chapter 5

Chapter 5

Uncertainty and Consumer Behavior

Introduction

• Choice with certainty is reasonably straightforward

• How do we make choices when certain variables such as income and prices are uncertain (making choices with risk)?

Describing Risk• To measure risk we must know:

1. All of the possible outcomes

2. The probability or likelihood that each outcome will occur

Describing Risk

• Interpreting Probability1. Objective Interpretation

• Based on the observed frequency of past events

2. Subjective Interpretation• Based on perception that an outcome will occur

Interpreting Probability

• Subjective Probability– Different information or different abilities to

process the same information can influence the subjective probability

– Based on judgment or experience

Describing Risk

• With an interpretation of probability, must determine 2 measures to help describe and compare risky choices1. Expected value

2. Variability

Describing Risk

• Expected Value– The weighted average of the payoffs or

values resulting from all possible outcomes• Expected value measures the central tendency;

the payoff or value expected on average

Expected Value – An Example

• Investment in offshore drilling exploration:

• Two outcomes are possible– Success – the stock price increases from $30

to $40/share– Failure – the stock price falls from $30 to

$20/share


• Objective Probability– 100 explorations, 25 successes and 75

failures– Probability (Pr) of success = 1/4 and the

probability of failure = 3/4


failure) of )(valuePr(failure

success) of )(valuePr(success EV

)($20/share43)($40/share41 EV

$25/share EV

Expected Value

• In general, for n possible outcomes:– Possible outcomes having payoffs X1, X2, …,

Xn

– Probabilities of each outcome is given by Pr1, Pr2, …, Prn

nn2211 XPr...XPrXPr E(X)

Describing Risk

• Variability– The extent to which possible outcomes of an

uncertain event may differ– How much variation exists in the possible

choice

Variability – An Example

• Suppose you are choosing between two part-time sales jobs that have the same expected income ($1,500)

• The first job is based entirely on commission

• The second is a salaried position

• There are two equally likely outcomes in the first job: $2,000 for a good sales job and $1,000 for a modestly successful one

• The second pays $1,510 most of the time (.99 probability), but you will earn $510 if the company goes out of business (.01 probability)



Outcome 1 Outcome 2

Prob. Income Prob. Income

Job 1: Commission .5 2000 .5 1000

Job 2: Fixed Salary .99 1510 .01 510

1500$ .5($1000).5($2000))E(X1


• Income from Possible Sales Job

Job 1 Expected Income

$1500.01($510).99($1510) )E(X2

Job 2 Expected Income

Variability

• While the expected values are the same, the variability is not

• Greater variability from expected values signals greater risk

• Variability comes from deviations in payoffs– Difference between expected payoff and

actual payoff


Deviations from Expected Income ($)

Outcome 1

Deviation Outcome 2

Deviation

Job 1$2000 $500 $1000 -$500

Job 21510 10 510 -900

Variability

• Average deviations are always zero so we must adjust for negative numbers

• We can measure variability with standard deviation – The square root of the average of the squares

of the deviations of the payoffs associated with each outcome from their expected value

Variability

• Standard deviation is a measure of risk– Measures how variable your payoff will be– More variability means more risk– Individuals generally prefer less variability –

less risk

Variability

• The standard deviation is written:

2222

11 )(Pr)(Pr XEXXEX

Standard Deviation – Example 1

Deviations from Expected Income ($)

Outcome 1

Deviation

Outcome 2

Deviation

Job 1 $2000 $500 $1000 -$500

Job 2 1510 10 510 -900

Standard Deviation – Example 1 • Standard deviations of the two jobs are:

500000,250

)000,250($5.0)000,250($5.0

1

1

50.99900,9

)100,980($01.0)100($99.0

2

2

2222

11 )(Pr)(Pr XEXXEX


• Job 1 has a larger standard deviation and therefore it is the riskier alternative

• The standard deviation also can be used when there are many outcomes instead of only two


• Job 1 is a job in which the income ranges from $1000 to $2000 in increments of $100 that are all equally likely

• Job 2 is a job in which the income ranges from $1300 to $1700 in increments of $100 that, also, are all equally likely

Outcome Probabilities - Two Jobs

Income

0.1

$1000 $1500 $2000

0.2

Job 1

Job 2

Job 1 has greater spread: greater

standard deviationand greater risk

than Job 2.

Probability

Decision Making – Example 1

• What if the outcome probabilities of two jobs have unequal probability of outcomes?– Job 1: greater spread and standard deviation– Peaked distribution: extreme payoffs are less

likely that those in the middle of the distribution

– You will choose job 2 again

Unequal Probability Outcomes

Job 1

Job 2

The distribution of payoffsassociated with Job 1 has a greater spread and standard

deviation than those with Job 2.

Income

0.1

$1000 $1500 $2000

0.2

Probability


• Suppose we add $100 to each payoff in Job 1 which makes the expected payoff = $1600– Job 1: expected income $1,600 and a

standard deviation of $500– Job 2: expected income of $1,500 and a

standard deviation of $99.50


• Which job should be chosen?– Depends on the individual– Some may be willing to take risk with higher

expected income– Some will prefer less risk even with lower

expected income

Risk and Crime Deterrence

• Attitudes toward risk affect willingness to break the law

• Suppose a city wants to deter people from double parking

• Monetary fines may be better than jail time

Risk and Crime Deterrence

• Costs of apprehending criminals are not zero, therefore– Fines must be higher than the costs to society– Probability of apprehension is actually less

than one

Risk and Crime Deterrence - Example

• Assumptions:1. Double-parking saves a person $5 in terms

of time spent searching for a parking space

2. The driver is risk neutral

3. Cost of apprehension is zero


• A fine greater than $5.00 would deter the driver from double parking– Benefit of double parking ($5) is less than the

cost ($6.00) equals a net benefit that is negative

– If the value of double parking is greater than $5.00, then the person would still break the law


• The same deterrence effect is obtained by either – A $50 fine with a 0.1 probability of being

caught resulting in an expected penalty of $5

or– A $500 fine with a 0.01 probability of being

caught resulting in an expected penalty of $5


• Enforcement costs are reduced with high fine and low probability

• Most effective if drivers don’t like to take risks

Preferences Toward Risk

• Can expand evaluation of risky alternative by considering utility that is obtained by risk– A consumer gets utility from income– Payoff measured in terms of utility

Preferences Toward Risk - Example

• A person is earning $15,000 and receiving 13.5 units of utility from the job

• She is considering a new, but risky job– 0.50 chance of $30,000– 0.50 chance of $10,000

Preferences Toward Risk - Example

• Utility at $30,000 is 18

• Utility at $10,000 is 10

• Must compare utility from the risky job with current utility of 13.5

• To evaluate the new job, we must calculate the expected utility of the risky job


• The expected utility of the risky option is the sum of the utilities associated with all her possible incomes weighted by the probability that each income will occur

E(u) = (Prob. of Utility 1) *(Utility 1)

+ (Prob. of Utility 2)*(Utility 2)

Preferences Toward Risk – Example

• The expected is:E(u) = (1/2)u($10,000) + (1/2)u($30,000)

= 0.5(10) + 0.5(18)

= 14– E(u) of new job is 14, which is greater than

the current utility of 13.5 and therefore preferred

Preferences Toward Risk• People differ in their preference toward

risk

• People can be risk averse, risk neutral, or risk loving


• Risk Averse– A person who prefers a certain given income

to a risky income with the same expected value

– The person has a diminishing marginal utility of income

– Most common attitude towards risk• Ex: Market for insurance

Risk Averse - Example

• A person can have a $20,000 job with 100% probability and receive a utility level of 16

