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Smith and F. A Hayek (above) see a positive role for social institutions and government participation. Adam Smith [1723- 1790], who was familiar with the work of the Physiocrats, advocated a social system based on ethics, markets and jurisprudence with a minimal role for government. 116 There are many arguments about the proper role of government. Some of the arguments are based on ideology while other disagreements arise on pragmatic grounds. Here are several possible roles for government: 6.1.4 Role of Government 6.1.5 PROPERTY RIGHTS One of the functions of government is to define and protect property rights. John Locke [1632-1704] argues the social contract is for the purpose of protecting property rights. Such diverse writers as Adam Smith [1723-1790] and Karl Marx [1818-1883] argue that this is one of the primary functions of governments. Property rights may also be defined and enforces by informal rules such as social institutions, civility, tradition, custom, mores and systems of ethics. 6.1.6 DOMESTIC JUSTICE Adam Smith included the enforcement of property rights under the establishment of domestic justice when he defined the role government. Domestic justice is broader and includes “protecting, as far as possible, every member of society from the injustice or oppression of every member of it... “ (Smith, Wealth of Nations, p 669) 6.1.7 NATIONAL DEFENSE While leaders and policy makers may argue about the level and nature of national defense, there are few who would argue that there is no reason for the state to provide protection from attack by other nations. The debate takes the form of the nature and extent of that national defense. National defense is 117 6.1.7 National Defense one of the best examples of a public or collective good. In the case of a public good, it is impossible to exclude a person from the consumption of the good and the marginal cost of an additional user is zero. In these conditions, the state often provides the good. 6.1.8 PROVISION OF COLLECTIVE OR PUBLIC GOODS Public goods are those goods whose property rights are not exclusive: it is not possible to exclude anyone from their use and the additional cost (marginal cost) of an additional user is zero. National defense is a case of a public good. If a baby is born in the country, it is not necessary to increase national defense. Clean air is another example of a
public good. Adam Smith included other public goods in this category. He referred to them as public institutions and public works. In the terminology of modern economics, these goods are often called quasi-public goods: the marginal cost of additional uses may be zero, but it is possible to exclude users. Roads, bridges, canals, navigational devices and the like could be paid for by tolls or financed by government. Smith includes education in this category of activities. He discusses specifically education of youth. He also says: “In the progress of the division of labor, the employment of the far greater part of those who live by labor, that is, of the great body of the people, comes to be confined to a few very simple operations, frequently one or two/ But the understandings of the greater part of men [sic] are necessarily formed by their ordinary employments. The man whose whole life is spent in performing a few simple operations, of which, the effects too are, perhaps, always the same, or very nearly the same, has no occasion to exert his understanding, or to exercise his invention in finding out expedients for removing difficulties which never occur. He naturally loses, therefore, the habit of such exertion, and generally becomes as stupid and ignorant as it is possible for a human creature to 118 6.1.8 Provision of collective or public goods become.” (Smith, Wealth of Nations, p 734) Smith continues on the next page: “But in every improved and civilized society this is the state into which the labouring poor, that is the great body of the people, must necessarily fall, unless the government takes some pains to prevent it.” The role of government in the provision of education and arts for individuals in society is controversial. Currently, there are a variety of debates ranging from voucher systems to the appropriate level of funding for English as a second language and special education. 6.1.9 PROMOTE COMPETITION The models of purely competitive markets show that the behavior of the individual sellers (and buyers) will be consistent with social welfare in the long run. When there are impediments to competition, the prices are distorted and incorrect signals encourage behavior that is less than socially optimal. As a result, governments often try to regulate the behavior or to promote competition. Most industrial nations have laws that make monopolization of markets, price fixing, collusion, tying contracts and other anti-competitive practices illegal. The Sherman Antitrust Act of 1890, the Clayton Act of
1914 and the Robinson-Patman Act of 1936 are examples. Information is important to any allocative system. It is necessary for agents in a market exchange to have information to value goods and negotiate contracts. Most societies see that one of the roles of government (if not a moral system) is to prevent fraud, deceit, and other methods of distorting information provided by buyers and sellers. The Securities Exchange Commission attempts to regulate financial information provided to the financial markets, insider trading is illegal, there are truth in advertising laws and agencies that regulate the content and quality of goods (food, drugs, etc.). 119 The development of policy and law in these areas is often controversial and vested interests attempt to manipulate the regulations in their favor. (Remember George Stigler’s capture theory of regulation.) 6.1.9 Promote Competition 6.1.10 SAFETY NET Most civilized societies try to provide a safety net for individuals who are unable to care for themselves. There are many disagreements about the criteria to be used to decide which people should be included in this group. 6.2 PROPERTY RIGHTS The concept of property rights is essential to any economic system. The analysis of property rights is complicated by several factors. First is the fact that when the term “property rights” is used, the listener usually subconsciously inserts the word “private.” In addition to private property, rights there are also public property rights and common property rights. Private property rights, in theory should apply to individuals but often private property rights is applied to publicly chartered organizations. Second, property rights can be justified by “natural rights” or by logic and pragmatism. John Locke [1632-1704], a natural law philosopher argues that humans have a natural right to the ownership of private property. This natural right to property stems from the fact that the individual has a right to their own labor and therefore a property right to the fruits of that labor when mixed with un-owned resources. Labor is the justification for property. Locke places two limitations on this right. He argues that the individual has a right to acquire property so long as nothing is wasted and there are sufficient resources left for others. (Locke, pp 115-126) The emotional context of property 120 6.2 Property Rights rights associated with the natural rights approach that also complicates the discussion and analysis of the structure of property rights in a social system. A pragmatic justification of property rights is based on defining property rights to achieve an objective.
That objective could be an optimal allocation or to maximize the monetary value of assets. Property rights justified on natural rights tends to be static while pragmatism tends to justify property rights that evolve to meet the needs of changing circumstances (population, technology, environment, etc.). Hayek, a market oriented economist, seems to focus on a pragmatic approach to property rights: Where the law of property is concerned, it is not difficult to see that the simple rules which are adequate to ordinary mobile “things” or “chattel” are not suitable for indefinite extension. We need only turn to the problems which arise in connection with land, particularly with regard to urban land in modern large towns, in order to realize that a conception of property which is based on the assumption that the use of a particular item of property affects only the interests of its owner breaks down..... The problem of the prevention of monopoly and the preservation of competition is raised much more acutely in certain other fields to which the concept of property has been extended only in recent times. I am thinking here of the extension of property to such rights and privileges as patents for inventions, copyright, trademarks, and the like. It seems to me beyond doubt that in these fields a slavish application of the concept of property as it has been developed of material thins has done a great deal to foster the growth of monopoly and that here drastic reforms may be required if competition is to be made to work. (Hayek, pp113-114)... It seems to me that, in general, the freedom of the individual by no means need to be extended to give all these freedoms to organized groups of individuals, and even that it may on occasion be the duty of governments to protect the individual against organized groups. It appears to me also as if historically in the field of the law of corporations we had a situation rather analogous to that in the field of the law of property to which I have already referred As in the law of property the rules developed for ordinary mobile property were extended uncritically and without appropriate modifications to all sorts of new rights: and thus the recognition of corporations as fictitious or legal person has had the effect that all the rights of a natural person were automatically extended to corporations. (Hayek, p 116) 121 Hayek is quoted at length because he is a market-oriented economist who recognized that property rights must evolve with changes in the economy and technology. He also recognizes that the form the property rights laws take is 6.2
Property Rights crucial to the operation of a market system. 6.2.1 PROPERTY RIGHTS AND MARKETS The operation markets and market exchange is facilitated by strong or “nonattenuated” property rights. The benefits and costs of exchange and use of resources and goods affect only the parties to the exchange. The welfare of individuals who are not engaged in the transaction or use of economic goods is not altered. Furubotn and Pejovich define property rights as: Property rights are understood as sanctioned behavioral relations among men [sic] that arise from the existence of goods and pertain to their use. These relations specify the norms of behavior with respect to goods that each and every person must observe in his daily interactions with other persons, or bear the cost of non-observance. The term “good” is used here for anything that yields utility or satisfaction to a person. Thus, and this point is important, the concept of property rights in the context of the new approach applies to all scarce goods. The concept encompasses both the rights over material things (to sell my typewriter) as well as ‘human’ rights (the right to vote, publish etcetera). The prevailing system of property rights in the community is, then, the sum of economic and social relations with respect to scarce resources in which individuals stand to each other. (Furubotn, p 3) These “sanctioned behavioral relations” include both the formal sanction of legal systems and informal sanctions of social institutions. A sense of community, social values, religion, politeness and respect for others are probably more efficient ways to enforce property rights than the enforcement of laws by the state. Property rights may be “private” property rights or “public” property rights. 122 Strong or non-attenuated property rights that facilitate the effective use of market exchange have three basic characteristics: 6.2.1 Property Rights And Markets • Exclusivity • Enforceability • Transferability EXCLUSIVITY It is impossible for the property rights to any good or resource to be completely exclusive. However, the greater the exclusivity the more likely market exchanges will produce improvements to the welfare of society. An exclusive property right is one where all the benefits and cost associated with a choice fall on the person(s) making the choice. If Nigel drinks a cup of tea, the costs and benefits of that act fall (for the most part) on Nigel. A case of nonexclusive property rights occurs
when Harold smokes a cigar in church. The smoke may impose significant costs on other members of the congregation. It might be possible that Aunt Mabel and others in the congregation could contract (or pay) with Harold not to smoke. If a voluntary contract is made, Harold is better off because he prefers the payment to smoking. Aunt Mabel and the congregation are better off because they were willing to pay Harold not to smoke. This assumes that Harold had a property right to smoke. An alternative view is to ban smoking in the church by assigning the property rights to smoke free air to Aunt Mabel and the others. If Harold wanted to smoke, he would have to contract with the congregation for the right to do so. EXTERNALITY The failure of exclusive property rights results in three problems in the market. First is the problem of “externalities.” The example of second hand 123 6.2.1 Property Rights And Markets smoke in the previous paragraph is an example. Pollution from a steel mill or odor from a pig farm are other examples. A negative externality results in “too much” or over use of a resource or good since the marginal costs to society exceed the marginal cost to the economic agent who makes the decision. The Environmental Protection Agency was created to deal with many of the problems of negative externalities. Externalities may also be positive. The marginal benefits to society are greater than the marginal benefits to the decision maker or economic agents engaged in an exchange. If I landscape my front lawn, it may increase the property values of my neighbor. The benefits to my neighbor are not taken into account by my decision. In general, the market signals an under utilization of goods and resources that have positive externalities PUBLIC GOODS A second problem is that of “public goods.” A public good is one in which the marginal cost of an additional user is zero and it is impossible to exclude anyone from its use. National defense is often used as an example of a public good. There are other goods like roads, bridges, etc. that may be treated as public goods even though it is possible to exclude users. These are sometimes referred to as “quasi-public goods. COMMON PROPERTY RESOURCES The third property rights problem is “common property resources.” A common property resource is one where users are not excluded but the marginal cost of users is positive. Garret Hardin’s 1968 article, “Tragedy of the Commons”
argues that common property tends to be overuse and can be driven to extinction. Passenger pigeons, whales, American bison, and fisheries are often cited as common property resources. The property rights for these common property resources are not clearly defined and are “fugitive” resources: whoever captures the resource has ownership rights. It is in the 124 6.2.1 Property Rights And Markets interests of the economic agents to capture as much as possible as quickly as possible. The result is the market signals an overuse of the resource. Treaties and government regulation may be used to establish property rights that will result in a more economic use of the resource. International treaty protects whales. State fish and game departments may sell license and regulate the capture of game. Externalities, public goods and common property resources are fodder for debates between pro and anti market advocates. The economics of non- exclusive property rights will be covered in more detail in later chapters. ENFORCEABILITY The establishment of property rights is fundamental to society. Social institutions and a sense of community (with a respect for others) establish the nature of property rights. John Locke, Adam Smith Karl Marx and many other writers have argued that one of the functions of government (or the “state”) is to define and enforce property rights. In a world of chattel and real property, property rights can be defined and enforced. In a world of intellectual property rights, computers, copy machines and all manner of devices to copy and transmit intellectual property with 0’s and 1’s, the enforcement of property rights is more problematic. As the society has shifted to greater emphasis of an “information” economy, intellectual property has become more important. Music, computer software, books, and knowledge of how to do things has made the enforcement of property rights and market exchanges difficult in many cases. The development of technology to electronically copy and transmit information has increased the problems of enforcing property rights to that information. Copyright and patent laws are examples of attempts to define and enforce property rights. Pharmaceuticals, DNA and knowledge are often the source of 125 6.2.1 Property Rights And Markets legal action. As the technology to develop, copy and transmit information improves, the enforcement of intellectual property rights will become more difficult and expensive to enforce. Many interesting economics questions will accompany these changes. TRANSFERABILITY In many cases, it is technically impossible to transfer property rights. The property rights to a person’s height or athletic skill cannot be transferred.
I cannot become a professional basketball player by purchasing a player’s height or skill. I might hire some one to coach me but there is no way to transfer property rights to height and skill. However, with the “advances” in science it may be possible to genetically modify a fetus with DNA from a person who has some physical characteristic that is desired. Often society will choose to prevent the transfer of property rights by making an exchange illegal. Buying and selling children is technically possible but societies usually choose to make it illegal. The Organ Transplantation Act of 1984 is another example. While it is technically feasible to transplant organs (heart, kidney, lung, pancreas, liver, etc.), the law makes it illegal to sell an organ for transplantation. However, it is now possible to travel to other countries to “buy” a kidney. There is some evidence that a black market (or illegal market) has been developing. There are also advocates of creating a market for transplantable organs. 6.2.2 ISSUES IN PROPERTY RIGHTS Technological change and structural changes in the modern economy pose great challenges for society and the evolution of property rights. Conventional thought holds that the industrial economies are undergoing a structural change. There is a shift from manufacturing to information and 126 6.2.2 Issues In Property Rights services. This shift has implications for the way in which property rights are assigned. As Hayek has pointed out, property rights cannot be static: the property rights that apply to chattel property of individuals may not apply equally well to intellectual property. Property rights that work for individuals may not work for organizations such as corporations. The nature of property rights is a major concern for modern society. Private property rights have long been seen as an important incentive for good stewardship. If chattel or land is “mine” I am more likely to use it wisely. This perspective is based on property rights that are exclusive and enforceable. A version of this view has been extended to intellectual property rights. If the property rights to ideas, inventions, patents, trademarks, copyrights are held privately, the owners will use them to the greatest advantage. These property rights also insure that individuals with have a strong incentive to create new ideas and inventions. At the same time, all new ideas and inventions are founded on prior knowledge. The material in this text is a conglomeration of ideas that have been debated for as long as humans have communicated. There is little new material presented
here. It consists of old ideas that have been restructured and combined with other ideas in new ways. Academic tradition and law provides for the use of these ideas. If authors do o appropriately cite sources of ideas, they are guilty of plagiarism. However, it is impossible to know the origins of all ideas that authors use. The evolution and creation of knowledge and technology depends on the availability knowledge from the past. If intellectual property rights are not flexible enough that the existing ideas and knowledge cannot be used to create new knowledge, progress and economic growth are impeded. Lawrence Lessig argues that property rights must be balanced between provision of 127 incentives and to allow others to use intellectual property to extend knowledge. Culture and knowledge progresses by building on the past: 6.2.2 Issues In Property Rights Creators here and everywhere are always and at all times building upon the creativity that went before and that surrounds them now. That building is always and everywhere at least partially done without permission and without compensating the original creator. No society, free or controlled, has ever demanded that every use be paid for or that permission for Walt Disney creativity must always be sought. Instead, every society has left a certain bit of its culture free for the taking—free societies more fully than unfree, perhaps, but all societies to some degree. (Lessig, Free Culture, p 29) The questions become: • What form should intellectual property rights take if creativity is to be promoted? How can property rights be structured to provide incentives for creators to • continue to develop new ideas? A free culture is not a culture without property: it is not a culture in which artists don’t get paid. A culture without property, or in which creators can’t get paid, is anarchy, not freedom. Anarchy is not what I advance here. Instead, the free culture that I defend in this book is a balance between anarchy and control. A free culture, like a free market, is filled with property. It is filled with rules of property and contract that get enforced by the state. But just as a free market is perverted if its property becomes feudal, so too can a free culture be queered by extremism in the property rights that define it. (Lessig, Free Culture, p xvi) There is a history of just such a property system that is well known in the Anglo-American tradition. It is called “feudalism.” Under feudalism, not only was property held by a relatively small number of individuals
and entities. And not only were the rights that ran with that property powerful and extensive. But the feudal system had a strong interest in assuring that property holders within that system not weaken feudalism by liberating people or property within their control to the free market. Feudalism depended upon maximum control and concentration. It fought any freedom that might interfere with that control. As Peter Drahos and John Braithwaite relate, this is precisely the choice we are now making about intellectual property. We will have an information society. That much is certain. Our only choice now is whether that information society will be free or feudal. The trend is toward the feudal. (Lessig, Free Culture, p 267) 128 As changes in technology pushes us into the age of information, the question of property rights will become more difficult. 6.2.2 Issues In Property Rights 129 7 Economic Way of Thinking 7 ECONOMIC WAY OF THINKING 7.1 MARKET EXCHANGE AS AN ALLOCATIVE MECHANISM Exchange is a voluntary transaction between two or more persons. The conditions of the transfer are clearly specified. It is a quid pro quo arrangement. Market exchange is a contract or agreement between the parties to the transaction. These agreements or contracts may be implied or explicit, formal or informal. There is no need for one party of the exchange to know the other. Each party only needs to know the terms of the exchange and that the other party will fulfill the agreement. There is no need for any relationship between the parties other than the exchange. In many ways anonymity of the parties to the exchange may make the exchange less complicated. Often it is more difficulty to sell your used car to a relative or friend than to a stranger. In other cases some of the features of reciprocity and redistribution may facilitate or improve the process of market exchange. In the diamond trade in New York City or on the farm in Iowa, participants may know and trust each other to meet the conditions of the market exchange. This reduces the effort or transaction cost of negotiating the agreement. In other cases redistribution by an authority may facilitate market exchange. An individual who fails to comply with the terms of the contract or exchange may by sued in a system of courts that has the authority to enforce the exchange. A major advantage of market exchange as an allocative mechanism is that once you have found others to contract or exchange with, each actor only needs information about their own preferences and what they are willing and able to do. It is not necessary that all
information be available in a central 130 7.1 Market Exchange as an Allocative Mechanism location or to a planner. It may be useful to think of a market as a communication system. The preferences and feasible alternatives available to each agent or individual are communicated through the market. Relative prices and quantities are pieces of information that may be used by the actors. The buyer of a good demonstrates that they prefer the good they purchase to the money or the other things that an equal amount of money would buy. Similarly, the seller demonstrates a preference for the money (or what it will buy) to the good they sold. A good sold for a price of €5 is valued at or is “worth” at least €5 to the buyer or the buyer would not have purchased the good. Risk and uncertainty are a part of virtually all human choices. While an individual may think they will receive some level of benefit or utility from a purchase, they may fail to do so. A second advantage attributed to the market is that it is flexible and provides information and incentive to encourage agents to adapt quickly to changes in technology, supplies of inputs and environmental conditions. In order for individuals and society to benefit from market exchange, there are two fundamental conditions that must hold. One is that exchanges must be voluntary. The other is that property rights must be “nonattenuated.” 131 7.1.1 Voluntary Exchange 7.1.1 VOLUNTARY EXCHANGE In neoclassical economics, the objective of an economy is to increase the welfare or utility of the individuals who make up the society. One of the basic concepts described in Chapter I Introduction was “Pareto Efficiency or Pareto Optimality.” To review, remember that a Pareto efficient or optimal solution to the allocation problem exists when all the alternatives that will improve the welfare (utility) of a least one person, without making anyone else “worse off” have be exhausted. Any alternative that will improve the welfare or utility of at least one person without decreasing the welfare or utility of another person would increase the welfare of society. This improvement is called a Pareto improvement and the result is said to be Pareto superior to the initial alternative. Generally, a person would enter into a voluntary exchange if they can improve their welfare or increase their utility. It is assumed that an individual who voluntarily enters into an exchange would not make himself or herself “worse off.” Therefore, any voluntary
exchange will increase the welfare of one or both parties and neither will be any worse off. Jeremy Bentham [1748-1832] attempted to make “utilitarianism” the operative mechanism to improve the welfare of society. He and many of his followers attempted to find a way to quantify utility and use it for decision-making. Bentham proposed a felicific calculus to make be used. However, it is not possible to make interpersonal comparisons of utility, i.e. if each of 100 persons is given one Euro (€) each there is no reason to believe that they would all get the same utility. Nor is it possible to assume that the utility or welfare of the group would be maximized by that distribution. Consider a distribution where every member of society is given 1 case of cola and 1 box of tea bags. Since individuals do not have the same preference 132 7.1.1 Voluntary Exchange for cola and tea, there is no guarantee this equal distribution of cola and tea would maximize the utility or welfare of the group. Information on the preferences of all individuals is not held in one central place, utility cannot be measured and summed, so it is impossible to redistribute cola and tea by eminent domain and insure an increase in total utility. Voluntary exchange is believed to increase the utility of the members of society. Individuals who prefer cola to tea should trade (or exchange) cola for tea with those individuals who prefer tea to cola. The utility of all individuals, whether they prefer tea or cola would increase (or at least not go down). The parties to the exchanges must have information about their own preferences and who the others are that are willing to trade. It would be helpful to have information about the preferences of others before one offers to trade. If I knew you liked tea did not like cola, I would offer to trade a small amount of tea for a large amount of cola. It would be to your advantage that I not know your true preferences. Information is valuable. You might try to convince me that you liked cola to get a “better deal.” This is called “haggling or bargaining.” The negotiations for a contract often include the process of discovering the preferences and the maximum amount the other person will trade for a good, i.e. “the best deal.” As trades are negotiated among the members of a society, information about these transactions becomes valuable. If you wish to buy or
sell a used car you may consult the Kelly Blue Book or Edmunds to find out the average prices that other exchanges. Providing false information may be regarded as fraud or deceit. In communities where others often know one another, one’s reputation is often based on “honest” dealings. In more complex societies, law and legal suits may be used to prosecute fraud and deception. The maximum price the buyer is willing and able to pay for a good is called the “reservation price of the buyer (RPB)” and the minimum price the seller 133 7.1.1 Voluntary Exchange will accept for the good is the “reservation price of the seller (RPS).” So long as the RPB is greater than the RPS, a trade can take place. If the RPS is greater than the RSB, no trade will occur. Neither the buyer nor seller wants the other party to know their reservation price. Haggling is the process by which a mutually agreeable price can be determined. The price at which the exchange will occur will be greater than the RPS and lower than the RPB (RPS>P>RPB). In the case of a single transaction, the price will be closer to the reservation price of the seller or buyer with the most information and the greatest skills in negotiation. The degree to which individuals adhere to a pure quid pro quo and consequentialist ethic may give individuals an advantage over individuals who are constrained by a deontological ethic. Over time an expected pattern of trade emerges. A given amount of cola is expected to trade for a specific number of tea bags. The ratio at which cola and tea trade can be called the exchange ratio. The exchange ratio is the price of one good in terms of another. This exchange ratio is determined by the preferences of the individuals, the relative amount and distribution of cola and tea. If it is established that on average, 1 cola trades for 5 tea bags, individuals who do not like cola will be willing to accept cola on trade because they know its will trade for tea. If 1 cola (1c) trades for 5 tea bags (5t), money can be used to facilitate the exchanges. The use of money results in monetary prices rather than prices in terms of other goods. The monetary price of cola will be labeled, PC, the price of tea Pt. The relative prices of cola and tea are established by the exchange ratio. If one col
a will trade for 5 tea bags, 1c = 5t, if P = $1 c implies P = $.20 t if P = $1 t implies P = $5 c 134 In microeconomics it is the relative prices that are important. If the exchange ratio is 1c = 5t, the “correct” set of prices can be either 7.1.1 Voluntary Exchange P = $1 c and P t = $.20 o r P = c $5 and P = $1 t Any voluntary exchange reflects the preferences of the parties to the exchange. If Joan buys a cola for €1, she must prefer the cola to €1 or she would have kept her money. If John sells Joan a cola for €1, he must prefer the €1 to the cola or he would have kept the cola. Therefore if Joan voluntarily buys a cola from John (who voluntarily sells it) they are both “better off” or have increased their utility. The problem arises as to what is meant by “voluntary.” Some actions, such as “duress” clearly violate the concept of voluntary. Any contract concluded under duress is unenforceable in most countries. Contracts or exchanges with minors are also unenforceable. If Joan holds a gun to John’s head to force him to sell the cola, that would clearly be duress or coercion and violate the conditions of voluntary exchange. If the instructor of a class suggests you buy his or her book, is that coercion? If your mother says, “You go ahead and do what you want to do but it will break my heart!” Is that coercion? “Voluntary” exchange is often a matter of degree. Often the only “voluntary” choice open to an individual in a pure market is to “exit.” The person may choose to participate or not. 7.1.2 ECONOMIC WAY OF THINKING Economic theory provides a “map” or structure to aid in the interpretation of economic data or information. The nature of the map (economic theory) determines the nature of the questions asked. Joan Robinson’s [1903-1983] 135 7.1.2 Economic Way of Thinking comment was, “If you don’t ask the right question, you won’t get the right answer.” Neoclassical micro
economics is based on the belief that individuals are rational and that they attempt to optimize. 7.1.2.1 INDIVIDUALS ARE RATIONAL 1. objectives are known 2. 3. all feasible alternatives are known each alternative is evaluated with respect to the objective 7.1.2.2 BENEFIT - COST FORMAT [PARETO EFFICIENCY/POTENTIAL] Most of economic theory is based on individuals making “optimal choices.” Objectives or goals are usually based on the maximization or minimization of some variable, i.e. the maximization of utility, output or profit or the minimization of cost per unit. Benefit/cost analysis is a basic approach that is used. If the benefits associated with a choice (alternative) exceed the costs incurred with the choice, there is an increase in net benefits. If the costs exceed the benefits of a choice, it will not increase net benefits. Notice that it is the cost and benefit associated with a choice. This requires “marginal analysis.” B/C analysis is a variation of the Pareto Potential criterion. 7.1.2.3 MARGINAL ANALYSIS Decisions in economics are always made at the “margin.” A decision to change one variable will cause a change in some other related variable. A change in the price of a good will change the quantity sold, a change in the quantity sold will change the total revenue collected. The change in total revenue caused by a change in units sold is called marginal revenue. The marginal concept is applied to a wide variety of relationships. In principles of 136 7.1.2 Economic Way of Thinking economics these are usually described as a “one unit” change in the variables. The Greek letter delta, D is used to identify a change calculated by subtraction. In other cases a derivative (d) or partial derivative (∂) will be used to denote a change that approaches 0. The use of marginal is applied to many economic relationships. In fact, the early period of the development of microeconomics (mid to late 19th century) was called the “marginalist revolution.” Below are some definitions of several useful marginal relationships. 1. Marginal Cost (MC) MC is defined as the change in Total Cost (TC) or variable cost (VC) caused by a one unit change in the quantity produced, output (Q). MC represents opportunity cost.
