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Chapter 1-33

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Queen's University
ECON 111
Ian James Cromb

Chapter 1: What is Economics? Economy- a system in which scarce resources such a labour, land, and machines are allocated among competing uses An economy is elf organizing in the sense that when individual consumers and producers act independently to pursue their own self-interests there is a spontaneous economic order Main Characteristics of Market Economies: Self Interest- individuals pursue their own self-interest, buying and selling Incentives- people respond to incentives. Sellers usually want to sell more when prices are high, buyers usually want to buy more when prices are low Market Prices and Quantities- determined in free markets in which would-be sellers compete to sell their products to would-be buyers Institutions- governed by a set of institutions largely created by government Economics is the study of the use of scarce resources to satisfy unlimited human wants Production possibilities boundary illustrates three concepts: scarcity, choice, and opportunity cost. Scarcity is indicated by the unattainable combinations outside the boundary by the need to choose among the alternative attainable points along the boundary; and the opportunity cost, by the negative slope of the boundary Microeconomics: the study of the causes and consequences of the allocation of resources as it is affected by the workings of the price system Macroeconomics: the study of the determination of economic aggregates such as total output, price level, employment, and growth Consumers and producers who are maximizers make marginal decisions - whether to buy or sell a little bit more or less of the many things that they buy and sell Specialization of labour- specialization of individual workers in the production of particular goods and services Globalization has allowed an increasing share of jobs and incomes is created Traditional Economy- behaviour is based primarily on tradition, custom and habit. Young men follow their father‟s footsteps stick to traditional patterns Command Econony- Central authority (government) chooses what to produce and how to produce it Free market- economic decisions are made by private households and firms Mixed Economy- combines elements of all three systems in determining economic behaviour Chapter 2: Economic Theories, Data and Graphs Normative statements- a statement about what out to be as opposed to what actually is. Depend on value judgements and cannot be evaluated solely by a recourse to facts Positive statements- do not involve value judgements. A statement about what actually is as opposed to what out to be. - Positive statements need not be true - the inclusion of a value judgement in a statement does not necessarily make the statement itself normative - Actual facts = positive, necessary to assess the truth of the statement = normative Disagreements among economists - Disagreements occur within economists because of poor communication - economists will also disagree with failure to acknowledge the full state of their ignorance - many are based on the positive/normative distinction where economists have different values and normative views play a large part in most discussions of public policy - importance of individual responsibility and argue - The world is so complex and no issue can be settled beyond any about, economists rarely agree unanimously on an issue Economists try to understand the world by developing theories and models that explain some of the things that have been seen - theories are constructed to explain things - theories are distinguished by variables, assumptions, and predictions - for example, the demand and supply theory Variables - A well-defined item such as the price or quantity of a commodity that can take on various specific values variable- one whose value is determined within the theory exogenous variable- influences the endogenous variables but is determined outside the theory Example: price of eggs and quantity of eggs are endogenous variables in our theory of the egg market- the weather is an exogenous variable because it doesn‟t influence the market for eggs but can effect number of eggs consumers demand or producers supply Assumptions - concern motives, directions of causation, and conditions under the theory is meant to apply motives- everyone pursues their own self-interest when making economic decisions, individuals maximize their utility while firms try to maximize their profits direction of causation- when economists assume that one variable is related to the other they assume a causal link between the two Example: supply of eggs that producers want increases and price of their chicken feed falls, causation runs from the price of the chicken feed to the supply of eggs Conditions of Application All theory is an abstraction from reality. If it were not it would merely duplicate the world in all its complexity and would add little to our understanding of it Maximizing profit is a hypothetical way in order for economists to make predictions Predictions- propositions that can be deduced from it (hypotheses Models Can be using visual aspects - circular flow of income and expenditure and the production possibilities boundary Or use model for specific quantitative version of a theory (decrease in the price of chicken feed will lead to an increase in the quantity of eggs supplied) Scientific approach is the central of the study of economics. Empirical observation leads to the construction of theories, theories generate specific predictions and predictions are tested by more detailed empirical observation. Theory and observation are in continuous interaction. Theories are tested with facts, and constantly modified to achieve a superior theory. Developing theories Rejection Versus Confirmation- theory designed to explain observation X will generate a prediction about some other variables (Y,Z) These other variables can be rejected by the data Statistical Analysis- can be used to test predictions and estimate numerical values of the function that describes the relationship - Economics consists of million uncontrolled „experiments‟ that go on everyday in the market place (if X increases, then Y will also increase) - households decide what to purchase given the changing prices, firms deciding what to produce and how, governments involved with taxes all change data Correlation Versus Casuation- “if X increases, Y will also increase” we are looking for the casual relationship as X creates a change in Y, if that is not the case where X and Y both rise the correlation is consistent but doesn‟t show a casual relationship - Most economic relationships involve causality. Economists must take care when predictions to distinguish between correlation and casualty. Bottom line: Correlation can establish the data are consistent with the theory; establishing a causality requires advanced statistical techniques Economic Data Index Number- an average that measures change over time of such variables as the price level and industrial production; conventionally expressed as a percentage relative to a base period (assigned value of 100) - Easier way to compare two variables or products that are measured in different units - We take the output of each subsequent ear and divide it by the output in the base year then multiply the result by 100 Consumer price index: average price paid by consumers for a particular basket of goods but it requires weighting of the products Cross-sectional data- a set of observations made at the same time across several different units (households, firms) time-series data- a set of observations made at successive periods of time - often quite useful we often know how specific economic numbers are changing over time Functions - functions are an easy way to allow us to express a functional relation between two variables (i.e. C = 800 + 0.8Y, Y being annual income and C being consumption on goods and services) - C is equal to 800 when Y is zero and rise by 80 cents for every $1 that Y rises - Graph that moves left bottom to right top = variables are positively related - Graph that moves from top left to bottom right = variables are negatively related Linear graphs- easier to simplify a real relation between two variables by assuming they are linearly related Non-Linear graphs- more accurate, can demonstrate marginal change, the change in the graph isn‟t always consistent - the slope of the curve changes as X changes Therefore the marginal response of Y to a change in X depends on the value of X - at either a minimum or maximum of a function the slope of the curve is zero. The marginal response of Y to a change in X is zero - Profits are maximized at the maximum of the graph Non-linear The slope of the curve changes as X changes, therefore, the marginal response of Y to a change in X depends on the value of X. Linear If we let X stand for whatever variable is measured on the horizontal axis and Y for whatever variable is measured on the vertical axis, the slope of a straight line is ∆Y/∆X Theories are designed to explain and predict what we se. A theory consists of a set of definitions of the variables to be employed a set of assumptions about how things behave and the conditions under which the theory is meant to apply. Economists make use of statistical analysis when