Teori Ekonomi Mikro - Ieupnyk - Com (Pdfdrive)
Teori Ekonomi Mikro - Ieupnyk - Com (Pdfdrive)
DOSEN:
DR. ARDITO BHINADI, SE., M.SI
II.Kompetensi Umum :
Pada akhir perkuliahan mahasiswa diharapkan mampu memahami dan menjelaskan model-model
ekonomi, pilihan dan permintaan, produksi dan penawaran, pasar kompetitif, kekuatan pasar,
penetapan harga di pasar input, dan kegagalan pasar.
1
Mahasiswa Fungsi-Fungsi Mahasiswa Papan tulis, Pertanyaan Ch 9
5 mampu Produksi Presentasi, LCD, Laptop, kuis/umpan
(Lima) memahami Ceramah dan balik
fungsi-fungsi diskusi
produksi
Mahasiswa Fungsi-Fungsi Mahasiswa Papan tulis, Pertanyaan Ch 10
6 mampu Biaya. Presentasi, LCD, Laptop, kuis/umpan
(Enam) memahami Ceramah dan balik
fungsi-fungsi diskusi
biaya.
Mahasiwa Maksimisasi Laba Mahasiswa Papan tulis, Pertanyaan Ch 11
7 mampu Presentasi, LCD, Laptop umpan balik
(Tujuh) menghitung Ceramah dan
maksimisasi Diskusi
laba.
Ujian Tengah Semester
Pertemuan Kompetensi Pokok/Sub-pokok Metoda Media Metoda Referensi
Ke Bahasan Pembelajaran Pembelajaran Evaluasi
Mahasiwa Model Persaingan Diskusi dan Papan tulis, Pertanyaan Ch 12
8 mampu Keseimbangan Kuis LCD, Laptop umpan balik
(Delapan) memahami Parsial
model
persaingan
keseimbangan
parsial.
Mahasiwa Keseimbangan Diskusi dan Papan tulis, Pertanyaan Ch 13
9 mampu Umum dan Kuis LCD, Laptop umpan balik
(Sembilan) memahami Kesejahteraan
keseimbangan
umum dan
kesejahteraan.
Mahasiwa Monopoli Diskusi dan Papan tulis, Pertanyaan Ch 14
10 mampu Kuis LCD, Laptop umpan balik
(Sepuluh) memahami
monopoli.
Mahasiwa Persaingan Tidak Diskusi dan Papan tulis, Pertanyaan Ch 15
11 mampu Sempurna Kuis LCD, Laptop umpan balik
(Sebelas) memahami
persaingan tidak
sempurna.
Mahasiwa Pasar Tenaga Kerja Diskusi dan Papan tulis, Pertanyaan Ch 16
12 mampu Kuis LCD, Laptop umpan balik
(Dua Belas) memahami pasar
tenaga kerja
Mahasiwa Asimetris Informasi Diskusi dan Papan tulis, Pertanyaan Ch 18
13 mampu Kuis LCD, Laptop umpan balik
(Tiga Belas) memahami
informasi
asimetris.
2
Mahasiwa Eksternalitas dan Diskusi dan Papan tulis, Pertanyaan Ch 19
14 mampu Barang Publik Kuis LCD, Laptop umpan balik
(Empat memahami
Belas) eksternalitas dan
barang publik.
1. Sumber Referensi
Nicholson, Walter and Christopher Snyder, 2008. Microeconomic Theory, Basic Principles and
Extensions, Tenth Edition, Thomson South-Western, United Stated of America.
2. Komponen Penilaian
3
Microeconomic Theory Chapter 1
Basic Principles and Extensions, 9e
By ECONOMIC MODELS
WALTER NICHOLSON
Slides prepared by
Linda Ghent
Eastern Illinois University
3 4
1
Verification of Economic Models Features of Economic Models
• We can use the profit-maximization model • Ceteris Paribus assumption
to examine these approaches
– is the basic assumption valid? do firms really • Optimization assumption
seek to maximize profits?
• Distinction between positive and
– can the model predict the behavior of real-world
normative analysis
firms?
5 6
2
Optimization Assumptions Positive-Normative Distinction
• Optimization assumptions generate • Positive economic theories seek to
precise, solvable models explain the economic phenomena that
is observed
• Optimization models appear to be • Normative economic theories focus on
perform fairly well in explaining reality what “should” be done
9 10
3
The Economic Theory of Value The Economic Theory of Value
• Labor Theory of Exchange Value • The Marginalist Revolution
– the exchange values of goods are determined by – the exchange value of an item is not determined
what it costs to produce them by the total usefulness of the item, but rather
• these costs of production were primarily affected by the usefulness of the last unit consumed
labor costs • because water is plentiful, consuming an additional
• therefore, the exchange values of goods were unit has a relatively low value to individuals
determined by the quantities of labor used to produce
them
– producing diamonds requires more labor than
producing water
13 14
• diamonds have a high marginal value and a high Quantity per period
Q*
marginal cost of production High price
15 16
4
Supply-Demand Equilibrium Supply-Demand Equilibrium
qD = 1000 - 100p • A more general model is
qS = -125 + 125p qD = a + bp
Equilibrium qD = qS qS = c + dp
Q* = 750 D
5
The Economic Theory of Value The Economic Theory of Value
• General Equilibrium Models • The production possibilities frontier can
– the Marshallian model is a partial be used as a basic building block for
equilibrium model general equilibrium models
• focuses only on one market at a time • A production possibilities frontier shows
– to answer more general questions, we the combinations of two outputs that
need a model of the entire economy can be produced with an economy’s
• need to include the interrelationships between resources
markets and economic agents
21 22
6
A Production Possibility Frontier A Production Possibility Frontier
• Suppose that the production possibility dy 1 4 x 2x
(225 2x 2 )1/ 2 ( 4 x )
frontier can be represented by dx 2 2y y
2x 2 y 2 225 • when x=5, y=13.2, the slope= -2(5)/13.2= -0.76
• To find the slope, we can solve for Y • when x=10, y=5, the slope= -2(10)/5= -4
y 225 2x 2
• the slope rises as y rises
• If we differentiate
dy 1 4 x 2x
(225 2x 2 )1/ 2 ( 4 x )
dx 2 2y y 25 26
7
Important Points to Note: Important Points to Note:
• Economics is the study of how scarce • The most commonly used economic
resources are allocated among model is the supply-demand model
alternative uses – shows how prices serve to balance
– economists use simple models to production costs and the willingness of
understand the process buyers to pay for these costs
29 30
31 32
8
Axioms of Rational Choice
• Completeness
Chapter 3 – if A and B are any two situations, an
individual can always specify exactly one of
PREFERENCES AND UTILITY these possibilities:
• A is preferred to B
• B is preferred to A
• A and B are equally attractive
3 4
1
Utility Utility
• Given these assumptions, it is possible to • Utility rankings are ordinal in nature
show that people are able to rank in order – they record the relative desirability of
all possible situations from least desirable commodity bundles
to most • Because utility measures are not unique,
• Economists call this ranking utility it makes no sense to consider how much
– if A is preferred to B, then the utility assigned more utility is gained from A than from B
to A exceeds the utility assigned to B • It is also impossible to compare utilities
U(A) > U(B) between people
5 6
Utility Utility
• Utility is affected by the consumption of • Assume that an individual must choose
physical commodities, psychological among consumption goods x1, x2,…, xn
attitudes, peer group pressures, personal
• The individual’s rankings can be shown
experiences, and the general cultural
by a utility function of the form:
environment
utility = U(x1, x2,…, xn; other things)
• Economists generally devote attention to
quantifiable options while holding – this function is unique up to an order-
constant the other things that affect utility preserving transformation
– ceteris paribus assumption
7 8
2
Economic Goods Indifference Curves
• In the utility function, the x’s are assumed • An indifference curve shows a set of
to be “goods” consumption bundles among which the
– more is preferred to less individual is indifferent
Quantity of y Quantity of y
Preferred to x*, y* Combinations (x1, y1) and (x2, y2)
provide the same level of utility
?
y* y1
? y2 U1
Worse
than
x*, y* Quantity of x Quantity of x
x* 9 x1 x2 10
Quantity of x Quantity of x
x1 x2 11 x1 x2 12
3
Indifference Curve Map Transitivity
• Each point must have an indifference • Can any two of an individual’s indifference
curve through it curves intersect?
The individual is indifferent between A and C.
Quantity of y Quantity of y The individual is indifferent between B and C.
Transitivity suggests that the individual
should be indifferent between A and B
Increasing utility
But B is preferred to A
C
because B contains more
B
U3 U1 < U2 < U3 U2 x and y than A
U2
A U1
U1
Quantity of x Quantity of x
13 14
Convexity Convexity
• A set of points is convex if any two points • If the indifference curve is convex, then
can be joined by a straight line that is the combination (x1 + x2)/2, (y1 + y2)/2 will
contained completely within the set be preferred to either (x1,y1) or (x2,y2)
Quantity of y Quantity of y
The assumption of a diminishing MRS is This implies that “well-balanced” bundles are preferred
equivalent to the assumption that all to bundles that are heavily weighted toward one
combinations of x and y which are commodity
preferred to x* and y* form a convex set
y1
(y1 + y2)/2
y*
U1 y2 U1
Quantity of x Quantity of x
x* 15 x1 (x1 + x2)/2 x2 16
4
Utility and the MRS Utility and the MRS
• Suppose an individual’s preferences for MRS = -dy/dx = 100/x2
hamburgers (y) and soft drinks (x) can
be represented by • Note that as x rises, MRS falls
utility 10 x y – when x = 5, MRS = 4
– when x = 20, MRS = 0.25
• Solving for y, we get
y = 100/x
5
Diminishing Marginal Utility Convexity of Indifference
and the MRS Curves
• Intuitively, it seems that the assumption • Suppose that the utility function is
of decreasing marginal utility is related to
the concept of a diminishing MRS utility x y
– diminishing MRS requires that the utility • We can simplify the algebra by taking the
function be quasi-concave
• this is independent of how utility is measured
logarithm of this function
– diminishing marginal utility depends on how U*(x,y) = ln[U(x,y)] = 0.5 ln x + 0.5 ln y
utility is measured
• Thus, these two concepts are different
21 22
6
Convexity of Indifference Convexity of Indifference
Curves Curves
• Suppose that the utility function is • Thus,
utility x 2 y 2
U *
• For this example, it is easier to use the
MRS x
2x x
transformation U * 2y y
U*(x,y) = [U(x,y)]2 = x2 + y2 y
25 26
U3
U2
U1
Quantity of x
27 28
7
Examples of Utility Functions Examples of Utility Functions
• Perfect Complements • CES Utility (Constant elasticity of
substitution)
utility = U(x,y) = min (x, y)
utility = U(x,y) = x/ + y/
Quantity of y
The indifference curves will be when 0 and
L-shaped. Only by choosing more
of the two goods together can utility utility = U(x,y) = ln x + ln y
be increased.
when = 0
U3 – Perfect substitutes = 1
U2 – Cobb-Douglas = 0
– Perfect complements = -
U1
Quantity of x
29 30
8
Homothetic Preferences Nonhomothetic Preferences
• For the general Cobb-Douglas function, • Some utility functions do not exhibit
the MRS can be found as homothetic preferences
utility = U(x,y) = x + ln y
U
x 1y y
MRS x U
U x y 1 x
MRS x y
1
y U 1
y y
33 34
U U U • Rearranging, we get
dU dx1 dx2 ... dxn U
x1 x2 xn
dx j x i
MRS( x i for x j )
dx i U
35 x j 36
9
Multigood Indifference Multigood Indifference
Surfaces Surfaces
• We will define an indifference surface • If the utility function is quasi-concave,
as being the set of points in n the set of points for which U k will be
dimensions that satisfy the equation convex
U(x1,x2,…xn) = k – all of the points on a line joining any two
points on the U = k indifference surface will
where k is any preassigned constant also have U k
37 38
10
Important Points to Note: Important Points to Note:
• A few simple functional forms can capture • It is a simple matter to generalize from
important differences in individuals’ two-good examples to many goods
preferences for two (or more) goods – studying peoples’ choices among many
– Cobb-Douglas function goods can yield many insights
– linear function (perfect substitutes) – the mathematics of many goods is not
– fixed proportions function (perfect especially intuitive, so we will rely on two-
complements) good cases to build intuition
– CES function
• includes the other three as special cases
41 42
11
Demand Functions
• The optimal levels of x1,x2,…,xn can be
expressed as functions of all prices and
Chapter 5 income
INCOME AND SUBSTITUTION • These can be expressed as n demand
EFFECTS functions of the form:
x1* = d1(p1,p2,…,pn,I)
x2* = d2(p1,p2,…,pn,I)
•
•
•
xn* = dn(p1,p2,…,pn,I)
Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2
1
Homogeneity Homogeneity
• With a Cobb-Douglas utility function • With a CES utility function
utility = U(x,y) = x0.3y0.7 utility = U(x,y) = x0.5 + y0.5
the demand functions are the demand functions are
0 .3 I 0.7 I 1 I 1 I
x* y* x* y*
px py 1 px / py px 1 py / px py
• Note that a doubling of both prices and • Note that a doubling of both prices and
income would leave x* and y* income would leave x* and y*
unaffected unaffected
5 6
A U3
U2
U1
Quantity of x
7 8
2
Increase in Income Normal and Inferior Goods
• If x decreases as income rises, x is an
inferior good • A good xi for which xi/I 0 over some
As income rises, the individual chooses range of income is a normal good in that
to consume less x and more y range
Quantity of y
3
Changes in a Good’s Price Changes in a Good’s Price
Suppose the consumer is maximizing Quantity of y To isolate the substitution effect, we hold
Quantity of y
utility at point A. “real” income constant but allow the
relative price of good x to change
If the price of good x falls, the consumer
will maximize utility at point B. The substitution effect is the movement
from point A to point C
B
A C The individual substitutes
A good x for good y
U2 because it is now
U1
U1
relatively cheaper
Quantity of x
Quantity of x Substitution effect
Total increase in x
13 14
4
Price Changes for Price Changes for
Normal Goods Inferior Goods
• If a good is normal, substitution and • If a good is inferior, substitution and
income effects reinforce one another income effects move in opposite directions
– when price falls, both effects lead to a rise in • The combined effect is indeterminate
quantity demanded – when price rises, the substitution effect leads
to a drop in quantity demanded, but the
– when price rises, both effects lead to a drop
in quantity demanded income effect is opposite
– when price falls, the substitution effect leads
to a rise in quantity demanded, but the
17
income effect is opposite 18
5
A Summary A Summary
• Utility maximization implies that (for normal • Utility maximization implies that (for inferior
goods) a rise in price leads to a decline in goods) no definite prediction can be made
quantity demanded for changes in price
– the substitution effect causes less to be – the substitution effect and income effect move
purchased as the individual moves along an in opposite directions
indifference curve
– if the income effect outweighs the substitution
– the income effect causes less to be purchased effect, we have a case of Giffen’s paradox
because the resulting drop in purchasing
power moves the individual to a lower
indifference curve 21 22
6
The Individual’s Demand Curve Shifts in the Demand Curve
• An individual demand curve shows the • Three factors are held constant when a
relationship between the price of a good demand curve is derived
and the quantity of that good purchased by – income
an individual assuming that all other – prices of other goods (py)
determinants of demand are held constant – the individual’s preferences
• If any of these factors change, the
demand curve will shift to a new position
25 26
7
Demand Functions and Curves Compensated Demand Curves
• The actual level of utility varies along
• Any change in income will shift these the demand curve
demand curves
• As the price of x falls, the individual
moves to higher indifference curves
– it is assumed that nominal income is held