MC = ΔTC ΔQ = ΔVC ΔQ 2. Marginal Benefit (MB) MB is defined as the change in total benefit (TB) caused by a one unit change in quantity consumed (Q). MB = ΔTB ΔQ 3. Marginal Utility (MU) MU is the change in utility caused by a change in quantity consumed (Q) MU = ΔTU ΔQ 4. Marginal Revenue (MR) MR is the change in Total Revenue (TR) caused by a one unit change in the quantity sold (Q). 137 7.1.2 Economic Way of Thinking MR = ΔTR ΔQ 5. Marginal Product (MP) The marginal product is the change in output (Q) caused by a change in a variable input (L or K). MP L = ΔQ ΔL, MP K = ΔQ ΔK 7.1.2.4 MARGINAL ANALYSIS AND OBJECTIVES 1. To maximize utility So long as the MU > MC, consume the next unit. If MU<MC reduce the level of consumption. Where MU=MC maximum utility is attained. If there are two or more goods that have a price (or cost), the process of utility maximization requires that each additional expenditure be made on the good that has the highest marginal utility. To maximize utility with several goods that have economic prices, the “equimarginal principle,” is used. = = … = MUY PY MU N MU X P X P N Subject to B ≥ P X Q X + PY QY +... + P N Q N When Pi = price of good i, B = budget, Qi = Quantity of good i 2. To maximize profit (P ) So long as the next unit of output can be produced at a cost that is less than it can be sold for, do it! When MR >MC, produce When MR <MC reduce output, Maximum profits when MR = MC 138 3. Maximum welfare of buyers and sellers 7.1.2 Economic Way of Thinking The market is a social institution that provides information to guide the allocation process in a society. Buyers should purchase additional units of a good so long as the MB > P. The producers (sellers) of a good should continue to produced and sell more of a good so long as the P > MC. The welfare of buyers and sellers will be maximized when MB = P = MC 7.1.2.5 APPENDIX I:
SCHOOLS OF ECONOMIC THOUGHT Human behavior can be viewed from many different perspectives. Sociology, political science, psychology, anthropology, history, and economics are just a few of the basic approaches to the study of the individuals and society. Within each of these disciplines there are differences in perspectives. In economics, there are “schools of thought” that have alternative approaches to the analysis of economic processes. These schools of thought may ask different questions and use different methods in their attempts to answer them. Within microeconomics the mainstream view is “Neoclassical economics” which is the topic of this outline. Other approaches include, Austrians, “Old” Institutionalists, “New” Institutionalists, Walrasians, Marxists, Public Choice theorists, law and economics, Chicago, Keynesian and social economics. Some of these schools focus on macroeconomics while others are primarily deal with microeconomic issues. While many of these schools have different approaches, there is often overlap. It is useful to know a little about some of these alternative approaches to understand how mainstream economics has developed and which aspects of Neoclassical economics might be subject to criticism and how it may be adapted. George Stigler (1911-1991), described a school of economic thought, 139 7.1.2 Economic Way of Thinking A school within a science is a collection of affiliated scientists who display a considerably higher degree of agreement up on a particular set of views than the science as a whole displays. It is essential to a school that there be many scientists outside it, or the school would have no one with whom to argue. Schools have received little study, and the following remarks are only casual impressions. A school must have a leader, because of the consensus of its members will normally be achieved and maintained by major scientific entrepreneurs. … If the school is united on methodology rather than substantive doctrines, its life will be longer, but also less influential…. A school may be based on policy views rather than upon economic analysis or scientific method…. [Stigler, The Economist as Preacher, Basil Blackwell, Oxford, 1982, p116] 7.1.2.6 MICROECONOMIC SCHOOLS OF ECONOMIC THOUGHT Economics, as an identifiable discipline, began with the Physiocrats. The Physiocrats, led by François Quesnay (1694-1774), emphasized a natural order and coined the phrase “Laisse
z faire, laissez passer.” They were strong advocates of free trade. Quesnay recognized the idea of a flow or circular flow of goods and money in the tableau. The Physiocrats were concerned with the relationship of the individual to society. They believed that free trade with minimal intervention by the state would allow a state of harmony to exist. They were reacting against the nationalistic policies of an economic policy called “Colbertism.” Colbertism was a set of mercantilist policies that emphasized national power that could be enhanced by strong regulation of economic activities. 7.1.2.6.1 (1) CLASSICAL ECONOMICS Adam Smith [1723-1791] knew some of the Physiocrats and used many of their ideas in the development of what was to become Classical economics. Smith’s ideas are to be found in The Theory of Moral Sentiments (1759), An Inquiry into the Nature and Causes of the Wealth of Nations (1776), and 140 7.1.2 Economic Way of Thinking Lectures on Jurisprudence (Lectures 1762-63 and 1766). Smith believed that social harmony would be the result of a system of morality, free markets and a set of laws. His primary concern was economic growth that was the result of specialization and the division of labor. Much of Classical economics was macroeconomics in its concern about economic growth and the division of income among the various factors of production (land, labor, and capital. Entrepreneurial ability as a factor was identified by Richard Cantillon [1680-1734] and popularized by J.B. Say [1767-1832]) Self-interested behavior within free markets, constrained by morality and law were the basis of the Smithian system. The Wealth of Nations provided the foundations for the Classical school of economics. Some members (such as David Ricardo and J.B. Say) of the school argued for free trade based on comparative advantage. Others (such as Thomas Malthus) argued for trade restrictions in the form of the “corn laws.” The corn laws had the effect of restricting the importation of grains. These restrictions reduced the supply and increased the price of grains used as food. From a microeconomic perspective, this changes the relative prices of goods. From a macroeconomic perspective, the functional distribution of income and economic growth are altered. The Classical economists tended to focus on the functional distribution of income (The functional
distribution refers to the distribution of income to the factors of production, land, labor and capital. These were aligned with social classes.), economic growth (or stagnation in a stationary state), and social harmony. Smith saw the division of labor, increase in population and the accumulation of capital as the forces that promoted economic growth. Ricardo, Malthus, Mill and other classical economists believed that decreasing returns in agriculture and population growth would result in a stationary state. 141 7.1.2 Economic Way of Thinking Smith (as well as Ricardo and most Classical Economists) noted that there was a “value in use” and a “value in exchange.” Consistent with the Classical focus on the use of markets as the primary allocative mechanism, value in exchange was considered as the topic of economic analysis. Generally, their approach began with a labor theory of value. Smith argued that “The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.” [Smith, WN, page 30] Smith and Ricardo were aware that utility was an necessary prerequisite for a good to be exchanged, but believed that the costs of production determined value. A cost of production theory of value is a broader approach that was ultimately accepted by Smith. Jeremy Bentham [1748-1832] is credited with contributing the foundation of “utilitarianism” to economics. Bentham presumed that human behavior was rational and was directed by “felicific calculus,” an evaluation of the pains and pleasures associated with each choice. In Bentham’s words: “Nature has placed mankind under the governance of two sovereign masters, pain and pleasure. It is for them alone to point out what we ought to do, as well as to determine what we shall do. On the one hand the standard of right and wrong, on the other the chain of causes and effects are fastened to their throne. They govern us in all we do, in all we say, in all we think: every effort we make to throw off our subjection, will serve but to demonstrate and confirm it. In words a man may pretend to abjure their empire: but in reality he will remain subject to it all the while. The principle of utility recognizes this subjection, and assumes it for the foundation of that system, the object of which is to rear the fabric of felicity by the hands of reason and law..
. By the principle of utility is meant that principle which approves or disapproves of every action whatsoever: and therefore, not only of every action of a private individual, but of every measurement of government. By utility is meant that property in any object, whereby it tends to produce benefit, advantage, pleasure, good, or happiness...or... to prevent the happening of mischief, pain, evil, or unhappiness to the party whose interest is considered: if that party be the community in general, then the happiness of the community: if a particular individual, then the happiness of that individual. 142 7.1.2 Economic Way of Thinking The community is a fictitious body, composed of the individual persons who are considered as constituting as it were its members. The interest of the community then is, what? -- the sum of the interests of the several members who compose it. It is vain to talk of the interest of the community, without understanding what is the interest of the individual. A thing is said to promote the interest... of an individual, when it tends to add to the sum total of his pleasures: or, what comes to the same thing, to diminish the sum total of his pains. Bentham offered utility as an alternative explanation for value. John Stuart Mill [1806-1873] can be regarded as a transitionary writer: he connects the Classical economists and Utilitarianism to the development of market-oriented microeconomics. Mill was an admirer and proponent of both Bentham and David Ricardo. Much of Mill’s work seems to be an effort to integrate Ricardian economics with Utilitarianism. The classical school of economics tended to advocate markets as the primary allocative mechanism. They followed the concept of natural liberty and are associated with the concept of “classical liberalism.” 7.1.2.6.2 (2) MARXIST Karl Marx [1818-1893] was a critic of the capitalist system and of most of the classical economists who justified the market system. Marx built on the labor theory of value as expressed by David Ricardo. Marx’s critique of capitalism can be found in a variety of his books and articles but perhaps the Economic and Philosophical Manuscripts [1844] and Das Kapital [1867, 1885,1894] are the best sources. Marx used “dialectical materialism’ to build a system to explain the historical process. His focus was on struggles between
the workers (proletariat) and the capitalists (bourgeoisie). He believed that the surplus created by the workers would be appropriated by the capitalists because they owned the means of production. This is what is meant by “exploitation. In the attempts to capture the surplus the capitalists would increase the amount of capital per worker and the rate of exploitation. As more and more capital was added, capital became less productive and 143 7.1.2 Economic Way of Thinking generated less profit. The problem was a falling rate of profit that increased the unemployed and reduced the number of “petty bourgeoisie.” Ultimately the capitalist system would fail due to contradictions within the system. Marx believed that the “modes of production” (the technical way that society produced the material requisites) determined the structure of society. However, there was a lag between changes in the modes of production and the social structure. 7.1.2.6.3 (3) MARGINALIST REVOLUTION A combination of forces encouraged the application of mathematics (particularly calculus) to the analysis of economic behavior. Bentham’s utilitarianism and classical economics coupled with the ideology and politics that accompanied the development of the industrial revolution brought about new perspectives and new problems. In seeking to explain relative prices, a utility theory of value emerges. The rate of change in total utility associated with a change in consumption (marginal utility) becomes the basis of value. Johann Heinrich von Thünen [1783-1850, German] was one of the early writers who began to apply mathematical methods in the economics of location theory and wages. Hermann Heinrich Gossen [1810-1858] clearly stated the principle of diminishing marginal utility and the equimarginal principle by 1854. Gossen’s approach was utilitarian and argued that value was primarily linked to subjective judgments about utility rather than the costs of production. A group of French engineers, developing criteria for making choices about roads, bridges and canals were influenced by both mathematics and the Physiocrats. Jules Dupuit [1804-1866, French], along with colleagues, had worked out the importance of marginal benefits and marginal costs in making decisions. Augustin Cournot [1801-1877, French], a French mathematician, 144 independently developed the use of marginal analysis in determining the behavior of firms who were competing in a market. The French engineers were quite advanced in the development of their analysis. [Eklund and
Hébert, 7.1.2 Economic Way of Thinking Secret Origins of Modern Microeconomics, University of Chicago Press, 1999] While the French probably developed marginal analysis before others, their work was not translated until later. William Stanley Jevons [1835-1882, English] and Carl Menger (1840-1921, Austrian) and Léon Walras [1834-1910, French] independently developed concepts of marginal utility to explain value and behavior. The differences among the French, English and Austrian economists are subtle but important. The French were attempting to use economic theory to evaluate choices at a public or social level. The English and the Austrians focused on individual choice. 7.1.2.6.4 (4) NEOCLASSICAL ECONOMICS Neoclassical economics grew out of Classical Economics and the Marginalist Revolution. Alfred Marshall (1842-1924, English Economist), Léon Walras (1834-1910, French/Swiss) and Vilfredo Pareto (1848-1923, Itallian/French/Swiss) were among the writers who were instrumental in the development of Neoclassical economics in the basic form that persists. Alfred Marshall is best known for his use of partial equilibrium that requires the concept of ceteris paribus. His focus is on individual and firm behavior in markets. Léon Walras developed the concept of general equilibrium that includes the interdependence of all markets. Marshall synthesized the cost of production theory of value of the classical school with the marginal utility of the marginalists. The cost of production theory of value suggests that supply determines price. The marginal utility approach attributes value to subjective choices and holds that price is determined by utility. Marshall argued that 145 supply and demand interact to determine price. He used the metaphor of a pair of scissors to emphasize his argument. 7.1.2 Economic Way of Thinking “We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or costs of production.” [Marshall, Principles of Economics, 8th edition, page 290] Vilfredo Pareto, Francis Ysidro Edgeworth [1845-1926] and Henry Sidgwick [1838-1900] were all instrumental in developing the idea of indifference functions that allows the use of ordinal concepts of utility. Most
of the materials in modern principles of microeconomics have evolved from the framework of Neo classical economics. And that is the focus of this outline. 7.1.2.6.5 (5) AUSTRIAN ECONOMICS Carl Menger and a group of followers (such as Eugen von Böhm-Bawerk [1851-1914], Friedrich von Wieser [1851-1926], Ludwig von Mises [1881- 1973] and Friedrich Hayek [1899-1992]) have developed an alternative view of microeconomic behavior. The Austrian approach views human behavior as “purposive,” (as opposed to rational). Markets are viewed as dynamic processes rather than the comparative statics of equilibrium outcomes in neoclassical economics. Behavior in conditions of disequilibria and processes by which individuals and systems might move toward equilibrium has been the focus of many Austrians. Uncertainty and lack of information play an important role in Austrian economics. As a consequence, the role of information and learning becomes an important aspect of economic behavior and participation in markets. For the Austrians, value is subjective and is determined by the individual. Many of the ideas of the Austrians have been incorporated into neoclassical or mainstream economics. Wieser is credited with coining the term “opportunity cost.” Imputing a value for inputs from the valuation of outputs has been 146 7.1.2 Economic Way of Thinking integrated into mainstream economics. Austrian economics supports the ideas of individual choice and a minimal role for government. 7.1.2.6.6 (6) INSTITUTIONAL ECONOMICS Thorstein Veblen (1857-1929) is regarded as the founder of the Institutionalist school of economics. Veblen reacted against the sterile, individualism of neoclassical economics and coined the term “neoclassical.” He argued that neoclassical economics is static (it primarily uses comparative statics) and is limited in its ability to deal with dynamic forces such as technology. The Institutionalists argue that human behavior is not “rational” but rather is social behavior and is guided by “habitual patterns of behavior” which are expressed as social institutions. Idle curiosity, desire to be a parent and respect for workmanship are three of the forces that influence human behavior. Veblen “…develops the idea that institutions are inhibitory and backward looking, while
science and technology are themselves dynamic and oriented toward change.” [Tilman, A Veblen Treasury, page xxiii] Tilman finds five ideas in Veblen that are representative of his contribution: • • • • • the emancipatory potential of the machine process antithesis between business and industry legal and political institutions as representing the vested interests the compulsive force of idea patterns the bankruptcy of commercial values The Institutionalists, like the Austrians are regarded as “heterodox” economists. 147 7.1.2 Economic Way of Thinking 7.1.2.6.7 (7) OTHERS Modern microeconomics is characterized by a variety of perspectives. The Chicago School, the Public Choice/Property Rights view, and the New Institutionalists represent variations on Neoclassical economics. These approaches tend to use Neoclassical economics to explain human behavior and the nature and structure of social institutions and organizations. Social economists offer alternative views and argue that modern microeconomics has become “imperialistic” in its attempts to explain all human and social behavior in terms of economics. In recent years, there has been a small group of economists who have been trying to place economic theory within a social context. Richard Swedberg and Amitai Etzioni are characteristic of some of the writers who hold a social perspective. The focus is on the role of society and its influence on the individual. Society is seen as more than the summation of individual utility functions and behavior. 148 8 Demand and Supply in a Market System 8 DEMAND AND SUPPLY IN A MARKET SYSTEM The market system is an interrelated set of markets for goods, services and inputs. A market is defined as the interaction of all potential buyers and sellers of a good or class of goods that are close substitutes. The economic analysis that is used to analyze the overall equilibrium that results from the interrelationships of all markets is called a “general equilibrium” approach. Partial equilibrium is the analysis of the equilibrium conditions in a single market (or a select subset of markets in a market system). In principles of economics, most models deal with partial equilibrium. In a partial equilibrium model, usually the process of a single market is considered. The behavior of potential buyers is represented by a market demand function. Supply represents the behavioral pattern of the producers/sellers. 8.1 DEMAND FUNCTION A demand function that represents the behavior of buyers, can be constructed for an individual or a group of
buyers in a market. The market demand function is the horizontal summation of the individuals’ demand functions. In models of firm behavior, the demand for a firm’s product can be constructed. The nature of the “demand function” depends on the nature of the good considered and the relationship being modeled. In most cases the demand relationship is based on an inverse or negative relationship between the price and quantity of a good purchased. The demand for purely competitive firm’s output is usually depicted as horizontal (or perfectly elastic). In rare cases, 149 under extreme conditions, a “Giffen good” may result in a positively sloped demand function. These Giffen goods rarely occur. It is important to identify the nature of the “demand function” being 8.1 Demand Function considered. 8.1.1 INDIVIDUAL DEMAND FUNCTION The behavior of a buyer is influenced by many factors: the price of the good, the prices of related goods (compliments and substitutes), incomes of the buyer, the tastes and preferences of the buyer, the period of time and a variety of other possible variables. The quantity that a buyer is willing and able to purchase is a function of these variables. An individual’s demand function for a good (Good X) might be written: QX = fX(PX, Prelated goods, income (M), preferences,... ) • • • • • QX = the quantity of good X PX = the price of good X Prelated goods = the prices of compliments or substitutes Income (M) = the income of the buyers Preferences = the preferences or tastes of the buyers The demand function is a model that “explains” the change in the dependent variable (quantity of the good X purchased by the buyer) “caused” by a change in each of the independent variables. Since all the independent variable may change at the same time it is useful to isolate the effects of a change in each of the e c i r P $8 $7 $6 $5 $4 $3 $2 $1 150 Demand 2 4 6 8 10 12 14 16 18 Quantity/ut Figure III.A.1 8.1.1 Individual Demand Function independent variables. To represent the demand relationship graphically, the effects of a change in PX on the QX are shown. The other variables, (Prelated goods, M, preferences,... ) are held constant
