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Utility Theory

Let's take a closer look at what's behind the demand curve and the behavior of consumers. How does a consumer decide to spend his/her income on the many different things that he/she wants, i.e., food, clothing, housing, entertainment? We assume that the goal of the consumer is to maximize his/her level of satisfaction or joy, constrained by his/her income.

Economists use the term utility as a measure of satisfaction, joy or happiness. How much satisfaction does a person gain from eating a pizza or watching a movie? Measuring utility is based solely on the preferences of the individual and has nothing to do with the price of the good.

I. Utility: In economics, utility does not mean useful or utilitarian or practical. Utility is a term that economists use for the satisfaction, pleasure or want-satisfying power of a good or service. Utility is common to all goods that are desired. The concept of utility is purely subjective, there is no way to objectively measure the amount of utility that a consumer might be able to obtain from a particular good. The utility that individuals receive from consuming a good depends on their tastes and preferences. Economists assume that tastes are given and are relatively stable.

A. Utility and Utils: Economists first developed utility theory in terms of units of measurable utility, to which they applied the term util. The ideas from such analysis are useful in understanding the way in which consumers choose among alternatives.

B. Total and Marginal Utility: Total utility is the amount of utility or satisfaction measured in utils from consuming a good or service. Total utility is the amount of satisfaction received from all the units of a good or service consumed. Total utility is maximized when the marginal utility per dollar of each good is equal and the entire budget is spent. Marginal utility is the change in total utility due to a one-unit change in the quantity of a good consumed. Marginal utility is the change in total utility from one additional unit of a good or service. Consumers make one choice over another depending on the marginal utility of the choices.

C. Applying Marginal Analysis to Utility: The formula for marginal utility is this: Marginal Utility = Change in total utility ÷ change in number of units consumed.

D. Example: If water provides a greater utility than diamonds, why are diamonds more expensive?

Chart: Marginal Utility of Diamonds

Chart: Marginal Utility of Water

Even though water provides a greater utility than diamonds, diamonds are more expensive because water is plentiful in most of the world, so its marginal utility is low.

 

II. Diminishing Marginal Utility

Let’s do an experiment in utility.

Step 01: Get some of your favorite candy, pastries or cookies.

Step 02: Take a bite and evaluate, on a scale from 0 to 100 (with 100 being the greatest utility), the level of utility from that bite. Record the marginal utility of that bite (i.e., how much you get from that one additional bite).

Step 03: Repeat step 02. It is important to be consistent with each unit consumed, i.e., the same size and no drinking milk or water part way though. When you run out of candy or your marginal utility goes to zero you can stop.

The law of diminishing marginal utility states that as more of the good is consumed, the additional satisfaction from another bite will eventually decline. The marginal utility is the satisfaction gained from each additional bite. As more of the good is consumed, we gain less additional satisfaction from consuming another unit. Thus even if a good were free and you could consume as much as you wanted, there would be a limit to the amount you would consume due to the law of diminishing marginal utility.

Summing the marginal utilities gives us the total utility. For example, let’s say the first chocolate was an 85 and the second chocolate had a marginal utility of 79, then the total utility from consuming two chocolates is 164. The total utility from consuming three chocolates is 85+79+73 = 237. As long as our marginal utility is positive our total utility increases although with diminishing marginal utility it increases at a decreasing rate.

Can marginal utility be negative? Yes. At a holiday dinner, you may overeat and suffer from indigestion afterwards to a point where you regret having eaten too much, but at the time of the dinner, you expected greater utility from eating the last of the meal. We would not willingly consume an item that gave us negative marginal utility. Then why would an individual stuff themselves during a hot dog eating contest where clearly the last hot dogs consumed are making them worse off? Although the marginal utility from the last hot dog itself makes the person worse off, the utility from winning the contest is greater, making the marginal utility positive.

The marginal utility of an item can change. For example, during a drought water provides a high positive marginal utility, and with more rain the marginal utility declines. At some point, there is too much rain. It turns from being a good utility to a bad one and the marginal utility of more rain, when it is already flooding, is negative.

Diminishing Marginal Utility (4:15)

III. Consumer Equilibrium is a condition in which total utility cannot increase by spending more of a given budget on one good and spending less on another good.

 

 

 

 

Table: Marginal Utility for Big Macs and Milkshakes (utils per day) ($2 each)

 

 

 

 

 

 

 

 

Consumer Equilibrium: Price of Big Mac = $2

 

 

 

 

 

 

Consumer Equilibrium: Price of Big Mac = $1

 

 

 

 

 

 

 

What happens to the number of Big Macs bought when the price drops?

To restore maximum total utility, the consumer spends more on Big Macs when the price drops.

IV. Optimizing Consumption Choices: Consumer optimum is a choice of a set of goods and services that maximizes the utility of each consumer, subject to limited income. This optimum is reached when the marginal utility of the last dollar spent on each good yields the same utility and all income is spent.

V. How a Price Change Affects the Consumer Optimum: Starting from the consumer optimum, let the price of good A decrease. Consumers respond to the price decrease by consuming more. Before the price change, the marginal utility per last dollar spent on each good was the same. With a lower price, the marginal utility of the last dollar spent on good A is greater than the marginal utility per dollar spent on other goods. If the law of diminishing marginal utility holds, the purchase and consumption of additional units of A causes the marginal utility per dollar spent on good A to fall. Eventually, the value of marginal utility per dollar spent on good A will fall by enough to equate it with the marginal utility per last dollar spent on each of the other goods and services consumed. This emphasizes the law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa.

