Uncertainty and Consumer Behavior

Chapter 5
Uncertainty and Consumer

Behavior
Introduction
Choice with certainty is reasonably
straightforward
How do we make choices when certain
variables such as income and prices are
uncertain (making choices with risk)?
Describing Risk
To measure risk we must know:
1. All of the possible outcomes

2. The probability or likelihood that each
outcome will occur
Describing Risk
Interpreting Probability
1. Objective Interpretation
Based on the observed frequency of past events
2. Subjective Interpretation
Based on perception that an outcome will occur
Interpreting Probability
Subjective Probability
Different information or different abilities to
process the same information can influence
the subjective probability
Based on judgment or experience
Describing Risk
With an interpretation of probability, must

determine 2 measures to help describe
and compare risky choices
1. Expected value
2. Variability
Describing Risk
Expected Value
The weighted average of the payoffs or values
resulting from all possible outcomes
Expected value measures the central tendency;
the payoff or value expected on average
Expected Value An Example

Investment in offshore drilling exploration:
Two outcomes are possible
Success the stock price increases from $30
to $40/share
Failure the stock price falls from $30 to
$20/share

Objective Probability
100 explorations, 25 successes and 75
failures
Probability (Pr) of success = 1/4 and the
probability of failure = 3/4

EV Pr(success)(value of success)
Pr(failure)(value of failure)
EV 1 4 ($40/share ) 3 4 ($20/share )
EV $25/share
Expected Value
In general, for n possible outcomes:
Possible outcomes having payoffs X1, X2, ,
Xn
Probabilities of each outcome is given by Pr 1,
Pr2, , Prn
E(X) Pr1X1 Pr2 X 2 ... Prn X n
Describing Risk
Variability
The extent to which possible outcomes of an
uncertain event may differ
How much variation exists in the possible
choice
Variability An Example
Suppose you are choosing between two
part-time sales jobs that have the same
expected income ($1,500)
The first job is based entirely on
commission
The second is a salaried position
There are two equally likely outcomes in
the first job: $2,000 for a good sales job
and $1,000 for a modestly successful one
The second pays $1,510 most of the time
(.99 probability), but you will earn $510 if
the company goes out of business (.01
probability)
Outcome 1
Prob.
Outcome 2
Income Prob.
Income
Job 1:
Commission
.5
2000
.5
1000
Job 2: Fixed
Salary
.99
1510
.01
510
Income from Possible Sales Job
Job 1 Expected Income
E(X1 ) .5($2000) .5($1000) $1500

Job 2 Expected Income
E(X 2 ) .99($1510) .01($510) $1500
Variability
While the expected values are the same,
the variability is not
Greater variability from expected values
signals greater risk
Variability comes from deviations in
payoffs
Difference between expected payoff and
actual payoff
Deviations from Expected Income ($)
Outcome Deviation Outcome Deviation
1
2
Job 1
Job 2
$2000
$500
$1000
-$500
1510
10
510
-900
Variability
Average deviations are always zero so we
must adjust for negative numbers
We can measure variability with standard
deviation
The square root of the average of the squares
of the deviations of the payoffs associated
with each outcome from their expected value
Variability
Standard deviation is a measure of risk
Measures how variable your payoff will be
More variability means more risk
Individuals generally prefer less variability
less risk
Variability
The standard deviation is written:
Pr1 X 1 E ( X ) Pr2 X 2 E ( X )
2
Standard Deviation Example 1

Deviations from Expected
Income ($)
Outcom Deviatio Outcom Deviatio
e1
n
e2
n
Job
1
$2000
$500
$1000
-$500
Job
2
1510
10
510
-900

Standard deviations of the two jobs are:
Pr1 X 1 E ( X ) Pr2 X 2 E ( X )
2
1 0.5($250,000) 0.5($250,000)
1 250,000 500
2 0.99($100) 0.01($980,100)
2 9,900 99.50

Job 1 has a larger standard deviation and
therefore it is the riskier alternative
The standard deviation also can be used
when there are many outcomes instead of
only two

Job 1 is a job in which the income ranges
from $1000 to $2000 in increments of
$100 that are all equally likely
Job 2 is a job in which the income ranges
from $1300 to $1700 in increments of
$100 that, also, are all equally likely
Outcome Probabilities - Two

Jobs
Job 1 has greater
spread: greater
standard deviation
and greater risk
than Job 2.
Probability
0.2
Job 2
0.1
Job 1
$1000
$1500
$2000
Income
Decision Making Example 1

What if the outcome probabilities of two
jobs have unequal probability of
outcomes?
Job 1: greater spread and standard deviation
Peaked distribution: extreme payoffs are less
likely that those in the middle of the
distribution
You will choose job 2 again
Unequal Probability Outcomes

The distribution of payoffs
associated with Job 1 has a
greater spread and standard
deviation than those with Job 2.
Probability
0.2
Job 2
0.1
Job 1
$1000
$1500
$2000
Income

Suppose we add $100 to each payoff in
Job 1 which makes the expected payoff =
$1600
Job 1: expected income $1,600 and a
standard deviation of $500
Job 2: expected income of $1,500 and a
standard deviation of $99.50

Which job should be chosen?
Depends on the individual
Some may be willing to take risk with higher
expected income
Some will prefer less risk even with lower
expected income
Risk and Crime Deterrence

Attitudes toward risk affect willingness to
break the law
Suppose a city wants to deter people from
double parking
Monetary fines may be better than jail time
Risk and Crime Deterrence

Costs of apprehending criminals are not
zero, therefore
Fines must be higher than the costs to society
Probability of apprehension is actually less
than one
Risk and Crime Deterrence Example
Assumptions:
1. Double-parking saves a person $5 in terms
of time spent searching for a parking space
2. The driver is risk neutral
3. Cost of apprehension is zero

A fine greater than $5.00 would deter the
driver from double parking
Benefit of double parking ($5) is less than the
cost ($6.00) equals a net benefit that is
negative
If the value of double parking is greater than
$5.00, then the person would still break the
law

The same deterrence effect is obtained by
either
A $50 fine with a 0.1 probability of being
caught resulting in an expected penalty of $5
or
A $500 fine with a 0.01 probability of being
caught resulting in an expected penalty of $5

Enforcement costs are reduced with high
fine and low probability
Most effective if drivers dont like to take
risks
Preferences Toward Risk

Can expand evaluation of risky alternative
by considering utility that is obtained by
risk
A consumer gets utility from income
Payoff measured in terms of utility
Preferences Toward Risk Example

A person is earning $15,000 and receiving
13.5 units of utility from the job
She is considering a new, but risky job
0.50 chance of $30,000
0.50 chance of $10,000
Preferences Toward Risk Example

Utility at $30,000 is 18
Utility at $10,000 is 10
Must compare utility from the risky job with
current utility of 13.5
To evaluate the new job, we must
calculate the expected utility of the risky
job

The expected utility of the risky option is
the sum of the utilities associated with all
her possible incomes weighted by the
probability that each income will occur
E(u) = (Prob. of Utility 1) *(Utility 1)
+ (Prob. of Utility 2)*(Utility 2)

Example
The expected is:
E(u) = (1/2)u($10,000) + (1/2)u($30,000)
= 0.5(10) + 0.5(18)
= 14
E(u) of new job is 14, which is greater than
the current utility of 13.5 and therefore
preferred

People differ in their preference toward
risk
People can be risk averse, risk neutral, or
risk loving

Risk Averse
A person who prefers a certain given income
to a risky income with the same expected
value
The person has a diminishing marginal utility
of income
Most common attitude towards risk
Ex: Market for insurance
Risk Averse - Example

