increase output to Q2, min cost
is K1 and L3 in short run.
C
Long-Run
Expansion Path
A
K2
Short-Run
Expansion Path
P
K1
In LR, can
change
capital and
min costs
falls to K2
and L2.
Q2
Q1
L1
L2
B
L3
D
F
Labor per year
Long Run Versus
Short Run Cost Curves
•
Long-Run Average Cost (LAC)
– Most important determinant of the shape of
the LR AC and MC curves is relationship
between scale of the firm’s operation and
inputs required to minimize cost
1. Constant Returns to Scale
– If input is doubled, output will double
– AC cost is constant at all levels of output
Long Run Versus Short Run
Cost Curves
2. Increasing Returns to Scale
– If input is doubled, output will more than
double
– AC decreases at all levels of output
3. Decreasing Returns to Scale
– If input is doubled, output will less than
double
– AC increases at all levels of output
Long Run Versus Short Run
Cost Curves
• In the long run:
– Firms experience increasing and decreasing
returns to scale and therefore long-run
average cost is “U” shaped.
– Source of U-shape is due to returns to scale
instead of decreasing returns to scale like the
short-run curve
– Long-run marginal cost curve measures the
change in long-run total costs as output is
increased by 1 unit
Long Run Versus Short Run
Cost Curves
• Long-run marginal cost leads long-run
average cost:
– If LMC < LAC, LAC will fall
– If LMC > LAC, LAC will rise
– Therefore, LMC = LAC at the minimum of
LAC
• In special case where LAC is constant,
LAC and LMC are equal
Long Run Average and Marginal
Cost
Cost
($ per unit
of output
LMC
LAC
A
Output
Long Run Costs
•
As output increases, firm’s AC of
producing is likely to decline to a point
1. On a larger scale, workers can better specialize
2. Scale can provide flexibility – managers can
organize production more effectively
3. Firm may be able to get inputs at lower cost if can
get quantity discounts. Lower prices might lead to
different input mix.
Long Run Costs
•
At some point, AC will begin to increase
1. Factory space and machinery may make it
more difficult for workers to do their jobs
efficiently
2. Managing a larger firm may become more
complex and inefficient as the number of
tasks increase
3. Bulk discounts can no longer be utilized.
Limited availability of inputs may cause price
to rise.
Long Run Costs
• When input proportions change, the firm’s
expansion path is no longer a straight line
– Concept of return to scale no longer applies
• Economies of scale reflects input
proportions that change as the firm
changes its level of production
Economies and Diseconomies
of Scale
• Economies of Scale
– Increase in output is greater than the increase
in inputs
• Diseconomies of Scale
– Increase in output is less than the increase in
inputs
• U-shaped LAC shows economies of scale
for relatively low output levels and
diseconomies of scale for higher levels
Long Run Costs
• Increasing Returns to Scale
– Output more than doubles when the quantities
of all inputs are doubled
• Economies of Scale
– Doubling of output requires less than a
doubling of cost
Long Run Costs
• Economies of scale are measured in terms
of cost-output elasticity, EC
• EC is the percentage change in the cost of
production resulting from a 1-percent
increase in output
EC 
C C
Q Q
 MC
AC
Long Run Costs
• EC is equal to 1, MC = AC
– Costs increase proportionately with output
– Neither economies nor diseconomies of scale
• EC < 1 when MC < AC
– Economies of scale
– Both MC and AC are declining
• EC > 1 when MC > AC
– Diseconomies of scale
– Both MC and AC are rising
Long Run Versus Short Run
Cost Curves
• We will use short and long run costs to
determine the optimal plant size
• We can show the short run average costs
for 3 different plant sizes
• This decision is important because once
built, the firm may not be able to change
plant size for a while
Long Run Cost with Economies
and Diseconomies of Scale
Long Run Cost with
Constant Returns to Scale
• The optimal plant size will depend on the
anticipated output
– If expect to produce q0, then should build
smallest plant: AC = $8
– If produce more, like q1, AC rises
– If expect to produce q2, middle plant is least
cost
– If expect to produce q3, largest plant is best
Long Run Cost with Economies
and Diseconomies of Scale
Long Run Cost with
Constant Returns to Scale
• What is the firm’s long run cost curve?
