ppd 503

Indifference curves

All same points on the indifference curve are equal, and points about it is better and any points below the curve is worse

Short-run production

Per extra uinit of labor added, how much more outcome do you get

1 - Prices and Markets

Positive vs. normative analysis • What is a market? • Supply and demand • Market equilibrium • Elasticity

Implications of non-satiation

Each letter is a bundle. Any bundle in the pink box is preferred to A A cannot be compared to the remaining bundles without additional information (more of one good, less if the other)

Example - multiple shifts

Now, suppose that instead both supply and demand increase, to QD = 14 - P and QS = 5 + 3P, respectively. How will the equilibrium price and quantity change relative to the original equilibrium? • QD = 14 - P, QS = 5 + 3P 14 - P = 5 + 3P 9 = 4P P* = 2.25, Q* = 11.75 • Initially had P* = 2 and Q* = 10. Quantity increased (as expected), and price increased (indicating that the change in demand had the dominant effect on price)

Putting supply and demand together

Once reach equilibrium, the price will stay constant unless something happens in the market

The supply and demand model

Used to explain how outcomes are determined in perfectly competitive markets • Not appropriate for analysis of other market structures Firms can only accurately be described as having "supply curves" if they're perfectly competitive

Short-run production

When average goed up, marginal is above average When average goes down, margincal is below average

Example: opportunity cost

You are thinking of driving to San Diego to spend next Saturday with your cousin. You purchased your car two years ago for $25,000 (sunk cost). Your monthly insurance payment on the car is $90 (fixed cost). If you do not go, you will spend the whole day working at the USC bookstore, where you earn $100 per day (implicit). The trip will require you to spend $40 on gas (explicit), and will cause your car's value to fall by $30 (implicit). What is the opportunity cost of this trip? $100 (implicit) + $40 (explicit) + $30 (implicit) = $170

Completely inelastic demand

insulin/necessities

Consumer choice

• A consumer achieves maximum well-being by choosing the consumption bundle that gives the highest level of utility that is attainable within the budget constraint they face

Example - consumer choice

• A consumer has $240 to spend on movies (which cost $15) and concerts (which cost $30) • What can we say about the optimal bundle of movies and concerts for this consumer? It will fall on the budget line described by 15QM+30QC = 240 (the consumers will fully utilize their resources) The indifference curve through this point will be tangent on the budget line. Since the price of counters is twice the price of movies, the MRS of the concert for movies will be 2 at this point (equivalently: the MRS of movies for concerts will be 1/2); on the margin, the consumer will value one concert at much at 2 movies

Budget constraint

• A consumer's budget constraint refers to the combinations of goods and services that the consumer can afford • The budget constraint is determined by the consumer's income and by the prices of goods and services

Income and substitution effects

• A decrease in the price of a good has two effects on consumption: 1. Consumers respond to the change in relative prices (one good has become relatively less expensive and the other has become relatively more expensive) 2. Consumers respond to an increase in purchasing power, as the price reduction makes the original bundle less expensive

Production costs - example

• A firm owns its office building and pays no rent for office space; does this mean that the cost of office space is zero for this firm? No, the building could have been rented out instead, this forgone resent is the opportunity cost of using the building as an office, and should be included in the economic cost of doing business • A person starts a business and does not pay herself a salary; does this mean that the cost of the owner's labor is zero? Nom she could havee worked elsewhere and earned a salary instead, the firegine salary is the opportunity cost of using the owenres time (assuming that working elsewhere is her best alternative), and should be included in the economic costs of doing business A firm is planning to move its headquarters, and has paid $500,000 for the option to buy a particular building • The price of the building is an additional $5 million (for a total expenditure of $5.5 million) • Suppose the firm finds an identical building priced at $5.25 million; which should it buy? The firm sould buy the first building, as the 500k is a sunk cost - it has already been paid and cannot be recovreed and should be ignored The decision faced now is weather to spend an additional 5 mil or an additional 5.25 mil