• The person could have a job with a 0.5 chance of earning $30,000 and a 0.5 chance of earning $10,000

Risk Averse – Example

• Expected Income of Risky JobE(I) = (0.5)($30,000) + (0.5)($10,000)

E(I) = $20,000

• Expected Utility of Risky Job

E(u) = (0.5)(10) + (0.5)(18)

E(u) = 14

Risk Averse – Example

• Expected income from both jobs is the same – risk averse may choose current job

• Expected utility is greater for certain job– Would keep certain job

• Risk averse person’s losses (decreased utility) are more important than risky gains

Risk Averse

• Can see risk averse choices graphically

• Risky job has expected income = $20,000 with expected utility = 14 – Point F

• Certain job has expected income = $20,000 with utility = 16– Point D

Income ($1,000)

Utility

The consumer is risk averse because she would prefer a certain income of

$20,000 to an uncertain expected income =

$20,000

E

10

10 20

14

16

18

0 16 30

A

C

D

Risk Averse Utility Function

F


• A person is said to be risk neutral if they show no preference between a certain income, and an uncertain income with the same expected value

• Constant marginal utility of income

Risk Neutral

• Expected value for risky option is the same as utility for certain outcomeE(I) = (0.5)($10,000) + (0.5)($30,000)

= $20,000

E(u) = (0.5)(6) + (0.5)(18) = 12

• This is the same as the certain income of $20,000 with utility of 12

Income ($1,000)10 20

Utility

0 30

6A

E

C

12

18

The consumer is riskneutral and is indifferentbetween certain eventsand uncertain events

with the same expected income.

Risk Neutral


• A person is said to be risk loving if they show a preference toward an uncertain income over a certain income with the same expected value– Examples: Gambling, some criminal activities

• Increasing marginal utility of income

Risk Loving

• Expected value for risky option – point FE(I) = (0.5)($10,000) + (0.5)($30,000)

= $20,000

E(u) = (0.5)(3) + (0.5)(18) = 10.5

• Certain income is $20,000 with utility of 8 – point C

• Risky alternative is preferred

Income ($1,000)

Utility

0 10 20 30

The consumer is riskloving because she

would prefer the gamble to a certain income.

Risk Loving

3A

E

C8

18

F10.5


• The risk premium is the maximum amount of money that a risk-averse person would pay to avoid taking a risk

• The risk premium depends on the risky alternatives the person faces

Risk Premium – Example

• From the previous example– A person has a .5 probability of earning

$30,000 and a .5 probability of earning $10,000

– The expected income is $20,000 with expected utility of 14


• Point F shows the risky scenario – the utility of 14 can also be obtained with certain income of $16,000

• This person would be willing to pay up to $4000 (20 – 16) to avoid the risk of uncertain income

• Can show this graphically by drawing a straight line between the two points – line CF

Income ($1,000)

Utility

0 10 16

Here, the risk premium is $4,000 because a certain income of $16,000 gives the person

the same expected utility as the

uncertain income with expected value

of $20,000.

10

18

30 40

20

14

A

CE

G

20

Risk Premium

F


Risk Aversion and Indifference Curves

• Can describe a person’s risk aversion using indifference curves that relate expected income to variability of income (standard deviation)

• Since risk is undesirable, greater risk requires greater expected income to make the person equally well off

• Indifference curves are therefore upward sloping


Standard Deviation of Income

ExpectedIncome

Highly Risk Averse: Anincrease in standarddeviation requires a large increase in income to maintainsatisfaction.

U1

U2

U3


Standard Deviation of Income

ExpectedIncome

Slightly Risk Averse:A large increase in standarddeviation requires only a small increase in incometo maintain satisfaction.

U1

U2

U3

Reducing Risk

• Consumers are generally risk averse and therefore want to reduce risk

• Three ways consumers attempt to reduce risk are:1. Diversification

2. Insurance

3. Obtaining more information

Reducing Risk

• Diversification– Reducing risk by allocating resources to a

variety of activities whose outcomes are not closely related

• Example: – Suppose a firm has a choice of selling air

conditioners, heaters, or both– The probability of it being hot or cold is 0.5– How does a firm decide what to sell?

Income from Sales of Appliances

Hot WeatherCold

Weather

Air conditioner sales

$30,000 $12,000

Heater sales 12,000 30,000

Diversification – Example

• If the firm sells only heaters or air conditioners their income will be either $12,000 or $30,000

• Their expected income would be:– 1/2($12,000) + 1/2($30,000) = $21,000


• If the firm divides their time evenly between appliances, their air conditioning and heating sales would be half their original values

• If it were hot, their expected income would be $15,000 from air conditioners and $6,000 from heaters, or $21,000

• If it were cold, their expected income would be $6,000 from air conditioners and $15,000 from heaters, or $21,000


• With diversification, expected income is $21,000 with no risk

• Better off diversifying to minimize risk

• Firms can reduce risk by diversifying among a variety of activities that are not closely related

Reducing Risk – The Stock Market

• If invest all money in one stock, then take on a lot of risk– If that stock loses value, you lose all your

investment value

• Can spread risk out by investing in many different stocks or investments– Ex: Mutual funds

Reducing Risk – Insurance

• Risk averse are willing to pay to avoid risk

• If the cost of insurance equals the expected loss, risk averse people will buy enough insurance to recover fully from a potential financial loss

The Law of Large Numbers

• Insurance companies know that although single events are random and largely unpredictable, the average outcome of many similar events can be predicted

• When insurance companies sell many policies, they face relatively little risk

Reducing Risk – Actuarially Fair

• Insurance companies can be sure total premiums paid will equal total money paid out

• Companies set the premiums so money received will be enough to pay expected losses

The Value of Information

• Risk often exists because we don’t know all the information surrounding a decision

• Because of this, information is valuable and people are willing to pay for it

The Value of Information

• The value of complete information– The difference between the expected value of

a choice with complete information and the expected value when information is incomplete

The Value of Information – Example

• Per capita milk consumption has fallen over the years

• The milk producers engaged in market research to develop new sales strategies to encourage the consumption of milk


• Findings– Milk demand is seasonal with the greatest

demand in the spring– Price elasticity of demand is negative and

small– Income elasticity is positive and large


• Milk advertising increases sales most in the spring

• Allocating advertising based on this information in New York increased profits by 9% or $14 million

• The cost of the information was relatively low, while the value was substantial (increased profits)

Behavioral Economics

• Sometimes individuals’ behavior contradicts basic assumptions of consumer choice– More information about human behavior might

lead to better understanding– This is the objective of behavioral

economics• Improving understanding of consumer choice by

incorporating more realistic and detailed assumptions regarding human behavior


• There are a number of examples of consumer choice contradictions– You take at trip and stop at a restaurant that

you will most likely never stop at again. You still think it fair to leave a 15% tip rewarding the good service.

– You choose to buy a lottery ticket even though the expected value is less than the price of the ticket


• Reference Points– Economists assume that consumers place a

unique value on the goods/services purchased

– Psychologists have found that perceived value can depend on circumstances

• You are able to buy a ticket to the sold out Cher concert for the published price of $125. You find out you can sell the ticket for $500 but you choose not to, even though you would never have paid more than $250 for the ticket.