testing their theories. They must take care to make distinction between correlation and causation. Index numbers express economic series in relative form. Values in each period are expressed in relation to the value in the base period which is given a value of 100. Cross-sectional graphs (show observations taken at the same time), Time-series graphs (observations on one variable taken over time), Scatter diagrams (show many points each one refers to specific observations on two different variables) Chapter 3: Demand supply and price Quantity Demanded: total amount of any particular good or service that consumers want to purchase in some time period - it is a desired quantity - amount consumers want to purchase when faced with a particular price, other products‟ prices, incomes, tastes and everything else - It may be different from the amount that consumers actually succeed in purchasing - the amount that consumers want to purchase may exceed the amount that they actually purchase - quantity demanded - desired purchases, quantity bought or quantity exchanged- actual purchases - quantity demanded refers to flow of purchases Stocks vs. Flows - flow variable has a time dimension - for example, quantity of Grade A large eggs purchased in Edmonton is a flow variable - Stock variable is at a point in time - for example, 20 000 dozen eggs on September 3rd - amount of income earned is a flow, amount of consumer‟s expenditure is a flow - amount of money in a bank account is a stock Quantity Demanded and Price - basic economic hypothesis is that the price of a product and the quantity demanded are related negatively, other things being equal - that is the lower the price the higher the quantity demanded, the higher the price the lower quantity demanded - Alfred Marshall created the „law of demand‟ Demand Schedules and Demand Curves - demand schedule: table showing the relationship between quantity demanded and the price of a commodity, other things being equal - lists quantity of carrots that would be demanded at various prices, given that all other variables are held constant - table gives quantities demanded for five selected prices, for example, but in fact a separate quantity would be demanded at every possible price - Demand curve: graphical representation of the relationship between quantity demanded and the price of a commodity other things being equal - demand: the entire relationship between the quantity demanded of a product and the price of that product - A single point on the curve or schedule is quantity demanded at that point - the demand curve is drawn with the assumption that everything except the product‟s own price is held constant. A change in any of the variables previously held constant will shift the demand curve to a new position (right) Determinants of Demand 1) consumers‟ income - average income rises = consumers can be expected to desire more of most products other things being equal - normal goods: goods which the quantity demanded increases when income rises - inferior goods: goods for which the quantity demanded falls when income rises - a change in the distribution of income shifts the demand also - will cause an increase in the demand for products bought most by consumers whose incomes increase and decrease in the demand for products bought by most consumers whose incomes decrease 2) Prices of other goods - the cheaper the product becomes relative to other products that can satisfy the same needs or desires - substitutes in consumption: goods that can be used in place of another good to satisfy similar needs or desires - for example, carrots can become cheap relative to broccoli either because the price of carrots falls or because the price of broccoli rises - rise in the price of a substitute for a product shifts the demand curve for the product to the right - Complements in consumption: goods that tend to be consumed together - For example, golf clubs and golf balls - the fall of the price of one will increase the quantity demanded of both products - the fall in the price of a complement for a product will shift that product‟s demand curve to the right 3) Tastes - tastes have a powerful effect on people‟s desired purchases - short-live fads or the latest versions of Super Mario or Need for Speed - in some cases research can change the perception of the quality of the product for example medical studies suggesting that drinking moderate amount of red win can have positive health effects 4) Population - increase in the population with purchasing power, the demands for all products purchased by new people will rise - increase in population will shift the demand curves for most products to the right 5) Expectations about the future - people‟s expectations about future values of variables may change demand - expectations of prices increasing will cause the demand to increase at that point in time to buy as much before the price rises Shifting in the demand curve - increase in the price of coffee caused by an increased demand for coffee - a shift in demand curve for coffee - more coffee demanded at each price therefore increases the price of coffee - another example would be if less coffee is being bought because of its rise in price - movement along the new demand curve reflects a change between two specific quantities demanded For example, A rise in the population and income in coffee-drinking countries shifts the demand curve for coffee to the right. This in turn raises the price of coffee The rising price of coffee is causing each individual household to cut back on its coffee purchases. The cutback is represented by an upward movement to the left along the new demand curve for coffee Change in demand: a change in the quantity demanded at each possible price of the commodity, represented by a shift in the whole demand curve change in quantity demanded: a change in the specific quantity of the good demanded represented by a change from one point on a demand curve to another point, on the original demand curve or on a new one Important: - A change in the price will cause either an increase or decrease in the quantity demanded whether it means to move along the demand curve upwards or downwards - when there is a change in demand and change in price the overall change in quantity demanded is the net effect of the shift in the demand curve and the movement along the new demand curve Quantity Supplied - the amount of a commodity that producers want to sell during some time period - it is a flow per unit of time - amount that producers are willing to offer for sale - not necessarily the amount that they succeed in selling which is expressed in quantity sold or quantity exchanged - ceteris paribus- all things equal Quantity Supplied and Price - a basic hypothesis of economics is that the price of the product and quantity supplied are related positively other things being equal. The higher the product‟s own price, the more its producers will supply; the lower the price, the less its producers will supply - supply schedule: a table showing the relationship between quantity supplied and the price of a commodity, other things being equal - supply curve: the graphical representation of the relationship between quantity supplied and the price of a commodity, other things being equal - positive slope indicates that quantity supplied increases when price increases - when economists makes statements about the conditions of supply they are not referring just to the particular quantity being supplied at the moment - they are referring to the entire supply curve, to the complete relationship between desired sales and all possible prices of the product - supply: the entire relationship between the quantity of some commodity that producers wish to sell and the price of that commodity other things being equal - a change in any of the variables (other than the product’s own price) that affects the quantity supplied will shift the supply curve to a new position Determinants of Supply 1) Prices of inputs - higher the price of an input (materials, labour, machines) the less will be the profit from making that product - therefore that higher price of any input used by a firm the less the firm will product and offer for sale at any given price of the product - shifts the supply curve to the left indicating that less will be supplied at any given price 2) Technology - Any technological innovation that decreases the amount of inputs needed per unit of output reduces production costs and hence will increase the profits that can be earned at any given price of the product - increased profitability leads to increased willingness to produce this change shifts the supply curve right 3) Government Taxes or subsidies - anything increasing the firms‟ costs will shift the supply curve left, anything decreasing the firms‟ costs will shift the supply curve to the right - governments put taxes on specific goods such as gasoline, cigarettes and alcohol - governments will subsidize producers for some products - pay a specific amount for each unit of the good produced - agricultural products for the most part 4) Prices of Other Products - changes in the price of one product may lead to changes in the supply of some other product because the two products are either substitutes or complements in the production process 5) Number of Suppliers - the total amount of any product supplied depends on the number of firms