Let's take a closer look at what's behind the demand curve
and the behavior of consumers. How does a consumer decide to spend his/her income
on the many different things that he/she wants, i.e., food, clothing, housing, entertainment?
We assume that the goal of the consumer is to maximize his/her level of satisfaction
or joy, constrained by his/her income.
Economists
use the term utility as a measure of satisfaction, joy or happiness. How
much satisfaction does a person gain from eating a pizza or watching a movie? Measuring
utility is based solely on the preferences of the individual and has nothing to
do with the price of the good.
I.
Utility:
In economics, utility does not mean useful or utilitarian or practical. Utility
is a term that economists use for the satisfaction, pleasure or want-satisfying
power of a good or service. Utility is common to all goods that are desired. The
concept of utility is purely subjective, there is no way to objectively measure
the amount of utility that a consumer might be able to obtain from a particular
good. The utility that individuals receive from consuming a good depends on
their tastes and preferences. Economists assume that tastes are given and are
relatively stable.
A. Utility and Utils: Economists first developed
utility theory in terms of units of measurable utility, to which they applied
the term util. The ideas from such analysis are useful in understanding the
way in which consumers choose among alternatives.
B. Total and Marginal Utility:
Total utility is the amount of utility or
satisfaction measured in utils from consuming a good or service. Total
utility is the amount of satisfaction received from all the units of a good
or service consumed. Total utility is maximized when the marginal utility per
dollar of each good is equal and the entire budget is spent.
Marginal utility
is the change in total utility due to a one-unit change in the quantity of a
good consumed. Marginal utility is the change in total utility from one
additional unit of a good or service. Consumers make one choice over another
depending on the marginal utility of the choices.
C. Applying Marginal Analysis
to Utility: The formula for marginal utility is this: Marginal Utility = Change
in total utility ÷ change in number of units consumed.
D. Example: If water provides a greater utility than diamonds, why are diamonds
more expensive?
Chart: Marginal Utility of Diamonds
Chart: Marginal Utility of Water
Even though water
provides a greater utility than diamonds, diamonds are more expensive because
water is plentiful in most of the world, so its marginal utility is low.
II.
Diminishing Marginal Utility
Let’s do an experiment
in utility.
Step 01: Get some of your favorite candy, pastries or cookies.
Step 02: Take a bite and evaluate, on a scale from 0 to 100 (with 100 being
the greatest utility), the level of utility from that bite. Record the marginal
utility of that bite (i.e., how much you get from that one additional bite).
Step 03: Repeat step 02. It is important to be consistent with each unit consumed,
i.e., the same size and no drinking milk or water part way though. When you
run out of candy or your marginal utility goes to zero you can stop.
The law of diminishing marginal utility states that as more of the good
is consumed, the additional satisfaction from another bite will eventually decline.
The marginal utility is the satisfaction gained from each additional bite. As
more of the good is consumed, we gain less additional satisfaction from consuming
another unit. Thus even if a good were free and you could consume as much as
you wanted, there would be a limit to the amount you would consume due to the
law of diminishing marginal utility.
Summing the marginal utilities gives us the total utility. For example, let’s
say the first chocolate was an 85 and the second chocolate had a marginal utility
of 79, then the total utility from consuming two chocolates is 164. The total
utility from consuming three chocolates is 85+79+73 = 237. As long as our marginal
utility is positive our total utility increases although with diminishing marginal
utility it increases at a decreasing rate.
Can marginal utility be negative? Yes. At a holiday dinner, you may overeat
and suffer from indigestion afterwards to a point where you regret having eaten
too much, but at the time of the dinner, you expected greater utility from eating
the last of the meal. We would not willingly consume an item that gave us negative
marginal utility. Then why would an individual stuff themselves during a hot
dog eating contest where clearly the last hot dogs consumed are making them
worse off? Although the marginal utility from the last hot dog itself makes
the person worse off, the utility from winning the contest is greater, making
the marginal utility positive.
The marginal utility of an item can change. For example, during a drought water
provides a high positive marginal utility, and with more rain the marginal utility
declines. At some point, there is too much rain. It turns from being a good
utility to a bad one and the marginal utility of more rain, when it is already
flooding, is negative.