Shifts in demand

• A given demand curve shows how quantity demanded corresponds to price, holding constant all other factors A change in one of these other factors might shift the demand curve • What else might demand for a good depend on besides the price at which it sells? Income Normal good (+) Inferior good (-), when income increases, decrease in buying a certain product (top ramen) Prices of related goods Substitute (+), serve as replacement or alternative, if alt price goes up,demand for alternate goes up Complement (-), price of one goes up, demand for both falls (pb&j) Tastes/preferences Expected future price (+), i expert price to be higher for good in future makes me more inclined to buy it now then demands goes up then price goes up + (-) indicates a positive (negative) relationship with the market demand curve

Shifts in supply

• A given supply curve shows how quantity supplied corresponds to price, holding constant all other factors • A change in one of these other factors might shift the supply curve • What else might the supply of a good depend on besides the price at which it sells? Input prices (-): Labor, capital, etc. Prices of alternatives (-): Alternative goods, or same good in a different market Technology (+) Expected future price (-) + (-) indicates a positive (negative) relationship with the market supply curve

Long-run production

• All inputs are variable in the long run, so firms must determine the optimal combination of capital and labor to produce a given quantity • Information about the production function can be represented graphically using isoquants, curves showing all combinations of inputs that lead to the same level of output • Does this sound like something else we've seen? - analogous to consumers indifference curve

Indifference curves

• An indifference curve represents all bundles that give the consumer the same level of satisfaction/well-being ("utility") We know that G is worse than A and E, so going the opposite way is a trade-off that cancels each other out.

Individual demand

• An individual's demand curve for a good shows the relationship between the price of the good and the quantity demanded by that individual • We can obtain an individual's demand curve by varying the price of the good (holding other factors constant) and seeing what happens to the optimal consumption choice

Interpreting price elasticity values

• As P and Q are negatively related, Ep is negative • It is often written as a positive number, with the implicit assumption being that it is referring to the magnitude of the (actually negative) price elasticity • If |Ep | is greater than 1, the percentage change in quantity is larger than the percentage change in price; we then say that demand is price elastic • If |Ep | is less than 1, the percentage change in quantity is smaller than the percentage change in price; we then say that demand is price inelastic

Market demand

• At any price, the quantity demanded by the market is the total quantity demanded by all individual consumers • The market demand curve is the horizontal sum of all individual demand curves (at each P, the sum of individual Q) • The vertical sum (at each Q, the sum of individual P) is something very different - this will come up later in the course when we discuss public goods

Solving the consumer choice problem

• At the optimal bundle, the indifference curve and the budget line are tangent (touch but don't cross, and have the same slope) • The slope of the budget line is -PF / PC • The slope of the indifference curve is -MRS • Since the optimal bundle must also be on the budget line, QF and QC satisfy two conditions: 𝑃𝐹𝑄𝐹 + 𝑃𝐶𝑄𝐶 = 𝐼 𝑀𝑅𝑆𝐹𝐶 = 𝑃𝐹 /𝑃C

Consumer behavior

• Basic question faced by consumers: what bundle of goods and services will I consume? • A bundle (or market basket) is a collection of one or more commodities (goods/services) • Consumer choice problem has two basic elements: preferences and budget

Competitive vs. noncompetitive markets

• Competitive markets: Large number of buyers and sellers; no individual buyer or seller can influence the price Perfectly competitive markets • Noncompetitive markets: Individual buyers or sellers can influence the price imperfectly competitive markets

2 - Consumer Behavior

• Foundational principles of economic analysis • Opportunity cost • Marginal analysis • Consumer behavior • Preferences • Budget constraints • Choices • Individual demand • Market demand

Market equilibrium: mathematical example

• If QD = 20 - 2P and QS = P - 1, what is the market equilibrium? • In an equilibrium, we must have QS = QD , which gives: 20 - 2P = P - 1 21 = 3P P* = 7 • Finally, substituting P* into the equation for either supply or demand gives Q* = 6 Error-checking tip: Substitute P* into both equations; if you have P* wrong, they'll give you different answers

Market equilibrium: more practice

• If QD = 300 - 6P and QS = 50 + 4P, what is the market equilibrium? Set QD=QS, solve for P Plug P in to both equations to check work