producing that product and offering it for sale - if profits are being earned by a firm, then more firms will choose to enter this industry and begin producing - supply curve shifts to the right due to the increase in the number of suppliers Change in Supply- a change in the quantity supplied at each possible price of the commodity represented by a shift in the whole supply curve change in quantity supplied- a change in the specific quantity supplied, represented by a change from one point on a supply curve to another point, either on the original supply curve or on a new one The Concept of a Market - market: designated a physical place where products were bought and sold - market: any situation in which buyers and sellers can negotiate the exchange of goods or services Graphical Analysis of a Market Excess demand (shortage) - at the given price, quantity demanded exceeds quantity supplied Excess Supply (surplus) - at the given price quantity supplied exceeds quantity demanded - excess supply causes downward pressure on price - more likely to cut prices - excess demand causes an upward pressure on price - more likely to raise prices Equilibrium Price; price at the quantity demanded equals the quantity supplied (market-clearing price) Disequilibrium: when a market has either excess demand or supply in the market Changes in Market Prices - in order to discover the effects of the four possible shifts that can occur in a graphical representation they use a method called comparative statics (the derivation of predictions by analyzing the effect of a change in some exogenous variable on the equilibrium - we drive predictions about how endogenous variables (equilibrium price and quantity) will change following a change in some exogenous variable (variables whose changes cause shifts in demand and supply curves) Increase in demand (curve shifts to right): creates a shortage at the initial equilibrium price and the unsatisfied buyers bid up the price. Rise in price causes a larger quantity to be supplied with the result that at the new equilibrium more is exchanged at a higher price Decrease in demand (curse shifts left): increase in supply creates a surplus at the initial equilibrium price, and the unsuccessful suppliers force the price down. This drop in price increases the quantity demanded and the new equilibrium is at a lower price and a higher quantity exchanged An increase in supply (shifts the supply curve right): increase in supply creates a surplus at the initial equilibrium price and the unsuccessful suppliers force the price down. Drop in price increases the quantity demanded and the new equilibrium is at a lower price and higher quantity exchanged A decrease in supply (shifts supply curve left): decrease in supply creates a shortage at the initial equilibrium price that causes the price to be bid up. This rise in price reduces the quantity demanded and the new equilibrium is at a higher price and lower quantity exchanged Absolute price: the amount of money that must be spent to acquire one unit of a commodity also called money price Relative price: the ratio of the money price of one commodity to the money price of another commodity; that is a ratio of two absolute prices In microeconomics whenever we refer to a change in the price of one product we mean a change in that product’s relative price; that is a change in the price of that product relative to the prices of all other goods Chapter 4: Elasticity Price Elasticity of Demand - when the demand is said to be elastic, the quantity demanded is quite responsive to changes in price - when the quantity demanded is unresponsive to changes in price it is said to be inelastic - the more responsive the quantity demanded is to changes in price, the less the change in equilibrium price and the greater the change in equilibrium quantity resulting from any given shift in the supply curve Measurement of Price Elasticity - The slope of the demand curve tells us the amount by which price must change to cause a unit change in quantity demanded - we are able to say that the demand curve in part (i) showed more responsiveness to price changes than the demand curve in part (ii) because two conditions were fulfilled ⁃ 1) Both curves were drawn on the same scale ⁃ - ⁃ 2) initial equilibrium prices were the same in both parts of the figure ⁃ - the larger the absolute change the larger the percentage change ⁃ Price Elasticity of demand- a measure of the responsiveness of quantity demanded to a change in the commodity‟s own price ⁃ - Percentage Change in Quantity Demanded / Percentage change in price ⁃ - Averages are used to avoid the ambiguity caused by the fact that when a price or quantity changes, the change is a different percentage of the original value than it is of the new value ⁃ - the measured elasticity of demand between any two points on the demand curve, call them A and B, are independent of whether the movement is from A to B or from B to A ⁃ ⁃ To Calculate: ⁃ ⁃ Change in Quantity / Average Quantity / Change in Price / Average Price ⁃ Q1-Q0/Qa / P1-P0/Pa ⁃ ⁃ Interpreting Numerical Elasticities ⁃ - Elasticity is zero when a change in price leads to no change in quantity demanded ⁃ In this case it is vertical demand ⁃ quite rare because it indicates that consumers do not alter their consumption at all when price changes ⁃ - Elasticity is very large when even a small change in price leads to an enormous change in quantity demanded ⁃ demand curve is flat ⁃ ⁃ Elasticity less than 1 = inelastic demand ⁃ Elasticity grater than 1 = elastic demand ⁃ elasticity is equal to 1 = unit elastic ⁃ ⁃ Elasticity is different at different parts of the demand curve ⁃ - Further up the more elastic the demand is ⁃ - further down the more inelastic it is (assuming the curve is a straight line downwards) ⁃ ⁃ What Determines Elasticity of Demand? ⁃ - determined by the availability of substitutes and the time period ⁃ ⁃ Availability of Substitutes ⁃ - A change in the price of products, such as Toyota and Mazada cars, with the prices the substitutes remaining constant can be expected to cause much substitution ⁃ - Products with close substitutes tend to had elastic demands ⁃ - products with no close substitutes tend to have inelastic demands ⁃ - Narrowly defined products have more elastic demands than do more broadly defined products ⁃ ⁃ Short Run and Long Run ⁃ - demand elasticity depends to a great extent on the time period being considered ⁃ - demand that is inelastic in the short run may prove to be elastic when enough time has passed ⁃ - the response to a price change and thus the measured price elasticity of demand will tend to be greater the longer the time span ⁃ - Short-run demand curve shows immediate response of quantity demanded to a change in price given the current stock of durable goods ⁃ - long -run demand curve shows the response of quantity demanded to a change in price after enough time has passed to change the stock of durable goods ⁃ - Long-run demand for a product is more elastic than the short-run demand ⁃ ⁃ Elasticity and Total Expenditure ⁃ - Total expenditure = Price x Quantity ⁃ - the change in total expenditure depends on the relative changes in the price and quantity ⁃ - because price and quantity move in opposite directions along a demand curve, one falling when the other rises, the change in total expenditure is ambiguous if all we know about the demand curve is that it has a negative slope ⁃ - Price decline of 10 percent: if quantity demanded rises by more than 10 percent (elastic demand) then quantity change will dominate and total expenditure will rise. If quantity demanded increases by less than 10 percent (inelastic demand) the the price change will dominate and the total expenditure will fall. ⁃ ⁃ Price Elasticity of Supply ⁃ - a measure of the responsiveness of quantity supplied to a change in the product‟s own price ⁃ - Percentage change in quantity supplied/ Percentage change in price ⁃ - increase in the price = increase in quantity supplied (positive slope) ⁃ - if the supply curve is vertical- the quantity supplied does not change as price changes - elasticity is zero ⁃ - horizontal supply has infinite elasticity - one critical price at which output is supplied but where a small drop in price will reduce the quantity that producers are willing to supply from an indefinitely large amount to zero ⁃ ⁃ Determinants of Supply Elasticity ⁃ ⁃ Substitution and Production Costs ⁃ - substitution depends on how easy it is for producers to shift from the production of other products to the one whose price has risen ⁃ Supply is said to be elastic due to easy switch ⁃ - costs output also are a factor in elasticity ⁃ if the costs of producing a unit of output rises rapidly as output rises, then the stimulus to expand production in response to a rise in price will quickly be choked off by increases in costs - in this case supply is inelastic ⁃ Short Run and Long Run ⁃ - it may be difficult to change quantity supplied in response to a price increase in a matter of weeks or months but easy to do so over years ⁃ - short-run supply shows the immediate response of quantity supplied to a change in price given producers‟ current capacity to product the good ⁃ - long-run supply curve- shows the response of quantity supplied to a change in price after enough time has passed to allow producers to adjust their productive capacity ⁃ - longer supply for a