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utility
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the benefits or customer value received by users of the product
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total utility
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the total amount of satisfaction obtained from consumption of a good or service
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marginal utility
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the extra usefulness or satisfaction a person gets from acquiring or using one more unit of a product
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principle of diminishing marginal utility
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as you consume more of a good, after some point, the marginal utility received from each additional unit of a good decreases with each additional unit consumed, other things equal
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consumption bundle
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the collection of all the goods and services consumed by that individual
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utility function
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gives the total utility generated by his or her consumption bundle
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consumer's problem
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maximize utility subject to the budget constraint
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finding the maximized amount of utility
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find MU, convert MU to MU per dollar, compare and choose best choice, subtract price from budget, repeat
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budget constraint
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all possible consumption combinations of goods that someone can afford, given the prices of goods, when all income is spent; the boundary of the opportunity set
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slope of budget constraint
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Px/Py
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indifference curves
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a curve that shows consumption bundles that give the consumer the same level of satisfaction
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why most indifference curves bow inward
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the absolute value of the slope in various places measures the trade-off willing to make between two goods that keeps utility constant
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marginal rate of substitution (MRS)
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the rate at which a consumer is willing to trade one good for another
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when can an indifference curve bow outward
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if you have lots of y, implies you're not willing to give up much y to get a unit of x
but if you have lower level of y, you are willing to give up more y to get an extra unit of x
(IC gets steeper as you move down curve to the right; implies you prefer extreme (almost all x or almost all y); not a reasonable assumption for most goods
but if you have lower level of y, you are willing to give up more y to get an extra unit of x
(IC gets steeper as you move down curve to the right; implies you prefer extreme (almost all x or almost all y); not a reasonable assumption for most goods
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when indifference curves do not bow inward
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you often get corner solutions - all of one good and zero of the other
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Can indifference curves cross?
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No
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the optimal bundle on a graph
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the slope of the budget constraint (BC) must equal the slope of the indifference curve (IC) - the IC will be tangent to the BC
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what happens to consumption as income increases
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increase in income is a parallel outward shift of the budget constraint
If both normal goods, consume more of each
If one is inferior, consume more of one and fewer of another and a new optimal bundle
If both normal goods, consume more of each
If one is inferior, consume more of one and fewer of another and a new optimal bundle
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substitution effect
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you substitute toward the good that is relatively cheaper
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income effect
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the change in consumption that results when a price increase causes real income to decline
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Giffen good
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a good for which an increase in the price raises the quantity demanded (strongly inferior good)
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unusual indifference curves
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for goods that are perfect substitutes, ICs will be straight lines
for good that are perfect complements, ICs will be right angles
for good that are perfect complements, ICs will be right angles
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explicit costs
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accounting costs: out of pocket payments to owners of factors of production - inputs used in production of a good or service like labor or capital
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implicit costs
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opportunity costs for which there are no explicit payments
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profit
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total revenue (p*q) minus total cost
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accounting profit
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what you would see on an income statement: total revenue minus explicit costs
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economic profit
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total revenue minus total cost, including both explicit and implicit costs
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competitive firm owners earn...
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zero economic profit (normal profits)
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production function
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the relationship between quantity of inputs used to make a good and the quantity of output of that good
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fixed input
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an input whose quantity is fixed for a period of time and cannot be varied (ex. shop prices)
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variable input
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an input whose quantity the firm can vary at any time (ex. ingredients)
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short run
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the period of time during which at least one of a firm's inputs is fixed
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long run
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the time period in which all inputs can be varied
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total product curve
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shows how the quantity of output depends on the quantity of the variable input, for a given quantity of the fixed input
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average product of an input
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total output divided by the amount of input used to produce this amount of output
Average product of labor (APL) = q of output/q of labor
Average product of labor (APL) = q of output/q of labor
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marginal product
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the increase in output that arises from an additional unit of input
Marginal product of labor (MPL) = change in q of output/change in q of labor
Marginal product of labor (MPL) = change in q of output/change in q of labor
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diminishing returns to an input
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when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input
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fixed costs (FC)
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costs that remain constant as output changes
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variable costs (VC)
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costs that vary with the quantity of output produced
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total cost (TC)
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fixed costs plus variable costs
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marginal cost (MC)
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the additional cost of each additional unit
change in TC/change in q of output
change in TC/change in q of output
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average total cost (ATC)
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total cost divided by the quantity of output
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average fixed cost (AFC)
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total fixed costs divided by quantity of output
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Average variable cost (AVC)
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total variable costs divided by quantity of output
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u-shaped ATC curve
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falls at low levels of output, then rises at higher levels