constant as the demand curve is derived
– this means that “real” income rises as the
price of x falls
29 30
8
Compensated Demand Curves Compensated &
Holding utility constant, as price falls... Uncompensated Demand
Quantity of y
px px
slope
px ' At px’’, the curves intersect because
py …quantity demanded the individual’s income is just sufficient
rises. to attain utility level U2
px ' ' px’
slope
py
px’’ px’’
px ' ' '
slope px’’’ x
py
xc
xc
U2
x’’ Quantity of x
x’ x’’ x’’’ x’ x’’ x’’’
Quantity of x Quantity of x
33 34
x px’’’ x
xc xc
35 36
9
Compensated & Compensated Demand
Uncompensated Demand Functions
• For a normal good, the compensated • Suppose that utility is given by
demand curve is less responsive to price utility = U(x,y) = x0.5y0.5
changes than is the uncompensated
• The Marshallian demand functions are
demand curve
x = I/2px y = I/2py
– the uncompensated demand curve reflects
both income and substitution effects • The indirect utility function is
– the compensated demand curve reflects only I
utility V ( I, px , py )
substitution effects 2p py0.5
0.5
x
37 38
10
A Mathematical Examination A Mathematical Examination
of a Change in Price of a Change in Price
• Our goal is to examine how purchases of • Instead, we will use an indirect approach
good x change when px changes • Remember the expenditure function
x/px minimum expenditure = E(px,py,U)
• Differentiation of the first-order conditions • Then, by definition
from utility maximization can be performed xc (px,py,U) = x [px,py,E(px,py,U)]
to solve for this derivative
– quantity demanded is equal for both demand
• However, this approach is cumbersome functions when income is exactly what is
and provides little economic insight 41 needed to attain the required utility level 42
11
A Mathematical Examination The Slutsky Equation
of a Change in Price
• The substitution effect can be written as
x x c x E
px px E px x c x
substituti on effect
px px
• The second term measures the way in U constant
which changes in px affect the demand • The income effect can be written as
for x through changes in purchasing
x E x E
power income effect
E px I px
– the mathematical representation of the
income effect
45 46
12
The Slutsky Equation The Slutsky Equation
x x x x x x
x x
px px U constant
I px px I
U constant
• The first term is the substitution effect • The second term is the income effect
– always negative as long as MRS is – if x is a normal good, then x/I > 0
diminishing • the entire income effect is negative
– the slope of the compensated demand curve – if x is an inferior good, then x/I < 0
must be negative • the entire income effect is positive
49 50
13
A Slutsky Decomposition A Slutsky Decomposition
• This total effect is the sum of the two • We can substitute in for the indirect utility
effects that Slutsky identified function (V)
• The substitution effect is found by 0.5(0.5 Ipx0.5 py0.5 )py0.5 0.25I
differentiating the compensated demand substituti on effect 1.5
p x px2
function
x c 0.5Vpy
0. 5
substituti on effect
px p1x.5
53 54
55 56
14
Marshallian Demand Price Elasticity of Demand
Elasticities
• Income elasticity of demand (ex,I) • The own price elasticity of demand is
always negative
x / x x I – the only exception is Giffen’s paradox
e x ,I
I / I I x
• The size of the elasticity is important
• Cross-price elasticity of demand (ex,py) – if ex,px < -1, demand is elastic
x / x x py – if ex,px > -1, demand is inelastic
ex ,py – if ex,px = -1, demand is unit elastic
py / py py x
57 58
15
Compensated Price Elasticities Compensated Price Elasticities
• It is also useful to define elasticities • If the compensated demand function is
based on the compensated demand xc = xc(px,py,U)
function
we can calculate
– compensated own price elasticity of
demand (exc,px)
– compensated cross-price elasticity of
demand (exc,py)
61 62
16
Compensated Price Elasticities Homogeneity
• The Slutsky equation shows that the • Demand functions are homogeneous of
compensated and uncompensated price degree zero in all prices and income
elasticities will be similar if • Euler’s theorem for homogenous
– the share of income devoted to x is small functions shows that
– the income elasticity of x is small
x x x
0 px py I
px py I
65 66
67 68
17
Engel Aggregation Cournot Aggregation
• We can see this by differentiating the • The size of the cross-price effect of a
budget constraint with respect to change in the price of x on the quantity
income (treating prices as constant) of y consumed is restricted because of
x y the budget constraint
1 px py
I I • We can demonstrate this by
differentiating the budget constraint with
x xI y yI
1 px py s x e x , I s y ey , I respect to px
I xI I yI
69 70
s x ex,px sy ey ,px s x
71 72
18
Demand Elasticities Demand Elasticities
• Calculating the elasticities, we get • We can also show
x px I p – homogeneity
ex ,px 2 x 1
px x p x I ex,px ex,py ex,I 1 0 1 0
px
– Engel aggregation
x py p
e x , py 0 y 0 s x e x , I s y ey , I 1 1 1
py x x
– Cournot aggregation
x I I
e x ,I 1 s x ex,px sy ey ,px ( 1) 0 s x
I x px I
px
73 74
75 76
19
Demand Elasticities Demand Elasticities
• We will use the “share elasticity” to • Thus, the share elasticity is given by
derive the own price elasticity
s x px py1 px px py1
s x px esx ,px
es x ,px 1 ex,px px s x (1 px py1 )2 (1 px py1 )1 1 px py1
px s x
• In this case, • Therefore, if we let px = py
px x 1 1
sx ex,px es x ,px 1 1 1.5
I 1 px py1 1 1
77 78
20
Consumer Surplus Consumer Welfare
• One way to evaluate the welfare cost of a
• An important problem in welfare price increase (from px0 to px1) would be
economics is to devise a monetary to compare the expenditures required to
measure of the gains and losses that achieve U0 under these two situations
individuals experience when prices
change expenditure at px0 = E0 = E(px0,py,U0)
81 82
U2
Quantity of x
83 84
21
Consumer Welfare Consumer Welfare
Quantity of y The consumer could be compensated so
that he can afford to remain on U1 • The derivative of the expenditure function
with respect to px is the compensated
C CV is the amount that the demand function
individual would need to be
A
compensated E ( px , py ,U0 )
B x c ( px , py ,U0 )
U1
px
U2
Quantity of x
85 86
px0 px0
xc(px…U0)
22
The Consumer Surplus
Consumer Welfare Concept
• Because a price change generally
involves both income and substitution • Another way to look at this issue is to
effects, it is unclear which compensated ask how much the person would be
demand curve should be used willing to pay for the right to consume all
of this good that he wanted at the
• Do we use the compensated demand
market price of px0
curve for the original target utility (U0) or
the new level of utility after the price
change (U1)?
89 90
xc(...U1)
x1 x0
Quantity of x
91 92
23
Consumer Welfare Consumer Welfare
px px
Is the consumer’s loss in welfare We can use the Marshallian demand
best described by area px1BApx0 curve as a compromise
[using xc(...U0)] or by area px1CDpx0
[using xc(...U1)]? The area px1CApx0
px1
C B px1
C B falls between the
px0
A Is U0 or U1 the px0
A sizes of the welfare
D appropriate utility D
x(px…)
losses defined by
target? xc(...U0) and
xc(...U0) xc(...U0)
xc(...U1)
xc(...U1) xc(...U1)
x1 x0 x1 x0
Quantity of x Quantity of x
93 94
24
Welfare Loss from a Price Welfare Loss from Price
Increase Increase
• If we assume that V = 2 and py = 2, • Suppose that we use the Marshallian
demand function instead
CV = 222(4)0.5 – 222(1)0.5 = 8
• If we assume that the utility level (V) x( px , py , I ) 0.5Ipx-1
falls to 1 after the price increase (and
used this level to calculate welfare loss), • The welfare loss from a price increase
from px = 1 to px = 4 is given by
CV = 122(4)0.5 – 122(1)0.5 = 4
4
px 4
Loss 0.5 Ipx-1dpx 0.5 I ln px
px 1
97 1 98
25
Revealed Preference and Revealed Preference and
the Substitution Effect the Substitution Effect
Quantity of y Suppose that, when the budget constraint is
• Consider two bundles of goods: A and B given by I1, A is chosen
• If the individual can afford to purchase A must still be preferred to B when income
is I3 (because both A and B are available)
either bundle but chooses A, we say that
A
A had been revealed preferred to B If B is chosen, the budget
B constraint must be similar to
• Under any other price-income that given by I2 where A is not
arrangement, B can never be revealed available
I2
preferred to A I3
I1
26
Negativity of the Negativity of the
Substitution Effect Substitution Effect
• Rearranging, we get • Suppose that only the price of x changes
pxC(xC - xD) + pyC(yC -yD) ≤ 0 (pyC = pyD)
pxD(xD - xC) + pyD(yD -yC) ≤ 0 (pxC – pxD)(xC - xD) ≤ 0
• This implies that price and quantity move
• Adding these together, we get in opposite direction when utility is held
(pxC – pxD)(xC - xD) + (pyC – pyD)(yC - yD) ≤ 0 constant
– the substitution effect is negative
105 106
27
Strong Axiom of Revealed Important Points to Note:
Preference
• If commodity bundle 0 is revealed • Proportional changes in all prices and
preferred to bundle 1, and if bundle 1 is income do not shift the individual’s
revealed preferred to bundle 2, and if budget constraint and therefore do not
bundle 2 is revealed preferred to bundle alter the quantities of goods chosen
3,…,and if bundle K-1 is revealed – demand functions are homogeneous of
degree zero in all prices and income
preferred to bundle K, then bundle K
cannot be revealed preferred to bundle 0
109 110
111 112
28
Important Points to Note: Important Points to Note:
• A rise in the price of a good also • The Marshallian demand curve
causes income and substitution effects summarizes the total quantity of a good
– for normal goods, less will be demanded demanded at each possible price
– for inferior goods, the net result is – changes in price prompt movements
ambiguous along the curve
– changes in income, prices of other goods,
or preferences may cause the demand
curve to shift
113 114
115 116
29
Important Points to Note: Important Points to Note:
• There are many relationships among • Welfare effects of price changes can
demand elasticities be measured by changing areas below
– own-price elasticities determine how a either compensated or ordinary
price change affects total spending on a demand curves
good – such changes affect the size of the
– substitution and income effects can be consumer surplus that individuals receive
summarized by the Slutsky equation by being able to make market transactions
– various aggregation results hold among
elasticities
117 118
119
30
The Two-Good Case
• The types of relationships that can
Chapter 6 occur when there are only two goods
DEMAND RELATIONSHIPS are limited
AMONG GOODS • But this case can be illustrated with two-
dimensional graphs
y1
In this case, we call x and y gross y1 In this case, we call x and y gross
complements substitutes
y0
y0 U1
U1
U0 x/py < 0 x/py > 0
U0
x0 x1 x1 x0
Quantity of x Quantity of x
3 4
1
A Mathematical Treatment Substitutes and Complements
• The change in x caused by changes in py • For the case of many goods, we can
can be shown by a Slutsky-type equation generalize the Slutsky analysis
x x x xi xi xi
y xj
py py U constant
I p j p j U constant
I
for any i or j
substitution income effect
effect (+) (-) if x is normal – this implies that the change in the price of
any good induces income and substitution
combined effect effects that may change the quantity of
(ambiguous) every good demanded
5 6
7 8
2
Asymmetry of the Gross Asymmetry of the Gross
Definitions Definitions
• One undesirable characteristic of the gross • Suppose that the utility function for two
definitions of substitutes and complements goods is given by
is that they are not symmetric
U(x,y) = ln x + y
• It is possible for x1 to be a substitute for x2
and at the same time for x2 to be a • Setting up the Lagrangian
complement of x1 L = ln x + y + (I – pxx – pyy)
9 10
3
Net Substitutes and Net Substitutes and
Complements Complements
• The concepts of net substitutes and • This definition looks only at the shape of
complements focuses solely on substitution
effects the indifference curve
– two goods are net substitutes if • This definition is unambiguous because
xi
the definitions are perfectly symmetric
0
p j U constant
xi x j
– two goods are net complements if
p j U constant
pi U constant
xi
0
p j U constant 13 14
15 16
4
Substitutability with Many Substitutability with Many
Goods Goods
• To prove this, we can start with the • In elasticity terms, we get
compensated demand function
eic1 eic2 ... einc 0
xc(p1,…pn,V)
• Since the negativity of the substitution
• Applying Euler’s theorem yields
effect implies that eiic 0, it must be the
xic x c x c case that
p1 p2 i ... pn i 0
p1 p2 pn
e
j i
c
ij 0
17 18
19 20
5
Composite Commodity Theorem Composite Commodity Theorem
• Let p20…pn0 represent the initial prices of • The individual’s budget constraint is
these other commodities I = p1x1 + p20x2 +…+ pn0xn = p1x1 + y
– assume that they all vary together (so that the
relative prices of x2…xn do not change) • If we assume that all of the prices p20…pn0
change by the same factor (t > 0) then the
• Define the composite commodity y to be
budget constraint becomes
total expenditures on x2…xn at the initial
prices I = p1x1 + tp20x2 +…+ tpn0xn = p1x1 + ty
23 24
6
Example: Composite Example: Composite
Commodity Commodity
• Suppose that an individual receives utility U ( x, y , z )
1 1 1
utility from three goods: x y z
– food (x) • The Lagrangian technique can be used
– housing services (y), measured in to derive demand functions
hundreds of square feet I I
x y
– household operations (z), measured by p x p x p y p x pz py py px py pz
electricity use
I
• Assume a CES utility function z
pz pz px pz py
25 26
7
Example: Composite Example: Composite
Commodity Commodity
• Now x can be shown as a function of I, • If py rises to 16 and pz rises to 4 (with px
px, and ph remaining at 1), ph would also rise to 4
I • The demand for x would fall to
x
py 3 px ph 100 100
x*
• If I = 100, px = 1, py = 4, and ph = 1, then 1 3 4 7
x* = 25 and spending on housing (h*) = • Housing purchases would be given by
75 100 600
Ph h* 100
29 7 7 30
8
Household Production Model Household Production Model
• Assume that there are three goods that • The individual’s goal is to choose x,y,
a person might want to purchase in the and z so as to maximize utility
market: x, y, and z utility = U(a1,a2)
– these goods provide no direct utility subject to the production functions
– these goods can be combined by the
a1 = f1(x,y,z)
individual to produce either of two home-
produced goods: a1 or a2 a2 = f2(x,y,z)
• the technology of this household production and a financial budget constraint
can be represented by a production function
pxx + pyy + pzz = I
33 34
35 36
9
The Linear Attributes Model The Linear Attributes Model
The ray 0x shows the combinations of a1 and a2
a2 available from successively larger amounts of good x • If the individual spends all of his or her
x
income on good x
The ray 0y shows the combinations of
y a1 and a2 available from successively x* = I/px
larger amounts of good y
• That will yield
The ray 0z shows the
combinations of a1 and
a1* = ax1x* = (ax1I)/px
z
a2 available from
successively larger
a2* = ax2x* = (ax2I)/px
amounts of good z
0 a1
37 38
y* y*
z* is the combination of
z a1 and a2 that would be z
obtained if all income was
spent on z
Z* z*
0 a1 0 a1
39 40
10
The Linear Attributes Model The Linear Attributes Model