product is more elastic than the short-run supply ⁃ ⁃ Important Example Where Elasticity Matters ⁃ - excise tax: tax on the sale of a particular commodity ⁃ - Tax incidence: has nothing to do with whether the government collects the tax directly from consumers or from firms ⁃ The burden of an excise tax is distributed between consumers and sellers in a manner that depends on the relative elasticities of supply and demand ⁃ - after the imposition of an excise tax, the difference between the consumer and seller prices is equal to the tax ⁃ - in the new equilibrium, the quantity exchanged is less than that exchanged before the imposition of the tax ⁃ - When demand is inelastic relative to supply, consumers bear most of the burden of excise taxes. When supply is inelastic relative to demand, producers bear more of the burden ⁃ CHECK OUT PAGE 88-89 ⁃ - demand for gasoline and cigarettes is inelastic but more in the short run than the long run ⁃ ⁃ Other Demand Elasticities ⁃ - changes in income and changes in prices of other products also lead to changes in demand and elasticity is a useful concept in measuring their effects ⁃ ⁃ Income elasticity of Demand ⁃ - a measure of the responsiveness of quantity demanded to a change in income ⁃ - Percentage change in quantity demand / percentage change in income ⁃ - Normal Goods: increases in income leads to increases in demand elasticity is positive ⁃ - Inferior goods: goods for which demand decreases in response to a rise in income have a demand elasticity negative ⁃ - Income-elastic: food, basic clothing (necessities) ⁃ - Income-inelastic: cars, TVS, refrigerators (luxuries) ⁃ TERMINOLOGY OF ELASTICITY - PAGE 92 ⁃ - the more necessary an item is in the consumption pattern of consumers, the lower is its income elasticity ⁃ ⁃ Cross Elasticity of Demand ⁃ - the responsiveness of demand to changes in the price of another product or another commodity ⁃ - ex. the change in the price of Y leads to an increase in demand for X - if substitutes ⁃ the increase in the price of Y leads to a reduction in demand for X - complements ⁃ - Complementary products have negative cross elasticities ⁃ - Substitute products have positive cross elasticities ⁃ - For example, Glass bottles and cans have high cross elasticity. Producer of bottles is thus in competition with the producer of cans. Bottle company raises its price and it will lose substantial sales to the can producer ⁃ Men‟s and women‟s shoes have low cross elasticity because they are not in close competition with each other Chapter 5: Markets in Action Interaction Among Markets - no industry or market exists in isolation from the economy‟s many other markets - technological improvement in natural-gas industry, for example, would have many effects in other markets - Changes in one market lead to changes in many other markets, the induced changes in those markets will change the first market - Economists call it: feedback - When we draw given demand and supply curves we assume that the prices of all other goods are constant - predicting feedback is difficult but we cannot ignore it Partial-equilibrium analysis: analysis of a single market in situations in which the feedback effects from other markets are ignored - in previous chapters we have used this and ignored feedback from other markets - If a specific market is quite small relative to the entire economy, changes in the market will be relatively small on other markets. Feedback on original market will in turn be even smaller - General equilibrium analysis: analysis of all the economy‟s markets simultaneously, recognizing the interactions among the various markets - analysis the feedback from other markets Government-Controlled Prices - governments fix the price a which a product must be bought and sold in the domestic market - government price controls are policies that attempt to hold the price at some disequilibrium value - some create a shortage or surplus - to determine the quantity exchanged requires voluntary market transaction from the buyer and seller - if quantity demanded is less than the quantity supplied demand will determine the amount exchanged while quantity supplied remains in hands of the producer - the opposite is also true - quantity exchanged is determined by the lesser of the quantity demand or quantity supplied Price Floor - minimum permissible price that can be charged for a particular good or service - if the price floor is set above equilibrium it will raise the price and it is said to be binding - binding price lead to excess supply either an unsold surplus will exist or someone (usually the government) must enter the market and buy the excess supply - farmers and workers have benefited the most by having price floors which enable them to sell their goods or services at prices above free-market levels - if demand is inelastic the producers earn more income in total (agricultural products especially) - the losses (by selling fewer units of the product) are spread across the purchasers Minimum Wage - firms are worse off because they are required to pay higher wages than before minimum wage was imposed - increase in costs by reducing their use of labor - workers who are lucky enough to get jobs get a higher wage than before - higher supply of labour than the demand for workers Price Ceilings - maximum price at which certain goods and services may be exchanged - set below the free-market equilibrium which lowers the price which it is said to be binding - leads to excess demand with the quantity exchanged being less than in the free-market equilibrium Allocating Product in Excess Demand - free markets allow the price to rise thereby allocating the available supplies among would-be purchasers - adjustment cannot happen in the presence of a binding price ceiling, some other method of allocation must be adopted - First come first served basis allocates tickets to concerts and set a price which demand exceeds the supply - Illegal market develops which “scapulars” resell tickets are market clearing prices - Seller‟s preference: sellers decide whom they will and will not sell their scarce supplies - governments can choose to ration the product based on allocation of products - only enough coupons, when rationed, is printed off to match the quantity supplied at the ceiling Black Markets - any market in which goods are sold illegally at prices that violate legal price control - Binding price ceilings always create the potential for a black market because a profit can be made by buying at the controlled price and selling at the black-market price Three goals of imposing price ceilings: 1) Restrict production (release resources for other uses) - If producers are willing to sell (illegally) at the prices above the price ceiling nothing restricts them to a specific quantity as long as they receive a price value above the restricted one that have incentive to increase their production 2) keep specific prices down - frustrate the second objective since the actual prices are not kept down - black-market price will be higher than the free-market 3) Satisfy notions of equity in the consumption of a product that is temporarily in the short supply - only those who can afford the black-market price will get much of the product Canadian Health Care- example of rationing in Canada Rent Controls: A Cast Study of Price Ceilings - many countries have developed into a second generation of rental control which focuses on regulating the rental housing market rather than controlling the price of the accommodation 1) There will be housing shortage in the sense that quantity demanded will exceed the quantity supplied 2) Shortage will lad to alternative allocation schemes- landlords may allocate by sellers‟ preferences or the government may intervene 3) Black markets will appear. Landlords may (illegally) require tenants to pay “key money” to equal the difference in value between free-market and controlled rents Short-run curve is quite inelastic while the long-run supply curve is highly elastic Rent Controls ran into issues 1) by having rent controls it could force people to move out 2) people may have to accept low-paying jobs just to stay in their apparent and not allow any new movement into the building Who Gains and Who Loses? - existing tenants are the principle gainers from a policy and are lucky enough to still live in housing - those lucky enough to live in rent-controlled housing gain more and more - Landlords suffer because they do not get the rate of return they expected on their investments - potential future tenants- lose because they will not be guaranteed housing the future therefore not being in a great position for getting to work or being in the right setting Policy Alternatives - market solution would be to let rents rise sufficiently to cover the rising costs if people decide they can‟t afford it and people won‟t rent apartments therefore ceasing construction This though is usually not the case - Can‟t avoid the fact that opportunity costs of good housing is high - binding rent controls create housing shortages - shortages can only be removed by subsidizing or produce public housing by the government - Governments can make the housing more affordable by providing assistance to those households Demand as “Value” and Supply as “Cost” - we can consider the highest price that consumers are willing to pay and the lowest price that producers are willing