. Figure III.A.1 shows the graphical representation of demand. Since (Prelated goods, M, preferences,... ) are held constant, the demand function in the graph shows a relationship between P X and QX in a given unit of time (ut). The demand function can be viewed from two perspectives. The demand is usually defined as a schedule of quantities that buyers are willing and able to purchase at a schedule of prices in a given time interval (ut), ceteris paribus. QX = f(PX), given incomes, price of related goods, preferences, etc. Demand can also be perceived as the maximum prices buyers are willing and able to pay for each unit of output, ceteris paribus. PX = f(QX), given incomes, price of related goods, preferences, etc. It is important to remember that the demand function is usually thought of as Q = f(P) but the graph is drawn with quantity on the X-axis and price on the Y-axis. While demand is frequently stated Q = f(P), remember that the graph and calculation of total revenue (TR) and marginal revenue (MR) are calculated on the basis of a change in quantity (Q). TR = f(Q) The calculation of “elasticity” is based on a change in quantity (Q) caused by a change in the price (P). It is important to clarify which variable is independent and which is dependent in a particular concept. 8.1.2 MARKET DEMAND FUNCTION When property rights are nonattenuated (exclusive, enforceable and transferable) the individual’s demand functions can be summed horizontally to obtain the market demand function. In Figure III.A.2 and Table III.A.2, a market demand function is constructed from the behavior of three people (the participants in a very small 151 8.1.2 Market Demand Function market. At a price of P1, Ann will voluntarily buy 2 units of the good based on her preferences, income and the prices of related goods. Bob and Cathy buys 3 units each. Their demand functions are represented by D A, DB and DC in Figure III.A.2. DB d DA d e c i r P P3 P2 P1 Figure III.A.2 Market Demand DM DC d 1 2 3 8 Q/ut The total amount demanded by the three individuals at P 1 is 8 units (2+3+3). At a
higher price each buys a smaller quantity. The demand functions can be summed horizontally if the property rights to the good are exclusive: Ann’s consumption of a unit precludes Bob or Cathy from the consumption of that good. In the case of public (or collective) goods, the consumption of national defense by one person (they are protected) does not preclude others from the same good. The behavior of a buyer was represented by the function: QX = fX(PX, Prelated goods, income (M), preferences,... ). For the market the demand function can be represented by adding the number of buyers (#B, or population), QX = fX(PX, Prelated goods, income (M), preferences,... #B) 152 Where #B represents the number of buyers. Using ceteris paribus the market demand may be stated QX = f(PX), given incomes, price of related goods, preferences, #B etc. 8.1.2 Market Demand Function 8.1.3 CHANGE IN QUANTITY DEMAND When demand is stated Q = f(P) ceteris paribus, a change in the price of the good causes a “change in quantity demanded.” The buyers respond to a higher (lower) price by purchasing a smaller (larger) quantity. Demand is an inverse relationship between price and quantity demanded. Only in unusual circumstances (a highly inferior good, a Giffen good) may a demand function have a positive relationship. A change in quantity demanded is a movement along a demand function caused by a change in price while other variables (incomes, prices of related goods, preferences, number of buyers, etc) are held constant. A change in quantity demanded is shown in Figure III.A.3. e c i r P $8 $7 $6 $5 $4 $3 $2 $1 An increase in quantity demanded is a movement along a demand curve (from point A to B) caused by a decrease in the price from $7 to $4. A decrease in quantity demanded is a movement along the demand function (from point B to A) caused by an increase in price from $4 to $7. A B Demand 2 4 6 8 10 12 14 16 18 Quantity/ut Figure III.A.3 153 8.1.4 Change in Demand 8.1.4 CHANGE IN DEMAND A change in demand is a “shift” or movement of
the demand function. A shift of the demand function can be caused by a change in: • incomes • the prices of related goods • preferences • the number of buyers. • Etc... A“change in demand” is shown in Figure III.A.4. Given the original demand (Demand), 10 units will be purchased at a price of $5. An increase in demand (DINCREASE) is to the right and at every price a larger quantity will be purchased. At $5, eighteen units are purchased. A decrease in demand is a shift to the left. At a price of $5 only 4 units are purchased. A smaller quantity will be bought at each price. e c i r P $8 $7 $6 $5 $4 $3 $2 $1 Given a demand function (Demand), an increase in demand is shown as DINCREASE. At each price a larger quantity is purchased. A decrease in demand is shown as DDECREASE. At each possible price the quantity purchased is less. Increase Decrease H G J DDECREAS E 6 8 10 2 4 DINREASE Demand 12 14 16 18 Quantity/ut Figure III.A.4 154 8.1.5 Inferior, Normal and Superior Goods 8.1.5 INFERIOR, NORMAL AND SUPERIOR GOODS A change in income will usually shift the demand function. When a good is a “normal” good, there is a positive relationship between the change in income and change in demand: an increase in income will increase (shift the demand to the right) demand. A decrease in income will decrease (shift the demand to the left) demand. An inferior good is characterized by an inverse or negative relationship between the change in income and change in demand. An increase in the income will decrease demand while a decrease in income will increase demand. e c i r P $8 $7 $6 $5 $4 $3 $2 $1 Increase Decrease H G J DDECREAS E 6 8 10 2 4 DINCREAS E Demand 12 14 16 18 Quantity/ut Figure III.A.2 A superior good is a special case of the normal good. There is a positive relationship between a change in income and the change in demand but, the percentage change in the demand is greater than the percentage change in income. In Figure III.A.2 an increase in income will shift the Demand function (“Demand”) for
a normal good to the right to DINCREASE. For an inferior good, a decrease in income will shift the demand to the right. For a normal good a decrease in income will shift the demand to DDECREASE. 155 8.1.6 Compliments and Substitutes 8.1.6 COMPLIMENTS AND SUBSTITUTES The demand for Xebecs (QX) is determined by the PX, income and the prices of related goods (PR). Goods may be related as substitutes (consumers perceive the goods as substitutes) or compliments (consumers use the goods together). If goods are substitutes, (shown in Figure III.A.3) a change in PY (in Panel B) will shift the demand for good X (in Panel A). Price PX Price PY2 DX* PY1 DY Substitutes Goods X and Y are substitutes, An increase in PY (from PY1 to PY2) decreases the quantity demanded for Y from Y1 to Y2. The demand for good X increases to DX. At PX the amount purchased increases from X2 to X3. A decrease in PY shifts DX to DX* (Amount of X decreases to X1). DX** DX X1 X2 X3 QX /ut Panel A Y2 Y1 Figure III.A.3 QY /ut Panel B An increase in PY (from PY1 to PY2) will reduce the quantity demanded for good Y (a move on DY). The reduced amount of Y will be replaced by purchasing more X. This is a shift of the demand for good X to the right (In Panel A, this is shown as a shift from D X to DX, an increase in the demand for good X). At PX a larger amount (X3) is purchased A decrease in PY will increase the quantity demanded for good Y. This will reduce the demand for good X, the demand for good X will shift to the left (from DX to DX*, a decrease). At PX (and all prices of good X) a smaller amount of X (X1) is purchased. In the case of compliments, there is an inverse relationship between the price of the compliment (PZ in Panel B, Figure III.A.4) and the demand for 156 8.1.6 Compliments and Substitutes good X. An increase in the price of good Z will reduce the quantity demanded for
good Z. Since less Z is purchased, less X is needed to compliment the reduced amount of Z (Z2). The demand for X in Panel A decreases for D X to DX*. An decrease in PZ will increase the quantity demanded of good Z and result in an increase in the demand for good X (from DX to DX in Panel A). Price PX Price PZ2 DX* PZ1 DZ Compliments Goods X and Z are compliments, An increase in PZ (from PZ1 to PZ2) decreases the quantity demanded for Z from Z1 to Z2. The demand for good X decreases to DX*. At PX the amount purchased decreases from X2 to X1. A decrease in PZ shifts DX to DX (Amount of X increases to X3). DX** DX X1 X2 X3 QX /ut Panel A Z2 Z1 Figure III.A.4 QZ /ut Panel B 8.1.7 EXPECTATIONS Expectations about the future prices of goods can cause the demand in any period to shift. If buyers expect relative prices of a good will rise in future periods, the demand may increase in the present period. An expectation that the relative price of a good will fall in a future period may reduce the demand in the current period. 8.2 SUPPLY FUNCTION A supply function is a model that represents the behavior of the producers and/or sellers in a market. QXS = fS(PX, PINPUTS, technology, number of sellers, laws, taxes, expectations... #S) PX = price of the good, 157 8.2 Supply Function PINPUTS = prices of the inputs (factors of production used) Technology is the method of production (a production function), laws and regulations may impose more costly methods of production taxes and subsidies alter the costs of production #S represents the number of sellers in the market. Like the demand function, supply can be viewed from two perspectives: Supply is a schedule of quantities that will be produced and offered for sale at a schedule of prices in a given time period, ceteris paribus. A supply function can be viewed as the minimum prices sellers are willing to accept for given quantities of output, ceteris paribus. 8.2.1.1 (1) GRAPH OF SUPPLY The relationship between the quantity produced TABLE III.A.5 and offered for sale and the price reflects opportunity cost.
Generally, it is assumed that there is a positive relationship between the price of the good and the quantity offered for sale. Figure III.A.5 is a graphical representation of a supply function. The equation for this supply function is Qsupplied= -10 + 2P. Table III.A5 also represents this supply function. 8.2.1.2 (2) CHANGE IN QUANTITY SUPPLIED Given the supply function, Qxs = fs(Px, Pinputs, Tech,...), a change in the price of the good (PX) will SUPPLY FUNCTION PRICE QUANTITY $5 $10 $15 $20 0 10 20 30 be reflected as a move along a supply function. In Figures III.A.5 and III.A.6 as the price increases from $10 to $15 the quantity supplied increases from 10 to 20. This can be visualized as a move from point A to point B on the supply 158 function. A “change in quantity supplied is a movement along a supply function.” This can also be visualized as a movement from one row to another in Table III.A.5. 8.2 Supply Function 8.2.1.3 (3) CHANGE IN SUPPLY G iven the supply function, Qxs = fs(Px, Pinputs, Tech,..., #S), a change in the prices of inputs (Pinputs) or technology will shift the supply function. A shift of the supply function to the right will be called an increase in supply. This means that at each possible price, a greater quantity will be offered for sale. In an e c i r P $20 $15 $10 $5 Supply C B A 10 20 Figure III.A.5 30 Q/ut equation form, an increase in supply can be shown by an increase in the quantity intercept. A decrease in supply is a shift to the left: at each possible price a smaller quantity is offered for sale. In an equation this is shown as a decrease in the intercept. Supply C B A A change in quantity supplied is a movement along a supply function that is “caused” by a change in the price of the good. In the graph to the right, as price increases from $10 to $15 the quantity supplied increases from 10 to 20. This can be visualized as a move from point A to point B along the supply function.
A decrease in supply would be a move from point B to point A as price fell from $15 to $10 e c i r P $20 $15 $10 $5 10 20 Figure III.A.6 30 Q/ut 159 A change in supply is a “shift” of the supply function. A decrease in supply is shown as a shift from Supply to Sdecrease in the graph. At a price of $15 a smaller amount is offered for sale. This decrease in supply might be “caused” by an increase in input prices, taxes, regulations or,... An increase in supply can be visualized as a movement of the supply function from Supply to Sincrease. e c i r P $20 $15 $10 $5 8.2 Supply Function Supply Sdecrease B C H Sincrease R E A 10 20 Figure III.A.7 30 Q/ut 8.3 EQUILIBRIUM Webster’s Encylopedic Unabridged Dictionary of the English Language defines equilibrium as “a state of rest or balance due to the equal action of opposing forces,” and “ equal balance between any powers, influences, etc.” The New Palgrave : A Dictionary or Economics identifies 3 concepts of equilibrium: • • • Equilibrium as a “balance of forces” Equilibrium as “a point from which there is no endogenous ‘tendency to change’” Equilibrium as an “ outcome which any given economic process might be said to be ‘tending towards’, as in the idea that competitive processes tend to produce determinant outcomes.”” In Neoclassical microeconomics, “equilibrium” is perceived as the condition where the quantity demanded is equal to the quantity supplied: the behavior of all potential buyers is coordinated with the behavior of all potential sellers. There is an equilibrium price that equates or balances the amount that agents want to buy with the amount that is produced and offered for sale (at that price). There are no forces (from buyers or sellers) that will alter the 160 equilibrium price or equilibrium quantity. Graphically, economists represent a market equilibrium as the intersection of the demand and supply functions. This is shown in Figure III.A.8. 8.3 Equilibrium e c i r P $20 $15 $10 $5 Supply C B A Demand 30 Q/ut 10 20 Figure III.
A.8 In the graph to the left, equilibrium is at the intersection of the demand and supply functions. This occurs at point B. The equilibrium price is $15 and the equilibrium quantity is 20 units. At the equilibrium price the quantity that buyers are willing and able to buy is exactly the same as sellers are willing to produce and offer for sale. This notion of equilibrium is one of the fundamental organizing concepts of neoclassical economics This is a mechanical, static conception of equilibrium. Neoclassical economics uses “comparative statics” as a method by which different states can be analyzed. In this approach to equilibrium in a market the explanation about how equilibrium is achieved does e c i r P $20 $15 $10 $5 not consider the possibility that some variables change at different rates of time. 161 J B S C D 20 13 Figure III.A.9 30 Q/ut 8.3 Equilibrium The process of achieving a state of equilibrium is based on buyers and sellers adjusting their behavior in response to prices, shortages and surpluses. In Figure III.A.9. If the price were at $20. the price is “too high” and the market is not in equilibrium. The amount of the good that agents are willing and able to buy at this price (quantity demanded) is less than sellers would like to sell (quantity supplied). At $20 buyers are willing and able to purchase 13 units while sellers produce and offer for sale 30 units. Sellers have 17 units that are not sold at this price. This is a surplus. In order to sell the surplus units, sellers lower their price. As the price falls from $20 the quantity supplied decreases and the quantity demanded increases. (Neither demand nor supply are changed.) As the price falls, the quantity supplied falls and the quantity demanded increases. At a price of $15 the amount that buyers are willing and able to purchase is equal to the amount sellers produce and offer for sale. When the market price is below the equilibrium price the quantity demanded exceeds the quantity supplied. At the price below equilibrium, buyers are willing and able to purchase an amount that is greater than the suppliers produce and offer for sale. The buyers will “bid up” the price by offering a higher price to get the quantity they want. The quantity demanded will fall while the quantity supplied rises in response to the higher price. An economic system has many agents who interact in many markets. General equilibrium is a condition where all agents acting in
all markets are in equilibrium at the same time. Since the markets are all interconnected a change or disequilibrium in one market would cause changes in all markets. Leon Walras [1801-1866] was a major contributor to the concept of general equilibrium. Kenneth Arrow [1921- ] and Gérard Debreu [1921- ], show the conditions that must be met to achieve general equilibrium. 162 Antoine Augustin Cournot, [1801-1877] adopted the concept of partial 8.3 Equilibrium equilibrium in 1838 out of mathematical expediency. (The New Palgrave ) Alfred Marshall [1842-1924] approach was to introduce the concept of time and the process of analyzing one market at a time. Neoclassical microeconomics tends to focus on partial equilibrium. It was Marshall who introduced the concept of ceteris paribus as a means to isolate and analyze each market separately. Marshall understood that all markets were interconnected but chose to analyze each market individually. The concept of partial equilibrium is used in introductory economics courses and for some analysis. 8.3.1 MARKET ADJUSTMENT TO CHANGE Market systems are favored by Neoclassical economists for three primary reasons. First, agents only need information about their own objectives and alternatives. The markets provide information to agents that may be used to identify and evaluate alternative choices that might be used to achieve objectives. Second, each agent acting in a market has incentives to react to the information provided. Third, given the information and incentives, agents within markets can adjust to changes. The process of market adjustment can be visualized as changes in demand and/or supply. 8.3.2 SHIFTS OR CHANGES IN DEMAND The demand function was defined from two perspectives: • A schedule of quantities that individuals were willing and able to buy at a schedule of prices during a given period, ceteris paribus. • The maximum prices that individuals are willing and able to pay for a schedule of quantities or a good during a given time period, ceteris paribus. 163 8.3.2 Shifts or Changes in Demand In both cases the demand function is perceived as a negative or inverse relationship between price and the quantity of a good that will be bought. The relationship between price and quantity is shaped by other factors or variables. Income, prices of substitutes, prices of compliments, preferences, number of buyers and expectations are among the many possible variables that influence the demand relationship. The demand function was expressed:
Qx = fx(Px, Pc, Ps, M, Preferences, #buyers,... ) Pc is the price of complimentary goods. Ps is the price of substitutes. M is income. Such proxies as gender, age, ethnicity, religion, etc represent preferences. Remember that a change in the price of the good (P x) is a change in quantity demanded or a movement along a demand function. A change in any other related variable will result in a shift of the demand function or a change in demand. In Figure III.A.10 the effects of a shift in demand are shown. If supply is constant, an increase in demand will result in an increase in both equilibrium price and quantity. A decrease in demand will cause both the equilibrium price and quantity to fall. 164 e c i r P P1 Pe P2 8.3.2 Shifts or Changes in Demand S Given the supply (S) and the demand (D), the equilibrium price in the market is Pe,. The equilibrium quantity is Qe. An increase in demand is represented by a shift of demand from D to D1. This will cause and increase in equilibrium price from Pe to P1 and equilibrium quantity from Qe to Q1. D2 D A decrease in demand to D2 will cause equilibrium price to fall to P2 and quantity to Q2. D1 Q2 Qe Q1 Q/ut Figure III.A.10 8.3.2.1 SHIFT OF SUPPLY Remember that the supply function was expressed, Qxs = fs (Px, Pinputs, Tech, regulations, # sellers,... #S), A change in the price of the good changes the quantity supplied. A change in any of the other variables will shift the supply function. An increase in supply can be visualized as a shift to the right, at each price a larger quantity is produced and offered for sale. A decrease in supply is a shift to the left: at each possible price a smaller quantity is offered for sale. If the supply shifts and demand remains constant, the equilibrium price and quantity will be altered. An increase in supply (while demand is constant) will cause the equilibrium price to decrease and the equilibrium quantity to increase. A decrease in supply will result in an increase is the equilibrium price and a decrease in equilibrium quantity. 165 e c i r P P2 Pe P1 8.3.2 Shifts or Changes in Demand S2 S S1 Given
the demand (D) and the supply (S), the equilibrium price in the market is Pe,. The equilibrium quantity is Qe. An increase in supply is represented by a shift of supply from S to S1. This will cause and decrease in equilibrium price from Pe to P1 and an increase in equilibrium quantity from Qe to Q1. A decrease in supply to S2 will cause equilibrium price to increase to P2 and equilibrium quantity to fall to Q2. Q2 Qe Q1 D Q/ut Figure III.A.11 8.3.2.2 CHANGES IN BOTH SUPPLY AND DEMAND When supply and demand both change, the direction of the change of either equilibrium price or quantity can be known but the effect on the other is indeterminate. An increase in supply will push the market price down and quantity up while an increase in demand will push both market price and quantity up. The effect on quantity of an increase in both supply and demand will increase the equilibrium quantity while the effect on price is dependent on the magnitude of the shifts and relative structure (slopes) of supply and demand. The effect of an increase in both supply and demand is shown in Figure III.A.12. e c i r P P2 Pe P1 Qe ’ Q1 Q* S S1 D1 D Given supply (S) and demand (D), the equilibrium price is Pe and quantity is Qe. An increase in supply to S1 results in a drop in price from Pe to P1 while quantity increases from Qe to Q1. If demand then increased to D1, the equilibrium quantity would increase to Q*. The price however, is pushed up. In this case the price is returned to Pe. If the shift in demand were greater of less (or the slopes of S and D) were different, the equilibrium price might rise, fall or remain the same; the change is indeterminate until we have more information. 166 Q/ut Figure III.A.12 When supply and demand both shift, the direction of change in either equilibrium price or quantity can be known but direction of change in the value 8.3.2 Shifts or Changes in Demand of the other is indeterminate. 8.3.3 EQUILIBRIUM AND THE MARKET Whether equilibrium is a stable condition from which there “is no endogenous tendency to change,” or and outcome which the “economic process is tending toward,” equilibrium represents a
coordination of objectives among buyers and sellers. The demand function represents a set of equilibrium conditions of buyers given the incomes, relative prices and preferences. Each individual buyer acts to maximize his or her utility, ceteris paribus. The supply function represents a set of equilibrium conditions given the objectives of sellers, the prices of inputs, prices of outputs, technology, the production function and other factors. The condition of equilibrium in a market, where supply and demand functions intersect (“quantity supplied is equal to the quantity demanded”) implies equilibrium conditions for both buyers and sellers. 167 9 Demand and Consumer Behavior 9 DEMAND AND CONSUMER BEHAVIOR Demand is a model of consumer behavior. It attempts to identify the factors that influence the choices that are made by consumer. In Neoclassical microeconomics, the objective of the consumer is to maximize the utility that can be derive given their preferences, income, the prices of related goods and the price of the good for which the demand function is derived. An individual’s demand function can be thought of as a series of equilibrium or optimal conditions that result as the price of a good changes. There are two approaches that may be used to explain an individual’s demand function: utility analysis and indifference analysis. The two approaches are compatible. 9.1 CONSUMER CHOICE AND UTILITY Utility is the capacity of a good (or service) to satisfy a want. It is one approach explain the phenomenon of value. Utilitarianism is the ethical foundation of Neoclassical microeconomics. Jeremy Bentham [1748-1832] formalized “utilitarianism.” Utility is a subject evaluation of value. Bentham seemed to intuitively grasp the notions of total an marginal or incremental utility. However, it was not until 1844 that Dupuit [1804-1866] linked marginal utility to the concept of demand. Heinrich Gossen [1810-1858] developed the “law of satiable wants” which is considered to be a forerunner of the “law of diminishing marginal utility. In 1871 William Stanley Jevons [1835-1882] used the term “final degree of utility” and Carl Menger [1840-1921] recognized that individuals rank order their preferences. It was Friedrich von Wieser, [1851- 1926] who first used the term “marginal utility.” 9.1.1 UTILITY