The market mechanism

• In a free market, prices adjust until the market "clears" (Q supplied equals Q demanded) • Characteristics of the equilibrium: QD = QS No surplus (excess supply; QS > QD ) No shortage (excess demand; QD > QS ) • A single price is determined, with no pressure on the price to change

Law of diminishing marginal returns

• In general, the marginal product of labor eventually begins to decline once the total amount of labor becomes sufficiently high • Important clarifications: • This does not mean that output decreases, just that each additional unit of labor increases it by a smaller amount • This result holds for a fixed level of technology and of all other inputs (not necessarily true when other inputs are also increased) • This is not a statement about worker quality; it is a statement about the production process for different numbers of equally capable workers • At low levels of labor input, MPL often increases as L increases (due to, for example, specialization) • Other inputs also exhibit diminishing marginal returns at sufficiently high levels of utilization

Short run vs. long run

• In practice, firms may not be able to change their input mix instantaneously • The short run is the period of time in which the level of one or more inputs cannot be changed • Fixed input: one whose quantity cannot be changed • Variable input: one whose quantity can be changed • We will think of capital as fixed, labor as variable (fairly typical) • The long run is the time period over which all of a firm's inputs can be changed (none are fixed) • The short run does not correspond to a specific amount of time in general (it depends on the production process) • E.g., capital may be adjustable fairly quickly in some cases, but not in others; short run may be a few days, several months, etc.

Production, costs, and profit maximization

• In the next couple of weeks, we turn our attention to the supply side of the market • We will answer questions such as: • How can producers determine the best combination of inputs to create a given level of output? • What does efficiency mean for producers? • How do producers determine what quantity of output to produce and what price to charge? • Where does the market supply curve come from?

Income effect

• Income effect: as the price of a good falls, the consumer's purchasing power (effective income) increases, resulting in a change in quantity demanded for that good • This component of the consumer's response is due only to the change in purchasing power (with relative prices held constant) • Normal good: P↓ effective income ↑ QD↑ • Inferior good: P↓ effective income ↑ QD↓

Marginal analysis

• Lots of economic analysis relies on rational economic behavior • What do I mean by "rational"? = whatever your preferences are, you act in pursuit of that as best as you can • Essential decision rule for rational economic behavior: MB = MC • MB: marginal benefit, MC: marginal cost • MB is the additional benefit gained from an action (defined analogously to MC) • When you see "marginal", think "additional"; has to do with "a little more" of something • In words: the optimal (best, most favorable) amount of any activity is that at which its MB is equal to its MC • You're going to hear the word "marginal" a lot in this course!

What is a market?

• Market: a collection of buyers and sellers whose interactions determine the price of a product or set of products • Boundaries may be defined by geography and by the range of products included • Two general categories Product markets (goods and services) Resource markets (factors of production) - goal of the market is to allocate resources - Goods are allocated to those who value them the most

Opportunity cost

• Opportunity cost: what is given up when taking an action • Also called the marginal cost of that action • Equal to the value of the best alternative that you've forgone by taking that action • Includes all relevant costs • Explicit costs: actual monetary payments, daily parking pass • Implicit costs: non-monetary costs (e.g., value of time) • Excludes irrelevant costs • Sunk costs: incurred in the past, cannot be recovered, non-refundable parking permit • Fixed costs: unaffected by this particular action/decision (but potentially affected by - and relevant to - other decisions), permit parking • Examples of each type of cost for today's class?