Diminishing Marginal Utility (4:15)
III. Consumer Equilibrium is a condition in
which total utility cannot increase by spending more of a given budget on one good
and spending less on another good.
Table: Marginal Utility
for Big Macs and Milkshakes (utils per day) ($2 each)
Consumer Equilibrium:
Price of Big Mac = $2
Consumer Equilibrium:
Price of Big Mac = $1
What happens to the
number of Big Macs bought when the price drops?
To restore maximum total utility, the consumer spends more on Big Macs when
the price drops.
IV.
Optimizing Consumption Choices:
Consumer optimum is a choice of a set of goods and services that maximizes the utility
of each consumer, subject to limited income. This optimum is reached when the marginal
utility of the last dollar spent on each good yields the same utility and all income
is spent.
V.
How a Price Change Affects the Consumer Optimum:
Starting from the consumer optimum, let the price of good A decrease. Consumers
respond to the price
decrease by consuming more. Before the price change, the marginal utility per last
dollar spent on each good was the same. With a lower price, the marginal utility
of the last dollar spent on good A is greater than the marginal utility per dollar
spent on other goods. If the law of diminishing marginal utility holds, the purchase
and consumption of additional units of A causes the marginal utility per dollar
spent on good A to fall. Eventually, the value of marginal utility per dollar spent
on good A will fall by enough to equate it with the marginal utility per last dollar
spent on each of the other goods and services consumed. This emphasizes the
law of demand, that is, as the price of a good declines, consumers will buy more
units of the good, and vice versa.
Two alternative explanations of demand
The Substitution Effect involves the price of a good when consumers substitute relatively
cheaper goods for relatively more expensive ones. It is a change
in the quantity demanded of a good or service caused by the change in its
price relative to substitutes. If the price of Pepsi falls and the price
of Coke remains unchanged, you will buy more Pepsi because it is less expensive
than Coke.
The Real-Income Effect occurs when a
change causes a change in the purchasing power of a buyer’s income. A decrease
in price will cause an increase in the quantity demanded since a fall in
the price of any good consumed results in an increase in real income (purchasing
power). As prices decline, your real income increases, increasing
your buying power, so you buy more units, ceteris paribus.
The substitution and income effect explanations prove the law of demand, that
is, as the price of a good declines, consumers will buy more units of the good,
and vice versa.
VI.
The Demand Curve Revisited:
Linking the law of diminishing marginal utility and rule of equal marginal
utilities per dollar gives a negative relationship between the quantity demanded
of a good or service and its price.
VII. Maximizing Utility
So how does the consumer decide what to purchase? Unfortunately everything has
a price and consumers only have so much money to spend. Consequently consumers
try to spend the limited money they have on what will give them the greatest
amount of satisfaction. The decision rule for utility maximization is to purchase
those items that give the greatest marginal utility per dollar and are affordable
or within the budget. Many grocery stores provide a tag that indicates the price
per pound for the good. This allows consumers to compare the cost per pound
for different brands or different sizes. The same concept is used for maximizing
utility but we divide the marginal utility by the price to get the marginal
utility per dollar.
VIII. How Businesses React
Knowing that individuals experience diminishing marginal utility, how do businesses
react? Recall that consumer surplus is the area below the demand curve but above
the price. Think of some examples of how businesses react given the law of diminishing
marginal utility.
One example is the price per unit based on package size. An ice cream store
has three different serving sizes -- a 6, 10 and 12 ounce cup. The price of
the smallest size, "Like It," is $4.29 or 71.5¢
per ounce. For just 32¢ more, one
can have four more ounces, "Love It," making the marginal cost per ounce 8¢
and the average cost per ounce 46¢.
Upgrading to the "Gotta Have It" size adds an additional two ounces with only
15.5¢ per ounce more and an average
cost per ounce of only 41¢. Certainly
the large size is cheaper per ounce, but not everyone wants to eat that large
of a serving. For those only wanting a small serving, the store takes advantage
of their greater willingness to pay for that portion size. Whether it's ice
cream, eggs, milk, popcorn or cereal, it is common practice to charge a higher
price per unit for a smaller package size. However it pays for consumers to
do the math since businesses will at times charge a higher price on the larger
packages size. If customers believe that bigger is always cheaper and fail to
do the math, they may get caught paying a higher price per unit.