168 9.1.1 Utility Since utility is subjective and cannot be observed and measured directly, it use here is for purposes of illustration. The objective in microeconomics is to maximize the satisfaction or utility of individuals given their preferences, incomes and the prices of goods they buy. A. TOTAL UTILITY (TU) AND MARGINAL UTILITY (MU) Total utility (TU) is defined as the amount of satisfaction or utility that one derives from a given quantity of a good. Marginal utility (MU) is defined as the change in total utility that can be attributed to a change in the quantity consumed. Total Utility = TU = f ( Q, preferences, …) Marginal Utility = MU = ΔTU ΔQ As a larger quantity of a good is consumed in a given period we expect that the TU will increase at a decreasing rate. It may eventually reach a maximum and then decline. Remember the last time you went to an all you can eat pizza place and ate too much? This is shown in Figure IV.A.1. As the quantity of pizza/day consumed increases, the TU derived from the pizza increases at a decreasing rate until the maximum or 27 is reached at the 5th pizza. 169 TU is a function of the individual’s preferences and the quantity consumed. In the illustration to the right, 10 units of utility are obtained by consuming 1pizza/day. The consumption of 2 pizzas/day results in a total of 18 units of satisfaction. The maximum satisfaction that can be derived from the consumption of pizza is 27. This occurs at 5 pizzas. If the individual eats more than 5 pizzas their total satisfaction declines. TUP 27 26 24 18 10 9.1.1 Utility TUP 1 2 3 4 5 Pizza/day Figure IV.A.1 Total Utility can be displayed in table form. The information contained in Figure IV.A.1 is shown in Table IV.1 Marginal utility (MU) is the change in TU that is “caused” by a change in the quantity consumed in the particular period of time. MU was defined: MU = Δ TU ΔQ TABLE IV.1 TOTAL & MARGINAL In Table IV.1 marginal utility is calculated by subtraction. The change in UTILITY quantity from row to row is 1 (D Q = 1). Therefore the change in total utility Quant can be calculated be subtracting the TU associated with each quantity from that
associated with the next quantity. In Table IV.1 the total utility (TU) derived from 1 unit of the good is 10. The TU derived from 2 units is 18: \ change in total utility (D TU) attributable to a one unit change in quantity (D Q) ity 0 1 2 3 TU 0 10 18 24 MU -- 10 the 8 6 is 8. 4 5 6 26 27 26 2 1 -1 170 9.1.1 Utility MU = Δ TU ΔQ = 8 1 = 8 The MU of the third unit is 6 [MU 3 = ΔTU ΔQ = 24 − 18 1 = 6 1 = 6] When the MU is calculated by subtraction, it can be visualized as the slope of the TU between two points. This is shown in Figure IV.A.2 The MU can be visualized as the slope of the TU between successive units of the good. In the graph to the right the MU of the third unit of Pizza is the slope of the TU between points A and B. Think of the slope of a line as rise over run. D TU rise and D Q is the run. In this example the D Q is 1 ( from the third to the fourth unit is 1). The D TU is 6 (24-18). \ rise over run or the slope of TU between points A and B is 6. TUP 27 26 24 18 10 MU = D TU D Q D TU B A D Q TUP 1 2 3 4 5 Pizza/day Figure IV.A.2 Marginal utility can be graphed, however remember that the MU calculated by subtraction is “between” successive units of the good. It is the slope of an arc defined by two points on a total utility function. This is shown in Figure IV.A.3 171 In the graph to the right, one unit of the good yields 18 units of satisfaction while 2 units of the good result in 30 units of satisfaction. ) can be shown Marginal Utility ( MU = ΔTU ΔQ as the slope of a line from point R to B. this is the red “arc” between the two points. The actual TU is shown by the curved blue line between R and B. 12 1 ΔTU ΔQ rise run slope MU TU of = = = = MU can be calculated as a derivative. At 2 units of the good the MU will be the slope of
the line GG’ tangent to TU at point B. 9.1.1 Utility G1 G B run TU 40 35 30 25 20 15 10 5 1 2 3 Q/ut Figure IV.A.3 The relationship between total utility (TU), marginal utility (MU) and average utility can be shown graphically. In Figure IV.A.4 the TU function has some peculiar characteristics so all-possible circumstances can be shown. In this example the total utility (TU) first increases at an increasing rate. Each additional unit of the good consumed up to the Q* amount causes larger and larger increases in TU. The MU will rise in this range. At Q* amount there is an inflection point in TU. This is consistent with the maximum of the MU. When AU is is a maximum, MU = AU. When TU is a maximum, MU is 0. This is shown in Figure IV.A.4 172 D 9.1.1 Utility TU TU In the graph to the right, TU increases at an increasing rate from 0 to Q* units of the good. At Q* there is an inflection point in TU. This is consistent with the maximum of the MU. Beyond Q* amount the TU increases at a decreasing rate. MU (the slope of TU) decreases. Q* is the “point of diminishing MU.” When MU > AU, AU is “pulled up.” When MU < AU, AU is “pulled down.” When MU = AU, AU is a maximum. (AU is unchanged, its slope is 0, \ AU is a maximum) At QM the TU is a maximum. At this output the slope of TU is 0. MU is the slope of TU \ MU = 0. MU AU Q/ut AU Q/ut MU Q* Q QM Figure IV.A.4 B. DIMINISHING MARGINAL UTILITY It is believed that as an individual consumes more and more of a given commodity during a given period of time, eventually each additional unit consumed will increase TU by a smaller increment, MU decreases. This is called “diminishing marginal utility.” As a person consumes larger quantities of a good in a given time period, additional units have less “value.” Adam Smith recognized this phenomenon when he posed this “diamond-water paradox.�
� Water has more utility than diamonds. However, since water is plentiful, its marginal value and hence its price is lower than the price of diamonds that are relatively scarce. 173 9.1.1 Utility C. BUDGET CONSTRAINT When goods are “free,” an individual should consume until the MU of a good is 0. This will insure that total utility is maximized. When goods are priced above zero and there is a finite budget, the utility derived from each expenditure must be maximized. An individual will purchase a good when the utility derived from a unit of the good X (MUX) is greater than the utility derived from the money used to purchase the good (MU$). Let the price of a good (PX) represent the MU of money and the MUX represent the marginal benefit (MBX) of a purchase. When the PX > MBX, the individual should buy the good. If the PX < MBX, they should not buy the good. Where PX = MBX, they are in equilibrium, they should not change their purchases. Given a finite budget (B) and a set of prices of the goods (PX, PY, PN) that are to be purchased, a finite quantity of goods (QX, QY, QN) can be purchased. The budget constraint can be expressed QY +… + P N Q N Where B = budget P N = price of N th good Q N = quantity of N th good For one good the maximum amount that can be purchased is determined by the budget and the price of the good. If the budget were 80€ and the price was 5€, it would be possible to buy 16 units. The amount that can be purchased is the budget (B) divided by the price of the good (PX). Q X that can be purchased = Budget Price = B P X The combinations of two goods that can be purchased can be shown graphically. The maximum of good X that can be purchased is. 174 9.1.1 Utility B P X, the amount of good Y is B PY All possible combinations of good X and Y that can be purchased lie along (and inside) a line connecting the X and Y intercepts. This is shown in Figure IV.A.5 In the graph to the right, the budget is 80€. When the price of good Y (PY) is 4€, a maximum of 20 units of good Y can be
purchased. This is shown as point A on the Y-axis. If the price of good X is 5€, a maximum of 16 units of X can be purchased. This is point H on the X-axis. The line AH represents the maximum combinations of goods X and Y that can be bought given the budget and prices. Any combination of goods that lies in the triangle OAH (yellow area) can be purchased. An increase in the budget will “shift” the budget constraint out. A decrease in the budget will shift it in. A change in the relative prices will “rotate” the constraint (change its slope). QY = B YP 80 4 = 20 A Budget constraint when B = 80€, PX = 5€ PY = 4€ H O = B XP 80 5 = 16 QX Figure IV.A.5 In order to maximize the utility derived from the two goods, the individual must allocate their budget to the “highest valued use.” This is accomplished by the use of marginal analysis. There are two steps to this process. First, the marginal utility of each unit of each good is considered. Second, the price of each good (or the relative prices) must be taken into account. It is believed that as a person consumes more and more of a (homogeneous) good in a given period of time, that eventually the total utility (TU) derived from that good will increase at a decreasing rate: the point of diminishing marginal utility (MU) will be reached. 175 9.1.1 Utility When there are two (or more) goods (with prices) and a budget, the individual will maximize TU by spending each additional dollar (euro, franc, pound or whatever monetary unit) on the good with the greatest marginal utility per unit of price. Consider the two goods in Table IV.2. P X ] [MU X TABLE IV.2 Maximizing TU of Two Goods Given Prices and Budget (B = $5) Xebecs (Good X) PX = $1 - PX1 = $.50 Yawls (Good Y) PY = $1 QX TUX 0 1 2 3 4 5 6 0 10 18 24 28 30 30 M U X M U X P X -- 10 8 6 4 2 0 MU X P X1 QY TUY MUY MU Y P Y -- 20 16 12 16 28 36 40 40 36 -- 16 12 8 4 0 -- 16
12 8 4 0 - 4 - 4 In Table IV.2 the preferences for two goods (good X, xebecs and good Y, yawls) is shown. The preferences determine the Total Utility (TU) and marginal utility (MU) that is derived from various units of the two goods. A change in preferences will change the utility as expressed by TU and/or MU. A 176 œ ß ø Œ º Ø 9.1.1 Utility preference state is one table. A change in preferences would be shown as a different table. Remember that for demand analysis preferences are subject to ceteris paribus. The effects of a change in price (of either good) or the budget can be shown within the given table. In Table IV.2 the preferences are given, the budget is $5, the PX is $1 and PY is $1. The marginal utility per dollar (price) is calculated P N ] for each good. The agent then spends each monetary unit ($, €, ₤ [ MU N or... ) on the good that has the highest MU N/PN. In Table IV.2 the individual would first buy a unit of good Y (yawls) to get 16 units of satisfaction. If they had bought a unit of good X (xebecs) they would have gotten 10 units of satisfaction for the dollar expenditure. The consumer decides on their next purchase. They can by an additional unit of yawls (for $1) and get 12 units of satisfaction or a unit of xebecs to get 10 units of satisfaction. They will by the second unit of yawls. The third dollar is spent on xebecs (10 units of satisfaction is preferred to 8). The fourth dollar is spent on either xebecs or yawls: the buyer is indifferent between the second xebec and third yawl. They have the same satisfaction. If the second xebec is purchased, the fifth dollar will be spent on the third unit of yawls. Given the preferences, PX = $1, PY = $1 and a budget of $5: the consumer will purchase 2 units of xebecs and three of yawls. The quantity of X purchased at $1 given PY, budget and preferences can be shown as point G in Figure IV.A.6.This is an equilibrium point for the consumer. When they b
uy two units of good X (2X) and three unit of good Y (3Y), they obtain 54 units of satisfaction (TUX for 2X is 18 and TUY of 3Y is 36). If they bought 1X and 4Y 177 their TU would be 50. If they bought 3X and 2Y their TU is 52. Clearly they cannot increase their utility by altering their purchases. 9.1.1 Utility Given the individual’s preferences shown in Table IV.2, a budget of $5 and PX =$1 and PY = $1, the individual will buy 2 units of good X. This is a point on the demand function for good X. A point on the demand for good Y could be shown on another graph. Here we will develop the demand for good X. Note that point G (2 units of X at $1) represents an equilibrium condition for the consumer. They cannot alter their purchases without reducing the total utility they derive from the $5 budget. Point W is derived by lowering the price of xebecs to $.50 e c i r P 1.50 1.00.50 G W Figure IV.A.6 1 2 3 4 5 6 QX/ut [Xebecs] A second point on the demand for good X can be derived by changing the price of good X while holding preferences, budget and Py constant. Decrease the price of xebecs (PX) from $1 to (PX1)$.50. This will increase the marginal utility per dollar spent on good X. This is shown in Table IV.2 in the column [MUX/PX1]. Following the same logic above the consumer would purchase 4 units of xebecs and 3 units of yawls with their $5 budget. Note that this results in 64 units of satisfaction. Reduce the amount of X by 2 units to buy one more unit of good Y and utility falls to 58. If the consumer tried to buy more X and less Y we will interpolate so 2.5 units of Y and 5 units of X can be purchased to yield 62 units of satisfaction. Given preferences in Table IV.2, B = $5, PY = $1 and PX1 = $.50, the consumer will purchase 4X. This can be shown as point W in our graph for the demand of xebecs in Figure IV.A.6. A portion of the demand
function for xebecs has been mapped and is shown as the line segment between points G and W. 178 9.1.1 Utility It is important to note that the demand function represents a series of equilibrium conditions for the consumer as the price of xebecs changes while other parameters remain constant. If PY, Budget or preferences changed, the demand for xebecs would shift. D. EQUIMARGINAL PRINCIPLE The process demonstrated in the previous section may be referred to as the equimarginal principle. It is a useful tool and can be used to optimize (maximize or minimize) variables in marginal analysis. It will be used again to find the minimum cost per unit combination of inputs into a production process. The rule for maximizing utility given a set of price and a budget is straightforward: if the marginal utility per dollar spent on good X is greater that the marginal utility per dollar spent of good Y, buy good X. If the marginal utility per dollar spent on good X is less that the marginal utility per dollar spent of good Y, buy good Y. Utility is maximized when the marginal utility per dollar spent is the same for all goods. This can be expressed for as many goods as necessary. Since there is a budget constraint, if the marginal utility per dollar of one good is greater than the MU/$ of another and the budget is all spent, the individual should buy less of one to obtain more of the other. The equimarginal principle can be expressed: MU x P x = MU y P y = ⋯ = MUn P n 179 9.1.1 Utility subject to the constraint, B > PxQx + PyQy +... + PnQn Where Pni = price of ith good, Qni = quantity of ith good and B = budget 9.1.2 INDIVIDUAL’S DEMAND FUNCTION The individual will tend to purchase more of a good at lower prices. This was shown in a graph as a negatively e c i r P $8 $7 $6 $5 $4 $3 $2 $1 Demand 2 4 6 8 10 12 14 16 18 Quantity/ut Figure IV.A.7 sloped function, Q = f(P). This is shown in Figure IV.A.7 (This graph was introduced in Section III). The inverse relationship between price and quantity is caused by the income and substitution effects. I INCOME EFFECT When
the price of a good that the individual buys increases and the income or budget remains constant, the “real income” goes down and the individual can’t buy as much as they did before the price change. If the price of a good goes down the real income goes up, therefore they effectively have more money and can buy more. This is called the income effect. At higher prices the real income is less so people buy fewer units of a good. At lower prices the real income is greater (even though the nominal income is constant) and they can buy more. II SUBSTITUTION EFFECT Individuals react to higher prices by looking for relatively lower priced substitutes. Or, conversely they will react to lower prices of a good by substituting it for a relatively higher priced good. 180 9.1.2 Individual’s demand function The income and substitution effects may be greater of smaller depending on the good being considered. Some goods may have a large income effect. Autos, computers and the like may have great income effects. In other cases the substitution effect may be larger. When considering the demand for soft drinks the substitution effect may be important. 9.1.3 MARKET DEMAND If the good has nonattenuated property rights (they are exclusive), the individuals’ demand functions can be summed horizontally to obtain the market demand function. This was described in Section III to review the idea note Figure IV.A.8 (Displayed originally as Figure III.A.2). DB d DA d e c i r P P3 P2 P1 Figure IV.A.8 Market Demand DM DC d 1 2 3 8 Q/ut 181 9.1.4 Consumer Surplus 9.1.4 CONSUMER SURPLUS The demand function can be viewed as the maximum that someone is willing an able to pay for each unit of a good. In Figure IV.A.9 someone is In the graph to the right, the supply and demand functions establish the equilibrium price at $5. Consumers are willing and able to pay more than $5 for all units up to the 10th unit. The difference between the market price and what the consumers are willing and able to pay is called consumer surplus. The area PER (in yellow) can be visualized as consumer surplus. If the market price were $5, note that the sellers are willing to produce and offer for sale the first 10 units at a cost less than $5. This is called producer surplus. It is area CEP
(in blue). The sum of consumer surplus and producer surplus is a measure of social welfare. The market has maximized the well being of both consumers and producers. e c i r P $8 $7 $6 $5 $4 $3 $2 $1 R P C Supply E Demand 2 4 6 8 Q 12 10 14 16 18 Quantity/ut Figure IV.A.9 willing and able to pay $9 or more for the first 2 units. If the market price were at equilibrium ($5 in this graph), the consumer would pay $5 while they were willing to pay in excess of $9 for each of the two units. Therefore, they received more utility (that they were willing and able to pay for) than they had to pay. The difference between the reservation price of the buyer (the maximum the buyers are willing and able to pay for each unit) and the market price is called consumer surplus. 9.1.5 PRODUCER SURPLUS The welfare of the producers can be shown in a similar manner. The supply function represents the minimum price the sellers will accept for each unit. Therefore, the difference between the market price and the reservation price of the seller (the minimum the seller will accept for each unit) represents producer surplus. This is represented by area CEP in Figure IV.A.9. 182 9.1.6 Elasticity 9.1.6 ELASTICITY Elasticity is a tool that is used to describe the relationship between two variables. Decision makers would like to describe how a change in price might alter the quantity demanded. A measure of this relationship is called the “own” price elasticity of demand. It is also useful to describe how a change in buyers’ income shifts the demand function for a good: this measure is called income elasticity. When the price of a related good (substitute or compliment) changes, the demand for a good will shift. Cross elasticity is a measure of the responsiveness of buyers of a good to changes in the prices of related goods. Elasticity is defined as E = percentage change of the dependent variable percentage change of the independent variable This is the percentage change in the dependent variable caused by a percentage change in the independent variable. 183 9.1.6 Elasticity (A) “OWN” PRICE ELASTICITY OF DEMAND [EP OR P ] I. DEFINITION OF EP The “own” price elasticity of demand is sometimes called price
elasticity or price elasticity of demand. The price elasticity of demand measures the responsiveness of buyers to changes in the goods “own” price. It reflects a movement along a given demand $ e c i r P 10 = 10 –1P P = 10 – 1Q B C Demand function or a change in quantity 1 2 3 4 5 6 7 8 9 10 Q/ut demanded. For illustrations of Figure IV.A.10 elasticity the demand function will be a linear function: Q = 10 – 1P. This simple demand function can also be expressed P = 10 – 1Q. It is important to note that less simple functions may not have this property. The graphical representation of this demand function (Q = 10 –1P) is shown in Figure IV.A.10. II. CALCULATION OF EP Price elasticity measures the percentage change in the quantity demanded “caused” by a percentage change in the price. In Figure IV.A.10, when the price of the good is $4 (at point B), six units will be purchased. Should the price increase to $8 (point A), the quantity purchased will decrease to 2 units. A decrease in price to $2 will cause an increase in the quantity demanded to 8 units of the good (point C). Notice that as the price increases from $4 to $8 (a + 100% ΔP), there is a change in quantity from 6 units to 2 units (a - 67% ΔQ). Using the definition of price elasticity, 184 E P = %ΔQ %ΔP = − 67 +100 = −. 67 9.1.6 Elasticity At the price of $4, the coefficient of “own” price elasticity of demand is -.67. This is the elasticity at a point on the demand (point B) for a specific price ($4) and quantity (6 units). A formula for calculating point price elasticity is: E P = Q 1 - Q 2 Q1 P1 - P1 = ΔQ ΔP x P1 Q 1 Q1 = 6 units, P1 = $ 4 Q 2 = 8 units, P 2 = $ 2 ΔQ = +2, ΔP = −2 E P = ΔQ ΔP ∗ P 1 Q1 = +2 −2 4 ∗ 6 = −1 ∗ 4 6 = −.67 Calculating the EP for a price change from $
4 to $2 in Figure IV.A.10, a move from point B to point C: Note that the EP is the same whether the price is increased from $4 to $8 or decreased from $4 to $2. The magnitude of the change does not affect the E P either. The coefficient of “own” price elasticity is unique to each point on the demand function. To calculate EP as the price falls from $8 to $4 (a move from point A to point B in Figure IV.A.10): 185 9.1.6 Elasticity Q1 = 2 units, P1 = $ 8 Q 2 = 6 units, P 2 = $ 4 ΔQ = +4, ΔP = −4 E P = ΔQ ΔP ∗ P 1 Q1 = +4 −4 8 ∗ 2 = −1 ∗ 4 1 = +−2 EP at $8 is –2, at $4 it is -.67. The coefficient is different at every point on the demand function even though the slope of the demand function is the same at every point. EP is determined by the slope of the demand [ ΔQΔP ] and the location on the demand [ P 1 Q1]. The demand, EP at every price, and total revenue (TR) are displayed in Table IV.3. Table IV.3 Q = 10 – 1P Demand, EP and Total Revenue (TR) EP 0 -0.11 -0.25 -0.43 -0.67 - 1.00 - 1.50 - 2.33 - 4.00 - 9.00 undefined TR 0 $9 $16 $21 $24 $25 $24 $21 $16 $9 0 Price Quantity $0 $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 10 186 The information in Table IV.3, The absolute value of EP can be categorized by its relationship to 1. Table IV.4 shows the categories of elastic, unitary elasticity and inelastic coefficients. 9.1.6 Elasticity When \|E p \|> 1, we call demand elastic, the percentage change in quantity is greater • than the percentage change in price. When demand is elastic price and total revenue (TR) move in opposite directions. When D P > 1, TR will decrease: when D P < 1, TR will increase. When \|E • than the percentage change in price. When demand