– Firms can change scale to change output in
the long run
– The long run cost curve is the dark blue
portion of the SAC curve which represents the
minimum cost for any level of output
– Firm will always choose plant that minimizes
the average cost of production
Long Run Cost with Economies
and Diseconomies of Scale
Long Run Cost with
Constant Returns to Scale
• The long-run average cost curve envelops
the short-run average cost curves
• The LAC curve exhibits economies of
scale initially but exhibits diseconomies at
higher output levels
Chapter 8
Profit Maximization and
Competitive Supply
Perfectly Competitive Markets
•
•
The model of perfect competition can be
used to study a variety of markets
Basic assumptions of Perfectly
Competitive Markets
1. Price taking
2. Product homogeneity
3. Free entry and exit
Perfectly Competitive Markets
1. Price Taking
– The individual firm sells a very small share of
the total market output and, therefore,
cannot influence market price
– Each firm takes market price as given – price
taker
– The individual consumer buys too small a
share of industry output to have any impact
on market price
Perfectly Competitive Markets
2. Product Homogeneity
– The products of all firms are perfect
substitutes
– Product quality is relatively similar as well as
other product characteristics
– Agricultural products, oil, copper, iron,
lumber
– Heterogeneous products, such as brand
names, can charge higher prices because
they are perceived as better
Perfectly Competitive Markets
3. Free Entry and Exit
– When there are no special costs that make it
difficult for a firm to enter (or exit) an industry
– Buyers can easily switch from one supplier
to another
– Suppliers can easily enter or exit a market
•
Pharmaceutical companies are not perfectly
competitive because of the large costs of R&D
required
When are Markets Competitive?
• Few real products are perfectly
competitive
• Many markets are, however, highly
competitive
– They face relatively low entry and exit costs
– Highly elastic demand curves
• No rule of thumb to determine whether a
market is close to perfectly competitive
– Depends on how they behave in situations
Profit Maximization
• Do firms maximize profits?
– Managers in firms may be concerned with
other objectives
•
•
•
•
Revenue maximization
Revenue growth
Dividend maximization
Short-run profit maximization (due to bonus or
promotion incentive)
– Could be at expense of long run profits
Profit Maximization
• Implications of non-profit objective
– Over the long run, investors would not support
the company
– Without profits, survival is unlikely in
competitive industries
• Managers have constrained freedom to
pursue goals other than long-run profit
maximization
Marginal Revenue, Marginal
Cost, and Profit Maximization
• We can study profit maximizing output for
any firm, whether perfectly competitive or
not
– Profit () = Total Revenue - Total Cost
– If q is output of the firm, then total revenue is
price of the good times quantity
– Total Revenue (R) = Pq
Marginal Revenue, Marginal
Cost, and Profit Maximization
• Costs of production depends on output
– Total Cost (C) = C(q)
• Profit for the firm, , is difference between
revenue and costs
 (q )  R (q )  C (q )
Marginal Revenue, Marginal
Cost, and Profit Maximization
• Firm selects output to maximize the
difference between revenue and cost
• We can graph the total revenue and total
cost curves to show maximizing profits for
the firm
• Distance between revenues and costs
show profits
Marginal Revenue, Marginal
Cost, and Profit Maximization
• Revenue is a curve, showing that a firm can only
sell more if it lowers its price
• Slope of the revenue curve is the marginal
revenue
– Change in revenue resulting from a one-unit increase
in output
• Slope of the total cost curve is marginal cost
– Additional cost of producing an additional unit of
output
Marginal Revenue, Marginal
Cost, and Profit Maximization
• If the producer tries to raise price, sales are zero
• Profit is negative to begin with, since revenue is
not large enough to cover fixed and variable
costs
• As output rises, revenue rises faster than costs
increasing profit