I. Elasticity:
In economics, elasticity is another word for responsiveness, the extent to which
a change in price will cause the quantity demanded to change, ceteris paribus.
II.
Price Elasticity of Demand (PED or Ed):
the responsiveness of the quantity demanded of a commodity to changes in its
price
The price elasticity of demand is defined
as the percentage change in quantity demanded divided by the percentage change
in price.
Relative Quantities Only: In the price elasticity
formula percentage changes in quantity demanded are divided by percentage
changes in price. Absolute changes are not considered only changes in relative
amounts.
Always Negative: The law of demand states that
quantity demanded is inversely related to the relative price. Thus,
an increase in the price leads to a decrease in the quantity demanded.
Price elasticity of demand will always be negative. The negative
sign is ignored.
[where
△
means “change in”]
Problem: The Direction Dilemma: When we move along a demand curve between two
points, we get different answers to elasticity depending on whether we are moving
up or down the demand curve. (Look at the two previous examples.)
Economists solve this problem of different base points by using the midpoints
as the base points of changes in prices and quantity demanded.
Percent of change is the difference between the two numbers divided by the
original number.
(#1
– #2) ÷ #1
If there is an increase
from 3 units to 5, what is the percent change?
(3-5) ÷ 3 = .66 = 66%.
There is a 66% increase.
If there is a decrease
from 5 units to 3, what is the percent change? (5-3) ÷ 5 = .40 = 40%. There
is a 40% decrease.
Calculating Elasticity: The use of average values
of changes in price and quantity avoids the problem caused by using different
prices as starting points. The average percentage change in price and quantity
is computed over a given price range.
To avoid the direction dilemma while finding price elasticity of demand, economists
use the following formula.
Price Elasticity Ranges:
In general, the demand for a good is said to be inelastic (or relatively
inelastic) when the PED is less than one (in absolute value): that is, changes
in price have a relatively small effect on the quantity of the good demanded.
The demand for a good is said to be elastic (or relatively elastic)
when its PED is greater than one (in absolute value): that is, changes in price
have a relatively large effect on the quantity of a good demanded.
Which demand curve is
for a vital medicine and which is for candy?
A is the demand
curve for medicine because medicine is a necessity with few substitutes
and the price can change with little effect on the quantity demanded.
B is the demand
curve for candy because candy has many substitutes so a price change can
bring about a big change in the quantity demanded.
Extreme Elasticities: There are two extremes in price elasticities of demand
– perfectly inelastic demand (represents total unresponsiveness of quantity
demanded to price changes) or zero elasticity (represents total responsiveness,
which is called infinitely or perfectly elastic demand).
Price elasticity of
demand applies only to a specific range of prices.
Price
Elasticity of Demand Ranges
Total
Revenue Curve
Determinants of the Price Elasticity of Demand
Availability of substitutes: The more
substitutes a product has, the more sensitive consumers are to a price change,
and the more elastic the demand curve. If an individual is on insulin or
another particular type of medication for which few close substitutes exist,
then an increase in the price results in very little change in the quantity
demanded of the good. The price elasticity of demand is directly related
to the availability of good substitutes for a product.
Percent of Income: The larger the purchase
is to one’s budget, the more sensitive consumers are to a price change,
and the more elastic the demand curve. The percent of income spent on the
good influences the elasticity of demand. Think of your annual expenditures
on toothpicks or pencils. If the price of those items increased, by
say 20 percent, the quantity demanded would likely decrease very little
due to your annual expenditures on the item. Spending $.60 instead of $.50
each year on toothpicks doesn’t dramatically change the quantity demanded.
However for those items that make up a greater portion of our income, we
are more responsive. If the price of a car increases by 20 percent, the
quantity demanded is likely to decline significantly. In general, the greater
percent of income spent on the good the more elastic it becomes, all else
held constant.
Luxury or necessity: Those items that
are a necessities in life are more inelastic than items that are a luxury.
