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Budget constraint

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Different conbinations of goods, A consumer can afford with a limited budget, at given prices

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Budget line

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Graphical representation of a budget constraint: Maximum affordable quantity of one good, for given amounts of another good

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Max

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Total entertainment budget = 100 per month, Price of a movie = 10, Price of a concert = 20

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Relative price

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Price of one good relative to the price of another

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Py

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Price of the good on the vertical axis

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Px

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Price of the good on the horizontal axis

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Px/Py

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The relative price of good X, The opportunity cost of one more unit of good X, the absolute value of the slope of the consumer's budget line

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Changes in income

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-An increase in income will shift the budget line upward and rightward -A decrease in income will shift the budget line downward and leftward -These shifts are parallel, changes in income do not affect the budget line's slope

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Changes in price

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The budget line rotates, the slope of the budget line changes, One of the intercepts of the budget line changes

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Rational Preferences satisfy two conditions

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1. Any two alternatives can be compared and one is preferred or else the two are valued equally 2. The comparisons are logically consistent or transitive -More is better: Always choose a point on the budget line, rather than a point below it

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Utility

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Quantitative measure of pleasure/satisfaction obtained from consuming goods and services

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Marginal Utility

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Change in total utility, From consuming an additional unit of a good or service

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Law of diminishing marginal utility

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As consumption of a good or service increases, marginal utility decreases

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Marginal Utility

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Can be zero

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Assumption

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Marginal utility for every good is positive, More is better

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Utility maximization

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Consumer will choose the point on the budget line, -Where marginal utility per dollar is the same for both goods: MUx/Px = MUy/Py -There is no further gain from reallocating expenditures in either direction

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A rise in income

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-Withe no change in prices -A new quantity demanded for each good -Individual preferences (marginal utility) *Normal good - quantity demanded increases *Inferior good - quantity demanded decreases

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Change in prices

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Decrease in the price of one good *Other things constant *Rotates the budget line rightward

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Individual demand curve

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Quantity of a good a consumer demands at each different price

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Substitution Effect

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-As the price of a good falls, the consumer substitutes that good in place of other goods whose prices have not changed -Arises from a change in the relative price of a good -It moves quantity demanded in the opposite direction to the price change

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Income effect

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-As the price of a good decreases, the consumer's purchasing power increases *Causing a change in quantity demanded for the good -Arises from a change in purchasing power over both goods

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Normal Goods

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-Substitution and income effects work together -Quantity demanded - moves in the opposite direction of the price -Always obey the law of demand

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Inferior goods

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-Substitution and income effects work against each other -Substitution effect virtually always dominates -Virtually always obey the law of demand

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Market demand curve

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Horizontally summing the individual demand curves of every consumer in the market Obeys the law of demand Downward sloping

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Extensions of the model

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-Incorporate choices amond many goods -Recognize saving and borrowing -Incorporate uncertainty and imperfect information -Behavioral economics: Subfield of economics, decision-making patterns that deviate from those predicted by traditional consumer theory

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Salience of a particular outcome

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The extent to which it "jumps out at them"

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Preference for defaults

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People tend to stick to the default choice

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Decision-making environment

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Environment in which a decision is made - can exert a strong and surprising influence

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Self-Binding

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To a narrower set of choices - long-run good

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Behavioral economics and policy

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-Financial incentive for firms to make "automatic contribution" by employees the default choice -People with gambling problems - voluntarily put themselves on a list that bans them from any casino -Industry-wide "vanilla" versions of mortgages, student loans, credit card agreements

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Behavioral economics and traditional theory

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-Traditional economic theory: assumes that consumers have rational preferences -Behavioral economics: analyzes decisions that violate rational preferences

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Model of consumer choice

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-Student's time allocation problem -Only two activities: studying economics and study french -Each of these activities costs times -Students "buy" points on their exams with hours spent studying

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Student's time allocation problem

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-Opportunity cost of scoring beter in French - Scoring lower in economics -Slope of budget line = -Pf/Pe = -2: Each additional point in French: sacrifice 2 points in economics

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New computer-assisted technique in French class

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-Learn more French with the same study time or to study less and learn the same amount -A decrease in the price of French points -Budget line rotates outward

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Assumptions

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-Rational preferences: an individual can compare any two options and decide which is best - Makes choices that are logically consistent -An individual prefers more of every good to less: Consumer - choose to be on budget line, rather than below it

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An indifference curve

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-All combinations of two goods that make the consumer equally well off -Slopes downward

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Marginal rate of substitution, MRSy,x

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-Of good y for good x along any segment of an indifference curve -Is the maximum rate at which a consumer would willingly trade units of y for units of x

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MRS at any point on the indifference curve

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The (absolute value of) the slope of the curve at that point -Maximum rate at which a consumer would willingly trade good y for a tiny bit more of good x