to accept for any given unit - it helps us think about how society as a whole benefits by producing and consuming any given amount of some product - for each unit of product the price on the market supply curve shows the lowest acceptable price to firms for selling that unit. this lowest acceptable price reflects the additional cost to firms from producing that unit Economic Surplus and Market Efficiency - for any given quantity of a product, the area below the demand curve and above the supply curve shows the economic surplus associated with the production and consumption of that product - economic surplus is the net value that society as a whole receives by producing and consuming the value of consuming is greater the the costs of resources necessary to produce - a market for a specific product is efficient if the quantity of the product produced and consumed is such that the economic surplus is maximized - total surplus and not is distribution between consumers and producers - A competitive market will maximize economic surplus and therefore be efficient when price is free to achieve its market-clearing equilibrium level - free interaction of demand and supply will result in market efficiency Market Efficiency and Price Controls - the imposition of a binding price floor in an otherwise free and competitive market leads to market inefficiency - When a price floor is put in place units gf goods and services to create the economic surplus are no longer there - deadweight loss caused by binding price floor and represents the overall loss of economic surplus to society - the size of the deadweight loss reflects market inefficiency - the imposition of a binding price ceiling in an otherwise free competitive market leads to market inefficiency - when price ceiling is imposed, goods are no longer produced or consumed and they are no longer part of the economic surplus (do not generate it) Output Quotas - government introduces a quota that restricts the total output of a product (typically agriculture) - output quotas are a pure benefit to producers as they give them profits and reduce costs - purchasing a quota is very expensive Cautionary Word - Redistribution between buyers and sellers; one group is made better off the other worse - reduction in overall amount of economic surplus gerenated in the market result is the society is made worse off and inefficient Chapter 6: Consumer Behaviour Marginal Utility and Consumer Choice - consumers are motivated to maximize their utility - theory of consumer behaviour can be developed by utility maximization - total utility: the total satisfaction resulting from the consumption of a given commodity by a consumer - marginal utility: additional satisfaction obtained from consuming one additional unit of a commodity Diminishing Marginal Utility - law of diminishing marginal utility: utility that any consumer drives from successive units of a particular product consumed over some period of time diminishes as total consumption of the product increases (if the consumption of all other products remains unchanged) Utility Schedules and Graphs - the marginal utility of consuming that product decreases at the total utility rises - Total revenue is maximized where marginal utility equals 0 Maximizing Utility - consumers seeks to maximized their total utility subject to the constraints they face- in particular their income and market prices Consumer’s Decision - to maximize utility a consumer should consume two products where both the marginal utilities are equal - in more detail the products should be at the point where marginal utility per dollar spent is equal to each other (Coke and burritos for example) - utility-maximizing consumer allocates expenditures so that the utility obtained from the last dollar spent on each product is equal - A consumer will switch their expenditure on a good for another in order to maximize the utility - only switches expenditures to the point where the consumer‟s utility is maximized - the condition required for a consumer to be maximizing utility for any pair of product is: MUx/Px = MUy/Py (Marginal utility of product/Price) - allocate the expenditure so that the utility gained from the last dollar spent on one product is equal to the utility gained from the last dollar spent on any other product An Alternative Interpretation MUx/MUy = Px/Py - right side is the relative price of two goods which is determined by the market - left side is the relative ability of two goods to add to utility For example: Price of 4 and 2 which equals = 2 and a MU of 12/4 = 3 Less of a product will be bought, and more of the other will be bought to match the quantities - only the marginal utility can be changed not the price - utility-maximization theory leads to predictions that can be tested empirically - usually leads to a negatively sloped demand curve Consumer’s Demand Curve - typically during an increase in the price there will be a right-side greater than left-side situation - As Alison (in example) buys less of Coke compared to other products than her utility of Coke will rise and increase the ratio on the left side - A rise on the price of a product (with all other determinants of demand held constant) leads each consumer to reduce the quantity demanded of the product - theory proves a negatively sloped demand curve Income and Substitution Effects of Price Changes - a lower in the price of ice cream, for example, will cause a fall int he relative price of ice cream and therefore lead consumes to substitute away from other products towards ice cream - due to the decrease in price of ice cream, consumer has more purchasing power or real income (income expressed in terms of the purchasing power of money income) available to spend on other products Substitution Effect - given the situation where an allowance is reduced to allow an individual to buy just as much ice cream the purchasing power will remain unchanged - if the behaviour remains unchanged then he will no longer be maximizing his utility - when the price falls, Tristan must increase his consumption to lower his utility - he must substitute away from other goods and toward ice cream - When purchasing power is held constant the change in quantity demanded of a good whose relative price has change is called the substitution effect of the price change Substitution effect increases the QD of a good whose price has fallen and reduces the QD of a good whose price has risen Income Effect - change in purchasing power, holding relative prices constant at their new value instead of looking at the relative price change holding purchasing power constant - a consumer will increase his consumption of a good with an increase in income - leads consumers to buy more of a product whose price has fallen provided that it is a normal good - the size of the income effect depends on the amount of income spent on that good whose price changes on the amount by which the price changes Slope of the Demand Curve - Because of the combined operation of the income and substitution effects, the demand curve for any normal commodity will be negatively sloped. Thus, a fall in price will increase the quantity demanded - the sum of the income and substitution effects determine how overall quantity demanded responds to the price reduction Giffen Goods - a good that has a positively sloped demand - inferior good for which the income effect outweighs the substitution effect giving a positive slope - the good must take a large portion of the total household expenditure and therefore have a large income effect - Concept given by Robert Giffen Conspicuous Consumption Goods - people buy diamonds because they are expensive - concept given by Thorstein Veblen - if a consumer buys a product at a higher price because of the high price - snob appeal people think they paid a high price - unlikely that the market demand is positively sloped demand Application to Taxation - taxes affect both supply of work and supply of saving Consumer Surplus: The Concept - Consumer surplus is the difference between the total value that consumers place on all units consumed of a commodity and the payment that they actually make to purchase that amount of the commodity - direct consequence of negatively sloped curves - easier way to think of it: you think of the individual‟s demand curve as showing his or her willingness to pay for successive units of the product - sum of the values placed on each successive unit consumed is the total value placed on the amount given - the actual market price of the product: $1 the amount the consumer values the product: $6. Because it is only her first litre of milk she will pay more for the product there technically making a profit - for any unit consumed, consumer surplus is the difference between the maximum amount the consumer is prepared to pay for that unit and the price the consumer actually pays - the market demand curve shows the valuation that consumers place on each unit of the product. For any given quantity the area under the demand curve and above the price line shows the consumer surplus received from consuming those units Paradox of Value - distinction between total value and marginal value is crucial - early economists struggled with what determined relative prices of products - Resolving issue: 1) distinction between total and marginal values of any product - area under the demand curve is a measure of