Food in general, salt, and life saving medical care are examples of necessities
and have lower price elasicities than luxury items such as: jewelry, yachts,
or vacation travel.
Market definition: The broader the
definition the fewer number of close available substitutes exist. If a single
gas station in town raises its price, there are several other gas stations
in town that sell a very similar product, thus the gas at a particular station
tends to be elastic. However, if we look at the entire market for gas, there
are few substitutes and the PED is inelastic.
Time period: The longer consumers have
to adjust, the more sensitive they are to a price change and the more elastic
the demand curve. In general, the price elasticity coefficient of demand
is higher the longer a price change persists. The longer the time period,
the more elastic a good becomes as more substitutes become available. If
the price of gas doubled, car owners would still need to buy gas. But in
time, they may choose to trade their larger vehicle in for one that is more
fuel efficient or uses an alternative fuel, or even choose to move to a
different apartment so that they are closer to work or able to use an alternative
method of public transportation. In the short run, the elasticity of gas
is estimated to be .2 while in the long run is .7.
How to Define the Short Run and the Long
Run: The long run is the period of time necessary for consumers to make
a full adjustment to a given price change, all other things held constant.
The short run is any period that is less than the long run.
III.
Cross-Price (or Cross) Elasticity of Demand (CPED)
measures the responsiveness of the quantity demanded for one good to a change
in the price of another good, ceteris paribus. It is measured as the percentage
change in the quantity demanded for the first good that occurs in response to the
percentage change in price of the second good. For example, if, in response to a
10% increase in the price of fuel, the demand of new cars that are fuel inefficient
decreased by 20%, the cross elasticity of demand would be -20%
÷ 10% = 2.
IV.
Income Elasticity of Demand (IED) measures the
responsiveness of the quantity demanded for a good or service to a change in the
income of the people demanding it, ceteris paribus. It is calculated as the
ratio of the percentage change in the quantity demanded to the percentage change
in income. For example, if in response to a 10% increase in income, the quantity
demanded for a good increased by 20%, the income elasticity of demand would be 20%
÷ 10% = 2.
V.
Price Elasticity of Supply (PES or Es):
a measure used in economics to show the responsiveness, or elasticity, of the
quantity supplied of a good or service to a change in its price. The elasticity
is defined as the percentage change in the quantity supplied divided by the percentage
change in price.
When the coefficient is less than one, the supply of the good can be described as
inelastic; when the coefficient is greater than one, the supply can be described
as elastic. An elasticity of zero indicates that the quantity supplied does
not respond to a price change: it is "fixed" in supply. Such goods often have no
labor component or are not produced, limiting the short run prospects of expansion.
If the coefficient is exactly one, the good is said to be unitary elastic.
The quantity of goods supplied can, in the short term, be different from the amount
produced, as manufacturers will have stocks which they can build up or run down.
Classifying Supply Elasticity: Supply is elastic
if a 1% increase in price elicits greater than 1% increase in the quantity supplied.
Supply is perfectly elastic if the slightest reduction in price will cause quantity
supplied to fall to zero. Supply is inelastic if a 1% increase in price elicits
a less than 1% increase in the quantity supplied. Supply is perfectly inelastic
if quantity supplied remains the same as price changes. If the percentage change
in the quantity supplied is just equal to the percentage change in the price,
then supply is unit-elastic.
Price Elasticity of Supply and Length of Time for
Adjustment: The longer the time for adjustment, the more price-elastic is the
supply curve. The reasons are (1) more firms are able to figure out ways to
increase or decrease production in an industry, and (2) more resources can flow
into (or out of) an industry through expansion (or contraction) of existing
firms.
Determinants of the Elasticity of Supply
Product type: The type of product impacts
how quickly a producer is able to respond to a change in price. A manufacturing
firm may be able to quickly adjust production levels with only minor adjustments
in the equipment while other products such as apples require several years
to establish a new orchard. Since child care services requires relatively
few skills compared to those of a physician, the supply elasticity of child
care services is more elastic than that of physician services. To provide
more physician care would require years of medical training.