A utility-maximizing individual would never • The model predicts that corner solutions
a2 consume positive quantities of all three
x goods
(where individuals consume zero amounts
Individuals with a preference toward
of some commodities) will be relatively
y
a1 will have indifference curves similar common
U1 to U0 and will consume only y and z
– especially in cases where individuals attach
Individuals with a preference value to fewer attributes than there are
toward a0 will have
U0
z
indifference curves similar
market goods to choose from
to U1 and will consume only
x and y
• Consumption patterns may change
abruptly if income, prices, or preferences
a1
0
41
change 42
11
Important Points to Note: Important Points to Note:
• Focusing only on the substitution • If a group of goods has prices that
effects from price changes does always move in unison, expenditures
provide a symmetric definition on these goods can be treated as a
– two goods are net substitutes if xi c/pj > “composite commodity” whose “price”
0 and net complements if xi c/pj < 0 is given by the size of the proportional
– because xic /pj = xjc /pi, there is no change in the composite goods’ prices
ambiguity
– Hicks’ second law of demand shows that
net substitutes are more prevalent
45 46
47
12
Production Function
• The firm’s production function for a
Chapter 9 particular good (q) shows the maximum
amount of the good that can be produced
PRODUCTION FUNCTIONS
using alternative combinations of capital
(k) and labor (l)
q = f(k,l)
Diminishing Marginal
Marginal Physical Product
Productivity
• To study variation in a single input, we
• The marginal physical product of an input
define marginal physical product as the
depends on how much of that input is
additional output that can be produced by
used
employing one more unit of that input
while holding other inputs constant • In general, we assume diminishing
marginal productivity
q
marginal physical product of capital MPk fk
k MPk 2f MPl 2f
q 2 fkk f11 0 2 fll f22 0
marginal physical product of labor MPl fl k k l l
l 3 4
1
Diminishing Marginal
Productivity Average Physical Product
• Because of diminishing marginal • Labor productivity is often measured by
productivity, 19th century economist average productivity
Thomas Malthus worried about the effect
output q f (k, l )
of population growth on labor productivity APl
labor input l l
• But changes in the marginal productivity of
labor over time also depend on changes in • Note that APl also depends on the
other inputs such as capital amount of capital employed
– we need to consider flk which is often > 0
5 6
2
A Two-Input Production A Two-Input Production
Function Function
• To find average productivity, we hold • In fact, when l = 30, both APl and MPl are
k=10 and solve equal to 900,000
APl = q/l = 60,000l - 1000l2
• APl reaches its maximum where • Thus, when APl is at its maximum, APl
APl/l = 60,000 - 2000l = 0 and MPl are equal
l = 30
9 10
l per period
11 12
3
Marginal Rate of Technical Marginal Rate of Technical
Substitution (RTS) Substitution (RTS)
• The slope of an isoquant shows the rate
at which l can be substituted for k • The marginal rate of technical
k per period substitution (RTS) shows the rate at
- slope = marginal rate of technical
substitution (RTS) which labor can be substituted for
capital while holding output constant
RTS > 0 and is diminishing for along an isoquant
A increasing inputs of labor
kA
dk
kB
B RTS (l for k )
q = 20 dl q q0
l per period
lA lB 13 14
4
RTS and Marginal Productivities RTS and Marginal Productivities
• Using the fact that dk/dl = -fl/fk along an
• To show that isoquants are convex, we isoquant and Young’s theorem (fkl = flk)
would like to show that d(RTS)/dl < 0
dRTS (fk2fll 2fk fl fkl fl 2fkk )
• Since RTS = fl/fk
dl (fk )3
dRTS d (fl / fk )
• Because we have assumed fk > 0, the
dl dl denominator is positive
dRTS [fk (fll flk dk / dl ) fl (fkl fkk dk / dl )] • Because fll and fkk are both assumed to be
negative, the ratio will be negative if fkl is
dl (fk )2
17
positive 18
5
A Diminishing RTS A Diminishing RTS
• Because • Cross differentiation of either of the
2
fll = 1200k - 6k 3l marginal productivity functions yields
fkk = 1200l 2 - 6kl 3 fkl = flk = 2400kl - 9k 2l 2
this production function exhibits which is positive only for kl < 266
diminishing marginal productivities for
sufficiently large values of k and l
– fll and fkk < 0 if kl > 200
21 22
23 24
6
Returns to Scale Returns to Scale
• If the production function is given by q =
• Smith identified two forces that come
f(k,l) and all inputs are multiplied by the
into operation as inputs are doubled
same positive constant (t >1), then
– greater division of labor and specialization
of function Effect on Output Returns to Scale
– loss in efficiency because management
f(tk,tl) = tf(k,l) Constant
may become more difficult given the larger
scale of the firm f(tk,tl) < tf(k,l) Decreasing
f(tk,tl) > tf(k,l) Increasing
25 26
7
Constant Returns to Scale Constant Returns to Scale
• The marginal productivity of any input • The production function will be
depends on the ratio of capital and labor homothetic
(not on the absolute levels of these • Geometrically, all of the isoquants are
inputs) radial expansions of one another
• The RTS between k and l depends only
on the ratio of k to l, not the scale of
operation
29 30
8
Elasticity of Substitution Elasticity of Substitution
• The elasticity of substitution () measures • Both RTS and k/l will change as we
the proportionate change in k/l relative to move from point A to point B
the proportionate change in the RTS along
k per period is the ratio of these
an isoquant proportional changes
%(k / l ) d (k / l ) RTS ln( k / l )
measures the
%RTS dRTS k / l ln RTS RTSA
A
RTSB
curvature of the
• The value of will always be positive isoquant
because k/l and RTS move in the same (k/l)A B q = q0
(k/l)B
direction 33
l per period
34
9
The Linear Production Function The Linear Production Function
• Suppose that the production function is Capital and labor are perfect substitutes
q = f(k,l) = ak + bl
• This production function exhibits constant k per period
RTS is constant as k/l changes
returns to scale
f(tk,tl) = atk + btl = t(ak + bl) = tf(k,l)
• All isoquants are straight lines
slope = -b/a
=
– RTS is constant
–= q2 q3
q1
l per period
37 38
q1
l per period
39 q3/b 40
10
Cobb-Douglas Production Cobb-Douglas Production
Function Function
• Suppose that the production function is • The Cobb-Douglas production function is
q = f(k,l) = Akalb A,a,b > 0 linear in logarithms
• This production function can exhibit any ln q = ln A + a ln k + b ln l
returns to scale – a is the elasticity of output with respect to k
f(tk,tl) = A(tk)a(tl)b = Ata+b kalb = ta+bf(k,l) – b is the elasticity of output with respect to l
– if a + b = 1 constant returns to scale
– if a + b > 1 increasing returns to scale
– if a + b < 1 decreasing returns to scale
41 42
11
Technical Progress Technical Progress
• Methods of production change over time • Suppose that the production function is
• Following the development of superior q = A(t)f(k,l)
production techniques, the same level where A(t) represents all influences that
of output can be produced with fewer go into determining q other than k and l
inputs – changes in A over time represent technical
– the isoquant shifts in progress
• A is shown as a function of time (t)
• dA/dt > 0
45 46
47 48
12
Technical Progress Technical Progress
• For any variable x, [(dx/dt)/x] is the • Since
proportional growth rate in x f k q k
– denote this by Gx eq,k
k f (k, l ) k q
• Then, we can write the equation in terms
of growth rates f l q l
eq,l
l f (k, l ) l q
f k f l
Gq GA Gk Gl
k f (k, l ) l f (k, l )
Gq GA eq,kGk eq,lGl
49 50
51 52
13
Technical Progress in the Important Points to Note:
Cobb-Douglas Function
• If all but one of the inputs are held
(ln A t ln k (1 ) ln l ) constant, a relationship between the
Gq
t single variable input and output can be
ln k ln l derived
(1 ) Gk (1 )Gl
t t – the marginal physical productivity is the
change in output resulting from a one-unit
increase in the use of the input
• assumed to decline as use of the input
increases
53 54
14
Important Points to Note: Important Points to Note:
• The returns to scale exhibited by a • The elasticity of substitution ()
production function record how output provides a measure of how easy it is to
responds to proportionate increases in substitute one input for another in
all inputs production
– if output increases proportionately with input – a high implies nearly straight isoquants
use, there are constant returns to scale – a low implies that isoquants are nearly
L-shaped
57 58
59
15
Definitions of Costs
• It is important to differentiate between
Chapter 10 accounting cost and economic cost
– the accountant’s view of cost stresses out-
COST FUNCTIONS of-pocket expenses, historical costs,
depreciation, and other bookkeeping
entries
– economists focus more on opportunity cost
1
Definitions of Costs Economic Cost
• Costs of Entrepreneurial Services
– accountants believe that the owner of a firm • The economic cost of any input is the
is entitled to all profits payment required to keep that input in
• revenues or losses left over after paying all input its present employment
costs – the remuneration the input would receive in
– economists consider the opportunity costs of its best alternative employment
time and funds that owners devote to the
operation of their firms
• part of accounting profits would be considered as
entrepreneurial costs by economists
5 6
2
Economic Profits Cost-Minimizing Input Choices
• Economic profits are a function of the • To minimize the cost of producing a
amount of capital and labor employed given level of output, a firm should
– we could examine how a firm would choose choose a point on the isoquant at which
k and l to maximize profit the RTS is equal to the ratio w/v
• “derived demand” theory of labor and capital
– it should equate the rate at which k can be
inputs
traded for l in the productive process to the
– for now, we will assume that the firm has rate at which they can be traded in the
already chosen its output level (q0) and marketplace
wants to minimize its costs
9 10
3
Cost-Minimizing Input Choices Cost-Minimizing Input Choices
• Cross-multiplying, we get • Note that this equation’s inverse is also
fk fl of interest
v w w v
fl fk
• For costs to be minimized, the marginal
productivity per dollar spent should be • The Lagrangian multiplier shows how
the same for all inputs much in extra costs would be incurred
by increasing the output constraint
slightly
13 14
C3 w/v C3
isoquant and the total cost
curve
C2 C2
4
Contingent Demand for Inputs Contingent Demand for Inputs
• In Chapter 4, we considered an • In the present case, cost minimization
individual’s expenditure-minimization leads to a demand for capital and labor
problem that is contingent on the level of output
– we used this technique to develop the being produced
compensated demand for a good • The demand for an input is a derived
• Can we develop a firm’s demand for an demand
input in the same way? – it is based on the level of the firm’s output
17 18
q00
l per period
19 20
5
The Firm’s Expansion Path Cost Minimization
• The expansion path does not have to be • Suppose that the production function is
a straight line Cobb-Douglas:
– the use of some inputs may increase faster q = kl
than others as output expands
• depends on the shape of the isoquants • The Lagrangian expression for cost
• The expansion path does not have to be minimization of producing q0 is
upward sloping L = vk + wl + (q0 - k l )
– if the use of an input falls as output expands,
that input is an inferior input
21 22
6
Cost Minimization Cost Minimization
• Suppose that the production function is • The first-order conditions for a minimum
CES: are
q = (k + l )/ L/k = v - (/)(k + l)(-)/()k-1 = 0
• The Lagrangian expression for cost L/l = w - (/)(k + l)(-)/()l-1 = 0
minimization of producing q0 is L/ = q0 - (k + l )/ = 0
L = vk + wl + [q0 - (k + l )/]
25 26
27 28
7
Average Cost Function Marginal Cost Function
• The average cost function (AC) is found • The marginal cost function (MC) is
by computing total costs per unit of found by computing the change in total
output costs for a change in output produced
C(v ,w, q )
average cost AC(v ,w, q ) C(v ,w, q )
q marginal cost MC(v ,w, q )
q
29 30
8
Graphical Analysis of Graphical Analysis of
Total Costs Total Costs
• Suppose instead that total costs start Total C
costs
out as concave and then becomes
convex as output increases Total costs rise
– one possible explanation for this is that dramatically as
there is a third factor of production that is output increases
fixed as capital and labor usage expands after diminishing
returns set in
– total costs begin rising rapidly after
diminishing returns set in
Output
33 34
Graphical Analysis of
Total Costs Shifts in Cost Curves
Average
and MC is the slope of the C curve • The cost curves are drawn under the
marginal
costs MC
If AC > MC, assumption that input prices and the
AC AC must be level of technology are held constant
falling – any change in these factors will cause the
If AC < MC, cost curves to shift
min AC
AC must be
rising
Output
35 36
9
Some Illustrative Cost Some Illustrative Cost
Functions Functions
• Suppose we have a fixed proportions • Suppose we have a Cobb-Douglas
technology such that technology such that
q = f(k,l) = min(ak,bl) q = f(k,l) = k l
• Production will occur at the vertex of the • Cost minimization requires that
L-shaped isoquants (q = ak = bl) w k
C(w,v,q) = vk + wl = v(q/a) + w(q/b) v l
v w w
C(w ,v , q ) a k l
a b v
37 38
10
Some Illustrative Cost Properties of Cost Functions
Functions
• Suppose we have a CES technology • Homogeneity
such that – cost functions are all homogeneous of
q = f(k,l) = (k + l )/ degree one in the input prices
• cost minimization requires that the ratio of input
• To derive the total cost, we would use prices be set equal to RTS, a doubling of all
the same method and eventually get input prices will not change the levels of inputs
purchased
C(v,w, q ) vk wl q1/ (v / 1 w / 1 )( 1) / • pure, uniform inflation will not change a firm’s
input decisions but will shift the cost curves up
C(v,w, q ) q1/ (v 1 w 1 )1/ 1
41 42
43 44
11
Concavity of Cost Function Properties of Cost Functions
At w1, the firm’s costs are C(v,w1,q1) • Some of these properties carry over to
If the firm continues to average and marginal costs
buy the same input mix
as w changes, its cost
– homogeneity
Costs Cpseudo
function would be Cpseudo – effects of v, w, and q are ambiguous
C(v,w,q1)
w1 w 45 46
12
Partial Elasticity of Substitution Size of Shifts in Costs Curves
• The partial elasticity of substitution
between two inputs (xi and xj) with • The increase in costs will be largely
prices wi and wj is given by influenced by the relative significance of
( x i / x j ) w j / w i ln( xi / x j ) the input in the production process
sij • If firms can easily substitute another
(w j / w i ) xi / x j ln( w j / w i )
input for the one that has risen in price,
• Sij is a more flexible concept than
there may be little increase in costs
because it allows the firm to alter the
usage of inputs other than xi and xj
when input prices change
49 50
13
Shifting the Cobb-Douglas Shifting the Cobb-Douglas
Cost Function Cost Function
• The Cobb-Douglas cost function is • If v = 3 and w = 12, the relationship is
C(v,w, q ) vk wl q1/ Bv / w / C(3,12, q ) 2q 36 12q