A person can have a $20,000 job with
100% probability and receive a utility level
of 16
The person could have a job with a 0.5
chance of earning $30,000 and a 0.5
chance of earning $10,000
Risk Averse Example

Expected Income of Risky Job
E(I) = (0.5)($30,000) + (0.5)($10,000)
E(I) = $20,000
Expected Utility of Risky Job

E(u) = (0.5)(10) + (0.5)(18)
E(u) = 14
Risk Averse Example

Expected income from both jobs is the
same risk averse may choose current
job
Expected utility is greater for certain job
Would keep certain job
Risk averse persons losses (decreased

utility) are more important than risky gains
Risk Averse
Can see risk averse choices graphically
Risky job has expected income = $20,000
with expected utility = 14
Point F
Certain job has expected income =

$20,000 with utility = 16
Point D
Risk Averse Utility Function

Utility
18
D
16
14
10
The consumer is risk

averse because she would
prefer a certain income of
$20,000 to an uncertain
expected income =
$20,000
10
16 20
30
Income ($1,000)

A person is said to be risk neutral if they
show no preference between a certain
income, and an uncertain income with the
same expected value
Constant marginal utility of income
Risk Neutral
Expected value for risky option is the
same as utility for certain outcome
E(I) = (0.5)($10,000) + (0.5)($30,000)
= $20,000
E(u) = (0.5)(6) + (0.5)(18) = 12
This is the same as the certain income of

$20,000 with utility of 12
Risk Neutral
E
Utility 18

neutral and is indifferent
between certain events
and uncertain events
with the same
expected income.
12
10
20
30
Income ($1,000)

A person is said to be risk loving if they
show a preference toward an uncertain
income over a certain income with the
same expected value
Examples: Gambling, some criminal activities
Increasing marginal utility of income
Risk Loving
Expected value for risky option point F
E(I) = (0.5)($10,000) + (0.5)($30,000)
= $20,000
E(u) = (0.5)(3) + (0.5)(18) = 10.5
Certain income is $20,000 with utility of 8

point C
Risky alternative is preferred
Risk Loving
Utility
E
18

loving because she
would prefer the gamble
to a certain income.
10.5
8
A
3
0
10
20
30
Income ($1,000)

The risk premium is the maximum
amount of money that a risk-averse
person would pay to avoid taking a risk
The risk premium depends on the risky
alternatives the person faces
Risk Premium Example

From the previous example
A person has a .5 probability of earning
$30,000 and a .5 probability of earning
$10,000
The expected income is $20,000 with
expected utility of 14

Point F shows the risky scenario the
utility of 14 can also be obtained with
certain income of $16,000
This person would be willing to pay up to
$4000 (20 16) to avoid the risk of
uncertain income
Can show this graphically by drawing a
straight line between the two points line
CF

Risk Premium
Utility
20
18
14
10
Here, the risk

premium is $4,000
because a certain
income of $16,000
gives the person
the same expected
utility as the
uncertain income
with expected value
of $20,000.
10
16
20
30
40
Income ($1,000)
Risk Aversion and Indifference

Curves
Can describe a persons risk aversion
using indifference curves that relate
expected income to variability of income
(standard deviation)
Since risk is undesirable, greater risk
requires greater expected income to make
the person equally well off
Indifference curves are therefore upward
sloping

Curves
Expected
Income
U3
U2
U1
Standard Deviation of Income
Highly Risk Averse: An

increase in standard
deviation requires a
large increase in
income to maintain
satisfaction.

Curves
Expected
Income
Slightly Risk Averse:

A large increase in standard
deviation requires only a
small increase in income
to maintain satisfaction.
U3
U2
U1
Standard Deviation of Income
Reducing Risk
Consumers are generally risk averse and

therefore want to reduce risk
Three ways consumers attempt to
reduce risk are:
1. Diversification
2. Insurance
3. Obtaining more information
Reducing Risk
Diversification
Reducing risk by allocating resources to a
variety of activities whose outcomes are not
closely related
Example:
Suppose a firm has a choice of selling air
conditioners, heaters, or both
The probability of it being hot or cold is 0.5
How does a firm decide what to sell?
Income from Sales of

Appliances
Hot Weather
Cold
Weather
Air
conditioner
sales
$30,000
$12,000
Heater sales
12,000
30,000
Diversification Example
If the firm sells only heaters or air
conditioners their income will be either
$12,000 or $30,000
Their expected income would be:
1/2($12,000) + 1/2($30,000) = $21,000
If the firm divides their time evenly between
appliances, their air conditioning and heating
sales would be half their original values
If it were hot, their expected income would be
$15,000 from air conditioners and $6,000 from
heaters, or $21,000
If it were cold, their expected income would be
$6,000 from air conditioners and $15,000 from
heaters, or $21,000
With diversification, expected income is
$21,000 with no risk
Better off diversifying to minimize risk
Firms can reduce risk by diversifying
among a variety of activities that are not
closely related
Reducing Risk The Stock

Market
If invest all money in one stock, then take
on a lot of risk
If that stock loses value, you lose all your
investment value
Can spread risk out by investing in many

different stocks or investments
Ex: Mutual funds
Reducing Risk Insurance

Risk averse are willing to pay to avoid risk
If the cost of insurance equals the
expected loss, risk averse people will buy
enough insurance to recover fully from a
potential financial loss
The Law of Large Numbers

Insurance companies know that although
single events are random and largely
unpredictable, the average outcome of
many similar events can be predicted
When insurance companies sell many
policies, they face relatively little risk
Reducing Risk Actuarially Fair

Insurance companies can be sure total
premiums paid will equal total money paid
out
Companies set the premiums so money
received will be enough to pay expected
losses
The Value of Information

Risk often exists because we dont know
all the information surrounding a decision
Because of this, information is valuable
and people are willing to pay for it

The value of complete information
The difference between the expected value of
a choice with complete information and the
expected value when information is
incomplete

Example
Per capita milk consumption has fallen
over the years
The milk producers engaged in market
research to develop new sales strategies
to encourage the consumption of milk

Example
Findings
Milk demand is seasonal with the greatest
demand in the spring
Price elasticity of demand is negative and
small
Income elasticity is positive and large

Example
Milk advertising increases sales most in
the spring
Allocating advertising based on this
information in New York increased profits
by 9% or $14 million
The cost of the information was relatively
low, while the value was substantial
(increased profits)
Behavioral Economics
Sometimes individuals behavior
contradicts basic assumptions of
consumer choice
More information about human behavior might
lead to better understanding
This is the objective of behavioral
economics
Improving understanding of consumer choice by
incorporating more realistic and detailed
assumptions regarding human behavior
There are a number of examples of
consumer choice contradictions
You take at trip and stop at a restaurant that
you will most likely never stop at again. You
still think it fair to leave a 15% tip rewarding
the good service.
You choose to buy a lottery ticket even though
the expected value is less than the price of
the ticket
Reference Points
Economists assume that consumers place a
unique value on the goods/services
purchased
Psychologists have found that perceived
value can depend on circumstances
You are able to buy a ticket to the sold out Cher
concert for the published price of $125. You find
out you can sell the ticket for $500 but you choose
not to, even though you would never have paid
more than $250 for the ticket.
Reference Points (cont.)
The point from which an individual makes a
consumption decision
From the example, owning the Cher ticket is
the reference point
Individuals dislike losing things they own
They value items more when they own them than
when they do not
Losses are valued more than gains
Utility loss from selling the ticket is greater than
original utility gain from purchasing it
Experimental Economics
Students were divided into two groups
Group one was given a mug with a market
value of $5.00
Group two received nothing
Students with mugs were asked how much
they would take to sell the mug back
Lowest price for mugs, on average, was $7.00
Experimental Economics (cont.)
Group without mugs was asked minimum
amount of cash they would except in lieu of
the mug
On average willing to accept $3.50 instead of
getting the mug
Group one had reference point of owning the

mug
Group two had reference point of no mug
Fairness
Individuals often make choices because they
think they are fair and appropriate
Charitable giving, tipping in restaurants
Some consumers will go out of their way to

punish a store they think is unfair in their
pricing
Manager might offer higher than market
wages to make for happier working
environment or more productive worker
Chapter 6
Production
Introduction
Our study of consumer behavior was
broken down into 3 steps:
Describing consumer preferences
Consumers face budget constraints
Consumers choose to maximize utility
Production decisions of a firm are similar

to consumer decisions
Can also be broken down into three steps
Production Decisions of a Firm

