It’s Not Fair If the Rules Aren’t Fair

This perspective relies on the symmetry principle—the requirement that people in similar situations should be treated similarly. In economics, this means equality of economic opportunity rather than equality of economic outcomes.

31. Maximizing Utility

• A consumer’s choices influence the total level of his or her utility some combination of goods generate more utility than others. The key assumption of marginal utility theory is that the household consumes the combination that maximizes its utility.

• Total utility is the total benefit that a person gets from the consumption of goods and services. As more of a good or service is consumed, total utility increases.
• Table 8.1 provides an example of utility from consuming movies and paperback books in a given week.

• Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. The table shows the marginal utility from movies.

Positive Marginal Utility

• When a good generates value, it has a positive marginal utility. Total utility increases as the quantity consumed increases.

Diminishing Marginal Utility

• Diminishing marginal utility is the principle that as more of a good or service is consumed, its marginal utility decreases. In the table the marginal utility diminishes as more movies are consumed.

· The theory of consumer behavior uses the law of diminishing marginal utility to explain how consumers allocate their incomes. The utility maximization model is built based on the following assumptions:

· 1. Consumers are assumed to be rational, trying to get the most value for their money.

· 2. Consumers’ incomes are limited because their individual resources are limited. They face a budget constraint.

· 3. Consumers have clear preferences for various goods and services, thus they know their MU for each successive units of the product.

· 4. Every item has a price tag. Consumers must choose among alternative goods with their limited money incomes.

· The Utility Maximization rule states: consumers decide to allocate their money incomes so that the last dollar spent on each product purchased yields the same amount of extra marginal utility.

· The algebraic statement is that consumers will allocate income in such a way that:

· MU of product A / price of A = MU of product B / Price of B = MU of product C / price of C = etc.

· It is marginal utility per dollar spent that is equalized. As long as one good provides more utility per dollar than another, the consumer will buy more of that good; as more of that product is bought, its MU diminishes until the amount of MU per dollar just equals that of the other products.

32. Predictions of Marginal Utility

A Fall in the Price of a Movie

A Change in the Quantity Demanded

• If the price of a good falls and other things remain the same, the marginal utility per dollar from that good rises. As a result, the consumer increases his or her purchases of that good in order to maximize utility. (As more of the good is purchased, its marginal utility decreases; as less of other goods are purchased, their marginal utilities increase. Eventually the consumer reaches a new equilibrium at which the marginal utility per dollar for all the goods is equal.)

A Change in Demand

• When the price of a good falls, it will have an impact on the demand for related goods (substitutes and complements in consumption). In our example, when movie prices fall, the demand for paperback books decreases, implying that movies and books are substitute goods.

A Rise in Income

• If a consumer’s income increases, the consumer will reach a new consumer equilibrium in which all the income is spent and the marginal utility per dollar from all goods is equal. Marginal utility theory predicts that as the consumer’s income increases, the demand for normal goods increases and the demand for inferior goods decreases.

Paradox of Value

• The paradox of value is that water, which is essential to life, costs little, but diamonds, which are useless in comparison to water, are expensive. The resolution to this paradox comes from distinguishing total utility from marginal utility. The total utility from water is much more than from diamonds. But we have so much water that its marginal utility is small. And we have so few diamonds that their marginal utility is high. When a household maximizes its utility, it makes the marginal utility per dollar equal for all goods. Because diamonds have a high marginal utility, they have a high price. Because water has a low marginal utility, it has a low price.

Temperature: An Analogy

• Like temperature, utility cannot be observed. A thermometer can be used to measure temperature, and whether temperature is measured in Celsius or Fahrenheit is essentially arbitrary. Similarly, units of measurement for utility are arbitrary, but they can still help us to predict consumption choices.

33. New Ways of Explaining Consumer Choices

Behavioral Economics

• Behavioral economics studies the ways in which limits on the human brain’s ability to compute and implement rational decisions influences economic behavior—both the decisions that people make and the consequences of those decisions for the way markets work.
• There are three impediments to rational choice: bounded rationality, bounded will-power, and bounded self-interest.

Bounded Rationality

• Bounded rationality is rationality that is bounded by the computing power of the human brain. Faced with uncertainty, consumers cannot rationally make choices and instead rely on other decision-making methods such as rules of thumb, listening to the views of others, or gut instinct.

