econ301finalslides (1)

8/17/2019 Econ301Finalslides (1)

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Chapter 5

Uncertainty and Consumer

Behavior


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"escribing #isk• $o measure risk we must know%

&' ll of the possible outcomes

)' $he probability or likelihood that eachoutcome will occur


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"escribing #isk

• Interpreting *robability&' +b,ective Interpretation

• Based on the observed fre-uency of past events

)' .ub,ective Interpretation• Based on perception that an outcome will occur


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Interpreting *robability

• .ub,ective *robability / "ifferent information or different abilities to

process the same information can influencethe sub,ective probability

/ Based on ,udgment or e0perience


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"escribing #isk

• 1ith an interpretation of probability2 mustdetermine ) measures to help describeand compare risky choices

&' 30pected value)' 4ariability


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"escribing #isk

• 30pected 4alue / $he weighted average of the payoffs or values

resulting from all possible outcomes• 30pected value measures the central tendency

the payoff or value e0pected on average


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30pected 4alue / n 30ample

• Investment in offshore drilling e0ploration%• $wo outcomes are possible

/ .uccess / the stock price increases from 678to 698:share / ;ailure / the stock price falls from 678 to

6)8:share


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• +b,ective *robability / &88 e0plorations2 )5 successes and


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failureof (value*r(failuresuccessof (value*r(success34

+

=

(6)8:share97(698:share9&34 +=

6)5:share34 =


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30pected 4alue

• In general2 for n possible outcomes% / *ossible outcomes having payoffs > &2 >) 2 ?2

> n / *robabilities of each outcome is given by *r &2

*r ) 2 ?2 *r n

nn2211 XPr ...XPr XPr E(X) +++=


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"escribing #isk

• 4ariability / $he e0tent to which possible outcomes of an

uncertain event may differ / How much variation e0ists in the possible

choice


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4ariability / n 30ample

• .uppose you are choosing between twopart@time sales ,obs that have the samee0pected income (6&2588

• $he first ,ob is based entirely oncommission

• $he second is a salaried position


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• $here are two e-ually likely outcomes inthe first ,ob% 6)2888 for a good sales ,oband 6&2888 for a modestly successful one

• $he second pays 6&25&8 most of the time('AA probability 2 but you will earn 65&8 ifthe company goes out of business ('8&probability



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4ariability / n 30ampleOutcome 1 Outcome 2

Prob. Income Prob. Income

Job 1:Commission '5 )888 '5 &888

Job 2: FixedSalary 'AA &5&8 '8& 5&8


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1500$.5($1000).5($2000))E(X 1 =+=


• Income from *ossible .ales obob & 30pected Income

$1500.01($510).99($1510))E(X 2 =+=ob ) 30pected Income


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4ariability

• 1hile the e0pected values are the same2the variability is not

• reater variability from e0pected valuessignals greater risk

• 4ariability comes from deviations inpayoffs / "ifference between e0pected payoff and

actual payoff


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Deviations rom !xpected Income "#$

Outcome1

Deviation Outcome2

Deviation

Job 16)888 6588 6&888 @6588

Job 2&5&8 &8 5&8 @A88


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4ariability

• verage deviations are always Dero so wemust ad,ust for negative numbers

• 1e can measure variability with standarddeviation / $he s-uare root of the average of the s-uares

of the deviations of the payoffs associatedwith each outcome from their e0pected value


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4ariability

• .tandard deviation is a measure of risk / Eeasures how variable your payoff will be / Eore variability means more risk / Individuals generally prefer less variability /

less risk


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4ariability

• $he standard deviation is written%

[ ] [ ]2222

11 )(Pr )(Pr X E X X E X −+−=


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.tandard "eviation / 30ample &

Deviations rom !xpectedIncome "#$

Outcome 1 Deviation Outcome 2 Deviation

Job1 6)888 6588 6&888 @6588

Job2 &5&8 &8 5&8 @A88


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.tandard "eviation / 30ample &• .tandard deviations of the two ,obs are%

500000,250

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

1

1

==

+=

σ

σ

50.99900,9

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

2

2

==

+=

σ

σ

[ ] [ ]2222

11 )(Pr )(Pr X E X X E X −+−=


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.tandard "eviation / 30ample &

• ob & has a larger standard deviation andtherefore it is the riskier alternative

• $he standard deviation also can be usedwhen there are many outcomes instead ofonly two


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.tandard "eviation / 30ample )

• ob & is a ,ob in which the income rangesfrom 6&888 to 6)888 in increments of6&88 that are all e-ually likely

• ob ) is a ,ob in which the income rangesfrom 6&788 to 6&


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+utcome *robabilities @ $woobs

Income

%.1

#1%%% #1&%% #2%%%

%.2

Job 1

Job 2

Job 1 'as (reater spread: (reater

standard deviationand (reater ris)

t'an Job 2.

Probability


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"ecision Eaking / 30ample &

• 1hat if the outcome probabilities of two ,obs have une-ual probability ofoutcomes! / ob &% greater spread and standard deviation / *eaked distribution% e0treme payoffs are less

likely that those in the middle of the

distribution / Fou will choose ,ob ) again


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Une-ual *robability +utcomes

Job 1

Job 2

*'e distribution o payo sassociated +it' Job 1 'as a(reater spread and standard

deviation t'an t'ose +it' Job 2.

Income

%.1

#1%%% #1&%% #2%%%

%.2

Probability


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"ecision Eaking / 30ample )

• .uppose we add 6&88 to each payoff inob & which makes the e0pected payoff =

6&G88 / ob &% e0pected income 6&2G88 and a

standard deviation of 6588 / ob )% e0pected income of 6&2588 and a

standard deviation of 6AA'58


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"ecision Eaking / 30ample )

• 1hich ,ob should be chosen! / "epends on the individual / .ome may be willing to take risk with higher

e0pected income / .ome will prefer less risk even with lower

e0pected income


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#isk and Crime "eterrence

• ttitudes toward risk affect willingness tobreak the law

• .uppose a city wants to deter people fromdouble parking

• Eonetary fines may be better than ,ail time


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#isk and Crime "eterrence

• Costs of apprehending criminals are notDero2 therefore / ;ines must be higher than the costs to society / *robability of apprehension is actually less

than one


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#isk and Crime "eterrence @30ample

• ssumptions%&' "ouble@parking saves a person 65 in terms

of time spent searching for a parking space)' $he driver is risk neutral7' Cost of apprehension is Dero


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• fine greater than 65'88 would deter thedriver from double parking / Benefit of double parking (65 is less than the

cost (6G'88 e-uals a net benefit that isnegative

/ If the value of double parking is greater than

65'882 then the person would still break thelaw


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• $he same deterrence effect is obtained byeither / 658 fine with a 8'& probability of being

caught resulting in an e0pected penalty of 65 or

/ 6588 fine with a 8'8& probability of being

caught resulting in an e0pected penalty of 65


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• 3nforcement costs are reduced with highfine and low probability

• Eost effective if drivers don t like to takerisks


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*references $oward #isk

• Can e0pand evaluation of risky alternativeby considering utility that is obtained byrisk / consumer gets utility from income / *ayoff measured in terms of utility


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*references $oward #isk @30ample

• Utility at 6782888 is &• Utility at 6&82888 is &8

• Eust compare utility from the risky ,ob withcurrent utility of &7'5• $o evaluate the new ,ob2 we must

calculate the expected utility of the risky ,ob


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• $he expected utility of the risky option isthe sum of the utilities associated with allher possible incomes weighted by theprobability that each income will occur