1. Production Technology
Describe how inputs can be transformed into
outputs
Inputs: land, labor, capital and raw materials

Outputs: cars, desks, books, etc.
Firms can produce different amounts of

outputs using different combinations of
inputs

2. Cost Constraints
Firms must consider prices of labor, capital
and other inputs
Firms want to minimize total production costs
partly determined by input prices
As consumers must consider budget
constraints, firms must be concerned about
costs of production

3. Input Choices
Given input prices and production
technology, the firm must choose how much
of each input to use in producing output
Given prices of different inputs, the firm may
choose different combinations of inputs to
minimize costs
If labor is cheap, firm may choose to produce

with more labor and less capital

If a firm is a cost minimizer, we can also
study
How total costs of production vary with output
How the firm chooses the quantity to
maximize its profits
We can represent the firms production

technology in the form of a production
function
The Technology of Production

Production Function:
Indicates the highest output (q) that a firm can
produce for every specified combination of
inputs
For simplicity, we will consider only labor (L)
and capital (K)
Shows what is technically feasible when the
firm operates efficiently

The production function for two inputs:
q = F(K,L)
Output (q) is a function of capital (K) and labor
(L)
The production function is true for a given
technology
If technology increases, more output can be
produced for a given level of inputs

Short Run versus Long Run
It takes time for a firm to adjust production
from one set of inputs to another
Firms must consider not only what inputs can
be varied but over what period of time that
can occur
We must distinguish between long run and
short run

Short Run
Period of time in which quantities of one or
more production factors cannot be changed
These inputs are called fixed inputs
Long Run
Amount of time needed to make all production
inputs variable
Short run and long run are not time

specific
Production: One Variable Input

We will begin looking at the short run
when only one input can be varied
We assume capital is fixed and labor is
variable
Output can only be increased by increasing
labor
Must know how output changes as the
amount of labor is changed (Table 6.1)
Observations:
1. When labor is zero, output is zero as well
2. With additional workers, output (q) increases
up to 8 units of labor
3. Beyond this point, output declines
Increasing labor can make better use of existing

capital initially
After a point, more labor is not useful and can be
counterproductive

Firms make decisions based on the
benefits and costs of production
Sometimes useful to look at benefits and
costs on an incremental basis
How much more can be produced when at
incremental units of an input?
Sometimes useful to make comparison on

an average basis

Average product of Labor - Output per unit
of a particular product
Measures the productivity of a firms labor
in terms of how much, on average, each
worker can produce
Output
q
APL
Labor Input L

Marginal Product of Labor additional
output produced when labor increases by
one unit
Change in output divided by the change in
labor
Output
q
MPL
Labor Input L

We can graph the information in Table 6.1
to show
How output varies with changes in labor
Output is maximized at 112 units
Average and Marginal Products

Marginal Product is positive as long as total output
is increasing
Marginal Product crosses Average Product at its
maximum

Output
per
Month
112
Total Product
C
60
At point D, output is
maximized.
B
A
0 1
2 3
5 6
7 8
10 Labor per Month

Output
per
Worker
Left of E: MP > AP & AP is increasing

Right of E: MP < AP & AP is decreasing
At E: MP = AP & AP is at its maximum
At 8 units, MP is zero and output is at max
30
Marginal Product
20
Average Product
10
0 1
2 3
5 6
7 8
10 Labor per Month
Marginal and Average Product

When marginal product is greater than the
average product, the average product is
increasing
When marginal product is less than the average
product, the average product is decreasing
When marginal product is zero, total product
(output) is at its maximum
Marginal product crosses average product at its
maximum
Product Curves
We can show a geometric relationship
between the total product and the average
and marginal product curves
Slope of line from origin to any point on the
total product curve is the average product
At point B, AP = 60/3 = 20 which is the same
as the slope of the line from the origin to point
B on the total product curve
Product Curves
q
AP is slope of line from

origin to point on TP
curve
q/L
112
TP
C
60
30
20
AP
10
MP
0 1 2 3 4 5 6 7 8 9 10
Labor
0 1 2 3 4 5 6 7 8 9 10
Labor
Product Curves
Geometric relationship between total
product and marginal product
The marginal product is the slope of the line
tangent to any corresponding point on the
total product curve
For 2 units of labor, MP = 30/2 = 15 which is
slope of total product curve at point A
Product Curves
q
MP is slope of line tangent to

corresponding point on TP
curve
112
TP 30
15
60
30
10
A
0 1 2 3 4 5 6 7 8 9 10
Labor
AP
MP
0 1 2 3 4 5 6 7 8 9 10
Labor

From the previous example, we can see
that as we increase labor the additional
output produced declines
Law of Diminishing Marginal Returns:
As the use of an input increases with other
inputs fixed, the resulting additions to
output will eventually decrease
Law of Diminishing Marginal

Returns
When the use of labor input is small and
capital is fixed, output increases
considerably since workers can begin to
specialize and MP of labor increases
When the use of labor input is large, some
workers become less efficient and MP of
labor decreases

Returns
Typically applies only for the short run
when one variable input is fixed
Can be used for long-run decisions to
evaluate the trade-offs of different plant
configurations
Assumes the quality of the variable input
is constant

Returns
Easily confused with negative returns
decreases in output
Explains a declining marginal product, not
necessarily a negative one
Additional output can be declining while total
output is increasing

Returns
Assumes a constant technology
Changes in technology will cause shifts in the
total product curve
More output can be produced with same
inputs
Labor productivity can increase if there are
improvements in technology, even though any
given production process exhibits diminishing
returns to labor
The Effect of Technological

Improvement
Output
Moving from A to B to
C, labor productivity is
increasing over time
100
O3
O2
50
O1
0 1
2 3
5 6
7 8
10
Labor per
time period
Production: Two Variable Inputs

Firm can produce output by combining
different amounts of labor and capital
In the long run, capital and labor are both
variable
We can look at the output we can achieve
with different combinations of capital and
labor Table 6.4

The information can be represented
graphically using isoquants
Curves showing all possible combinations of
inputs that yield the same output
Curves are smooth to allow for use of

fractional inputs
Curve 1 shows all possible combinations of
labor and capital that will produce 55 units of
output
Isoquant Map
E
Capital 5
per year
Ex: 55 units of output

can be produced with
3K & 1L (pt. A)
OR
1K & 3L (pt. D)
4
3
q3 = 90
D
q2 = 75
q1 = 55
Labor per year

Diminishing Returns to Labor with
Isoquants
Holding capital at 3 and increasing labor
from 0 to 1 to 2 to 3
Output increases at a decreasing rate (0, 55,
20, 15) illustrating diminishing marginal
returns from labor in the short run and long
run

Diminishing Returns to Capital with
Isoquants
Holding labor constant at 3 increasing
capital from 0 to 1 to 2 to 3
Output increases at a decreasing rate (0, 55,
20, 15) due to diminishing returns from capital
in short run and long run
Diminishing Returns
Capital 5
per year
Increasing labor
holding capital
constant (A, B, C)
OR
Increasing capital
holding labor constant
(E, D, C
4
3
C
D
q3 = 90
E
q2 = 75
q1 = 55
Labor per year