Time: Time is a key determinant of
supply. In the case of apples and some other agriculture products, the immediate
elasticity of supply is very inelastic, i.e., there are only so many apples
available for sale today. However, with time producers are able to
respond to the increase in price, manufacturing firms can build new facilities,
farmers can plant additional acres to the particular crop. Thus in time,
the elasticity of supply becomes more elastic.
Production capacity: If a firm is already
operating at full capacity, then to increase supply would require building
additional facilities and purchasing new equipment. A firm that is operating
at below full capacity can respond to a price increase quicker than a firm
that is already at full capacity.
Input substitution (Flexibility and
Mobility): As the price of a good increases, how easily can inputs that
were used in the production of another good be switched over to producing
the good with the higher price?
VI. Using Elasticities
A firm’s profit is determined
by taking the total revenue minus the total cost. Total revenue is equal
to the price each unit sells for times the quantity or number of units sold. One
of the key decisions in business is determining what price to charge. We know from
the law of demand, that as the price increases/decreases the quantity demanded decreases/increases,
but the question is by how much? Does total revenue increase or decrease as we raise
or lower the price? The answer is, as is often the case in economics, it all
depends.
Let’s assume that the demand
for a given product can be represented by the equation, price = 100 - 0.5(quantity).
If the current price is $10 and the quantity demanded is 180, then a two dollar
increase in the price reduces the quantity demanded by four units. But even though
four units less are sold, the additional two dollars per unit sold increases the
total revenue.
P = 100 - 0.5(Q)
P1 = $10 Q1 = 180
TR = $1,800
P2 = $12 Q1 = 176
TR = $2,112
If the price is $90, the
quantity demanded is 20. Raising the price by two dollars decreases the quantity
demanded by four units. In this case, the total revenue would decline when the price
is increased.
P = 100 - 0.5(Q)
P1 = $90 Q1 = 20 TR = $1,800
P2 = $92 Q1 = 16 TR = $1,472
Understanding elasticities
is critical when making pricing decisions in business. For example, Disneyland and
Disneyworld offer a lower price for state residents. Since residents are closer
and can go more often, their elasticity of demand is more elastic and total revenue
for the company increases by decreasing the price. Nonresidents are less sensitive
to price changes; vacationers that are required to travel a long ways will likely
only go once during the year. Given that their demand is less elastic, the company
makes greater profits by charging them a higher price.
If a company can divide
their customers into different groups that have different elasticities, they are
able to charge each group according their elasticity of demand. These groups may
be by age, such as children rates or senior citizen discounts, or by geographical
region, as shown in the example above.
Understanding cross price
elasticities, businesses may reduce the price of a good below their actual cost.
These loss leaders are priced to get the customers into the store and while
purchasing that item, they also will purchase other items.
VII.
Government: Tax Incidence
Governments
can also use elasticities when determining the tax incidence or what portion of
a tax is ultimately borne by the consumers and the producers. Governments often
tax addictive substances such as alcohol and cigarettes since demand is relatively
inelastic. The government justifies these sin taxes in two ways. Since these
products can contribute to poorer health and additional medical costs that are often
paid for by all citizens, it is appropriate to tax those individuals using the products.
The second justification is that the demand for these products is inelastic so that
imposing a tax significantly increases tax revenues.
Elasticities
are used to determine how much of a tax is borne by the producer verses the consumer.
For example, when a tax is imposed on cigarettes, producers are able to pass along
most of the burden of the tax by raising the price. If the supply is more elastic
than demand, then the producer will bear a greater burden of the tax.
An institution that hires and organizes resources to produce and sell goods
and services, a firm is an organization that brings
together different factors of production, such as labor, land, capital and entrepreneurial
skill to produce a product or service that it hopes can be sold for a profit.
The entrepreneur is a residual claimant who makes profits and bears losses.
The Legal Organization
of Firms: The basic organization of all firms can be thought of in
terms of a few simple structures, the most important of which are the proprietorship,
partnership, and the corporation.
Proprietorship: A business owned by
one individual who makes the business decisions, receives all of the profits,
and is legally responsible for all of the debts of the firm.
Advantages of Proprietorships: They
are easy to form and to dissolve. All decision-making power resides
with the sole proprietor. Its profit is taxed only once.