3(u = (*rob' of Utility & J(Utility &

K (*rob' of Utility ) J(Utility )


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*references $oward #isk /30ample

• $he e0pected is%3(u = (&:) u(6&82888 K (&:) u(6782888

= 8'5(&8 K 8'5(&= &9

/ 3(u of new ,ob is &92 which is greater thanthe current utility of &7'5 and therefore

preferred


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*references $oward #isk• *eople differ in their preference toward

risk

• *eople can be risk averse, risk neutral, or risk loving


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• #isk verse / person who prefers a certain given income

to a risky income with the same e0pectedvalue

/ $he person has a diminishing marginal utilityof income

/ Eost common attitude towards risk• 30% Earket for insurance


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#isk verse @ 30ample

• person can have a 6)82888 ,ob with&88L probability and receive a utility levelof &G

• $he person could have a ,ob with a 8'5chance of earning 6782888 and a 8'5chance of earning 6&82888


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#isk verse / 30ample

• 30pected Income of #isky ob3(I = (8'5 (6782888 K (8'5 (6&828883(I = 6)82888

• 30pected Utility of #isky ob3( u = (8'5 (&8 K (8'5 (&3( u = &9


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#isk verse / 30ample

• 30pected income from both ,obs is thesame / risk averse may choose current

,ob• 30pected utility is greater for certain ,ob

/ 1ould keep certain ,ob• #isk averse person s losses (decreased

utility are more important than risky gains


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#isk verse

• Can see risk averse choices graphically• #isky ,ob has e0pected income = 6)82888

with e0pected utility = &9 / *oint ;

• Certain ,ob has e0pected income =6)82888 with utility = &G / *oint "


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Income "#1,%%%$

-tility

*'e consumer is ris)averse because s'e +ouldpre er a certain income o

#2%,%%% to an uncertainexpected income #2%,%%%

E

1%

1% 2%

1/

10

1

% 10 %

A

C

D

#isk verse Utility ;unction

F


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• person is said to be ris) neutral if theyshow no preference between a certainincome2 and an uncertain income with thesame e0pected value

• Constant marginal utility of income


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#isk Meutral

• 30pected value for risky option is thesame as utility for certain outcome3(I = (8'5 (6&82888 K (8'5 (6782888

= 6)828883(u = (8'5 (G K (8'5 (& = &)

• $his is the same as the certain income of6)82888 with utility of &)


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Income "#1,%%%$1% 2%

-tility

% %

0 A

E

C 12

1

*'e consumer is ris)neutral and is indi erentbet+een certain events

and uncertain events+it' t'e same

expected income.

#isk Meutral


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• person is said to be ris) lovin( if theyshow a preference toward an uncertainincome over a certain income with thesame e0pected value / 30amples% ambling2 some criminal activities

• Increasing marginal utility of income


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#isk Noving

• 30pected value for risky option / point ;3(I = (8'5 (6&82888 K (8'5 (6782888

= 6)828883(u = (8'5 (7 K (8'5 (& = &8'5

• Certain income is 6)82888 with utility of / point C

• #isky alternative is preferred


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Income "#1,%%%$

-tility

% 1% 2% %

*'e consumer is ris)lovin( because s'e

+ould pre er t'e (ambleto a certain income.

#isk Noving

A

E

C

1

F 1%.&


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• $he ris) premium is the ma0imumamount of money that a risk@averseperson would pay to avoid taking a risk

• $he risk premium depends on the riskyalternatives the person faces


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#isk *remium / 30ample

• ;rom the previous e0ample / person has a '5 probability of earning

6782888 and a '5 probability of earning

6&82888 / $he e0pected income is 6)82888 with

e0pected utility of &9


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• *oint ; shows the risky scenario / theutility of &9 can also be obtained withcertain income of 6&G2888

• $his person would be willing to pay up to69888 ()8 / &G to avoid the risk ofuncertain income

• Can show this graphically by drawing astraight line between the two points / lineC;


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Income "#1,%%%$

-tility

% 1% 10

3ere, t'e ris)premium is #/,%%%because a certainincome o #10,%%%(ives t'e person

t'e same expectedutility as t'e

uncertain income+it' expected value

o #2%,%%%.

1%

1

% /%

2%

1/ A

C E

G

2%

4is) Premium

F


#i k i d I diff


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#isk version and IndifferenceCurves

• Can describe a person s risk aversionusing indifference curves that relatee0pected income to variability of income

(standard deviation• .ince risk is undesirable2 greater riskre-uires greater e0pected income to makethe person e-ually well off

• Indifference curves are therefore upwardsloping

#i k i d I diff


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Standard Deviation o Income

!xpectedIncome

3i('ly 4is) 5verse: 5nincrease in standarddeviation re6uires alar(e increase inincome to maintain

satis action.

U 1

U 2

U 3

#isk ersion and Indifference


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Standard Deviation o Income

!xpectedIncome

Sli('tly 4is) 5verse:5 lar(e increase in standarddeviation re6uires only asmall increase in incometo maintain satis action.

U 1

U 2

U 3


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#educing #isk

• Consumers are generally risk averse andtherefore want to reduce risk

• $hree ways consumers attempt toreduce risk are%

&' "iversification)' Insurance7' +btaining more information


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#educing #isk

• "iversification / #educing risk by allocating resources to a

variety of activities whose outcomes are not

closely related• 30ample%

/ .uppose a firm has a choice of selling air

conditioners2 heaters2 or both / $he probability of it being hot or cold is 8'5 / How does a firm decide what to sell!

Income from ales of


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Income from .ales of ppliances

3ot 7eat'er Cold7eat'er

5irconditionersales

6782888 6&)2888

3eater sales &)2888 782888


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"iversification / 30ample

• If the firm sells only heaters or airconditioners their income will be either6&)2888 or 6782888

• $heir e0pected income would be% / &:)(6&)2888 K &:)(6782888 = 6)&2888


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• If the firm divides their time evenly betweenappliances2 their air conditioning and heatingsales would be half their original values

• If it were hot2 their e0pected income would be6&52888 from air conditioners and 6G2888 fromheaters2 or 6)&2888

• If it were cold2 their e0pected income would be6G2888 from air conditioners and 6&52888 fromheaters2 or 6)&2888


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• 1ith diversification2 e0pected income is6)&2888 with no risk

• Better off diversifying to minimiDe risk• ;irms can reduce risk by diversifying

among a variety of activities that are notclosely related

#educing #isk / $he tock


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#educing #isk / $he .tockEarket

• If invest all money in one stock2 then takeon a lot of risk / If that stock loses value2 you lose all your

investment value• Can spread risk out by investing in many

different stocks or investments

/ 30% Eutual funds


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#educing #isk / Insurance

• #isk averse are willing to pay to avoid risk• If the cost of insurance e-uals the

e0pected loss2 risk averse people will buyenough insurance to recover fully from apotential financial loss


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$he Naw of Narge Mumbers

• Insurance companies know that althoughsingle events are random and largelyunpredictable2 the average outcome ofmany similar events can be predicted

• 1hen insurance companies sell manypolicies2 they face relatively little risk


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#educing #isk / ctuarially ;air

• Insurance companies can be sure totalpremiums paid will e-ual total money paidout

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


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$he 4alue of Information

• #isk often e0ists because we don t knowall the information surrounding a decision

• Because of this2 information is valuableand people are willing to pay for it


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$he 4alue of Information /


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$he 4alue of Information /30ample

• *er capita milk consumption has fallenover the years

• $he milk producers engaged in marketresearch to develop new sales strategiesto encourage the consumption of milk