• Reference Points (cont.)– The point from which an individual makes a

consumption decision– From the example, owning the Cher ticket is

the reference point• Individuals dislike losing things they own• They value items more when they own them than

when they do not• Losses are valued more than gains• Utility loss from selling the ticket is greater than

original utility gain from purchasing it


• Experimental Economics– Students were divided into two groups– Group one was given a mug with a market

value of $5.00– Group two received nothing– Students with mugs were asked how much

they would take to sell the mug back• Lowest price for mugs, on average, was $7.00


• Experimental Economics (cont.)– Group without mugs was asked minimum

amount of cash they would except in lieu of the mug

• On average willing to accept $3.50 instead of getting the mug

– Group one had reference point of owning the mug

– Group two had reference point of no mug


• Fairness– Individuals often make choices because they

think they are fair and appropriate• Charitable giving, tipping in restaurants

– Some consumers will go out of their way to punish a store they think is “unfair” in their pricing

– Manager might offer higher than market wages to make for happier working environment or more productive worker

Chapter 6

Production

Introduction

• Our study of consumer behavior was broken down into 3 steps: – Describing consumer preferences– Consumers face budget constraints– Consumers choose to maximize utility

• Production decisions of a firm are similar to consumer decisions– Can also be broken down into three steps

Production Decisions of a Firm

1. Production Technology– Describe how inputs can be transformed into

outputs• Inputs: land, labor, capital and raw materials• Outputs: cars, desks, books, etc.

– Firms can produce different amounts of outputs using different combinations of inputs


2. Cost Constraints– Firms must consider prices of labor, capital

and other inputs– Firms want to minimize total production costs

partly determined by input prices– As consumers must consider budget

constraints, firms must be concerned about costs of production


3. Input Choices– Given input prices and production

technology, the firm must choose how much of each input to use in producing output

– Given prices of different inputs, the firm may choose different combinations of inputs to minimize costs• If labor is cheap, firm may choose to produce with

more labor and less capital


• If a firm is a cost minimizer, we can also study– How total costs of production vary with output– How the firm chooses the quantity to

maximize its profits

• We can represent the firm’s production technology in the form of a production function

The Technology of Production

• Production Function:– Indicates the highest output (q) that a firm can

produce for every specified combination of inputs

– For simplicity, we will consider only labor (L) and capital (K)

– Shows what is technically feasible when the firm operates efficiently


• The production function for two inputs:

q = F(K,L)– Output (q) is a function of capital (K) and labor

(L)– The production function is true for a given

technology• If technology increases, more output can be

produced for a given level of inputs


• Short Run versus Long Run– It takes time for a firm to adjust production

from one set of inputs to another– Firms must consider not only what inputs can

be varied but over what period of time that can occur

– We must distinguish between long run and short run


• Short Run– Period of time in which quantities of one or

more production factors cannot be changed– These inputs are called fixed inputs

• Long Run– Amount of time needed to make all production

inputs variable

• Short run and long run are not time specific

Production: One Variable Input

• We will begin looking at the short run when only one input can be varied

• We assume capital is fixed and labor is variable– Output can only be increased by increasing

labor– Must know how output changes as the

amount of labor is changed (Table 6.1)


• Observations:1. When labor is zero, output is zero as well

2. With additional workers, output (q) increases up to 8 units of labor

3. Beyond this point, output declines• Increasing labor can make better use of existing

capital initially• After a point, more labor is not useful and can be

counterproductive


• Firms make decisions based on the benefits and costs of production

• Sometimes useful to look at benefits and costs on an incremental basis– How much more can be produced when at

incremental units of an input?

• Sometimes useful to make comparison on an average basis


• Average product of Labor - Output per unit of a particular product

• Measures the productivity of a firm’s labor in terms of how much, on average, each worker can produce

L

q

Input Labor

Output APL


• Marginal Product of Labor – additional output produced when labor increases by one unit

• Change in output divided by the change in labor

L

q

Input Labor

Output MPL


• We can graph the information in Table 6.1 to show– How output varies with changes in labor

• Output is maximized at 112 units

– Average and Marginal Products• Marginal Product is positive as long as total output

is increasing• Marginal Product crosses Average Product at its

maximum

At point D, output is maximized.

Labor per Month

Outputper

Month

0 2 3 4 5 6 7 8 9 101

Total Product

60

112

A

B

C

D


Average Product


10

20

Outputper

Worker

30

80 2 3 4 5 6 7 9 101 Labor per Month

E

Marginal Product

•Left of E: MP > AP & AP is increasing•Right of E: MP < AP & AP is decreasing•At E: MP = AP & AP is at its maximum•At 8 units, MP is zero and output is at max

Marginal and Average Product

• When marginal product is greater than the average product, the average product is increasing

• When marginal product is less than the average product, the average product is decreasing

• When marginal product is zero, total product (output) is at its maximum

• Marginal product crosses average product at its maximum

Product Curves

• We can show a geometric relationship between the total product and the average and marginal product curves– Slope of line from origin to any point on the

total product curve is the average product– At point B, AP = 60/3 = 20 which is the same

as the slope of the line from the origin to point B on the total product curve

Product Curves

10

30

q/L

80 2 3 4 5 6 7 9 101Labor

q

112

Labor

0 2 3 4 5 6 7 8 9 101

C

60 B20

AP is slope of line from origin to point on TP curve

TP

MP

AP

Product Curves

• Geometric relationship between total product and marginal product– The marginal product is the slope of the line

tangent to any corresponding point on the total product curve

– For 2 units of labor, MP = 30/2 = 15 which is slope of total product curve at point A

Product Curves

Labor0 2 3 4 5 6 7 8 9 101

q

60

112

30

15

10

30

q

4 80 2 3 5 6 7 9 101Labor

A

MP is slope of line tangent to corresponding point on TP curve

TP

MP

AP


• From the previous example, we can see that as we increase labor the additional output produced declines

• Law of Diminishing Marginal Returns: As the use of an input increases with other inputs fixed, the resulting additions to output will eventually decrease

Law of Diminishing Marginal Returns

• When the use of labor input is small and capital is fixed, output increases considerably since workers can begin to specialize and MP of labor increases

• When the use of labor input is large, some workers become less efficient and MP of labor decreases


• Typically applies only for the short run when one variable input is fixed

• Can be used for long-run decisions to evaluate the trade-offs of different plant configurations

• Assumes the quality of the variable input is constant


• Easily confused with negative returns – decreases in output

• Explains a declining marginal product, not necessarily a negative one– Additional output can be declining while total

output is increasing


• Assumes a constant technology– Changes in technology will cause shifts in the

total product curve– More output can be produced with same

inputs– Labor productivity can increase if there are

improvements in technology, even though any given production process exhibits diminishing returns to labor

The Effect of Technological Improvement

Output

50

100

Labor pertime period0 2 3 4 5 6 7 8 9 101

A

O1

C

O3

O2

B

Moving from A to B to C, labor productivity is

increasing over time

Production: Two Variable Inputs

• Firm can produce output by combining different amounts of labor and capital

• In the long run, capital and labor are both variable

• We can look at the output we can achieve with different combinations of capital and labor – Table 6.4


• The information can be represented graphically using isoquants– Curves showing all possible combinations of

inputs that yield the same output

• Curves are smooth to allow for use of fractional inputs– Curve 1 shows all possible combinations of

labor and capital that will produce 55 units of output

Isoquant Map

Labor per year1 2 3 4 5

Ex: 55 units of output can be produced with

3K & 1L (pt. A) OR

1K & 3L (pt. D)

q1 = 55

q2 = 75

q3 = 90

1

2

3

4

5Capitalper year

D

E

A B C


• Diminishing Returns to Labor with Isoquants

• Holding capital at 3 and increasing labor from 0 to 1 to 2 to 3 – Output increases at a decreasing rate (0, 55,