Substituting Among Inputs
Companies must decide what combination of
inputs to use to produce a certain quantity of
output
There is a trade-off between inputs, allowing
them to use more of one input and less of
another for the same level of output

Substituting Among Inputs
Slope of the isoquant shows how one input
can be substituted for the other and keep the
level of output the same
The negative of the slope is the marginal rate
of technical substitution (MRTS)
Amount by which the quantity of one input can be
reduced when one extra unit of another input is
used, so that output remains constant

The marginal rate of technical substitution
equals:
Change in Capital Input

MRTS
Change in Labor Input
MRTS K
(for a fixed level of q )
L

As labor increases to replace capital
Labor becomes relatively less productive
Capital becomes relatively more productive
Need less capital to keep output constant
Isoquant becomes flatter
Marginal Rate of
Technical Substitution
Capital
per year
Negative Slope measures

MRTS;
MRTS decreases as move down
the indifference curve
1
1
2/3
Q3 =90
1
1/3
Q2 =75
Q1 =55
5
Labor per month
MRTS and Isoquants

We assume there is diminishing MRTS
Increasing labor in one unit increments from 1 to 5
results in a decreasing MRTS from 1 to 1/2
Productivity of any one input is limited
Diminishing MRTS occurs because of

diminishing returns and implies isoquants are
convex
There is a relationship between MRTS and
marginal products of inputs
MRTS and Marginal Products

If we increase labor and decrease capital
to keep output constant, we can see how
much the increase in output is due to the
increased labor
Amount of labor increased times the marginal
productivity of labor
( MPL )(L)

Similarly, the decrease in output from the
decrease in capital can be calculated
Decrease in output from reduction of capital
times the marginal produce of capital
( MPK )(K )

If we are holding output constant, the net
effect of increasing labor and decreasing
capital must be zero
Using changes in output from capital and
labor we can see
(MPL )( L) (MPK )( K) 0

Rearranging equation, we can see the
relationship between MRTS and MPs
(MPL )( L) (MPK )( K) 0
(MPL )(L) - (MPK )( K)
(MPL )
L
MRTS
( MPK )
K
Isoquants: Special Cases
Two extreme cases show the possible

range of input substitution in production
1. Perfect substitutes
MRTS is constant at all points on isoquant
Same output can be produced with a lot of
capital or a lot of labor or a balanced mix
Perfect Substitutes
Capital
per
month
Same output can be

reached with mostly
capital or mostly labor
(A or C) or with equal
amount of both (B)
C
Q1
Q2
Q3
Labor
per month
Isoquants: Special Cases

2. Perfect Complements
Fixed proportions production function
There is no substitution available between
inputs
The output can be made with only a specific
proportion of capital and labor
Cannot increase output unless increase both
capital and labor in that specific proportion
Fixed-Proportions
Production Function
Capital
per
month
Same output can

only be produced
with one set of
inputs.
Q3
C
Q2
B
K1
Q1
Labor
per month
L1
Returns to Scale
In addition to discussing the tradeoff
between inputs to keep production the
same
How does a firm decide, in the long run,
the best way to increase output?
Can change the scale of production by
increasing all inputs in proportion
If double inputs, output will most likely
increase but by how much?
Returns to Scale
Rate at which output increases as inputs
are increased proportionately
Increasing returns to scale
Constant returns to scale
Decreasing returns to scale
Returns to Scale
Increasing returns to scale: output more
than doubles when all inputs are doubled
Larger output associated with lower cost
(cars)
One firm is more efficient than many (utilities)
The isoquants get closer together
Increasing Returns to Scale

Capital
(machine
hours)
The isoquants
move closer
together
4
30
20
2
10
5
10
Labor (hours)
Returns to Scale
Constant returns to scale: output
doubles when all inputs are doubled
Size does not affect productivity
May have a large number of producers
Isoquants are equidistant apart
Returns to Scale
Capital
(machine
hours)
A
6
30
4
2
0
2
Constant
Returns:
Isoquants are
equally spaced
10
5
10
15
Labor (hours)
Returns to Scale
Decreasing returns to scale: output less
than doubles when all inputs are doubled
Decreasing efficiency with large size
Reduction of entrepreneurial abilities
Isoquants become farther apart
Returns to Scale
Capital
(machine
hours)
Decreasing Returns:
Isoquants get further
apart
30
2
10
5
10
20
Labor (hours)
Chapter 7
The Cost of Production
Measuring Cost:
Which Costs Matter?
For a firm to minimize costs, we must
clarify what is meant by costs and how to
measure them
It is clear that if a firm has to rent equipment
or buildings, the rent they pay is a cost
What if a firm owns its own equipment or
building?
How are costs calculated here?
Measuring Cost:
Which Costs Matter?
Accountants tend to take a retrospective
view of firms costs, whereas economists
tend to take a forward-looking view
Accounting Cost
Actual expenses plus depreciation charges for
capital equipment
Economic Cost
Cost to a firm of utilizing economic resources
in production, including opportunity cost
Measuring Cost:
Which Costs Matter?
Economic costs distinguish between costs
the firm can control and those it cannot
Concept of opportunity cost plays an
important role
Opportunity cost
Cost associated with opportunities that are
foregone when a firms resources are not put
to their highest-value use
Opportunity Cost
An Example
A firm owns its own building and pays no rent
for office space
Does this mean the cost of office space is
zero?
The building could have been rented instead
Foregone rent is the opportunity cost of using
the building for production and should be
included in the economic costs of doing
business
Opportunity Cost
A person starting their own business must
take into account the opportunity cost of
their time
Could have worked elsewhere making a
competitive salary
Measuring Cost:
Which Costs Matter?
Although opportunity costs are hidden and
should be taken into account, sunk costs
should not
Sunk Cost
Expenditure that has been made and cannot
be recovered
Should not influence a firms future economic
decisions
Sunk Cost
Firm buys a piece of equipment that
cannot be converted to another use
Expenditure on the equipment is a sunk
cost
Has no alternative use so cost cannot be
recovered opportunity cost is zero
Decision to buy the equipment might have
been good or bad, but now does not matter
Prospective Sunk Cost

An Example
Firm is considering moving its headquarters
A firm paid $500,000 for an option to buy a
building
The cost of the building is $5 million for a total
of $5.5 million
The firm finds another building for $5.25
million
Which building should the firm buy?
Prospective Sunk Cost

The first building should be purchased
The $500,000 is a sunk cost and should
not be considered in the decision to buy
What should be considered is
Spending an additional $5,250,000 or
Spending an additional $5,000,000
Measuring Cost:
Which Costs Matter?
Some costs vary with output, while some

remain the same no matter the amount of
output
Total cost can be divided into:
1. Fixed Cost
Does not vary with the level of output
2. Variable Cost
Cost that varies as output varies
Fixed and Variable Costs

Total output is a function of variable inputs
and fixed inputs
Therefore, the total cost of production
equals the fixed cost (the cost of the fixed
inputs) plus the variable cost (the cost of
the variable inputs), or
TC FC VC
Fixed and Variable Costs

Which costs are variable and which are
fixed depends on the time horizon
Short time horizon most costs are fixed
Long time horizon many costs become
variable
In determining how changes in production
will affect costs, must consider if fixed or
variable costs are affected.
Fixed Cost Versus Sunk Cost