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• ;indings / Eilk demand is seasonal with the greatest

demand in the spring

/ *rice elasticity of demand is negative andsmall

/ Income elasticity is positive and large



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• Eilk advertising increases sales most inthe spring

• llocating advertising based on thisinformation in Mew Fork increased profitsby AL or 6&9 million

• $he cost of the information was relativelylow2 while the value was substantial(increased profits


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Behavioral 3conomics

• .ometimes individuals behaviorcontradicts basic assumptions ofconsumer choice

/ Eore information about human behavior mightlead to better understanding / $his is the ob,ective of be'avioral

economics• Improving understanding of consumer choice by

incorporating more realistic and detailedassumptions regarding human behavior


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• $here are a number of e0amples ofconsumer choice contradictions / Fou take at trip and stop at a restaurant that

you will most likely never stop at again' Foustill think it fair to leave a &5L tip rewardingthe good service'

/ Fou choose to buy a lottery ticket even thoughthe e0pected value is less than the price ofthe ticket


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• #eference *oints / 3conomists assume that consumers place a

uni-ue value on the goods:services

purchased / *sychologists have found that perceivedvalue can depend on circumstances

• Fou are able to buy a ticket to the sold out Cher

concert for the published price of 6&)5' Fou findout you can sell the ticket for 6588 but you choosenot to2 even though you would never have paidmore than 6)58 for the ticket'


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• 4e erence Points "cont.$ / $he point from which an individual makes a

consumption decision

/ ;rom the e0ample2 owning the Cher ticket isthe reference point• Individuals dislike losing things they own• $hey value items more when they own them than

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

original utility gain from purchasing it


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• 30perimental 3conomics / .tudents were divided into two groups / roup one was given a mug with a market

value of 65'88 / roup two received nothing / .tudents with mugs were asked how much

they would take to sell the mug back• Nowest price for mugs2 on average2 was 6


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• 30perimental 3conomics (cont' / roup without mugs was asked minimum

amount of cash they would e0cept in lieu of

the mug• +n average willing to accept 67'58 instead of

getting the mug / roup one had reference point of owning the

mug / roup two had reference point of no mug


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• ;airness / Individuals often make choices because they

think they are fair and appropriate

• Charitable giving2 tipping in restaurants / .ome consumers will go out of their way topunish a store they think is OunfairP in theirpricing

/ Eanager might offer higher than marketwages to make for happier workingenvironment or more productive worker


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Chapter G

*roduction

d


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Introduction

• +ur study of consumer behavior wasbroken down into 7 steps% / "escribing consumer preferences

/ Consumers face budget constraints / Consumers choose to ma0imiDe utility

• *roduction decisions of a firm are similarto consumer decisions / Can also be broken down into three steps

d f


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*roduction "ecisions of a ;irm

&' *roduction $echnology / "escribe how inputs can be transformed into

outputs

• Inputs% land2 labor2 capital and raw materials• +utputs% cars2 desks2 books2 etc'

/ ;irms can produce different amounts ofoutputs using different combinations ofinputs

d i i i f i


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)' Cost Constraints / ;irms must consider prices of labor2 capital

and other inputs

/ ;irms want to minimiDe total production costspartly determined by input prices

/ s consumers must consider budgetconstraints2 firms must be concerned aboutcosts of production

* d i " i i f i


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7' Input Choices / iven input prices and production

technology2 the firm must choose how much

of each input to use in producing output / iven prices of different inputs2 the firm may

choose different combinations of inputs tominimiDe costs• If labor is cheap2 firm may choose to produce

with more labor and less capital

* d i " i i f i


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• If a firm is a cost minimiDer2 we can alsostudy / How total costs of production vary with output

/ How the firm chooses the -uantity toma0imiDe its profits

• 1e can represent the firm s production

technology in the form of a production unction

$h $ h l f * d i


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$he $echnology of *roduction

• *roduction ;unction% / Indicates the highest output ( q that a firm can

produce for every specified combination of

inputs / ;or simplicity2 we will consider only labor (N

and capital (Q / .hows what is technically feasible when the

firm operates efficiently

$h $ h l f * d i


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• $he production function for two inputs%q = ;(Q2N

/ +utput ( q is a function of capital (Q and labor(N

/ $he production function is true for a giventechnology

• If technology increases2 more output can beproduced for a given level of inputs

$h $ h l f * d i


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• .hort #un versus Nong #un / It takes time for a firm to ad,ust production

from one set of inputs to another

/ ;irms must consider not only what inputs canbe varied but over what period of time thatcan occur

/ 1e must distinguish between long run andshort run

$h $ h l f * d i


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• .hort #un / *eriod of time in which -uantities of one or

more production factors cannot be changed

/ $hese inputs are called fi0ed inputs• Nong #un / mount of time needed to make all production

inputs variable• .hort run and long run are not time

specific

* d ti % + 4 i bl I t


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*roduction% +ne 4ariable Input

• 1e will begin looking at the short runwhen only one input can be varied

• 1e assume capital is fi0ed and labor isvariable / +utput can only be increased by increasing

labor

/ Eust know how output changes as theamount of labor is changed ($able G'&

* d ti % + 4 i bl I t


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* d ti % + 4 i bl I t


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• +bservations%&' 1hen labor is Dero2 output is Dero as well)' 1ith additional workers2 output ( q increases

up to units of labor 7' Beyond this point2 output declines

• Increasing labor can make better use of e0istingcapital initially

• fter a point2 more labor is not useful and can becounterproductive

* d ti % + 4 i bl I t


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• ;irms make decisions based on thebenefits and costs of production

• .ometimes useful to look at benefits andcosts on an incremental basis / How much more can be produced when at

incremental units of an input!

• .ometimes useful to make comparison onan average basis

* d ti % + 4 i bl I t


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• verage product of Nabor @ +utput per unitof a particular product

• Eeasures the productivity of a firm s laborin terms of how much2 on average2 eachworker can produce

Lq==

Input Labor Output

AP L

*rod ction% +ne 4 ri ble Inp t


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• Earginal *roduct of Nabor / additionaloutput produced when labor increases byone unit

• Change in output divided by the change inlabor

Lq

∆

∆=

∆

∆=

Input Labor Output MP L



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• 1e can graph the information in $able G'&to show / How output varies with changes in labor

• +utput is ma0imiDed at &&) units / verage and Earginal *roducts

• Earginal *roduct is positive as long as total outputis increasing

• Earginal *roduct crosses verage *roduct at itsma0imum



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t point "2 output isma0imiDed'

8abor per 9ont'

Outputper9ont'

% 2 / & 0 ; 1%1

*otal Product

0%

112

A

B

C

D




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5vera(e Product


1%

2%

Outputper

7or)er

%

% 2 / & 0 ; 1%1 8abor per 9ont'

E 9ar(inal Product

•Neft of 3% E* R * S * is increasing•#ight of 3% E* T * S * is decreasing• t 3% E* = * S * is at its ma0imum• t units2 E* is Dero and output is at ma0

Earginal and verage *roduct


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Earginal and verage *roduct

• 1hen marginal product is greater than theaverage product2 the average product isincreasing

• 1hen marginal product is less than the averageproduct2 the average product is decreasing• 1hen marginal product is Dero2 total product

(output is at its ma0imum• Earginal product crosses average product at its

ma0imum

*roduct Curves


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*roduct Curves

• 1e can show a geometric relationshipbetween the total product and the averageand marginal product curves

/ .lope of line from origin to any point on thetotal product curve is the average product

/ t point B2 * = G8:7 = )8 which is the sameas the slope of the line from the origin to pointB on the total product curve