where – C = 480 to produce q =40
/ /
B ( ) – AC = C/q = 12
• If we assume = = 0.5, the total cost – MC = C/q = 12
curve is greatly simplified:
C(v,w, q ) vk wl 2qv 0.5w 0.5
53 54
55 56
14
Contingent Demand for Inputs Contingent Demand for Inputs
• Suppose we have a fixed proportions • For this cost function, contingent
technology demand functions are quite simple:
• The cost function is C(v ,w , q ) q
k c (v ,w , q )
v w v a
C(w ,v , q ) a
a b C(v ,w , q ) q
l c (v ,w , q )
w b
57 58
q 1/ B
v
59 60
15
Contingent Demand for Inputs Short-Run, Long-Run
Distinction
C
l c (v ,w , q ) q 1/ Bv / w / • In the short run, economic actors have
w
/
only limited flexibility in their actions
w
q 1/ B • Assume that the capital input is held
v constant at k1 and the firm is free to
• The contingent demands for inputs vary only its labor input
depend on both inputs’ prices • The production function becomes
q = f(k1,l)
61 62
16
Short-Run Total Costs Short-Run Marginal and
k per period Average Costs
Because capital is fixed at k1,
the firm cannot equate RTS • The short-run average total cost (SAC)
with the ratio of input prices function is
SAC = total costs/total output = SC/q
• The short-run marginal cost (SMC) function
k1
is
q2
q1
SMC = change in SC/change in output = SC/q
q0
l per period
l1 l2 l3
65 66
Output Output
q0 q1 q2 67 q0 q1 68
17
Relationship between Short- Important Points to Note:
Run and Long-Run Costs
• A firm that wishes to minimize the
• At the minimum point of the AC curve: economic costs of producing a
– the MC curve crosses the AC curve particular level of output should
• MC = AC at this point choose that input combination for
– the SAC curve is tangent to the AC curve which the rate of technical substitution
• SAC (for this level of k) is minimized at the same (RTS) is equal to the ratio of the
level of output as AC
inputs’ rental prices
• SMC intersects SAC also at this point
AC = MC = SAC = SMC
69 70
18
Important Points to Note: Important Points to Note:
• All cost curves are drawn on the • Input demand functions can be derived
assumption that the input prices are from the firm’s total-cost function
held constant through partial differentiation
– when an input price changes, cost curves – these input demands will depend on the
shift to new positions quantity of output the firm chooses to
• the size of the shifts will be determined by the produce
overall importance of the input and the • are called “contingent” demand functions
substitution abilities of the firm
– technical progress will also shift cost
curves 73 74
19
The Nature of Firms
• A firm is an association of individuals
Chapter 11 who have organized themselves for the
purpose of turning inputs into outputs
PROFIT MAXIMIZATION
• Different individuals will provide different
types of inputs
– the nature of the contractual relationship
between the providers of inputs to a firm
may be quite complicated
Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2
1
Profit Maximization Profit Maximization
• A profit-maximizing firm chooses both • If firms are strictly profit maximizers,
its inputs and its outputs with the sole they will make decisions in a “marginal”
goal of achieving maximum economic way
profits – examine the marginal profit obtainable
– seeks to maximize the difference between from producing one more unit of hiring one
total revenue and total economic costs additional laborer
5 6
2
Output Choice Second-Order Conditions
• To maximize economic profits, the firm • MR = MC is only a necessary condition
should choose the output for which for profit maximization
marginal revenue is equal to marginal • For sufficiency, it is also required that
cost
d 2 d' (q )
dR dC 0
MR MC
2
dq q q * dq q q *
dq dq
• “marginal” profit must be decreasing at
the optimal level of q
9 10
3
Marginal Revenue Marginal Revenue
• If a firm faces a downward-sloping • Suppose that the demand curve for a sub
demand curve, marginal revenue will be sandwich is
q = 100 – 10p
a function of output
• Solving for price, we get
• If price falls as a firm increases output,
marginal revenue will be less than price p = -q/10 + 10
• This means that total revenue is
R = pq = -q2/10 + 10q
• Marginal revenue will be given by
13
MR = dR/dq = -q/5 + 10 14
4
Marginal Revenue and Marginal Revenue and
Elasticity Elasticity
• This means that
q dp q dp 1
MR p p1 p1
dq p dq eq,p < -1 MR > 0
eq,p
– if the demand curve slopes downward,
eq,p = -1 MR = 0
eq,p < 0 and MR < p
– if the demand is elastic, eq,p < -1 and
eq,p > -1 MR < 0
marginal revenue will be positive
• if the demand is infinitely elastic, eq,p = - and
marginal revenue will equal price
17 18
5
Average Revenue Curve Marginal Revenue Curve
• If we assume that the firm must sell all • The marginal revenue curve shows the
its output at one price, we can think of extra revenue provided by the last unit
the demand curve facing the firm as its sold
average revenue curve • In the case of a downward-sloping
– shows the revenue per unit yielded by demand curve, the marginal revenue
alternative output choices
curve will lie below the demand curve
21 22
output
q1
MR 23 24
6
The Constant Elasticity Case The Constant Elasticity Case
• We showed (in Chapter 5) that a • This means that
demand function of the form R = pq = kq(1+b)/b
q = apb and
has a constant price elasticity of MR = dr/dq = [(1+b)/b]kq1/b = [(1+b)/b]p
demand equal to b
• This implies that MR is proportional to
• Solving this equation for p, we get price
p = (1/a)1/bq1/b = kq1/b where k = (1/a)1/b
25 26
p* = MR SAC p* = MR SAC
SAVC SAVC
output output
q* q*
27 28
7
Short-Run Supply by a Short-Run Supply by a
Price-Taking Firm Price-Taking Firm
price price SMC
If the price falls to
SMC
p***, the firm will
p**
produce q***
p* = MR SAC p* = MR SAC
SAVC SAVC
8
Short-Run Supply by a Short-Run Supply
Price-Taking Firm
price SMC
• Suppose that the firm’s short-run total cost
curve is
SAC SC(v,w,q,k) = vk1 + wq1/k1-/
SAVC
where k1 is the level of capital held
The firm’s short-run constant in the short run
supply curve is the
SMC curve that is • Short-run marginal cost is
above SAVC
SC w (1 ) / /
output SMC(v ,w, q, k1 ) q k1
q
33 34
35 36
9
Profit Functions Profit Functions
• A firm’s economic profit can be • A firm’s profit function shows its
expressed as a function of inputs maximal profits as a function of the
= pq - C(q) = pf(k,l) - vk - wl prices that the firm faces
• Only the variables k and l are under the ( p,v,w ) Max (k, l ) Max[ pf (k, l ) vk wl ]
k ,l k ,l
firm’s control
– the firm chooses levels of these inputs in
order to maximize profits
• treats p, v, and w as fixed parameters in its
decisions
37 38
39 40
10
Properties of the Profit Properties of the Profit
Function Function
• Nonincreasing in input prices • Convex in output prices
– if the firm responded to an increase in an – the profits obtainable by averaging those
input price by not changing the level of that from two different output prices will be at
input, its costs would rise least as large as those obtainable from the
• profits would fall average of the two prices
( p1,v ,w ) ( p2 ,v ,w ) p p2
1 ,v ,w
2 2
41 42
11
Producer Surplus in the Producer Surplus in the
Short Run Short Run
SMC SMC
price price
If the market price The firm’s profits
is p1, the firm will rise by the shaded
p2 p2
produce q1 area
p1 p1
If the market price
rises to p2, the firm
will produce q2
output output
q1 q2 q1 q2
45 46
47 48
12
Producer Surplus in the Producer Surplus in the
Short Run Short Run
SMC
price
Suppose that the • The extra profits available from facing a
firm’s shutdown price of p1 are defined to be producer
price is p0 surplus
p1 p1
p producer surplus ( p1,...) ( p0 ,...) q( p)dp
0
p0
output
q1
49 50
51 52
13
Producer Surplus in the Profit Maximization and
Short Run Input Demand
• Because the firm produces no output at • A firm’s output is determined by the
the shutdown price, (p0,…) = -vk1 amount of inputs it chooses to employ
– profits at the shutdown price are equal to the – the relationship between inputs and
firm’s fixed costs outputs is summarized by the production
• This implies that function
producer surplus = (p1,…) - (p0,…) • A firm’s economic profit can also be
= (p1,…) – (-vk1) = (p1,…) + vk1 expressed as a function of inputs
– producer surplus is equal to current profits (k,l) = pq –C(q) = pf(k,l) – (vk + wl)
plus short-run fixed costs 53 54
14
Profit Maximization and Input Demand Functions
Input Demand
• To ensure a true maximum, second- • In principle, the first-order conditions can
order conditions require that be solved to yield input demand functions
kk = fkk < 0 Capital Demand = k(p,v,w)
Labor Demand = l(p,v,w)
ll = fll < 0
kk ll - kl2 = fkkfll – fkl2 > 0
• These demand functions are
unconditional
– capital and labor must exhibit sufficiently – they implicitly allow the firm to adjust its
diminishing marginal productivities so that output to changing prices
marginal costs rise as output expands
57 58
dw p
fl l
dw
• Since fll 0, l/w 0
l w
59 60
15
Two-Input Case Two-Input Case
• For the case of two (or more inputs), the • When w falls, two effects occur
story is more complex – substitution effect
– if there is a decrease in w, there will not • if output is held constant, there will be a
only be a change in l but also a change in tendency for the firm to want to substitute l for k
in the production process
k as a new cost-minimizing combination of
inputs is chosen – output effect
• when k changes, the entire fl function changes • a change in w will shift the firm’s expansion
path
• But, even in this case, l/w 0 • the firm’s cost curves will shift and a different
output level will be chosen
61 62
16
Output Effect Cross-Price Effects
Output will rise to q1 • No definite statement can be made
k per period about how capital usage responds to a
Thus, the output effect
wage change
also implies a negative
relationship between l – a fall in the wage will lead the firm to
and w substitute away from capital
– the output effect will cause more capital to
be demanded as the firm expands
q1
q0 production
l per period
65 66
17
Important Points to Note: Important Points to Note:
• In order to maximize profits, the firm • If a firm is a price taker, its output
should choose to produce that output decisions do not affect the price of its
level for which the marginal revenue is output
equal to the marginal cost – marginal revenue is equal to price
• If the firm faces a downward-sloping
demand for its output, marginal
revenue will be less than price
69 70
71 72
18
Important Points to Note: Important Points to Note:
• The firm’s reactions to the various • The firm’s profit function yields
prices it faces can be judged through particularly useful envelope results
use of its profit function – differentiation with respect to market price
– shows maximum profits for the firm given yields the supply function
the price of its output, the prices of its – differentiation with respect to any input
inputs, and the production technology price yields the (inverse of) the demand
function for that input
73 74
19
Market Demand
• Assume that there are only two goods
Chapter 12 (x and y)
THE PARTIAL EQUILIBRIUM – An individual’s demand for x is
COMPETITIVE MODEL Quantity of x demanded = x(px,py,I)
– If we use i to reflect each individual in the
market, then the market demand curve is
n
Market demand for X xi ( px , py , Ii )
Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 i 1 2
x1* + x2* = X*
3 4
1
Shifts in the Market Shifts in Market Demand
Demand Curve
• The market demand summarizes the • Suppose that individual 1’s demand for
ceteris paribus relationship between X oranges is given by
and px x1 = 10 – 2px + 0.1I1 + 0.5py
– changes in px result in movements along the and individual 2’s demand is
curve (change in quantity demanded) x2 = 17 – px + 0.05I2 + 0.5py
– changes in other determinants of the
• The market demand curve is
demand for X cause the demand curve to
X = x1 + x2 = 27 – 3px + 0.1I1 + 0.05I2 + py
shift to a new position (change in demand)
5 6
2
Generalizations Generalizations
• Suppose that there are n goods (xi, i = 1,n) • The market demand function for xi is the
with prices pi, i = 1,n. sum of each individual’s demand for that
• Assume that there are m individuals in the good
m
economy X i xij ( p1,..., pn , I j )
• The j th’s demand for the i th good will j 1
3
Timing of the Supply Response Pricing in the Very Short Run
• In the analysis of competitive pricing, the
• In the very short run (or the market
time period under consideration is
period), there is no supply response to
important
changing market conditions
– very short run
– price acts only as a device to ration demand
• no supply response (quantity supplied is fixed)
• price will adjust to clear the market
– short run
– the supply curve is a vertical line
• existing firms can alter their quantity supplied, but
no new firms can enter the industry
– long run
• new firms may enter an industry 13 14
Quantity
Q*
15 16
4
Perfect Competition Short-Run Market Supply
• A perfectly competitive industry is one • The quantity of output supplied to the
that obeys the following assumptions: entire market in the short run is the sum
– there are a large number of firms, each of the quantities supplied by each firm
producing the same homogeneous product – the amount supplied by each firm depends
– each firm attempts to maximize profits on price
– each firm is a price taker • The short-run market supply curve will
• its actions have no effect on the market price be upward-sloping because each firm’s
– information is perfect short-run supply curve has a positive
– transactions are costless slope
17 18
5
Short-Run Supply Elasticity A Short-Run Supply Function
• The short-run supply elasticity describes • Suppose that there are 100 identical
the responsiveness of quantity supplied firms each with the following short-run
to changes in market price supply curve
% change in Q supplied QS P qi (P,v,w) = 10P/3 (i = 1,2,…,100)
eS,P
% change in P P QS • This means that the market supply
• Because price and quantity supplied are function is given by
positively related, eS,P > 0 100 100
10P 1000P
Qs qi
i 1 i 1 3 3
21 22
6
Equilibrium Price Equilibrium Price
Determination Determination
• The equilibrium price depends on many The interaction between
exogenous factors Price market demand and market
S supply determines the
– changes in any of these factors will likely equilibrium price
result in a new equilibrium price
P1
Q1 Quantity
25 26
Q1 Q2 Quantity q1 q2 Quantity
27 28
7
Shifts in Supply and Shifts in Supply and
Demand Curves Demand Curves
• Demand curves shift because • When either a supply curve or a
– incomes change demand curve shift, equilibrium price
– prices of substitutes or complements change and quantity will change
– preferences change • The relative magnitudes of these
• Supply curves shift because changes depends on the shapes of the
– input prices change supply and demand curves
– technology changes
– number of producers change
29 30
P’
P’ P’ P’
P
P P
P
D D’ D’
D D D
8
Changing Short-Run Equilibria Changing Short-Run Equilibria
• Suppose that the market demand for • Suppose instead that the demand for
luxury beach towels is luxury towels rises to
QD = 10,000 – 500P QD = 12,500 – 500P
and the short-run market supply is • Solving for the new equilibrium, we find
QS = 1,000P/3 P* = $15
• Setting these equal, we find Q* = 5,000
P* = $12 • Equilibrium price and quantity both rise