Fixed cost and sunk cost are often
confused
Fixed Cost
Cost paid by a firm that is in business
regardless of the level of output
Sunk Cost
Cost that has been incurred and cannot be
recovered
Measuring Cost:
Which Costs Matter?
Personal Computers
Most costs are variable
Largest component: labor
Software
Most costs are sunk
Initial cost of developing the software
Measuring Costs
Marginal Cost (MC):
The cost of expanding output by one unit
Fixed costs have no impact on marginal cost,
so it can be written as:
VC TC
MC
q
q
Measuring Costs
Average Total Cost (ATC)
Cost per unit of output
Also equals average fixed cost (AFC) plus
average variable cost (AVC)
TC
ATC
AFC AVC
q
TC TFC TVC
ATC
q
q
q
A Firms Short Run Costs
A Firms Short Run Costs
Determinants of Short Run Costs

The rate at which these costs increase
depends on the nature of the production
process
The extent to which production involves
diminishing returns to variable factors
Diminishing returns to labor

When marginal product of labor is decreasing

If marginal product of labor decreases
significantly as more labor is hired
Costs of production increase rapidly
Greater and greater expenditures must be made to
produce more output
If marginal product of labor decreases only

slightly as increase labor
Costs will not rise very fast when output is increased
Determinants of Short Run

Costs An Example
Assume the wage rate (w) is fixed relative
to the number of workers hired
Variable costs is the per unit cost of extra
labor times the amount of extra labor: wL
VC wL
MC
q
q

Costs An Example
Remembering that
Q
MPL
L
And rearranging
L
1
L for a 1 unit Q
Q MPL

Costs An Example
We can conclude:
w
MC
MPL
and a low marginal product (MPL) leads
to a high marginal cost (MC) and vice
versa

Consequently
MC decreases initially with increasing returns
0 through 4 units of output
MC increases with decreasing returns

5 through 11 units of output
Cost Curves for a Firm

TC
Cost 400
($ per
year)
Total cost
is the vertical
sum of FC
and VC.
300
VC
Variable cost
increases with
production and
the rate varies with
increasing and
decreasing returns.
200
Fixed cost does not

vary with output
100
50
0
10
11
12
13
FC
Output
Cost Curves
MC
ATC
AVC
AFC
Cost Curves
When MC is below AVC, AVC is falling

When MC is above AVC, AVC is rising
When MC is below ATC, ATC is falling
When MC is above ATC, ATC is rising
Therefore, MC crosses AVC and ATC at the
minimums
The Average Marginal relationship
Cost Curves for a Firm

The line drawn from
P
the origin to the
variable cost curve: 400
TC
VC
Its slope equals AVC

300
The slope of a point
on VC or TC equals
200
MC
Therefore, MC =
100
AVC at 7 units of
output (point A)
A
FC
1
10
11
12
13
Output
Cost in the Long Run

In the long run a firm can change all of its
inputs
In making cost minimizing choices, must
look at the cost of using capital and labor
in production decisions
Cost Minimizing Input Choice

How do we put all this together to select inputs to
produce a given output at minimum cost?
Assumptions
Two Inputs: Labor (L) and capital (K)
Price of labor: wage rate (w)
The price of capital
r = depreciation rate + interest rate

Or rental rate if not purchasing
These are equal in a competitive capital
market

The Isocost Line
A line showing all combinations of L & K that
can be purchased for the same cost
Total cost of production is sum of firms labor
cost, wL, and its capital cost, rK:
C = wL + rK
For each different level of cost, the equation
shows another isocost line

Rewriting C as an equation for a straight
line:
K = C/r - (w/r)L
Slope of the isocost:
-(w/r) is the ratio of the wage rate to rental cost of

capital.
This shows the rate at which capital can be
substituted for labor with no change in cost
Choosing Inputs
We will address how to minimize cost for a
given level of output by combining
isocosts with isoquants
We choose the output we wish to produce
and then determine how to do that at
minimum cost
Isoquant is the quantity we wish to produce
Isocost is the combination of K and L that
gives a set cost
Producing a Given Output at

Minimum Cost
Capital
per
year
Q1 is an isoquant for output Q1.

There are three isocost lines, of
which 2 are possible choices in
which to produce Q1.
K2
Isocost C2 shows quantity

Q1 can be produced with
combination K2,L2 or K3,L3.
However, both of these
are higher cost combinations
than K1,L1.
K1
Q1
K3
C0
L2
L1
C1
L3
C2
Labor per year
Input Substitution When an

Input Price Change
If the price of labor changes, then the
slope of the isocost line changes, -(w/r)
It now takes a new quantity of labor and
capital to produce the output
If price of labor increases relative to price
of capital, and capital is substituted for
labor
Input Substitution When an

Input Price Change
Capital
per
year
K2
If the price of labor

rises, the isocost curve
becomes steeper due to
the change in the slope -(w/L).
The new combination of K

and L is used to produce Q1.
Combination B is used in
place of combination A.
B
A
K1
Q1
C2
L2
L1
C1
Labor per year

How does the isocost line relate to the
firms production process?
MRTS - K
MPL
Slope of isocost line K

MPL
MPK
MPK
when firm minimizes cost

The minimum cost combination can then
be written as:
MPL
MPK
Minimum cost for a given output will occur

when each dollar of input added to the
production process will add an equivalent
amount of output.

If w = $10, r = $2, and MPL = MPK, which
input would the producer use more of?
Labor because it is cheaper
Increasing labor lowers MPL
Decreasing capital raises MPK
Substitute labor for capital until
MPL MPK
w
r

Cost minimization with Varying Output
Levels
For each level of output, there is an isocost
curve showing minimum cost for that output
level
A firms expansion path shows the minimum
cost combinations of labor and capital at each
level of output
Slope equals K/L
A Firms Expansion Path

Capital
per
year
The expansion path illustrates

the least-cost combinations of
labor and capital that can be
used to produce each level of
output in the long-run.
150 $3000
Expansion Path
100
$200
0
C
75
B
50
300 Units
A
25
200 Units
50
100
150
200
300
Labor per year
Expansion Path and Long Run

Costs
Firms expansion path has same
information as long-run total cost curve
To move from expansion path to LR cost
curve
Find tangency with isoquant and isocost
Determine min cost of producing the output
level selected
Graph output-cost combination
A Firms Long Run Total Cost

Curve
Cost/
Year
Long Run Total Cost
F
3000
E
2000
1000
100
200
300
Output, Units/yr
Long Run Versus Short Run

Cost Curves
In the short run, some costs are fixed
In the long run, firm can change anything
including plant size
Can produce at a lower average cost in long
run than in short run
Capital and labor are both flexible
We can show this by holding capital fixed

in the short run and flexible in long run
The Inflexibility of Short Run

Production
Capital E
per
year
Capital is fixed at K1.