20, 15) illustrating diminishing marginal returns from labor in the short run and long run


• Diminishing Returns to Capital with Isoquants

• Holding labor constant at 3 increasing capital from 0 to 1 to 2 to 3– Output increases at a decreasing rate (0, 55,

20, 15) due to diminishing returns from capital in short run and long run

Diminishing Returns

Labor per year1 2 3 4 5

Increasing labor holding capital

constant (A, B, C) OR

Increasing capital holding labor constant

(E, D, C

q1 = 55

q2 = 75

q3 = 90

1

2

3

4

5Capitalper year

D

E

A B C


• Substituting Among Inputs– Companies must decide what combination of

inputs to use to produce a certain quantity of output

– There is a trade-off between inputs, allowing them to use more of one input and less of another for the same level of output


• Substituting Among Inputs – Slope of the isoquant shows how one input

can be substituted for the other and keep the level of output the same

– The negative of the slope is the marginal rate of technical substitution (MRTS)

• Amount by which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant


• The marginal rate of technical substitution equals:

)( qLKMRTS

InputLaborinChange

InputCapitalinChangeMRTS

of level fixed a for


• As labor increases to replace capital– Labor becomes relatively less productive– Capital becomes relatively more productive– Need less capital to keep output constant– Isoquant becomes flatter

Marginal Rate ofTechnical Substitution

Labor per month

1

2

3

4

1 2 3 4 5

5Capital per year

Negative Slope measures MRTS;

MRTS decreases as move down the indifference curve

1

1

1

1

2

1

2/3

1/3

Q1 =55

Q2 =75

Q3 =90

MRTS and Isoquants

• We assume there is diminishing MRTS– Increasing labor in one unit increments from 1 to 5

results in a decreasing MRTS from 1 to 1/2– Productivity of any one input is limited

• Diminishing MRTS occurs because of diminishing returns and implies isoquants are convex

• There is a relationship between MRTS and marginal products of inputs

MRTS and Marginal Products• If we increase labor and decrease capital

to keep output constant, we can see how much the increase in output is due to the increased labor– Amount of labor increased times the marginal

productivity of labor

))(( LMPL

MRTS and Marginal Products

• Similarly, the decrease in output from the decrease in capital can be calculated– Decrease in output from reduction of capital

times the marginal produce of capital

))(( KMPK


• If we are holding output constant, the net effect of increasing labor and decreasing capital must be zero

• Using changes in output from capital and labor we can see

0 K))((MP L))((MP KL


• Rearranging equation, we can see the relationship between MRTS and MPs

MRTSK

L

MP

L

K

)(

)

))(

L

KL

KL

(MP

K))((MP- (MP

0 K))((MP L))((MP

Isoquants: Special Cases

• Two extreme cases show the possible range of input substitution in production

1. Perfect substitutes– MRTS is constant at all points on isoquant– Same output can be produced with a lot of

capital or a lot of labor or a balanced mix

Perfect Substitutes

Laborper month

Capitalper

month

Q1 Q2 Q3

A

B

C

Same output can be reached with mostly capital or mostly labor (A or C) or with equal amount of both (B)

Isoquants: Special Cases

2. Perfect Complements– Fixed proportions production function– There is no substitution available between

inputs– The output can be made with only a specific

proportion of capital and labor– Cannot increase output unless increase both

capital and labor in that specific proportion

Fixed-ProportionsProduction Function

Labor per month

Capitalper

month

L1

K1Q1

A

Q2

Q3

B

C

Same output can only be produced with one set of inputs.

Returns to Scale

• In addition to discussing the tradeoff between inputs to keep production the same

• How does a firm decide, in the long run, the best way to increase output?– Can change the scale of production by

increasing all inputs in proportion– If double inputs, output will most likely

increase but by how much?

Returns to Scale

• Rate at which output increases as inputs are increased proportionately– Increasing returns to scale– Constant returns to scale– Decreasing returns to scale

Returns to Scale

• Increasing returns to scale: output more than doubles when all inputs are doubled– Larger output associated with lower cost

(cars)– One firm is more efficient than many (utilities)– The isoquants get closer together

Increasing Returns to Scale

10

20

30

The isoquants move closer together

Labor (hours)5 10

Capital(machine

hours)

2

4

A

Returns to Scale• Constant returns to scale: output

doubles when all inputs are doubled– Size does not affect productivity

– May have a large number of producers

– Isoquants are equidistant apart

Returns to Scale

Constant Returns:

Isoquants are

equally spaced

20

30

Labor (hours)155 10

A

10

Capital(machine

hours)

2

4

6

Returns to Scale• Decreasing returns to scale: output less

than doubles when all inputs are doubled– Decreasing efficiency with large size

– Reduction of entrepreneurial abilities

– Isoquants become farther apart

Returns to Scale

Labor (hours)

Capital(machine

hours)

Decreasing Returns:Isoquants get further apart

1020

10

4

A

30

5

2

Chapter 7

The Cost of Production

Measuring Cost:Which Costs Matter?

• For a firm to minimize costs, we must clarify what is meant by costs and how to measure them– It is clear that if a firm has to rent equipment

or buildings, the rent they pay is a cost– What if a firm owns its own equipment or

building?• How are costs calculated here?


• Accountants tend to take a retrospective view of firms’ costs, whereas economists tend to take a forward-looking view

• Accounting Cost– Actual expenses plus depreciation charges for

capital equipment

• Economic Cost– Cost to a firm of utilizing economic resources

in production, including opportunity cost


• Economic costs distinguish between costs the firm can control and those it cannot– Concept of opportunity cost plays an

important role

• Opportunity cost– Cost associated with opportunities that are

foregone when a firm’s resources are not put to their highest-value use

Opportunity Cost

• An Example– A firm owns its own building and pays no rent

for office space– Does this mean the cost of office space is

zero?– The building could have been rented instead– Foregone rent is the opportunity cost of using

the building for production and should be included in the economic costs of doing business

Opportunity Cost

• A person starting their own business must take into account the opportunity cost of their time– Could have worked elsewhere making a

competitive salary


• Although opportunity costs are hidden and should be taken into account, sunk costs should not

• Sunk Cost– Expenditure that has been made and cannot

be recovered– Should not influence a firm’s future economic

decisions

Sunk Cost

• Firm buys a piece of equipment that cannot be converted to another use

• Expenditure on the equipment is a sunk cost– Has no alternative use so cost cannot be

recovered – opportunity cost is zero– Decision to buy the equipment might have

been good or bad, but now does not matter

Prospective Sunk Cost

• An Example– Firm is considering moving its headquarters– A firm paid $500,000 for an option to buy a

building– The cost of the building is $5 million for a total

of $5.5 million– The firm finds another building for $5.25

million– Which building should the firm buy?