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average-marginal rule
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when the marginal is greater than the average, it brings the average up
when the average is greater than the marginal, it brings the average down
MC crosses ATC at the lowest point
when the average is greater than the marginal, it brings the average down
MC crosses ATC at the lowest point
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perfect competition
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many firms; identical products and substitutes; price takers; no advertising; no barriers to entry; MC=MR; P=MC; no long run profits
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monopolistic competition
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many firms; some product differentiation; many close substitutes; non-price competition; advertising; some barriers to entry; MC=MR; P>MC; no long run profits (without product improvements)
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oligopoly
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few firms; some or no product differentiation; many close substitutes; may have non-price competition; may have advertising; significant barriers to entry; MC=MR; P>MC if can collude; long run profits if collusion is successful
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monopoly
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one firm; complete product differentiation; no close substitutes; price-makers; no advertising for market share; total barriers to entry; MC=MR; P>MC; long run profits
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price-taker
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a firm that faces a given market price and whose quantity supplied has no effect on that price; a perfectly competitive firm
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marginal revenue (MR)
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the change in total revenue from selling one more unit of a product
change in TR/change in q of output
change in TR/change in q of output
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optimal output rule
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MC=MR
profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost
profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost
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positive profits in the short run
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TR>TC; profit = TR-TC (p q - ATC q)
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firm breaks even
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TR=TC; no economic profit; P=ATC
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negative profits (losses) in the short run
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TR<TC; economic losses; P<ATC
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shut down
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shut down in the short run if P<AVC (can't cover variable costs)
firm should not shut down even with losses if TR>ATC because of sunk costs - costs that cannot be recovered when the production decision is being made
firm should not shut down even with losses if TR>ATC because of sunk costs - costs that cannot be recovered when the production decision is being made
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when should a firm exit in the long run
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if P<ATC
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examples of barriers to entry
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1. control of scare resource of input (De Beers diamonds)
2. government-created barriers (patents - temporary monopolies in the use of sale of invention; copyright - sole right to profit from work)
3. natural monopoly where it is cheaper for a single firm to produce enough output to meet the entire demand curve - related to economies of scale and increasing returns to scale
2. government-created barriers (patents - temporary monopolies in the use of sale of invention; copyright - sole right to profit from work)
3. natural monopoly where it is cheaper for a single firm to produce enough output to meet the entire demand curve - related to economies of scale and increasing returns to scale
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constant returns to scale
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if a firm doubles all factors of production and output doubles
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increasing returns to scale (economies of scale)
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if a firm doubles all factors of production and output more than doubles (here, large factories are more efficient)
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monopolist demand curve
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downward sloping
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monopolist profit-maximizing output and price
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MC=MR at the profit-maximizing quantity of output; MR is decreasing in the number of units sold
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Monopoly Surplus
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CS: area below D and above P over to quantity exchanged
PS: area below P and above MC over to quantity exchanged
compared to socially optimal q, social welfare is lower so there is DWL (output is too low)
PS: area below P and above MC over to quantity exchanged
compared to socially optimal q, social welfare is lower so there is DWL (output is too low)
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monopolies and public policy: what to do?
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1. Break it apart (Sherman Antitrust Act of 1890)
- Most famous examples are Standard Oil, AT&T
- Can also prevent formation (Ex. Comcast/Time Warner in 2015)
2. Regulate it
- Regulate prices and quantities
- But hard to get prices and incentives right: shortages and surpluses
- Done for utilities
3. Nationalize it
-Taking privately-controlled companies, industries, or assets and putting them under the control of the government
4. Do nothing
- Market forces still operate
- Cost of government intervention may exceed benefit
- Most famous examples are Standard Oil, AT&T
- Can also prevent formation (Ex. Comcast/Time Warner in 2015)
2. Regulate it
- Regulate prices and quantities
- But hard to get prices and incentives right: shortages and surpluses
- Done for utilities
3. Nationalize it
-Taking privately-controlled companies, industries, or assets and putting them under the control of the government
4. Do nothing
- Market forces still operate
- Cost of government intervention may exceed benefit
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price discrimination
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charging different prices to different consumers for the same good
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perfect price discrimination
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occurs when a firm charges the maximum amount that buyers are willing to pay for each unit
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imperfect price discrimination
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groups of consumers are charged different prices (more common)
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hurdle method
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offer lower prices only to buyers who are willing to overcome some hurdle; by imposing a cost on consumers who really want a discount, the firm can segment the market based on opportunity cost of time (mail in coupons, temporary sales and knowing where and when)
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interdependence
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when the costs and benefits of one's actions depend on what others do
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game theory
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the study of how people behave in strategic situations
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payoff matrix
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a table that shows the payoffs that each firm earns from every combination of strategies by the firms
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Prisoner's Dilemma
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a particular "game" between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial
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dominant strategy
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a strategy that is best for a player in a game regardless of the strategies chosen by the other players
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Nash equilibrium (noncooperative equilibrium)
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a situation in which each player in a game chooses the action that maximizes their payoff, given the actions of other players, and ignoring the effects of their action on the payoffs received by those other players; no one can improve their payoff by changing strategy
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oligopolies and game theory
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when oligopolies coordinate, they behave like monopolies; when they fail to coordinate, they behave like perfectly competitive firms
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sequential games
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players make decisions one after another, so one player responds to the known decisions of other players
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Stag Hunt Game
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a game where either player can gain largely from cooperation or gain little by defection; depends on trust of other player
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Chicken Game
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win/lose equilibriums are stable
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cartels
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institutionalized form of oligopoly
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