To produce q1, min cost at K1,L1.
If increase output to Q2, min cost
is K1 and L3 in short run.
Long-Run
Expansion Path
A
K2
Short-Run
Expansion Path
K1
In LR, can
change
capital and
min costs
falls to K2
and L2.
Q2
Q1
L1
L2
L3
Labor per year
Long Run Versus

Short Run Cost Curves
Long-Run Average Cost (LAC)

Most important determinant of the shape of
the LR AC and MC curves is relationship
between scale of the firms operation and
inputs required to minimize cost
1. Constant Returns to Scale

If input is doubled, output will double
AC cost is constant at all levels of output

Cost Curves
2. Increasing Returns to Scale
If input is doubled, output will more than
double
AC decreases at all levels of output
3. Decreasing Returns to Scale

If input is doubled, output will less than
double
AC increases at all levels of output

Cost Curves
In the long run:
Firms experience increasing and decreasing
returns to scale and therefore long-run
average cost is U shaped.
Source of U-shape is due to returns to scale
instead of decreasing returns to scale like the
short-run curve
Long-run marginal cost curve measures the
change in long-run total costs as output is
increased by 1 unit

Cost Curves
Long-run marginal cost leads long-run
average cost:
If LMC < LAC, LAC will fall
If LMC > LAC, LAC will rise
Therefore, LMC = LAC at the minimum of
LAC
In special case where LAC is constant,

LAC and LMC are equal
Long Run Average and Marginal

Cost
Cost
($ per unit
of output
LMC
LAC
Output
Long Run Costs
As output increases, firms AC of

producing is likely to decline to a point
1. On a larger scale, workers can better specialize
2. Scale can provide flexibility managers can
organize production more effectively
3. Firm may be able to get inputs at lower cost if can
get quantity discounts. Lower prices might lead to
different input mix.
Long Run Costs
At some point, AC will begin to increase

1. Factory space and machinery may make it
more difficult for workers to do their jobs
efficiently
2. Managing a larger firm may become more
complex and inefficient as the number of
tasks increase
3. Bulk discounts can no longer be utilized.
Limited availability of inputs may cause price
to rise.
Long Run Costs

When input proportions change, the firms
expansion path is no longer a straight line
Concept of return to scale no longer applies
Economies of scale reflects input

proportions that change as the firm
changes its level of production
Economies and Diseconomies

of Scale
Economies of Scale
Increase in output is greater than the increase
in inputs
Diseconomies of Scale
Increase in output is less than the increase in
inputs
U-shaped LAC shows economies of scale

for relatively low output levels and
diseconomies of scale for higher levels
Long Run Costs

Increasing Returns to Scale
Output more than doubles when the quantities
of all inputs are doubled
Economies of Scale
Doubling of output requires less than a
doubling of cost
Long Run Costs

Economies of scale are measured in
terms of cost-output elasticity, EC
EC is the percentage change in the cost of
production resulting from a 1-percent
increase in output
C
C
EC
Q Q
MC
AC
Long Run Costs

EC is equal to 1, MC = AC
Costs increase proportionately with output
Neither economies nor diseconomies of scale
EC < 1 when MC < AC

Economies of scale
Both MC and AC are declining
EC > 1 when MC > AC

Diseconomies of scale
Both MC and AC are rising

Cost Curves
We will use short and long run costs to
determine the optimal plant size
We can show the short run average costs
for 3 different plant sizes
This decision is important because once
built, the firm may not be able to change
plant size for a while
Long Run Cost with Economies

and Diseconomies of Scale
Long Run Cost with

Constant Returns to Scale
The optimal plant size will depend on the
anticipated output
If expect to produce q0, then should build
smallest plant: AC = $8
If produce more, like q1, AC rises
If expect to produce q2, middle plant is least
cost
If expect to produce q3, largest plant is best

Long Run Cost with

What is the firms long run cost curve?
Firms can change scale to change output in
the long run
The long run cost curve is the dark blue
portion of the SAC curve which represents the
minimum cost for any level of output
Firm will always choose plant that minimizes
the average cost of production

Long Run Cost with

The long-run average cost curve envelops
the short-run average cost curves
The LAC curve exhibits economies of
scale initially but exhibits diseconomies at
higher output levels
Chapter 8
Profit Maximization and
Competitive Supply
Perfectly Competitive Markets
The model of perfect competition can be

used to study a variety of markets
Basic assumptions of Perfectly
Competitive Markets
1. Price taking
2. Product homogeneity
3. Free entry and exit

1. Price Taking
The individual firm sells a very small share of
the total market output and, therefore,
cannot influence market price
Each firm takes market price as given price
taker
The individual consumer buys too small a
share of industry output to have any impact
on market price

2. Product Homogeneity
The products of all firms are perfect
substitutes
Product quality is relatively similar as well as
other product characteristics
Agricultural products, oil, copper, iron,
lumber
Heterogeneous products, such as brand
names, can charge higher prices because
they are perceived as better

3. Free Entry and Exit
When there are no special costs that make it
difficult for a firm to enter (or exit) an industry
Buyers can easily switch from one supplier
to another
Suppliers can easily enter or exit a market
Pharmaceutical companies are not perfectly

competitive because of the large costs of R&D
required
When are Markets Competitive?

Few real products are perfectly
competitive
Many markets are, however, highly
competitive
They face relatively low entry and exit costs
Highly elastic demand curves
No rule of thumb to determine whether a

market is close to perfectly competitive
Depends on how they behave in situations
Profit Maximization
Do firms maximize profits?
Managers in firms may be concerned with
other objectives
Revenue maximization
Revenue growth
Dividend maximization
Short-run profit maximization (due to bonus or
promotion incentive)
Could be at expense of long run profits
Profit Maximization
Implications of non-profit objective
Over the long run, investors would not support
the company
Without profits, survival is unlikely in
competitive industries
Managers have constrained freedom to

pursue goals other than long-run profit
maximization
Marginal Revenue, Marginal

Cost, and Profit Maximization
We can study profit maximizing output for
any firm, whether perfectly competitive or
not
Profit () = Total Revenue - Total Cost
If q is output of the firm, then total revenue is
price of the good times quantity
Total Revenue (R) = Pq

Costs of production depends on output
Total Cost (C) = C(q)
Profit for the firm, , is difference between

revenue and costs
(q) R(q) C (q)

Firm selects output to maximize the
difference between revenue and cost
We can graph the total revenue and total
cost curves to show maximizing profits for
the firm
Distance between revenues and costs
show profits

Revenue is a curve, showing that a firm can only
sell more if it lowers its price
Slope of the revenue curve is the marginal
revenue
Change in revenue resulting from a one-unit increase
in output
Slope of the total cost curve is marginal cost

Additional cost of producing an additional unit of
output

If the producer tries to raise price, sales are zero
Profit is negative to begin with, since revenue is
not large enough to cover fixed and variable
costs
As output rises, revenue rises faster than costs
increasing profit
Profit increases until it is maxed at q*
Profit is maximized where MR = MC or where
slopes of the R(q) and C(q) curves are equal
Profit Maximization Short Run

Cost,
Revenue,
Profit
($s per
year)
Profits are maximized where MR (slope

at A) and MC (slope at B) are equal
C(q)
A
R(q)
Profits are
maximized
where R(q)
C(q) is
maximized
q0
q*
Output
(q)

Profit is maximized at the point at which
an additional increment to output leaves
profit unchanged
R C
R C
0
q q q
MR MC 0
MR MC
The Competitive Firm

Demand curve faced by an individual firm
is a horizontal line
Firms sales have no effect on market price
Demand curve faced by whole market is

downward sloping
Shows amount of goods all consumers will
purchase at different prices

Price
$ per
bushel
Industry
Price
$ per
bushel
Firm
$4
$4
D
100
200
Output
(bushels)
100
Output
(millions
of bushels)

The competitive firms demand
Individual producer sells all units for $4
regardless of that producers level of output
MR = P with the horizontal demand curve
For a perfectly competitive firm, profit
maximizing output occurs when
MC (q ) MR P AR
Choosing Output: Short Run

We will combine revenue and costs with
demand to determine profit maximizing
output decisions
In the short run, capital is fixed and firm
must choose levels of variable inputs to
maximize profits
We can look at the graph of MR, MC, ATC
and AVC to determine profits
A Competitive Firm
MC
Price
50
Lost Profit
for q2>q*
Lost Profit
for q2>q*
40
AR=MR=P
ATC
AVC
30
q1 : MR > MC
q2: MC > MR
q*: MC = MR
20
10
0
q1
q q2
*
10
11
Output
Choosing Output: Short Run

