MGEA01 Textbook Ch1-12.docx

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Economics for Management Studies
Michael H O

MGEA01 Textbook notes Part 1: What is Economics? Chapter 1 Economic Issues and Concepts Productivity Growth - Reason for long-term increase in Canadian’s average living standards - Productivity: measure of how much output/income produced by one hour of work effort o Gradually rising but recently slowed Population Aging - Due to decrease in fertility and increased life-expectancy - Will be decline in labour force growth rate due to retirement o More difficult to find workers so higher wages o Increase in public health-care spending  increase tax rates or reduce spending Climate Change - Reduction in agricultural productivity - Design for economic policy to reduce GHG emission without slowly material living standards - Global diplomacy Global Financial Stability - Avoid similar 2007-2008 US housing market crash leading to recession Rising Government Debt - Increased spending in effort to dampen recession effects Globalization - Tariffs - Greater competition 1.1 What is Economics? - Study of use of scarce resources to satisfy unlimited human wants Resources - Factors of production: used to produce goods and services o Land: natural endowments, arable land, forests, lakes, crude oil, minerals o Labour: mental and physical human resources, entrepreneurial capacity, managerial skills o Capital: manufactured aids for production, tools, machinery, buildings - What is produced in goods and services o Goods: tangible o Services: intangible - Production: making goods or services - Consumption: using goods or services to satisfy wants Scarcity and Choice - Scarcity implies choice must be made and choice implies existence of costs Opportunity Cost - Cost of using resources for certain purpose, measured by benefit given up by not using them in best alternative use o Ex: resources that can produce 20 km of road are best used to produce one hospital; opportunity cost of a hospital is 20 km of road or opportunity cost of 20 km of road is one hospital Production Possibilities Boundary - Production possibilities boundary/curve/frontier: o Curve showing which alternative combinations of commodities can just be attained if all resources are used efficiently o Boundary between attainable and unattainable output combinations o Negative slope because when all resources used efficiently, producing more of one requires less of the other o Scarcity: unattainable combination outside boundary choice o Choice: need to choose among alternative attainable points along boundary o Opportunity cost: negative slope of boundary - Curved line boundary  opportunity cost of either good increases as amount of it produced increases o Usually used to represent country o Because each factor of production not equally important in producing all goods  Ex: military goods vs. civilian goods  arable land from military uses to civilian - Straight line boundary  opportunity cost of one good stays constant no matter how much produced Four Keys Economic Problems 1. What is Produced and How? - Resource allocation: allocation of economy’s scarce resources among alternative uses 2. What is Consumed and by Whom?  - Distribution of nation’s total output - Consume all goods? Trading? 3. Why are Resources Sometimes Idle? - Unemployment 4. Is Productive Capacity Growing? - Represented as outward shift of production possibilities boundary Economics and Government Policy - Microeconomics: study of causes and consequences of allocation of resources as it is affected by workings of price system o What is produced, what is consumed and by whom - Macroeconomics: study of determination of economic aggregates, such as total output, price level, employment, growth o Idleness of resources, growth of economy’s productivity capacity - Government policies important in ^ - Market failure: when free markets lead to too much of some goods produced (pollution) and too little of others (parks) 1.2 The Complexity of Modern Economics The Nature of Market Economies - Economy: system in which scarce resources (land, labour, capital) are allocated among competing uses Self­Organizing  - Free-market economies are self-organizing - Spontaneous economic order when consumers and producers act independently to pursue self-interests, responding to prices in open markets Efficiency  - Efficiency: resources available are organized to produce various goods and services that people want to purchase and produce with least amount of resources - Free market economies guided by “invisible hand” Incentives and Self­Interest - Pursue own interests, what is best for them and their families - Sellers when to sell more when prices are high, buyers want to buy more when prices are low - Market prices and quantities determined by ^ collective interactions - Transactions governed by institutions o Private property, freedom to enter into contracts, rule of law  Defined by laws from legislatures and enforced by police and courts The Decision Makers and Their Choices - Decision makers o Consumers o Producers o Government How Are Decisions Made? - Producers and consumers decisions are maximizing and marginal Maximizing Decisions - Try to do as well as possible for themselves - Maximize well-being, utility , profits Marginal Decisions - Decide whether will be better off by buying or selling a little more or little less Flow of Income and Expenditure - Goods market - - goods and services - -> firms (producers) – factor services - -> factor markets – payments for - -> individuals (consumers) -- payments for - -> goods market - Goods market - - goods - -> individuals (consumers) - - factors - -> factor markets - - services - -> firms (producers) - - services - -> goods market - Distribution of income: how total income distributed among citizens Production and Trade - Specialization and division of labour Specialization - Specialization of labour: specialization of individual workers in production of particular good or service - Abilities differ – production greater - Abilities improve when concentrating on one job – learning by doing Division by Labour - Specialization within production of particular product - Breaking up production process into series of specialized tasks, each done by different worker Mass Production - Work divided into highly specialized tasks with specialized machinery Flexible Manufacturing  - Employers in a team where everyone able to do everyone’s job - Individual artisans re-appeared as people prefer individual crafts rather than mass- production Money and Trade - Specialization must be accompanied by trade - Barter: directly trading good for other goods o Requires double coincidence of wants - Money facilitate trade Globalization - Increased importance of int’l trade - Rapid reduction in transportation costs - Revolution in information technology - Relocation to lower costs means domestic workers are laid off o Used as threats towards government 1.3 Is There an Alternative to the Market Economy? Types of Economic Systems - Traditional, command, free-market Traditional Economies  - Behaviour based on tradition, custom, habit - Best in unchanging environment Command Economies - Decisions determined by central authority (usually gov’t), centralization of decision making Free­Market Economies - Decisions made by independent producers and consumers, decentralized - Coordination is the market-determined prices – price systems - Government provides background Mixed Economies - Every economy combines the three economies in practice The Great Debate - Karl Marx – although free markets successful in producing high levels of output, could not ensure fair distribution among citizens - Failure of central planning: o Failure of coordination o Failure of quality control o Misplaced incentives o Environmental degradation Government in the Mixed Economy - Government policies on private property and freedom of contract, laws of ownership and contract, institutions such as police and courts - Intervene to correct market failures - Public goods – not provided by markets because usage not restricted to those who pay o Defense and police - Externalities: imposing costs on those who have no say in transaction o Pollution - Equity issues in letting free market determine incomes Summary 1.1 What is Economics? - Scarcity fundamental problem making it necessary to have a mechanism to choose what will be produced - Opportunity cost measures cost of obtaining a unit of one product in term of number of units of other products that could have been obtained instead - Production possibilities boundaries shows all combinations of goods that can be produced by economy