Q* = 4,000
33 34
9
Mathematical Model of Mathematical Model of
Supply and Demand Supply and Demand
• The supply relationship can be shown as • To analyze the comparative statics of
QS = S(P,) this model, we need to use the total
differentials of the supply and demand
– is a parameter that shifts the supply curve
functions:
• S/ = S can have any sign
dQD = DPdP + Dd
– S/P = SP > 0 dQS = SPdP + Sd
• Equilibrium requires that QD = QS • Maintenance of equilibrium requires that
dQD = dQS
37 38
10
Long-Run Analysis Long-Run Analysis
• In the long run, a firm may adapt all of its • New firms will be lured into any market
inputs to fit market conditions for which economic profits are greater
– profit-maximization for a price-taking firm than zero
implies that price is equal to long-run MC – entry of firms will cause the short-run
• Firms can also enter and exit an industry industry supply curve to shift outward
in the long run – market price and profits will fall
– perfect competition assumes that there are – the process will continue until economic
no special costs of entering or exiting an profits are zero
industry
41 42
43 44
11
Long-Run Competitive Long-Run Equilibrium:
Equilibrium Constant-Cost Case
• We will assume that all firms in an • Assume that the entry of new firms in an
industry have identical cost curves industry has no effect on the cost of
– no firm controls any special resources or inputs
technology – no matter how many firms enter or leave
• The equilibrium long-run position an industry, a firm’s cost curves will remain
requires that each firm earn zero unchanged
economic profit • This is referred to as a constant-cost
industry
45 46
Price Price
P = MC = AC Price Price Market price rises to P2
SMC MC SMC MC
S S
AC AC
P2
P1 P1
D’
D D
q1 Quantity
47 q1 Quantity
48
Quantity Q1 Quantity Q1 Q2
A Typical Firm Total Market A Typical Firm Total Market
12
Long-Run Equilibrium: Long-Run Equilibrium:
Constant-Cost Case Constant-Cost Case
In the short run, each firm increases output to q2 In the long run, new firms will enter the industry
Economic profit > 0 Economic profit will return to 0
Price Price Price
SMC MC SMC MC Price
S S
S’
AC AC
P2
P1 P1
D’ D’
D D
q1 q2 Quantity
49 q1 Quantity
50
Quantity Q1 Q2 Quantity Q1 Q3
A Typical Firm Total Market A Typical Firm Total Market
q1 Quantity
51 52
Quantity Q1 Q3
A Typical Firm Total Market
13
Infinitely Elastic Long-Run Shape of the Long-Run
Supply Supply Curve
• To find the long-run equilibrium for this • The zero-profit condition is the factor that
market, we must find the low point on the determines the shape of the long-run cost
typical firm’s average cost curve curve
– where AC = MC – if average costs are constant as firms enter,
AC = q2 – 20q + 100 + 8,000/q long-run supply will be horizontal
MC = 3q2 – 40q + 100 – if average costs rise as firms enter, long-run
– this occurs where q = 20 supply will have an upward slope
• If q = 20, AC = MC = $500 – if average costs fall as firms enter, long-run
supply will be negatively sloped
– this will be the long-run equilibrium price 53 54
existing firms
– new firms may increase the demand for
tax-financed services P1
55 q1 Quantity
56
Quantity Q1
A Typical Firm (before entry) Total Market
14
Long-Run Equilibrium: Long-Run Equilibrium:
Increasing-Cost Industry Increasing-Cost Industry
Suppose that market demand rises to D’ Positive profits attract new firms and supply shifts out
Market price rises to P2 and firms increase output to q2 Entry of firms causes costs for each firm to rise
Price MC Price SMC’ MC’
SMC Price Price
S S
S’
AC’
AC
P2
P3
P1 P1
D’ D’
D D
q1 q2 Quantity
57 q3 Quantity
58
Quantity Q1 Q2 Quantity Q1 Q3
A Typical Firm (before entry) Total Market A Typical Firm (after entry) Total Market
AC’
S’ – new firms may attract a larger pool of
LS trained labor
– entry of new firms may provide a “critical
p3 mass” of industrialization
p1 • permits the development of more efficient
D’ transportation and communications networks
D
q3 Q1 Q3 59
Quantity 60
Quantity
A Typical Firm (after entry) Total Market
15
Long-Run Equilibrium: Long-Run Equilibrium:
Decreasing-Cost Case Decreasing-Cost Industry
Suppose that we are in long-run equilibrium in this industry Suppose that market demand rises to D’
P = MC = AC Market price rises to P2 and firms increase output to q2
Price Price Price
SMC MC SMC MC Price
S S
AC AC
P2
P1 P1
D’
D D
q1 Quantity
61 q1 q2 Quantity
62
Quantity Q1 Quantity Q1 Q2
A Typical Firm (before entry) Total Market A Typical Firm (before entry) Total Market
S’ S’
AC’ AC’
P1 P1
P3 D’ P3
D D D’ LS
q1 q3 Quantity
63 q1 q3 64
Q3 Quantity
Quantity Q1 Q3 Quantity Q1
A Typical Firm (before entry) Total Market A Typical Firm (before entry) Total Market
16
Classification of Long-Run Classification of Long-Run
Supply Curves Supply Curves
• Constant Cost • Decreasing Cost
– entry does not affect input costs – entry reduces input costs
– the long-run supply curve is horizontal at – the long-run supply curve is negatively
the long-run equilibrium price sloped
• Increasing Cost
– entry increases inputs costs
– the long-run supply curve is positively
sloped
65 66
17
Comparative Statics Analysis Comparative Statics Analysis
of Long-Run Equilibrium of Long-Run Equilibrium
• Assume that we are examining a • A shift in demand that changes the
constant-cost industry equilibrium industry output to Q1 will
• Suppose that the initial long-run change the equilibrium number of firms to
equilibrium industry output is Q0 and the n1 = Q1/q*
typical firm’s output is q* (where AC is • The change in the number of firms is
minimized) Q1 Q0
n1 n0
q*
• The equilibrium number of firms in the
– completely determined by the extent of the
industry (n0) is Q0/q* demand shift and the optimal output level for
69 70
the typical firm
71 72
18
Rising Input Costs and Rising Input Costs and
Industry Structure Industry Structure
• Suppose that the total cost curve for a
• At q = 22, MC = AC = $672 so the long-
typical firm in the bicycle industry is
run equilibrium price will be $672
TC = q3 – 20q2 + 100q + 8,000
• If demand can be represented by
and then rises to QD = 2,500 – 3P
19
Producer Surplus in the Producer Surplus in the
Long Run Long Run
• In the constant-cost case, input prices • Long-run producer surplus represents
are assumed to be independent of the the additional returns to the inputs in an
level of production industry in excess of what these inputs
– inputs can earn the same amount in would earn if industry output was zero
alternative occupations
– the area above the long-run supply curve
• In the increasing-cost case, entry will bid and below the market price
up some input prices • this would equal zero in the case of constant
– suppliers of these inputs will be made better costs
off 77 78
79 80
20
Ricardian Rent Ricardian Rent
The owners of low-cost firms will earn positive profits The owners of the marginal firm will earn zero profit
AC
AC
S S
P* P*
D D
q* Quantity Q* Quantity
81 q* Quantity Q* 82
Quantity
Low-Cost Firm Total Market Marginal Firm Total Market
21
Ricardian Rent Ricardian Rent
• The long-run profits for the low-cost firms • It is the scarcity of low-cost inputs that
will often be reflected in the prices of the creates the possibility of Ricardian rent
unique resources owned by those firms
• In industries with upward-sloping long-
– the more fertile the land is, the higher its
run supply curves, increases in output
price
not only raise firms’ costs but also
• Thus, profits are said to be capitalized generate factor rents for inputs
inputs’ prices
– reflect the present value of all future profits
85 86
22
Important Points to Note: Important Points to Note:
• In the long run, the number of firms is • The shape of the long-run supply curve
variable in response to profit opportunities depends on how entry and exit affect
– the assumption of free entry and exit implies firms’ input costs
that firms in a competitive industry will earn – in the constant-cost case, input prices do not
zero economic profits in the long run (P = AC) change and the long-run supply curve is
– because firms also seek maximum profits, the horizontal
equality P = AC = MC implies that firms will – if entry raises input costs, the long-run supply
operate at the low points of their long-run curve will have a positive slope
average cost curves
89 90
91 92
23
Perfectly Competitive
Price System
• We will assume that all markets are
Chapter 13 perfectly competitive
– there is some large number of homogeneous
GENERAL EQUILIBRIUM AND goods in the economy
WELFARE • both consumption goods and factors of
production
– each good has an equilibrium price
– there are no transaction or transportation
costs
Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 – individuals and firms have perfect information
2
1
General Equilibrium Edgeworth Box Diagram
• Construction of the production possibility
• Assume that there are only two goods, x
curve for x and y starts with the
and y
assumption that the amounts of k and l
• All individuals are assumed to have are fixed
identical preferences
• An Edgeworth box shows every possible
– represented by an indifference map
way the existing k and l might be used to
• The production possibility curve can be produce x and y
used to show how outputs and inputs are – any point in the box represents a fully
related employed allocation of the available
5 resources to x and y 6
Capital
in x – they illustrate the actual production outcomes
production
Ox
Total Labor 7 8
Labor in x production
2
Edgeworth Box Diagram Edgeworth Box Diagram
Point A is inefficient because, by moving along y1, we can increase
• We will use isoquant maps for the two x from x1 to x2 while holding y constant
Oy
goods
– the isoquant map for good x uses Ox as the y1
origin
Total Capital
– the isoquant map for good y uses Oy as the y2
origin
x2
• The efficient allocations will occur where A
x1
y1
y1
p4
y2
Total Capital
Total Capital
y2 p3
x4
y3
p2
x2 x3
y4 p1
A x1
x2
x1
Ox Ox
Total Labor 11 Total Labor 12
3
Production Possibility Frontier Production Possibility Frontier
Each efficient point of production
• The locus of efficient points shows the Quantity of y
becomes a point on the production
maximum output of y that can be Ox p1
possibility frontier
y4
produced for any level of x y3
p2
The negative of the slope of
– we can use this information to construct a y2
p3
the production possibility
production possibility frontier frontier is the rate of product
• shows the alternative outputs of x and y that transformation (RPT)
p4
y1
can be produced with the fixed capital and
labor inputs that are employed efficiently
Quantity of x
x1 x2 x3 x4 Oy
13 14
dy
RPT (of x for y ) (along OxOy )
dx
15 16
4
Shape of the Production Shape of the Production
Possibility Frontier Possibility Frontier
• The production possibility frontier shown • Suppose that the costs of any output
earlier exhibited an increasing RPT combination are C(x,y)
– this concave shape will characterize most – along the production possibility frontier,
production situations C(x,y) is constant
• RPT is equal to the ratio of MCx to MCy • We can write the total differential of the
cost function as
C C
dC dx dy 0
x y
17 18
5
Shape of the Production Opportunity Cost
Possibility Frontier
• The production possibility frontier
• But we have assumed that inputs are demonstrates that there are many
homogeneous possible efficient combinations of two
• We need an explanation that allows goods
homogeneous inputs and constant • Producing more of one good
returns to scale necessitates lowering the production of
• The production possibility frontier will be the other good
concave if goods x and y use inputs in – this is what economists mean by opportunity
different proportions cost
21 22
6
Concavity of the Production Determination of
Possibility Frontier Equilibrium Prices
• The RPT can be calculated by taking the
• We can use the production possibility
total differential:
frontier along with a set of indifference
dy ( 2x ) x
2xdx 2ydy 0 or RPT curves to show how equilibrium prices
dx 2y y
are determined
• The slope of the production possibility – the indifference curves represent
frontier increases as x output increases individuals’ preferences for the two goods
– the frontier is concave
25 26
Determination of Determination of
Equilibrium Prices Equilibrium Prices
If the prices of x and y are px and py, There is excess demand for x and
Quantity of y Quantity of y
society’s budget constraint is C excess supply of y
C C
Output will be x1, y1 The price of x will rise and
y1 y1 the price of y will fall
Individuals will demand x1’, y1’ excess
supply
y1 ’ y1 ’
U3 U3
U2 C U2 C
px px
U1 slope U1 slope
py py
Quantity of x x1 ’
Quantity of x
x1 x1 ’ 27 x 28
1 excess demand
7
Determination of Comparative Statics Analysis
Equilibrium Prices
• The equilibrium price ratio will tend to
Quantity of y C* The equilibrium prices will
be px* and py*
persist until either preferences or
C
production technologies change
The equilibrium output will
y1
be x1* and y1* • If preferences were to shift toward good
y1 *
x, px /py would rise and more x and less
y1 ’
U3
y would be produced
U2 C – we would move in a clockwise direction
px
U1 slope
py
along the production possibility frontier
C*
Quantity of x
x x1 * x1 ’ px* 29 30
slope
1 py*
– this will lower the relative price of x The relative price of x will fall
– more x will be consumed More x will be consumed
• if x is a normal good
U3
– the effect on y is ambiguous U2
U1
31 x1 * x2 *
Quantity of x 32
8
General Equilibrium Pricing General Equilibrium Pricing
• Suppose that the production possibility • Profit-maximizing firms will equate RPT
frontier can be represented by and the ratio of px /py
x 2 + y 2 = 100 x px
RPT
• Suppose also that the community’s y py
preferences can be represented by • Utility maximization requires that
U(x,y) = x0.5y0.5
y px
MRS
x py
33 34
35 36
9
The Corn Laws Debate The Corn Laws Debate
Quantity of Quantity of
manufactured If the corn laws completely prevented manufactured Removal of the corn laws will change
goods (y)
trade, output would be x0 and y0 goods (y) the prices to px’ and py’
Output will be x1’ and y1’
The equilibrium prices will be
y1 ’
px* and py* Individuals will demand x1 and y1
y0 y0
y1
U2 U2
U1 U1
px '
px* slope
slope py '
py*
Quantity of Grain (x) Quantity of Grain (x)
x0 x1 ’ x0 x1
37 38
39 40
imports of grain
10
The Corn Laws Debate The Corn Laws Debate
A repeal of the corn laws would result in a movement from p3 to
p1 where more y and less x is produced
Oy
• If we assume that grain production is
relatively capital intensive, the movement
y1 from p3 to p1 causes the ratio of k to l to
p4
y2 rise in both industries
Total Capital
p3
x4 – the relative price of capital will fall
y3
p2 – the relative price of labor will rise
x3
y4 p1 • The repeal of the corn laws will be
x2
x1 harmful to capital owners and helpful to
Ox
Total Labor 41
laborers 42
11
Existence of General Existence of General
Equilibrium Prices Equilibrium Prices
• Suppose that there are n goods in fixed • We will write this demand function as
supply in this economy dependent on the whole set of prices (P)
– let Si (i =1,…,n) be the total supply of good i Di (P)
available • Walras’ problem: Does there exist an
– let pi (i =1,…n) be the price of good i equilibrium set of prices such that
• The total demand for good i depends on Di (P*) = Si
all prices for all values of i ?