The point where MR = MC, the profit
maximizing output is chosen
MR = MC at quantity, q*, of 8
At a quantity less than 8, MR > MC, so more
profit can be gained by increasing output
At a quantity greater than 8, MC > MR,
increasing output will decrease profits
A Competitive Firm Positive

Profits
Price
50
40
Profit per
unit = PAC(q) = A
to B
MC
Total
Profit =
ABCD
AR=MR=P
ATC
30 C
Profits are
determined
by output per
unit times
quantity
AVC
20
10
0
q1
q q2
*
10
11
Output

A firm does not have to make profits
It is possible a firm will incur losses if the P
< AC for the profit maximizing quantity
Loss
A Competitive Firm Losses

MC
Price
C
ATC
At q : MR =
MC and P <
ATC
Losses =
(P- AC) x q*
or ABCD
*
P = MR
AVC
q*
Output
Short Run Production

Why would a firm produce at a loss?
Might think price will increase in near future
Shutting down and starting up could be costly
Firm has two choices in short run

Continue producing
Shut down temporarily
Will compare profitability of both choices
Short Run Production

When should the firm shut down?
If AVC < P < ATC, the firm should continue
producing in the short run
Can cover all of its variable costs and some of its
fixed costs
If AVC > P < ATC, the firm should shut down

Cannot cover its variable costs or any of its fixed
costs
A Competitive Firm Losses

MC
Price
ATC
Losses
D
P < ATC but
AVC so
firm will
continue to
produce in
short run
P = MR
AVC
q*
Output
Competitive Firm Short Run

Supply
Supply curve tells how much output will be
produced at different prices
Competitive firms determine quantity to
produce where P = MC
Firm shuts down when P < AVC
Competitive firms supply curve is portion

of the marginal cost curve above the AVC
curve
A Competitive Firms
Short-Run Supply Curve
Price
($ per
unit)
The firm chooses the

output level where P = MR = MC,
as long as P > AVC.
Supply is MC
above AVC
MC
P2
ATC
P1
AVC
P = AVC
q1
q2 Output
A Competitive Firms
Supply is upward sloping due to
diminishing returns
Higher price compensates the firm for the
higher cost of additional output and
increases total profit because it applies to
all units
A Competitive Firms
Over time, prices of product and inputs
can change
How does the firms output change in
response to a change in the price of an
input?
We can show an increase in marginal costs
and the change in the firms output decisions
The Response of a Firm to

a Change in Input Price
Price
($ per
unit)
MC2
Savings to the firm
from reducing output
Input cost increases

and MC shifts to MC2
and q falls to q2.
MC1
$5
q2
q1
Output
The Short-Run Market Supply

Curve
As price rises, firms expand their production
Increased production leads to increased
demand for inputs and could cause increases in
input prices
Increases in input prices cause MC curve to rise
This lowers each firms output choice
Causes industry supply to be less responsive to
change in price than would be otherwise
Elasticity of Market Supply

Measures the sensitivity of industry output to
market price
The percentage change in quantity supplied,
Q, in response to 1-percent change in price
Es (Q / Q) /( P / P )

When MC increases rapidly in response to
increases in output, elasticity is low
When MC increases slowly, supply is relatively
elastic
Perfectly inelastic short-run supply arises when
the industrys plant and equipment are so fully
utilized that new plants must be built to achieve
greater output
Perfectly elastic short-run supply arises when
marginal costs are constant
Producer Surplus in the Short

Run
Price is greater than MC on all but the last unit of
output
Therefore, surplus is earned on all but the last
unit
The producer surplus is the sum over all units
produced of the difference between the market
price of the good and the marginal cost of
production
Area above supply curve to the market price
Producer Surplus for a Firm

Price
($ per
unit of
output)
MC
Producer
Surplus
AVC
B
A
P
At q* MC = MR.
Between 0 and q,
MR > MC for all units.
Producer surplus
is area above MC
to the price
q*
Output
The Short-Run Market Supply

Curve
Sum of MC from 0 to q*, it is the sum of
the total variable cost of producing q*
Producer Surplus can be defined as the
difference between the firms revenue and
its total variable cost
We can show this graphically by the
rectangle ABCD
Revenue (0ABq*) minus variable cost (0DCq*)
Producer Surplus for a Firm

Price
($ per
unit of
output)
MC
Producer
Surplus
AVC
B
A
q*
Producer surplus
is also ABCD =
Revenue minus
variable costs
Output
Producer Surplus Versus Profit

Profit is revenue minus total cost (not just
variable cost)
When fixed cost is positive, producer
surplus is greater than profit
Producer Surplus PS R - VC
Profit R - VC - FC
Producer Surplus Versus Profit

Costs of production determine magnitude
of producer surplus
Higher cost firms have less producer surplus
Lower cost firms have more producer surplus
Adding up surplus for all producers in the
market given total market producer surplus
Area below market price and above supply
curve
Producer Surplus for a Market

Price
($ per
unit of
output)
Market producer surplus is

the difference between P*
and S from 0 to Q*.
P*
Producer
Surplus
D
Q*
Output
Choosing Output in the Long

Run
In short run, one or more inputs are fixed
Depending on the time, it may limit the
flexibility of the firm
In the long run, a firm can alter all its

inputs, including the size of the plant
We assume free entry and free exit
No legal restrictions or extra costs
Choosing Output in the Long

Run
In the short run, a firm faces a horizontal
demand curve
Take market price as given
The short-run average cost curve (SAC) and

short-run marginal cost curve (SMC) are low
enough for firm to make positive profits (ABCD)
The long-run average cost curve (LRAC)
Economies of scale to q2
Diseconomies of scale after q2
Output Choice in the Long Run

Price
LMC
LAC
SMC
SAC
$40
A
P = MR
$30
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
q1
q2
q3
Output
Output Choice in the Long Run

In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD.
Price
LMC
LAC
SMC
SAC
$40
A
P = MR
G
$30
q1
q2
q3
Output
Long-Run Competitive
Equilibrium
For long run equilibrium, firms must have
no desire to enter or leave the industry
We can relate economic profit to the
incentive to enter and exit the market
Equilibrium
Zero-Profit
A firm is earning a normal return on its
investment
Doing as well as it could by investing its
money elsewhere
Normal return is firms opportunity cost of
using money to buy capital instead of
investing elsewhere
Competitive market long run equilibrium
Equilibrium
Entry and Exit
The long-run response to short-run profits is
to increase output and profits
Profits will attract other producers
More producers increase industry supply,
which lowers the market price
This continues until there are no more profits
to be gained in the market zero economic
profits
Equilibrium Profits
Profit attracts firms
Supply increases until profit = 0
$ per
unit of
output
$ per
unit of
output
Firm
Industry
S1
LMC
$40
LAC
P1
S2
P2
$30
D
q2
Output
Q1
Q2
Output
Equilibrium Losses
Losses cause firms to leave
Supply decreases until profit = 0
$ per
unit of
output
Firm
LMC
$ per
unit of
output
LAC
$30
P2
$20
P1
Industry
S2
S1
D
q2
Output
Q2
Q1
Output
Equilibrium
1. All firms in industry are maximizing profits
MR = MC
2. No firm has incentive to enter or exit

industry
Earning zero economic profits
3. Market is in equilibrium
QD = QS
Chapter 9
The Analysis of Competitive
Markets
Consumer and Producer

Surplus
When government controls price, some

people are better off
May be able to buy a good at a lower price
But what is the effect on society as a

whole?
Is total welfare higher or lower and by how much?
A way to measure gains and losses from

government policies is needed

Surplus
1. Consumer surplus is the total benefit or
value that consumers receive beyond
what they pay for the good
Assume market price for a good is $5
Some consumers would be willing to pay
more than $5 for the good
If you were willing to pay $9 for the good and
pay $5, you gain $4 in consumer surplus