with all resources efficiently employed o Movement from one point to another along boundary requires reallocation of resources - Basic questions and dealt with by policies: o What is produced and how o What is consumed and by whom o Why are resources sometimes idle o Is productivity capacity growing 1.2 The Complexity of Modern Economies - Market economy self-organizing – individuals acting independently to pursue self-interests and responding to prices determined in open markets, collective outcome is coordinated - Incentives and self-interest - Consumers make decisions to maximize well-being or utility, producers make decisions to maximize profits - Interaction of consumers and producers illustrated by circular flow of income and expenditure - Specialization and division of labour - Transportation and communications technology 1.3 Is There an Alternative to the Market Economy? - Pure types: traditional, command, free-market - All mixed in practice - Governments create and enforce institutions such as private property and freedom of contract, intervene to correct market failures, redistribute income in interests of equity Part 2: An Introduction to Demand and Supply Chapter 2 Economic Theories, Data, and Graphs  2.1 Positive and Normative Statements - Normative statement: what ought to be as opposed to what actually is - Positive statement: about what actually is as opposed to what ought to be - Positive statements need not be true and inclusion of value does not make it normative Disagreements Among Economists 2.2 Building and Testing Economic Theories What Are Theories? Variables - Well-defined item, such as price or quantity of commodity, that can take on various specific values - Endogenous variable: value determined within theory; induced/dependent variable o Price and quantity of eggs - Exogenous variable: determined outside the theory, influences endogenous variable; autonomous/independent variable o Weather Assumptions - Theory assumptions concern motives, directions of causation, conditions under which theory is meant to apply Motives - Pursuing own self-interest and maximizing utility or profit - Assume to know what they want and how to get what they want Directions of Causation - Causal link between two variables when one is related to another Conditions of Application - Used to specify conditions under which theory is meant to hold - Theory is abstraction from reality Predictions - Propositions deduced from theory Testing theories - Confronting predictions with evidence - Empirical observation  construction of theories  generate specific predictions  tested by more detailed empirical observation Rejection Versus Confirmation - Theory to explain some observation and look for confirming evidence Statistical Analysis Correlation Versus Causation 2.3 Economic Data Index Numbers - Measure of variable, conventionally expressed relative to base period, which is assigned the value 100 - Easier to compare relative changes rather than absolute changes How to Build an Index Number - Base period – variable at some point in time to be compared with others - Subsequent years divided by base year output and multiply by 100 - Index number expresses value of given year as percentage of its value in base year - Value of index in any given period = Absolute value in given period / Absolute value in base period * 100 - Only comparable with base year, not years in between More Complex Index Numbers - Consumer Price Index (CPI): weighted average Graphing Economic Data - Variable come in two basic forms Cross­Sectional and Time­Series Data - Cross-sectional data: set of observations made at the same time across different units ( - households, firms, or countries); different observations on one variable in different places at same point in time - Time-series data: observations of one variable at successive periods of time o How numbers are changing over time Scatter Diagrams - Show relation between two different variables; graph showing two variables, one horizontal and the other vertical, each point representing values of variables for particular unit of observation 2.4 Graphing Economic Theories - Theories build on assumptions on relationships between variables Functions - Y is a function of X when there is only one possible value of Y for every X o Relation is Functional relation between variables - Relation can be expressed in different ways Verbal Statement Schedule - Table showing selected values Mathematical Equation Graph Graphing Functions - Positively related when both variables go up - Negatively related when variables moving in opposite directions - Linearly related – straight lines The Slope of a Straight Line - Slopes show how much one variable changes as the other changes - Defined as amount of change in vertical variable per unit change in horizontal variable - Slope of a straight line = change in Y / change in X Non­linear Functions - Marginal change: change in X when a bit more or a bit less is spent on Y - Diminishing marginal response: payoff diminishes as more is spent - Slope of curve changes as X changes - Marginal response of Y to change in X depends on value of X - Tangent line to measure non-linear function Functions with a Minimum or a Maximum - At minimum of maximum of function, slope of curve is 0  thus at minimum or maximum, marginal response of Y to change in X is 0 Summary 2.1 Positive and Normative Statements - Way the world works vs. how the world ought to work 2.2 Building and Testing Economic Theories 2.3 Economic Data - Index numbers express economic series in relative form - Graphed in o Cross-sectional graphs: observations taken at the same time o Time-series graphs: observations on one variable over time o Scatter diagrams: specific observations on two different variables 2.4 Graphing Economic Theories - Positive slope when both increase - Negative slope when one increases and other decreases - Marginal response of variable gives amount it changes in response to change in second variable - Marginal response is zero on functions with maximum or minimum Chapter 3 Demand, Supply, and Price 3.1 Demand Quantity Demanded - Quantity demanded: total amount of good or service that consumers want to purchase during time period o Desired quantity – amount consumers want to purchase with factors of price, other prices, incomes, tastes, population, expectations about future o Flow of purchases referred as so much per period of time - Quantity bought/exchanged: actual purchases - Ceteris paribus: holding all other variables constant; other things being equal; all other influencing variables do not change - Flow variable: variable per unit of time o Ex: 2000 eggs mean nothing  2000 eggs per hour Amount of water is flowing into the bathtub - Stock variable: variable with value at a point in time o Ex: 10 000 on September 3 , 2013 At any point in time, a bathtub holds this much water Quantity Demanded and Price - Law of demand: o Price of product and quantity demanded are negatively related, ceteris paribus  The lower the price, the higher the demand Demand Schedules and Demand Curve - Demand schedule: table showing relationship between quantity demanded and price of commodity, ceteris paribus - Demand curve: graphical representation of relationship between quantity demanded and price ceteris paribus o Negative slope indicates quantity demanded increases as price falls - Demand: entire relationship between quantity demanded of product and price, ceteris paribus; entire demand curve/slope o Quantity demanded is just one point Shifts in the Demand Curve - Assumption that in demand curve everything except price is constant  when other variables change, demand curve shifts - More is desired at price: demand curve shifts right so that price corresponds to higher quantity - Less desired at price: demand curve shifts left so that price corresponds to lower quantity 1. Consumers’ Income - Change in income: o Normal goods: quantity demanded of goods increases when income rises o Inferior goods: quantity demanded of goods falls when income rises - Change in income distribution o Demand increases for products bought most by consumers with income increase o Demand decreases for products bought most by consumers with income decrease 2. Prices of Other Goods - Substitutes in production: goods used in place of another good to satisfy similar needs o Cheaper/more expensive products relative to others  Ex: apples become relatively cheaper to orange because price of apple falls or price of orange rises  still more consumers substitute oranges for apples o Rise in price shifts demand curve to the right - Complement in consumption: goods that tend to be consumed together o