Production & Business
Microeconomics
Lecture 4
Spring 2012
ICES High School Workshops
Paul Mueller & Ryan Safner
Economic Behavior
• Consumption:
– Destruction of utility
• Production:
– Creation of utility
• Exchange:
– Transfer of property rights over goods
Studying (hours)
Equimarginal Principle
10
9
8
7
6
5
4
3
2
1
Marginal
Cost
• MB < MC: Do more!
• MB > MC: Do less!
• MB = MC: Optimal
– “Indifference”
Marginal
Benefit
1 2 3 4 5 6 7 8 9 10
Playing Video Games (hours)
Production – Motivation
• Say’s Law
– Supply (overall) creates its own demand (overall)
– “Commodities are paid for by commodities”
It is worth while to remark, that a product is no sooner
created, than it, from that instant affords a market for
other products to the full extent of its own value…Thus,
the mere circumstance of the creation of one product
immediately opens a vent for other goods.
A Treatise on Political Economy (1855) I.XV.8
Jean-Baptiste Say
(1767-1832)
Thus, it is the aim of good government to stimulate
production, of bad government to encourage
consumption.
Ibid. I.XV.20
Factors of Production
• Y = f(T, L, K, E)
– Output (Y) is a function of inputs:
Factor
Is Owned By
Exchanges For
Land (T)
Landowners
Rent
Labor (L)
Laborers
Wages
Capital (K)
Capitalists
Interest
Entrepreneurship (E) Entrepreneurs
Profits
Fac
Land
• All means provided by nature
• Land supply is FIXED
• Earns rent
Labor
• The personal expenditure of energy
• Earns wages
• Opportunity cost is leisure
Capital
• Preexisting goods that are used in the
production of other (lower-order) goods
Capital Structure
Are factors in
the production of
Are factors in
the production of
Livestock
Plants
Labor
3rd Order
Goods
Turkey
Cheese
Lettuce
Tomatoes
Bread
Labor
Turkey
Sandwich
2nd Order
Goods
1st Order
Goods
Toward Consumption
Toward Nature
CONSUMPTION
Capital
• Capital is resolved back to land and labor
• Capital is a time-saving device
Capital
Land
Labor
Capital/Labor Substitution
For Y =100; TC= wL+rK
With $5 Wages
With $10 Wages
$5(100) = $500
OR
$5(1)+$700(1) = $705
$10(100) = $1,000
OR
$10(1)+$700(1) = $710
Savings & Investment
Saving
Investment
The Production of a Fishing Net
• Production structure lengthens
– Takes more time
– Adds more stages
– Higher-order goods
Sticks
Labor
3rd Order
Goods
Fishing Net
Labor Labor
2nd Order
Goods
Fish
Fish
1st Order
Goods
Time
Interest
Interest rate (%)
• We save based on our time preference
(impatience)
• Interest rate: discount on future (in terms of
The Market for Loanable Funds
present goods)
10
9
8
7
6
5
4
3
2
1
𝐹𝑉
𝑃𝑉 =
1+𝑟
𝑛
Supply of
Loanable
Funds
(savings)
Demand
for
Loanable
1 2 3 4 5 6 7 8 9 10
Funds
Quantity ($M)
Capital
• Savers provide time services, a “springboard”
• Releases labor for other tasks
Entrepreneurship
• Organizes production and bears risk
• Earns residual profits (revenues – costs)
Entrepreneurship – Interpretations
• Who are entrepreneurs?
To act with confidence beyond the range of familiar
beacons and to overcome that resistance requires
aptitudes that are present in only a small fraction of
the population and that define the entrepreneurial
type as well as the entrepreneurial function…It
consists in getting things done…[They] revolutionize
the pattern of production by exploiting an invention
or, more generally, an untried technological
possibility for producing a new commodity or
producing an old one in a new way, by opening up a
new source of supply of materials or a new outlet for
products, by reorganizing an industry and so on.
1947. Capitalism, Socialism, and Democracy: p.132)
Joseph A. Schumpeter
(1883-1950)
Israel Kirzner
(1930-)
Entrepreneurship – Interpretations
• Who are entrepreneurs?
The entrepreneurial element in the
economic behavior of market participants
consists…in their alertness to previously
unnoticed changes in circumstances which
may make it possible to get far more in
exchange for whatever they have to offer
than was hitherto possible.
1973. Competition & Entrepreneurship: 15
Joseph A. Schumpeter
(1883-1950)
Israel Kirzner
(1930-)
Entrepreneurship – Interpretations
• Equilibrating or disequilbrating?
