In the short run, firms face two types of costs: fixed costs (FC), incurred by the firm at any level of output, and variable costs (VC), which vary with the level of output. Added together, FC and VC equal total costs (TC). Marginal costs (MC) are the costs of producing an additional unit, measured by the change in TC divided by the change in output. MC decrease initially, then increase with the level of output in accordance with the law of diminishing returns, which holds that additional output decreases as more of one input is added and other inputs are held constant. Because adding inputs costs money, increasing output becomes increasingly costly.
Say someone wants to open a donut factory. First he needs to purchase a building and all the necessary equipment – the FC. To begin production, he has to buy donut materials, such as sugar, icing, etc., and hire a worker to make the donuts – the VC. Initially, MC are low. The owner already has the building and equipment, and pays a small additional amount for a worker and materials. As production rises, the worker can produce donuts efficiently for 8 hours per day. To further increase production, the owner may decide to hire more workers. At first, two workers work more efficiently together than one worker by himself, because two workers can divide the donut-making process into specialized tasks. Eventually, however, if the owner hires too many workers, they get in each others’ way because they all have to share the same equipment and space. Albeit paid the same as the first two workers, each additional worker produces less efficiently. As a result, the costs of producing additional donuts – the MC – increase.
If one graphed the number of donuts produced and the MC of producing the donuts, with the quantity of donuts on the x-axis and the MC of production on the y-axis, the graph would look like a supply curve – the only difference being that a supply curve would have price (P) instead of MC. The profit-maximizing donut factory owner is only willing to produce donuts at a level of output where P is equal to or greater than MC. Therefore, by substituting P for MC on the graph, one can get a good idea of the donut firm’s supply curve. Regardless of the market structure, all firms maximize profits at the output level where MC equals marginal revenue (MR) – the additional revenue a firm receives from selling an additional unit.
At the donut factory, MC decrease and profits rise after adding the second worker, motivating the owner to hire more workers. On adding too many workers, however, output starts to slow and MC exceed MR; to reverse that trend and maximize profits, the firm cuts back on its donut output by reducing VC, i.e., the number of workers. By definition, average revenue (AR) is the P per unit. In a perfectly competitive market, AR and MR are the same because P is constant – firms are too small and too numerous for any one to affect the market price. Because P is always the same, incremental revenue is equal to per unit revenue. If P = AR and AR = MR, then P = MR. And if firms maximize profits where MR = MC, then in perfectly competitive markets, firms maximize profits where MC = P. As a result, the short-run supply curve for an individual profit-maximizing firm in a perfectly competitive market is exactly the same as the MC curve.
In the short run, profit-maximizing firms still produce when costs exceed revenues, as long as average variable costs (AVC) are lower than P at the profit-maximizing output level. Because firms suffer losses equal to FC if they produce no output, then as long as P is higher than a firm’s minimum AVC, the firm is better off producing because it can cover its VC and use remaining revenues to cover some FC. If P falls below the minimum AVC, however, it is more profitable not to produce, because the firm cannot cover VC at any output level. As a result, the short-run supply curve for an individual profit-maximizing firm in a perfectly competitive market is the increasing part of its short-run MC curve starting above the minimum AVC.
Sunday, September 5, 2010
Utility and Consumption
The notion of “utility,” or satisfaction, is generally used to explain how consumers choose among different consumption options. The law of diminishing marginal utility holds that the amount of additional satisfaction consumers get from consuming each additional unit of a good or service decreases with each unit consumed. Because consumers get less and less satisfaction from additional units, they become less and less willing to pay the market price for each additional unit; therefore, consumers buy more when prices fall and less when prices rise. This inverse relationship explains why the demand curve is negatively sloped.
Understanding the law of diminishing marginal utility allows one to understand the equimarginal principle, which holds that maximum satisfaction or utility occurs when the marginal utility per last dollar spent on a good or service is exactly the same as the marginal utility per last dollar spent on any other good or service. If, for example, the consumption of an additional unit of good A yielded more marginal utility per dollar than the consumption of an additional unit of other goods, to maximize satisfaction individuals should spend less money on the other goods and consume more of good A until the marginal utility per dollar of good A falls to the same marginal utility per dollar of the other goods. Conversely, if good B yielded less marginal utility per dollar than the common level, consumers would buy less of good B and more of other goods until the marginal utility per last dollar of good B rose to that of the common level.