Describing preference rankings

• Ordinal vs. cardinal rankings: • An ordinal ranking places bundles in the order of most preferred to least preferred, but does not indicate how much one bundle is preferred to another • A cardinal ranking would allow preferences to be quantified and measured in basic units • Utility is the numerical value we use to describe an individual's level of well-being, larger number is a better • We do this by assigning a level of utility (single numerical value) to each bundle of goods and services • The actual unit of measurement for utility is not important, and ordinal rankings are sufficient to explain how most individual decisions are made • For our purposes, a higher utility level indicates a more-preferred bundle, but nothing more - other than being bigger/smaller than one another, the utility values themselves are arbitrary • We'll come back to cardinal utility later in the course (necessary when decisions involve risk/uncertainty)

Example - budget line

• PC = $2, PF = $6, I = $24 • Budget line is 2QC + 6QF = 24 • Maximum quantity of clothing: I/PC = 24/2 = 12 • Maximum quantity of food: I/PF = 24/6 = 4 • Slope of budget line = -PF / PC = -3 • The magnitude of the slope is the relative price of food in terms of clothing (the amount of clothing that must be given up to obtain one more unit of food)

Positive vs. normative analysis

• Positive analysis uses theories and models for explanation and prediction, purely factual claims - Addresses factual questions: "what will occur?" • Examples: How much will homelessness decrease if we provide subsidies for developing mixed-income housing in downtown Los Angeles? How much will gasoline consumption decrease in response to an increase in the gasoline excise tax? How will the mix of vehicles on the road change? • Normative analysis addresses issues from the perspective of "what ought to be?", going beyond facts, includes preference Should there be subsidies for developing mixedincome housing in downtown L.A.? If so, how large should they be? Should there be an excise tax on gasoline? If so, how much should it be? • Normative analysis involves value judgments, but is still informed by positive analysis

Price elasticity of demand

• Price elasticity of demand measures the sensitivity of quantity demanded to price changes • It is the % change in the quantity demanded for a good that results from a 1% increase in its own price • Bonus feature of elasticity: does not rely on units of measurement (unlike slope) • For example, what if we were estimating demand for oranges, and switched from pounds to tons? What if we switched the currency from U.S. dollars to Euros?

The technology of production

• Production: the process of combining inputs to create an output • Categories of inputs (factors of production) • We will focus on labor and capital • Labor: human effort • Capital: all produced means of production • Other inputs could include land and raw materials • For initial intuition, it's easiest to think of "output" as a material good; once you have a grasp on the concepts, you can think of it much more broadly • For example, "output" could refer to students' educational outcomes, which depend on "inputs" such as labor (e.g., teachers), raw materials (e.g., paper, books), and capital (e.g., facilities)

The firm's production decision

• Similar in many respects to the decision faced by consumers • Consumers seek to maximize utility by choosing the combination of goods and services that gives them the highest level of utility that is attainable given the budget constraint they face • Firms seek to maximize profits by choosing the combination of inputs that enables them to produce the desired level of output at the lowest cost allowed by their production technology

Production costs

• So far, we have only discussed the different ways that a particular level of output could be produced (feasible combinations of inputs) • Ultimately, we want to determine how a particular level of output should be produced (optimal combination of inputs) • This requires us to measure the costs associated with the use of inputs • Analogous to consumer choice problem: not sufficient to know preferences, also need to consider budget constraint A firm's cost of producing a given level of output is the opportunity cost faced by the owners of the firm (everything they must give up to produce that level of output) • Includes explicit costs (rent paid, interest paid, wages paid, costs of materials, etc.) • Includes implicit costs (forgone rent, forgone interest, etc.)

Substitution effect

• Substitution effect: as the price of a good falls, the consumer substitutes toward that good and away from other goods • This describes the part of the consumer's response that is due only to the change in the relative price of the good (i.e., holding the level of utility constant) • This always moves quantity demanded in the direction opposite to the relative price change

Market mechanism: summary

• Supply and demand interact to determine the market-clearing price • When a market is not in equilibrium, prices will adjust to alleviate a shortage or surplus and return the market to equilibrium - price sends a signal for market to self correct

Shifts in demand

• Terminology: demand shifts versus movement along the demand curve A change in the price of this good causes movement along the demand curve (change in quantity demanded) A change in any other relevant variable causes the demand curve itself to shift (change in demand), resulting in a new eqiulibrium

Shifts in supply

• Terminology: supply shifts versus movement along the supply curve A change in the price of this good causes movement along the supply curve (change in quantity supplied) A change in any other relevant variable causes the supply curve to shift (change in supply), resulting in a new equilibrium