Prospective Sunk Cost

The first building should be purchased

• The $500,000 is a sunk cost and should not be considered in the decision to buy

• What should be considered is– Spending an additional $5,250,000 or– Spending an additional $5,000,000


• Some costs vary with output, while some remain the same no matter the amount of output

• Total cost can be divided into:

1. Fixed Cost– Does not vary with the level of output

2. Variable Cost – Cost that varies as output varies

Fixed and Variable Costs

• Total output is a function of variable inputs and fixed inputs

• Therefore, the total cost of production equals the fixed cost (the cost of the fixed inputs) plus the variable cost (the cost of the variable inputs), or…

VC FC TC

Fixed and Variable Costs

• Which costs are variable and which are fixed depends on the time horizon

• Short time horizon – most costs are fixed• Long time horizon – many costs become

variable• In determining how changes in production

will affect costs, must consider if fixed or variable costs are affected.

Fixed Cost Versus Sunk Cost

• Fixed cost and sunk cost are often confused

• Fixed Cost– Cost paid by a firm that is in business

regardless of the level of output

• Sunk Cost – Cost that has been incurred and cannot be

recovered


• Personal Computers– Most costs are variable – Largest component: labor

• Software– Most costs are sunk– Initial cost of developing the software

Measuring Costs

• Marginal Cost (MC):– The cost of expanding output by one unit– Fixed costs have no impact on marginal cost,

so it can be written as:

Δq

ΔTC

Δq

ΔVC MC

Measuring Costs

• Average Total Cost (ATC)– Cost per unit of output– Also equals average fixed cost (AFC) plus

average variable cost (AVC)

q

TVC

q

TFC

q

TC ATC

AVCAFC q

TC ATC

A Firm’s Short Run Costs

Determinants of Short Run Costs

• The rate at which these costs increase depends on the nature of the production process– The extent to which production involves

diminishing returns to variable factors

• Diminishing returns to labor– When marginal product of labor is decreasing


• If marginal product of labor decreases significantly as more labor is hired– Costs of production increase rapidly– Greater and greater expenditures must be made to

produce more output

• If marginal product of labor decreases only slightly as increase labor– Costs will not rise very fast when output is increased

Determinants of Short Run Costs – An Example

• Assume the wage rate (w) is fixed relative to the number of workers hired

• Variable costs is the per unit cost of extra labor times the amount of extra labor: wL

q

Lw

q

VC MC


• Remembering that

L MPL

Q

LMP

1

Q

L Qunit 1 afor L

And rearranging


• We can conclude:

LMP MCw

…and a low marginal product (MPL) leads to a high marginal cost (MC) and vice versa


• Consequently– MC decreases initially with increasing returns

• 0 through 4 units of output

– MC increases with decreasing returns• 5 through 11 units of output

Cost Curves for a Firm

Output

Cost($ peryear)

100

200

300

400

0 1 2 3 4 5 6 7 8 9 10 11 12 13

VC

Variable costincreases with production and

the rate varies withincreasing and

decreasing returns.

TC

Total costis the vertical

sum of FC and VC.

FC50

Fixed cost does notvary with output

Cost Curves

0

20

40

60

80

100

120

0 2 4 6 8 10 12

Output (units/yr)

Co

st (

$/u

nit

) MC

ATC

AVC

AFC

Cost Curves

• When MC is below AVC, AVC is falling• When MC is above AVC, AVC is rising• When MC is below ATC, ATC is falling• When MC is above ATC, ATC is rising• Therefore, MC crosses AVC and ATC at the

minimums– The Average – Marginal relationship

Cost Curves for a Firm

• The line drawn from the origin to the variable cost curve:– Its slope equals AVC– The slope of a point

on VC or TC equals MC

– Therefore, MC = AVC at 7 units of output (point A)

1 2 3 4 5 6 7 8 9 10 11 12 13

Output

P

100

200

300

400

FC

VC

TC

A

Cost in the Long Run

• In the long run a firm can change all of its inputs

• In making cost minimizing choices, must look at the cost of using capital and labor in production decisions

Cost Minimizing Input Choice

• How do we put all this together to select inputs to produce a given output at minimum cost?

• Assumptions– Two Inputs: Labor (L) and capital (K)– Price of labor: wage rate (w)– The price of capital

• r = depreciation rate + interest rate

• Or rental rate if not purchasing

• These are equal in a competitive capital market


• The Isocost Line– A line showing all combinations of L & K that

can be purchased for the same cost– Total cost of production is sum of firm’s labor

cost, wL, and its capital cost, rK:

C = wL + rK– For each different level of cost, the equation

shows another isocost line


• Rewriting C as an equation for a straight line:– K = C/r - (w/r)L– Slope of the isocost:

• -(w/r) is the ratio of the wage rate to rental cost of capital.

• This shows the rate at which capital can be substituted for labor with no change in cost

rwLK

Choosing Inputs

• We will address how to minimize cost for a given level of output by combining isocosts with isoquants

• We choose the output we wish to produce and then determine how to do that at minimum cost– Isoquant is the quantity we wish to produce– Isocost is the combination of K and L that

gives a set cost

Producing a Given Output at Minimum Cost

Labor per year

Capitalper

year

Isocost C2 shows quantity Q1 can be produced with

combination K2,L2 or K3,L3.However, both of these

are higher cost combinationsthan K1,L1.

Q1

Q1 is an isoquant for output Q1.

There are three isocost lines, of which 2 are possible choices in

which to produce Q1.

C0 C1 C2

AK1

L1

K3

L3

K2

L2

Input Substitution When an Input Price Change

• If the price of labor changes, then the slope of the isocost line changes, -(w/r)

• It now takes a new quantity of labor and capital to produce the output

• If price of labor increases relative to price of capital, and capital is substituted for labor

Input Substitution When an Input Price Change

C2

The new combination of K and L is used to produce Q1.

Combination B is used in place of combination A.K2

L2

B

C1

K1

L1

A

Q1

If the price of laborrises, the isocost curve

becomes steeper due to the change in the slope -(w/L).

Labor per year

Capitalper

year


• How does the isocost line relate to the firm’s production process?

K

LMP

MP- MRTS L

K

rw

LK

lineisocost of Slope

costminimizesfirmwhenrw

MPMP

K

L

Cost in the Long Run• The minimum cost combination can then

be written as:

– Minimum cost for a given output will occur when each dollar of input added to the production process will add an equivalent amount of output.

rwKL MPMP


• If w = $10, r = $2, and MPL = MPK, which input would the producer use more of?– Labor because it is cheaper

– Increasing labor lowers MPL

– Decreasing capital raises MPK

– Substitute labor for capital until

r

MP

w

MP KL


• Cost minimization with Varying Output Levels– For each level of output, there is an isocost

curve showing minimum cost for that output level

– A firm’s expansion path shows the minimum cost combinations of labor and capital at each level of output

– Slope equals K/L

A Firm’s Expansion Path

Expansion Path

The expansion path illustratesthe least-cost combinations oflabor and capital that can be used to produce each level of

output in the long-run.

Capitalper

year

25

50

75

100

150

50Labor per year

100 150 300200

A

$2000

200 Units

B

$3000

300 Units

C

Expansion Path and Long Run Costs

• Firm’s expansion path has same information as long-run total cost curve

• To move from expansion path to LR cost curve– Find tangency with isoquant and isocost– Determine min cost of producing the output

level selected– Graph output-cost combination

A Firm’s Long Run Total Cost Curve

Long Run Total Cost

Output, Units/yr100 300200

Cost/ Year

1000

2000

3000

D

E

F

Long Run Versus Short Run Cost Curves

• In the short run, some costs are fixed

• In the long run, firm can change anything including plant size– Can produce at a lower average cost in long

run than in short run– Capital and labor are both flexible

• We can show this by holding capital fixed in the short run and flexible in long run

Capital is fixed at K1.To produce q1, min cost at K1,L1.If increase output to Q2, min cost

is K1 and L3 in short run.