Bounded Will-Power

• Bounded will-power is the less-than-perfect will-power that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret.

Bounded Self-Interest

• Bounded self-interest is the limited self-interest that sometimes results in suppressing our own interests to help others.

The Endowment Effect

• The endowment effect is the tendency for people to value something more highly simply because they own it.

Neuroeconomics

• Neuroeconomicsis the study of the activity of the human brain when a person makes an economic decision. Different decisions appear to activate different areas of the brain. Some decisions are made in the pre-frontal cortex, which is where memories are stored and data analyzed. These decisions might be deemed rational. Other decisions are made in the hippocampus, which is where memories of anxiety and fear are stored. These decisions might be deemed irrational.

Controversy

• Whether economics should focus on explaining the decisions we observe or on what goes on inside people’s heads is the source of controversy.

34. Consumption Possibilities

A household’s consumption choices are constrained by its income and the prices of the goods and services available. A household’s budget linedescribes the limits to its consumption choices.

The figure to the right shows a budget line for a household that buys only pizzas and books. The household can buy any combination of pizza and books that lies on or within the budget line. Combinations that lie beyond the budget line are unaffordable.

Budget Equation

We can describe the budget line by using a budget equation, which states that income equals expenditure.

Calling the price of a book PB, the quantity of books QB, the price of a pizza PP, the quantity of pizza QP, and income Y, we can write a budget equation as PB´ QB+ PP´ QP= Y, which can be rearranged into slope-intercept form as QB = Y/PB - (PP/PB) ´ QP.

A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. In the figure above, in terms of books, the household’s real income is Y/PB(5 books), which is the vertical intercept of the budget line.

A relative price is the price of one good divided by the price of another good. The magnitude of the slope of the budget line, (PP/PB), is the relative price of a pizza in terms of a book. A relative price is an opportunity cost, so the relative price of a pizza in terms of books gives the opportunity cost of a pizza in terms of books forgone.

When the price of the good measured along the horizontal axis (pizzas) changes, the budget line rotates around the vertical intercept. If the price of the good falls, the budget line rotates outward and becomes steeper; if the price of the good rises, the budget line rotates inward and becomes steeper.

When income changes, the budget line shifts and its slope does not change. If income increases, the budget line shifts outward; if income decreases, the budget line shifts inward.

35. Preferences and Indifference Curves

• A preference map shows how a person ranks various combinations of goods and services.
• Indifference curves are used to illustrate a person’s preference map. An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. The figure to the right shows three of a person’s indifference curves between pizza and books.

· The consumer is indifferent among all the points on any particular indifference curve.

· The consumer prefers points above any particular indifference curve to points on the curve. And the consumer prefers points on the indifference curve to points below the curve. In the figure, the consumer prefers any point on indifference curve I₂ to any point on I₁ and any point on I₃ to any point on I₂.

Marginal Rate of Substitution

• The marginal rate of substitution (MRS) is the rate at which a person will give up good y (the good measured on the y-axis) to get an additional unit of good x (the good measured on the x-axis) and at the same time remaining indifferent (remaining on the same indifference curve).

· The magnitude of the slope of the indifference curve at any point measures the marginal rate of substitution between the goods. If the indifference curve is steep, the MRS is high; if the indifference curve is flat, the MRS is small.

· The diminishing marginal rate of substitution is the general tendency for a person to be willing to give up less of good y to get one unit of good x, and at the same time remain indifferent, as the quantity of x increases. This principle implies that indifference curves generally become flatter moving along them to the right.

Degree of Substitutability

• The indifference curves between most goods are bowed in, with a diminishing MRS.
• The indifference curves for perfect substitutes are linear, with a constant MRS.
• The indifference curves for perfect complements are L-shaped. Utility increases (the consumer moves to a higher indifference curve) only if the quantity of both goods x and y increases.

36. Predicting Consumer Choices

Best Affordable Choice

• The consumer will select his or her best affordable point. This point:

· is on the budget line,

· is on the highest attainable indifference curve,

· has a marginal rate of substitution between the two goods equal to the relative price of the two goods.

