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Substitution Effect
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Getting to old utility level when faced with new price (assuming same income)
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Goal of the Seller/Firm
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Whereas the buyer/consumer maximized utility, the seller/firm maximizes profits (technology) given constraints (prices of inputs/technology). Technology converts inputs into goods, which leads to revenue.
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The seller's environment: a perfectly competitive market
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1. No consumer or firm is big enough to influence the market price
2. Firms in the market produce identical goods
3. Free entry and exit in the market
4. Perfectly competitive input market
2. Firms in the market produce identical goods
3. Free entry and exit in the market
4. Perfectly competitive input market
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3 Components of the Firm's Optimization Problem
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1. Making the good: turning the inputs/raw materials into a good/service. This is represented by the technology/production function. Inputs are land, machines/capital, labor, etc.
2. Producing the good entails costs: costs of inputs and how efficient the technology is.
3. But production also entails benefits by selling the goods: profits
2. Producing the good entails costs: costs of inputs and how efficient the technology is.
3. But production also entails benefits by selling the goods: profits
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Short Run
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Only some factors can be varied while others cannot be. For instance, capital is a fixed input/factor of production. Labor is a variable input/factor of production
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Long Run
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All inputs can be varied
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Production Function
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Transforming inputs into outputs: f(K,L) = Q, where K is capital and L is labor. Think in terms of flow—K capital hours and L worker hours.
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Marginal product of an input (labor, capital)
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How much more or less output do I get as I change inputs
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Increasing/Decreasing Marginal Product
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How fast/slow output increases/decreases as I change inputs
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Marginal product of labor (MPL)
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The additional output produced from one more worker hour (holding K constant).
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Marginal product of labor (MPK)
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The additional output produced from one more machine hour (holding L constant)
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What happens to the value of MPL as L increases? holding K constant
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If we look at the production function, we see an upward sloping graph (positive slope, MPL , but diminishing marginal product). At low levels of input, marginal product can increase (specialization, learning). This is where we have an increasing marginal product of an input. But eventually, the marginal product will decrease (decreasing marginal product of an input), to the point where output starts decreasing too.
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What do costs depend on?
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Inputs and the efficiency of the technology
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Total Cost Equation
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TC(q) = FC + VC(q) where q is the output
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Average Total Cost Equation (cost per unit of output)
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ATC(q) = TC(q)/q = AVC(q) + AFC(q)
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Average Variable Cost (variable cost per unit)
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AVC(q) = VC(q)/q
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Average Fixed Cost (fixed cost per unit)
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AFC(q) = FC/q
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Marginal cost (cost of producing one more unit)
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MC(q) = delta TC(q)/delta q. The only source of the marginal cost is the variable cost!
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What is the relationship between marginal cost and marginal product?
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Marginal cost is inversely related to the marginal product. Reasoning: MC is the additional cost of producing one more unit of output. To produce that additional unit, I need more inputs. If marginal product is decreasing, I need more input to produce that additional unit of output. So, MC increases. If marginal product is increasing, I need less input to produce that additional unit of output. So, MC falls. Technology (production function) is closely related to cost curves.
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Cost Curves (MC, ATC, AFC, AVC), graphically
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ATC and AVC are the slope of the line from the origin to the point on TC or VC
MC curve comes from the slope of the TC or VC curves
MC cuts the lowest points of ATC and AVC from below
MC curve comes from the slope of the TC or VC curves
MC cuts the lowest points of ATC and AVC from below
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Total Cost and Variable Cost Curves, graphically
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TC and VC curves come from technology.
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When MC < ATC and AVC, what do we know about ATC and AVC?
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MC is the slope of TC and VC, so ATC and AVC decrease when MC < ATC, AVC.
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