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Indifference map

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-A set of indifference curves that describe one persons' preferences -Any point on a higher indifference curve is preferred to any point on a lower one

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Optimal combination of goods

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-The point on the budget line where an indifference curve is tangent to the budget line -That combination on the budget line for which MRSy,x = Px/Py

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A rise in income

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-With no change in prices -Leads to a new quantity demanded for each good -Quantity demanded increases (normal good) -Quantity demanded decreases (inferior good) -Depends on the individual's preferences (indifference map)

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Changes in price

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-Budget line rotates -Quantity demanded changes -Downward sloping demand curve

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Profit

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Total revenue minus total cost

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Business firm

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-Organization, owned and operated by private individuals -Specializes in production (Process of combining inputs to make goods and services

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Technology

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Methods available for combining inputs to produce a good or service

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Assumption

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Production technology used by pirm uses only inputs: capital and labor

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Long Run

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A time horizon long enough for a firm to vary all of its inputs

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Inputs

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Variable: An input whose usage can change over some time period Fixed: An input whose quantity must remain constant over some time period

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Short run

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A time horizon during which at least one of the firm's inputs cannot be varied

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Total product

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The maximum quantity of output that can be produced from a given combination of inputs (Example: maximum output for each number of workers)

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Total product curve

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-Horizontal axis: number of workers -Vertical axis: total product

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Marginal product of labor (MPL = Delta Q/ Delta L)

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-The additional output produced when one more worker is hired -Change in total product (Q) divided by the change in the number of workers employed (L) -Tells us the rise in output produced when one more worker is hired

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Marginal returns to labor

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-Increasing: The marginal product of labor increases as more labor is hired -Diminishing: The marginal product of labor decreases as more labor is hired

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Law of diminishing (marginal) returns

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-A we continue to add more of any one input, holding the other inputs constant -Its marginal product will eventually decline

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A firm's total cost

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-Of producing a given level of output -Is the opportunity cost of the owners *Everything they must give up in order to produce that amount of output *Implicit and explicit cost - Review!

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Sunk cost

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-Cost that has been paid or must be paid -Regardless of any future action being considered -Should not be considered when making decisions

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Cost

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-Explicit: Involve actual payments -Implicit: No money changes hands, Forgone rent, interest, labor income

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Least-Cost Rule

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A firm produces any given output level using the lowest cost combination of inputs available

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Least-cost input combination depends on...

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-Nature of the firm's technology -Prices the firm must pay for its inputs -Time horizon for the firm's planning

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Costs

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*Fixed: Costs of fixed inputs, remain constant as output changes -Total fixed cost: The cost of all inputs that are fixed in the short run -Average fixed cost (AFC = TFC/Q): Total fixed cost divided by the quantity of output produced *Variable: Costs of variable inputs, change with output -Total variable cost: The cost of all variable inputs used in produced a particular level of output -Average variable cost (AVC = TVC / Q): Totalvariable cost divided by the quantity of output prduced *Total cost (TC = TFC + TVC) - The costs of all inputs, fixed and variable, used to produce a given output level in the short run -Average total cost (ATC = TC / Q): Total cost divided by the quantity of output produced

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Marginal cost (MC = delta TC / delta Q)

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-The increase in total cost from producing one more unit of output -It tells us how much cost rises per unit increase in output

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Explaining the shape of the MC curve

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-When the marginal product of labor (MPL) rises, marginal cost (MC) falls -When MPL falls, MC rises -Since MPL ordinarily rises and then falls, MC will do the opposite -MC curve is U-shaped: Increasing then diminishing marginal returns to labor

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ATC curve is U-shaped

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-Because AFC decreases and AVC first decreases, then increases -At low levels of output, AVC and AFC are both falling, so the ATC curve slopes downward -At higher levels of output, rising AVC overcomes falling AFC, and the ATC curve slopes upward

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AVC curve is U-shaped

answer

Because MC curve is U-shaped (increasing and then diminishing returns to labor)

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MC curve

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Crosses both the AVC curve and then the ATC curve at their respective minimum points

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In the long run

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-No fixed inputs; no fixed costs -All inputs and all costs are variable

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Output production

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Least cost rule

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Long run total cost

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(LRTC) Cost of producing each quantity of output when all inputs are variable and the least -cost input mix is chosen

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Long-run average total cost

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(LRATC - LRTC / Q) -Cost per unit of producing each quantity of output, i nthe long run, when all inputs are variable -Long-run total cost divided by quantity

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Relationship between long-run and short-run costs

answer

-LRTC is less than or equal to Total Cost -LRATC is less than or equal to Average Total Cost

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Plant

answer

The collection of fixed inputs at a firm's disposal

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Size of the firm's plant

answer

-Can be changed in the long run -Cannot be changed in the short run

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