The Inflexibility of Short Run Production

Long-RunExpansion Path

Labor per year

Capitalper

year

L2

Q2

K2

D

C

F

E

Q1

A

BL1

K1

L3

PShort-RunExpansion Path

In LR, can change capital and min costs falls to K2 and L2.

Long Run VersusShort Run Cost Curves

• Long-Run Average Cost (LAC)– Most important determinant of the shape of

the LR AC and MC curves is relationship between scale of the firm’s operation and inputs required to minimize cost

1. Constant Returns to Scale– If input is doubled, output will double– AC cost is constant at all levels of output


2. Increasing Returns to Scale– If input is doubled, output will more than

double– AC decreases at all levels of output

3. Decreasing Returns to Scale– If input is doubled, output will less than

double– AC increases at all levels of output


• In the long run:– Firms experience increasing and decreasing

returns to scale and therefore long-run average cost is “U” shaped.

– Source of U-shape is due to returns to scale instead of decreasing returns to scale like the short-run curve

– Long-run marginal cost curve measures the change in long-run total costs as output is increased by 1 unit


• Long-run marginal cost leads long-run average cost:– If LMC < LAC, LAC will fall– If LMC > LAC, LAC will rise– Therefore, LMC = LAC at the minimum of LAC

• In special case where LAC is constant, LAC and LMC are equal

Long Run Average and Marginal Cost

Output

Cost($ per unitof output

LAC

LMC

A

Long Run Costs

• As output increases, firm’s AC of producing is likely to decline to a point

1. On a larger scale, workers can better specialize

2. Scale can provide flexibility – managers can organize production more effectively

3. Firm may be able to get inputs at lower cost if can get quantity discounts. Lower prices might lead to different input mix.

Long Run Costs

• At some point, AC will begin to increase1. Factory space and machinery may make it

more difficult for workers to do their jobs efficiently

2. Managing a larger firm may become more complex and inefficient as the number of tasks increase

3. Bulk discounts can no longer be utilized. Limited availability of inputs may cause price to rise.

Long Run Costs

• When input proportions change, the firm’s expansion path is no longer a straight line– Concept of return to scale no longer applies

• Economies of scale reflects input proportions that change as the firm changes its level of production

Economies and Diseconomies of Scale

• Economies of Scale– Increase in output is greater than the increase

in inputs

• Diseconomies of Scale– Increase in output is less than the increase in

inputs

• U-shaped LAC shows economies of scale for relatively low output levels and diseconomies of scale for higher levels

Long Run Costs

• Increasing Returns to Scale– Output more than doubles when the quantities

of all inputs are doubled

• Economies of Scale– Doubling of output requires less than a

doubling of cost

Long Run Costs

• Economies of scale are measured in terms of cost-output elasticity, EC

• EC is the percentage change in the cost of production resulting from a 1-percent increase in output

ACMC

QQCCEC

Long Run Costs

• EC is equal to 1, MC = AC– Costs increase proportionately with output– Neither economies nor diseconomies of scale

• EC < 1 when MC < AC– Economies of scale– Both MC and AC are declining

• EC > 1 when MC > AC– Diseconomies of scale– Both MC and AC are rising


• We will use short and long run costs to determine the optimal plant size

• We can show the short run average costs for 3 different plant sizes

• This decision is important because once built, the firm may not be able to change plant size for a while

Long Run Cost with Economiesand Diseconomies of Scale

Long Run Cost withConstant Returns to Scale

• The optimal plant size will depend on the anticipated output– If expect to produce q0, then should build

smallest plant: AC = $8

– If produce more, like q1, AC rises

– If expect to produce q2, middle plant is least cost

– If expect to produce q3, largest plant is best


• What is the firm’s long run cost curve?– Firms can change scale to change output in

the long run– The long run cost curve is the dark blue

portion of the SAC curve which represents the minimum cost for any level of output

– Firm will always choose plant that minimizes the average cost of production


• The long-run average cost curve envelops the short-run average cost curves

• The LAC curve exhibits economies of scale initially but exhibits diseconomies at higher output levels

Chapter 8

Profit Maximization and Competitive Supply

Perfectly Competitive Markets

• The model of perfect competition can be used to study a variety of markets

• Basic assumptions of Perfectly Competitive Markets1. Price taking

2. Product homogeneity

3. Free entry and exit


1. Price Taking– The individual firm sells a very small share of

the total market output and, therefore, cannot influence market price

– Each firm takes market price as given – price taker

– The individual consumer buys too small a share of industry output to have any impact on market price


2. Product Homogeneity– The products of all firms are perfect

substitutes– Product quality is relatively similar as well as

other product characteristics– Agricultural products, oil, copper, iron,

lumber– Heterogeneous products, such as brand

names, can charge higher prices because they are perceived as better


3. Free Entry and Exit– When there are no special costs that make it

difficult for a firm to enter (or exit) an industry– Buyers can easily switch from one supplier

to another– Suppliers can easily enter or exit a market

• Pharmaceutical companies are not perfectly competitive because of the large costs of R&D required

When are Markets Competitive?

• Few real products are perfectly competitive

• Many markets are, however, highly competitive– They face relatively low entry and exit costs– Highly elastic demand curves

• No rule of thumb to determine whether a market is close to perfectly competitive– Depends on how they behave in situations

Profit Maximization

• Do firms maximize profits?– Managers in firms may be concerned with

other objectives• Revenue maximization• Revenue growth• Dividend maximization• Short-run profit maximization (due to bonus or

promotion incentive)– Could be at expense of long run profits

Profit Maximization

• Implications of non-profit objective– Over the long run, investors would not support

the company– Without profits, survival is unlikely in

competitive industries

• Managers have constrained freedom to pursue goals other than long-run profit maximization

Marginal Revenue, Marginal Cost, and Profit Maximization

• We can study profit maximizing output for any firm, whether perfectly competitive or not– Profit () = Total Revenue - Total Cost– If q is output of the firm, then total revenue is

price of the good times quantity– Total Revenue (R) = Pq


• Costs of production depends on output– Total Cost (C) = C(q)

• Profit for the firm, , is difference between revenue and costs

)()()( qCqRq


• Firm selects output to maximize the difference between revenue and cost

• We can graph the total revenue and total cost curves to show maximizing profits for the firm

• Distance between revenues and costs show profits


• Revenue is a curve, showing that a firm can only sell more if it lowers its price

• Slope of the revenue curve is the marginal revenue– Change in revenue resulting from a one-unit increase

in output

• Slope of the total cost curve is marginal cost– Additional cost of producing an additional unit of

output


• If the producer tries to raise price, sales are zero• Profit is negative to begin with, since revenue is

not large enough to cover fixed and variable costs

• As output rises, revenue rises faster than costs increasing profit

• Profit increases until it is maxed at q*• Profit is maximized where MR = MC or where

slopes of the R(q) and C(q) curves are equal

Profit Maximization – Short Run

0

Cost,Revenue,

Profit($s per

year)

Output

C(q)

R(q)A

B

(q)q0 q*

Profits are maximized where MR (slope at A) and MC (slope at B) are equal

Profits are maximized where R(q) – C(q) is maximized


• Profit is maximized at the point at which an additional increment to output leaves profit unchanged