• The figure shows the best affordable point, 2 pizzas and 3 books. This combination is on the budget, and hence is “affordable”. It also is on the highest indifference curve so that the marginal rate of substitution equals the relative price of the two goods, and hence the point is “best.”

A Change In Price

• The price effect shows how a change in the price of a good affects the quantity of that good consumed.
• When the price of the good on the x-axis falls, the budget line rotates around the y-axis intercept and becomes flatter. The person moves to a new consumption point. The new consumption bundle satisfies all three properties: It is on the new budget line, it is on the highest attainable indifference curve, and the MRS equals the slope of the new budget line.
• When the price of a good changes, tracking the change in the quantity of the good consumed reveals the demand curve for that good.

Substitution Effect and Income Effect

• For a normal good, a rise in price always decreases the quantity consumed. This result is shown by breaking the price effect into two parts, as illustrated in the figure in which the price of movies rises:

· The substitution effectis the effect of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original situation and the new one. The substitution effect is showing by moving the new budget line (with its new slope) so that it is tangent to the initial indifference curve. This procedure creates a (hypothetical) new best affordable point using the initial indifference curve and the hypothetical budget line. Comparing the initial best affordable point to this new one captures the substitution effect. In the figure this compares point a to point b. The substitution effect of a rise in price always leads to a decrease in the quantity consumed.

The income effect is the effect on the quantity bought of a change in income sufficient to shift the hypothetical budget line used to measure the substitution effect so that it is the same as the actual new budget line. This process is the movement from point b to point d in the figure. For a rise in price, this change requires a decrease in income. For a normal good, the decrease in income decreases the quantity consumed. So for a normal good, the substitution effect and the income effect reinforce each other: both demonstrate that the quantity consumed decreases.

37. Work-Leisure Choices

Labor Supply

• A household’s labor supply decisions can be analyzed using the same model of consumer choice. In this case, the two “goods” are leisure and income (from working). The income generated from working can then be used to purchase all other goods.
• The household must allocate its time between leisure and work. The opportunity cost of an hour of leisure (that is, not working for an hour) is the wage rate.
• A figure showing the indifference curves and the income-time budget line is to the right. The maximum leisure is 168 hours a week, in which case the person’s income is zero. The initial budget line is the gray line.
• The person’s best affordable point is point a. The person has 134 hours of leisure a week, which means the person supplies 34 hours of labor a week.
• An increase in the wage rate rotates the budget line upward, as shown in the figure. With the new, higher budget line, the person moves to the new best point, point b. At this point, the quantity of leisure consumed decreases, which means that the quantity of labor supplied increases.

· The increase in the wage rate has a substitution effect and an income effect. The substitution effect occurs because an increase in the wage rate increases the opportunity cost of leisure, so people respond by substituting away from leisure. But the higher wage rate also increases the household’s income and the income effect leads to an increase in the demand for leisure, which is a normal good.

· Between points a and b in the figure, the substitution effect dominates, so an increase in the wage rate increases the quantity of labor supplied. But if the wage rate increased more, so that the household could reach indifference curve I₃, the income effect would dominate and the increase in wage rate would decrease the quantity of labor supplied.

38. The Firm and Its Economic Problem

· A firm is an institution that hires factors of production and organizes those factors to produce and sell goods and services

· The firm’s goal is to maximize its profit. If a firm fails to maximize profit it is either eliminated through competition or bought out by other firms seeking to maximize profit.

Accounting Profit and Economic Profit

· A firm’s accounting profit is the firm’s revenues minus expenses and depreciation.

· A firm’s economic profit is equal to total revenue minus total cost, with total cost measured as the opportunity cost of production.

A Firm’s Opportunity Cost of Production

· A firm’s decisions respond to opportunity cost and economic profit. A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production.

· Opportunity costs of production include the cost of resources that are bought in the market, owned by the firm, or supplied by the firm’s owner.

39. A Firm’s Opportunity Cost of Production

· A firm’s decisions respond to opportunity cost and economic profit. A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production.

· Opportunity costs of production include the cost of resources that are bought in the market, owned by the firm, or supplied by the firm’s owner.

a. For example, renting capital means the firm is paying a rental cost reflecting the opportunity cost to the owner of the capital when someone else using the capital. However, if the firm buys capital it incurs an opportunity cost of using its own capital, which is called the implicit rental rate of capital.The implicit rental rate includes economic depreciation, which is the change in the market value of capital over a given period, and the interest forgone, which is the lost potential return on the funds that were used to acquire the capital.