Fall in price of one increases quantity demanded of both products o Fall in price shifts demand curve to the right o Ex: cars and gas prices 3. Tastes - Long-lasting or short-term - Shifts product in favour demand curve to the right 4. Population - Increase in population with purchasing power, demands for products will rise - Shifts demand curves to the right 5. Expectations about the Future - Rightward shift in demand curve  increase in demand o Rise in income, rise in price of substitute, fall in price of complement, change in tastes, increase in population, anticipation of future event that will increase price - Leftward shift in demand curve  decrease in demand o Fall in come, fall in price of substitute, rise in price of complement, change in tastes, decrease in population, anticipation of future event that will decrease price Movements Along the Curve Versus Shifts of the Whole Curve - Demand refers to entire demand curve - Quantity demanded refers to particular point on demand curve - Change in demand: change in quantity demanded at each possible price, represented by shift in entire demand curve - Change in quantity demanded: change in specific quantity of good demanded, represented by change from one point on demand curve to another on either original demand curve or on new one - Increase in demand and increase in price  increase in quantity at initial price whereas movement along new demand curve causes decrease in quantity demanded 3.2 Supply Quantity Supplied - Quantity supplied: amount of commodity that producers want to sell during a time period - Flow variable - Quantity sold/quantity exchanged: amount successfully sold - Influenced by: o Price of product o Price of inputs o Technology o Government taxes or subsidies o Price of other products o Number of suppliers Quantity Supplied and Price - Price and quantity positively related; higher the product’s price, the more its producers will supply Supply Schedules and Supply Curves - Supply schedule: table showing relationship between quantity supply and price of commodity, ceteris paribus - Supply curve: graphical representation of relationship between quantity supplied and price of commodity, ceteris paribus o Single point on curve refers to quantity supplied at that price - Supply: entire relationship between quantity of some commodity that producers wish to sell and price of commodity, ceteris paribus Shifts in the Supply Curve - Shift in supply curve means that at each price there is change in quantity supplied - Supply AND demand: change in any of variables other than product’s own price affecting quantity supplied will shift curve to new position 1. Price of Inputs - Inputs: all things firm uses to produce outputs o Materials, labour, machines - The more expensive the input, the less the firm will produce and offer for sale 2. Technology - Innovations decreasing amount of inputs needed per unit of output reduces production costs 3. Government Taxes or Subsidies - Taxes make it more expensive, subsidies make it less 4. Prices of Other Products - Change in price of one product may lead to changes in supply of other product because the two are substitutes or complements 5. Number of Supplies - Increasing suppliers shifts supply curve right Movements Along the Curve Versus Shifts of the Whole Curve - Change in supply: change in quantity supplied at every price represented by shift in whole supply curve - Change in quantity supplied: change in specific quantity supplied represented by change from one point on supply curve to another on either original or new curve o Result from change in supply with price constant, movement along given curve because of change in price, or both 3.3 The Determination of Price - Three conditions for price determination in market to be described by demand-and-supply mode 1. Large number of consumers of product, each one small relative to size of market 2. Large enough number of producers of product, each small relative to size of market 3. Producers willing to sell homogeneous versions of product The Concept of a Market - Market: situation in which buyers and sellers negotiate exchange of goods or services - Different degrees of competition - Perfectly competitive markets: number of buyers and sellers large enough so that no one has influence on market price Market Equilibrium - Excess demand: quantity demanded excess quantity supplied at given price - Excess supply: quantity supplied exceeds quantity demanded at given price - Excess supply causes downwards pressure on price - Excess demand causes upward pressure on price - Equilibrium price: price at which quantity demanded equals quantity supplied; aka market- clearing price o Will stay until disturbed by change in market condition shifting curve(s) - Disequilibrium price: price at which quantity demanded does not equal quantity supplied - Disequilibrium :market in which there is excess demand or excess supply Changes in Market Equilibrium - Demand/supply curve will shift in any changes in any variables influencing quantity demanded or supplied (except price) - Possible shifts: (REFER TO FIGURE 3-8 PG.72) o Increase in demand – rightward shift in demand curve  Increase in equilibrium price and equilibrium quantity exchanged  Increase in demand creates shortage at initial price, buyers bid up price, rise in price causes larger quantity to be supplied; more exchanged at higher price o Decrease in demand – leftward shift in demand curve  Decrease in equilibrium price and equilibrium quantity exchanged  Decrease in demand creates surplus at initial price, sellers bid rice down, less product supplied; less exchanged at lower price o Increase in supply – rightward shift un supply curve  Increase in equilibrium price and decrease in equilibrium quantity exchanged  Increase in supply creates surplus at initial price and sellers force price down, increases quantity demanded; lower price and higher quantity o Decrease in supply – leftward shift in supply curve  Increase in equilibrium price and decrease in equilibrium quantity exchanged  Decrease in supply creates shortage at initial price, prices bid up, reduces quantity demanded; higher price and lower quantity - Comparative statics: derivation of predictions by analyzing effect of change in exogenous variable on equilibrium o How endogenous variables (equilibrium price and quantity) change following exogenous variables (causing shifts in demand and supply curves) Relative Prices and Inflation - Absolute price/money price: amount of money that must be spent to acquire one unit of commodity - Relative price: ratio of absolute price of one to absolute price of another; ratio of two absolute prices - When referring to price of product, mean a change in product’s relative price – price of product relative to prices of all other goods Summary 3.1 Demand - Quantity demanded: amount of product that consumers want to purchase - Flow expressed as so much per period of time - Determined by tastes, income, product’s price, prices of other products, population size, future expectations - Relationship between quantity demanded and price represented by demand curve showing how much will be demanded at each price - Quantity demanded increases as price of product falls - Negatively sloped - Change in demand: shift in demand curve represents change in quantity demanded at each price - Increase in demand shifts curve right - Movement along demand curve (caused by change in product price) and shift of demand curve (caused by change in any other factors of demand) 3.2 Supply - Quantity supplied: amount of good that producers wish to sell - Flow quantity as so much per period of time - Depends on product price, inputs cost, number of suppliers, government taxes or subsidies, state of technology , prices of other products - Relationship between quantity supplied and price represented by supply curve showing how much will be supplied at each price - Quantity supplied increases when price increases - Positively sloped - Change in supply: shift in supply curve indicates change in quantity supply at each price - Increase in supply shifts curve right - Movement along supply curve ( change in product price) and shift of supply curve (change in any other factor of supply) 3.3 The Determination of Price - Equilibrium price: price at which quantity demanded equals quantity supplied - Excess demand of excess supply - Price rise when excess demand fall when excess upply - Comparative statics determine effects of shift in demand or supply o Increase in demand raises price and quantity o Decrease in demand lowers both o Increase in supply raises quantity but lowers price o Decrease in supply lowers quantity but raises