the total value placed on all units the consumer consumes - marginal value is measured at the market price. They don‟t purchase products below hit his value 2) supply plays an important role in determine the market price as demand - because the market price of a product depends on both demand and supply, there is nothing paradoxical in there being a product on which consumers place a high total value (such as water) selling for a low price and hence having a low marginal value - product that is relatively scare will have a high market price and consumption will stop where consumers place a high value on the last unit consumed - limited quantities or skills = greater price and willingness to pay for it ⁃ Appendix: Indifference curves ⁃ - indifference theory is based on the much weaker assumption of two consumption bundles they prefer without having to say by how much they prefer it ⁃ - marginal utility theory distinguishing total and marginal values ⁃ ⁃ Indifference Curves ⁃ - a person can prefer a new bundle depending on his relative valuation that they place on it ⁃ - for example, gaining 5 more units of food and losing 5 units of clothing ⁃ - if the personal values the extra units the same as the forgone units than he is said to be indifferent between the two bundles ⁃ - the consumer is indifferent between the combinations indicated by any two points on one indifference curve ⁃ - all the points on the indifference curve are equal to that individual‟s eyes ⁃ - points above the curve are superior to the points on the curve and the points below and left are the bundles that are inferior to bundles represented by points on the curve ⁃ - any point above the indifference curve is preferred to any point along that same indifference curve, any point on the curve is preferred than any below it ⁃ ⁃ Diminishing Marginal Rate of Substitution ⁃ - how much of units a person may be willing to give up ⁃ - the amount of one product that a consumer is willing to give up to get one more units of another product ⁃ - first basic assumption of indifference theory is that the algebraic value of MRS between two goods is always negative ⁃ - negative slope means that increasing consumption of one product will lead to a decrease in consumption of another product ⁃ - Say you have a large amount of food and a small amount of clothing --> you are more willing to give up an extra unit of clothing for more food rather than give up a unit of food for clothing ⁃ - marginal rate of substitution changes when the amounts of two products consumed changes ⁃ - diminishing marginal rate of substitution is the second basic assumption of indifference theory ⁃ - as you move down the curve, more willing to give up food for units of clothing ⁃ ⁃ Indifference Map ⁃ - the further the indifference curve shifts or is from the origin ⁃ - a set of indifference curves is called a indifference map ⁃ - when economists say that a consumer’s tastes are given, they do not mean consumer’s current consumption pattern is given; rather they mean that the consumers entire indifference map is given ⁃ ⁃ Budget Line ⁃ - the quantities of goods available to a consumer given money income and the price of goods ⁃ - shows all the combinations an individual of food and clothing if his spends a fixed amount of money (for example 720 a week) ⁃ ⁃ Properties of a Budget Line ⁃ 1) Points on budget line indicate bundles of products that use up the consumer‟s entire income ⁃ 2) points between the budget line and origin indicate bundles of products that cost less than consumer‟s income ⁃ 3) points above budget line indicate combination of products that cost more than consumer‟s income ⁃ Budget line shows all combinations of products that are available to the consumer given his money income and the prices of the goods that he purchases ⁃ E (money income) = Pf (price of food) x F (quantities of food) + Pc (price of clothes) x C (quantities of clothing) ⁃ ⁃ Slope of Budget Line ⁃ - In our situation the slope of the line is 2 ⁃ - therefore we must forgo the purchase of 2 units of clothing to acquire 1 extra unit of food ⁃ - relative price determines the slope of the budget line ⁃ - in terms of the example in our book we can find the slope with the equation Pf/Pc ⁃ - this means that 24$ per unit of food/12$ per unit of clothing = slope of 2 ⁃ - what is significant about the budget line is that it reflects his opportunity cost (of food in terms of clothing) ⁃ - To move along the budget line (from x=0) Hugh in this case must move along the budget line which in turn causes less consumption of clothing --> the slope determines how much clothing he must give up to obtain an additional unit of food ⁃ - opportunity cost of food in terms of clothing is measured by the (absolute value of the) slope of the budget one, which is equal to the relative price ratio, Pf/Pc ⁃ - for example in order to obtain one more unit of food, it will have an opportunity cost of 2 clothing units ⁃ ⁃ Consumer’s Utility-Maximizing Choices ⁃ - indifference map describes the preferences of a consumer and budget line describes the possibilities available to a consumer ⁃ - put together the curves can predict what the consumer will actually do ⁃ - ideally the individual would want to reach the highest possible indifference curve ⁃ - the consumer’s utility is maximized at the point where an indifference curve is tangent to the budget line. At that point, the consumer’s marginal rate of substitution for the two goods is equal to the relative prices of the two goods ⁃ - the indifference curve must be tangent to the budget line in order for Hugh to reach a higher curve by altering his purchases ⁃ - an individual could take in return a good that he values more than what the market does ⁃ - supposing that Hugh is presented with market prices that he cannot change then by analyzing how he adjust to these prices by choosing a bundle of goods such that, his own subjective evaluation of the goods coincides with the valuations given by the market prices ⁃ ⁃ Consumer’s Reaction to a Change in Income ⁃ - change in Hugh‟s income will shift his budget line ⁃ - expansion of consumption possibilities ⁃ - if we move the budget line through all possible levels of income and join up al the maximizing points we can trace out a income-consumption line ⁃ Consumer’s reaction to a Change in Price ⁃ - consumer‟s will react to a change in price by buying less or more of that good ⁃ BOTH OF THESE SITUATIONS ARE ON PAGE 144 ⁃ ⁃ Deriving the Demand Curve ⁃ - we can derive the demand curve for one of the productions based on the price- consumption line of two products ⁃ - when there are many products a change in the price of one product generally causes substitution toward all other goods (or away from) ⁃ - every point on the price-consumption line corresponds to both a price of the product and a quantity demanded; this is the information required for a demand curve ⁃ - price-consumption line shows how consumer‟s purchases react to change in one price with money income and other prices being held constant ⁃ - process of finding the demand curve when giving the price-consumption line on pg. 146 ⁃ ⁃ Income and Substitution Effects ⁃ - we make the distinction between the income effect and substitution effect by using indifference curves ⁃ - in indifference theory, the income effect is removed by changing money income until the original level of utility - the original indifference curve - can be achieved ⁃ - slightly different method but results are very similar ⁃ - the substitution effect is defined by sliding the budget line around a fixed indifferent curve ⁃ - the income effect is defined by a parallel shift of the budget line ⁃ page 147 demonstrates how to shift the indifference curve after a price change in order to reach the original indifference curve ⁃ - to remove the income effect, imagine reducing the consumer’s moey income until the original indifference curve is just attainable ⁃ - the consumer moves from point A0 to point A1 which is the result of an substitution effect ⁃ - to measure income effect we restore money income - the consumer moves from point A1 to final point A2 Chapter 6: Supplementary Chapter Labour Supply The Basic Set-Up - we have studied how households allocate their limited income across the purchases of various consumer goods - income was assumed to be a fixed amount determined outside the model of consumer behaviour - “endowment” of the household - when studying the labour supply decision of a household the endowment is no longer money but „time‟ - H- the time endowment of household to be split between labour and leisure, so H = +L (amount to time hours, days, week) - we assumed that households have time to allocate between labour and leisure - leisure is considered to be „good‟ and labour „bad‟ - when it comes to allocating our time to the labour market we earn wage, w - total income in a period = wL - the household can then spend their income on other „good‟ in the model, consumption C which is assumed to have a price equal to 1 - L: time spent working, a bad - l: time spent leisure activities, a good - w: wage rate faced by the household - wL: labour income earned by the household - C=wL: consumption by the household, a good Preferences - preferences over the two goods in the model, leisure and consumption are defined by normal indifference curves (assumed that both consumption and leisure are normal