*roduct Curves


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*roduct Curves

1%

%

6


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*roduct Curves

• eometric relationship between totalproduct and marginal product / $he marginal product is the slope of the line

tangent to any corresponding point on thetotal product curve / ;or ) units of labor2 E* = 78:) = &5 which is

slope of total product curve at point

*roduct Curves


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*roduct Curves

8abor % 2 / & 0 ; 1%1

6

0%

112

%

1&

1%

%

6

/% 2 & 0 ; 1%18abor

A

9P is slope o line tan(ent tocorrespondin( point on *Pcurve

TP

MP

AP



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• ;rom the previous e0ample2 we can seethat as we increase labor the additionaloutput produced declines

• 8a+ o Diminis'in( 9ar(inal 4eturns % s the use of an input increases with otherinputs fi0ed2 the resulting additions to

output will eventually decrease

Naw of "iminishing Earginal


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#eturns• 1hen the use of labor input is small and

capital is fi0ed2 output increasesconsiderably since workers can begin to

specialiDe and E* of labor increases• 1hen the use of labor input is large2 some

workers become less efficient and E* of

labor decreases



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#eturns• $ypically applies only for the short run

when one variable input is fi0ed• Can be used for long@run decisions to

evaluate the trade@offs of different plantconfigurations

• ssumes the -uality of the variable inputis constant



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#eturns• 3asily confused with negative returns /

decreases in output• 30plains a declining marginal product2 not

necessarily a negative one / Additional output can be declining while total

output is increasing



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#eturns• ssumes a constant technology

/ Changes in technology will cause shifts in thetotal product curve

/ Eore output can be produced with sameinputs

/ Nabor productivity can increase if there areimprovements in technology2 even though anygiven production process e0hibits diminishingreturns to labor

$he 3ffect of $echnological


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ImprovementOutput

&%

1%%

8abor per time period% 2 / & 0 ; 1%1

A

O 1

C

O 3

O 2

B

9ovin( rom 5 to = toC, labor productivity isincreasin( over time

*roduction% $wo 4ariable Inputs


115/286

roduction% $wo 4ariable Inputs

• ;irm can produce output by combiningdifferent amounts of labor and capital

• In the long run2 capital and labor are bothvariable

• 1e can look at the output we can achievewith different combinations of capital and

labor / $able G'9



116/286




117/286


• $he information can be representedgraphically using iso6uants / Curves showing all possible combinations of

inputs that yield the same output• Curves are smooth to allow for use of

fractional inputs

/ Curve & shows all possible combinations oflabor and capital that will produce 55 units ofoutput

Iso-uant Eap


118/286

Iso uant Eap

8abor per year 1 2 / &

!x: && units o outputcan be produced +it'

> ? 18 "pt. 5$ O4

1> ? 8 "pt. D$

q 1 = &&

q 2 = &

q 3 = ;%

1

2

/

&Capitalper year

D

E

A B C



119/286


• "iminishing #eturns to Nabor withIso-uants

• Holding capital at 7 and increasing laborfrom 8 to & to ) to 7 / +utput increases at a decreasing rate (82 552

)82 &5 illustrating diminishing marginal

returns from labor in the short run and longrun



120/286


• "iminishing #eturns to Capital withIso-uants

• Holding labor constant at 7 increasingcapital from 8 to & to ) to 7 / +utput increases at a decreasing rate (82 552

)82 &5 due to diminishing returns from capital

in short run and long run

"iminishing #eturns


121/286

iminishing #eturns

8abor per year 1 2 / &

Increasin( labor'oldin( capital

constant "5, =, C$O4

Increasin( capital'oldin( labor constant

"!, D, C

q 1 = &&

q 2 = &

q 3 = ;%

1

2

/

&Capitalper year

D

E

A B C



122/286


• .ubstituting mong Inputs / Companies must decide what combination of

inputs to use to produce a certain -uantity of

output / $here is a trade@off between inputs2 allowingthem to use more of one input and less ofanother for the same level of output



123/286


• .ubstituting mong Inputs / .lope of the iso-uant shows how one input

can be substituted for the other and keep the

level of output the same / $he negative of the slope is the mar(inal rateo tec'nical substitution "94*S$

• mount by which the -uantity of one input can bereduced when one e0tra unit of another input isused2 so that output remains constant



124/286


• $he marginal rate of technical substitutione-uals%

)( q L

K MRTS

Input Labor inChange Input Capital inChange MRTS

of levelfi0edafor ∆

∆−=

−=



125/286


• s labor increases to replace capital / Nabor becomes relatively less productive / Capital becomes relatively more productive

/ Meed less capital to keep output constant / Iso-uant becomes flatter

Earginal #ate of $ h i l b i i


126/286

$echnical .ubstitution

Labor per month

1

2

/

1 2 / &

&Capital per year @e(ative Slope measures

94*SA94*S decreases as move do+n

t'e indi erence curve

1

1

1

1

2

1

2<

1<

Q 1 =&&

Q 2 = &

Q 3 =;%

E#$. and Iso-uants


127/286

E#$. and Iso uants

• 1e assume there is diminishing E#$. / Increasing labor in one unit increments from & to 5

results in a decreasing E#$. from & to &:) / *roductivity of any one input is limited

• "iminishing E#$. occurs because ofdiminishing returns and implies iso-uants areconve0

• $here is a relationship between E#$. andmarginal products of inputs

E#$ d E i l * d


128/286

E#$. and Earginal *roducts• If we increase labor and decrease capital

to keep output constant2 we can see howmuch the increase in output is due to the

increased labor / mount of labor increased times the marginal

productivity of labor

))(( L MP L ∆=

E#$. and Earginal *roducts


129/286

E#$. and Earginal roducts

• .imilarly2 the decrease in output from thedecrease in capital can be calculated / "ecrease in output from reduction of capital

times the marginal produce of capital

))(( K MP K ∆=



130/286

$ g

• If we are holding output constant2 the neteffect of increasing labor and decreasingcapital must be Dero

• Using changes in output from capital andlabor we can see

0 K) )( (MP L) )( (MP K L =∆+∆



131/286

$ g

• #earranging e-uation2 we can see therelationship between E#$. and E*s

MRTS K L

MP

L

K

=∆

∆−=

∆=∆

=∆+∆

)()

))(

L

K L

K L

(MP

K) )( (MP -(MP

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

Iso-uants% .pecial Cases


132/286

p

• $wo e0treme cases show the possiblerange of input substitution in production

&' *erfect substitutes / E#$. is constant at all points on iso-uant / .ame output can be produced with a lot of

capital or a lot of labor or a balanced mi0

*erfect .ubstitutes


133/286

8abor per mont'

Capitalpermont'

Q 1 Q 2 Q 3

A

B

C

Same output can bereac'ed +it' mostlycapital or mostly labor"5 or C$ or +it' e6ualamount o bot' "=$

Iso-uants% .pecial Cases


134/286

p

)' *erfect Complements / ;i0ed proportions production function / $here is no substitution available between

inputs / $he 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

;i0ed@*roportions* d ti ti


135/286

*roduction ;unction

8abor per mont'

Capitalper

mont'

L1

K 1 Q 1 A

Q 2

Q 3

B

C

Same output canonly be produced+it' one set oinputs.

#eturns to .cale


136/286

• In addition to discussing the tradeoffbetween inputs to keep production thesame

• How does a firm decide2 in the long run2the best way to increase output! / Can change the scale of production by

increasing all inputs in proportion / If double inputs2 output will most likelyincrease but by how much!