MRS and relative valuation

• The MRS of X for Y is the amount of good Y that a consumer is willing to give up for one more unit of good X (shown by slope of indifference curve) • This implies that one more unit of X is worth the same to the consumer as MRS units of Y • E.g., if the MRS of food for clothing is 6, then the consumer values a unit of food just as much as 6 units of clothing • In other words: on the margin, a unit of X is worth MRS times as much to this consumer as a unit of Y

MRTS and marginal products

• The MRTS of labor (L) for capital (K) is the amount of capital that a firm can replace with one more unit of labor (graphically: slope of the isoquant) • This implies that the marginal output from one more unit of labor is the same as that from the last MRTS units of capital (MPL = MRTS*MPK ) • So, MRTS can also be expressed as MRTS = MPL /MPK (the marginal productivity of labor relative to capital) • E.g., if labor is (on the margin) 4 times as productive as capital, one additional unit of labor can replace 4 units of capital

Budget line

• The budget line consists of all combinations of goods for which the total amount of money spent is equal to the consumer's income • QF = quantity of food purchased, PF = price of food • PFQF = amount of money spent on food • QC = quantity of clothing, PC = price of clothing • PCQC = amount of money spent on clothing • The budget line for a consumer with income I who can buy only food and clothing can then be written as: 𝑃𝐹𝑄𝐹 + 𝑃𝐶𝑄𝐶 = 𝐼

Demand

• The demand curve measures how many units of a good consumers are willing to buy at each price Holds other relevant factors constant; more on this later Perspective of buyer • This price-quantity relationship can be described by the following equation: 𝑄𝐷 = 𝐷(𝑃) - how much would be purchased at every possible price point • When we talk about the "demand" for a product, we are not talking about a single number (QD at a particular P), but rather this relationship between quantity and price (the demand curve itself)

Elasticity

• The effects of many policies depend on how responsive individuals are to changes in things like prices and income For example, a gas tax will harm consumers without many environmental benefits if gasoline consumers are not very responsive to changes in price • Elasticity is how we measure the responsiveness of one variable to another It tells us the percentage change in one variable that results from a 1-percent change in another variable

Market equilibrium

• The equilibrium price is that at which supply and demand meet, agreement abt desired amount of activity The equilibrium quantity is the quantity that consumers demand and producers supply at the equilibrium price • "Equilibrium" refers to a state of rest; in what sense is this market at rest at this price and quantity?

Marginal rate of substitution

• The marginal rate of substitution (MRS) quantifies the amount of one good that a consumer is willing to give up to obtain more of another good • Graphically, the MRS is reflected in the slope of the indifference curve

What happened to MB and MC?

• The optimal bundle is that at which the budget line and indifference curve are tangent; why is this important? • The slope of the indifference curve (MRSFC) is the amount of clothing that the consumer is willing to give up for one more unit of food: in other words, the MRS is the marginal benefit of food, expressed in units of clothing (not dollars) • The slope of the budget line (PF / PC ) is the amount of clothing that the consumer is required to give up for one more unit of food: in other words, the price ratio is the marginal cost of food, expressed in units of clothing • Our "equal slopes" condition (MRSFC = PF / PC ) is just another way of writing MB = MC!

Price elasticity of demand

• The primary determinant of elasticity is the availability of substitutes • A product with more (or very close) substitutes will have higher elasticity • A good with few substitutes will have lower elasticity (tend to be price inelastic) • Elasticity also depends on the breadth of the defined market • E.g., organic tomatoes may be very price elastic; produce is less elastic; food as a whole is very price inelastic

The technology of production

• The production function describes the relationship between the inputs used and the resulting output • With two inputs, the production function is q = f(K,L) • Output (q) is a function of capital (K) and labor (L) • This is the level of output that is technically feasible when the producer operates efficiently (no waste) • A production function applies with constant technology • "Technology" refers to how effectively a firm is able to transform inputs into outputs • An increase in technology allows more output to be produced inputs