price o Absolute price is price in terms of money o Relative price is in relation of other products Chapter 4 Elasticity 4.1 Price Elasticity of Demand - Decrease in supply causes price to rise and quantity to fall – how much will each change? Depends on price elasticity of demand - Demand is elastic when quantity demanded is responsive to change in prices - Demand is inelastic when quantity demanded is unresponsive to change in prices - The more responsive the quantity demanded is to changes in price, the less the change I equilibrium price and greater the change in equilibrium quantity resulting from shift in supply curve The Measurement of Price Elasticity  - To see price elasticity, demand curve on same scale and price and quantity were the same - Slope of demand curve shows amount by which price must change to cause unit change in quantity demanded - Same price and quantity means needn’t distinguish between percentage change and absolute change - More relevant to know percentage change o Compare increase in quantity demanded of cheese, t-shirts, and coffee machine if each reduces $2 o Also useful to know initial quantity demanded - Price elasticity of demand/demand elasticity (): measure of responsiveness of quantity demanded to change in commodity’s own price -  = % change in quantity demanded / % change in price - Variable causing change in quantity demanded is product’s own price, aka own-price elasticity of demand The Use of Average Price and Quantity in Computing Elasticity  - Use of averages to avoid ambiguity caused by fact that when price or quantity changes, change is different percentage of original value than of its new value (refer to example) - Use of averages for prices and quantities mean that measured elasticity of demand between any two points on demand curve is independent of whether movement is from A to B or B to A - Ex: Original price = 5 New price = 3 Average price = 4 Percentage decrease in price = [(5-3)/4]*100 = 50% instead of 2/5 * 100 = 40% or 2/3 * 100 = 67% -  = (ΔQ /average Q) / (Δp / average p) = (Q1 – Q0 / average Q) / (p1 – p0 / average p) - Elasticity is unit free Interpreting Numerical Elasticities - Demand curves have negative slopes so increase in price associated with decrease in quantity demanded - The more responsive the quantity demanded to a change in price, the greater the elasticity and the larger the  - Demand elasticity value can vary from zero to infinity - Elasticity is 0 when change in price leads to no change in quantity demanded o Vertical demand curve - Elasticity is large when small change in price leads to large change in quantity demanded o Almost horizontal demand curve o Horizontal demand curve when elasticity is infinite - Inelastic demand: elasticity < 1; percentage change in quantity demanded < percentage change in price - Elastic demand: elasticity > 1; percentage change in quantity demanded > percentage change in price - Unit elastic: elasticity = 1; percentage change in quantity demanded = percentage change in price - Linear demand curve only has constant elasticity when vertical or horizontal What Determines Elasticity of Demand?  - Availability of substitutes, time period Availability of Substitutes - Fall in price leads consumers to buy more of product and less of substitutes, rise in price leads consumers to buy less of product and more of substitutes - Products with close substitutes tend to have more elastic demands; products with no close substitutes tend to have inelastic demands - Narrowly defined products have more elastic demands than d more broadly defined products Short Run and Long Run - Inelastic demand in short run may be elastic later – takes time to develop substitutes - Response to price change and thus price elasticity of demand will be greater the longer the time span - Short-run demand curve shows immediate response of quantity demanded to change in price - Long-run demand curve shows response of quantity demanded to change in price after enough time to develop substitutes - Effects of increase in supply: o In short-run, movement down the inelastic short-run demand curve causing large fall in price but small increase in quantity o In long-run, demand more elastic so price and quantity above short-run equilibrium Elasticity and Total Expenditure  - Quantity demanded increases as price falls but total expenditure depends on price elasticity of demand o Depends on relative change in price and quantity - Total Expenditure = Price * Quantity 4.2 Price Elasticity of Supply - Price elasticity of supply: measure of responsiveness of quantity supplied to change in product’s own price - S= Percentage change in quantity supplied / Percentage change in price - Increase in price causes increase in quantity supplied - Positive slopes - Price and quantity change in same direction - S= (ΔQ /average Q) / (Δp / average p) - Elastic supply:  > 1 S - Inelastic supply:  S 1 - Vertical supply curve:  =S0; quantity supplied does not change as price changes - Horizontal supply curve:  = Snfinity; Determinants of Supply Elasticity Substitution and Production Costs - Ease of substitution varies on how easy it is to shift form production from one to another - Cost of producing a unit of output as output rises o If production cost rises as rapidly as output, supply tends to be inelastic o If production cost rises slowly as production increases, supply tends to be elastic Short Run and Long Run - Difficulty in changing quantity supplied in changing quantity supplied in response to price increase in short amount of time - Short-run supplied curve shows immediate response of quantity supplied to change in price given producers’ current capacity to produce good - Long-run supply curve shows response of quantity supplied to change in price after enough time to adjust productive capacity - Long-run supply for product is more elastic than short-run supply - If increase in supply: o Short-run immediate shift in demand, increase in price but only small quantity increase 4.3 An Important Example Where Elasticity Matters - Excise tax: tax on sale of particular commodity - Tax incidence: location of tax burden; identity of ultimate tax bearer - Burden of tax incidence distributed between consumers and sellers in manner that depends on relative Elasticities of supply and demand - Consumer price: price paid by consumer - Seller price: price ultimately received by seller - With excise tax, difference between consumer price and seller price differ by amount of tax - Excise tax reduces supply curve causing movement along demand curve, reducing equilibrium quantity, raising consumer price and lowering seller price - Difference between consumer price and seller price same as amount of excise tax - After imposition of excise tax, difference between consumer and seller prices equal to tax; in new equilibrium, quantity exchanged less than exchange before tax - When demand is inelastic relative to supply, consumers bear most of tax burden, when supply is inelastic relative to demand, producers bear most of tax 4.2 Other Demand Elasticities - Change in income and prices of other products also lead to changes in quantity demanded (other than price) Income Elasticity of demand - Income elasticity of demand: measure of responsiveness of quantity demanded to a change in income - Y= percentage change in quantity demanded / percentage change in income - Normal goods: good for which quantity demanded rises as income rises; positive income elasticity - Inferior goods: good for which quantity demanded falls as income rises; negative income elasticity Luxury Versus Necessities - Necessities: products for which income elasticity of demand is positive but less than 1 - Luxuries: products for which income elasticity of demand is positive and greater than 1 - The more necessary an item, the lower its income elasticity - Inferior goods have negative income elasticity because increase in income leads to reduction in quantity demanded o Ex: instant noodles Cross Elasticity of Demand - Cross elasticity of demand: responsiveness of quantity demanded to change in price of another product - XY percentage change in quantity demanded of good X / percentage change in price of good Y - Change in price of good Y causes demand curve for good X to shift - If X and Y are substitutes, increase in Y leads to increase in demand for X - If X and Y are complements, increase in Y leads to reduction in demand for X - Positive of negative signs of cross Elasticities tell whether goods are substitutes or complements Summary 4.1 Price Elasticity of Demand - Price elasticity of demand is measure of extent to which quantity demanded of product responds to change in price -  = % change in quantity demanded / % change in price - % change calculated as change divided by average value - Elasticity as positive number from zero to infinity - Elasticity < 1 inelastic - % change in quantity demanded less than % change in price - Elasticity > 1 elastic - % change in quantity demanded more than % change in price - Determinant of demand elasticity is availability of substitutes - Items with few substitutes in short run tend to develop more later – demand more elastic in long run than short run - Elasticity and total expenditure related o Elasticity less than 1, total expenditure positively related with price o Elasticity 1, total expenditure does not change as price changes 4.2 Price Elasticity of Supply - Elasticity of supply measures extend to which quantity supplied changes when price of product changes -  = % change in quantity supplied / % change in price S - Supply tends to be more elastic in long run than short run because takes more time to alter output in response to price changes 4.3 An Important Example Where Elasticity Matters - Distribution of burden of excise tax between costumers and producers depends on relative Elasticities of supply and demand for product - The less elastic demand is relative to supply, the more of the burden of an excise tax falls on consumers 4.4 Other Demand Elasticities - Income elasticity of demand is measure of extent to which quantity demanded of some product changes as income changes - Y= % change in quantity demanded / % change in income - Cross elasticity of demand is measure of extent to which quantity demanded of one product changes when price of different product changes -  = % change in quantity demanded of good X / % change in price of good Y XY - Used to define products that are substitutes (positive cross elasticity) or complements (negative cross elasticity) Chapter 5 Markets in Action 5.1 The Interaction Among Markets - Markets do not work in isolation - Feedback: change in one markets affecting others affect the first - Partial equilibrium analysis: analysis of single market in isolation, ignoring feedbacks from induced changes in other markets - If specific market is small relative to entire economy, changes will have small effects on others, whose feedback effects will be even smaller - General-equilibrium analysis: analysis of all economy’s markets simultaneously, recognizing interactions among various markets 5.1 Government­Controlled Prices - Mostly in labour and rental housing markets - In free market, equilibrium price equates quantity demanded with quantity supplied - Government price controls are policies attempting to hold price at disequilibrium value o Holding price below equilibrium value creates shortage at controlled price o Holding price above equilibrium value creates surplus at controlled price Disequilibrium Prices - Quantity exchanged is determined by the lesser of quantity demanded or quantity supplied Price Floors - Price floor: minimum permissible price that can be charged for good o No effect if below free-market equilibrium o Binding if above equilibrium since raises prices o Ex: rules making it illegal to sell below price or gov’t buying excess supply - Binding prices floors lead to excess supply - Ex: people succeeding in selling products are price floors better off than selling at equilibrium price Price ceilings - Price ceiling: maximum price at which certain goods and services may be exchanged o No effect above free-market equilibrium o Binding if below free-market equilibrium, lowers price - Leads to excess demand - Invites black market Allocating a Product in Excess Demand - First-come first-served basis - Sellers’ preferences: allocation of commodities in excess demand by decision of sellers - Gov’t can ration the product o Only enough ration coupons to match quantity supplied at price ceiling o Distributed equally or on criterion basis Black Markets - From binding price ceilings because profit can be made from buying at controlled price and selling at black-market price - Black market: goods sold at price violating legal price control - Gov’t goals when setting price ceilings: o Restrict production  if can sell at prices higher than price ceiling price, incentive to produce more at higher price o Keep specific prices down  actual prices not kept down, if quantity below equilibrium, black-market prices higher than free-market price o Satisfy notions of equity in consumption of product that is temporarily in short supply  sold only to those who can afford black-market price 5.2 Rent Controls: A Case Study of Price Ceilings The Predicted Effects of Rent Control - Case of price ceilings 1. Shortage of rental housing  quantity demanded will exceed quantity supplied a. Below free-market levels  quantity of rent less than free-market rents 2. Shortage leads to alternative allocation scheme a. Sellers’ preference, gov’t intervention (security-of-tenure law protecting tenants from eviction) 3. Black markets a. Key money equal to difference b. Force tenants out without security-of-tenure - Rent control applied to durable goods - Short-run supply curve inelastic – not much change - Long-run supply curve elastic – funds will go elsewhere if expected rate of return falls - Shortage mainly from increase in demand and not decrease in supply - Existing tenants accommodations poorly suited to needs, new tenants difficulty finding rental accommodations except at black-market prices Who Gains and Who Loses? - Existing tenants principal gainers, as gap between controlled and free-market grows and rent available falls - Landlords suffer, do not get expected rate of return - Future tenants, not enough rent so live far from needed places Policy Alternatives - Meant to protect lower-income tenants - Market solution lets rent rise enough to cover rising costs and if people cannot afford, construction ceases; however, likely that consumers will put more towards consuming of housing - Binding rent control creates shortages - Gov’t can remove shortage if subsidizes or produce public housing at taxpayer expense; provide income assistance 5.3 An Introduction to Market Efficiency Demand as “Value” and Supply as “Cost” - For each unit of product, price on demand curve shows value to consumers from consuming that unit o Maximum price reflect value consumers place on product - For each unit of product, price on supply curve shows lowest acceptable price for firms to sell that unit o Reflects additional cost to firm from producing that unit Economic Surplus and Market Efficiency - For any given quantity of product, area below demand curve and above supply curve shows economic surplus associated with production and consumption of that product - Economic surplus is net value that society as a whole receives by producing and consuming the product - Arises because firms and consumers took resources with lower value (shown by eight of supply curve) and transformed it into something valued (shown by height of demand curve) - Value of consumption is greater than cost necessary to produce - Producing and consuming adds value and generates benefits for society - Competitive market will maximize economic surplus and be efficient when price is free to achieve market-clearing level Market Efficiency and Price Controls - Price floor, quantity exchanged decreases - Deadweight loss caused by binding price floor representing overall loss of economic surplus to society o Size reflects extent of market inefficiency o Area between quantity exchanged equilibrium and at the quantity exchanged at the price floor and price floor/price ceiling One Final Application: Output Quotas - Output quota restricts total output o Distributes quotas (licenses to produce) - Prices rise - Deadweight loss of output quota showing overall loss of economic surplus between the two quantities - Binding output quotas lead to reduction in output and reduction in overall economic surplus A Cautionary Word - Effect of gov’t policies to control prices o Redistribution between buyers and sellers – one better off while other worse off o Reduction in overall amount of economic surplus – inefficient outcome and society worse off - Gov’t desire to help specific group of people; overall costs worthwhile to achieve effect - Normative judgement with policy that redistributes economic surplus but reduces total amount of economic surplus available Summary 5.1 The Interaction Among Markets - Partial-equilibrium analysis of single market in isolation of others - General-equilibrium analysis study of all markets 5.2 Government-Controlled Prices - Policies attempting to hold price at disequilibrium value - Binding price floor above equilibrium price o Leads