Another way of thinking about satisfaction involves indifference curves, which show how consumers react to different combinations of products. On a graph of indifference curves, one good appears on the x axis and the other good appears on the y axis. At any point along a given curve, consumers are equally satisfied with the combination of products – each point brings the same level of utility. Superimposing an income curve over a set of indifference curves shows all the different combinations of the two goods and/or services a consumer can purchase with a fixed budget. Consumers maximize their satisfaction when their income curve barely runs tangent to the highest indifference curve. If the price of good Y falls and the price of good X stays constant, the point of tangency changes, and satisfaction increases as consumers can buy more of good Y and reach higher indifference curves. If the price of good Y rises, satisfaction decreases as consumers are forced to move to lower indifference curves. Moreover, the diminishing marginal rate of substitution explains that, all else constant, the rate at which an individual must give up one good increases in order to obtain additional units of the other good. Good Y must therefore become relatively cheaper in order for individuals to be persuaded to take a little more of good Y in exchange for less of good X.
Indifference curves and marginal utility theory both show that to maximize total satisfaction, a consumer’s ratio of marginal utility to price must be the same for all goods and services. Consumers therefore demand more when prices fall and less when prices rise; as a result, the demand curve is negatively sloped. Conceptually, this phenomenon can be explained two different ways. If the price falls, the substitution effect holds that consumers tend to increase consumption because the good has become relatively cheaper than similar goods and consumers will get more satisfaction per dollar at the lower price. The income effect explains that when prices fall and consumers’ income stays the same, real income increases. In effect, consumers are wealthier, so they can buy a greater amount of the cheaper good and, for that matter, other goods. (Conversely, if the price rises, the substitution effect holds that consumers buy less, because the good has become relatively more expensive compared to similar goods. The income effect holds that consumers consume less because they are, in real terms, less wealthy.)
Understanding the law of diminishing marginal utility allows one to understand the equimarginal principle, which holds that maximum satisfaction or utility occurs when the marginal utility per last dollar spent on a good or service is exactly the same as the marginal utility per last dollar spent on any other good or service. If, for example, the consumption of an additional unit of good A yielded more marginal utility per dollar than the consumption of an additional unit of other goods, to maximize satisfaction individuals should spend less money on the other goods and consume more of good A until the marginal utility per dollar of good A falls to the same marginal utility per dollar of the other goods. Conversely, if good B yielded less marginal utility per dollar than the common level, consumers would buy less of good B and more of other goods until the marginal utility per last dollar of good B rose to that of the common level.
Another way of thinking about satisfaction involves indifference curves, which show how consumers react to different combinations of products. On a graph of indifference curves, one good appears on the x axis and the other good appears on the y axis. At any point along a given curve, consumers are equally satisfied with the combination of products – each point brings the same level of utility. Superimposing an income curve over a set of indifference curves shows all the different combinations of the two goods and/or services a consumer can purchase with a fixed budget. Consumers maximize their satisfaction when their income curve barely runs tangent to the highest indifference curve. If the price of good Y falls and the price of good X stays constant, the point of tangency changes, and satisfaction increases as consumers can buy more of good Y and reach higher indifference curves. If the price of good Y rises, satisfaction decreases as consumers are forced to move to lower indifference curves. Moreover, the diminishing marginal rate of substitution explains that, all else constant, the rate at which an individual must give up one good increases in order to obtain additional units of the other good. Good Y must therefore become relatively cheaper in order for individuals to be persuaded to take a little more of good Y in exchange for less of good X.
Indifference curves and marginal utility theory both show that to maximize total satisfaction, a consumer’s ratio of marginal utility to price must be the same for all goods and services. Consumers therefore demand more when prices fall and less when prices rise; as a result, the demand curve is negatively sloped. Conceptually, this phenomenon can be explained two different ways. If the price falls, the substitution effect holds that consumers tend to increase consumption because the good has become relatively cheaper than similar goods and consumers will get more satisfaction per dollar at the lower price. The income effect explains that when prices fall and consumers’ income stays the same, real income increases. In effect, consumers are wealthier, so they can buy a greater amount of the cheaper good and, for that matter, other goods. (Conversely, if the price rises, the substitution effect holds that consumers buy less, because the good has become relatively more expensive compared to similar goods. The income effect holds that consumers consume less because they are, in real terms, less wealthy.)