Di (p1,…,pn) for i =1,…,n
45 46
12
Walras’ Law Walras’ Law
• A final observation that Walras made • Walras’ law holds for any set of prices
was that the n excess demand equations (not just equilibrium prices)
are not independent of one another • There can be neither excess demand for
• Walras’ law shows that the total value of all goods together nor excess supply
excess demand is zero at any set of
prices
n
P ED (P ) 0
i 1
i i
49 50
13
Walras’ Proof of the Existence Walras’ Proof of the Existence
of Equilibrium Prices of Equilibrium Prices
• Using the provisional prices p1’ and p2’, • The importance of Walras’ proof is its
solve for p3’ ability to demonstrate the simultaneous
– proceed in this way until an entire set of nature of the problem of finding
provisional relative prices has been found equilibrium prices
• In the 2nd iteration of Walras’ proof, • Because it is cumbersome, it is not
p2’,…,pn’ are held constant while a new generally used today
equilibrium price is calculated for good 1
• More recent work uses some relatively
– proceed in this way until an entire new set of simple tools from advanced mathematics
prices is found 53 54
x
0 X* 1
55 56
14
Brouwer’s Fixed-Point Theorem Brouwer’s Fixed-Point Theorem
• A mapping is a rule that associates the • A mapping is continuous if points that are
points in one set with points in another set “close” to each other are mapped into other
– let X be a point for which a mapping (F) is points that are “close” to each other
defined • The Brouwer fixed-point theorem considers
• the mapping associates X with some point Y = F(X)
mappings defined on certain kinds of sets
– if a mapping is defined over a subset of n-
– closed (they contain their boundaries)
dimensional space (S), and if every point in S
is associated (by the rule F) with some other – bounded (none of their dimensions is infinitely
point in S, the mapping is said to map S into large)
itself 57
– convex (they have no “holes” in them) 58
p
i 1
i 59 60
15
Proof of the Existence of Free Goods
Equilibrium Prices
• Equilibrium does not really require that
• We will assume that the feasible set of excess demand be zero for every market
prices (S) is composed of all
• Goods may exist for which the markets
nonnegative numbers that sum to 1
are in equilibrium where supply exceeds
– S is the set to which we will apply Brouwer’s demand (negative excess demand)
theorem
– it is necessary for the prices of these goods
– S is closed, bounded, and convex
to be equal to zero
– we will need to define a continuous mapping
– “free goods”
of S into itself
61 62
63 64
16
Mapping the Set of Prices Mapping the Set of Prices
Into Itself Into Itself
• We define the mapping F(P) for any • Two problems exist with this mapping
normalized set of prices (P), such that • First, nothing ensures that the prices will
the ith component of F(P) is given by be nonnegative
F i(P) = pi + EDi (P) – the mapping must be redefined to be
• The mapping performs the necessary F i(P) = Max [pi + EDi (P),0]
task of appropriately raising or lowering – the new prices defined by the mapping must
prices be positive or zero
65 66
into itself
– we will assume that this normalization has • For this point,
been done pi* = Max [pi* + EDi (P*),0] for all i
67 68
17
Application of Brouwer’s A General Equilibrium with
Theorem Three Goods
• This says that P* is an equilibrium set of • The economy of Oz is composed only of
prices three precious metals: (1) silver, (2)
– for pi* > 0, gold, and (3) platinum
pi* = pi* + EDi (P*) – there are 10 (thousand) ounces of each
EDi (P*) = 0 metal available
– For pi* = 0,
• The demands for gold and platinum are
pi* + EDi (P*) 0
EDi (P*) 0 p2 p3 p2 p
D2 2 11 D3 2 3 18
69
p1 p1 p1 p1 70
18
A General Equilibrium with Smith’s Invisible Hand
Three Goods Hypothesis
• Because Walras’ law must hold, we know • Adam Smith believed that the
p1ED1 = – p2ED2 – p3ED3 competitive market system provided a
• Substituting the excess demand functions powerful “invisible hand” that ensured
for gold and silver and substituting, we get resources would find their way to where
they were most valued
p22 p2 p3 pp p2
p1ED1 2 p2 2 3 2 3 8 p3 • Reliance on the economic self-interest
p1 p1 p1 p1
of individuals and firms would result in a
p22 p2 p p desirable social outcome
ED1 2 2 32 2 8 3
p12
p1 p1 p1 73 74
19
Efficiency in Production Efficient Choice of Inputs for a
Single Firm
• An allocation of resources is efficient in
production (or “technically efficient”) if no • A single firm with fixed inputs of labor
further reallocation would permit more of and capital will have allocated these
one good to be produced without resources efficiently if they are fully
necessarily reducing the output of some employed and if the RTS between
other good capital and labor is the same for every
output the firm produces
• Technical efficiency is a precondition for
Pareto efficiency but does not guarantee
Pareto efficiency 77 78
20
Efficient Choice of Inputs for a Efficient Allocation of
Single Firm Resources among Firms
• From the first two conditions, we can see • Resources should be allocated to those
that firms where they can be most efficiently
fk g k
used
fl gl – the marginal physical product of any
• This implies that resource in the production of a particular
good should be the same across all firms
RTSx (k for l) = RTSy (k for l)
that produce the good
81 82
• Assume that the total supplies of capital • Substituting, the maximization problem
and labor are k’ and l’ becomes
x = f1(k1, l1) + f2(k’ - k1, l’ - l1)
83 84
21
Efficient Allocation of Efficient Allocation of
Resources among Firms Resources among Firms
• First-order conditions for a maximum • These first-order conditions can be
are rewritten as
x f f f f f1 f f1 f2
1 2 1 2 0 2
k1 k1 k1 k1 k 2 k1 k 2 l1 l2
22
Efficient Choice of Output Efficient Choice of Output
by Firms by Firms
Firm A is relatively efficient at producing cars, while Firm B If each firm was to specialize in its efficient product, total
is relatively efficient at producing trucks output could be increased
Cars Cars 1 Cars Cars 1
2 RPT 2 RPT
RPT 1 RPT 1
1 1
100 100 100 100
Theory of Comparative
Advantage Efficiency in Product Mix
• The theory of comparative advantage • Technical efficiency is not a sufficient
was first proposed by Ricardo condition for Pareto efficiency
– countries should specialize in producing – demand must also be brought into the
those goods of which they are relatively picture
more efficient producers • In order to ensure Pareto efficiency, we
• these countries should then trade with the rest
of the world to obtain needed commodities
must be able to tie individual’s
– if countries do specialize this way, total
preferences and production possibilities
world production will be greater together
91 92
23
Efficiency in Product Mix Efficiency in Product Mix
• The condition necessary to ensure that Output of y Suppose that we have a one-person (Robinson
Crusoe) economy and PP represents the
the right goods are produced is combinations of x and y that can be produced
P
MRS = RPT
– the psychological rate of trade-off between Any point on PP represents a
the two goods in people’s preferences must point of technical efficiency
be equal to the rate at which they can be
traded off in production
Output of x
P
93 94
Output of x
T(x,y) = 0
P
95 96
24
Efficiency in Product Mix Efficiency in Product Mix
• Crusoe’s problem is to maximize his • First-order conditions for an interior
utility subject to the production maximum are
constraint L U T
0
x x x
• Setting up the Lagrangian yields
L U T
L = U(x,y) + [T(x,y)] 0
y y y
L
T ( x, y ) 0
97
98
25
Competitive Prices and Efficiency in Production
Efficiency
• Because all agents face the same • In minimizing costs, a firm will equate
prices, all trade-off rates will be the RTS between any two inputs (k and
equalized and an efficient allocation will l) to the ratio of their competitive prices
be achieved (w/v)
– this is true for all outputs the firm produces
• This is the “First Theorem of Welfare
– RTS will be equal across all outputs
Economics”
101 102
103 104
26
Efficiency in Production Efficiency in Production
• Recall that the RPT (of x for y) is equal • Thus, the profit-maximizing decisions
to MCx /MCy of many firms can achieve technical
• In perfect competition, each profit- efficiency in production without any
maximizing firm will produce the output central direction
level for which marginal cost is equal to • Competitive market prices act as
price signals to unify the multitude of
• Since px = MCx and py = MCy for every decisions that firms make into one
firm, RTS = MCx /MCy = px /py coherent, efficient pattern
105 106
107 108
27
Departing from the
Laissez-Faire Policies Competitive Assumptions
• The correspondence between
competitive equilibrium and Pareto • The ability of competitive markets to
efficiency provides some support for the achieve efficiency may be impaired
laissez-faire position taken by many because of
economists – imperfect competition
– government intervention may only result in – externalities
a loss of Pareto efficiency – public goods
– imperfect information
109 110
28
Public Goods Imperfect Information
• Public goods have two properties that • If economic actors are uncertain about
make them unsuitable for production in prices or if markets cannot reach
markets equilibrium, there is no reason to expect
– they are nonrival that the efficiency property of
• additional people can consume the benefits of competitive pricing will be retained
these goods at zero cost
– they are nonexclusive
• extra individuals cannot be precluded from
consuming the good
113 114
Distribution Distribution
• Although the First Theorem of Welfare • Assume that there are only two people
Economics ensures that competitive in society (Smith and Jones)
markets will achieve efficient allocations, • The quantities of two goods (x and y) to
there are no guarantees that these be distributed among these two people
allocations will exhibit desirable are fixed in supply
distributions of welfare among individuals • We can use an Edgeworth box diagram
to show all possible allocations of these
goods between Smith and Jones
115 116
29
Distribution Distribution
OJ
UJ 1
US1
OS Total X
117 118
30
Contract Curve Exchange with Initial
UJ1
OJ
Endowments
UJ2
• Suppose that the two individuals
US4
possess different quantities of the two
UJ3
goods at the start
UJ4 US3 – it is possible that the two individuals could
both benefit from trade if the initial
US2 allocations were inefficient
A
US1
Contract curve
OS
121 122
A
USA
123 OS 124
31
Exchange with Initial Exchange with Initial
Endowments OJ
Endowments OJ
Neither individual would be Only allocations between M1
willing to accept a lower level and M2 will be acceptable to
of utility than A gives both
UJA UJA
M2
M1
A A
USA USA
OS 125 OS 126
32
Important Points to Note: Important Points to Note:
• Preferences and production • Competitive markets can establish
technologies provide the building equilibrium prices by making marginal
blocks upon which all general adjustments in prices in response to
equilibrium models are based information about the demand and
– one particularly simple version of such a supply for individual goods
model uses individual preferences for two – Walras’ law ties markets together so that
goods together with a concave production such a solution is assured (in most cases)
possibility frontier for those two goods
129 130
131 132
33
Important Points to Note:
• Competitive markets need not yield
equitable distributions of resources,
especially when initial endowments are
very skewed
– in theory any desired distribution can be
attained through competitive markets
accompanied by lump-sum transfers
• there are many practical problems in
implementing such transfers
133
34
Monopoly
1
Technical Barriers to Entry Legal Barriers to Entry
• Another technical basis of monopoly is • Many pure monopolies are created as a
special knowledge of a low-cost matter of law
productive technique – with a patent, the basic technology for a
– it may be difficult to keep this knowledge product is assigned to one firm
out of the hands of other firms – the government may also award a firm an
• Ownership of unique resources may exclusive franchise to serve a market
also be a lasting basis for maintaining a
monopoly
5 6
2
Profit Maximization Profit Maximization
• Since MR = MC at the profit-maximizing Price MC The monopolist will maximize
output and P > MR for a monopolist, the profits where MR = MC
9 10
where eQ,P is the elasticity of demand – the firm’s “markup” over marginal cost
depends inversely on the elasticity of market
for the entire market
demand
11 12
3
Monopoly Profits Monopoly Profits
• Monopoly profits will be positive as long • The size of monopoly profits in the long
as P > AC run will depend on the relationship
• Monopoly profits can continue into the between average costs and market
long run because entry is not possible demand for the product
– some economists refer to the profits that a
monopoly earns in the long run as
monopoly rents
• the return to the factor that forms the basis of
the monopoly
13 14
4
Monopoly with Linear Demand Monopoly with Linear Demand
• Suppose that the market for frisbees • To maximize profits, the monopolist
has a linear demand curve of the form chooses the output for which MR = MC
Q = 2,000 - 20P • We need to find total revenue
or TR = PQ = 100Q - Q2/20
P = 100 - Q/20 • Therefore, marginal revenue is
• The total costs of the frisbee producer MR = 100 - Q/10
are given by
while marginal cost is
C(Q) = 0.05Q2 + 10,000
MC = 0.01Q
17 18
19 20
5
Monopoly with Linear Demand Monopoly and Resource
Allocation
• The inverse elasticity rule specifies that • To evaluate the allocational effect of a
P MC 1 1 monopoly, we will use a perfectly
competitive, constant-cost industry as a
P eQ,P 3
basis of comparison
• Since P* = 75 and MC = 50, this – the industry’s long-run supply curve is
relationship holds infinitely elastic with a price equal to both
marginal and average cost
21 22
6
Welfare Losses and Elasticity Welfare Losses and Elasticity
• Assume that the constant marginal (and • The competitive price in this market will
average) costs for a monopolist are be
given by c and that the compensated Pc = c
demand curve has a constant elasticity:
and the monopoly price is given by
Q = Pe
where e is the price elasticity of demand c
Pm
(e < -1) 1
1
e
25 26
7
Welfare Losses and Elasticity Welfare Losses and Elasticity
• Taking the ratio of these two surplus • Monopoly profits are given by
measures yields
e 1 c
m PmQm cQm c Qm
CSm 1 1 1
CSc 1 1 e
e e e 1
c
• If e = -2, this ratio is ½ c c 1
m e
– consumer surplus under monopoly is half 1 1 1 1 1 1 e
what it is under perfect competition 29 e e e 30
8
Monopoly and Product Quality Monopoly and Product Quality
• Suppose that consumers’ willingness to • First-order conditions for a maximum are
pay for quality (X) is given by the inverse P
demand function P(Q,X) where P (Q, X ) Q CQ 0
Q Q
P/Q < 0 and P/X > 0
– MR = MC for output decisions
• If costs are given by C(Q,X), the P
monopoly will choose Q and X to Q CX 0
X X
maximize
– Marginal revenue from increasing quality by
= P(Q,X)Q - C(Q,X)
one unit is equal to the marginal cost of
33 making such an increase 34
9
Monopoly and Product Quality Price Discrimination
• A monopoly engages in price
• Even if a monopoly and a perfectly
discrimination if it is able to sell otherwise
competitive industry chose the same
identical units of output at different prices
output level, they might opt for diffferent
quality levels • Whether a price discrimination strategy is
– each is concerned with a different margin feasible depends on the inability of
in its decision making buyers to practice arbitrage
– profit-seeking middlemen will destroy any
discriminatory pricing scheme if possible
• price discrimination becomes possible if resale is
37 costly 38
Q2
10
Perfect Price Discrimination Perfect Price Discrimination
• Therefore,
• Recall the example of the frisbee
P = 100 - Q/20 = MC = 0.1Q
manufacturer
Q* = 666
• If this monopolist wishes to practice
perfect price discrimination, he will want • Total revenue and total costs will be
to produce the quantity for which the Q* Q2
666
11
Market Separation Market Separation
If two markets are separate, maximum profits occur by
• This implies that setting different prices in the two markets
Price
1
(1 ) The market with the less
Pi ej P1 elastic demand will be
Pj (1 1 ) charged the higher price
P2
ei
• The profit-maximizing price will be MC MC
12
Third-Degree Price Third-Degree Price
Discrimination Discrimination
• The allocational impact of this policy can be • If this monopoly was to pursue a single-
evaluated by calculating the deadweight price policy, it would use the demand
losses in the two markets function
– the competitive output would be 18 in market 1 Q = Q1 + Q2 = 48 – 3P
and 12 in market 2 • So marginal revenue would be
DW 1 = 0.5(P1-MC)(18-Q1) = 0.5(15-6)(18-9) = 40.5 MR = 16 – 2Q/3
DW 2 = 0.5(P2-MC)(12-Q2) = 0.5(9-6)(12-6) = 9 • Profit-maximization occurs where
49
Q = 15 P = 11 50
13
Two-Part Tariffs Two-Part Tariffs
• Because the average price paid by any • One feasible approach for profit
demander is maximization would be for the firm to set
p’ = T/q = a/q + p p = MC and then set a equal to the
this tariff is only feasible if those who consumer surplus of the least eager
pay low average prices (those for whom buyer
q is large) cannot resell the good to – this might not be the most profitable
approach
those who must pay high average
– in general, optimal pricing schedules will
prices (those for whom q is small)
depend on a variety of contingencies
53 54
14
Regulation of Monopoly Regulation of Monopoly
• Natural monopolies such as the utility, • Many economists believe that it is
communications, and transportation important for the prices of regulated
industries are highly regulated in many monopolies to reflect marginal costs of
countries production accurately
• An enforced policy of marginal cost
pricing will cause a natural monopoly to
operate at a loss
– natural monopolies exhibit declining
average costs over a wide range of output
57 58
An unregulated monopoly will Other users are offered the lower price
maximize profit at Q1 and P1 of P2
P1
If regulators force the The profits on the sales to high-
P1 price customers are enough to
monopoly to charge a
C1
C1 price of P2, the firm will cover the losses on the sales to
suffer a loss because low-price customers
C2 C2
AC
P2 < C2 AC
P2 MR MC P2 MC
Quantity Quantity
Q1 Q2 D Q1 Q2 D
59 60
15
Regulation of Monopoly Regulation of Monopoly
• Another approach followed in many • Suppose that a regulated utility has a
regulatory situations is to allow the production function of the form
monopoly to charge a price above q = f (k,l)
marginal cost that is sufficient to earn a
• The firm’s actual rate of return on
“fair” rate of return on investment
capital is defined as
– if this rate of return is greater than that
which would occur in a competitive market, pf (k, l ) wl
s
there is an incentive to use relatively more k
capital than would truly minimize costs
61 62
16
Regulation of Monopoly Regulation of Monopoly
• Therefore, 0<<1 and the first-order • Because s0>v and <1, this means that
conditions for a maximum are: pfk < v
L • The firm will hire more capital than it
pfl w (w pfl ) 0
l would under unregulated conditions
L – it will also achieve a lower marginal
pfk v (s0 pfk ) 0
k productivity of capital
L
wl s0 pf (k, l ) 0
65 66
17
Important Points to Note: Important Points to Note:
• Relative to perfect competition, • Monopolies may opt for different levels
monopoly involves a loss of consumer of quality than would perfectly
surplus for demanders competitive firms
– some of this is transferred into monopoly • Durable good monopolists may be
profits, whereas some of the loss in
constrained by markets for used goods
consumer surplus represents a
deadweight loss of overall economic
welfare
– it is a sign of Pareto inefficiency
69 70
71 72
18
Pricing Under
Homogeneous Oligopoly
• We will assume that the market is
Chapter 15 perfectly competitive on the demand side
TRADITIONAL MODELS OF – there are many buyers, each of whom is a
price taker
IMPERFECT COMPETITION
• We will assume that the good obeys the
law of one price
– this assumption will be relaxed when product
differentiation is discussed
Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2
1
Oligopoly Pricing Models Oligopoly Pricing Models