to excess supply – cannot be sold or gov’t buys it - Binding price ceiling below equilibrium price o Leads to excess demand, incentive for black marketeers to buy at controlled price and sell at higher price 5.3 Rent Controls: A Case Study of price Ceilings - Rent control form of price ceiling - Shortage of rentals and allocation by sellers’ preferences - Supply of rent more elastic in long run than short run- housing shortage by rent control worsens over time 5.4 An Introduction to Market Efficiency - Demand curve shows consumer willingness to pay for each unit - Area below demand curve shows overall value consumers place on that quantity - Supply curve show lowest price producers prepared to accept - Area below demand curve and above supply curve (up to there) shows economic surplus generated by production and consumption - Economic surplus measure of market efficiency - Surplus maximized when quantity exchanged determined by intersection of demand and supply curves – efficient - Intervening policies lead to reduction of economic surplus Chapter 6 Consumer Behaviour 6.1 Marginal Utility and Consumer Choice Assume that when consumers make choice, motivated to maximize utility: total satisfaction consumers derive from goods and services they consume Total utility: total satisfaction resulting from consumption of given commodity by consumer o Ex: total utility of consuming 5 bottles of juice per day is total satisfaction that those 5 juices provide Marginal utility: additional satisfaction obtained from consuming one additional unit of commodity o Ex: marginal utility of 5 juice consumed is the additional satisfaction provided by consumption of fifth juice each day Diminishing Marginal Utility - Central hypothesis of utility theory aka law of diminishing marginal utility: o Utility that consumer derives from successive units of particular product consumed over some period of time diminishes as total consumption of product increases (holding constant consumption of all other products) Utility Schedules and Graphs - Pg.126 - Total utility rises, but marginal utility declines, as consumption increases - Utility from each additional unit is less than that of previous one – marginal utility declines as quantity consumed rises Maximizing Utility - Consumers seek to maximize total utility subject to constraints they face – income, market prices Consumer’s Decision - How can consumers decide to allocate consumption in way to maximize utility? - Utility maximizing consumer allocates expenditures so that marginal utility obtained from last dollar spent on each product is equal - Marginal utility per dollar on X = MU /Xp x - Condition required for consumer to be maximizing utility for pair of products: o MU /Xp =xMU / py y An Alternative Interpretation  - Rearrange MU / X = Mx / p ty gey o MU x MU = y / x y - Right side is relative price of the two goods o Determined market and beyond individual control o React to prices - Left side is relative ability of two goods to add to utility o Within individual control because in determining quantities of different goods to buy, determines marginal utility - If 2 sides unequal, can increase total utility by rearranging purchases of X and Y Is This Realistic?  - Used to predict implications now explain thought process The Consumer’s Demand Curve - To derive consumer’s demand curve for product, ask what happens when there is change in price of product - Ex: o X represents juice, Y represents al other products taken together o What will Alison do if with all other prices remaining constant, there is increase in price of juice? o Can do better than spending less on everything else to spend more on juice o When price of juice rises, right side increases, but until Alison adjusts consumption, left side unchanged o After price change and before Alison reacts:  MU of juice / MU of Y < Price of juice / Price of Y o Hypothesis of diminishing marginal utility tells us that as she buys fewer bottles of juice, marginal utility of juice will rise and thereby increase ratio on left side o In response to increase in price of juice, reduce juice consumption until marginal utility of juice rises sufficiently that equation is restored o Rise in price of product with other determinants of demand constant leads consumer to reduce quantity demanded of product Market Demand Curves - All consumers will behave as above – thus theory of consumer behaviour predicts negatively sloped market demand curve in addition to negatively sloped demand curve for individual consumer - Market demand curves show relationship b/w product’s price and amount demanded by consumers - Market demand curve is horizontal sum of demand curves of individual consumers o Horizontal because add quantities demanded at given price - Add quantities demanded by consumers at each price, and result is market demand curve 6.2 Income and Substitution Effects of Price Changes - Alternative method for slope of individual’s demand curve rather relationship b/w than law of diminishing marginal utility and slope of individual’s demand curve - Fall in price of X o Reduction in price of X means fall in relative price of X, leading individual to substitute away from other products towards X o Because price of X fallen, more purchasing power or real income: income expressed in terms of purchasing power of money income – quantity of goods and services that can be purchased with money income The Substitution Effect - To isolate effect of change in relative price when price of X falls, consider what would happen if reduce individual’s money income to restore original purchasing power - Utility maximization requires ratio of marginal utility to price be same for all goods - If no change in behaviour with fall in price, utility not maximized - Quantity of X unchanged bur price fallen - To maximize utility after price drop, must increase consumption (reduce marginal utility) of X and reduce consumption of other goods o Substitute away from other goods and toward X - When purchasing power held constant, change in quantity demanded of good whose relative has changed is substitution effect: change in quantity of good demanded resulting from change in relative price (holding real income constant) o Increases quantity demanded of good whose price has fallen and reduces quantity demanded of good whose price has risen The Income Effect - Substitution effect – reduce money income following price reduction to see effect of relative price change, holding purchasing power constant - Now, effect of change in purchasing power, holding relative prices constant at new value - Income effect: change in quantity of good demanded resulting from change in real income (holding prices constant); change in quantity of X as result of reaction to increased real income - Size of income effect depends on amount of income spent on X and by amount price changes The Slope of the Demand Curve - Substitution effect leads consumers to increase demand for goods whose prices fall - Income effect leads consumers to buy more of all normal goods whose prices fall o NORMAL GOODS PRICES FALL RELATIVE TO CHANGE IN INCOME??? - Because of combined operation of income and substitution effects, demand curve for normal good will be negatively sloped – fall in price will increase quantity demanded - Sum of income and substitution effects determine total effect of price change, thus how overall quantity demanded responds to price reduction o All normal goods have negatively sloped demand curves, also for most inferior goods o Demand curves for inferior goods negatively sloped unless income effect outweighs substitution effect o Normal good – income and substitution effects work in same direction o Inferior good – income effect only partially offsets substitution effect o Few inferior goods, Giffen goods – income effect outweighs substitution effect Giffen Goods  - Giffen good: inferior good for which income effect outweighs substitution effect so that demand curve is positively sloped o Inferior good – reduction in real income leads households to purchase more of that good o Good must take large proportion of total household expenditure and therefore have large income effect Conspicuous Consumption Goods - (Veblen) some products consumed not for intrinsic qualities but because of snob appeal o The more expensive a commodity, the greater its ability to confer status of purchaser - When individual buys more goods at higher price because of higher price violates law of demand o What really appeals is what other people think o But would still buy more at lower price (hence negatively sloped demand curves) as long as were sure that people thought they had paid high