Applied Economics for Managers, Session 4 Notes

APPLIED ECONOMICS FOR MANAGERS: SESSION 4 I. SUPPLY AND DEMAND: THE BASICS A. SUPPLY AND DEMAND DETERMINE EQUILIBRIUM PRICE AND QUANTITY B. DEMAND CURVE: 1. SCHEDULE INDICATING TOTAL AMOUNT WILLINGLY BOUGHT AT EACH ALTERNATIVE PRICE (START WITH P AXIS READ OVER TO CURVE AND DOWN TO Q AXIS) 2. SCHEDULE INDICATING MARGINAL VALUE OR VALUE OF LAST UNIT CONSUMED (START WITH Q AXIS READ UP TO CURVE AND OVER TO P AXIS) 3. SENSITIVITY OF QUANTITY DEMANDED TO PRICE MEASURED BY ELASTICITY OF DEMAND: ∆Q Q P 1 εD = − =− ∆P P Q SLOPE C. SUPPLY CURVE 1. SCHEDULE INDICATING TOTAL AMOUNT WILLINGLY BROUGHT TO MARKET AT EACH ALTERNATIVE PRICE (START WITH P AXIS READ OVER TO CURVE AND DOWN TO Q AXIS) 2. SCHEDULE INDICATING MARGINAL COST OR COST OF PRODUCING THE LAST UNIT PRODUCED (START WITH Q AXIS READ UP TO CURVE AND OVER TO P AXIS) 3. SENSITIVITY OF QUANTITY SUPPLIED TO PRICE MEASURED BY ELASTICITY OF SUPPLY: 1 ∆Q Q P ELASTICIY OF SUPPLY: ηs = = ∆P P Q SLOPE D. DEMAND SHOCKS MOVE EQUILIBRIUM PRICE AND QUANTITY IN THE SAME DIRECTION E. SUPPLY SHOCKS MOVE EQUILIBRIUM PRICE AND QUANTITY IN OPPOSITE DIRECTIONS FOR LINEAR CURVE, ELASTICITY IS DIFFERENT AT DIFFERENT POINT OVER THE CURVE $/UNIT P0 ELASTIC INELASTIC P1 D Q0 | Q1 EFFECTS OF A SHOCK FALL MOST HEAVILY ON THE SIDE OF THE MARKET THAT IS LEAST ELASTIC S’ $/UNIT AMOUNT OF PRICE RISE AMOUNT OF TAX OR COST INCREASE S D Q II. THE FORMAL THEORY OF CONSUMER BEHAVIOR A. UTILITY THEORY 1. TOTAL UTILITY VS MARGINAL UTILITY 2. DIMINISHING MARGINAL UTILITY B. BUDGET CONSTRAINTS AND UTILITY MAXIMIZATION 1. FORMAL STATEMENT OF THE CONSUMER’S PROBLEM: a. CHOOSE A COLLECTION OF GOODS & SERVICES— QUANTITIES OF X1, X2, . . . XN THAT MAXIMIZES UTILITY b. SUBJECT TO THE BUDGET CONSTRAINT: B ≥ P1X1 + P2X2 + . . . + PNXN 2. THE SOLUTION: a. SPEND THE ENTIRE BUDGET: B = P1X1 + P2X2 + . . . + PNXN b. SATISFY THE EQUI-MARGINAL PRINCIPLE: MU N MU 1 MU 2 = = . . . = PN P1 P2 C. THE LOGIC OF THE EQUIMARGINAL PRINCIPLE 1. CONSUME A LITTLE LESS OF SAY X1, I.E., GIVE UP ∆X1 ⇒ SAVINGS OF P1∆X1 ⇒ LOSS OF UTILITY OF MU1∆X1 2. CAN NOW CONSUME MORE OF X2. HOW MUCH MORE? NEW EXPENDITURE ON X2 = AMOUNT SAVED = P1∆X1 P ∆X ⇒ AMOUNT OF X2 BOUGHT = ∆X2 = 1 1 P2 ⇒ GAIN IN UTILITY IS MU2∆X2 3. IF INITIAL BUNDLE WAS BEST, UTILITY SHOULD NOT RISE P ∆X MU 2 MU1 MU1 ⇒ MU 2 ∆X 2 = MU 2 1 1 = MU1∆X1 ⇒ = ⇒ P1 = P2 P2 P2 P1 MU 2 D. SOME IMPLICATIONS OF UTILITY THEORY 1. DEMAND CURVES SLOPE DOWNWARD MU N MU 1 MU 2 = = . . . = PN P1 P2 a. A RISE IN P1 REQUIRES MU1 TO RISE, TOO b. MU1 ONLY RISES IF X1 FALLS DUE TO DIMINISHING MARGINAL UTILITY 2. NO MUTUALLY BENEFICIAL TRADES BETWEEN CONSUMERS LEFT 3. PRICE MEASURES VALUE AT THE MARGIN IF MU1 3 TIMES MU2, THEN A UNIT OF MU1 ⇒ P1 = P2 X1 IS WORTH 3 UNITS OF X2 AT THE MU 2 MARGIN, I.E., P1 = 3P2 III. PRODUCER BEHAVIOR A. OBJECTIVE: PROFIT MAXIMIZATION, I.E., MAXIMIZE THE DIFFERENCE BETWEEN REVENUE AND COSTS, R(Q) – C(Q) B. REVENUE: PRICE TIMES QUANTITY = PQ 1. TOTAL REVENUE 2. MARGINAL REVENUE C. COST CONCEPTS 1. TOTAL COST = TC(Q) 2. AVERAGE COST = TC(Q ) Q 3. MARGINAL COST = ∆TC(Q ) dTC = ∆Q dQ D. NECESSARY CONDITION FOR PROFIT MAXIMIZATION: MARGINAL REVENUE = MARGINAL COST F. SUPPLY CURVE FOR THE COMPETITIVE INDUSTRY 1. P = MC FOR EACH FIRM 2. AT ANY GIVEN P, DETERMINE Q THAT LEADS TO MC EQUAL TO THAT PRICE AT EACH FIRM 3. ADD OUTPUT OF EACH FIRM TOGETHER TO GET TOTAL INDUSTRY OUTPUT AT THAT PRICE 4. REPEAT FOR OTHER PRICE LEVELS INTUITION: PROFIT EARNED ON ANY UNIT IS P – MC OF THAT UNIT P – MC > 0, q0 + 1 UNIT ADDS TO PROFIT POOL P – MC < 0, q0 + 1 UNIT TAKES AWAY FROM PROFIT POOL PROFIT POOL FROM 1ST q0TH UNITS PIZZA CONSUMPTION AND TOTAL VS MARGINAL UTILITY Total Utility 230 210 175 100 1 2 3 4 5 6 Quantity 4 5 6 Quantity Marginal Utility 100 75 35 10 1 2 3