• The quasi-competitive model assumes • The Cournot model assumes that firm i
price-taking behavior by all firms treats firm j’s output as fixed in its
– P is treated as fixed
decisions
– qj/qi = 0
• The cartel model assumes that firms • The conjectural variations model
can collude perfectly in choosing assumes that firm j’s output will respond
industry output and P to variations in firm i’s output
– qj/qi 0
5 6
2
Cartel Model Cartel Model
• The assumption of price-taking behavior • In this case, the cartel acts as a
may be inappropriate in oligopolistic multiplant monopoly and chooses qi for
industries each firm so as to maximize total
– each firm can recognize that its output industry profits
decision will affect price = PQ – [C1(q1) + C2(q2) +…+ Cn(qn)]
• An alternative assumption would be that n
firms act as a group and coordinate their f (q1 q2 ... qn )[q1 q2 ... qn ] Ci (qi )
decisions so as to achieve monopoly i 1
profits
9 10
qi qi
• This implies that MC
MR(Q) = MCi(qi)
• At the profit-maximizing point, marginal D
MR
revenue will be equal to each firm’s QM
Quantity
marginal cost 11 12
3
Cartel Model Cournot Model
• There are three problems with the cartel • Each firm recognizes that its own
solution decisions about qi affect price
– these monopolistic decisions may be illegal – P/qi 0
– it requires that the directors of the cartel
• However, each firm believes that its
know the market demand function and
each firm’s marginal cost function decisions do not affect those of any
– the solution may be unstable other firm
• each firm has an incentive to expand output – qj /qi = 0 for all j i
because P > MCi
13 14
4
Cournot Model Cournot’s Natural Springs
Duopoly
• Price will exceed marginal cost, but • Assume that there are two owners of
industry profits will be lower than in the natural springs
cartel model – each firm has no production costs
• The greater the number of firms in the – each firm has to decide how much water
industry, the closer the equilibrium point to supply to the market
will be to the competitive result • The demand for spring water is given
by the linear demand function
Q = q1 + q2 = 120 - P
17 18
19 20
5
Cournot’s Natural Springs Cournot’s Natural Springs
Duopoly Duopoly
• The profit-maximizing output, price, and • The two firms’ revenues (and profits) are
level of profit are given by
Q = 60 1 = Pq1 = (120 - q1 - q2) q1 = 120q1 - q12 - q1q2
P = 60 2 = Pq2 = (120 - q1 - q2) q2 = 120q2 - q22 - q1q2
= 3,600 • First-order conditions for a maximum are
• The precise division of output and 1 2
profits is indeterminate 120 2q1 q2 0 120 2q2 q1 0
q1 q2
21 22
6
Conjectural Variations Model Conjectural Variations Model
• In markets with only a few firms, we can • For each firm i, we are concerned with
expect there to be strategic interaction the assumed value of qj /qi for ij
among firms – because the value will be speculative,
• One way to build strategic concerns into models based on various assumptions
about its value are termed conjectural
our model is to consider the
variations models
assumptions that might be made by one
• they are concerned with firm i’s conjectures
firm about the other firm’s behavior about firm j’s output variations
25 26
7
Price Leadership Model Price Leadership Model
We can derive the demand curve facing
D represents the market demand curve
Price Price the industry leader
SC SC
D D
Quantity Quantity
29 30
QL Quantity QC QL QT Quantity
31 32
8
Price Leadership Model Stackelberg Leadership Model
• This model does not explain how the • The assumption of a constant marginal
price leader is chosen or what happens cost makes the price leadership model
if a member of the fringe decides to inappropriate for Cournot’s natural
challenge the leader spring problem
• The model does illustrate one tractable – the competitive fringe would take the entire
example of the conjectural variations market by pricing at marginal cost (= 0)
model that may explain pricing behavior – there would be no room left in the market
in some instances for the price leader
33 34
9
Stackelberg Leadership Model Product Differentiation
• Solving this simultaneously with firm 2’s • Firms often devote considerable
reaction function, we get resources to differentiating their
q1 = 60 products from those of their competitors
q2 = 30 – quality and style variations
P = 120 – (q1 + q2) = 30 – warranties and guarantees
1 = Pq1 = 1,800 – special service features
2 = Pq2 = 900 – product advertising
• Again, there is no theory on how the
leader is chosen 37 38
10
Product Differentiation Product Differentiation
• We will assume that there are n firms • Because there are n firms competing in
competing in a particular product group the product group, we must allow for
– each firm can choose the amount it spends different market prices for each (p1,...,pn)
on attempting to differentiate its product • The demand facing the ith firm is
from its competitors (zi)
pi = g(qi,pj,zi,zj)
• The firm’s costs are now given by
total costs = Ci (qi,zi)
• Presumably, pi/qi 0, pi/pj 0,
pi/zi 0, and pi/zj 0
41 42
11
Product Differentiation Spatial Differentiation
• The demand curve facing any one firm • Suppose we are examining the case of
may shift often ice cream stands located on a beach
– it depends on the prices and product – assume that demanders are located
differentiation activities of its competitors uniformly along the beach
• one at each unit of beach
• The firm must make some assumptions • each buyer purchases exactly one ice cream
in order to make its decisions cone per period
• The firm must realize that its own actions – ice cream cones are costless to produce but
may influence its competitors’ actions carrying them back to one’s place on the
beach results in a cost of c per unit traveled
45 46
12
Spatial Differentiation Spatial Differentiation
• The coordinate of point E is
L
pB pA cy
a x y b
x
c
pB pA
a+x+y+b=L x Lab x
c
1 p pA
x L a b B
A E B 2 c
1 p pB
y L a b A
2 c
49 50
51 52
13
Spatial Differentiation Spatial Differentiation
• These can be solved to yield:
L
ab
pA c L a x y b
3
14
Entry Entry
• Whether firms in an oligopolistic • If firms are price takers:
industry with free entry will be directed – P = MR = MC for profit maximization, P =
to the point of minimum average cost AC for zero profits, so production takes
place at MC = AC
depends on the nature of the demand
facing them • If firms have some control over price:
– each firm will face a downward-sloping
demand curve
– entry may reduce profits to zero, but
production at minimum average cost is not
57 ensured 58
q’ q* qm Quantity ci = 9 + 4qi
59 60
15
Monopolistic Competition Monopolistic Competition
• Each firm also faces a demand curve • To find the equilibrium n, we must
for its product of the form: examine each firm’s profit-maximizing
303 choice of pi
qi 0.01(n 1)pi 0.01 p j
j i n • Because
• We will define an equilibrium for this i = piqi – ci
industry to be a situation in which prices the first-order condition for a maximum is
must be equal i 303
0.02(n 1)pi 0.01 p j 0.04(n 1) 0
– pi = pj for all i and j pi j i n
61 62
• Applying the equilibrium condition that pi • Substituting in the expression for pi, we
= pj yields find that
pi
30,300
4 30,300 303 4(303) 4(303)
9
(n 1)n n 2 (n 1) n n
• P approaches MC (4) as n gets larger 63
n 101 64
16
Monopolistic Competition Monopolistic Competition
• The final equilibrium is • If each firm faces a similar demand
pi = pj = 7 function, this equilibrium is sustainable
qi = 3 – no firm would find it profitable to enter this
i = 0 industry
• In this equilibrium, each firm has pi = ACi, • But what if a potential entrant adopted a
but pi > MCi = 4 large-scale production plan?
• Because ACi = 4 + 9/qi, each firm has – the low average cost may give the potential
entrant considerable leeway in pricing so as
diminishing AC throughout all output to tempt customers of existing firms to
ranges 65 switch allegiances 66
17
Perfectly Contestable Market Perfectly Contestable Market
This market would be unsustainable
in a perfectly contestable market
• Therefore, to be perfectly contestable,
Price MC
Because P > MC, a the market must be such that firms earn
AC potential entrant can take zero profits and price at marginal costs
one zero-profit firm’s
P* market away and – firms will produce at minimum average cost
encroach a bit on other – P = AC = MC
P’
firms’ markets where, at
the margin, profits are • Perfect contestability guides market
d
attainable equilibrium to a competitive-type result
mr’ mr d’
q’ q* q’ Quantity
69 70
n = Q*/q*
D
– this number may be relatively small (unlike
Quantity
the perfectly competitive case) q* 2q* 3q* Q*=4q*
71 72
18
Barriers to Entry Barriers to Entry
• If barriers to entry prevent free entry and • The completely flexible type of hit-and-
exit, the results of this model must be run behavior assumed in the contestable
modified markets theory may be subject to barriers
– barriers to entry can be the same as those to entry
that lead to monopolies or can be the result – some types of capital investments may not
of some of the features of oligopolistic be reversible
markets – demanders may not respond to price
• product differentiation differentials quickly
• strategic pricing decisions
73 74
19
A Contestable Natural A Contestable Natural
Monopoly Monopoly
• If there are no entry barriers, a potential • If electricity production is fully
entrant can offer electricity customers a contestable, the only price viable under
lower price and still cover costs threat of potential entry is average cost
– this monopoly solution might not represent Q = 1,000 - 5P = 1,000 – 5(AC)
a viable equilibrium
Q = 1,000 - 5[100 + (8,000/Q)]
Q2 - 500Q + 40,000 = 0
(Q - 400)(Q - 100) = 0
77 78
20
Important Points to Note: Important Points to Note:
• In markets with few firms, output and • The Cournot model provides a
price decisions are interdependent tractable approach to oligopoly
– each firm must consider its rivals’ markets, but neglects important
decisions strategic issues
– modeling such interdependence is
difficult because of the need to consider
conjectural variations
81 82
83 84
21
Allocation of Time
• Individuals must decide how to allocate
Chapter 16 the fixed amount of time they have
• We will initially assume that there are
LABOR MARKETS only two uses of an individual’s time
– engaging in market work at a real wage
rate of w
– leisure (nonwork)
1
Utility Maximization Utility Maximization
• The individual’s problem is to maximize • Dividing the two, we get
utility subject to the full income constraint
U / c
• Setting up the Lagrangian w MRS (h for c )
U / h
L = U(c,h) + (24w – c – wh)
• To maximize utility, the individual should
• The first-order conditions are choose to work that number of hours for
L/c = U/c - = 0 which the MRS (of h for c) is equal to w
L/h = U/h - = 0 – to be a true maximum, the MRS (of h for c)
must be diminishing
5 6
2
Income and A Mathematical Analysis
Consumption Substitution Effects of Labor Supply
The substitution effect is the movement
from point A to point C • We will start by amending the budget
The income effect is the movement constraint to allow for the possibility of
from point C to point B nonlabor income
B The individual c = wl + n
C
A chooses more
U2
leisure as a result • Maximization of utility subject to this
U1
of the increase in constraint yields identical results
w
Leisure
– as long as n is unaffected by the labor-
leisure choice
substitution effect < income effect 9 10
3
Dual Statement of the Problem Dual Statement of the Problem
• A small change in w will change the • This means that a labor supply
minimum expenditures required by function can be calculated by partially
E/w = -l differentiating the expenditure function
– this is the extent to which labor earnings – because utility is held constant, this
are increased by the wage change function should be interpreted as a
“compensated” (constant utility) labor
supply function
lc(w,U)
13 14
4
Cobb-Douglas Labor Supply Cobb-Douglas Labor Supply
• Suppose that utility is of the form • The Lagrangian expression for utility
maximization is
U c h
L = ch + (w + n - wh - c)
• The budget constraint is
• First-order conditions are
c = wl + n
L/c = c-h - = 0
and the time constraint is
L/h = ch- - w = 0
l+h=1
– note that we have set maximum work time L/ = w + n - wh - c = 0
to 1 hour for convenience 17 18
5
Cobb-Douglas Labor Supply Cobb-Douglas Labor Supply
21 22
6
CES Labor Supply Market Supply Curve for Labor
To derive the market supply curve for labor, we sum
• Solving for leisure gives the quantities of labor offered at every wage
w n
h Individual A’s
w w 1 w supply curve w Individual B’s w
sA supply curve Total labor S
and sB supply curve
w*
w 1 n
l(w, n ) 1 h
w w 1
lA* l lB* l l* l
lA* + lB* = l*
25 26
l l l
7
Labor Market Equilibrium Mandated Benefits
At w*, the quantity of labor demanded is
equal to the quantity of labor supplied • A number of new laws have mandated
real wage
At any wage above w*, the quantity
that employers provide special benefits
S
of labor demanded will be less to their workers
than the quantity of labor supplied – health insurance
At any wage below w*, the quantity – paid time off
w*
of labor demanded will be greater – minimum severance packages
than the quantity of labor supplied
D
• The effects of these mandates depend
l* quantity of labor on how much the employee values the
29 benefit 30
8
Mandated Benefits Mandated Benefits
• Equilibrium in the labor market then • If workers derive no value from the
requires that mandated benefits (k = 0), the mandate
a + b(w + k) = c – d(w + t) is just like a tax on employment
• This means that the net wage is – similar results will occur as long as k < t
c a bk dt bk dt • If k = t, the new wage falls precisely by
w ** w * the amount of the cost and the
bd bd bd
equilibrium level of employment does not
change
33 34
35 36
9
Wage Variation Wage Variation
• Human Capital • Compensating Differentials
– differences in human capital translate into – individuals prefer some jobs to others
differences in worker productivities – desirable job characteristics may make a
– workers with greater productivities would be person willing to take a job that pays less
expected to earn higher wages than others
– while the investment in human capital is – jobs that are unpleasant or dangerous will
similar to that in physical capital, there are require higher wages to attract workers
two differences – these differences in wages are termed
• investments are sunk costs compensating differentials
• opportunity costs are related to past investments
37 38
10
Monopsony in the Monopsony in the
Labor Market Labor Market
Note that the quantity of
• If the total cost of labor is wl, then Wage
MEl
labor demanded by this
firm falls short of the
wl w level that would be hired
MEl w l S
in a competitive labor
l l market (l*)
• In the competitive case, w/l = 0 and w*
The wage paid by the
MEl = w w1 firm will also be lower
than the competitive
• If w/l > 0, MEl > w D
level (w*)
Labor
l1 l*
41 42
11
Labor Unions Labor Unions
• If association with a union was wholly • We will assume that the goals of the
voluntary, we can assume that every union are representative of the goals of
member derives a positive benefit its members
• With compulsory membership, we • In some ways, we can use a monopoly
cannot make the same claim model to examine unions
– even if workers would benefit from the – the union faces a demand curve for labor
union, they may choose to be “free riders” – as the sole supplier, it can choose at which
point it will operate
• this point depends on the union’s goals
45 46
12
Labor Unions Modeling a Union
The union may wish to maximize the total
Wage
employment of its members • A monopsonistic hirer of coal miners
This occurs where faces a supply curve of
S D=S l = 50w
l3 workers will be
w3
hired and paid a
• Assume that the monopsony has a
wage of w3 MRPL curve of the form
D MRPl = 70 – 0.1l
MR
Labor • The monopsonist will choose to hire 500
l3
workers at a wage of $10
49 50
51 52
13
A Union Bargaining Model A Union Bargaining Model
• This two-stage game can be solved by • Assuming that l* solves the firm’s
backward induction problem, the union’s goal is to choose w
• The firm’s second-stage problem is to to maximize utility
maximize its profits: U(w,l) = U[w,l*(w)]
= R(l) – wl and the first-order condition for a
• The first-order condition for a maximum is maximum is
U1 + U2l’ = 0
R’(l) = w
U1/U2 = l’
53 54
55 56
14
Important Points to Note: Important Points to Note:
• An increase in the real wage rate • A competitive labor market will
creates income and substitution establish an equilibrium real wage
effects that operate in different rate at which the quantity of labor
directions in affecting the quantity of supplied by individuals is equal to the
labor supplied quantity demanded by firms
– this result can be summarized by a
Slutsky-type equation much like the
one already derived in consumer
theory
57 58
59 60
15
Properties of Information
• Information is not easy to define
Chapter 18 – it is difficult to measure the quantity of
information obtainable from different
THE ECONOMICS OF actions
INFORMATION – there are too many forms of useful
information to permit the standard price-
quantity characterization used in supply
and demand analysis
1
The Value of Information The Value of Information
• Assume an individual forms subjective • Assume that information can be
opinions about the probabilities of two measured by the number of “messages”
states of the world (m) purchased
– “good times” (probability = g) and “bad – g and b will be functions of m
times” (probability = b)
• Information is valuable because it helps
the individual revise his estimates of
these probabilities
5 6
2
The Value of Information The Value of Information
• First-order conditions for a constrained
maximum are: • The first two equations show that the
individual will maximize utility at a point
L dWg dWb where the subjective ratio of expected
gU ' (Wg ) bU ' (Wb )
m dm dm marginal utilities is equal to the price
d g d b dWg ratio (pg /pb)
U (Wg ) U (Wb ) pg
dm dm dm • The last equation shows the utility-
dWb
pb pm 0 maximizing level of information to buy
dm
9 10
3
Moral Hazard Moral Hazard
• Moral hazard is the effect of insurance • Suppose a risk-averse individual faces
coverage on individuals’ decisions to the risk of a loss (l) that will lower
take activities that may change the wealth
likelihood or size of losses – the probability of a loss is
– parking an insured car in an unsafe area – this probability can be lowered by the
– choosing not to install a sprinkler system in amount the person spends on preventive
an insured home measures (a)
13 14
4
Behavior with Insurance Behavior with Insurance
and Perfect Monitoring and Perfect Monitoring
• Suppose that the individual may purchase • The person can maximize expected utility
insurance (premium = p) that pays x if a by choosing x such that W 1 = W 2
loss occurs • The first-order condition is
• Wealth in each state becomes
E
W1 = W 0 - a - p (1 )U ' (W1 )1 l U (W1 )
a a a
W2 = W 0 - a - p - l + x
• A fair premium would be equal to U ' (W2 )1 l U (W2 ) 0
a a
p = x 17 18
5
Moral Hazard Adverse Selection
• In the simplest case, the insurer might set • Individuals may have different probabilities
a premium based on the average of experiencing a loss
probability of loss experienced by some • If individuals know the probabilities more
group of people accurately than insurers, insurance
– no variation in premiums allowed for specific markets may not function properly
precautionary activities
– it will be difficult for insurers to set premiums
• each individual would have an incentive to reduce
his level of precautionary activities
based on accurate measures of expected loss
21 22
W* W1 W* W1
23 24
6
Adverse Selection Adverse Selection
The lines show the market opportunities for each • If insurers have imperfect information
person to trade W 1 for W2 by buying fair insurance
W2 about which individuals fall into low- and
certainty line
high-risk categories, this solution is
F
slope
(1 l ) unstable
l
G – point F provides more wealth in both states
The low-risk person will
W*- l E
– high-risk individuals will want to buy
maximize utility at point
slope
(1 H )
F, while the high-risk insurance that is intended for low-risk
H
person will choose G individuals
W* W1 – insurers will lose money on each policy sold
25 26
W* W1 W* W1
27 28
7
Adverse Selection Adverse Selection
Suppose that insurers offer policy G. High-risk
individuals will opt for full insurance.