• Profit increases until it is maxed at q*
• Profit is maximized where MR = MC or where
slopes of the R(q) and C(q) curves are equal
Profit Maximization – Short Run
Cost,
Revenue,
Profit
($s per
year)
Profits are maximized where MR (slope
at A) and MC (slope at B) are equal
C(q)
A
R(q)
Profits are
maximized
where R(q) –
C(q) is
maximized
B
0
q0
q*
Output
(q)
Marginal Revenue, Marginal
Cost, and Profit Maximization
• Profit is maximized at the point at which an
additional increment to output leaves profit
unchanged
  RC

q

R
q

C
q
0
 MR  MC  0
MR  MC
The Competitive Firm
• Demand curve faced by an individual firm
is a horizontal line
– Firm’s sales have no effect on market price
• Demand curve faced by whole market is
downward sloping
– Shows amount of goods all consumers will
purchase at different prices
The Competitive Firm
Price
$ per
bushel
Industr
y
Price
$ per
bushel
Firm
S
$4
$4
d
D
100
200
Output
(bushels)
100
Output
(millions
of bushels)
The Competitive Firm
• The competitive firm’s demand
– Individual producer sells all units for $4
regardless of that producer’s level of output
– MR = P with the horizontal demand curve
– For a perfectly competitive firm, profit
maximizing output occurs when
MC ( q )  MR  P  AR
Choosing Output: Short Run
• We will combine revenue and costs with
demand to determine profit maximizing
output decisions
• In the short run, capital is fixed and firm
must choose levels of variable inputs to
maximize profits
• We can look at the graph of MR, MC, ATC
and AVC to determine profits
A Competitive Firm
MC
Price
Lost Profit
for q2>q*
Lost Profit
for q2>q*
50
A
40
AR=MR=P
ATC
AVC
30
q1 : MR > MC
q2: MC > MR
q*: MC = MR
20
10
0
1
2
3
4
5
6
7
q1
8
q*
9
q2
10
11
Output
Choosing Output: Short Run
• The point where MR = MC, the profit
maximizing output is chosen
– MR = MC at quantity, q*, of 8
– At a quantity less than 8, MR > MC, so more
profit can be gained by increasing output
– At a quantity greater than 8, MC > MR,
increasing output will decrease profits
A Competitive Firm – Positive
Profits
Price
50
40
MC
Total
Profit =
ABCD
A
D
AR=MR=P
ATC
Profit per
unit = PAC(q) = A
to B
30 C
Profits are
determined
by output per
unit times
quantity
AVC
B
20
10
0
1
2
3
4
5
6
7
q1
8
q*
9
q2
10
11
Output
The Competitive Firm
• A firm does not have to make profits
• It is possible a firm will incur losses if the P
< AC for the profit maximizing quantity
– Loss
A Competitive Firm – Losses
MC
Price
C
ATC
B
D
A
P = MR
q *:
At
MR =
MC and P <
ATC
Losses =
(P- AC) x q*
or ABCD
AVC
q*
Output
Short Run Production
• Why would a firm produce at a loss?
– Might think price will increase in near future
– Shutting down and starting up could be costly
• Firm has two choices in short run
– Continue producing
– Shut down temporarily
– Will compare profitability of both choices
Short Run Production
• When should the firm shut down?
– If AVC < P < ATC, the firm should continue
producing in the short run
• Can cover all of its variable costs and some of its
fixed costs
– If AVC > P < ATC, the firm should shut down
• Cannot cover its variable costs or any of its fixed
costs
A Competitive Firm – Losses
MC
Price
ATC
Losses
C
B
D
P < ATC but
AVC so
firm will
continue to
produce in
short run
A
P = MR
AVC
F
E
q*
Output
Competitive Firm – Short Run
Supply
• Supply curve tells how much output will be
produced at different prices
• Competitive firms determine quantity to
produce where P = MC
– Firm shuts down when P < AVC
• Competitive firms’ supply curve is portion
of the marginal cost curve above the AVC
curve
A Competitive Firm’s
Short-Run Supply Curve
Price
($ per
unit)
The firm chooses the
output level where P = MR = MC,
as long as P > AVC.
Supply is MC
above AVC
MC
S
P2
ATC
P1
AVC
P = AVC
q1
q2 Output
A Competitive Firm’s
Short-Run Supply Curve
• Supply is upward sloping due to
diminishing returns
• Higher price compensates the firm for the
higher cost of additional output and
increases total profit because it applies to
all units
A Competitive Firm’s
Short-Run Supply Curve
• Over time, prices of product and inputs
can change
• How does the firm’s output change in
response to a change in the price of an
input?
