23.09.2010
Rational consumers
Profit-maximizing firms
Competitive markets
Government is ignored for now
For firms; rationality means maximizing profits.
Profit = revenue − costs
Revenue = pQ, where p = price and Q = quantity
Profit = pQ − costs
Many firms sell identical products to many consumers.
Firms and consumers are price takers in competitive
markets.
Firms provide as much output as consumers will buy.
Each firm can sell as much as it wants: the size of the firm is
small compared to the size of the market.
If firms charge a price higher than the market price, they lose
all their customers.
All firms in the industry charge the same price.
Scarcity forces us to make choices.
Economists assume individuals and firms make
choices rationally:
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Pursue what they see as their own self-interest
Weigh costs and benefits as they see them
If benefits > costs, take the action
However, different people have different interests
Economists do not judge people's preferences.
Individuals and firms often make decisions with little or
no information.
◦ Is the car a lemon?
◦ Will the worker be productive?
◦ Will the investment be profitable?
Rationality applies to acquiring information to answer
these questions.
If the benefit of more information > the cost of acquiring
the information, the information is acquired.
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23.09.2010
Combines self-interested consumers, profit-maximizing firms,
and competition
The model is tested by comparing its predictions with actual
markets.
Economists believe this model can provide answers to the
four basic questions:
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Government is not needed to answer these questions in the
basic competitive model.
Income is an incentive for consumers, workers, investors,
and firms.
Consumer or household income is personal income.
Firm income is revenue divided between costs and profit.
The basic competitive model is efficient.
◦ That means scarce resources are not wasted.
◦ It is not possible to produce more of one good without
producing less of another good.
◦ It is not possible to make one person better off without
making someone else worse off.
◦ Known as Pareto efficiency
What is produced, and in what quantities?
How are goods produced?
For whom are those goods produced?
Who decides the answers to the first three questions, and how?
The right of the owner to use and sell his or her property.
With well-defined property rights, access is excludable,
rivalrous, and transferable.
A combination of freedom and responsibility is crucial to
markets.
◦ Freedom: Individuals and firms must be free to be creative and try
new techniques.
◦ Responsibility: Individuals must reap the reward if successful or suffer
the losses if not.
Well-defined property rights permit incentives to provide
rewards and costs.
If rewards are tied to performance, then a problem arises
when many people help to produce a good or service.
◦ Who contributed what?
◦ Who are the most productive employees; is the hot salesperson good
or just lucky?
Even if pay can be tied to performance, how does one
measure performance?
If compensation is tied to performance, this leads to
inequality since different people perform differently.
◦ However, if this inequality is from luck, would another criterion of
compensation do "better"?
◦ Some economists hold equality as a value in its own right.
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23.09.2010
Providing appropriate incentives is a fundamental economic
problem.
Profits provide incentives for firms to produce the goods
individuals want.
Wages provide incentives for individuals to work.
Property rights provide people with important incentives, to
invest, save, and to put their assets to the best possible use.
Alice has $160 to spend on CDs and books. The price of a
CD is $16 and the price of a book is $20.
She can buy either 10 CDs and no books or 8 books and no
CDs or some combination in between.
Bob has 6 hours of free time every day after we
subtract time spent:
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If the price of books falls to $10, Alice's budget constraint
rotates outward along the book axis (the x axis).
Alice's new budget constraint is:
◦ Flatter than her previous budget constraint because books are
relatively cheaper now.
◦ Farther from the origin than her previous budget constraint. The lower
price for books has increased her purchasing power, and her
opportunity set has expanded.
Opportunity sets are combinations of goods.
Due to the scarcity of money or time, not all combinations of
goods are attainable.
Bob can listen to 6 CDs and watch no videos or watch 3 videos
and listen to no CDs or some combination in between.
Working
Getting ready for work
Commuting
Sleeping
It takes Bob 1 hour to listen to a CD and 2 hours to
watch a video.
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23.09.2010
The PPC is a producer's constraint.
With a given quantity of inputs, a firm can only produce
certain quantities of goods.
Guns versus butter
The boundary of what can be produced is the production
possibilities curve.
Inside the PPC, a firm can produce more of both goods by
moving out to the curve.
◦ Steel makes great artillery shells but not butter.
◦ Cows' udders do not make good weapons.
The optimal production mix is always on the curve.
The opportunity cost is the value of the next best alternative
when one makes a choice.
◦ Time and budget constraints and production possibilities curves
illustrate the cost of one option in terms of the other: opportunity cost.
◦ The cost of an education is:
◦ So points interior to the curve are inefficient.
◦ Economists want to know the source of these inefficiencies, what
resources are unemployed.
PPCs are curved, bowed out from the origin. Why?
Guns and butter have different inputs.
Tuition
Room and board
Books
Travel expenses
Opportunity cost: lost earnings from not working for four years
The opportunity cost is often used by the government when it
considers the costs and benefits of a program.
Sunk costs are non-recoverable expenditures.
◦ Sunk costs play no role in deciding whether to continue an activity.
◦ Setup costs are sunk costs.
◦ The installation charge to turn on electricity is a sunk cost.
Marginal costs are the extra costs of small changes in
production or consumption.
◦ Marginal costs are the additional costs of producing or consuming
one additional unit.
◦ Monthly electric bills are marginal costs.
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