goods) Budget Line - maximum amount consumers can spend on consumption is what they earn: C = wL - labour supply is limited by the total amount of time available and the amount the household decides to take in leisure: C = wL = w(H-l) = wH - w - Wage Rate: can be interpreted as the reward for labour or opportunity cost (or relative price) of leisure - the slope of the budget line represents the relative price of one good (leisure) in terms of another (consumption) Consumer Equilibrium - household maximizes its utility by consuming at the point where it reaches its highest possible indifference curve - occurs where the tangent line is to the budget line Due to the slopes being equal mrs = w - in equilibrium, marginal rate of substitution (internal trade-off in terms of taste) is equal to relative price ratio (external trade-off in terms of possibilities - in the example, we can find the labour supply buy subtracting the H-l (two x quantities) Non-Labour Income - income it can consume regardless of how much it chooses to work - generated from saving, government benefit - when the line shifts upwards due to this income the slope remains unchanged because wage is the same Wage Changes - if there is a change in wage there will be change on substitution effect and the income effect - it has a new slope but is still tangent to the original curve - the increase in wages means that leisure has become more expensive relative to consumption - income effect can be illustrate from by a move from the IC curve to the new BL line - both the substitution and income effects push the household to increase consumption but with substitution effect favouring less leisure and the income effect favouring more leisure we cannot be sure whether leisure will rise or fall in the face of a wage increase Reservation Wage - the wage below which the household will chose not to participate in the labour market - usually there is no wage or to supply any labour - at the reservation wage the household is just indifferent between choosing point N and supplying the first unit of labour The wage at which the budget line - increasing the wage rate in a reservation wage situation shows that at low wages there is an increase in the labour supply - substitution effect of a wage increase outweighs the income effect - at the reservation wage, the household is just indifferent between choosing point N and supplying the first unit of labour. Since the increase in wage from w* to w’ has resulted in an increase in the labour supply (none to some) then it is clear a low wages just about the reservation wage, the substitution effect of a wage increase outweighs the income effect Summing-Up: the Labour Supply Curve Household Labour Supply - according to Figure S1-5, below w* is our reservation wages - the household will choose to supply no labour and for a least some wages above w* - the below w‟ the substitution effect outweighs the income effect and labour supply increases - if above this wage rate there could be the effect of the income effect outweighing the substitution effect and labour supply falling in the face of increasing wages Market Labour Supply - the bend back of the curve only occurs due to the household‟s preferences therefore we would not expect the market labour supply curve to look like the figure we have talked about Saving Supply Basic Set-up - assumed that household lives for two periods, the present or working life and the future during which it will be retired - household has income equal to I that will earn in the present and decide how to allocate between saving S and present consumption Cp - consumption is considered to be a „good‟ and saving is only useful because it provides a method for transferring some of its current income to consumption in the future Cf I- endowment of the household in terms of income earned in the present to be split between saving and present consumption, I = Cp + S Cp - present consumption, a good S = I - Cp - saving R- the interest rate faced by the household (1+)S- total return to saving earned by the household Cf = (1+r)S - future consumption by the household, a good Preferences - future and present consumption are normal goods Budget Line - maximum amount consumers can spend on future consumption is what they can earn in the saving market Cf= (1+r)S - saving is limited to the total amount of income available: Cf = (1+r)S = (1+r)I-(1+r)Cp - the budget line represents the relative price of one good in terms of another Consumer Equilibrium - maximizes utility where the highest possible indifference curve is - in equilibrium the marginal rate of substation is equal to the relative price ratio - household income is equal to I to begin with and choses Cp in present consumption the saving is I - Cp Income Changes - budget line shifts outwards - slope of the budget line remains the same because the interest rate is unchanged - future and present consumption are normal goods therefore the original future consumption was E the household would choose some point on the new budget line between A and B Interest Rate Changes - it will have both a substitution effect and an income effect - if faced with budget line B‟ it would choose a bundle like S with more future consumption and less present consumption - increase in interest rate means that present consumption has become more expensive relative to future consumption - both eh income and substation effects are pushing the household to increase future consumption - with the substitution effect favouring less present consumption and income favouring more present consumption we can‟t be sure whether present consumption will rise or fall in the face of interest rate increase - consumption in the future rises because given the increase in the interest rate each dollar of saving is now more productive at generating future consumption than before therefore we can have an increase in future consumption even with less saving Summing-Up Household Saving Supply - there is no analog to reservation wage - no reservation interest rate as it were - the only way to have consumption in the future is through saving - household saving supply is likely to be fairly inelastic and have a “backward-bending” range Market Saving Supply - bend only occurs due to the household‟s preferences - given the opposing nature of the substitution and income effects of an interest change we would expect the market supply curve to be fairly inelastic Chapter 7: Producers in the Short Run Producers in the Short-Run Organization of Firms Single Proprietorship- one owner, personally responsible for the business, unlimited liability Ordinary partnership- two or more joint owners each who is responsible for the company Limited Partnership- General partners (take part in running the business and liable for firm‟s debts), Limited Partners (no part in the running of the business, liability it limited to amount they invest into the enterprise) State-owned enterprise- owned by government but usually under direction of more or less independent state-appointed board (crown corporations) Non-profit Organizations- explicit objective of providing goods and services to customers but having any profits that are generated remain within the organization and not to individuals MNEs- firms that are located in more than one country (multinational enterprises) Financing of Firms - money a firm raises to carry on business separate from the real capital - types include equity (provided by owners of the firm) and debt (borrowed from creditors outside the firm) Equity - corporation requires funds from its owners in return for shares, stock or equities - paid in in dividends - Retained earnings is an important source of financing (business keeps current profits) Debt - creditors are not owner‟s but those that have given out IOUs - example is a bond obligation to pay a principle, interest, interest rate, and amount at the end of the term Goals of Firms - firms need to be socially responsible when maximizing profits (retaining profits but at the same time not risking resources or be detrimental to what runs the society or company) 1) maximize profits, 2) firm is a single decision-making unit desire to maximize profits is assumed to motivate all decisions made within a firm and decisions are assumed to be unaffected by the peculiarities of the persons making the decisions and by the organizational structure in which they work - responsibility should go beyond the responsibility to the stockholders Production, Costs and Profits Production - firm needs inputs to create outputs - Intermediate products: all outputs that are used as inputs by other producers in a further stage of production - Example: one firm mines iron ore and sells it to a manufacture - Production function: technological relationship between the inputs that a firm uses and the output that it produces Q = f(L,K) - Q is flow of output, K is flow of capital services, L is flow of labour services, f is production itself Costs and Profits Firms make profits based on the revenues they make subtracted by the expenses of the company Economic Profits vs. Accounting Accounting profits = Revenues - Explicit costs (costs that are actually involved in a purchase of goods or services by the firm) Economic Profit (Pure profit) = Revenues - (Explicit + Implicit costs) Implicit costs- small costs accountants don‟t feel is important (opportunity cost of owner‟s