Table of Contents utility THEORY I. Utility: Utility is a term that economists use for satisfaction 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 measure the amount of utility that a consumer might be able to obtain from a particular good. Utility does not mean “useful” or “utilitarian” or practical. The utility that individuals receive from consuming a good depends on their tastes and preferences. This chapter presents consumer decision making based on utility maximization. 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. Marginal utility is the change in total utility due to a one-unit change in the quantity of a good consumed. 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.
II. Diminishing Marginal Utility: The principle that as more of any good or service is consumed, the extra benefits of additional units eventually declines. There are eventually smaller and smaller increases in total utility from the consumption of a good or a service as more is consumed during a given time period. III. 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. IV. 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. A) The Substitution Effect: The substitution effect involves in price of a good when consumers substitute relatively cheaper goods for relatively more expensive ones. 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).
V. 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. elasticity I. Price Elasticity: Elasticity means responsiveness. In this section the extent to which a change in price will cause quantity demanded to change, other things constant. A) Price Elasticity of Demand: 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. 1. 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. 2. 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.
B) 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.
II. Price Elasticity Ranges: A good has an elastic demand whenever the price elasticity of demand is greater than 1. A good has unit elastic demand whenever the price elasticity of demand is equal to 1. A good has inelastic demand whenever the price elasticity of demand is less than 1. 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; the other represents total responsiveness, which is called infinitely or perfectly elastic demand. III. Determinants of the Price Elasticity of Demand: A) Existence of Substitutes: The closer the substitutes and the more substitutes there are for a particular commodity, the greater will be its price elasticity of demand. If the goods are perfect substitutes, the price elasticity of the good will be infinity. B) Share of Budget: The greater the percentage of total budget spent on the commodity, the greater is a person’s price elasticity of demand for that commodity. C) Time for Adjustment: The longer any price change persists, the greater the price elasticity of demand, other things held constant. Price elasticity of demand is greater in the long run than in the short run. 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.
IV. Cross Price Elasticity of Demand: The percentage change in the quantity demanded of one good (holding its price constant) divided by the percentage change in the price of a related good. When two goods are substitutes, the cross elasticity of demand will be positive. When two related goods are complements, the cross elasticity of demand will be negative. V. Income Elasticity of Demand: The percentage change in quantity demanded for any good holding its price constant divided by the percentage change in income; the responsiveness of the quantity demanded to changes in income holding its relative price constant. Income elasticity of demand refers to a horizontal shift in the demand curve in response to changes in income. VI. Elasticity of Supply: The elasticity supply refers to the responsiveness of the quantity supplied of a commodity to a change in its price. Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price. A) Classifying Supply Elasticity: Supply is elastic if a 1 percent increase in price elicits greater than 1 percent 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 percent increase in price elicits a less than 1 percent 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. B) 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.
rent I. 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. A) Determining Land Rent: Rent is determined by the demand for land interacting with a fixed supply of land. B) 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. C) 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.
II. Firms and Profits: 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. A) 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. 1. 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. (a) 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. (b) Disadvantage of Proprietorships: The proprietor faces unlimited liability. Proprietorships have limited ability to raise funds. Proprietorships normally end when the proprietor dies.
2. 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. (a) 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. (b) 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.
3. 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. (a) 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. (b) 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.
B) The Profits of a Firm: 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. C) Opportunity Cost of Capital: The normal rate of return is the amount that must be paid to an investor to induce investment in business. The normal rate of return is also the opportunity cost of capital. D) Opportunity Cost of Owner-Provided Labor and Capital: The wage or salary that the owner could have made in his/her highest valued employment working for someone else, and the return that he/she could have made on owner provided capital such as land or buildings. E) Accounting Profit Versus Economic Profit: Economic profits are the difference between total revenues and explicit and implicit costs. Accounting profits are the difference between total revenues and explicit costs. F) The Goal of the Firm: Profit Maximization: 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.
III. 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. A) Interest and Credit: Variations in the rate of annual interest that must be paid for credit depend on the following factors. 1. 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. 2. Risk: The greater the risk of non-repayment of the loan, other things being equal, the greater the interest rate charged. 3. 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.
B) 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. C) 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. D) Interest Rates and Present Value: Present value is 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.
IV. Corporate Financing Methods: A) 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. B) 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. C) Reinvestment: Profits or depreciation reserves reinvested to purchase new capital equipment.
V. 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. A) 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. B) 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.
SHORT-RUN VS. LONG-RUN I. Short-Run Versus Long-Run: The short-run is a time period when some inputs, such as plant size, cannot be changed. The long run is a time period in which all factors of production can be varied. II. 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. A) The Production Function B) 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.
III. Diminishing Marginal Returns: The law of diminishing returns is the observation that with 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. IV. 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. A) Total Fixed Costs: Costs that do not vary with output. B) Total Variable Costs: Costs that vary with the rate of production. C) Short-Run Average Cost Curves: 1. Average Fixed Costs (AFC): Total fixed costs divided by number of units produced. 2. Average Variable Costs (AVC): Total variable costs divided by number of units produced. 3. Average Total Costs (ATC): Total costs divided by number of units produced sometimes called average per-unit total costs.
D) 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. E) 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. F) 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.
V. 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. VI. 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. A) 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.
VII. 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. A) Reasons for Economies of Scale: 1. Specialization: As a firm’s scale of operation increases, the opportunities for specialization in the use of resource inputs also increase. 2. 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. 3. 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.
B) 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.
VIII. Minimum Efficient Scale: The lowest rate of output per unit time period at which average costs reach a minimum for a particular firm. | 