#eturns to .cale


137/286

• #ate at which output increases as inputsare increased proportionately / Increasing returns to scale

/ Constant returns to scale / "ecreasing returns to scale

#eturns to .cale


138/286

• Increasin( returns to scale % output morethan doubles when all inputs are doubled / Narger output associated with lower cost

(cars / +ne firm is more efficient than many (utilities / $he iso-uants get closer together

Increasing #eturns to cale


139/286

Increasing #eturns to .cale

1%2%

%

*'e iso6uantsmove closerto(et'er

8abor "'ours$& 1%

Capital"mac'ine

'ours$

2

/

A

#eturns to cale


140/286

#eturns to .cale

• Constant returns to scale % outputdoubles when all inputs are doubled / .iDe does not affect productivity / Eay have a large number of producers / Iso-uants are e-uidistant apart

#eturns to cale


141/286

#eturns to .cale

Constant4eturns:

Iso6uants are

e6ually spaced

2%

%

8abor "'ours$1&& 1%

A

1%

Capital"mac'ine

'ours$

2

/

0

#eturns to cale


142/286

#eturns to .cale

• Decreasin( returns to scale % output lessthan doubles when all inputs are doubled / "ecreasing efficiency with large siDe / #eduction of entrepreneurial abilities / Iso-uants become farther apart

#eturns to cale


143/286

#eturns to .cale

8abor "'ours$

Capital"mac'ine

'ours$

Decreasin( 4eturns:

Iso6uants (et urt'erapart

1%2%

1%

/

A

%

&

2


144/286

Chapter <

$he Cost of *roduction

Eeasuring Cost%1hich Costs Eatter!


145/286

1hich Costs Eatter!• ;or a firm to minimiDe costs2 we must

clarify what is meant by costs and how tomeasure them

/ It is clear that if a firm has to rent e-uipmentor buildings2 the rent they pay is a cost / 1hat if a firm owns its own e-uipment or

building!• How are costs calculated here!



146/286

1hich Costs Eatter!• ccountants tend to take a retrospective

view of firms costs2 whereas economiststend to take a forward@looking view

• ccounting Cost / ctual e0penses plus depreciation charges forcapital e-uipment

• 3conomic Cost / Cost to a firm of utiliDing economic resources

in production2 including opportunity cost



147/286

1hich Costs Eatter!• 3conomic 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 putto their highest@value use

+pportunity Cost


148/286

• n 30ample / firm owns its own building and pays no rent

for office space / "oes this mean the cost of office space is

Dero! / $he building could have been rented instead / ;oregone rent is the opportunity cost of using

the building for production and should beincluded in the economic costs of doingbusiness

+pportunity Cost


149/286

• person starting their own business musttake into account the opportunity cost oftheir time

/ Could have worked elsewhere making acompetitive salary



150/286

1hich Costs Eatter!• lthough opportunity costs are hidden and

should be taken into account2 sunk costsshould not

• Sun) Cost / 30penditure that has been made and cannot

be recovered

/ .hould not influence a firm s future economicdecisions

.unk Cost


151/286

• ;irm buys a piece of e-uipment thatcannot be converted to another use

• 30penditure on the e-uipment is a sunk

cost / Has no alternative use so cost cannot be

recovered / opportunity cost is Dero

/ "ecision to buy the e-uipment might havebeen good or bad2 but now does not matter

*rospective .unk Cost


152/286

• n 30ample / ;irm is considering moving its head-uarters / firm paid 65882888 for an option to buy a

building / $he cost of the building is 65 million for a total

of 65'5 million / $he firm finds another building for 65')5

million / 1hich building should the firm buy!

*rospective .unk Cost


153/286

$he first building should be purchased• $he 65882888 is a sunk cost and should

not be considered in the decision to buy

• 1hat should be considered is / .pending an additional 652)582888 or / .pending an additional 6528882888



154/286

1hich Costs Eatter!• .ome costs vary with output2 while some

remain the same no matter the amount ofoutput

• $otal cost can be divided into%&' ;i0ed Cost

/ "oes not vary with the level of output

)' 4ariable Cost / Cost that varies as output varies

;i0ed and 4ariable Costs


155/286

• $otal output is a function of variable inputsand fi0ed inputs

• $herefore2 the total cost of production

e-uals the fi0ed cost (the cost of the fi0edinputs plus the variable cost (the cost ofthe variable inputs 2 or?

4C;C$C +=

;i0ed and 4ariable Costs


156/286

• 1hich costs are variable and which arefi0ed depends on the time horiDon

• .hort time horiDon / most costs are fi0ed

• Nong time horiDon / many costs becomevariable• In determining how changes in production

will affect costs2 must consider if fi0ed orvariable costs are affected'

;i0ed Cost 4ersus .unk Cost


157/286

• ;i0ed cost and sunk cost are oftenconfused

• ;i0ed Cost

/ Cost paid by a firm that is in businessregardless of the level of output

• .unk Cost

/ Cost that has been incurred and cannot berecovered



158/286

1hich Costs Eatter!• *ersonal Computers

/ Eost costs are variable / Nargest component% labor

• .oftware / Eost costs are sunk / Initial cost of developing the software

Eeasuring Costs


159/286

• Earginal Cost (EC % / $he cost of e0panding output by one unit / ;i0ed costs have no impact on marginal cost2

so it can be written as%

Δq ΔTC

Δq ΔVC

MC ==

Eeasuring Costs


160/286

• verage $otal Cost ( $C / Cost per unit of output / lso e-uals average fi0ed cost ( ;C plus

average variable cost ( 4C

q

TVC

q

TFC

q

TC ATC +==

AVC AFCq

TC ATC +==

;irm s .hort #un Costs


161/286

;irm s .hort #un Costs


162/286

"eterminants of .hort #un Costs


163/286

• $he rate at which these costs increasedepends on the nature of the productionprocess

/ $he e0tent to which production involvesdiminishing returns to variable factors• "iminishing returns to labor

/ 1hen marginal product of labor is decreasing



164/286

• If marginal product of labor decreasessignificantly as more labor is hired / Costs of production increase rapidly / reater and greater e0penditures 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

"eterminants of .hort #unCosts / n 30ample


165/286

Costs / n 30ample• ssume the wage rate ( w is fi0ed relative

to the number of workers hired• 4ariable costs is the per unit cost of e0tra

labor times the amount of e0tra labor% w N

q Lw

∆

∆=∆

∆=q

VC MC



166/286

• #emembering that

L

MPL ∆∆

=∆ Q

LMP1

QL

Qunit1aforL ∆=∆∆

=∆∆

nd rearranging



167/286

• 1e can conclude%

LMP MC w

=

?and a low marginal product (E* N leadsto a high marginal cost (EC and viceversa



168/286

• Conse-uently / EC decreases initially with increasing returns

• 8 through 9 units of output

/ EC increases with decreasing returns• 5 through && units of output

Cost Curves for a ;irm


169/286

Output

Cost"# per year$

1%%

2%%

%%

/%%

% 1 2 / & 0 ; 1% 11 12 1

BC

Bariable costincreases +it'production and

t'e rate varies +it'increasin( and

decreasin( returns.

*C

*otal costis t'e vertical

sum o FCand BC.