price - Unlikely that market demand curve is positively sloped o Lower-income consumers will buy expensive commodities if prices fall – commodities sufficiently inexpensive suggesting that positively sloped demand curves for few individual wealthy households more likely than positively sloped market demand curve for same commodity 6.3 Consumer Surplus - Consumer behaviour explains demand curves o Law of diminishing marginal utility The Concept - Consumer surplus: diff b/w total value that consumers place on all units consumed of commodity and payment actually make to purchase amount of commodity o Diff b/w market price and max price consumer willing to pay to obtain unit - Consequence of negatively sloped demand curves - Think of individual’s demand curve as willingness to pay for successive units of product - Ex: values individual puts on litres of milk consumed each week – pay progressively smaller amounts for each additional unit consumed  EXAMPLE CONFUSING PG.136??? o If market price is $1/L, buy 6L of milk/week o Sum of values placed on each L is total value on all litres o Will keep buying milk as long as values each L at least as much as market price - For any unit consumed, consumer surplus is the difference b/w maximum amount consumer is prepared to pay for and price consumer actually pays - Market demand curve shows valuation that consumers place on each unit of product; for any given quantity, area under demand curve and above price line shows consumer surplus received from consuming units - Total consumer surplus is area under demand curve and above price line o Area under demand curve shows total valuation placed on all units consumed The Paradox of Value - Necessary products such as water have low prices compared to luxury products such as diamonds - Distinction b/w total and marginal value o Total value – area under demand curve of total value placed on all units consumed o Marginal value – consumer values last unit consumed of any product at market price - Supply plays an equally important role as demand - Two products can have diff market prices (marginal prices) even if respective prices don’t reflect total value consumers place on goods - Market rice doesn’t just reflect total value placed on product – supply also matters - Good that is plentiful will have low price and will be consumed where all consumers place low value on last unit consumed, whether or not place high value on total consumption - Product scarce will have high market price and consumption will stop when consumers place high value on last unit consumed regardless of value placed on total consumption - Because market price of product depends on demand supply, product which consumers place at high total value (water) selling for low price and hence having low marginal value Summary  6.1 Marginal Utility and Consumer Choice - Marginal utility theory distinguishes b/w total utility from consumption of all units and incremental/marginal utility derived from consuming one more unit - Assumption in marginal utility theory is that utility consumers derive from consumption of successive units of product diminishes as number of units consumed increases - Consumers assume to make decisions to maximize utility - Utility maximizing consumers make choices such that utilities derived from last dollar spend on each product are equal - For goods X, Y, utility maximized when MU / pX= MX / p Y Y - Demand curves have negative slopes because when price of one product falls, each consumer responds by increasing purchases of product sufficiently to restore ratio of product’s marginal utility to now lower price (MU/p) to same level achieved for all other demands - Market demand curves for any product are derived by horizontally summing all of individual demand curves for product 6.2 Income and Substitution Effects of Price Changes - Change in price of product generates income and substitution effect - Substitution effect – reaction of consumer to change in relative prices, with purchasing power/real income held constant - Income effect – leads consumer to increase purchases of product whose relative prices has fallen - Income effect – reaction of consumer to change in purchasing power/real income caused by price change, holding relative prices constant at new level o Fall in one price will lead to increase in consumer’s real income, thus to increase in purchase of normal goods - Combined income and substitution effects ensure that quantity demanded of any normal good will increase when price falls o Normal goods have negatively sloped demand curves - Inferior good has negatively sloped demand curve unless income effect strong enough to outweigh substitution effect o Rarely, and is Giffen good 6.3 Consume Surplus - For each unit of product, consumer surplus is diff b/w what willing to pay and what actually pay - Arises because demand curves are negatively sloped and purchase units up to point where value of marginal unit consumed (marginal value) equals market price o All units before marginal, consumers value produce more than price and thus consumer surplus o Distinction b/w total and marginal values  Paradox of values involves confusion o Price related to marginal value that consumers place on habit more or less of product  No necessary relationship to total value placed on all units consumed Appendix to Chapter 6 Indifference Curves 6A.1 Indifference Curves - Indifference curve shows all combinations of products yielding same utility o Consumer is indifferent b/w combinations indicated by any 2 points on one indifference curve - Any point above indifference curve is preferred to any point on indifference curve; any point on curve is preferred to any point below it Diminishing Marginal Rate of Substitution - Marginal rate of substitution (MRS): amount of one product that consumer is willing to give up to get one more unit of another [Stopped here; only going to get relevant parts of appendices] 6A.2 The Budget Line - Indifference curves illustrate consumer’s tastes - Budget line illustrates available alternatives o Shows quantities of goods available given money incomes and prices of goods Chapter 7 Producers in the Short Run - Supply curve to understand how determined by firm behaviour - Compare real world firm with economic theory ones - Concepts of cost, revenues, profits - Profit determining allocation of resources - Determining most profitable quantity to produce and supply, see how cost vary with output - Short run – firm can only change some input, output governed by law of diminishing returns 7.1 What Are Firms? Organization of Firms - 6 organization ways: 1. Single proprietorship: 1 owner-manager personally responsible for all business aspects incl. debts 2. Ordinary partnership: 2 or more joint owners each personally responsible for all partnership’s debts 3. Limited partnership: 2 types of partners: a. General partners run business and liable for all firm’s debts b. Limited partners no part in running business and liability limited to amount invested 4. Corporation: firm with legal existence separate from owners; owners not personally responsible for anything done in firm’s name, though directors may be o Shares of private corporation not traded on exchange stocks unlike public corporation’s 5. State-owned enterprise: gov’t owned firm – Crown corporations; usually under direction of ~independent state-owned enterprise similar to corporation’s 6. Non-profit organizations: firms providing goods and services with objective of just covering costs – NGOs; profits generated remains w/ organization and not individuals, some goods/services free of charge o Revenue through sales and donations - Multinational enterprises (MNEs): firms operating in more than 1 country o Unusual for single proprietorship and ordinary partnership, common for limited partnerships o Int’l trade, globalization - Not all economic production within firms – gov’t agencies provide goods/services w/o direct charge but through general tax revenues Financing of Firms - Financial capital: $ firm raises for carrying on business - Real capital: firm’s physical assets o Factories, machinery, offices, vehicles, stocks - Basic types of financial capital: equity and debt Equity - Funds provided by owners of firm - Individual proprietorship and partnership: 1 or more owner provides required funds - Corporation acquires funds from owners in return for stocks, shares, equities – ownership certificates o Money goes to company and shareholders become owners risking loss of money and gaining right to share in firm’s profits o Dividends: profits paid to shareholders o Retained earnings: firm raising money by retaining current profits rather than paying