– We can show an increase in marginal costs
and the change in the firm’s output decisions
The Response of a Firm to
a Change in Input Price
Price
($ per
unit)
MC2
Savings to the firm
from reducing output
Input cost increases
and MC shifts to MC2
and q falls to q2.
MC1
$5
q2
q1
Output
The Short-Run Market Supply
Curve
• As price rises, firms expand their production
• Increased production leads to increased
demand for inputs and could cause increases in
input prices
• Increases in input prices cause MC curve to rise
• This lowers each firm’s output choice
• Causes industry supply to be less responsive to
change in price than would be otherwise
Elasticity of Market Supply
• Elasticity of Market Supply
– Measures the sensitivity of industry output to
market price
– The percentage change in quantity supplied,
Q, in response to 1-percent change in price
E s  (  Q / Q ) /(  P / P )
Elasticity of Market Supply
• When MC increases rapidly in response to
increases in output, elasticity is low
• When MC increases slowly, supply is relatively
elastic
• Perfectly inelastic short-run supply arises when
the industry’s plant and equipment are so fully
utilized that new plants must be built to achieve
greater output
• Perfectly elastic short-run supply arises when
marginal costs are constant
Producer Surplus in the Short
Run
• Price is greater than MC on all but the last unit of
output
• Therefore, surplus is earned on all but the last
unit
• The producer surplus is the sum over all units
produced of the difference between the market
price of the good and the marginal cost of
production
• Area above supply curve to the market price
Producer Surplus for a Firm
Price
($ per
unit of
output)
MC
Producer
Surplus
AVC
B
A
P
At q* MC = MR.
Between 0 and q,
MR > MC for all units.
Producer surplus
is area above MC
to the price
q*
Output
The Short-Run Market Supply
Curve
• Sum of MC from 0 to q*, it is the sum of
the total variable cost of producing q*
• Producer Surplus can be defined as the
difference between the firm’s revenue and
its total variable cost
• We can show this graphically by the
rectangle ABCD
– Revenue (0ABq*) minus variable cost
(0DCq*)
Producer Surplus for a Firm
Price
($ per
unit of
output)
MC
Producer
Surplus
AVC
B
A
D
P
C
q*
Producer surplus
is also ABCD =
Revenue minus
variable costs
Output
Producer Surplus Versus Profit
• Profit is revenue minus total cost (not just
variable cost)
• When fixed cost is positive, producer
surplus is greater than profit
Producer
Surplus
 PS  R - VC
Profit    R - VC - FC
Producer Surplus Versus Profit
• Costs of production determine magnitude
of producer surplus
– Higher cost firms have less producer surplus
– Lower cost firms have more producer surplus
– Adding up surplus for all producers in the
market given total market producer surplus
– Area below market price and above supply
curve
Producer Surplus for a Market
Price
($ per
unit of
output)
S
Market producer surplus is
the difference between P*
and S from 0 to Q*.
P*
Producer
Surplus
D
Q*
Output
Choosing Output in the Long
Run
• In short run, one or more inputs are fixed
– Depending on the time, it may limit the
flexibility of the firm
• In the long run, a firm can alter all its
inputs, including the size of the plant
• We assume free entry and free exit
– No legal restrictions or extra costs
Choosing Output in the Long
Run
• In the short run, a firm faces a horizontal
demand curve
– Take market price as given
• The short-run average cost curve (SAC) and
short-run marginal cost curve (SMC) are low
enough for firm to make positive profits (ABCD)
• The long-run average cost curve (LRAC)
– Economies of scale to q2
– Diseconomies of scale after q2
Output Choice in the Long Run
Price
LMC
LAC
SMC
SAC
$40
D
A
P = MR
C
B
$30
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
q1
q2
q3
Output
Output Choice in the Long Run
In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD.