Basic Principles of Supply and Demand
A change in the quantity demanded of a good or service is caused by a change in the price of the good or service. When supply decreases and the price rises, consumers’ willingness to purchase the good or service decreases. When supply increases and the price falls, consumers’ willingness to purchase the good or service increases. When the quantity demanded of a good or service changes, the set of prices and quantities of the original demand schedule remains constant. The demand curve does not shift, instead, changes in quantity demanded are depicted by a movement along the demand curve, from one price-quantity pair on the curve to a new price-quantity pair on the curve.
By contrast, a change in demand occurs when consumers’ willingness to purchase a good or service increases or decreases because of some factor other than a price change, such as a change in consumers’ income levels, a change in the size of the population, changes in the prices and availability of substitute goods, changes in the prices and availability of complementary goods, changes in individual, cultural, and social tastes, or other special influences. If, for example, everyone suddenly wanted an iPhone because they saw Sean Connery using one in a movie, the shift in cultural taste would trigger an increase in demand for iPhones and a decrease in demand for Blackberrys, despite the fact that the prices of iPhones and Blackberrys hadn’t changed. When demand changes, the set of prices and quantities changes from the set of prices and quantities of the original demand schedule. Changes in demand are depicted by a shift of the demand curve from its original position – to the right if demand increases and to the left if demand decreases.
A change in the quantity supplied occurs when the price of the good or service changes. As demand for a good or service increases and the price rises, producers tend to supply more of that good or service, because they profit from utilizing more input factors and increasing output. If demand decreases and the price of the good or service falls, producers supply less of the good or service, because utilizing more inputs to supply a larger quantity is no longer profitable. When the quantity supplied of a good or service changes, the set of prices and quantities of the original supply schedule remains constant. Changes in quantity supplied are depicted by a movement along the supply curve, from one price-quantity pair on the curve to a new price-quantity pair on the curve.
By contrast, a change in supply occurs when producers’ willingness to supply a good or service changes because of factors other than the price of the good or service, such as technology, input prices, sellers’ expectations, taxes, subsidies, the number of sellers, or other special influences. Producers are primarily concerned with production costs: when they increase, producers tend to supply less; when they decrease, producers tend to supply more. If, for example, the cost of electricity goes up, producers will supply less because production costs have increased. If the government lowers the minimum wage, producers will supply more because production costs have decreased. When supply changes, the set of prices and quantities changes from the set of prices and quantities of the original supply schedule. Changes in supply are depicted by a shift of the supply curve – to the right if supply increases and to the left if supply decreases.
By contrast, a change in demand occurs when consumers’ willingness to purchase a good or service increases or decreases because of some factor other than a price change, such as a change in consumers’ income levels, a change in the size of the population, changes in the prices and availability of substitute goods, changes in the prices and availability of complementary goods, changes in individual, cultural, and social tastes, or other special influences. If, for example, everyone suddenly wanted an iPhone because they saw Sean Connery using one in a movie, the shift in cultural taste would trigger an increase in demand for iPhones and a decrease in demand for Blackberrys, despite the fact that the prices of iPhones and Blackberrys hadn’t changed. When demand changes, the set of prices and quantities changes from the set of prices and quantities of the original demand schedule. Changes in demand are depicted by a shift of the demand curve from its original position – to the right if demand increases and to the left if demand decreases.
A change in the quantity supplied occurs when the price of the good or service changes. As demand for a good or service increases and the price rises, producers tend to supply more of that good or service, because they profit from utilizing more input factors and increasing output. If demand decreases and the price of the good or service falls, producers supply less of the good or service, because utilizing more inputs to supply a larger quantity is no longer profitable. When the quantity supplied of a good or service changes, the set of prices and quantities of the original supply schedule remains constant. Changes in quantity supplied are depicted by a movement along the supply curve, from one price-quantity pair on the curve to a new price-quantity pair on the curve.
By contrast, a change in supply occurs when producers’ willingness to supply a good or service changes because of factors other than the price of the good or service, such as technology, input prices, sellers’ expectations, taxes, subsidies, the number of sellers, or other special influences. Producers are primarily concerned with production costs: when they increase, producers tend to supply less; when they decrease, producers tend to supply more. If, for example, the cost of electricity goes up, producers will supply less because production costs have increased. If the government lowers the minimum wage, producers will supply more because production costs have decreased. When supply changes, the set of prices and quantities changes from the set of prices and quantities of the original supply schedule. Changes in supply are depicted by a shift of the supply curve – to the right if supply increases and to the left if supply decreases.
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