FC&%

Fixed cost does notvary +it' output

Cost Curves


170/286

MC

ATC

AVC

AFC

Cost Curves


171/286

• 1hen EC is below 4C2 4C is falling• 1hen EC is above 4C2 4C is rising• 1hen EC is below $C2 $C is falling

• 1hen EC is above $C2 $C is rising• $herefore2 EC crosses 4C and $C at theminimums / $he verage / Earginal relationship

Cost Curves for a ;irm


172/286

• $he line drawn fromthe origin to thevariable cost curve% / Its slope e-uals 4C

/ $he slope of a pointon 4C or $C e-ualsEC

/ $herefore2 EC =

4C at < units ofoutput (point 1 2 / & 0 ; 1% 11 12 1

Output

P

1%%

2%%

%%

/%%

FC

BC

*C

A

Cost in the Nong #un


173/286

• In the long run a firm can change all of itsinputs

• In making cost minimiDing choices2 must

look at the cost of using capital and laborin production decisions

Cost EinimiDing Input Choice


174/286

• How do we put all this together to select inputs toproduce a given output at minimum cost!• ssumptions

/ $wo Inputs% Nabor (N and capital (Q /

*rice of labor% wage rate (w / $he price of capital

• r = depreciation rate K interest rate• +r rental rate if not purchasing

• $hese are e-ual in a competitive capitalmarket



175/286

• $he Isocost Nine / line showing all combinations of N S Q that

can be purchased for the same cost

/ $otal cost of production is sum of firm s laborcost2 wN2 and its capital cost2 rQ%

C = wN K rQ / ;or each different level of cost2 the e-uation

shows another isocost line



176/286

• #ewriting C as an e-uation for a straightline% / Q = C:r @ (w:r N

/ .lope of the isocost%• @(w:r is the ratio of the wage rate to rental cost ofcapital'

• $his shows the rate at which capital can be

substituted for labor with no change in cost

( )r w

L K −=

∆

∆

Choosing Inputs


177/286

• 1e will address how to minimiDe cost for agiven level of output by combiningisocosts with iso-uants

• 1e choose the output we wish to produceand then determine how to do that atminimum cost / Iso-uant is the -uantity we wish to produce

/ Isocost is the combination of Q and N thatgives a set cost

*roducing a iven +utput atEinimum Cost


178/286

8abor per year

Capital

per year

Isocost C 2 s'o+s 6uantity

Q 1 can be produced +it'combination K2,L2 or K3,L3.

3o+ever, bot' o t'eseare 'i('er cost combinations

t'an K1,L1.

Q 1

Q 1 is an iso6uant or output Q 1.There are three isocost li es, o!"hich 2 are #ossi$le choices i

"hich to #ro%&ce Q1.

C ' C 1 C 2

AK 1

L1

K 3

L3

K 2

L2

Input .ubstitution 1hen anInput *rice Change


179/286

p g• If the price of labor changes2 then the

slope of the isocost line changes2 @(w:r• It now takes a new -uantity of labor and

capital to produce the output• If price of labor increases relative to price

of capital2 and capital is substituted for

labor

Input .ubstitution 1hen anInput *rice Change


180/286

p g

C 2

*'e ne+ combination o Kand L is used to produce Q 1.

Combination B is used inplace o combination A.K 2

L2

B

C 1

K 1

L1

A

Q 1

I t'e price o labor rises, t'e isocost curve

becomes steeper due tot'e c'an(e in t'e slope (")L*.

8abor per year

Capitalper

year



181/286

• How does the isocost line relate to thefirm s production process!

K

L

MPMP-

M !" −=

∆

∆= L

K

r w

L K −=

∆∆= #ini%o&o%tof "#o'

costminimiDesfirmwhenr w

MP MP

K

L =



182/286

• $he minimum cost combination can thenbe written as%

/ Einimum cost for a given output will occurwhen each dollar of input added to theproduction process will add an e-uivalentamount of output'

r w K LMPMP

=



183/286

• If w = 6&82 r = 6)2 and E* N = E* Q2 whichinput would the producer use more of! / Nabor because it is cheaper

/ Increasing labor lowers E* N / "ecreasing capital raises E* Q / .ubstitute labor for capital until

r MP

w MP K L =



184/286

• Cost minimiDation with 4arying +utputNevels / ;or each level of output2 there is an isocost

curve showing minimum cost for that outputlevel

/ firm sexpansion pat' shows the minimumcost combinations of labor and capital at each

level of output / .lope e-uals ∆ Q:∆ N

;irm s 30pansion *ath


185/286

!xpansion Pat'

*'e expansion pat' illustratest'e least cost combinations o labor and capital t'at can beused to produce eac' level o

output in t'e lon( run.

Capitalper

year

2&

&%

&

1%%

1&%

&%8abor per year

1%% 1&% %%2%%

A

#2%%%

2%% -nits

B

# %%%

%% -nits

C

30pansion *ath and Nong #unCosts


186/286

• ;irm s e0pansion path has sameinformation as long@run total cost curve• $o move from e0pansion path to N# cost

curve / ;ind tangency with iso-uant and isocost / "etermine min cost of producing the output

level selected / raph output@cost combination

;irm s Nong #un $otal CostCurve


187/286

8on( 4un *otal Cost

Output, -nits


188/286

• In the short run2 some costs are fi0ed• In the long run2 firm can change anything

including plant siDe

/ Can produce at a lower average cost in longrun than in short run / Capital and labor are both fle0ible

• 1e can show this by holding capital fi0edin the short run and fle0ible in long run

$he Infle0ibility of .hort #un*roduction


189/286

Capital is ixed at >1.*o produce 61, min cost at >1,81.I increase output to E2, min cost

is >1 and 8 in s'ort run.

8on( 4un!xpansion Pat'

8abor per year

Capitalper

year

L2

Q 2

K 2

D

C

F

E

Q 1

A

BL1

K 1

L3

+ S'ort 4un!xpansion Pat'

In 84, canc'an(e

capital andmin costsalls to >2

and 82.

Nong #un 4ersus.hort #un Cost Curves


190/286

• Nong@#un verage Cost (N C / Eost important determinant of the shape of

the N# C and EC curves is relationshipbetween scale of the firm s operation andinputs re-uired to minimiDe cost

&' Constant #eturns to .cale / If input is doubled2 output will double / C cost is constant at all levels of output

Nong #un 4ersus .hort #unCost Curves


191/286

)' Increasing #eturns to .cale / If input is doubled2 output will more than

double /

C decreases at all levels of output7' "ecreasing #eturns to .cale / If input is doubled2 output will less than

double / C increases at all levels of output



192/286

• In the long run% / ;irms e0perience increasing and decreasingreturns to scale and therefore long@runaverage cost is OUP shaped'

/ .ource of U@shape is due to returns to scaleinstead of decreasing returns to scale like theshort@run curve

/ Nong@run marginal cost curve measures thechange in long@run total costs as output isincreased by & unit



193/286

• Nong@run marginal cost leads long@runaverage cost% / If NEC T N C2 N C will fall

/ If NEC R N C2 N C will rise / $herefore2 NEC = N C at the minimum ofN C

• In special case where N C is constant2N C and NEC are e-ual

Nong #un verage and EarginalCost


194/286

Output

Cost"# per unit

o output

85C

89C

A

Nong #un Costs


195/286

• s output increases2 firm s C ofproducing is likely to decline to a point&' +n a larger scale2 workers can better specialiDe)' .cale can provide fle0ibility / managers can

organiDe production more effectively7' ;irm may be able to get inputs at lower cost if can

get -uantity discounts' Nower prices might lead todifferent input mi0'

Nong #un Costs


196/286

• t some point2 C will begin to increase&' ;actory space and machinery may make itmore difficult for workers to do their ,obsefficiently

)' Eanaging a larger firm may become morecomple0 and inefficient as the number oftasks increase

7' Bulk discounts can no longer be utiliDed'Nimited availability of inputs may cause priceto rise'