is inelastic, price and TR move in the same direction. When D P > 1, TR will increase: when D P < 1, TR will decrease. • p \|< 1, we call demand inelastic, the percentage change in quantity is less p\|= 1, TR will be a maximum. This is called unitary elasticity Where \|E 187 9.1.6 Elasticity Table IV.4 Q = 10 – 1P Demand, EP and Total Revenue (TR) Price Quantity $0 $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 10 EP\| 0<1 (inelastic).11<1 (inelastic).25<1 (inelastic).43<1 (inelastic).67<1 (inelastic) 1 = 1 (unitary) 1.50>1 (elastic) 2.33>1 (elastic) 4.00>1 (elastic) 9.00>1 (elastic) undefine d TR 0 $9 $16 $21 $24 $25 $24 $21 $16 $9 0 To solve the problem of a different coefficient of price elasticity at every price, average or “arc” elasticity between two prices will be used. The two prices should represent reasonable upper and lower bounds that the price might be expected to fall between. The average or “arc” price elasticity is calculated by: 188 9.1.6 Elasticity E P arc = ΔQ ΔP Q1 + Q 2) ∗( P1 + P 2 If the price of the good in the example were expected to generally be between $2 and $4, the average elasticity would be calculated: The average elasticity between $2 and $4 is -.43 and is inelastic. An increase in the price in this range will increase TR. A decrease in price will decrease TR. Q1 = 6 units, P1 = $ 4 Q 2 = 8 units, P 2 = $ 2 ΔQ = +2, ΔP = −2 P 1 + P 2 Q1 + Q 2 ΔQ ΔP E P = ∗ = +2 −1 ∗ 6 14 = −. 43 III MID-POINT AND EP A useful short cut to understanding the relative elasticity along a demand function is to use the mid-point. For any linear demand function the mid- point can be located by dividing the
Q-intercept (or P-intercept) by 2. In Figure IV.A.11 the mid- point is at 5 units and $5. At this quantity (and price), EP will be unitary or its absolute value is 1. This will also be the maximum of $ e c i r P 10 EP\| > 1, elastic range \|EP\| = 1 \|EP\| < 1, inelastic range 10 Q/ut Figure IV.A.11 the total revenue (TR). The “top” half the linear demand function (at higher 189 prices) will be elastic. The “lower” half the demand function (lower prices) will be inelastic. 9.1.6 Elasticity IV PRICE ELASTICITY AND TOTAL REVENUE The demand function is a relationship $ J between price and quantity. Price elasticity is determined by the slope of the demand function and the location (price and quantity) on the demand function. Total P1 P1 2 Revenue (TR) is the product of price and TR H D = AR Q1 2 Figure IV.A.11.5 Q1 Q/ut quantity. (TR = PQ). As a consequence, demand, EP and TR are related. Table IV.4 shows the relationships. The demand function is elastic in the upper portion. At the mid-point of a linear demand function, EP is unitary (EP = -1). It is also at this mid-point that TR will be at a maximum. In Figure IV.A.11.5, the demand (or average revenue, AR) has a Q-intercept of Q1 and a P-intercept of P1. At point H (the mid-point of the demand at one half P1 and Q1) the value of EP is –1. The upper portion of the demand is elastic. Note that the demand has a negative slope and TR has a positive slope. This will help you remember that price and TR move in the opposite directions. As price rises, TR will decrease. As price decreases, TR will increase. In the lower portion, the demand is inelastic. Both TR and demand have negative slopes. As price increases, TR will rise. As price falls, TR will decrease. The maximum value of TR will occur at the quantity were EP is unitary. The maximum value of TR is at point J. The slope of TR at this point is 0. Price elasticity is
useful to explain the relationship of price and TR. It does not provide information about profits. Profits (P ) are defined as total revenue 190 9.1.6 Elasticity minus total costs (P ” TR – TC). To determine the output and price that result in maximum profits, we must know both TR and TC. Demand (D) is a functional relationship between price and quantity that will be purchased. Total revenue (TR) is the product of price and quantity. (TR = PQ). Therefore, the demand for a firm’s product determines the revenues the firm Average Revenue = AR = TR Q obtains from the sale of its output. The average revenue (AR) and marginal revenue (MR) are also of interest in the analysis of a firm’s behavior. AR is the revenue per unit sold. It is calculated by dividing the total revenue by the quantity, Marginal revenue (MR) is the change in TR caused by a (1 unit) change in the quantity sold. Marginal Revenue = MR = Δ TR ΔQ P, 2 $ 0 Figure IV.A.11.5a MR 5 AR Dema nd 1 0 Q/ ut Consider an example demand function P = 20-2Q (shown in Figure IV.A.11.5a). Total revenue is TR = PQ, and P=20-2Q. By substitution, TR=(20-2Q)Q = 20Q-2Q2 Average revenue the revenue per unit, 191 9.1.6 Elasticity AR = = TR Q 20Q 2 2Q Q = 20 Q2 Notice that the AR is the same as the demand function. This will always be true. Marginal revenue (MR) is defined as the change in TR caused by a one unit MR = ΔTR ΔQ ≈ dTR dQ = 20− 4Q change in the quantity. Notice that the MR function (MR = 20 – 4Q) has twice the slope as the demand (D) and AR functions. Since MR decreases twice as fast as AR (or D), it will intersect the Q axis halfway between the origin and the intercept of the AR function. Note that if the slope of the Demand were 0, and the MR fell at twice the rate, the slope of MR would also be 0 (2 times 0 is still 0). As a result when the demand is perfectly elastic (has a slope of 0, demand is horizontal) the AR and MR will coincide. Profits (
∏) are defined as the difference between the total revenue (TR) and total cost (TC), ∏ = TR –TC. The relationship between demand an revenue V DETERMINANTS OF EP Price Elasticity of demand is influenced by: 192 9.1.6 Elasticity 1. Availability of substitutes Generally, the more substitutes that are available, the more elastic the demand for a good. The demand for a class of goods (soft drinks) is usually more inelastic than the demand for a specific brand of the good (Pepsi or Coca-Cola). A Firm may try to differentiate their product to make the demand relatively more inelastic. 2. Proportion of item in budget When the expenditures on a product are a relatively small portion of a budget, the demand is relatively more elastic. 3. Time available to adapt The longer that consumers or buyers have to make adjustments in their behavior, the more elastic the demand is likely to be. The absolute value of the short run price elasticity of demand for gasoline would be smaller than the absolute value of the long run price elasticity of demand. The longer time allows consumers more opportunity to adjust to price changes. VI INTERPRETATION OF EP Some examples of price elasticities of demand reported in Microeconomics for Today, [Tucker, p 123, South-Western College Publishing, 1999. Sources Archibald and Gillingham, Houthakker and Taylor, Voith] are presented in Table IV.5. Note that the demand is relatively more elastic for longer periods. Some goods, like movies, are inelastic in the short run and elastic in the long run. The coefficient or price elasticity can be used to estimate the percentage change in the quantity that consumers are willing and able to buy given a percentage change in the price. It is important to understand that this measure does not apply to the equilibrium conditions in the market. 193 9.1.6 Elasticity Table IV.5 Selected Price Elasticities Item Short Run EP Long Run EP Automobiles Movies Medical Care Gasoline -1.87 -.087 -.31 -.20 -2.24 -3.67 -.92 -.70 In Table IV.5 the short run EP for gasoline is -.2. This suggests that a 1% increase in price will reduce the quantity demanded by.2%. A 10% decrease in price would increase the quantity demanded by 2%. In the case of movies, a 1% increase in the price would change the
quantity demanded by 3.67% in the long run. (B) INCOME ELASTICITY OF DEMAND The responsiveness of buyers to changes in their incomes is measured by income elasticity. While EP measures a movement along a demand function as the price changes, income elasticity (EM) measure a shift of the demand function caused by a change in income. Income elasticity (EM) is defined: [ E M ≡ Δ Q Δ Income] In Figure IV.A.12 the original demand function is represented as D. D1 represents a decrease in demand (at each price a smaller quantity is purchased. When a larger quantity is purchased at each price, this will represent an increase of demand to D2. 194 $ e c i r P 10 9 8 7 6 5 4 3 2 1 Given the original demand function (D), consumers are willing and able to purchase 5 units of the good. If income increased by 50% and “caused” the demand to shift to D2, where 8 units are purchased at $5. This is 9.1.6 Elasticity (D) Q = 10 – 1P (D1) Q1 = 7 - 1P (D2) Q2 = 13 – 1P A B C D1 D D2 1 2 3 4 5 6 7 8 9 10 Q/ut Figure IV.A.12 a 60% increase in demand. Income elasticity (EM) is calculated: E M = %ΔQ %ΔM = +60 +50 = +1. 2 In this case, an increase in income resulted in an increase in demand. A decrease in income might decrease the demand (to D1). In this case income E M = %ΔQ %ΔM = − 60 − 50 = +1. 2 elasticity would be When EM is positive, the good is called a normal good. If an increase in income reduces demand (or a decrease in income increases demand), EM will be negative and the good is categorized as an inferior good. a. EM < 0 means the good is inferior, i.e. for an increase in income the quantity purchased will decline or for a decrease in income the quantity purchased will increase 195 9.1.6 Elasticity b. 1 > E M> 0 means the good is a normal good, for an increase in income the quantity purchased will increase but by a smaller percentage than the percentage change in income. c. For EM > 1 the good is considered
a superior good. CROSS ELASTICITY Cross elasticity (EXY) is used as a measure of the relationship between two goods. EXY is defined as: E XY ≡ % Δ Q x % Δ P y Consider two goods that are substitutes: butter and margarine. Cross elasticity cam be used to measure the relationship between the price of butter and the demand for margarine (EMargarine- butter) or the relationship between the demand for butter and the price of margarine (E butter-margarine). The value of EXY is not the same as or equal to EYX. In Figure IV.A.13 the concept of EXY is shown. P M P MH P M Q MH Q Q M Panel A D BH D B Q BH Q /ut B Panel B Figure IV.A.13 D M /ut M 196 9.1.6 Elasticity In panel A, the demand for margarine (DM) is shown. At a price of PM, the quantity demanded is QM. In Panel B, the demand for butter (DB) is shown. At a price of PB, the quantity demanded is QB. If the price of margarine increased to PMH (in Panel A), the quantity of margarine demanded decreases to Q MH. Since less margarine is purchased, the demand for butter increases to DBH (in Panel B). Given the higher demand for butter the butter demanded (given the higher price of margarine) has increased. A decrease in the price of margarine would shift the demand for butter to the left (decrease). The coefficient of cross elasticity would be positive. In the case of complimentary goods, an increase (decrease) in the price of tennis balls would reduce (increase) the demand for tennis rackets. The coefficient of cross elasticity would be negative. If EXY is close to zero, that would be evidence that the two goods were not related. If EXY were positive or negative and significantly different from zero, it could be used as evidence that the two goods are related. It is possible that EXY might be positive or negative and the two goods are not related. The price of gasoline has gone up and the demand for PC’s has also increased. This does not mean that gasoline and PC’s are substitutes. 197 9.1.6 Elasticity • When E When E • compliments xy > 0, [a positive number] this suggests that the two goods are
substitutes xy < 0, [a negative number] this suggests that the two goods are 9.1.6.1 ELASTICITY AND BUYER RESPONSE Elasticity is a convenient tool to describe how buyers respond to changes in relevant variables. Price elasticity (EP) measures how buyers respond to changes in the price of the good. It measures a movement along a demand function. It is used to describe how much more of less the quantity demanded is as the price falls or rises. Income elasticity (EM) is a measure of how much the demand function shifts as the income(s) of the buyer(s) changes. Cross elasticity (EXY) measures how much changes in the price of a related good will shift the demand function. Elasticity can be calculated to estimate the relationship between any two related variables. 198 10 Production and Cost 10 PRODUCTION AND COST Decisions about production require individual agents to make decisions about the allocation and use of physical inputs. Objectives of agents, technology, availability and quality of inputs determine the nature of these decisions. Since the objectives are often pecuniary, it is often necessary to relate the decisions about the physical units of inputs and outputs to the costs of production. If the prices of the inputs and the production relationships are known (or understood), it is possible to calculate or estimate all the cost relationships for each level of output. In practice however, the decision maker will probably have partial information about some of the costs and will need to estimate production relationships in order to make decisions about the relative amounts of the different inputs to be used. 10.1 PRODUCTION Production is the process of altering resources or inputs so they satisfy more wants. Before goods can be distributed or sold, they must be produced. Production, more specifically, the technology used in the production of a good (or service) and the prices of the inputs determine the cost of production. Within the market model, production and costs of production are reflected in the supply function. Production processes increase the ability of inputs (or resources) to satisfy wants by: • a change in physical characteristics • a change in location • a change in time • a change in ownership 199 10.1 Production At its most simplistic level, the economy is a social process that allocates relatively scarce resources to satisfy relatively unlimited wants. To achieve this objective, inputs or resources must be allocated to those uses that have the greatest value. In a market setting, this is achieved by buyers (consumers) and sellers (producers
) interacting. Consumers or buyers wish to maximize their utility or satisfaction given (or constrained by) their incomes, preferences and the prices of the goods they may buy. The behavior of the buyers or consumers is expressed in the demand function. The producers and/or sellers have other objectives. Profits may be either an objective or constraint. As an objective, a producer may seek to maximize profits or minimize cost per unit. As a constraint the agent may desire to maximize “efficiency,” market share, rate of growth or some other objective constrained by some “acceptable level of profits. In the long run, a private producer will probably find it necessary to produce an output that can be sold for more than it costs to produce. The costs of production (Total Cost, TC) must be less than the revenues (Total Revenue, TR). Given a production relationship (Q = f (labor, land, capital, technology, …)) and the prices of the inputs, all the cost relationships can be calculated. Often, in the decision making process, information embedded in cost data must be interpreted to answer questions such as: • “How many units of a good should be produced (to achieve the objective)?” • “How big should may plant be?’ or How many acres of land should I plant in potatoes?” Once the question of plant size is answered, there are questions, • “How many units of each variable input should be used (to best achieve the objective)?” • “To what degree can one input be substituted for another in the production process?” 200 10.1 Production The question about plant size involves long run analysis. The questions about the use of variable inputs relate to short-run analysis. In both cases, the production relationships and prices of the inputs determine the cost functions and the answers to the questions. Often decision-makers rely on cost data to choose among production alternatives. In order to use cost data as a “map” or guide to achieve production and/or financial objectives, the data must be interpreted. The ability to make decisions about the allocation and use of physical inputs to produce physical units of output (Q or TP) requires an understanding of the production and cost relationships. The production relationships and prices of inputs determine costs. Here the production relationships will be used to construct the cost functions. In the decision making process, incomplete cost data is often used to make production decisions. The theory of production and costs provides the road map to the
achievement of the objectives. 10.1.1 (1) PRODUCTION UNIT In the circular flow diagram found in most principles of economics texts, production takes place in a “firm” or “business.” When considering the production-cost relationships it is important to distinguish between firms and plants. A plant is a physical unit of production. The plant is characterized by physical units of inputs, such as land ® or capital (K). This includes acres of land, deposits of minerals, buildings, machinery, roads, wells, and the like. The firm is an organization that may or may not have physical facilities and engage in production of economic goods. In some cases the firm may manage a single plant. In other instances, a firm may have many plants or no plant at all. 201 10.1.1 (1) Production Unit The cost functions that are associated with a single plant are significantly different from those that are associated with a firm. A single plant may experience economies in one range of output and diseconomies of scale in another. Alternatively, a firm may build a series of plants to achieve constant or even increasing returns. General Motors Corp. is often used as an example of an early firm that used decentralization to avoid rising costs per unit of output in a single plant. Diversification is another strategy to influence production and associated costs. A firm or plant may produce several products. Alfred Marshall (one of the early Neoclassical economists in the last decade of the 19th century) considered the problem of “joint costs. “ A firm that produces two outputs (beef and hides) will find it necessary to “allocate” costs to the outputs. Unless specifically identified, the production and cost relationships will represent a single plant with a single product. 10.1.2 (2) PRODUCTION FUNCTION A production function is a model (usually mathematical) that relates possible levels of physical outputs to various sets of inputs, eg. Q = f (Labor, Kapital, Land, technology,... ). To simplify the world, we will use two inputs Labor (L) and Kapital (K) so, Q = f (L, K, technology,...). Here we will use a Cobb-Douglas production function that usually takes the form: Q = ALaKb. In this simplified version, each production function or process is limited to increasing, constant or decreasing returns to scale over the range of production. In
more complex production processes, “economies of scale” (increasing returns) may initially occur. As the plant becomes larger (a larger fixed input in each successive short-run period), constant returns 202 10.1.2 (2) Production Function may be expected. Eventually, decreasing returns or “diseconomies of scale” may be expected when the plant size (fixed input) becomes “too large.” This more complex production function is characterized by a long run average cost (cost per unit of output) that at first declines (increasing returns), then is horizontal (constant returns) and then rises (decreasing returns). 10.1.3 (3) TIME AND PRODUCTION As the period of time is changed, producers have more opportunities to alter inputs and technology. Generally, four time periods are used in the analysis of production: “market period” - A period of time in which the producer cannot change any inputs nor technology can be altered. Even output (Q) is fixed. “Short-run”- A period in which technology is constant, at least one input is fixed and at least one input is variable. “Long-run” - A period in which all inputs are variable but technology is constant. “The very Long-run” - During the very long-run, all inputs and technology change. Most analysis in accounting, finance and economics is either long run or short-run. 203 10.1.4 (4) Production in the Short-Run 10.1.4 (4) PRODUCTION IN THE SHORT-RUN In the short-run, at least one input is fixed and technology is unchanged during the period. The fixed input(s) may be used to refer to the “size of a plant.” Here K is used to represent capital as the fixed input. Depending on the production process, other inputs might be fixed. For heuristic purposes, we will vary one input. As the variable input is altered, the output (Q) changes. The relationship between the variable input (here L is used for “labor”) and the output (Q) can be viewed from several perspectives. The short-run production function will take the form A change in any of the fixed inputs or technology will alter the short-run Q = f (L), K and technology are fixed or held constant Q Or TP production function. In the short run, the relationship between the
physical inputs and output can be describes from several perspectives. The relationship can be described as the total product, the output per unit of input (the average product, AP) O or the change in output that is attributable to a change in the variable input (the marginal product, MP). 204 B TP A LA LB Figure V.1 Input (L) 10.1.4 (4) Production in the Short-Run Total product (TP or Q) is the total output. Q or TP = f(L) given a fixed size of plant and technology. Average product (APL) is the output per unit of input. AP = TP/L (in this case the output per worker). APL is the average product of labor. AP L = output Input = TP L = Q L Marginal Product (MPL) is the change in output “caused” by a change in the variable input (L), MP L = ΔT P ΔL = ΔQ ΔL (A) TOTAL AND MARGINAL PRODUCT Over the range of inputs there are four possible relationships between Q and L (1) TP or Q can increase at an increasing rate. MP will increase, (In Figure V.1 this range is from O to LA.) (2) TP may pass through an inflection point, in which case MP will be a maximum. (In Figure V.1, this is point A at LA amount of input.) TP or Q may increase at a constant rate over some range of output. In this case, MP will remain constant in this range. (3) TP might increase at a decreasing rate. This will cause MP to fall. This is referred to as “diminishing MP.” In Figure V.1, this is shown in the range from LA to LB. (4) If “too many” units of the variable input are added to the fixed input, TP can decrease, in which case MP will be negative. Any addition of L beyond L B will reduce output: the MP of the input will be negative. It would be foolish to continue adding an input (even if it were “free”) when the MP is negative. The relationship between the total product (TP) and the marginal product (MP) can be shown. In Figure V.2, note that the inflection point in the TP function is at the same level of input (LA) as the maximum of the MP. It is also important 205 10.