The return to the owner for the owner’s entrepreneurial ability is profit. The return for this input that an entrepreneur can expect to receive on the average is called normal profit. The normal profit is part of the firm’s opportunity cost. Economic profit is a firm’s total revenue minus its opportunity cost. Because normal profit is part of the firm’s opportunity costs, economic profit is profit over and above normal profit.

40. Technological and Economic Efficiency

· There typically are many different combinations of inputs that can produce a specific level of output. Technological efficiency occurs when a firm produces a given output by using the least amount of inputs. Economic efficiency occurs when the firm produces a given output at the least possible cost. An economically efficient production process is always technologically efficient. But, a technologically efficient process might not be economically efficient.

· The table has 4 different methods of producing a unit of output. The columns show the number of units of labor and capital needed to produce 1 unit of output.

b. Method 2 is technologically inefficient because it uses the same amount of capital but more labor than does Method 1.

c. Which method is economically efficient depends on the prices of labor and capital. If labor is $10 per unit and capital is $1, then Method 1 is economically efficient (with a cost of $60 per unit of output). If labor is $1 per unit and capital is $10 per unit, then Method 4 is economically efficient (with a cost of $30 per unit of output).

41. Information and Organization

A firm organizes production by combining and coordinating productive resources using a mixture of command systems and incentive systems.

· Acommand system uses a managerial hierarchy. Commands pass downward through the hierarchy and information (feedback) passes upward.

· An incentive system uses a market-like mechanism inside the firm.

· The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. For example, the stockholders of a firm are the principals and the managers of the firm are their agents. Stockholders wish to provide incentives to the managers to bring the manager’s decisions in line with profit maximization. Firms cope with the principal-agent problem in many ways:

d. Ownership: Firms’ owners often offer managers partial ownership of the firm to give the managers an incentive to maximize the firm’s profits, which is the goal of the owners.

e. Incentive pay: Firms’ owners can links managers’ or workers’ pay to the firm’s performance, such as its sales, to help align the managers’ and workers’ interests with those of the owners.

f. Long-term contracts: Firms’ owners can tie managers’ or workers’ long-term rewards to the long-term performance of the firm.

42. Types of Business Organization

A proprietorship is a firm with a single owner. This owner has unlimited legal liability, which means the owner has legal responsibility for all debts incurred by the firm up to an amount equal to the entire wealth of the owner. The proprietor is the only one who makes management decisions and is the sole claimant of the firm’s profit. Profits are taxed the same as the owner’s other income.

A partnership is a firm with two or more owners. Each partner has unlimited legal liability. The partners must agree upon a management structure and agree how to divide up the profits from the firm. Profits from partnerships are taxed as the personal income of the owners.

A corporation is a firm that is owned by one or more stockholders with limited liability, which means the owners have legal liability only for the initial value of their investment so the personal wealth of the stockholders is not at risk if the firm goes bankrupt. The profit of corporations is taxed twice—once as a corporate tax on the firm’s profits, and then again as income taxes paid by stockholders receiving their after-tax profits distributed as dividends.

Proprietorships are the most common form of business organization but corporations account for the majority of revenue received by all types of business organization

43. Markets and the Competitive Environment

The competitive environment, also known as the market structure, is the dynamic system in which your business competes. The state of the system as a whole limits the flexibility of your business. World economic conditions, for example, might increase the prices of raw materials, forcing companies that supply your industry to charge more, raising your overhead costs. At the other end of the scale, local events, such as regional labor shortages or natural disasters, also affect the competitive environment.

Direct Competitors
Your direct competitors provide products or services similar to yours. For example, a small computer repair business competes with other local computer repair businesses, as well as large retail stores that offer computer repair services. Small retail shops compete with warehouse clubs and big-box retail stores that use their huge buying power to lower overhead costs, enabling them to offer steep discounts that small stores can’t afford.

Indirect Competitors
In addition to direct competitors, some businesses also face competition from providers of dissimilar products or services. For example, a fine dining restaurant competes with other local restaurants, but it also competes with nearby supermarkets that offer ready-to-eat meals. And a pottery studio that relies heavily on children’s birthday parties must compete with other family-friendly establishments that offer children’s activities, such as roller rinks, theme restaurants and children’s museums.