Disadvantage of Proprietorships:
The proprietor faces unlimited liability. Proprietorships have limited
ability to raise funds. Proprietorships normally end when the proprietor
dies.
Partnership: A partnership is a business
owned by two or more co-owners, partners, who share the responsibilities
and the profits of the firm and are individually liable for all of the debts
of the partnership.
Advantages of Partnerships: They
are easy to form. Partnerships often help reduce the costs of monitoring
job performance. They permit more effective specialization in occupations
where, for legal or other reasons, the multiple talents needed for success
are unlikely to be uniform across individuals. The income of the partnerships
is treated as personal income and is subject only to personal taxation.
Disadvantages of Partnerships: The
partners each have unlimited liability. Decision-making is generally
more costly in a partnership than a proprietorship. Dissolution of the
partnership is generally necessary when a partner dies or voluntary
withdraws or when one or more partners wish to remove someone from the
partnership.
Corporation: A legal entity that may
conduct business in its own name just as an individual does. The owners
of a corporation, called shareholders, own shares of the firm’s profits
and have limited liability.
Advantages of Corporations: Owners
of a corporation (the shareholders) enjoy limited liability. The law
treats the corporation as a legal entity in and of itself; thus, the
corporation continues to exist even if one or more owners of the corporation
cease to be owners. Corporations are better able to raise large sums
of financial capital.
Disadvantages of Corporations: The
profits of the corporation are subject first to corporate taxation.
If any after-tax profits are distributed to shareholders as dividends,
such payments are treated as personal income to the shareholders and
subject to personal taxation. Corporations are potentially subject to
problems associated with the separation of ownership and control.
Corporate Financing Methods
Share of Stock: Stock is a legal claim to a
share of a corporation’s future profits. If it is common stock, it incorporates
certain voting rights regarding major policy
decisions of the corporation. If it is preferred stock its owners are accorded preferential
treatment in the payment of dividends.
Bond: A bond is a legal claim against a firm
that usually entitles the owner of the bond to receive a fixed annual coupon payment,
plus a lump-sum payment at the bond’s maturity date; bonds are issued in return
for funds lent to the firm.
Reinvestment: Profits or depreciation reserves
reinvested to purchase new capital equipment.
The Markets for Stocks and Bonds:
The largest and most prestigious of these markets are the New York Exchange
(NYSE) and the New York Bond Exchange, both located in New York City. More than
2,500 stocks are traded on the NYSE.
The Theory of Efficient Markets: The theory that all
publicly available information is incorporated in the price of stocks leaving no
forecastable profit opportunities. Stock prices thus follow a random walk where
prices are said to move independently in securities markets and that there are no
predictable trends that can be used to get rich quick.
Inside Information: Information about what is happening
in a corporation that is not available to the general public. This information allows
an investor to beat the market.
The objective of a firm is to maximize economic
profit. Profit is limited by: market structure (We’ll look at market structures
in the next unit.) and the technological (Technological doesn’t necessarily
mean technology.) constraints of production. The
firm is assumed to try to make the difference between total costs and total
revenues as large as possible. This allows the firm to be better able to obtain
financing and, thus, to grow.
Technology constraints: The quantity of output is limited by the
productivity of inputs. These constraints are different depending on the
time frame.
A firm’s production decisions depend on how those decisions affect
economic profit. Economic profit = revenue
minus opportunity cost. Economic profit is not the same as accounting profit
because opportunity cost is not identical to accounting cost.
Accounting profit is the difference between total
revenues and explicit costs. Explicit costs are costs that business managers
must take into account, because they must be paid. Economists are interested
in both explicit and implicit costs. Implicit costs are costs managers do not
necessarily have to take into account, such as the opportunity cost of owner-provided
factors of production.
A firm’s opportunity costs are divided into
explicit costs and implicit costs.
Explicit cost (money costs) is the amount a firm pays for its needed
factors of production (land, labor, capital, entrepreneurship).
Implicit cost
is the value of foregone opportunities. A firm incurs implicit cost when
it uses its own capital and uses its owner’s time or financial
resources. They represent a firm’s opportunity cost of using its own
resources or those provided by its owners without a corresponding cash
payment.