[T]he history of the productive apparatus…is a history
of revolutions…
Industrial mutation—if I may use that biological
term—that incessantly revolutionizes the economic
structure from within, incessantly destroying the old
one, incessantly creating a new one. This process of
Creative Destruction is the essential fact about
capitalism. It is what capitalism consists in and what
every capitalist concern has got to live in.
1947. Capitalism, Socialism, and Democracy: p.83)
Joseph A. Schumpeter
(1883-1950)
Israel Kirzner
(1930-)
Entrepreneurship – Interpretations
• Equilibrating or disequilbrating?
[Businessmen lie awake at night fearing]
competition which commands a decisive
cost or quality advantage which strikes not
at the margins of the profits and the
outputs of the existing firms but at their
foundations and their very lives.
1947. Capitalism, Socialism, and
Democracy: p.83)
Joseph A. Schumpeter
(1883-1950)
Israel Kirzner
(1930-)
Entrepreneurship – Interpretations
• Equilibrating or disequilbrating?
[Entrepreneurship is] the ability to see where
new products have become unsuspectedly
valuable to consumers and where new methods
of production have, unknown to others,
become feasible. [It] consists not of shifting the
curves of cost or of revenues which face him,
but of noticing that they have in fact shifted.
1973. Competition & Entrepreneurship: 15
Joseph A. Schumpeter
(1883-1950)
Israel Kirzner
(1930-)
Stock
The Theory of the Firm
• Producers organize into business firms. Why?
• Coase:
– Transactions costs
– Flexible wage contracts
Ronald H. Coase
(1910-)
“The Nature of the Firm” (1937)
Principle-Agent Problem
• Shareholders (principles) hire professional
managers (agents) to run company for them
• Difficult to monitor, conflicts of interest
Shareholders (principles)
Goal: maximize company profit
Managers (agents)
Goal: maximize personal salary
The Firm Graphed
Curve
Definition
Total Physical Product (TPP) Total output
Average Physical Product
(APP)
Output per unit of input
Marginal Physical Product
(MP)
Output of additional unit
of input
Total Value Product (TVP)
Total output * price
Average Value Product
(ARP)
Output * price per unit of
input
Marginal Value Revenue
(MVR)
Value of additional unit of
input
Formula
Q(𝐿) = 𝑓(𝐿, 𝐾, 𝑇, 𝐸)
𝑄 𝐿
𝐿
∆𝑄 𝐿
∆𝐿
𝑄(𝐿)𝑃
𝑄(𝐿)𝑃
𝐿
∆𝑃𝑄(𝑙)
∆𝐿
The Firm, Graphed
Curve
Definition
Formula
Total Cost (TC)
Cost at level of output
Average Cost (AC)
Cost per unit
𝐶 𝑞
𝑞
Marginal Cost (MC)
Cost of additional unit
∆𝐶 𝑞
∆𝑞
Total Revenue (TR)
Revenue at level of output
Average Revenue (AR)
Revenue per unit
Marginal Revenue (MR)
Revenue from additional
unit
Profit (𝜋)
Total Revenues minus total
costs
𝐶(𝑞) = 𝑓(𝐿, 𝐾, 𝑇, 𝐸)
𝑇𝑅 = 𝑃𝑞
𝑃𝑞
𝐴𝑅 =
= 𝑃 = 𝐷𝑒𝑚𝑎𝑛𝑑!
𝑞
∆𝑃𝑞
∆𝑞
𝜋 = 𝑇𝑅 − 𝑇𝐶
The Firm, Graphed
Price
MONOPOLIST
10
9
8
7
6
5
4
3
2
1
MC
AC
MR
Demand (AR)
1 2 3 4 5 6 7 8 9 10
Quantity/Time
• Optimum Production
Q* at MC = MR
• Optimum Price at Q*
level of Demand
curve
• P>MC, markup
• Supernormal profits
(TR>TC)
Additional Production Relationships
• Isoquants & Marginal Rate of Technical
Substitution
Additional Production Relationships
• Economies of Scale
Sources & Further Reading
• Coase, Ronald. 1937. “The Nature of the Firm.”
Economica 4 (16): 386–405
• Hayek, F.A. 1948. Individualism and Economic
Order.
• Kirzner, Israel. 1973. Competition &
Entrepreneurship.
• Say, Jean Baptiste. 1855. A Treatise on Political
Economy.
• Schumpeter, Joseph. 1947. Capitalism, Socialism,
and Democracy.