Price
LMC
LAC
SMC
SAC
$40
D
A
P = MR
C
B
G
$30
F
q1
q2
q3
Output
Long-Run Competitive
Equilibrium
• For long run equilibrium, firms must have
no desire to enter or leave the industry
• We can relate economic profit to the
incentive to enter and exit the market
Long-Run Competitive
Equilibrium
• Zero-Profit
– A firm is earning a normal return on its
investment
– Doing as well as it could by investing its
money elsewhere
– Normal return is firm’s opportunity cost of
using money to buy capital instead of
investing elsewhere
– Competitive market long run equilibrium
Long-Run Competitive
Equilibrium
• Entry and Exit
– The long-run response to short-run profits is
to increase output and profits
– Profits will attract other producers
– More producers increase industry supply,
which lowers the market price
– This continues until there are no more profits
to be gained in the market – zero economic
profits
Long-Run Competitive
Equilibrium – Profits
•Profit attracts firms
•Supply increases until profit = 0
$ per
unit of
output
$ per
unit of
output
Firm
Industry
S1
LMC
$40
LAC
P1
S2
P2
$30
D
q2
Output
Q1
Q2
Output
Long-Run Competitive
Equilibrium – Losses
•Losses cause firms to leave
•Supply decreases until profit = 0
$ per
unit of
output
Firm
LMC
$ per
unit of
output
LAC
$30
Industry
S2
P2
S1
P1
$20
D
q2
Output
Q2
Q1
Output
Long-Run Competitive
Equilibrium
1. All firms in industry are maximizing profits
– MR = MC
2. No firm has incentive to enter or exit
industry
– Earning zero economic profits
3. Market is in equilibrium
– QD = QS
Chapter 9
The Analysis of Competitive
Markets
Consumer and Producer
Surplus
• When government controls price, some
people are better off
– May be able to buy a good at a lower price
• But what is the effect on society as a
whole?
– Is total welfare higher or lower and by how much?
• A way to measure gains and losses from
government policies is needed
Consumer and Producer
Surplus
1. Consumer surplus is the total benefit or
value that consumers receive beyond
what they pay for the good
– Assume market price for a good is $5
– Some consumers would be willing to pay
more than $5 for the good
– If you were willing to pay $9 for the good and
pay $5, you gain $4 in consumer surplus
Consumer and Producer
Surplus
• The demand curve shows the willingness
to pay for all consumers in the market
• Consumer surplus can be measured by
the area between the demand curve and
the market price
• Consumer surplus measures the total net
benefit to consumers
Consumer and Producer
Surplus
2. Producer surplus is the total benefit or
revenue that producers receive beyond
what it costs to produce a good
– Some producers produce for less than
market price and would still produce at a
lower price
– A producer might be willing to accept $3 for
the good but get $5 market price
– Producer gains a surplus of $2
Consumer and Producer
Surplus
• The supply curve shows the amount that a
producer is willing to take for a certain
amount of a good
• Producer surplus can be measured by the
area between the supply curve and the
market price
• Producer surplus measures the total net
benefit to producers
Consumer and Producer
Surplus
Price
9
Consumer
Surplus
S
Between 0 and Q0
consumer A receives
a net gain from buying
the product-consumer surplus.
5
Producer
Surplus
3
D
QD
QS
Q0
Between 0 and Q0
producers receive
a net gain from
selling each product-producer surplus.
Quantity
Consumer and Producer
Surplus
• To determine the welfare effect of a
governmental policy, we can measure the
gain or loss in consumer and producer
surplus
• Welfare Effects
– Gains and losses to producers and
consumers
Consumer and Producer
Surplus
• When government institutes a price
ceiling, the price of a good can’t go above
that price
• With a binding price ceiling, producers and
consumers are affected
• How much they are affected can be
determined by measuring changes in
consumer and producer surplus
Consumer and Producer
Surplus
• When price is held too low, the quantity
demanded increases and quantity
supplied decreases
• Some consumers are worse off because
they can no longer buy the good
– Decrease in consumer surplus
• Some consumers are better off because
they can buy it at a lower price
– Increase in consumer surplus
Consumer and Producer
Surplus
• Producers sell less at a lower price
• Some producers are no longer in the
market
• Both of these producer groups lose and
producer surplus decreases
• The economy as a whole is worse off
since surplus that used to belong to
producers or consumers is simply gone
Price Control and Surplus
Changes
Price
Consumers that
cannot buy, lose B
Consumers that can
buy the good gain A
S
The loss to producers
is the sum of
rectangle A and
triangle C
B
P0
A
C
Triangles B and C are
losses to society –
dead weight loss
Pmax
D
Q1
Q0
Q2
Quantity
Price Controls and Welfare
Effects
• The total loss is equal to area B + C
• The deadweight loss is the inefficiency of
the price controls – the total loss in surplus
(consumer plus producer)
• If demand is sufficiently inelastic, losses to
consumers may be fairly large
– This can have effects in political decisions
Price Controls With Inelastic
Demand
D
Price
S
B
P0
Pmax
With inelastic demand,
triangle B can be larger
than rectangle A and
consumers suffer net
losses from price controls.