Implicit rental rate is the forgone income from using your assets,
rather than renting them to other firms. The implicit rental rate of
capital is made up of economic depreciation and implicit interest.
Economic depreciation is the change in the market price of a
piece of capital over a given time period, what you lose by not doing
something else with that piece of capital. This is an opportunity cost.
It is not the same as accounting depreciation, which involves using
a number of conventional rules to determine the loss of value in a piece
of capital over time.
Implicit Interest: The funds tied up in capital goods could
have been invested in other things that yield a return (e.g. interest
income). This is an opportunity cost.
Cost of the owner's resources: the income that the owner could
have earned in the best alternative job. Normal profit is the expected
return for supplying entrepreneurial ability.
Rent:
Economic rent is a payment for the use of any resource over and above its opportunity
cost. It can be viewed as a payment to resource owners in excess of what would
be necessary to call forth that amount of the resource.
Determining land rent: Rent is determined
by the demand for land interacting with a fixed supply of land.
Economic rent to labor: Pure economic
rents can explain part of the difference between the extraordinary earnings
of highly successful musicians and average musicians. Part of the wages
of superstars consists of economic rents because they would work for less
than they earn.
Economic rents and the allocation of resources:
Economic rents allocate resources to their highest valued uses. Those who
can most efficiently use the resources offer the highest payment.
Interest:
Interest is the payment for current rather than future command over resources,
the cost of obtaining credit, and the return paid to owners of capital.
Interest and Credit: Variations in the
rate of annual interest that must be paid for credit depend on the following
factors.
Length of Loan: In some cases,
the longer the loan will be outstanding, other things being equal, the
greater will be the interest rate charged.
Risk: The greater the risk of non-repayment
of the loan, other things being equal, the greater the interest rate
charged.
Handling Charges: The larger the
amount of the loan, the smaller the handling (or administrative) charges
are as a percentage of the total loan and, other things being equal,
the lower the interest rate.
Real Versus Nominal Rates: The market
rate of interest expressed in terms of today’s dollars is the nominal interest
rate. The real rate of interest is obtained by subtracting the anticipated
rate of inflation from the nominal rate of interest.
The Allocative Role of Interest: Interest
is a price that allocates loanable funds (credit) to consumers and to business.
Investment or capital projects with rates of return higher than the market
rate of interest in the credit market will be undertaken. The interest rate,
thus, allocates loanable funds to industries whose investments yield the
highest returns and where resources will be the most productive.
Present Value: the value of a future amount expressed in today’s
dollars; the most that someone would pay today to receive a certain sum
at some point in the future
Interest Rate: the amount of money paid per year to savers as a
percentage of the amount saved
II.
Short-Run Versus Long-Run:
The short-run is a time period when some inputs, such as plant
size, cannot be changed, a period of time in which the quantity
of at least one input is fixed. The long
run is a time period in which all factors of production can be varied,
a period of time in which the quantities of all inputs can be
varied.
Relationship
Between Output and Inputs:
The relationship between output and labor and capital inputs is
as follows: output per unit time period equals some function of
capital and labor inputs. Production is any activity that results
in the conversion of resources into products that can be used in
consumption.
The Production Function
Short Run vs. Long Run Production (1:21)
Average and Marginal Physical Product:
Average physical product is total product divided by the variable input.
Marginal physical product is the change in total product that occurs when
there is a one-unit change in the variable input.
Diminishing Marginal Returns:
The law of diminishing returns is the observation that successive increases
in a variable factor of production such as labor, added to fixed factors of
production, will reach a point beyond which the extra or marginal product that
can be attributed to each additional unit of the variable factor of production
will decline.
In other words, when more and more of a variable resource is added to a
given amount of a fixed resource, the resulting change in output will
eventually diminish and could become negative.
Short-Run Costs to the
Firm: In the short run some inputs are
fixed and some are variable and thus total costs consist of fixed and variable
costs. Also, total costs include both explicit and implicit costs.
Total Fixed Costs: Costs that do not
vary with output.
Total Variable Costs: Costs that vary
with the rate of production.