to shareholders Debt - Funds borrowed from creditors (individuals, institutions) outside of firm - Lent money for return for form of loan agreement - Firms borrow from commercial banks, financial institutions channeling money from depositors to invested borrowers - Borrow money directly from non-bank lenders with loan agreements  debt instruments, bonds: debt instrument carrying specified amount, schedule of interest payments and usually date for redemption of face value - 2 characteristics common to all loan agreements: o Principal: obligation to repay amount borrowed o Interest: obligation to make form of payment to lender o Redemption date: time at which principal to be repaid o Term: amount of time b/w issue of debt and redemption date Goals of Firms - 2 assumptions about firm behavior: o Firms are profit-maximizers – make as much profit for owners as possible o Each firm is single, consistent decision-making unit - Public discussion about firms being socially responsible 7.2 Production, Costs, and Profits  Production - Inputs to produce - 4 categories of input o Outputs from other firm  Intermediate products  Spark plugs, electricity, steel o Provided directly by nature  Land owned or rented o Services of workers and managers employed o Services of physical capital  Facilities, machines - Trace intermediate products back to source, all by services of factors of production (Ch1) o Land, labour, capital - Production function: functional/technological relation showing maximum output produced by any given combination of inputs o Q=f(L, K) o Q: flow of output K: flow of capital services L: flow of labour services f: production function - Change s in firm’s technology alters relationship b/w inputs and outputs, reflected by changes in f Costs and Profits - Production function specifies maximum amount of output that can be obtained from inputs - Profits by taking revenues from selling outputs and subtracting costs from inputs Economic Versus Accounting Profits - Accounting: begin with firm’s revenues and subtract all explicit costs (costs involving purchase of goods/services by firm, ex: workers, rental, interest) - Accounting profits Revenues-Explicit costs - Economic: subtract explicit cost and implicit costs o Items for which there is no market transaction but still opportunity cost for firm o 2 implicit costs:  Opportunity cost of owner’s time  Opportunity cost of owner’s capital - Economic profit (pure profit) =revenues-(Explicit costs + Implicit costs) = Accounting profits-Implicit costs Opportunity Cost of Time - Esp. small and new firms, owners spend time developing business, pay less than what they could earn if offer labour services to other firms - Ex: entrepreneur earning $1000/month though could be earning $4000/month at other job  implicit cost to her firm of $3000/month (economic profit) Opportunity Cost of Financial Capital - What could be earned by lending amount to someone else in riskless loan? o Ex: government bond (no risk of default) w/ return 4%/year  risk-free rate of return on capital  opportunity cost since firm could close operations, lend out money and earn 4% return - What firm could earn in addition to ^ amount by lending money to another firm where risk of default equal to firm’s own risk of loss o Ex: return of 3%  risk premium at a cost – if firm does not expect to earn this much in own operations, could close down and lend money to equally risk firm and earn 7% (4% pure return + 3% risk premium - Possible for firm to have positive accounting profits and – economic profits - If accounting profits represent return equal to what is available if owner’s capital and time were used elsewhere, then opportunity costs just covered - Profits – return to owners - Economist interest in how profits affect resource allocation Profits and Resource Allocation - When resources valued by opportunity-cost principle, costs show how much would earn if used in best alternative uses - If revenues exceed opportunity cost, firm will be earning pure or economic profits - Owners will move resources into industry because earnings available greater there than alternatives - If economic losses, resources more highly valued in other uses - Economic profits and losses play signalling role in workings of free-market system - If 0 economic profits, no incentive for resources to move into or out of industry Profit­Maximizing Output - π= TR-TC Level of output maximizing firm’s profit = total revenue (sale of output)-total cost (production of output) - What happens to output depends on revenues and costs Time Horizons for Decision Making - Classify decisions making firms into 3 types: how to best use existing plant and equipment; what new plant equipment and production processes to select, given known technical possibilities – long run; how to encourage, adapt to, development of new technique – very long run The Short Run - Short run: time period in which quantity of some inputs cannot be increased beyond fixed amount available o Fixed factors: input whose quantity cannot be changed in short run  Usually element of capital (plant, equipment) but also land, management services, supply of skilled labour - Variable factors: input whose quantity can be changed over time period under consideration; inputs not fixed but can be varied in short run - not specific period of time The Long Run - Long run: time period in which all inputs may be varied but existing technology of production unchanged - not specific period of time - when firm planning to go into business, expand scale of operations, branch out new products/areas, change production method – planning decisions The Very Long Run - Very long run: time period long enough for technological possibilities 7.3 Production in the Short Run - Fixed factors of production – stock of capital - Variable inputs – intermediate inputs and labour services Total, Average, and Marginal Products - Total product (TP): total amount produced by firm during time period o Changes as variable factors used with given amount of fixed factor o Quantity lf labour increases as total output increases o Average product = Total product/Labour o Marginal product = change Total product/ change Labour  Change in output from level of labour input to another o Total product curve shows total product - Average product (AP): total product divided by number of units of variable factor used in production o AP = TP/L - As more labour is used, average product rises then falls - Point of diminishing average productivity: level of labour input at which average product reaches maximum - Marginal product (MP): change in total output resulting from one more unit of variable factor o MP = ΔTP/ ΔL o Change in output caused by change in quantity of variable factor o Point of diminishing marginal productivity: level of labour input at which marginal product reaches maximum Diminishing Marginal Product  - Law of diminishing returns: hypothesis that if increasing quantities of variable factor are applied to given quantity of fixed factors, marginal product of variable factor will eventually decrease - To increase output in SR, more variable factor combined with given amount of fixed factor - Ex: shop with 1 worker who must do everything, add more workers and get division of labour, but too many workers result in inefficiency because of fixed amount of space and machinery - Increase in population growth would be accompanied by fall in living standard – take into account improvements in techniques or production The Average­Marginal Relationship - Average returns also diminish - If increasing quantities of variable are applied to given quantity of fixed factors, average product will decrease - MP curve cuts AP curve at AP’s maximum point - Average product curve slopes upward as long as marginal product curve is above it o Doesn’t matter whether marginal product curve is upward or downward sloping o Marginal must exceed average - If marginal greater than average, average rising - If marginal less than average, average falling 7.4 Costs in the Short Run Defining Short­Run Costs Total Cost (TC) - Sum of all costs that firm incurs to produce given level of output - 2 parts: total fixed cost, total variable cost - TC = TFC+TVC Total Fixed Cost (TFC) - Cost of fixed factor(s) not varying with level of output - Aka overhead cost - Ex: renting factory Total Variable Cost (TVC) - Cost of variable factors varying directly with level of output o Rises when output rises and vice-versa o Ex: cost of labour Average Total Cost (ATC) - Total cost of producing number of units of output divided by number of units - Calculated as sum of average f
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