Substitution between inputs

• The slope of the isoquant shows how one output can be substituted for the other while keeping the level of output constant • Marginal rate of technical substitution (MRTS): the amount of an input that can be replaced by one more unit of another input, with output remaining constant • Does this sound like something else we've seen? Analogous to consumer's MRS (amount of a good that can be substituted for one unit of another, with utility remaining constant) • Graphically, the MRTS is the magnitude of the isoquant's slope

Supply

• The supply curve measures how many units of a good producers are willing to produce/sell at each possible market price Holds other relevant factors constant; more on this later Perspective of seller • This price-quantity relationship can be described by the following equation: 𝑄𝑆 = 𝑆(𝑃) • When we talk about the "supply" of a good, we are generally not referring to a single number (QS at a particular P), but rather to this relationship between quantity and price (the supply curve itself)

3 - Production and Costs

• The technology of production • One variable input • Two variable inputs • The costs of production • Short run • Long run

Consumer preferences

• Three basic assumptions • Preferences are complete • Any two bundles A and B can be compared (either A is preferred, or B is preferred, or consumer is indifferent) • Preferences are transitive • If A preferred to B and B to C, then A preferred to C • More of a good is better than less (non-satiation) • If less of something is preferred to more, it is called a "bad", not a "good"; we deal with these by considering elimination of a bad as the "good" in question

Individual demand

• Two important properties to note from previous analysis • The consumer's utility changes as we move along the demand curve (income is held constant, not utility; at lower prices, utility is higher) • At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the slope of the indifference curve is equal to the slope of the budget line

Solving the consumer choice problem

• Two steps to find the optimal bundle: Budget constraint: spend the money Determine the set of bundles that fully utilize the consumer's resources (none wasted) Preferences: find the "best mix" Find the combinations of goods at which the slope of the indifference curve is equal to the slope of the budget line • Only one point will satisfy both of these conditions: this bundle is the best choice

Market demand

• We have treated individuals' demands as independent here; not always an accurate assumption • Positive network externality: an individual's demand increases as more of the good or service is consumed by others • Examples? Phone • Negative network externality: individual demand decreases as others consume more • Examples? freeway • We will not consider network externalities (doing this correctly requires harder math), but they do exist • I mention this because textbook covers them (with lots of handwaving), and as an example of more sophisticated analysis that can build on what we're doing (we make some simplifying assumptions, but they're not critical, can be relaxed if desired)

Short-run production

• When capital is fixed, the only way to increase output is by employing more labor • The increase in output resulting from the addition of one more unit of labor is called the marginal product of labor (MPL ) MPL = ∆𝑞/∆𝐿 • We may also be interested in the average product of labor (average output per unit of labor) APL = 𝑞 /L Average are descriptive, and not useful at all

Summary: income and substitution effects

• When price decreases: • Normal good • Substitution effect: increase consumption • Income effect: increase consumption • Net effect: increase consumption (SE>0 + IE>0 TE>0) • Implies downward-sloping demand curve (P↓ Q↑) • Inferior good • Substitution effect: increase consumption • Income effect: decrease consumption • Net effect: theoretically ambiguous (SE>0 + IE<0 TE ???), but in practice essentially always increase consumption (i.e., substitution effect is larger than income effect) • Still expect downward-sloping demand curve, even though upward-sloping theoretically possible

Marginal analysis

• Why is the optimal level of an activity that at which MB = MC? • Any unit of an activity that has MB > MC makes you better off; any unit with MB < MC makes you worse off • If MB > MC at the current level of this activity, you should do more of it (haven't exhausted all worthwhile units) • If MB < MC at the current level of this activity, you should do less of it (last unit was not worthwhile) • If you cannot increase your well-being by increasing or decreasing the level of this activity, it must be the case that MB = MC • For yes/no decisions (not choice of level of activity), decision rule is a bit simpler but follows the same logic: an action should be taken if it has MB > MC

Shifts in supply and demand

•Supply and demand shifts need not occur in isolation from one another • E.g., World War II's effects on labor market • What might happen to the market-clearing price and equilibrium quantity if... • Supply and demand both increase? • Supply increases and demand decreases? • Supply decreases and demand increases? • Supply and demand both decrease?