Short-Run Average Cost Curves:
Average Fixed Costs (AFC): Total
fixed costs divided by number of units produced.
Average Variable Costs (AVC): Total
variable costs divided by number of units produced.
Average Total Costs (ATC): Total
costs divided by number of units produced sometimes called average per-unit
total costs.
Marginal Cost: The change in total costs
due to a change in production of one unit, i.e., change in total cost divided
by change in output. When the marginal physical product (MPP) rises MC will
fall. When MPP falls (the point of diminishing marginal returns) MC will
begin to rise.
Relationship Between Average and Marginal
Costs: When marginal costs are less then both average total costs and
average variable costs, the latter two are falling. Conversely, when marginal
costs are greater than both average total costs and average variable costs,
the latter two are rising. Finally, marginal cost will equal both average
total costs and average variable costs at their respective minimum points.
Minimum Cost Points: The marginal cost
curve intersects the minimum point of the average total cost curve and the
minimum point of the average variable cost curve.
Relationship Between Diminishing
Marginal Returns and Cost Curves: Short-run
firm cost curves reflect the law of diminishing marginal returns. Given a constant
price of a variable input, MC declines as long as marginal product of the variable
resource goes up. At the point of diminishing marginal returns, MC will reach
a minimum. MC will then rise as the marginal product of the variable input declines.
The result is an MC curve that slopes down, hits a minimum, and slopes up. The
ATC curve and AVC curve are similarly affected. They will have a U shape in
the short run.
Long Run Cost Curves:
In the long run, all factors of production are variable. Long-run curves
are sometimes called planning curves, and the long run is sometimes called the
planning horizon.
Long-Run Average Cost Curve: This curve
is the locus of points representing the minimum unit cost of producing any
given rate of output, given current technology and resource prices, also,
the planning curve.
Why the Long-Run Average
Cost Curve is U-shaped: The reason it
is U-shaped is economies of scale that occur when output increases lead to decreases
in long-run average costs. Constant returns to scale is a situation in which
the long-run average cost curve of a firm remains flat, or horizontal, as output
increases. Diseconomies of scale occur when increases in output lead to increases
in long-run average costs.
Economies of Scale:
exist when the average cost of production by one firm becomes smaller as
the rate of output increases
Reasons for Economies of Scale
Specialization: As a firm’s scale
of operation increases, the opportunities for specialization in the
use of resource inputs also increase.
Dimensional Factor: Large-scale
firms require proportionately less input per unit of output simply because
certain inputs do not have to be physically doubled in order to double
the output.
Improved Productive Equipment: The
larger the scale of the enterprise, the more the firm is able to take
advantage of larger-volume (output capacity) types of machinery.
Why a Firm Might Experience Diseconomies
of Scale: One of the basic reasons that a firm could expect to run into
diseconomies of scale is that there are limits to efficient functioning
of management. Also, as more workers are hired a more than proportionate
increase in managers and staff people may be needed causing increased costs
per unit.
Minimum Efficient Scale:
The lowest rate of output per unit time period at which average costs
reach a minimum for a particular firm.
III. The analysis of short-run production is most concerned with the connection between the amount of product generated
by a firm and the quantity of the variable
input used. This gives rise to three
related product notions: total product, marginal product and average product.
Total, Marginal and Average Product
Labor
(workers/day)
Total
(toys/day)
Marginal
(toys/1 more unit)
Average
(toys/worker)
A
0
0
B
1
4
4
4
C
2
10
6
5
D
3
13
3
4.33
E
4
15
2
3.75
F
5
16
1
3.20
Total product is the total output produced.
Total Product Curve
Marginal product is the increase in total
product from a one-unit increase in an input.
Marginal Product Curve
Marginal product is measured by the slope of the total product curve.
Increasing marginal returns occur when the marginal product of an additional
worker exceeds that of the previous worker.
Decreasing marginal returns occur when the marginal product of an additional
worker is less than that of the previous worker.
Law of Diminishing Returns: As a firm uses more of a variable input, with
a given quantity of fixed inputs, the marginal product of the variable input
eventually diminishes.
Average product of an Input is the total
product divided by the quantity of an input.