A competitive environment is where there are several similar firms that are competing for the same market segment. These firms normally produce products of the same nature and form and whose uses are more or less the same. However, because of the competition that exists for the market, these firms are likely to differentiate their products to endear them to a larger number of consumers compared to their rivals.

44. Markets and Firms

The theory of the firm consists of a number of economic theories that describe, explain, and predict the nature of the firm, company, or corporation, including its existence, behavior, structure, and relationship to the market

In simplified terms, the theory of the firm aims to answer these questions:

1. Existence. Why do firms emerge, why are not all transactions in the economy mediated over the market?

2. Boundaries. Why is the boundary between firms and the market located exactly there as to size and output variety? Which transactions are performed internally and which are negotiated on the market?

3. Organization. Why are firms structured in such a specific way, for example as to hierarchy or decentralization? What is the interplay of formal and informal relationships?

4. Heterogeneity of firm actions/performances. What drives different actions and performances of firms?

5. Evidence. What tests are there for respective theories of the firm?

Firms exist as an alternative system to the market-price mechanism when it is more efficient to produce in a non-market environment. For example, in a labor market, it might be very difficult or costly for firms or organizations to engage in production when they have to hire and fire their workers depending on demand/supply conditions. It might also be costly for employees to shift companies every day looking for better alternatives. Similarly, it may be costly for companies to find new suppliers daily. Thus, firms engage in a long-term contract with their employees or a long-term contract with suppliers to minimize the cost or maximize the value of property rights

45. Short-Run Technology Constraint

The Short Run is a time frame in which the quantity of one or more

resources used in production is fixed.For most firms the capital is fixed in the short run. Other resources used by the firm (such as labor, raw materials, and

energy) can be changed in the short run. Short-run decisions are easily reversed.

The marginal product of labor is the change in total product that results from a one-unit increase in the quantity of labor employed, with all other inputs remaining the same.Almost all production processes are like the one shown here and have:

Initially increasing marginal returns When the marginal product of a worker exceeds the marginal product of the previous worker, the marginal product of labor increases and the firm experiences increasing marginal returns. Eventually diminishing marginal Returns When the marginal product of a worker is less than the marginal

product of the previous worker, the marginal product of labor decreases and the firm experiences diminishing marginal returns.

46. Product Schedules, Product Curves, The law of diminishing returns

Total product is the maximum output that a given quantity of labor can produce. The marginal product of labor is the increase in total product that results from a one-unit increase in the quantity of labor employed with all other inputs remaining the same. The average product of labor is equal to the total product of labor divided by the quantity of labor. The table to the right has examples of these product schedules.

Product Curves

The total product curve illustrates the total product schedule. The slope of the total product curve equals the marginal product of labor at that quantity of labor.

The marginal product curve shows the additional output generated by each additional unit of labor. The marginal product of labor curve (MP) has an upside-down U shape. Increasing marginal returns occurs when the marginal product of an additional worker is greater than the marginal product of the previous worker. At low levels of employment, increasing marginal returns is likely because hiring an additional worker allows large gains from specialization. Eventually these gains become small or nonexistent and diminishing marginal returns set in. Diminishing marginal returns occur when the marginal product

of an additional worker is less than the marginal product of the previous worker. The law of diminishing returns states that as a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production, the marginal product of the variable factor eventually diminishes.

The average product curve shows the average product that is generated by labor at each level of labor. As the figure shows, the average product of labor curve (AP) has an upside-down U shape.

As the figure shows, the marginal product curve and the average product curve are related: when the marginal product of labor exceeds the average product of labor, the average product of labor increases; when the marginal product of labor is less than the average product of labor, the average product of labor decreases; and the marginal product of labor equals the average product of labor when the average product of labor is at its maximum.

47. Short-Run Cost

Total Cost

· Total cost (TC) is the cost of all the factors of production a firm uses. Total fixed cost (TFC) is the cost of the firm’s fixed factors. Total variable cost (TVC) is the cost of the firm’s variable factors. Total cost is the sum of total fixed cost plus total variable cost so TC = TFC + TVC.

Date: 2015-12-11; view: 1522