MCMR

MCMR

q

C

q

R

q

CR

0

0

The Competitive Firm

• Demand curve faced by an individual firm is a horizontal line– Firm’s sales have no effect on market price

• Demand curve faced by whole market is downward sloping– Shows amount of goods all consumers will

purchase at different prices


d$4

Output (bushels)

Price$ per bushel

100 200

FirmIndustry

D

$4

S

Price$ per bushel

Output (millions of bushels)

100


• The competitive firm’s demand– Individual producer sells all units for $4

regardless of that producer’s level of output– MR = P with the horizontal demand curve– For a perfectly competitive firm, profit

maximizing output occurs when

ARPMRqMC )(

Choosing Output: Short Run

• We will combine revenue and costs with demand to determine profit maximizing output decisions

• In the short run, capital is fixed and firm must choose levels of variable inputs to maximize profits

• We can look at the graph of MR, MC, ATC and AVC to determine profits

q2

A Competitive Firm

10

20

30

40

Price

50

MC

AVC

ATC

0 1 2 3 4 5 6 7 8 9 10 11Outputq*

AR=MR=PA

q1 : MR > MCq2: MC > MRq*: MC = MR

q1

Lost Profit for q2>q*Lost Profit

for q2>q*

Choosing Output: Short Run

• The point where MR = MC, the profit maximizing output is chosen– MR = MC at quantity, q*, of 8– At a quantity less than 8, MR > MC, so more

profit can be gained by increasing output– At a quantity greater than 8, MC > MR,

increasing output will decrease profits

A Competitive Firm – Positive Profits

10

20

30

40

Price

50

0 1 2 3 4 5 6 7 8 9 10 11Outputq2

MC

AVC

ATC

q*

AR=MR=PA

q1

D

C B Profits are determined

by output per unit times quantity

Profit per unit = P-AC(q) = A to B

Total Profit = ABCD


• A firm does not have to make profits

• It is possible a firm will incur losses if the P < AC for the profit maximizing quantity– Loss

A Competitive Firm – Losses

Price

Output

MC

AVC

ATC

P = MRD

At q*: MR = MC and P < ATCLosses = (P- AC) x q* or ABCD

q*

A

BC

Short Run Production

• Why would a firm produce at a loss?– Might think price will increase in near future– Shutting down and starting up could be costly

• Firm has two choices in short run– Continue producing– Shut down temporarily– Will compare profitability of both choices

Short Run Production

• When should the firm shut down?– If AVC < P < ATC, the firm should continue

producing in the short run• Can cover all of its variable costs and some of its

fixed costs

– If AVC > P < ATC, the firm should shut down• Cannot cover its variable costs or any of its fixed

costs

A Competitive Firm – Losses

Price

Output

P < ATC but AVC so firm will continue to produce in short run

MC

AVC

ATC

P = MRD

q*

A

BC

Losses

EF

Competitive Firm – Short Run Supply

• Supply curve tells how much output will be produced at different prices

• Competitive firms determine quantity to produce where P = MC– Firm shuts down when P < AVC

• Competitive firms’ supply curve is portion of the marginal cost curve above the AVC curve

A Competitive Firm’sShort-Run Supply CurvePrice($ per

unit)

Output

MC

AVC

ATC

P = AVC

P2

q2

The firm chooses theoutput level where P = MR = MC,

as long as P > AVC.

P1

q1

S

Supply is MC above AVC

A Competitive Firm’sShort-Run Supply Curve

• Supply is upward sloping due to diminishing returns

• Higher price compensates the firm for the higher cost of additional output and increases total profit because it applies to all units

A Competitive Firm’sShort-Run Supply Curve

• Over time, prices of product and inputs can change

• How does the firm’s output change in response to a change in the price of an input?– We can show an increase in marginal costs

and the change in the firm’s output decisions

MC2

q2

Input cost increases and MC shifts to MC2

and q falls to q2.

MC1

q1

The Response of a Firm toa Change in Input PricePrice($ per

unit)

Output

$5

Savings to the firmfrom reducing output

The Short-Run Market Supply Curve

• As price rises, firms expand their production• Increased production leads to increased demand

for inputs and could cause increases in input prices

• Increases in input prices cause MC curve to rise• This lowers each firm’s output choice• Causes industry supply to be less responsive to

change in price than would be otherwise

Elasticity of Market Supply

• Elasticity of Market Supply– Measures the sensitivity of industry output to

market price– The percentage change in quantity supplied,

Q, in response to 1-percent change in price

)//()/( PPQQEs

Elasticity of Market Supply

• When MC increases rapidly in response to increases in output, elasticity is low

• When MC increases slowly, supply is relatively elastic

• Perfectly inelastic short-run supply arises when the industry’s plant and equipment are so fully utilized that new plants must be built to achieve greater output

• Perfectly elastic short-run supply arises when marginal costs are constant

Producer Surplus in the Short Run

• Price is greater than MC on all but the last unit of output

• Therefore, surplus is earned on all but the last unit

• The producer surplus is the sum over all units produced of the difference between the market price of the good and the marginal cost of production

• Area above supply curve to the market price

ProducerProducerSurplusSurplus

Producer surplus is area above MC

to the price

Producer Surplus for a FirmPrice($ per

unit ofoutput)

Output

AVCAVCMCMC

AABB

PP

qq**

At q* MC = MR.Between 0 and q,

MR > MC for all units.

The Short-Run Market Supply Curve

• Sum of MC from 0 to q*, it is the sum of the total variable cost of producing q*

• Producer Surplus can be defined as the difference between the firm’s revenue and its total variable cost

• We can show this graphically by the rectangle ABCD– Revenue (0ABq*) minus variable cost (0DCq*)

Producer surplus is also ABCD = Revenue minus variable costs

Producer Surplus for a FirmPrice($ per

unit ofoutput)

Output


AVCAVCMCMC

AABB

PP

qq**

CCDD

Producer Surplus Versus Profit

• Profit is revenue minus total cost (not just variable cost)

• When fixed cost is positive, producer surplus is greater than profit

VC- R PS Surplus Producer

FC - VC- R Profit

Producer Surplus Versus Profit

• Costs of production determine magnitude of producer surplus– Higher cost firms have less producer surplus– Lower cost firms have more producer surplus– Adding up surplus for all producers in the

market given total market producer surplus– Area below market price and above supply

curve

DD

PP**

QQ**


Market producer surplus isthe difference between P*

and S from 0 to Q*.

Producer Surplus for a Market

Price($ per

unit ofoutput)

Output

SS

Choosing Output in the Long Run

• In short run, one or more inputs are fixed– Depending on the time, it may limit the

flexibility of the firm

• In the long run, a firm can alter all its inputs, including the size of the plant

• We assume free entry and free exit– No legal restrictions or extra costs

Choosing Output in the Long Run

• In the short run, a firm faces a horizontal demand curve– Take market price as given

• The short-run average cost curve (SAC) and short-run marginal cost curve (SMC) are low enough for firm to make positive profits (ABCD)

• The long-run average cost curve (LRAC)– Economies of scale to q2

– Diseconomies of scale after q2

q1

BC

AD

In the short run, thefirm is faced with fixedinputs. P = $40 > ATC.Profit is equal to ABCD.

Output Choice in the Long RunPrice

Output

P = MR$40

SACSMC

q3q2

$30

LAC

LMC

Output Choice in the Long Run

Price

Outputq1

BC

ADP = MR$40

SACSMC

q3q2

$30

LAC

LMC

In the long run, the plant size will be increased and output increased to q3.