1.4 (4) Production in the Short-Run to understand that the maximum of the TP occurs when the MP of the input is zero at LB. (B) AVERAGE, MARGINAL AND TOTAL PRODUCT The average product (AP) is related to both the TP and MP. Construct a ray (OR in Figure V.2) from the origin to a tangent point (H) on the TP. This will locate the level of input where the AP is a maximum, LH. Note that at LH level of input, APL is a maximum and is equal to the MPL. When the MP is greater than the AP, MP “pulls” AP up. When MP is less than AP, it “pulls” AP down. MP will always intersect the AP at the maximum of the AP. 206 Figure V.2 In Figure V.2, the total product (TP) function is shown in the upper panel. TP = f (L) This is a short run function which implies that there is a set of fixed inputs (a scale of plant) and a given state of technology. The TP initially increases at an increasing rate. This may be caused by specialization and division of labour. At point A there is an inflection point in the TP function. Beyond LA amount of labour, the TP increases at a decreasing rate until it reaches a maximum at point B. If additional units of labour are used beyond LB, the output (Q or TP) will decline. In the lower panel of Figure V.2 the average product (AP) and marginal product (MP) are shown. At LA amount of labour (determined by the inflection point in TP at point A in the top panel), the MP will reach a maximum at point A’. When the TP increases at an increasing rate, MP rises. When TP increases at a decreasing rate, MP decreases. When TP is a maximum, MP is zero at point B’ in the lower panel. MP is the slope of the TP function. At LH amount of labour the AP will be a maximum at point H’. this is consistent with the tangency of the ray from the origin with the TP function in the top panel. When the AP is a maximum it will be equal to the MP. When MP >AP, AP will increase. When MP<AP, the AP will decrease. 10.1.4 (4) Production in the Short-Run Q Or TP R B H TP
A O MPL LA LH LB Input (L) A’ MP H’ APL B’ LA LH LB Input (L) Figure V.2 Technical Efficiency = Output Input Technical efficiency was defined as a ratio of output to input, AP = TP L = output ( Q ) input ( L, given K ) 207 10.1.4 (4) Production in the Short-Run The AP is a ratio of TP or Q or output to a variable input and a set of fixed input(s). The maximum of the AP is the “technically efficient” use of the variable input (L) given plant size. Remember that K is fixed in the short-run. (C) REVIEW OF PRODUCTION RELATIONSHIPS In the short-run, as a variable input is added to a fixed input (plant size) the TP may increase at an increasing rate. As TP increases at an increasing rate MP for the variable input will rise. So long as the MP is greater than the AP of the variable input, AP will rise. This range is caused by a more “efficient mix” of inputs. Initially, there is “too much” of the fixed input and not enough of the variable input. Eventually, as more variable inputs are added there may be an inflection point in the TP. It is also possible that the TP might increase at a constant rate in a range. An inflection point in the TP is where the “curvature” of the TP changes: it is changing from increasing at an increasing rate (concave from above or convex from below) to increasing at a decreasing rate (convex from above or concave from below). At this point, the MP of the variable input will be a maximum. AP will be rising. At some point, the TP will begin to increase at a decreasing rate. There is “too much variable input” for the fixed input. Productivity of each additional input will be less: MP will fall in this range. AP of the variable input may be greater or less than the MP in this range. If MP is greater than AP, AP will be increasing. If MP is less than AP, AP will be decreasing. A ray from the origin and tangent to the TP function (line OR in Figure V.2) will identify the level of variable input where the AP will be a maximum. At this point MP will equal AP. Since the fixed input is constant
, AP is the 208 10.1.4 (4) Production in the Short-Run equivalent of out measure of technical efficiency for a given scale of plant determined by the fixed input: Tech. Efficiency = output input = TP L ( given fixed input ) = AP of the varible input 10.1.5 COST Producers who desire to earn profits must be concerned about both the revenue (the demand side of the economic problem) and the costs of production. Profits (P ) are defined as the difference between the total revenue (TR) and the total cost (TC). The concept of “efficiency” is also related to cost. 10.1.5.1 (1) OPPORTUNITY COST The relevant concept of cost is “opportunity cost.” This is the value of the next best alternative use of a resource or good. It is the value sacrificed when a choice is made. A person who opens their own business and decides not to pay himself or herself any wages must realize that there is a “cost” associated with their labor, they sacrifice a wage that they could have earned in some other use. A worker earns a wage based on their opportunity cost. An employer must pay a worker a wage that is equal to or greater than an alternative employer would pay (opportunity cost) or the worker would have an incentive to change jobs. Capital has a greater mobility than labor. If a capital owner can earn a higher return in some other use, they will move their resources. The opportunity cost for any use of land is its next highest valued use as well. It is also crucial to note that the entrepreneur also has an opportunity cost. If the 209 entrepreneur is not earning a “normal profit” is some activity they will seek other opportunities. The normal profit is determined by the market and is 10.1.5 Cost considered a cost. 10.1.5.2 (2) IMPLICIT AND EXPLICIT COST The opportunity costs associated with any activity may be explicit, out of pocket, expenditures made in monetary units or implicit costs that involve sacrifice that is not measured in monetary terms. It is often the job of economists and accountants to estimate implicit costs and express them in monetary terms. Depreciation is an example. Capital is used in the production process and it is “used” up, i.e. its value depreciates. Accountants assume the expected life of the asset and a path (
straight line, sum of year’s digits, double declining, etc) to calculate a monetary value. In economics both implicit and explicit opportunity costs are considered in decision making. A “normal profit” is an example of an implicit cost of engaging in a business activity. An implied wage to an owner-operator is an implicit opportunity cost that should be included in any economic analysis. 10.1.6 COSTS AND PRODUCTION IN THE SHORT-RUN If the short-run production function (Q =f(L) given fixed input and technology) and the prices of the inputs are known, all the short-run costs can be calculated. Often the producer will know the costs at a few levels of output and must estimate or calculate the production function in order to make decisions about how many units of the variable input to use or altering the size of the plant (fixed input). Fixed Cost (FC) is the quantity of the fixed input times the price of the fixed input. FC is total fixed cost and may be referred to as TFC. 210 10.1.6 Costs and Production in the Short-Run Average Fixed Cost (AFC) is the FC divided by the output or TP, Q, (remember Q=TP). AFC is fixed cost per Q. Variable Cost (VC) is the quantity of the variable input times the price of the variable input. Sometimes VC is called total variable cost (TVC). Average Variable Cost (AVC) is the VC divided by the output, AVC = VC/Q. It is the variable cost per Q. Total Cost (TC) is the sum of the FC and VC. Average Total Cost (AC or ATC) is the total cost per unit of output. AC = TC/Q. Marginal cost (MC) is the change in TC or VC “caused” by a change in Q (or TP). Remember that fixed cost do not change and therefore do not influence MC. In Principles of Economics texts and courses MC is usually described as the change in TC associated with a one unit change in output, MC = ΔTC ΔQ (for infinitely small D Q, MC= dTC d Q ) MC will intersect AVC and AC at the minimum points on each of those cost functions. 10.1.7 GRAPHICAL REPRESENTATIONS OF PRODUCTION AND COST RELATIONSHIPS The short-run, total product function and the price of the variable input(s) determine the variable cost
(VC or TVC) function. In Figure V.3, the short-run TP function and VC function are shown. 211 10.1.7 Graphical Representations of Production and Cost Relationships Figure V.3 In Figure V.3 the production relationship is linked to the variable cost. In the upper panel, the TP function is shown. Q = f(L) (Given fixed input and technology) TP initially increases at an increasing rate to point A where LA amount of variable input is used. There is an inflection point at point A. TP then increases at a decreasing rate to a maximum at point B produced by LB amount of input. Beyond LB amount of input the TP declines. Using LA amount of labour, QA amount of output is produced. At input level LB, QB output results. In the lower panel, VC is expressed as a function of Q, VC = f(Q) (Given fixed input and technology) The vertical axis, (TP or Q) in the upper panel becomes the horizontal axis (Q) in the lower panel. The horizontal axis (L) in the upper panel is multiplied by the PL and becomes the vertical axis in the lower panel. The VC function is the TP function “rotated and looked at from the back side.” When the TP increases at an increasing rate, the VC increases at a decreasing rate. When the TP increases at a decreasing rate, VC will increase at an increasing rate. When the TP decreases at the quantity of input increases, the VC would increase while output would decrease. Q Or TP QB QA O VC (PL*L) PLxLB PLxLA 0 B TP A LA Input (L) LB VC B' A' QA QB Figure V.3 Q/ut In the range from 0 to LA amount of labor, the output increases from 0 to QA. TP increases at an increasing rate in this range. The MP L is increasing as additional units of labor are added. Since the VC (total variable cost) is the price of labor times the quantity of labor used (LPL), VC will increase at a decreasing rate. The MC will be decreasing in this range. 212 10.1.7 Graphical Representations of Production and Cost Relationships In the range from LA to LB amount of labor the output rises from QA to QB, TP increases at a decreasing rate (MP will be decreasing in this range.). Variable cost (VC) will increase at an increasing rate (MC will be rising
). At the inflection point (A) in the production relationship, MP will be a maximum. This is consistent with the inflection point (A’) in the VC function. At the maximum of TP (LB amount of labor, output QB) at point B, the VC function will “turn back” and as output decreases the VC will continue to rise. A “rational” producer would cease to add variable inputs when those additions reduce output. 10.1.7.1 (1) VARIABLE COST (VC OR TVC) AND AVERAGE VARIABLE COST (AVC) The total variable cost is determined by the price of the variable input and the TP function. The average variable cost is simply the variable cost per unit of output (TP or Q), AVC = VC Q. In Figure V.4 the VC is shown with 3 points identified. A’ is on the TVC at the level of output where there is an inflection point. This will be the same output level were the MC is a minimum. Point C is found by constructing a ray, OM from the origin to a point of tangency on the VC. The level of output will be the minimum of the AVC (also the maximum of the AP). At this point the MC will equal the AVC. When MC is less than AVC, AVC will decline. When MC is greater than AVC,C will rise. MC will always equal AVC at the minimum of the AVC. 213 10.1.7 Graphical Representations of Production and Cost Relationships VC (PLL) PLxLB PL x LC PLxLA 0 $, AVC Figure V.4 In Figure V.4 The relationships among the variable cost (VC), average variable cost (AVC) and the marginal cost (MC) are shown. In the top panel there are three points that are unique and can be used to identify what is happening to the MC and AVC. At point A’ there is an inflection point in the VC. At point B’ the slope of the VC is infinity. Point C is identified by a ray from the origin that is tangent to the VC at point C. Point A’ is associated with QA amount of output. At QA output the MC will be a minimum at A in the lower panel. As the TP increases at an increasing rate, the MP rises, the VC increases at
a decreasing rate and MC decreases. Beyond QA output, the TP increases at a decreasing rate, MP falls, VC increases at an increasing rate and MC will increase. At QC output, identified by the VC B' M C A' QA Qc QB Q/ut MC AV C C* A* QA Qc Figure V.4 Q/utt 10.1.7.2 (2) ATC, AVC, MC AND AFC The fixed cost is determined by the amount of the fixed input and its price. In the short-run the fixed cost does not change. As the output (Q) increases the average fixed cost (AFC) will decline. Since AFC = Fixed Cost Q 214 10.1.7 Graphical Representations of Production and Cost Relationships as long as Q increases, AFC will decrease, it approaches the Q axis “asymptotically.” The average total cost (ATC) is the total cost per unit of output. ATC = TC Q = AFC + AVC In Figure V.5, the AFC is shown declining over the range of output. The vertical distance between the ATC and AVC is the same as AFC. The location or shape of the AVC is not $ Q related to the AFC. The MC is not relate to the AFC but will intersect both the AVC and ATC at their minimum points. 10.1.8 RELATIONSHIP OF MC AND AVC TO MPL AND APL MC AC AVC AFC Q/ut Figure V.5 In Figure V.6 there are three panels. The first shows the TP or short-run production function. The second is the marginal (MP) and average (AP) product functions associated with the short-run production function. In the third panel the related marginal cost (MC) and average variable cost (AVC) function are shown. There are three points easily identifiable on the TP function: the inflection point (A), the point of tangency with a ray from the point of origin (H) and the maximum of the TP (B). Each of these points identifies a level (an amount) of 215 10.1.8 Relationship of MC and AVC to MPL and APL the variable input (L) and a quantity of output. These points are associated with characteristics of the MP and AP functions. Figure V.6 The average variable cost (AVC) and the average product (AP) are closely related. Marginal cost (
MC) reflects the marginal product (MP). In the three panels of Figure V.6, the total product (TP in the upper panel) is related to the AP and MP in the middle panel. The lower panel shows the relationship of average variable cost (AVC) and marginal cost (MC) to AP, MP and TP. As the variable input (L in this example) increases to LA the TP in the upper panel increases at an increasing rate to point A. In this range the marginal product (in the middle panel) will rise. When more than LA amount of the labour input is used, the MP will decrease for each additional unit. The inflection point at A in the upper panel is consistent with the maximum of the MP at point A* in the middle panel. Point H on the TP function (in the upper panel) is constructed by passing a ray from the origin to a point of tangency on the TP function. This identifies LH amount of labour. In the middle panel the AP of labour will rise up to LH amount of input. Notice that in this range the MP is above or greater than the AP. When MP>AP, the AP will be increasing. At point H* in the middle panel, AP will be a maximum. At this point MP = AP. As the input is increased above LH, the AP will fall. When MP < AP, AP will be decreasing. At the maximum of the TP (at point B in the upper panel) LB amount of the variable input is used. At this level of labour (LB), the MP will be zero. It is important to note that when MP = 0, TP is a maximum. In the lower panel, MC will be at a minimum at the output level (QA) where MP is a maximum (QA output at LA input). AVC will be a minimum at QH output. This is where MC=AVC. This is at output level QH produced by LH labour. When AVC is a minimum, AP will be a maximum. When MC<AVC, AVC will be decreasing. When MC>AVC, AVC will increase. When AVC=MC, AVC is a minimum. R B TP H A LA LH LB Input (L) A* H* APL MPL B* LA LH Input (L) LB MC AVC (1/APH)PL = AVCH (1/MPA)PL =MCA QA QH Q Figure V
.6 Q QB QH QA MPL APL MPA APH AVC MC ACH MCA 216 10.1.8 Relationship of MC and AVC to MPL and APL At point A, with LA amount of labor and QA output the inflection point in TP is associated with the maximum of the MP. This maximum of the MP function is associated with the minimum of the MC. MC = 1 MPL ( price of labour). Since MP>AP, the AP is increasing. MC<AVC, so AVC is decreasing. At point H, the AP is a maximum at this level of input (L H). At this level of input use the output (QH) has a minimum of the average variable cost (AVC). At this AVC, the MC will equal the MC. Point B represents the level of input (LB) where the output (QB) is a maximum. At this level the MPL will be zero. 10.1.9 PRODUCTION AND COST TABLES The data from production functions and the prices of inputs determines all the cost functions. In the following example a short-run production function is given. In the table below the columns K, L and TP reflect short-run production. The plant size is determined by capital (K) that is 5 in the example. Since the PK = $3, the fixed cost (FC) is $15 at all levels of output. The price of the variable input (L) is $22. The variable cost (VC) can be calculated for each level of input use and associated with a level of output (Q). Total cost (TC) is the sum of FC and VC. The average cost functions can be calculated: AFC = FC/Q, AVC - VC/Q and ATC =AFC + AVC =TC/Q. Given the production function and the prices of the inputs, the cost functions are shown in Table V.1. 217 10.1.9 Production and Cost Tables Marginal cost in the table is an estimate. Remember that MC = Δ TC ΔQ. Since quantity is not changing at a constant rate of one, the MP will be used to represent ΔQ. This is not precisely MC but is only an estimate. Table V.1 Production and Cost The cost functions constructed from the data in Table V.1 are shown in Figure V.7. Note that the MC intersects the AVC and ATC at the minimum points on
those functions. The vertical distance between ATC and AVC is the same as the AFC. The AFC is unrelated to the MC and AVC. In this example the average fixed cost is less than the average variable cost and MC at every level of output. This is coincidence. In some other production process it might be greater at each level of output. 218 10.1.9 Production and Cost Tables Figure V.7 It is relevant that the AVC and MC are equal at the first unit of output. This will always be true. This also means that MC = Δ TC ΔQ = ΔVC ΔQ. 219 10.1.10 Production and Cost in the Long-run 10.1.10 PRODUCTION AND COST IN THE LONG-RUN Long-run Production describes a period in which all inputs (and Q) are variable while technology is constant. A Cobb-Douglas production function can be used to describe the relationships. There are a variety of other forms production functions can take, however the Cobb-Douglas is the simplest to describe. A short-run production function (Q = f(L) is a cross section from a long-run production function. 10.1.10.1 (1) LONG RUN PRODUCTION The long run production function is multidimensional, two or more inputs and output changes. If there are 2 inputs and one output, the long run production relationship is 3 dimensional. Using a topological map of “isoquants,” three dimensions can be shown in two dimensions. Figure V.8 is a representation of a long run production model using isoquants and isocosts. This model is an attempt to represent a three- dimensional model in two dimensions. It can be thought of as a “topological map” of production. In Figure V.8, two different levels of output of the good are shown. The term “isoquant” means equal quantity. In the graph two isoquants are shown. Q1 and Q2 represent two different levels of output. There are an infinite number of isoquants, one for each possible level of output but only two are shown. The isoquant (Q1) represents all combinations of labor (L) and capital (K) that will produce Q1 amount of output. Three input combinations that will produce Q1 output are identified in the graph (points J, B and H). while there are an infinite number of input combinations that lie along the is
oquant (Q1), only these three are marked. Isoquant Q2 is a larger output than Q1. Only input combination LA, KA at point A is identified. 220 10.1.10 Production and Cost in the Long-run Two isocost functions are also shown in Figure V.8. These are TC1 and TC2. “Isocost” means equal cost. All output combinations that lie on TC1 require the same expenditure. All output combinations that cost less than TC1 lie inside the isocost. Output combinations that cost more than TC1 lie outside the isocost. TC2 represents a greater cost than TC1. The isocost function can be located by finding the intercepts on the K-axis (capital axis) and L-axis (labor axis). The L-intercept is found by dividing the total cost (TC 1 by the price of labor. If TC1 were $200 and the price of labor were $5 the L-intercept (L) would be 40 units of labor, i.e. 40 units of labor at $5 each will cost $200. If the price of capital were $4, the K-intercept for TC1 is K (200/4 = 50). A straight line between these two intercepts identifies all combinations of labor and capital that cost $200. In Figure V.8, the isoquants are represented as Q1 and Q2. There are an infinite number of isoquants, one for each possible quantity of output. In our example only two are shown. Along a given isoquant (Q1) there is a constant level of output. Q2 represents a greater output level. Along Q1 the output remains constant for different combinations of inputs (L and K) Input combination depicted by point J (KA capital and LJ labour) results in the same output as the input combination KB and LB at point B. The slope of the isoquant between point J and B represent the marginal rate of substitution, the rate at which one input can be substituted for another holding output constant. The line TC1 represents a given expenditure or isocost. Each point along the isocost represents different combinations of inputs that costs the same amount (TC1). Point B (using KB and LB) is the lowest cost combination of inputs to produce Q1 amount of output. K K** K* KA KB KH J A B H LJ LB TC1
L* LA Figure V.8 Q2 Q1 TC2 L** L 221 10.1.10 Production and Cost in the Long-run Q1 output could be produced by using KA capital and LJ labor (point J on Q1). Point H (LA labor and KH capital will also result in Q1 output. Notice that both points J and H lie outside the isocost TC 1. Since point B lies on TC1, that input combination cost less than those at point J and H. If Q 1 output is desired, TC1 is the lowest cost of production that can be attained. This is accomplished by using LB labor and KB capital. The lowest cost of producing Q2 given the price of labor and capital is at point A. The slope of the isoquant represents the rate at which one input can be substituted for another and still produce the same output. The slope of the isocost represents relative price so of the inputs. The lowest cost combination of inputs is at the point of tangency between the isocost and the isoquant. When the isocost function is tangent to an isoquant, it identifies the combination of inputs that minimizes the cost per unit for that level of output. The short-run production relationships are cross-sections taken out of the isoquant map. In intermediate microeconomics you will study the cost and production relationships in the isoquant map. 10.1.10.2 (2) LONG-RUN COSTS The long-run costs are derived from the production function and the prices of the inputs. No inputs are fixed in the long run, so there are no fixed costs. All costs are variable in the long run. The long run can be thought of as a series of short-run periods that reflect the cross-sections taken out of Figure V.8. Consequently, the long run costs can be derived from a series of short-run cost functions. In principles of economics the “envelope curve” is used as an approximation of the long run average cost function. In Figure V.9, there are series of short run average cost (AC) functions shown. Each represents a 222 10.1.10 Production and Cost in the Long-run different size plant. Plant size A is represented by ACA. As the plant gets larger, up to plant size ACD,, the short-run AC function associated with each larger plant size is lower and further from the vertical axis. This
range is sometimes referred to as “economies of scale.” Generally it happens from specialization and/or division of labor. Plant D, represented by ACD, represents the plant with the lowest cost per unit. As the plant size increases above D, the short-run average cost begins to rise. This region is often referred to as “diseconomies of scale.” Lack of information to make wise production choices is usually given as the reason for the increasing cost per unit as plant size increases above plant D. AC LRAC AC A c lc AC B AC C AC D AC E AC F LRAC The Q LC Figure V.9 Q/ut envelope curve or LRAC is constructed by passing a line so it is smooth and just touches each of the short-run AC functions. Within each short-run period there is a short run AC, MC, AVC and AFC. The firm or plant will move from one set of short-run curves by changing the fixed input. In Figure V.8 this would be the same as moving from one cross section to another. RETURNS TO SCALE The terms “economies of scale,” “increasing returns to scale,” “constant returns to scale,” “decreasing returns to scale” and “diseconomies of scale” are frequently used. These terms involve subtle and complicated concepts that 223 10.1.10 Production and Cost in the Long-run apply to the long run production process. In principles of economics they are simplified. Conceptually, returns to scale implies that all inputs are variable. Given a Cobb-Douglas production function of the form Q = A La Kβ. Q is output or quantity, L is quantity of labor and K is the quantity of capital. A, a and b are parameters that are determined by the technology of producing a specific product. When a +b = 1, the production process demonstrates “constant returns to scale.” If L and K both increased by 10%, output (Q) would also increase by 10%. This is consistent with a long run average cost (envelope) function that has a slope of 0. When a +b > 1, production has increasing returns. A 10% increase in both L and K results in a larger percentage (say 20%) increase in output (Q). This is consistent with the declining portion of the long run average cost function (LRAC). This tends to be
the result of specialization and division of labor. It is sometimes referred to as economies of scale or economies of mass production. There may be a variety of forces that cause the LRAC to decline. Not all these forces are actually economies of scale. A larger firm (or monopsonist) may be able to negotiate lower prices for inputs. This is not economies of scale, it is a transfer of income or wealth from one group to another. When a +b < 1, decreasing returns are said to exist. As both inputs increase 10%, output (Q) will increase by a smaller percentage (say 6%). This condition is consistent with the rising portion of the long run average cost function (LRAC). As a firm gets larger it may lack the information about various aspects of the production process and be unable to coordinate all the processes. This is the reason that a planned economy does not always produce optimal results. 224 In Figure V.9 economies of scale are said to exist up to output QLC. Diseconomies of scale occur as output expands about QLC. 10.1.10 Production and Cost in the Long-run 225 11 Optimization and Markets 11 OPTIMIZATION AND MARKETS Economics can be viewed as a social science or as a tool for decision science. As a tool economics provides some insights that help identify optimal choices with respect to specific alternatives. One of the basic precepts of Neoclassical microeconomics is that voluntary markets for goods with nonattenuated property rights will provide the information and incentives that coordinate individual behavior to achieve the maximum utility for society. Most of Neoclassical economics presumes that the agent is trying to maximize or minimize (optimize) some objective with respect to a set of constraints. Rational choices require three basic steps: • • • Identify the objective Identify all feasible alternatives Develop a criteria to evaluate each alternative with respect to the objective 11.1 OBJECTIVE, CONSTRAINTS AND ALTERNATIVES The objective is a function of the values and preferences of the individual agent. Experience, social background as well as many other social and psychological characteristics that relate to the individual determine the nature of the agent’s objectives. Economic agents have a variety of objectives. (1) There are a variety of objectives that an agent might have. These include profits, utility, sales, market share, income, growth,...With in a firm different individuals may have different objectives. The CEO may want to maximize profits while the Vice president of engineering may want to minimize the