time, opportunity cost of owner‟s capital) Opportunity cost of time: owner pays herself only 1000 dollars when she could be paid 4000 in another job Opportunity cost of capital: money that goes towards capital and its areas of other uses (pg. 155) Economists include both implicit and explicit costs in their measurement of profits whereas accounting profits include only explicit costs. Economic profits are therefore less than accounting profits - firm can have positive accounting profits even though economic profits are zero - economists are interested in resource allocation and this is their best option to find it Profits and Resource Allocation if the revenues of all firms exceed opportunity costs the firms in the industry will be earning pure economic profits - economic profits and losses play a huge role in workings of a free-market system - industry‟s resources could be used to other uses to maximize profits - Economic profits can signal whether a resource should be moved or not Profit-Maximizing Output - pi = TR - TC = Profit-Maximizing output - profits as output varies depends on what happens to booth revenues and costs Time Horizons for Decision Making Decisions a firm makes: 1) How best to use existing plant and equipment (short-run) 2)what new plant and equipment and production processes to select (long-run) 3) development of new techniques (very long-run) Short-Run - A time period where the quantity of some inputs (fixed factors) cannot be changed - usually an element of capital, can be land plant equipment - Inputs are not fixed but can be varied in the short-run which are variable factors - timelines for the short-run depend on the company - short run is the length of time over which some firm’s factors of production are fixed Long-run - time period in which all inputs may be varied but the basic technology of production cannot be changed - expands scale of operations, branch into new products or areas, change method of production - length of time over which firm’s factors of production can be varied but technology is fixed Very Long Run - very long run is the length of time over which all the firm’s factors of production and its technology can be varied Production in the Short-Run - focus on the relationship between capital and labour - when output is varied, more or less labour is applied to a constant amount of capital Total, Average, Marginal Products Total Product: total amount that is produced during a given period of time Will change as more or less of the variable factor is used in conjunction with the given amount of the fixed factor Average Product: total product divided by number of units of the variable factor used to produce it AP = TP/L The level of labour input at which the average product reaches maximum is called point of diminishing average productivity Marginal Product: change in total product resulting from the use of one additional unit of labour MP = Change in TP/ Change in L - as we vary the quantity of labour, with capital being fixed, output changes Diminishing Marginal Product Law of Diminishing Returns: states that if increasing amounts of a variable factor are applied to a given quantity of fixed factor (holding level of technology constant) eventually a situation will be reached in which the marginal product of the variable factor declines - in order to increase output in the short run more of the variable factor is combined with the given amount of fixed factor - each unit of variable factor has less and less fixed factor to work with - eventually labour begins to add less and less to the total output Average-Marginal Relationship - average returns are also expected to diminish - average product slopes upward as long as the marginal product curve is above it - marginal > average it is rising, marginal < average it is decreasing Costs in the Short Run Total Cost- sum of all the costs that a firm incurs to product a given level of output TC = TFC + TVC Total Fixed Cost- cost of fixed factors, overhead costs, costs of production that do not vary with level of output Total Variable Cost- cost of variable factors - varies directly with level of output, rises when output rises and falls when output falls Average Total Cost- total cost of producing any given number of units of output divided by the number of units tells us the average total cost per unity of output ATC = AFC + AVC --> TC/Q Average Fixed Cost- total fixed cost divided by the number of units of output tells us the averaged fixed cost per unit of output - declines continually as output increases because the amount of fixed cost attributed to each unit of output falls (spreading overhead) AFC = TFC/Q Average Variable Cost- total variable cost divided by the number of units of output AVC = TVC/Q Marginal Cost - increase in total cost resulting from a one-unit increase in the level of output MC = Change in TC / Change in Quantity Short-Run Cost Curves AFC- increases the level of output lead to a steadily decline in fixed cost per unity (spreading overhead) AVC - changes in cost as the output rises from one level to another ATC- Sum of the AFC and AVC MC- change in costs as output rises from one level to another U-Shaped Cost curves: opposite of the product curves Eventually diminishing average product of the variable factor implies eventually increase average variable cost Eventually diminishing marginal product of the variable factor implies eventually increasing marginal costs Capacity - level of output that corresponds to the minimum short-run average total cost - largest output that can be produced without encountering rising average costs per unit - firm is above capacity if above where the AVC and MC intersect and excess capacity if below it Shifts in Short-Run Cost Curves 1) Fixed factor used by the firm is held constant 2) factor prices - per labour, per capital Change in Factor Prices - can dramatically change the firms‟ costs - increase in wage leads to a larger variable cost Also increases MC because MC is based on variable costs Changes in Amount of Fixed Factor - larger factor is in place increases the fixed costs - more work and labour is needed therefore increases costs - reduces average and marginal costs Chapter 8: Producers in the Long Run Producers in the Long Run Long Run: No Fixed Factors - short run: there is at least one fixed factor - long run: factors can be varied and there are numerous ways to produce any given output - profit-maximizing the firm will try to be technically efficient (given number of inputs are combined in such a way as to maximize the level of output) - in order to maximize profit along with technical efficiency, the firm must choose among many technically efficient options one that produces are given level of output at a lower cost - choices of labour and capital are considered to be long-run choices (all factors of production are variable) - decisions are important because it can result in negative or positive profits Profit Maximization and Cost Minimization - produce at the lowest cost - cost minimization: an implication of profit maximization that firms choose the production method that produces any given level of output at the lowest possible cost Long-Run Cost Minimization - the firm should substitute one factor for another factor as long as the marginal production of the one factor per dollar spent on it is greater than the marginal product of the other factor per dollar spent on it - the firm is not minimizing costs if they are equal - K = capital, L = labour, pL and pK = prices of two factors MPK/pK = MPL/pL - whenever ratio of the marginal product of each factor to its price is not equal for all factors, there are possibilities for actor substitutions that will reduce costs (for a given level of output) ex. MPk/Pk = 40/10 = 4 < MPL/pL = 20/2 = 10 Last dollar spent on capital only adds 4 units, last dollar spent on labour adds 10 units - the firm can reduce its cost of produced its current output by increasing labour and decreasing capital Law of diminishing returns states that with other inputs held constant, increase in the amount of one facto used will decrease that factor‟s marginal product MPk/MPL = pK/pL - left side compares the contribution to output of the last unit of capital to last unit of labour - right side shows the cost of additional unit of capital compared to cost of an additional unit of labour - only when the ratio of marginal products is exactly equal to the ratio of factor prices is the firm using the cost-minimizing production method - profit-maximizing firms adjust the quantities of factors they use to the prices of the factors given by the market - depending on whether the right side is greater than the left side or the opposite occurs Principle of Substitution - profit-maximizing firms will react to changes in factor prices by changing their methods of production (principle of substitution - principle that methods of production will change if relative prices of inputs change with relatively more of the cheaper input and relatively less of the more expensive input being used) - methods of production will change if the relative prices of factors change. Relatively more of the cheaper factor and relatively less of the more expensive factor will be used - plays an essential role in resource allocation because it relates to the way the firm responds to changes in r
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