Long-run profit, EFGD > short runprofit ABCD.

FG

Long-Run Competitive Equilibrium

• For long run equilibrium, firms must have no desire to enter or leave the industry

• We can relate economic profit to the incentive to enter and exit the market


• Zero-Profit– A firm is earning a normal return on its

investment– Doing as well as it could by investing its

money elsewhere– Normal return is firm’s opportunity cost of

using money to buy capital instead of investing elsewhere

– Competitive market long run equilibrium


• Entry and Exit– The long-run response to short-run profits is

to increase output and profits– Profits will attract other producers– More producers increase industry supply,

which lowers the market price– This continues until there are no more profits

to be gained in the market – zero economic profits

Long-Run Competitive Equilibrium – Profits

S1

Output Output

$ per unit ofoutput

$ per unit ofoutput

LAC

LMC

D

S2

$40 P1

Q1

Firm Industry

Q2

P2

q2

$30

•Profit attracts firms•Supply increases until profit = 0

Long-Run Competitive Equilibrium – Losses

S2

Output Output

$ per unit ofoutput

$ per unit ofoutput

LAC

LMC

D

S1

P2

Q2

Firm Industry

Q1

P1

q2

$20

$30

•Losses cause firms to leave•Supply decreases until profit = 0


1. All firms in industry are maximizing profits– MR = MC

2. No firm has incentive to enter or exit industry– Earning zero economic profits

3. Market is in equilibrium– QD = QS

Chapter 9

The Analysis of Competitive Markets

Consumer and Producer Surplus

• When government controls price, some people are better off– May be able to buy a good at a lower price

• But what is the effect on society as a whole?– Is total welfare higher or lower and by how much?

• A way to measure gains and losses from government policies is needed


1. Consumer surplus is the total benefit or value that consumers receive beyond what they pay for the good– Assume market price for a good is $5– Some consumers would be willing to pay

more than $5 for the good– If you were willing to pay $9 for the good and

pay $5, you gain $4 in consumer surplus


• The demand curve shows the willingness to pay for all consumers in the market

• Consumer surplus can be measured by the area between the demand curve and the market price

• Consumer surplus measures the total net benefit to consumers


2. Producer surplus is the total benefit or revenue that producers receive beyond what it costs to produce a good– Some producers produce for less than

market price and would still produce at a lower price

– A producer might be willing to accept $3 for the good but get $5 market price

– Producer gains a surplus of $2


• The supply curve shows the amount that a producer is willing to take for a certain amount of a good

• Producer surplus can be measured by the area between the supply curve and the market price

• Producer surplus measures the total net benefit to producers


Between 0 and Q0 producers receive

a net gain from selling each product--

producer surplus.

ConsumerSurplus

Quantity

Price

S

D

Q0

5

9

Between 0 and Q0

consumer A receives a net gain from buying

the product-- consumer surplus.

ProducerSurplus

3

QD QS


• To determine the welfare effect of a governmental policy, we can measure the gain or loss in consumer and producer surplus

• Welfare Effects– Gains and losses to producers and

consumers


• When government institutes a price ceiling, the price of a good can’t go above that price

• With a binding price ceiling, producers and consumers are affected

• How much they are affected can be determined by measuring changes in consumer and producer surplus


• When price is held too low, the quantity demanded increases and quantity supplied decreases

• Some consumers are worse off because they can no longer buy the good– Decrease in consumer surplus

• Some consumers are better off because they can buy it at a lower price– Increase in consumer surplus


• Producers sell less at a lower price

• Some producers are no longer in the market

• Both of these producer groups lose and producer surplus decreases

• The economy as a whole is worse off since surplus that used to belong to producers or consumers is simply gone

The loss to producers is the sum of

rectangle A and triangle C

B

A C

Consumers that can buy the good gain A

Price Control and Surplus Changes

Quantity

Price

S

D

P0

Q0

Pmax

Q1 Q2

Consumers that cannot buy, lose B

Triangles B and C are losses to society – dead weight loss

Price Controls and Welfare Effects

• The total loss is equal to area B + C

• The deadweight loss is the inefficiency of the price controls – the total loss in surplus (consumer plus producer)

• If demand is sufficiently inelastic, losses to consumers may be fairly large– This can have effects in political decisions

B

APmax

C

Q1

With inelastic demand, triangle B can be larger

than rectangle A and consumers suffer net

losses from price controls.

S

D

Price Controls With Inelastic Demand

Quantity

Price

P0

Q2

Price Controls and Natural Gas Shortages

• From example in Chapter 2, 1975 Price controls created a shortage of natural gas

• What was the effect of those controls?– Decreases in surplus and overall loss for

society– We can measure these welfare effects from

the demand and supply of natural gas


• QS = 14 + 2PG + 0.25PO

– Quantity supplied in trillion cubic feet (Tcf)

• QD = -5PG + 3.75PO

– Quantity demanded (Tcf)

• PG = price of natural gas in $/mcf

• PO = price of oil in $/b


• Using PO = $8/b and gives equilibrium values for natural gas– PG = $2/mcf and QG = 20 Tcf

• Price ceiling was set at $1/mcf

• Showing this graphically, we can see and measure the effects on producer and consumer surplus

GS

GD QQ

B

A

C

The gain to consumers is rectangle A minus triangle

B, and the loss to producers is rectangle A

plus triangle C.

SD

2.00

2.40

Price($/mcf)

Quantity (Tcf)0 5 10 15 20 25 3018

(Pmax)1.00



• Measuring the Impact of Price Controls– A = (18 billion mcf) x ($1/mcf) =

$18 billion– B = (1/2) x (2 b. mcf) x ($0.40/mcf) =

$0.4 billion– C = (1/2) x (2 b. mcf) x ($1/mcf) =

$1 billion


• Measuring the Impact of Price Controls in 1975– Change in consumer surplus

• = A - B = 18 - 0.4 = $17.6 billion Gain

– Change in producer surplus• = A + C = 18 + 1 = $19.0 billion Loss

– Dead Weight Loss• = B + C = 0.4 + 1 = $1.4 billion Loss

The Efficiency ofa Competitive Market

• In the evaluation of markets, we often talk about whether it reaches economic efficiency– Maximization of aggregate consumer and

producer surplus

• Policies such as price controls that cause dead weight losses in society are said to impose an efficiency cost on the economy

The Efficiency ofa Competitive Market

• If efficiency is the goal, then you can argue that leaving markets alone is the answer

• However, sometimes market failures occur– Prices fail to provide proper signals to

consumers and producers– Leads to inefficient unregulated competitive

market

Types of Market Failures

1. Externalities– Costs or benefits that do not show up as part

of the market price (e.g. pollution)– Costs or benefits are external to the market

2. Lack of Information– Imperfect information prevents consumers

from making utility-maximizing decisions

• Government intervention may be desirable in these cases

The Efficiency of a Competitive Market

• Other than market failures, unregulated competitive markets lead to economic efficiency

• What if the market is constrained to a price higher than the economically efficient equilibrium price?

BA

C

Price Control and Surplus Changes

Quantity

Price

S

D

P0

Q0

Pmin

Q1 Q2

When price is regulated to be no lower than Pmin, the

deadweight loss given by triangles B and C

results.

The Efficiency of a Competitive Market

• Deadweight loss triangles B and C give a good estimate of the efficiency cost of policies that force price above or below market clearing price

• Measuring effects of government price controls on the economy can be estimated by measuring these two triangles

chapter 5

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