cost per unit and the person in charge of marketing may want to maximize the growth in sales or market share. The objectives may not be consistent so some sort or hierarchical or bureaucratic process must resolve the 226 11.1 Objective, constraints and alternatives inconsistency. In a market setting, competing objectives of individuals is believed to be reconciled by voluntary transactions or exchanges. (2) The achievement of any objective is subject to a set of constraints. Constraints may be technology, quantity of factors of production, quality of factors, profits, utility, sales, market share, income, growth, social institutions, values, law or a myriad of other possibilities. The constraints and objectives can be structured in a variety of ways. For instance, a firm may try to maximize market share (objective) subject to the constraint that they earn a 12% return on capital investment. Alternatively, a firm might try to maximize the rate of return on capital subject to the constraint that they maintain a 20% market share. An individual might try to maximize income subject to the constraint that they have 30 days of leisure time per year or they might try to maximize their leisure time subject to the constraint that they have at least $50,000 income per year. 11.2 CRITERIA TO EVALUATE ALTERNATIVES Choice implies that the agent has alternatives to choose among. Once the agent has identified the objective and constraints they must evaluate each alternative with respect to the objective. The criteria they use for this evaluation is crucial to their choice. Generally, the criteria will involve two aspects: efficiency and ethics. (1) Efficiency is the measure of how well one achieves objectives given a set of constraints. Efficiency is not in and of itself the objective. The word “efficiency” is a popular term and is often used to justify choices and behavior. Reconsider the concepts of efficiency discussed in the Introduction. 227 11.2 Criteria to evaluate alternatives Technical Efficiency = Objective constraints = output input = Q y + Q x ( L, K, …, technology) Technical efficiency is conceptually measured as a ratio of output to input. For any given set of inputs, technology and output of one good, the maximum output of the other good is technically efficient. Technical efficiency can be considered in the production of a single good. In the short run where one input is fixed (say K), the maximum efficiency of the variable input (say L) occurs at the maximum of the APL (where MPL = APL). The level of technical
efficiency of labor is a function of the amount of K as well as technology. Technical efficiency does not consider the value or relative prices of either inputs or outputs. In physics efficiency the concept of efficiency can be calculated by the different measures of energy (or the capacity to do work). Foot-pounds, foot-pounds per sec, Ergs, Joules, horsepower, horsepower- hours, BTU, kilowatts are all measures of energy. The input and output of energy of a particular process (internal combustion engine, electric motor, etc) can often be measured. From the perspective of economics technical efficiency can be more problematic. What is the efficiency of an automobile? This depends on the measures of inputs and outputs chosen. Typically, miles per gallon may be used as a measure. Miles traveled is the presumed output and “gallons of fuel” is the input. This measure presumes that the number of miles traveled is the sole objective output. Passenger miles, passenger safety, status of owner, or many other measures may better reflect the desired output or objective of the automobile. The same problem exists for the inputs. The presumption is that fuel is the only input. The other inputs such as energy to produce the tons of steel to create the car may be ignored. 228 11.2 Criteria to evaluate alternatives The optimization (maximization) of technical efficiency can occur by maximizing the outputs for a given input or by minimizing the inputs for a given output. It is not possible to maximize output and minimize inputs at the same time. If a public health agency instituted a policy to immunize preschoolers for DPT (diphtheria, pertussis and tetanus) and wanted to maximize efficiency, the problem could be framed in two ways. First, they might be allocated a set of recourses (vaccine, personnel, offices, etc) and then try to vaccinate as many children as possible. Alternatively, they might try to vaccinate all children by using as few resources as possible. Neither the process nor the results are the same. In the transformation or production possibilities model, technical efficiency lies on the transformation or production possibilities frontier. Review the earlier discussion of technical efficiency in the Introduction. The location and shape of the PPF is determined by technology, quantity and quality of inputs. It represents all output combinations possible. The quantity and quality of inputs are fixed. The task is to maximize the outputs. The output combination identified at point H is “technically inefficient.” More of good Y
or good X (or more of both) can be produced with the same set of inputs and technology. All technically efficient solutions lie on the PPF. Technical efficiency does not answer the question about which output combination is preferred or most valuable. Allocative or economic efficiency is required to answer that question Figure I.A.6 Q X Allocative or economic efficiency includes the values or relative prices of outputs and inputs. The benefit or value of a choice is represented by the product of the price and quantity of each good or output (value of output = PxQx +PyQy +... +PnQn). The value of the inputs or cost is represented by the product of the prices and quantities of the inputs (cost = PLL + PKK + …+ PiQi). Allocative efficiency is 229 The location and shape of the PPF is determined by technology, quantity and quality of inputs. It represents all output combinations possible. The quantity and quality of inputs are fixed. The task is to maximize the outputs. The output combination identified at point H is “technically inefficient.” More of good Y or good X (or more of both) can be produced with the same set of inputs and technology. All technically efficient solutions lie on the PPF. Technical efficiency does not answer the question about which output combination is preferred or most valuable. Allocative or economic efficiency is required to answer that question. 11.2 Criteria to evaluate alternatives attained when we maximize the value of the outputs relative to the value of the inputs. The cost is minimized for a given output or output is maximized for a given cost. The economically efficient solution must lie on the production possibilities function. Pareto efficiency is the condition where there are no alternatives that will increase the welfare (utility) of one person without reducing the welfare (utility) of any other person(s). Once an output combination on the production possibility function is attained, that output combination is Pareto Optimal. The output combination at point H is not Pareto Optimal. Irrespective of individual preferences a move from point H to output combinations at point B or D (or any where in the area HDB represent “Pareto Improvements.” Each alternative in the area HDB is “Pareto Superior” to the alternative represent by point H. If the current output combination were at point E, it would be Pareto Optimal even if it were not he highest valued output. Any increase
in good Y (or X) would require a decrease in good X (or Y). The individuals who prefer X (or Y) to Y (or X) would be “worse off” (their utility or welfare is lower). If the output is currently at point H, the area HDB is called “Pareto Safe.” Q Y A B C D H E F Figure I.A.6 Q X Pareto efficiency is a restrictive criteria and tends to promote the status quo. Most choices involve marginal benefits and marginal costs that change the welfare or utility of more than one individual. The Pareto efficiency criterion fails to justify choices that result in the highest valued use of resources (economic efficiency). To remedy this problem the criterion of Pareto Potential is used. Pareto Potential justifies the choice of an alternative so long as the “winners” (individuals whose utility increased) can hypothetically compensate the “losers” (individuals whose utility decreased) and still be better off. This is the foundation of criteria such as Benefit/cost analysis, rate of return on 230 The output combination at point H is not Pareto Optimal. Irrespective of individual preferences a move from point H to output combinations at point B or D (or any where in the area HDB represent “Pareto Improvements.” Each alternative in the area HDB is “Pareto Superior” to the alternative represent by point H.If the current output combination were at point E, it would be Pareto Optimal even if it were not he highest valued output. Any increase in good Y (or X) would require a decrease in good X (or Y). The individuals who prefer X (or Y) to Y (or X) would be “worse off” (their utility or welfare is lower).If the output is currently at point H, the area HDB is called “Pareto Safe.” 11.2 Criteria to evaluate alternatives investment and internal rates of return. The problem with Pareto Potential is that it introduces the question of equity. Consider the problem of breaching dam is the Pacific Northwest. There are winners and losers. Environmentalists, individuals who benefit from anadromous fish and agents who earn income from tourists are some of the winners. Electricity generators and farmers are examples of losers. Even if the marginal benefits of breaching the dam exceeded the marginal costs, there is no
mechanism to insure the winners would compensate the losers. There is necessarily a judgment about the morality of the dams and the imposition of costs and benefits of various groups of individuals. This example also illustrates the issue that the status quo tends to be supported by the Pareto Optimality criterion. Building the dams imposed costs and conferred benefits on different groups of people just as breaching the dams will. As societies and individuals change their preferences, technology and environments change and alter the objectives and optimal use of scarce resources. In an ideal world, informed individuals engaged in voluntary exchanges will result in transfers of property rights that are Pareto improvements and lead to economic efficiency. (2)Equity is a judgment about the rightness or wrongness of the objective. Earlier, deontological and consequentialist ethics were discussed. Any objective can be ethical or unethical based on the type of ethical system used. Remember that microeconomics relies primarily on a consequential ethic called “Utilitarianism” and is directly related to the concept of Pareto Potential. If the benefits exceed the costs of an action, the consequence is an increase in utility. This does not mean that deontological ethics (based on duty) are not necessary for a reasonably functioning society. It is important to consider the morality of our objectives and the sacrifices that must be made to achieve them. 231 11.2.1 MARGINAL ANALYSIS 11.2.1 Marginal Analysis R F The Marginalist Revolution in economics during the last half of the 19th century provided F’ R’ economists with a useful tool to find maximums and minimums given functional relationships between variables. Basically, this Marginalist Revolution was the application of calculus to economic analysis. One of the purposes of economics is to maximize of minimize a given variable by making choices. Choices are always made at the margin. A saying attributed to some anonymous Chinese philosopher is “The longest journey begins with the first step.” This is used here to point out that every decision is a change from an initial state. In production, the manager must understand that a change in an input such as labor “causes” a change in output. A consumer must understand that a change in quantity consumed alters the level of utility. A seller must understand that a change in price alters the quantity sold and the total revenue. Marginal analysis is the analysis of rates of changes in variables. Every time the word “marginal” is used in economics it is related to a
change in a dependent variable “caused” by a change in an independent variable. The rate of change can be interpreted as the slope of a line. The slope of a line is often defined as “rise over run.” The rise is usually the change in the dependent variable while the run is the change in the independent variable. For example, the cost of producing more of one good, given full employment, requires a sacrifice of some other good. This was demonstrated in a Production Possibilities model. The slope of the PPF is called the “Marginal Rate of Transformation” (MRT). This is shown in Figure VI.1. The PPF function shows all combinations of Yawls (Y) and Xebecs (X) that can be produced given inputs and technology. 232 11.2.1 Marginal Analysis 50 45 30 19 C A D A 200 35 38 Figure VI.1 E A 40 Xebecs (X) At point B, an increase in X (D X=15, the run) requires a sacrifice of 15 units of Y (D Y=-15) This tradeoff is called the Marginal Rate of Transformation (MRT) and is illustrated by the line RR’. When the MRT (or slope) is calculated by subtracting values (D ), the marginal value is the slope of an arc between the points. When the slope is calculated by a derivative, the value of D X approaches 0, so the marginal value is represented by the slope of a tangent. In this example, it the slope of FF’ at point B. If the output were at X = 20, Y = 45 (shown as point B in Figure VI.1), an increase in Xebecs would require a decrease in the output of Y. The increase in X from 20 to 35 is 15 units of X. This is labeled as D X = 15 (35-20=15) and is the “run.” The change in Y (D Y) is -15 (30-45= -15) and is called the “rise.” The line RR’ represents the change in Y (D Y) caused by the change in X (D X). Slope of RR' = rise run = ΔY ΔX The slope of RR’ is, or the change in Y caused by a change in X -15 ( rise ) 15 ( run ) = −1 Calculus lets the
change in X approach 0. When the change in X approaches 0, the change in Y is shown by the line FF’ which is tangent to the PPF at point B. In principles of economics calculus is not normally required so the term marginal is calculated by differences and is represented by the slope of a straight line. When a function is nonlinear, the slope between two points is the slope of an arc. 233 11.2.1 Marginal Analysis It is crucial to remember that the marginal value (cost, benefit, etc) is the value associated with a specific choice. (1) marginal benefit (MB) is the change in total benefits associated with a choice. For an individual MB might be MU for a firm it may be MR (2) marginal cost (MC) is the change in total cost (or variable cost since fixed costs don’t change) caused by a change in and activity, usually production. (3) marginal decision rule You should engage in any activity so long as the MB > MC, the optimal level of activity is where MB = MC, when MC>MB you should not undertake the activity. There is a variation of this rule called the equimarginal rule. The marginal decision rule can be illustrated by the decision to gather wild blackberries (good X). The cost of travel to the blackberry patch is treated here as a sunk (fixed) cost, we are already at the patch. How many berries shall we pick? The answer depends on our analysis of the benefits and costs of each unit of berries we pick. Generally, the marginal benefits of berries will tend to decrease primarily because of diminishing marginal utility. The marginal benefit (MB) of each unit of berries is shown in Figure VI.2. Typically we will gather the berries that are easiest to pick first. These are the berries MB and MC B MC P= MB= MC C 0 E R 73 Figure VI.2 234 MB Berries/ut 11.2.1 Marginal Analysis that are approximately waist level and on the outside of the bushes. As we pick more berries we have to reach further up or down and into the bushes where there are thorns. The marginal cost (MC) of berries rises. The MC of each unit of berries is also shown in Figure VI.2. The MB function decreases as more berries are obtained. The area under the MB function up to the quantity obtained represents the total benefits (TB). In Figure VI.2 when 73 units are picked, TB
is the area 0REB. The MC rises as berries become more difficult to pick. MC represents the marginal cost of each unit. The total costs (TC) is the area under the MC function. When 73 units of berries are picked, the TC will be represented by the area 0REC (the area in blue). The first units of berries are picked because the marginal benefit of each unit (MB) is greater than the marginal cost (MC). There is a net benefit obtained from each unit. Seventy- three units of berries are picked because the MB of the first 73 units is greater than the MC of those units. The TB is 0REB: the TC is 0REC. The net benefit is the area CEB (in yellow). Net benefits are maximized when MB = MC. This rule has several applications. • • Where MR = MC, profits are maximized Where MB = P (cost), utility is maximized This rule was first clearly stated by the French engineer/economist, Jules Dupuit in the 1830’s. 235 11.2.2 Market Exchange and Efficiency 11.2.2 MARKET EXCHANGE AND EFFICIENCY The ideal market has two important characteristics: Individuals voluntarily contract among themselves. There is no coercion and each • is informed of their preferences (objectives) and alternatives. They make informed judgments about the outcomes of their choices. The individuals exchange goods that are characterized by nonattenuated property • rights. Nonattenuated property rights are exclusive, enforceable and transferable. The benefits and cost associated with the production or consumption of any good falls only on the agents engaged in the contract or transaction. Under these conditions, from a utilitarian perspective, no one would rationally engage in a voluntary exchange if it made them worse off. Therefore, any voluntary exchange must lead to Pareto superior results. Individual agents know their preferences (objectives) and react to any changes by altering their choices. The idealized market results in individuals who constantly reappraise their objectives and alternatives and alter choices to maximize their welfare. Since exchanges are perceived to be voluntary, no individual would choose to make themselves worse off. Voluntary markets of goods with nonattenuated property rights are consistent with the Utilitarian Ethic and Pareto Efficiency. 236 11.2.3 Prices as Information MB and MC B MC P= MB= MC E C 0 R 73 Figure VI.2 MB Berries/ut 11.2.3 PRICES AS INFORMATION The function of the market is
to coordinate the preferences and behavior of the buyers and sellers. There are two important elements that are necessary if markets are to perform this task of coordination. First, buyers and sellers must have information. Prices, or more precisely relative prices perform this task. Secondly, buyers and sellers must have an incentive to respond to the information contained in prices. Using Figure VI.2 again, the role of prices can be shown. The MB function represents the buyers’ evaluations of their marginal benefits. As the quantity of berries increases, the marginal value goes down, The MB function is negatively sloped and resembles a demand function. It is not a demand function because it does not include the ability to buy the goods. It only measures the buyers’ evaluation of marginal benefits. Notice the MB of the 73rd unit to the buyers is P. Similarly, the MC function represents the opportunity cost or producing each unit. The MC of producing the 73 rd unit is also P. For all unit of berries, up to and including, the 73rd unit, the MB is greater than the MC. We could restate this: the marginal benefit from each of 237 11.2.3 Prices as Information the first 73 units is greater than its opportunity cost. The value (MB) that buyers have for each of the first 73 units is greater than the market price of P. The sellers sacrifice an opportunity cost of less than P on each of the first 73 units. The price of P represents the marginal value (MB) of the last unit exchanged to the buyers. P also represents the marginal value (MC) of the last unit exchanged to the sellers. A price of P provides information about both the buyers and sellers evaluations. Since MB = MC produces maximum net benefit, the ideal is where the price reflects MB and MC, MB = P = MC. So long as the price is less than the MB of the buyers, additional units will be purchased. Once the P > MB buyers cease to purchase the good. When the P > MC, sellers will produce and offer units for sale. Once the P < MC, the sellers will cease production. 238 12 Pure Competition 12 PURE COMPETITION Purely competitive markets are used as the benchmark to evaluate market performance. It is generally believed that market structure influences the behavior and performance of agents within the market. Structure influences conduct which, in turn affects performance. 12.1 MARKET STRUCTURE Neoclassical microeconomics is an explanation of the behavior of individuals, firms, and organizations within a
market context. Their behavior is thought to be a function of their objectives and the constraints that exist because of technology, quantity/quality of inputs and market structure. Market structures can be characterized by sellers or buyers or both. Most economics texts classify markets by seller. Generally, they identify 4 basic types of markets: (1) pure (or perfect) competition, (2) monopolistic (or imperfect) competition, (3) oligopolistic competition, and (4) monopoly. Pure competition is believed to produce ideal results in the allocation of resources. Monopoly is usually depicted as having less than optimal outcomes. The basic market structures based on sellers is shown in Figure VII.1 239 12.1 Market Structure Figure VII.1 Ideal outcomes Market Structure Deviate from Ideal Pure Competition 1. Many sellers 2. homogeneous products 3. relative ease of entry Imperfect or Monopolistic Competition 1. Many sellers 2. differentiated products 3. relative ease of entry Oligopoly 1. Few sellers (interdependence) 2. identical or differentiated product 3. BTE Monopoly 1. one seller 2. no close substitutes 3 complete BTE Pure competition and Monopoly are at each end of the spectrum of markets. In fact, probably neither occur in market economies. Pure competition and monopoly are the boundaries and the “real world” (wherever that is) lies somewhere between the two extremes. Pure competition provides the benchmark that can be use to evaluate markets. The physician who attends you knows that 98.6o is a benchmark. Your temperature may not be precisely 98.6o, but if it deviates significantly, that deviation suggests problems. It might be in your best interests to know what the “normal” temperature is and the cause of the deviation from “normal.” 240 12.1.1 Characteristics of Pure Competition 12.1.1 CHARACTERISTICS OF PURE COMPETITION The idealized purely competitive market insures that no buyer or seller has any market power or ability to influence the price. The sellers in a purely competitive market are price takers. The market sets the price and each seller reacts to that price by altering the variable input and output in the short run. In the long rung they can alter the scale of plant (size of the fixed input in each short run period). The conditions that ensure no seller has any market pose are: Large number of sellers (and buyers), no one of which can influence the market. • Homogeneous output, buyers
see goods as perfect substitutes. • Relatively “free” entry and exit to and from the market. Sellers cannot charge a price above the market price because sellers see all other goods in the market as perfect substitutes. They can buy those goods at the market price. 12.2 THE FIRM IN PURE COMPETITION A purely competitive market is characterized by a large number of relatively small firms. No single firm can influence the market price and are considered price takers. In Figure VII.2 graphs representing a purely competitive market and one firm are shown. Panel A.VII.2 represents the market. DM and SM represent the market demand and supply functions. If the market is in equilibrium the equilibrium price and quantities are PEM and QEM respectively. Notice that the quantity measured along the Q-axis in Panel A represent large quantities. 241 $, e c i r P PEM $, e c i r P PEM P* 12.2 The Firm in Pure Competition Df ARf=MRf SM EM $, e c i r P PEM DM QEM Qx(1027) Panel A.VII.2 (Market) Figure VII.2 Qx/ut Panel B.VII.2 (Firm) SM SM* EM $, e c i r P PEM P* DM Df ARf=MRf D, AR, MR* QEM Qx(1027) Panel A.VII.3 (Market) Figure VII.3 Panel B.VII.3 (Firm) Qx/ut Panel B.VII.2 represents a single firm in the market. Note that the quantity measured along the Q-axis in Panel B is small relative to that in Panel A. The firm accounts for a very small portion of the goods offered for sale in the market. Since there are a a large number of firms in the market with identical or homogeneous products, buyers have no preference for any one firm’s product. The demand faced by a single firm is perfectly elastic at the market 242 12.2 The Firm in Pure Competition price. This is represented as a horizontal line at the price of P EM in Panel B. Remember that demand and AR coincide. Marginal revenue decreases at twice the rate (has twice the slope of the AR) as a linear AR function. Since the slope the AR for the purely competitive firm is 0, the MR does not decrease and lies along the demand and AR functions. Consider an increase in the market supply shown
in Figure VII.3. The market supply function increases from SM to SM* in Panel A.VII.3. As a result, the equilibrium price (in Panel A) in the market falls from P EM to P. The equilibrium quantity will rise. Since the market price has fallen, the demand, AR and MR functions faced by the firm will fall to D, AR* and MR*. (As shown in Panel B.VII.3.) Note that a decrease in market supply will shift the firm’s demand function up. An increase (decrease) in market demand would shift the firm’s demand up (down). Changes in the conditions in the market alter the price. These changes in price provide information to the firms who then react to those changes. 12.2.1 PROFIT MAXIMIZATION IN THE SHORT RUN If the firm’s objective is to maximize profits (∏), they must maximize the difference between total revenue (TR) and total cost (TC). ∏ = TR –TC. It is possible to identify the output level that will maximize profits for the firm if the MR and MC functions are known. Where MR = MC, profits will be maximized (or losses minimized). Before we consider these problems there are several points to reconsider. • A normal profit is included as a cost of production just as wages, interest, rent and materials costs are expenses. • The objective of the firm is to maximize profits (not revenue) • MC is the change in TC (or VC) caused by a change in output. 243 12.2.1 Profit Maximization in the Short Run MC = ΔTC ΔQ = ΔVC ΔQ • AC is the total cost per unit. It is calculated by dividing TC by Q. AC tends to fall and then rise as output increases. When MC is less than AC, AC is decreasing. When MC is greater than AC, AC will be increasing. When MC equals AC, AC will be a AC = TC Q minimum. • AVC is the variable cost per unit. AVC is the variable cost per unit. It is calculated by dividing VC by Q. AVC tends to fall and then rise as output increases. When MC is less than AVC, AVC is decreasing. When MC is greater than AVC, AVC will be increasing. When MC equals AVC, AVC will be a minimum. AVC = VC Q • The vertical distance between AC and AVC is the AFC. (
AFC = AC-AVC) AFC will tend to decrease as long as output (Q) increases. • Demand faced by a purely competitive firm is perfectly elastic (horizontal, straight line) at the market price. The AR is the same as the demand function. • • MR falls at twice the rate of AR. Since AR has a slope of 0 in a purely competitive market, MR and AR are the same in a purely competitive market. • MR = price in a purely competitive market. • A firm will offer additional units for sale so long as the price they obtain is greater than the opportunity cost (MC) of producing the units. The behavior of the firm in the short run can be shown using total values (TR and TC) or unit values (MR, MC and AC), R T C T TR TC B B W 0 TC TR 12.2.1.1 SHORT RUN PROFITS USING TR AND TC C B’ B A Maximum profits will occur at the output level where there is the greatest vertical distance between TR and TC, when TR>TC. In Q A Figure VII.4 Q B Q c 244 Q/ut 12.2.1 Profit Maximization in the Short Run Figure VII.4 the TR and TC functions for a firm are shown. The TR is a straight line (with a constant slope). TR is price times quantity. Since TR is a linear function this implies that the price for all quantities are the same, the firm is in a purely competitive market (the demand is perfectly elastic at the market price.). MR is defined as the change in TR associated with a change in Q. MR is the slope of TR, so MR is the price. The TC intercept is at W, which is the fixed cost and shows that this is a graph depicting a short run condition. The TC function increases at a decreasing rate that implies that MC is falling and MP of the variable input is rising. Beyond the inflection point in the TC, TC increases at an increasing rate. The model shows “break-even” points (A and C) at output level Q A and QC. At these break-even point the firm is earning a normal profit. (Remember normal profits are included in the cost functions.) Between output levels Q A and QC, the TR>TC. This means that economic profits (∏) exist. Maximum ∏ occur at output level QB., the greatest vertical distance between TR and TC. Note that at point A (producing Q