Surplus
The demand curve shows the willingness
to pay for all consumers in the market
Consumer surplus can be measured by
the area between the demand curve and
the market price
Consumer surplus measures the total net
benefit to consumers

Surplus
2. Producer surplus is the total benefit or
revenue that producers receive beyond
what it costs to produce a good
Some producers produce for less than
market price and would still produce at a
lower price
A producer might be willing to accept $3 for
the good but get $5 market price
Producer gains a surplus of $2

Surplus
The supply curve shows the amount that a
producer is willing to take for a certain
amount of a good
Producer surplus can be measured by the
area between the supply curve and the
market price
Producer surplus measures the total net
benefit to producers

Surplus
Price
Consumer
Surplus
S
Between 0 and Q0
consumer A receives
a net gain from buying
the product-consumer surplus.
5
Producer
Surplus
3
D
QD
QS
Q0
Between 0 and Q0
producers receive
a net gain from
selling each product-producer surplus.
Quantity

Surplus
To determine the welfare effect of a
governmental policy, we can measure the
gain or loss in consumer and producer
surplus
Welfare Effects
Gains and losses to producers and
consumers

Surplus
When government institutes a price
ceiling, the price of a good cant go above
that price
With a binding price ceiling, producers and
consumers are affected
How much they are affected can be
determined by measuring changes in
consumer and producer surplus

Surplus
When price is held too low, the quantity
demanded increases and quantity
supplied decreases
Some consumers are worse off because
they can no longer buy the good
Decrease in consumer surplus
Some consumers are better off because

they can buy it at a lower price
Increase in consumer surplus

Surplus
Producers sell less at a lower price
Some producers are no longer in the
market
Both of these producer groups lose and
producer surplus decreases
The economy as a whole is worse off
since surplus that used to belong to
producers or consumers is simply gone
Price Control and Surplus

Changes
Price
Consumers that
cannot buy, lose B
Consumers that can

buy the good gain A
S
The loss to producers
is the sum of
rectangle A and
triangle C
B
P0
Triangles B and C are

losses to society
dead weight loss
Pmax
D
Q1
Q0
Q2
Quantity
Price Controls and Welfare

Effects
The total loss is equal to area B + C
The deadweight loss is the inefficiency of
the price controls the total loss in surplus
(consumer plus producer)
If demand is sufficiently inelastic, losses to
consumers may be fairly large
This can have effects in political decisions
Price Controls With Inelastic

Demand
D
Price
S
B
P0
Pmax
With inelastic demand,

triangle B can be larger
than rectangle A and
consumers suffer net
losses from price controls.
Q1
Q2
Quantity
Price Controls and

Natural Gas Shortages
From example in Chapter 2, 1975 Price
controls created a shortage of natural gas
What was the effect of those controls?
Decreases in surplus and overall loss for
society
We can measure these welfare effects from
the demand and supply of natural gas
Price Controls and

QS = 14 + 2PG + 0.25PO
Quantity supplied in trillion cubic feet (Tcf)
QD = -5PG + 3.75PO
Quantity demanded (Tcf)
PG = price of natural gas in $/mcf

PO = price of oil in $/b
Price Controls and

Using PO = $8/b and
G
Q DG Qgives
S
equilibrium values for natural gas
PG = $2/mcf and QG = 20 Tcf
Price ceiling was set at $1/mcf

Showing this graphically, we can see and
measure the effects on producer and
consumer surplus
Price Controls and

Price
($/mcf)
S
The gain to consumers is
rectangle A minus triangle
B, and the loss to
producers is rectangle A
plus triangle C.
2.40
B
2.00
C
A
(Pmax)1.00
10
15 18 20
25
30 Quantity (Tcf)
Price Controls and

Measuring the Impact of Price Controls
A = (18 billion mcf) x ($1/mcf) =
$18 billion
B = (1/2) x (2 b. mcf) x ($0.40/mcf) =
$0.4 billion
C = (1/2) x (2 b. mcf) x ($1/mcf) =
$1 billion
Price Controls and

Measuring the Impact of Price Controls in
1975
Change in consumer surplus
= A - B = 18 - 0.4 = $17.6 billion Gain
Change in producer surplus

= A + C = 18 + 1 = $19.0 billion Loss
Dead Weight Loss

= B + C = 0.4 + 1 = $1.4 billion Loss
The Efficiency of
a Competitive Market
In the evaluation of markets, we often talk
about whether it reaches economic
efficiency
Maximization of aggregate consumer and
producer surplus
Policies such as price controls that cause

dead weight losses in society are said to
impose an efficiency cost on the
economy
The Efficiency of
a Competitive Market
If efficiency is the goal, then you can argue
that leaving markets alone is the answer
However, sometimes market failures
occur
Prices fail to provide proper signals to
consumers and producers
Leads to inefficient unregulated competitive
market
Types of Market Failures

1. Externalities
Costs or benefits that do not show up as part
of the market price (e.g. pollution)
Costs or benefits are external to the market
2. Lack of Information
Imperfect information prevents consumers
from making utility-maximizing decisions
Government intervention may be

desirable in these cases
The Efficiency of a Competitive

Market
Other than market failures, unregulated
competitive markets lead to economic
efficiency
What if the market is constrained to a
price higher than the economically efficient
equilibrium price?
Price Control and Surplus

Changes
Price
S
Pmin
A
When price is
regulated to be no
lower than Pmin, the
deadweight loss given
by triangles B and C
results.
P0
D
Q1
Q0
Q2
Quantity
The Efficiency of a Competitive

Market
Deadweight loss triangles B and C give a
good estimate of the efficiency cost of
policies that force price above or below
market clearing price
Measuring effects of government price
controls on the economy can be estimated
by measuring these two triangles

Uncertainty and Consumer Behavior

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Uncertainty and Consumer Behavior

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Chapter 5

Uncertainty and Consumer

To measure risk we must know:

1. All of the possible outcomes

Based on the observed frequency of past events

Based on perception that an outcome will occur

With an interpretation of probability, must

Expected Value An Example

Expected Value An Example

Expected Value An Example

E(X) Pr1X1 Pr2 X 2 ... Prn X n

E(X1 ) .5($2000) .5($1000) $1500

E(X 2 ) .99($1510) .01($510) $1500

Standard Deviation Example 1

Standard Deviation Example 1

Standard Deviation Example 1

Standard Deviation Example 2

Outcome Probabilities - Two

Decision Making Example 1

Unequal Probability Outcomes

Decision Making Example 2

Decision Making Example 2

Risk and Crime Deterrence

Risk and Crime Deterrence

Risk and Crime Deterrence Example

Risk and Crime Deterrence Example

Risk and Crime Deterrence Example

Risk and Crime Deterrence Example

Preferences Toward Risk

Preferences Toward Risk Example

Preferences Toward Risk Example

Preferences Toward Risk

Preferences Toward Risk

Preferences Toward Risk

Preferences Toward Risk

Risk Averse - Example

Risk Averse Example

Expected Utility of Risky Job

Risk Averse Example

Risk averse persons losses (decreased

Certain job has expected income =

Risk Averse Utility Function

The consumer is risk

Preferences Toward Risk

This is the same as the certain income of

The consumer is risk

Preferences Toward Risk

Increasing marginal utility of income

Certain income is $20,000 with utility of 8

The consumer is risk

Preferences Toward Risk

Risk Premium Example

Risk Premium Example

Risk Premium Example

Here, the risk

Risk Aversion and Indifference

Risk Aversion and Indifference

Standard Deviation of Income

Highly Risk Averse: An

Risk Aversion and Indifference

Slightly Risk Averse:

Standard Deviation of Income