Nong #un Costs


197/286

• 1hen input proportions change2 the firm se0pansion path is no longer a straight line / Concept of return to scale no longer applies

• 3conomies of scale reflects inputproportions that change as the firmchanges its level of production

3conomies and "iseconomiesof .cale


198/286

• 3conomies of .cale / Increase in output is greater than the increasein inputs

• "iseconomies of .cale / Increase in output is less than the increase in

inputs• U@shaped N C shows economies of scale

for relatively low output levels anddiseconomies of scale for higher levels

Nong #un Costs


199/286

• Increasing #eturns to .cale / +utput more than doubles when the -uantities

of all inputs are doubled

• 3conomies of .cale / "oubling of output re-uires less than adoubling of cost

Nong #un Costs


200/286

• 3conomies of scale are measured interms of cost@output elasticity2 3 C• 3C is the percentage change in the cost of

production resulting from a &@percentincrease in output

AC MC

QQ

C C E C

=∆

∆=

Nong #un Costs


201/286

• 3 C is e-ual to &2 EC = C / Costs increase proportionately with output / Meither economies nor diseconomies of scale

• 3 C T & when EC T C / 3conomies of scale / Both EC and C are declining

• 3 C R & when EC R C

/ "iseconomies of scale / Both EC and C are rising



202/286

• 1e will use short and long run costs todetermine the optimal plant siDe• 1e can show the short run average costs

for 7 different plant siDes• $his decision is important because once

built2 the firm may not be able to change

plant siDe for a while

Nong #un Cost with 3conomiesand "iseconomies of .cale


203/286

Nong #un Cost withConstant #eturns to .cale


204/286

• $he optimal plant siDe will depend on theanticipated output / If e0pect to produce - 8 2 then should build

smallest plant% C = 6 / If produce more2 like - &2 C rises / If e0pect to produce - ) 2 middle plant is least

cost / If e0pect to produce - 7 2 largest plant is best



205/286



206/286

• 1hat is the firm s long run cost curve! / ;irms can change scale to change output inthe long run

/ $he long run cost curve is the dark blueportion of the . C curve which represents theminimum cost for any level of output

/ ;irm will always choose plant that minimiDes

the average cost of production



207/286



208/286

• $he long@run average cost curve envelopsthe short@run average cost curves• $he N C curve e0hibits economies of

scale initially but e0hibits diseconomies athigher output levels


209/286

Chapter

*rofit Ea0imiDation andCompetitive .upply

*erfectly Competitive Earkets


210/286

• $he model of perfect competition can beused to study a variety of markets• Basic assumptions of *erfectly

Competitive Earkets&' *rice taking)' *roduct homogeneity

7' ;ree entry and e0it



211/286

&' *rice $aking / $he individual firm sells a very small share ofthe total market output and2 therefore2cannot influence market price

/ 3ach firm takes market price as given / pricetaker

/ $he individual consumer buys too small a

share of industry output to have any impacton market price



212/286

)' *roduct Homogeneity / $he products of all firms are perfectsubstitutes

/ *roduct -uality is relatively similar as well asother product characteristics

/ gricultural products2 oil2 copper2 iron2lumber

/ Heterogeneous products2 such as brandnames2 can charge higher prices becausethey are perceived as better



213/286

7' ;ree 3ntry and 30it / 1hen there are no special costs that make itdifficult for a firm to enter (or e0it an industry

/ Buyers can easily switch from one supplierto another

/ .uppliers can easily enter or e0it a market• *harmaceutical companies are not perfectly

competitive because of the large costs of #S"re-uired

1hen are Earkets Competitive!


214/286

• ;ew real products are perfectly competitive• Eany markets are2 however2 highly

competitive / $hey face relatively low entry and e0it costs / Highly elastic demand curves

• Mo rule of thumb to determine whether amarket is close to perfectly competitive / "epends on how they behave in situations

*rofit Ea0imiDation


215/286

• "o firms ma0imiDe profits! / Eanagers in firms may be concerned withother ob,ectives

• #evenue ma0imiDation• #evenue growth• "ividend ma0imiDation• .hort@run profit ma0imiDation (due to bonus or

promotion incentive / Could be at e0pense of long run profits

*rofit Ea0imiDation


216/286

• Implications of non@profit ob,ective / +ver the long run2 investors would not supportthe company

/ 1ithout profits2 survival is unlikely incompetitive industries

• Eanagers have constrained freedom topursue goals other than long@run profitma0imiDation

Earginal #evenue2 EarginalCost2 and *rofit Ea0imiDation


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• 1e can study profit ma0imiDing output forany firm2 whether perfectly competitive ornot / *rofit ( π = $otal #evenue @ $otal Cost / If - is output of the firm2 then total revenue is

price of the good times -uantity / $otal #evenue (# = *-



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• Costs of production depends on output / $otal Cost (C = C(-• *rofit for the firm2 π 2 is difference between

revenue and costs

)()()( qC q Rq −=π


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• #evenue is a curve2 showing that a firm can onlysell more if it lowers its price• .lope of the revenue curve is the marginal

revenue / Change in revenue resulting from a one@unit increase

in output

• .lope of the total cost curve is marginal cost / dditional cost of producing an additional unit of

output



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• If the producer tries to raise price2 sales are Dero• *rofit is negative to begin with2 since revenue isnot large enough to cover fi0ed and variablecosts

• s output rises2 revenue rises faster than costsincreasing profit• *rofit increases until it is ma0ed at -J• *rofit is ma0imiDed where E# = EC or where

slopes of the #(- and C(- curves are e-ual

*rofit Ea0imiDation / .hort #un


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%

Cost,4evenue,

Pro it"#s per

year$

Output

C"6$

4"6$

5

=

"6$q ' q

Pro its are maximi ed +'ere 94 "slopeat 5$ and 9C "slope at =$ are e6ual

Pro its aremaximi ed+'ere 4"6$ GC"6$ is

maximi ed



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• *rofit is ma0imiDed at the point at whichan additional increment to output leavesprofit unchanged

MC MR MC MR

qC

q R

q

C R

=

=−=

=∆

∆−

∆

∆=

∆

∆

−=

0

0π

π


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$he Competitive ;irm


225/286

% #/

Output"bus'els$

Price# perbus'el

1%% 2%%

FirmIndustry

D

#/

-

Price# perbus'el

Output"millionso bus'els$

1%%



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• $he competitive firm s demand / Individual producer sells all units for 69regardless of that producer s level of output

/ E# = * with the horiDontal demand curve / ;or a perfectly competitive firm2 profit

ma0imiDing output occurs when

AR P MRq MC ===)(

Choosing +utput% .hort #un


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• 1e will combine revenue and costs withdemand to determine profit ma0imiDingoutput decisions

• In the short run2 capital is fi0ed and firmmust choose levels of variable inputs toma0imiDe profits

•1e can look at the graph of E#2 EC2 $Cand 4C to determine profits

Competitive ;irm

Price C


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q 2

1%

2%

%

/%

Price

&%

A/C

ATC

% 1 2 / & 0 ; 1% 11Outputq

A0= 0=+ A

q 1 0 C q 2 C 0 q C = 0

q 1

8ost Pro itor 62H68ost Pro it

or 62H6

Choosing +utput% .hort #un


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• $he point where E# = EC2 the profitma0imiDing output is chosen / E# = EC at -uantity2 -J2 of / t a -uantity less than 2 E# R EC2 so more

profit can be gained by increasing output / t a -uantity greater than 2 EC R E#2

increasing output will decrease profits

Competitive ;irm / *ositive*rofits

Price C


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1%

2%

%

/%

Price

&%

% 1 2 / & 0 ; 1% 11Outputq 2

A/C

ATC

q

A0= 0=+ A

q 1

D

C = Pro its aredetermined by output per

unit times6uantity

Pro it perunit P5C"6$ 5to =

*otalPro it 5=CD



231/286

• firm does not have to make profits• It is possible a firm will incur losses if the *T C for the profit ma0imiDing -uantity