A) the firm obtains a normal profit. If they produce and additional unit the MC (slope of TC at point A) is less than the slope of the TR (MR), i.e. they can produce additional units for less than someone is willing to pay for them. At output level Q B, the slope of the TC (MC) is equal to the slope of the TR (MR). If they attempt to increase output above QB, the cost of additional units (shown by the slope of the TC) increases faster the increase in TR (shown by the slope to TR). Where the slope of the TC (MC) is the same as the slope of the TR (MR), profits (the vertical distance between TR and TC) are maximized. 245 12.2.1 Profit Maximization in the Short Run 12.2.1.2 SHORT RUN PROFITS USING UNIT COST AND REVENUE The process of determining the output level that maximizes profits in the short run can also be made by an analysis of the unit cost and revenue functions. MC and MR determine whether to produce a given output of not. If the cost of and additional unit (MC) is less than the revenue obtained from that same additional unit (MR), producing the additional units will add to profits (or reduce losses). If the cost of additional units of output (MC) cost more than they add to revenue (MR), the firm should not produce the additional units. The rules for profit maximization are simple: • • • MR >MC, produce it! MR < MC, don’t produce it! When MR = MC, you are earning maximum profits! The process of determining the profit maximizing level of output using unit cost and revenue functions is shown in Figure VII.5. Figure VII.5 represents a single firm in a purely competitive market. It must be pure competition because of the perfectly elastic demand function at the price P. D, MR and AR are all horizontal functions at the price P. As output increases from 0 to QC the AVC decreases. AC decreases up to output QB. Both AVC and AC are U-shaped functions. Remember the AP of the variable input increases while the AVC falls. The MC falls (up to output QA) and then rises intersecting AVC and AC at their minimum points. At outputs QA and QJ the firm has break-even points, normal profits exist at output level QA and QJ. The firm produces where MR
= MC (point H) to maximize profits at output level QH. Since AR > AC at this level, the firm earns above normal profits. $ P CM CB CC A H M B C MC J AC AVC D, AR, MR 0 QA QC QB QH QJ Q/ut Figure VII.5 246 12.2.1 Profit Maximization in the Short Run The firm will produce units so long as the market price (P, which is equal to MR when Demand is perfectly elastic.) is greater than the cost of producing the additional unit (MC). If MC is greater than the price (or MR) the firm will not produce. All possible profits are captured where MR = MC. This is shown as point H at output level QH in Figure VII.5. At output level QH, where MR = MC, profits are a maximum and can be shown as the area CMMHP (the area in yellow). Total revenue (TR) is area 0QHHP. TR is calculated by price multiplied by quantity, in this model, PQ H is the area 0QHHP. Total cost (TC) is area 0QHMCM (the product of the AC and quantity, which is CMQH. Profits are the difference between TR and TC, area CMMHP or (P-CM)QM. 12.2.1.3 LOSS MINIMIZATION AND SHUTDOWN IN THE SHORT RUN In the short run the maximum the firm must loose is its fixed cost. If the firm can recover all its variable cost it may as well operate unless it sees no hope of improvement in the future. In Figure VII.5 the firm is earning above normal profits by producing at QH output. If the price were to fall to CB (which is consistent with the minimum of the AC function) the firm would earn normal profits. (Remember that normal profits are included in the cost functions as an opportunity cost for the entrepreneur.) If the price falls below C B, the firm will lose money, i.e. will earn less than normal profits. So long as the price is above CC, the firm is recovering all the variable cost and a little more to offset the fixed cost that it would have lost if the firm would have shutdown. At a price of CC, the firm is recovering all its variable cost and losing its fixed cost (which it would have done anyway if it had closed down.). Therefore, so long as the firm can recover
all its variable costs at a price of CC, it may as well operate in the short run. Point C, at a price of CC and output of QC is called 247 12.2.1 Profit Maximization in the Short Run the shutdown point. It will always be at the point where the MC intersects the AVC (the minimum of the AVC). In the long run all costs are variable, therefore the shut down point in the long run is the minimum of the LRAC where MC= LRAC. There may be other reasons for operating a production facility. In some cases individuals may operate at less than normal profits because the get non- monetary benefits from being in a particular line of work or being “their own boss.” A government may encourage firms that produce particular products to operate for reasons of national defense or national pride. In these cases public policy may be used to subsidize the firms that would find it necessary to shut down in a free market economy. 12.2.2 PROFITS IN LONG RUN PURE COMPETITION In the long run, producers are able to alter their scale of plant. The LRAC or envelope curve was constructed from a series of short run periods with different plant sizes. In the long run the firm is essentially able to select the scale of plant (or a specific set short run production and cost functions associated with a specific fixed (in the short run) input). The is essentially the meaning of “relative ease of exit and entry from the market. Another crucial aspect of long run pure competition is that the demand faced by the firm is perfectly elastic at the market price. The AR and MR functions coincide with the firm’s demand function. Because the firm’s demand function is perfectly elastic, they cannot raise their price above the market price. If they do, their sales will fall to 0. There is no reason to lower their price below the market price because they can sell all they want to a the market price. The firms in pure competition have no “market power.” Market power, in microeconomics, refers to the ability of an agent to raise the price 248 12.2.2 Profits in Long Run Pure Competition and not have their sales fall to 0. A quick review of price elasticity suggests that market power is influenced by a firm’s demand function. Purely competitive firms are price takers. These firms have no incentive to advertise. The largest producer in a purely competitive market can sell all
are maximizing their profits given circumstances (They have no incentive to change output or plant size, they are in equilibrium.), The price is equal to the MC (This is the condition to optimize the welfare of the individuals in society given the income distribution.) 250 12.2.2 Profits in Long Run Pure Competition The process of long run equilibrium in pure competition can be shown in Figure VII.6. You may remember part of Figure VII.6 as Figure VII.3. Both the market and an individual firm’s demand and cost (supply) functions are shown. In Figure VII.6, it is apparent that a market price below P* would result in the firm’s AC exceeding the AR at all levels. If this were the case firms would earn less than normal profits and would have an incentive to leave the market. As firms leave the market, the market supply decreases (shifts to the left) and the market price would rise. There are two important features in pure competition. First each firm is a price taker and has no market power. The demand function faced by the firm is perfectly elastic at the equilibrium price established in the market. This is because the output of the purely competitive firms is homogeneous and there are a large number of sellers, none of whom can influence the market price. Secondly, entry and exit from the market is relatively free. Above normal profits attract new producer/seller that increases the market supply driving the market price down. If profits are below normal, firms exit the market. This reduces the market supply and drives the price up. Long run equilibrium in a purely competitive market is established when the D (AR and MR) is just tangent to the long run average cost function (LRAC). This will be at the minimum of the LRAC where its slope is 0 (the demand function faced by the firm has a slope of 0). Firm earn normal profits at this point and there is no incentive to enter or leave the market. There is no incentive to alter plant size or change the output level. At the point of long run equilibrium in Figure VII.6 at point C, the following conditions will exist: 251 12.2.2 Profits in Long Run Pure Competition AR = AC: Firms earn a normal profit. There is no incentive for firms to enter or • leave the market. LRMC = LRAC: the firm is operating with the plant size that results in the • lowest cost per unit, i.e. the fewest resources per unit of output
are used. • MR =LRMC: the firm has no incentive to alter output or plant size. P = MR =MC: the price reflects the marginal value of the good to the buyers and • the marginal cost to the producer/seller. Long run equilibrium in pure competition results in an optimal allocation of resources. The price reflects the marginal benefits of the buyers and the marginal cost of production. The user of the last unit of the good places a value (the price they are willing and able to pay) on the good equal to the cost of producing that unit of the good. Units of the good between 0 and the equilibrium quantity have a greater value than the cost of production. The purely competitive model provides a benchmark or criteria to evaluate the performance of a market: MB = P = MC. The marginal benefit (MB) to the buyer is suggested by the price they are willing and able to pay. The MB to the seller is the marginal revenue (MR) they earn. The marginal cost (MC) reflects the opportunity cost to society. 252 13 Firms With “Market Power” 13 FIRMS WITH “MARKET POWER” Pure competition results in an optimal allocation or resources given the objective of an economic system to allocate resources to their highest valued uses or to allocate relative scarce resource to maximize the satisfaction of (unlimited) wants in a cultural context. Pure competition is the ideal that is be benchmark to evaluate the performance markets. The economic theory of monopolistic competitive markets, oligopoly and monopoly is used to suggest the nature of problems that may exist when firms or agents have market power and are able to distort prices away from the purely competitive optimum. The existence of market power is tied to the demand conditions the firm faces. If their product is (or can be differentiated), consumers may have a preference for one firm’s output relative to others. A negatively sloped demand function (less than perfectly elastic) allows the firm to raise its price and not have its sales fall to zero. In pure competition, the firms may all try to influence market demand (eat Colorado Beef, Eat Black Angus Beef, Drink Florida orange juice, etc) but individual producers do not advertise their own product (Eat Rancher Jones’s Beef). Many agricultural markets are close to pure competition. In many cases some producers try to differentiate their products. Organic produce is one example. In pure competition, the firms’ outputs are homogeneous. If the firm has is no opportunity to differentiate their product they have no incentive
to advertise and to try to influence the demand for their product. If a product can be differentiated by altering the characteristics of the good or simply by convincing the consumers that the product is different, the firm achieves market power. Market power is the ability to have some control over the price 253 13 Firms With “Market Power” of the good offered for sale. Advertising can be used to differentiate a product or increase the demand for a product. The crucial factor is the demand for the firm’s output must be negatively sloped: the firm becomes a “price maker.” The extent to which a firm is a price maker (i.e. has market power) is partially determined by the price elasticity of demand in the relevant price range. Note that when the seller selects a price (price maker) the demand function determines the quantity that will be purchased. The conditions of entry or barriers to entry (BTE) are also important determinants of market power. If there are significant BTE, a firm or firms may be able to sustain above normal profits over time because other firms are prevented from entry to capture the above normal profits. Monopoly is the market structure that is usually associated with the greatest market power. The monopolist produces a good with no close substitutes (increased probability the demand is relatively inelastic) and there are barriers to entry. Firms in monopolistic competition or imperfectly competitive markets are more likely to have limited market power because there are many firms with differentiated products (there are substitutes) and there is relative ease of entry and exit into the market. 254 13.1 Monopoly 13.1 MONOPOLY A monopoly is a market characterized by a single seller of a good with no close substitutes and barriers to entry. Monopolies rarely occur in a pure form. There are almost always substitutes or methods of possible entry into a market. When the term “monopoly” is used it is usually referring to a degree of monopoly or market power. In many cases the existence of a monopoly results in regulation or the enforcement of antitrust laws that attempt to introduce competition to reduce market power. The definition of monopoly requires a judgment about the phrase “no close substitutes” and what “barriers to entry” mean. I might be the only producer of mink lined, titanium trash cans. This is not relevant as a monopoly since there are many good substitutes: plastic or steel containers or even brown paper bags will serve as trash containers. There are substitutes
for the electricity (KWH) produced by a public utility. It is possible to purchase a portable generator powered by an internal combustion engine or use candles for use in your home. However, neither of these can be regarded as a close substitute. The concept of cross elasticity of demand can be used to identify whether two goods are substitutes on not. ( Cross price elasticity of demand ) E XY ≡ %Δ Q X %Δ PY [a change in the quantity of good X, caused by a change in the price of good Y ] Barriers to entry are another important characteristic of monopoly. Complete barriers to entry (BTE) make it impossible for competing firms to inter a market. However, in n most cases, BTE are not complete but are relative. Firms’ entry into a market can be restricted by a variety of factors. BTE’s can be due to: 255 13.1 Monopoly • • • The ownership of a key resource or location maybe important. ALCOA’s monopoly in aluminum was at first due to a patent on a low cost process to reduce bauxite into aluminum. After the patent expired, their ownership of bauxite reserves allowed them to maintain their monopoly position. In earlier times there may have been only one location on a river where a dam could be built to power a gristmill. A movie theatre gains monopoly power over its sale of popcorn by prohibiting customers from bringing their own food into the theatre. Information or knowledge not available to others. (Industrial secrets). Knowledge about a process may kept secret (rather than using a patent since patent information is publicly available). Legal barriers such as license, franchise, patent, copyright, etc. ALCOA’s monopoly began when the government gave them a patent on a low cost method of reducing bauxite to aluminum. Other methods of making aluminum are possible but cannot compete with the method pioneered and patented by ALCOA. A State park might license a firm to provide prepared foods within the boundary of the park. This would confer market power on the firm unless their price was regulated. A city that licenses a taxi company gives them market power. They may license several taxi companies so that there is some competition and or they may regulate the services and rates. Public utilities often have a license to operate in a specific area. In return for this monopoly power, they are subject to regulation. In fact, the British colonies that became the United States and Canada were the result or grants from the
British government. Hudson Bay Company and the East India Companies were firms that were granted rights to operate in specific areas. • Natural monopoly caused by economies of scale usually associated with a cost structure with a high fixed cost relative to variable costs. A natural monopoly is the result of significant economies of scale due to a high fixed cost. As the output increases the LRAC falls. If the market demand intersects the LRAC as it falls (or at its minimum), a natural monopoly exists. 256 13.1.1 Profit Maximization In a Monopoly C T, R T ) $ ( TRM RM MT TC TCM CM QM Figure VIII.1 QT TR Q/ut 13.1.1 PROFIT MAXIMIZATION IN A MONOPOLY Since a monopoly is characterized by a single seller, the market demand and the demand faced by the firm are the same. The demand will tend to be negatively Figure VIII.1 represents profit maximization by a firm in a monopoly market. The TR function increases up to an output level of QT then it declines. Remember that any negatively sloped demand function is elastic at high prices (top half of demand where price increases reduce TR) and inelastic at low prices (bottom half of demand where price increases increase TR). The TC increases at a decreasing rate, passes an inflection point and then increases at 257 13.1.1 Profit Maximization In a Monopoly an increasing rate. Maximum profits is occurs at the output level where TR >TR by the greatest vertical distance. This occurs at output Q M. Profits are reflected by the vertical distance, CMRM, or TRM-TCM. At point CM the slope of the TC (MC) is the same as the slope of the TR at point RM (MR). The maximum TR occurs at point MT at output level QT. If the firm increases output from QM to QT profits will decrease because the costs of the additional units (QT-QM) is greater than the additional revenue produced by those units of output. Unit cost and revenue functions can also be used to show the output and price decisions of a monopolist. In Figure VIII.2 the demand, AR, MR, MC and AC cost functions are shown. In Figure VIII.2, revenue and cost functions for a monopolist are shown. The demand and AR are negatively sloped, so the MR falls at twice the rate and intersects the Qaxis half way between the origin and AR (or demand
of the buyers. The negative slope of a firm’s demand function in imperfect competition results in a different result than in pure competition. 259 13.1.2 Imperfect Competition and Monopolistic Competition The conditions of entry and exit to and from a monopolistically competitive market are similar to the purely competitive market: there are no major BTE. Entry and exit are relatively easy. The relative ease of entry/exit makes the long run results of an imperfectly competitive market different from a monopoly. 13.1.3 DEMAND FACED BY MONOPOLISTICALLY (IMPERFECTLY) COMPETITIVE FIRM The market demand is the result of a horizontal summation of the individual buyer’s demand functions. The market demand function can be divided among the sellers. A simplified example is shown in Figure VIII.3. If 80 units are demanded in the market at a price of $5, a sum of 80 units is demanded from the sellers in the market. To simplify, assume 3 firms in the market. The demand for firm A’s product at $5 is 17 units. The demand for firm B’s output is 30 units. Therefore, 33 units of output from firm C must be demanded. If a fourth firm entered the market, there is no reason to believe that the buyers would desire more at a price of $5. The demand for one or all firms’ products would necessarily shift to the left (decrease in demand) by the same number of units that the entrant (firm C) would sell at that price. $ D a D b Figure VIII.3 The entry of firms will mean each existing firm will have a smaller share of the market and are faced by $5 more substitutes. Entry implies that the demand each firm faces for its E D M 17 30 33 260 80 Q/ut 13.1.3 Demand Faced by Monopolistically (Imperfectly) Competitive Firm product will decrease (shift to the left) and become relatively more elastic at each price. Each firm would like to capture a larger share of the market and make the demand for its product more inelastic. Advertising is an attempt to alter buyers’ perceptions and increase the demand. Economists identify two types of advertising: informative and persuasive. Informative advertising provides buyers with information about availability, features and relative prices. It helps the market to perform allocation processes. A grocery who advertises milk at $1.39 per gallon in its store (plant
) at the corner of High Street and Broadway, has helped the market to perform. Persuasive advertising is an attempt to alter preference functions. Driving a new SUV makes one a member of the right social group. Smoking a (given brand) makes one sexier or more macho, independent or whatever. It is not clear that persuasive advertising improves the ability of the market to allocate resources. It must also be noted that advertising increases the costs of the firm and alters the output decisions and profits. 13.1.4 PROFIT MAXIMIZATION IN IMPERFECT OR MONOPOLISTIC COMPETITION If the firm in an imperfectly competitive market has profit maximization as an objective, they will produce the output where marginal cost is equal to the marginal revenue. Short run profit maximization is shown in Figure VIII.4. 261 13.1.4 Profit Maximization in Imperfect or Monopolistic Competition Short run profit maximization for a firm in imperfect competition occurs at the output QJ. This output level is found at point J where MR=MC. At this level of output, the vertical intersects AC at R. The firm is producing QJ units at a cost of C* per unit. Total cost (TC) would be CQJ or area 0QJRC (the area in yellow). The firm can sell QJ units at a price of P. Total Revenue (TR) is PQJ or area 0QJHP. Profits (? =TR-TC) are shown by area CRHP* or (P-C)QJ. Short run equilibrium in monopolistic competition resembles the equilibrium conditions in a monopoly. However, entry in monopolistic competition will drive profits to normal in the long run. $ P* C* H R J MC AC D, AR MR 0 QJ QM Q/ut Figure VIII.4 In the long run, above normal profits will attract the entry of firms into monopolistic competition. Below normal profits will encourage firms to exit. As firms enter the market demand is split among a larger number of firms which will shift the demand for each firm to the left (decrease) and probably make it more inelastic. There are more substitutes. Exit of firms will shift the demand for each firm’s output to the right (increase). Entry to and exit from the industry occur until the profits for each firm are normal, i.e. the AR = AC. The results of
long run equilibrium in a monopolistically competitive market are shown in Figure VIII.5. The logical result of profit maximizing monopolistically competitive markets is to encourage firms to build plants that are smaller than optimal, i.e. a larger plant can produce with fewer inputs per unit of output (or costs per unit of output). Further inefficiency is expected since the inefficient plant is operated at an output level that is less than the minimum point on the SRAC. This result is due to the fact that the MR must be lower than AR when AR is negatively sloped. Therefore MR=MC at less than the price which lies on the demand (or AR) function. Since the demand is negatively sloped and AC is usually U- 262 13.1.4 Profit Maximization in Imperfect or Monopolistic Competition shaped, the point of tangency between AR and LRAC (normal profits) will lie to the left of the minimum cost per unit of output. This is sometimes called the “excess capacity theorem:” firms build plants that are too small and operate them at less than full capacity. Above normal profits attract firms to enter the market. The demand for each firm’s output is reduced and becomes more elastic (shifts to the left and is flatter at each price). If AR is less than LRAC firms leave and demand faced by each firm increases. Equilibrium is attained when AR = AC and firms cannot make adjustments to increase profits above normal. Where MR+MC, at point J, the firm produces QJ output that is sold at a price of P. At QJ output, the cost per unit of output is also P. Firms are earning a normal profit. Note that P* is necessarily above MC and the firm has a plant size that is less than optimal and operates at less than the minimum cost per unit. $ P* MC* LRMC LRAC SRAC* H J QJ D, AR Q/ut MR Figure VIII.5 13.2 OLIGOPOLY An oligopoly is a market that is characterized by the interdependence of firms. The outcomes that follow from the decisions of one firm are dependent on what the other firms do. Augustin Cournot (1801-1877), a French mathematician/economist developed the theory of monopoly and then considered the effects of two interdependent competitors (sellers) in a duopoly. Cournot’s analysis of two sellers of spring water clearly established that the price and output of one seller was
a reaction to the price and output of the other seller. If the two collude they can act as a single monopolist and 263 divide monopoly profits. If they compete, Cournot concluded that the output 13.2 Oligopoly would be [ N1 ( N+ 1 )] times the competitive output. As the number of competitors (N) increases, the result approaches the purely competitive result. Cournot’s recognition of the interdependence of sellers provided the foundation for a variety of approaches to explain the interdependent behavior of oligopolists. In the 1930’s the “kinked demand” model [published by Paul Sweezy in August 1939 and by R.L. Hall and C.J. Hitch in May 1939] and the “administered price hypothesis” [Gardner C. Means in 1935] were developed as an attempt to explain price rigidities in some markets during the great depression. In 1943 John von Neumann and Oskar Morgenstern published a path breaking work on game theory. Game theory has been used to try to explain the behavior of independent competitors. There have been a variety of other models that attempted to explain the interdependent behavior in oligopolies. The number of models is evidence that it is a difficult task and there are problems with most approaches. The kinked demand model is used here to emphasize the interdependence of oligopolistic behavior rather than to explain the determination of price. 13.2.1 KINKED DEMAND MODEL The kinked demand model begins with an oligopoly that has two sellers of a homogeneous good. The typical characteristics that constitute an oligopoly are: 264 13.2.1 Kinked Demand Model A “few” firms: the concept of “few” means that there are few enough sellers that • they recognize their interdependence. • The output may be homogeneous or differentiated. Primary metals industries are examples of oligopolies with homogeneous goods. Instant breakfast drink mixes are an example of an oligopoly with differentiated products. • In an oligopoly there are usually significant barriers to entry. Figure VIII.6 is a graphical representation of the demand and revenue functions of a firm in a oligopoly that is modeled as a kinked demand. A single firm in a two firm duopoly is represented. The current price is P and output is Q. Point H must lie on “the” demand function. The nature of the perceived demand
depends on what the firm believes its competitor will do. There are two possibilities with respect to price. Either the competitor will follow every price change or they will ignore every price change. DD assumes the competition will follow every price change; DD assumes that price changes are ignored. MR* is associated with DD and MR is associated with DD. If there is “excess capacity” the firm may realistically expect that their price cuts will be followed and price increases will be ignored. The demand for price increases is DH and for price cuts is HD. The total demand is DHD. The sections of the MR associated with the demand DHD is DJ, then a gap from JF and then the remainder of MR. D $ P 0 MC1 MC2 H J D* F MR MR* D Q Figure VIII.6 Q/ut The kinked demand model is dependent on the firm believing that the competitor will follow price cuts but not price increases. If there is additional capacity available (firms can increase output without increasing plant size), a price cut will followed. The reasoning is that if the competitor does not follow the price cut, firm will entice customers away from the competitor. Therefore, the competition must follow price cuts or lose customers and sales. The demand function relative to price cuts in inelastic: cut price and TR falls. The perception is that the competition will not follow a firm’s price increases. If they do not follow they will get the firm’s customers and sales. The demand above the prevailing price is relatively elastic: raise price and TR falls. At the 265 13.2.1 Kinked Demand Model prevailing price, there is a kink in the demand function and an associated gap or discontinuity in the MR (shown as the gap from J to F in Figure VIII.6). The marginal cost function can rise to MC1 or fall to MC2 with no change in output or price. The kinked demand model of the Great Depression was used as evidence that concentrated markets were rigid and failed to respond to changing conditions. Pro market advocates obviously attached the model and its conclusions. All models of market structure must be considered as examples. When analyzing a market, it is not a mater of selecting and applying one of the market models presented in principles of microeconomics. You must consider all the relevant characteristics of the firms and the market and then construct a workable model to explain the question you have asked. 13

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