Chapter 1
Appendix
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Indifference Curve Analysis
 Market Baskets are combinations of
various goods.
 Indifference Curves are curves
connecting various market basket
combinations of goods that make an
individual equally happy.
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Assumptions about
Preferences




Persons can rank market baskets.
Rankings are transitive.
More is preferred to less.
The marginal rate of substitution is
diminishing.
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Indifference Curves and
Indifference Maps
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Expenditure on Other Goods
per Month (Dollars)
Figure 1A.1 Indifference Curves
B1
60
B2
50
U1
0
40 50
Gasoline per Month (Gallons)
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Qx
U2
U3
The Marginal Rate of
Substitution
 The amount of expenditure on
other goods that a person will give
up in order to get an additional unit
of another good is called the
marginal rate of substitution.
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The Budget Constraint
 The budget constraint is the
combination of goods that can be
afforded by a person.
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The Budget Constraint
in Algebraic Terms
I = PxQx + SPiQi
Where: I is income
Pi is the price of good i
Qi is the amount of good i purchased
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Expenditure on All Expenditure on
Other Goods Except Gasoline per
Gasoline per Month
Month
Expenditure on Other Goods
per Month (Dollars)
Figure 1A.2 The Budget Constraint
100
60
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A
C
F
D
B
Qx
0
40
100
Gasoline per Month (Gallons)
Expenditure on Other Goods
per Month (Dollars)
Figure 1A.3 Consumer Equilibrium
A
E
40
U3
U2
U1
B
0
60
Qx
Gasoline per Month (Gallons)
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Equilibrium Condition
PX = MBX
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Expenditure on Other Goods
per Month (Dollars)
Figure 1A.4 Changes in Income
A'
A
0
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B
Qx per Month
B'
Expenditure on Other Goods
per Month (Dollars)
Figure 1A.5 Changes in the Price of Good X
A
0
B''
B
Qx per Month
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B'
Figure 1A.6 Income and Substitution Effects
Expenditure on Other Goods
per Month (Dollars)
150
50
100
E'
E1
20
E2
U1
40 45
The Income Effect
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U2
60
The Substitution Effect
Qx
Gasoline
per Month
(Gallons)
The Law of Demand
 The demand curve is downward
sloping.
 As the price rises the quantity
demanded falls.
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Price
Figure 1A.7 The Law of Demand
D = MB
0
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Qx per Month
Price Elasticity of Demand
ED =
% Change in Quantity Demanded
% Change in Price
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=
DQD/QD
DP/P
Consumer Surplus
 Net benefit that consumers obtain from
a good.
 Total benefit to consumers from obtaining a
good, less the money they give up to get
the good.
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Figure 1A.8 Consumer Surplus
A
Price
Consumer Surplus
B
P
Market Price
D = MB
0
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Q1
Gasoline per Month
Figure 1A.9 The Work Leisure Choice
Income per Day
A
40
0
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E
U3
U2
U1
16
Leisure Hours per Day
B
24
Budget line for time allocation
I = w(24 – L)
Where:
I is income
W is wage
L is the amount of
time devoted to leisure
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Analysis of Production and Cost
 The Production Function is the
expression of the maximum output
obtainable from any combination of
inputs.
 The Short Run is the period of time in
which some inputs cannot be changed.
 The Long Run is the period of time in
which all inputs can be changed.
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Marginal Product
 The increase in output
associated with a one unit
increase in an input is called
the Marginal Product.
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Isoquants
 Isoquants are curves that show alternative
combinations of variable inputs that can be
used to produce a given amount of output.
 The Marginal Technical Rate of Substitution is
the amount of one input that can be given up
with one additional unit of another input while
keeping output constant.
 It is the slope of the isoquant.
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Isocost Lines
Lines that show combinations of variable inputs that
are of equal cost are called Isocost Lines
C = PLL + PKK
Where: C is the total cost
PL is the price of labor (typically the wage)
L is the units of labor employed
PK is the price of capital (typically a rental price or an interest
rate to reflect the opportunity cost of that capital)
K is the units of capital employed
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Figure 1A.10 Isoquant Analysis
Labor Hours per Month
Isocost Lines
E
L*
Monthly Output = Q1
0
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K*
Machine Hours per Month
Cost Minimization
Costs are minimized for every level of
output where:
MRTSKL = PK/PL
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Cost Functions






Total Cost
Variable Cost
Average Cost
Average Variable Cost
Average Fixed Cost
Marginal Cost
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Returns to Scale
 Constant Returns to Scale
 AC = MC
 AC and MC are constant
 Increasing Returns to Scale
 AC < MC
 AC is diminishing
 Decreasing Returns to Scale
 AC > MC
 AC is increasing
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Profit Maximization
Assumption: All firms seek to maximize profits.
Operationally that means that firms will
set production where Marginal Revenue
equals Marginal Cost; MC = MR.
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Perfect Competition
The situation where:
 There are many buyers and sellers such that
no one has market power.
 The product being sold is homogenous.
 There are no legal or economic barriers to
entry.
 Information is freely available.
In such a case the market price is the Marginal
Revenue to the firm and that firm will maximize
profits where P = MC.
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Figure 1A.11 Short-Run Cost Curves and Profit
Maximization under Perfect Competition
MC
Price and Cost
Producer
Surplus
AC
E
P
D = MR
AVC min = F
0
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Q*
Output per Month
Short-Run Supply
 Under perfect competition,
Supply is the Marginal Cost
curve emanating from the
minimum of average variable
cost
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Producer Surplus
 Producer Surplus is the difference
between the market price and the
minimum price for which the firm would
sell the product. It is the area under the
price line and above the marginal cost
curve. It also represents the profit less
fixed costs to the firm.
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Normal and Economic Profit
 Normal Profit is the opportunity cost of
resources of owner-supplied inputs. The
value of the firm owners’ time (typically
measured by their next job opportunity) plus
any other inputs provided by the owner(s).
 Economic Profit is any profit to the firm that is
above normal profit.
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Long Run Supply
 In the long run, economic profit is driven
to zero under competition.
 P = LRMC = LRACmin
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Figure 1A.12 Long-Run Competitive Equilibrium
LRMC
Price
LRAC
LRAC min = P
0
D = MR
Q*
Output per Month
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Figure 1A.13 Long-Run Supply: The Case of A
Constant-Costs Competitive Industry
Price
Long-Run Supply
LRACmin = P
0
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Output per Year
Figure 1A.14 A Perfectly Inelastic Supply Curve
Price
Supply
0
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Q1
Output per Year
Price Elasticity of Supply
ES =
% Change in Quantity Supplied
% Change in Price
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=
DQS/QS
DP/P