• If a market has asymmetric information,
W2
the equilibria must be separated in certainty line
Insurers cannot offer
some way F
any policy that lies
– high-risk individuals must have an above UH because
UH
incentive to purchase one type of G they cannot prevent
insurance, while low-risk purchase another W*- l E
high-risk individuals
from taking advantage
of it
W* W1
29 30
8
Adverse Selection The Principal-Agent
Relationship
• Market signals can be drawn from a
number of sources • One important way in which asymmetric
– the economic behavior must accurately information may affect the allocation of
reflect risk categories resources is when one person hires
– the costs to individuals of taking the another person to make decisions
signaling action must be related to the – patients hiring physicians
probability of loss – investors hiring financial advisors
– car owners hiring mechanics
– stockholders hiring managers
33 34
9
The Principal-Agent The Principal-Agent
Relationship Relationship
Profits Profits
If the manager is also the The owner-manager maximizes
owner of the firm, he will profit because any other owner-
maximize his utility at manager will also want b* in
profits of * and benefits of benefits
b*
* * b* represents a true
cost of doing business
U1 U1
Owner’s constraint Owner’s constraint
Benefits Benefits
b* b*
37 38
10
The Principal-Agent The Principal-Agent
Relationship Relationship
Profits
Given the manager’s budget
• The firm’s owners are harmed by having
constraint, he will maximize
utility at benefits of b** to rely on an agency relationship with
Agent’s constraint
the firm’s manager
*
Profits for the • The smaller the fraction of the firm that
**
U2 firm will be *** is owned by the manager, the greater
***
U1
the distortions that will be induced by
Owner’s constraint
Benefits
this relationship
b* b**
41 42
11
Using the Corporate Jet Using the Corporate Jet
• Because jet use is expensive, = 800 • If the directors find it difficult to monitor
(thousand) if j =0 and = 162 if j =1 the CEO’s jet usage, this could mean
– the directors will be willing to pay the new that the firm ends up with < 0
CEO up to 638 providing that they can • The owner’s may therefore want to
guarantee that he will not use the
create a contract where the
corporate jet for personal use
compensation of the new CEO is tied to
– a salary of more than 400 will just be
profit
sufficient to get a potential candidate to
accept the job without jet usage
45 46
12
The Owner-Manager The Owner-Manager
Relationship Relationship
• One option would be to pay no • The manager will choose a* and receive
compensation unless the manager an income that just covers costs
chooses a* and to pay an amount equal to IM = s(a*) – c(a*) – c0 = (a*) – f – c(a*) – c0 = 0
c(a*) + c0 if a* is chosen
• This compensation plan makes the agent
• Another possible scheme is s(a) = (a) – f, the “residual claimant” to the firm’s profits
where f = (a) – c(a*) – c0
– with this compensation package, the
manager’s income is maximized by setting
s(a)/a = /a = 0 49 50
13
Hidden Action Hidden Information
• Because owners observe only and not • When the principal does not know the
’, they can only use actual profits in their incentive structure of the agent, the
compensation function incentive scheme must be designed
– a risk averse manager will be concerned that using some initial assumptions about the
actual profits will turn out badly and may agent’s motivation
decline the job – will be adapted as new information becomes
• The owner might need to design a available
compensation scheme that allows for
profit-sharing
53 54
55 56
14
Important Points to Note: Important Points to Note:
• The presence of asymmetric • If insurers are unable to monitor the
information may affect a variety of behavior of insured individuals
market outcomes, many of which are accurately, moral hazard may arise
illustrated in the context of insurance – being insured will affect the willingness to
theory make precautionary expenditures
– insurers may have less information – such behavioral effects can arise in any
about potential risks than do insurance contractual situation in which monitoring
purchasers costs are high
57 58
15
Externality
• An externality occurs whenever the
Chapter 19 activities of one economic agent affect
the activities of another economic agent
EXTERNALITIES AND in ways that are not reflected in market
PUBLIC GOODS transactions
– chemical manufacturers releasing toxic
fumes
– noise from airplanes
– motorists littering roadways
Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. 1 2
1
Externalities in Utility Public Goods Externalities
• Externalities can also occur if the • Public goods are nonexclusive
activities of an economic agent directly – once they are produced, they provide
affect an individual’s utility benefits to an entire group
– externalities can decrease or increase – it is impossible to restrict these benefits to
utility the specific groups of individuals who pay
• It is also possible for someone’s utility to for them
be dependent on the utility of another
utility = US(x1,…,xn;UJ)
5 6
2
Externalities and Allocative Externalities and Allocative
Inefficiency Inefficiency
• Assume that good x is produced using • For example, y could be produced
only good y according to downriver from x and thus firm y must
xo = f(yi) cope with any pollution that production of
• Assume that the output of good y x creates
depends on both the amount of x used in • This implies that g1 > 0 and g2 < 0
the production process and the amount
of x produced
yo = g(xi,xo)
9 10
11 12
3
Finding the Efficient Allocation Finding the Efficient Allocation
• The six first-order conditions are • Taking the ratio of the first two, we find
L/xc = U1 + 3 = 0 MRS = U1/U2 = 3/4
• The third and sixth equation also imply
L/yc = U2 + 4 = 0
that
L/xi = 2g1 + 3 = 0 MRS = 3/4 = 2g1/2 = g1
L/yi = 1fy + 4 = 0 • Optimality in y production requires that
L/xo = -1 + 2g2 - 3 = 0
the individual’s MRS in consumption
equals the marginal productivity of x in
L/yo = -2 - 4 = 0 13 the production of y 14
4
Inefficiency of the Inefficiency of the
Competitive Allocation Competitive Allocation
• Reliance on competitive pricing will result • But the producer of x would choose y
in an inefficient allocation of resources input so that
• A utility-maximizing individual will opt for Py = Pxfy
MRS = Px/Py Px/Py = 1/fy
and the profit-maximizing producer of y • This means that the producer of x would
would choose x input according to disregard the externality that its
Px = Pyg1 production poses for y and will
17
overproduce x 18
5
Production Externalities Production Externalities
• Assuming that newsprint sells for $1 per
foot and workers earn $50 per day, firm • When firm x does have a negative
x will maximize profits by setting this externality ( < 0), its profit-maximizing
wage equal to the labor’s marginal decision will be unaffected (lx* = 400
product and x* = 40,000)
x • But the marginal product of labor will be
50 p 1,000lx0.5
lx lower in firm y because of the externality
• lx* = 400
• If = 0 (no externalities), ly* = 400 21 22
6
Production Externalities Production Externalities
• Total output increased with no change • If firm x was to hire one more worker, its
in total labor input own output would rise to
• The earlier market-based allocation x = 2,000(401)0.5 = 40,050
was inefficient because firm x did not – the private marginal value product of the
take into account the effect of its hiring 401st worker is equal to the wage
decisions on firm y • But, increasing the output of x causes
the output of y to fall (by about 21 units)
• The social marginal value product of the
25
additional worker is only $29 26
7
Solutions to the A Pigouvian Tax on Newsprint
Externality Problem
Price MC’
A tax equal to these • A suitably chosen tax on firm x can
additional marginal cause it to reduce its hiring to a level at
S = MC costs will reduce
output to the socially which the externality vanishes
p2
optimal level (x2) • Because the river can handle pollutants
tax The price paid for the with an output of x = 38,000, we might
good (p2) now consider a tax that encourages the firm
reflects all costs to produce at that level
D
Quantity of x
x2
29 30
8
Taxation in the General Taxation in the General
Equilibrium Model Equilibrium Model
• With the optimal tax, firm x now faces a • The Pigouvian tax scheme requires that
net price of (px - t) and will choose y regulators have enough information to
input according to set the tax properly
py = (px - t)fy – in this case, they would need to know firm
y’s production function
• The resulting allocation of resources will
achieve
MRS = px/py = (1/fy) + t/py = (1/fy) - g2
33 34
9
Pollution Rights The Coase Theorem
• The first-order condition for a maximum • The key feature of the pollution rights
is equilibrium is that the rights are well-
y/xo = pyg2 + r = 0
defined and tradable with zero
r = -pyg2 transactions costs
• The equilibrium solution is identical to • The initial assignment of rights is
that for the Pigouvian tax irrelevant
– from firm x’s point of view, it makes no – subsequent trading will always achieve the
difference whether it pays the fee to the same, efficient equilibrium
government or to firm y 37 38
39 40
10
The Coase Theorem Attributes of Public Goods
• The independence of initial rights • A good is exclusive if it is relatively easy
assignment is usually referred to as the to exclude individuals from benefiting
Coase Theorem from the good once it is produced
– in the absence of impediments to making
• A good is nonexclusive if it is
bargains, all mutually beneficial
transactions will be completed impossible, or very costly, to exclude
– if transactions costs are involved or if individuals from benefiting from the
information is asymmetric, initial rights good
assignments will matter
41 42
11
Public Good Public Goods and
Resource Allocation
• A good is a pure public good if, once • We will use a simple general equilibrium
produced, no one can be excluded from model with two individuals (A and B)
benefiting from its availability and if the • There are only two goods
good is nonrival -- the marginal cost of – good y is an ordinary private good
an additional consumer is zero • each person begins with an allocation (yA* and
yB*)
– good x is a public good that is produced
using y
x = f(ysA + ysB)
45 46
12
Public Goods and Public Goods and
Resource Allocation Resource Allocation
• The first-order conditions for a maximum • We can now derive the optimality
are condition for the production of x
L/ysA = U1Af’ - U2A + U1Bf’ = 0 • From the initial first-order condition we
know that
L/ysB = U1Af’ - U2B + U1Bf’ = 0
U1A/U2A + U1B/U2B = 1/f’
• Comparing the two equations, we find
MRSA + MRSB = 1/f’
U2B = U2A
• The MRS must reflect all consumers
49
because all will get the same benefits 50
Failure of a Failure of a
Competitive Market Competitive Market
• Production of x and y in competitive • For public goods, the value of producing
markets will fail to achieve this allocation one more unit is the sum of each
– with perfectly competitive prices px and py, consumer’s valuation of that output
each individual will equate his MRS to px/py – individual demand curves should be added
– the producer will also set 1/f’ equal to px/py vertically rather than horizontally
to maximize profits • Thus, the usual market demand curve
– the price ratio px/py will be too low will not reflect the full marginal valuation
• it would provide too little incentive to produce x
51 52
13
Inefficiency of a Inefficiency of a
Nash Equilibrium Nash Equilibrium
• Suppose that individual A is thinking • The first-order condition for a maximum
about contributing sA of his initial y is
endowment to the production of x U1Af’ - U2A = 0
• The utility maximization problem for A is U1A/U2A = MRSA = 1/f’
then • Because a similar argument can be
choose sA to maximize UA[f(sA + sB),yA - sA] applied to B, the efficiency condition will
fail to be achieved
– each person considers only his own benefit
53 54
14
The Roommates’ Dilemma The Roommates’ Dilemma
• If person 1 believes that person 2 will • We can show that this solution is
not buy any paintings, he could choose inefficient by calculating each person’s
to purchase one and receive utility of MRS
U1(x,y1) = 11/3(1,000)2/3 = 100 U i / x y
MRSi i
while person 2’s utility will be U i / y i 2 x
U2(x,y2) = 11/3(1,500)2/3 = 131 • At the allocations described,
• Person 2 has gained from his free-riding MRS1 = 1,000/2 = 500
position MRS2 = 1,500/2 = 750
57 58
15
The Roommates’ Dilemma Lindahl Pricing of
Public Goods
• Substituting into the budget constraint, • Swedish economist E. Lindahl
we get suggested that individuals might be
0.20(y1 + y2) + 100x = 600 willing to be taxed for public goods if they
x=2 knew that others were being taxed
y1 + y2 = 2,000 – Lindahl assumed that each individual would
• The allocation of the cost of the be presented by the government with the
proportion of a public good’s cost he was
paintings depends on how each expected to pay and then reply with the
roommate plays the strategic financing level of public good he would prefer
game 61 62
16
Lindahl Pricing of Shortcomings of the
Public Goods Lindahl Solution
• An equilibrium would occur when • The incentive to be a free rider is very
A+B = 1 strong
– the level of public goods expenditure – this makes it difficult to envision how the
favored by the two individuals precisely information necessary to compute
generates enough tax contributions to pay equilibrium Lindahl shares might be
for it computed
MRSA + MRSB = (A + B)/f’ = 1/f’ • individuals have a clear incentive to understate
their true preferences
65 66
67 68
17
Important Points to Note: Important Points to Note:
• Public goods provide benefits to • Private markets will tend to
individuals on a nonexclusive basis - underallocate resources to public
no one can be prevented from goods because no single buyer can
consuming such goods appropriate all of the benefits that
– such goods are usually nonrival in that such goods provide
the marginal cost of serving another
user is zero
69 70
71
18