/ Noss

Competitive ;irm / Nosses

C


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Price

Output

C

A/C

ATC

+ = 0 D

5t q : 94 9C and P 5*C8osses "P 5C$ x q or 5=CD

q

A

BC

.hort #un *roduction


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• 1hy would a firm produce at a loss! / Eight think price will increase in near future / .hutting down and starting up could be costly

• ;irm has two choices in short run / Continue producing / .hut down temporarily

/ 1ill compare profitability of both choices


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Competitive ;irm / Nosses

C


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Price

Output

P 5*C but5BC soirm +ill

continue toproduce ins'ort run

C

A/C

ATC

+ = 0 D

q

A

BC

8osses

E F


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Competitive ;irm s.hort@#un .upply CurvePrice

"# per *'e irm c'ooses t'e


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unit$

Output

9C

5BC

5*C

P 5BC

P 2

6 2

output level +'ere P 94 9C,as lon( as P H 5BC.

P 1

6 1

S

Supply is 9Cabove 5BC

Competitive ;irm s.hort@#un .upply Curve


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• .upply is upward sloping due todiminishing returns• Higher price compensates the firm for the

higher cost of additional output andincreases total profit because it applies toall units

Competitive ;irm s.hort@#un .upply Curve


239/286

• +ver time2 prices of product and inputscan change• How does the firm s output change in

response to a change in the price of aninput! / 1e can show an increase in marginal costs

and the change in the firm s output decisions

$he #esponse of a ;irm toa Change in Input *ricePrice


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9C 2

q 2

Input cost increasesand C s'i ts to C 2 and q alls to q 2 .

9C 1

q 1

"# per unit$

Output

#&

Savin(s to t'e irmrom reducin( output

$he .hort@#un Earket .upplyCurve

• s price rises2 firms e0pand their production


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p p p• Increased production leads to increased

demand for inputs and could cause increases ininput prices

• Increases in input prices cause EC curve to rise• $his lowers each firm s output choice• Causes industry supply to be less responsive to

change in price than would be otherwise

3lasticity of Earket .upply


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• 3lasticity of Earket .upply / Eeasures the sensitivity of industry output tomarket price

/ $he percentage change in -uantity supplied22 in response to &@percent change in price

)()( P P QQ E s

∆∆=

3lasticity of Earket .upply

• 1hen EC increases rapidly in response to


243/286

p y pincreases in output2 elasticity is low

• 1hen EC increases slowly2 supply is relativelyelastic

• Per ectly inelastic short@run supply arises whenthe industry s plant and e-uipment are so fullyutiliDed that new plants must be built to achievegreater output

• Per ectly elastic short@run supply arises whenmarginal costs are constant

*roducer .urplus in the .hort#un

• *rice is greater than EC on all but the last unit of


244/286

goutput

• $herefore2 surplus is earned on all but the lastunit

• $he producer surplus is the sum over all unitsproduced of the difference between the marketprice of the good and the marginal cost ofproduction

• rea above supply curve to the market price

*roducer .urplus for a ;irmPrice


245/286

Producer Producer SurplusSurplus

Producer surplusis area above 9C

to t'e price

"# per unit o

output$

Output

A/C A/C C C

A ABB

+ +

q q

5t q C = 0.=et+een % and q,

0 C or all units .

$he .hort@#un Earket .upplyCurve


246/286

• .um of EC from 8 to -J2 it is the sum ofthe total variable cost of producing -J• *roducer .urplus can be defined as the

difference between the firm s revenue andits total variable cost

• 1e can show this graphically by therectangle BC"

/ #evenue (8 B-J minus variable cost (8"C-J


247/286

*roducer .urplus 4ersus *rofit


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• *rofit is revenue minus total cost (not ,ustvariable cost• 1hen fi0ed cost is positive2 producer

surplus is greater than profit

4C@#*..urplus*roducer ==

;C@4C@#*rofit ==

*roducer .urplus 4ersus *rofit


249/286

• Costs of production determine magnitudeof producer surplus / Higher cost firms have less producer surplus / Nower cost firms have more producer surplus / dding up surplus for all producers in the

market given total market producer surplus / rea below market price and above supply

curve

*roducer .urplus for a EarketPrice - -


250/286

DD

+ +

Q Q

Producer Producer SurplusSurplus

9ar)et producer surplus ist'e di erence bet+een +

and - rom % to Q .

"# per unit o

output$

Output

Choosing +utput in the Nong#un


251/286

• In short run2 one or more inputs are fi0ed / "epending on the time2 it may limit thefle0ibility of the firm

• In the long run2 a firm can alter all itsinputs2 including the siDe of the plant

• 1e assume free entry and free e0it / Mo legal restrictions or e0tra costs

Choosing +utput in the Nong#un

• In the short run2 a firm faces a horiDontal


252/286

demand curve / $ake market price as given

• $he short@run average cost curve (. C and

short@run marginal cost curve (.EC are lowenough for firm to make positive profits ( BC"

• $he long@run average cost curve (N# C / 3conomies of scale to - ) / "iseconomies of scale after - )

+utput Choice in the Nong #unPrice

L C


253/286

q 1

BC

AD

In t'e s'ort run, t'eirm is aced +it' ixed

inputs. + = #/% H ATC.Pro it is e6ual to ABCD.

Output

+ = 0 #/%

-AC - C

q 3q 2

# %

LAC

+utput Choice in the Nong #unPrice L C

In t'e lon( run, t'e plant si e +ill beincreased and output increased to q 3.

8on( r n pro it EFGD H s'ort r n


254/286

Outputq 1

BC

AD+ = 0 #/%

-AC - C

q 3q 2

# %

LAC 8on( run pro it, EFGD H s'ort runpro it ABCD.

F G

Nong@#un Competitive3-uilibrium

l ilib i 2 fi h


255/286

• ;or long run e-uilibrium2 firms must haveno desire to enter or leave the industry• 1e can relate economic profit to the

incentive to enter and e0it the market


•V @* fi


256/286

Vero@*rofit / firm is earning a normal return on itsinvestment

/ "oing as well as it could by investing itsmoney elsewhere

/ Mormal return is firm s opportunity cost ofusing money to buy capital instead of

investing elsewhere / Competitive market long run e-uilibrium


•3 d 30i


257/286

3ntry and 30it / $he long@run response to short@run profits isto increase output and profits

/ *rofits will attract other producers / Eore producers increase industry supply2

which lowers the market price / $his continues until there are no more profits

to be gained in the market / Dero economicprofits

Nong@#un Competitive3-uilibrium / *rofits

# per# per Fi I d

•Pro it attracts irms•Supply increases until pro it %


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- 1

Output Output

# perunit o output

# perunit o output

LAC

L C

D

- 2 #/% + 1

Q 1

Firm Industry

Q 2

+ 2

q 2

# %

Nong@#un Competitive3-uilibrium / Nosses

# per# per Fi I d

•8osses cause irms to leave•Supply decreases until pro it %


259/286

- 2

Output Output

# perunit o output

# perunit o output

LAC

L C

D

- 1+ 2

Q 2

Firm Industry

Q 1

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