C
A
Q1
Q2
Quantity
Price Controls and
Natural Gas Shortages
• From example in Chapter 2, 1975 Price
controls created a shortage of natural gas
• What was the effect of those controls?
– Decreases in surplus and overall loss for
society
– We can measure these welfare effects from
the demand and supply of natural gas
Price Controls and
Natural Gas Shortages
• QS = 14 + 2PG + 0.25PO
– Quantity supplied in trillion cubic feet (Tcf)
• QD = -5PG + 3.75PO
– Quantity demanded (Tcf)
• PG = price of natural gas in $/mcf
• PO = price of oil in $/b
Price Controls and
Natural Gas Shortages
• Using PO = $8/b and
gives
Q Q
equilibrium values for natural gas
G
D
G
S
– PG = $2/mcf and QG = 20 Tcf
• Price ceiling was set at $1/mcf
• Showing this graphically, we can see and
measure the effects on producer and
consumer surplus
Price Controls and
Natural Gas Shortages
Price
($/mcf)
D
S
The gain to consumers is
rectangle A minus triangle
B, and the loss to
producers is rectangle A
plus triangle C.
2.40
B
2.00
C
A
(Pmax)1.00
0
5
10
15 18 20
25
30 Quantity (Tcf)
Price Controls and
Natural Gas Shortages
• Measuring the Impact of Price Controls
– A = (18 billion mcf) x ($1/mcf) =
$18 billion
– B = (1/2) x (2 b. mcf) x ($0.40/mcf) =
$0.4 billion
– C = (1/2) x (2 b. mcf) x ($1/mcf) =
$1 billion
Price Controls and
Natural Gas Shortages
• Measuring the Impact of Price Controls in
1975
– Change in consumer surplus
• = A - B = 18 - 0.4 = $17.6 billion Gain
– Change in producer surplus
• = A + C = 18 + 1 = $19.0 billion Loss
– Dead Weight Loss
• = B + C = 0.4 + 1 = $1.4 billion Loss
The Efficiency of
a Competitive Market
• In the evaluation of markets, we often talk
about whether it reaches economic
efficiency
– Maximization of aggregate consumer and
producer surplus
• Policies such as price controls that cause
dead weight losses in society are said to
impose an efficiency cost on the
economy
The Efficiency of
a Competitive Market
• If efficiency is the goal, then you can argue
that leaving markets alone is the answer
• However, sometimes market failures
occur
– Prices fail to provide proper signals to
consumers and producers
– Leads to inefficient unregulated competitive
market
Types of Market Failures
1. Externalities
– Costs or benefits that do not show up as part
of the market price (e.g. pollution)
– Costs or benefits are external to the market
2. Lack of Information
– Imperfect information prevents consumers
from making utility-maximizing decisions
•
Government intervention may be
desirable in these cases
The Efficiency of a Competitive
Market
• Other than market failures, unregulated
competitive markets lead to economic
efficiency
• What if the market is constrained to a price
higher than the economically efficient
equilibrium price?
Price Control and Surplus
Changes
Price
S
Pmin
A
When price is
regulated to be no
lower than Pmin, the
deadweight loss given
by triangles B and C
results.
B
P0
C
D
Q1
Q0
Q2
Quantity
The Efficiency of a Competitive
Market
• Deadweight loss triangles B and C give a
good estimate of the efficiency cost of
policies that force price above or below
market clearing price
• Measuring effects of government price
controls on the economy can be estimated
by measuring these two triangles

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