Two alternative explanations of demand

The Substitution Effect involves the price of a good when consumers substitute relatively cheaper goods for relatively more expensive ones. It is a change in the quantity demanded of a good or service caused by the change in its price relative to substitutes. If the price of Pepsi falls and the price of Coke remains unchanged, you will buy more Pepsi because it is less expensive than Coke.

The Real-Income Effect occurs when a change causes a change in the purchasing power of a buyer’s income. A decrease in price will cause an increase in the quantity demanded since a fall in the price of any good consumed results in an increase in real income (purchasing power). As prices decline, your real income increases, increasing your buying power, so you buy more units, ceteris paribus.

The substitution and income effect explanations prove the law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa.

VI. The Demand Curve Revisited: Linking the law of diminishing marginal utility and rule of equal marginal utilities per dollar gives a negative relationship between the quantity demanded of a good or service and its price.

VII. Maximizing Utility

So how does the consumer decide what to purchase? Unfortunately everything has a price and consumers only have so much money to spend. Consequently consumers try to spend the limited money they have on what will give them the greatest amount of satisfaction. The decision rule for utility maximization is to purchase those items that give the greatest marginal utility per dollar and are affordable or within the budget. Many grocery stores provide a tag that indicates the price per pound for the good. This allows consumers to compare the cost per pound for different brands or different sizes. The same concept is used for maximizing utility but we divide the marginal utility by the price to get the marginal utility per dollar.

 

VIII. How Businesses React

Knowing that individuals experience diminishing marginal utility, how do businesses react? Recall that consumer surplus is the area below the demand curve but above the price. Think of some examples of how businesses react given the law of diminishing marginal utility.

One example is the price per unit based on package size. An ice cream store has three different serving sizes -- a 6, 10 and 12 ounce cup. The price of the smallest size, "Like It," is $4.29 or 71.5¢ per ounce. For just 32¢ more, one can have four more ounces, "Love It," making the marginal cost per ounce 8¢ and the average cost per ounce 46¢. Upgrading to the "Gotta Have It" size adds an additional two ounces with only 15.5¢ per ounce more and an average cost per ounce of only 41¢. Certainly the large size is cheaper per ounce, but not everyone wants to eat that large of a serving. For those only wanting a small serving, the store takes advantage of their greater willingness to pay for that portion size. Whether it's ice cream, eggs, milk, popcorn or cereal, it is common practice to charge a higher price per unit for a smaller package size. However it pays for consumers to do the math since businesses will at times charge a higher price on the larger packages size. If customers believe that bigger is always cheaper and fail to do the math, they may get caught paying a higher price per unit.

 

Test Yourself: Utility Theory

Elasticity

I. Elasticity: In economics, elasticity is another word for responsiveness, the extent to which a change in price will cause the quantity demanded to change, ceteris paribus.

II. Price Elasticity of Demand (PED or E_d): the responsiveness of the quantity demanded of a commodity to changes in its price

The price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price.

Relative Quantities Only: In the price elasticity formula percentage changes in quantity demanded are divided by percentage changes in price. Absolute changes are not considered only changes in relative amounts.

Always Negative: The law of demand states that quantity demanded is inversely related to the relative price. Thus, an increase in the price leads to a decrease in the quantity demanded. Price elasticity of demand will always be negative. The negative sign is ignored.

 

 

[where △ means “change in”]

Problem: The Direction Dilemma: When we move along a demand curve between two points, we get different answers to elasticity depending on whether we are moving up or down the demand curve. (Look at the two previous examples.) Economists solve this problem of different base points by using the midpoints as the base points of changes in prices and quantity demanded.

Percent of change is the difference between the two numbers divided by the original number.

(#1 – #2) ÷ #1

If there is an increase from 3 units to 5, what is the percent change? (3-5) ÷ 3 = .66 = 66%. There is a 66% increase.

If there is a decrease from 5 units to 3, what is the percent change? (5-3) ÷ 5 = .40 = 40%. There is a 40% decrease.

 

Calculating Elasticity: The use of average values of changes in price and quantity avoids the problem caused by using different prices as starting points. The average percentage change in price and quantity is computed over a given price range. To avoid the direction dilemma while finding price elasticity of demand, economists use the following formula.

Price Elasticity Ranges: In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded.

Which demand curve is for a vital medicine and which is for candy?

A is the demand curve for medicine because medicine is a necessity with few substitutes and the price can change with little effect on the quantity demanded.

B is the demand curve for candy because candy has many substitutes so a price change can bring about a big change in the quantity demanded.

Extreme Elasticities: There are two extremes in price elasticities of demand – perfectly inelastic demand (represents total unresponsiveness of quantity demanded to price changes) or zero elasticity (represents total responsiveness, which is called infinitely or perfectly elastic demand).

Price elasticity of demand applies only to a specific range of prices.

Determinants of the Price Elasticity of Demand

Availability of substitutes: The more substitutes a product has, the more sensitive consumers are to a price change, and the more elastic the demand curve. If an individual is on insulin or another particular type of medication for which few close substitutes exist, then an increase in the price results in very little change in the quantity demanded of the good.  The price elasticity of demand is directly related to the availability of good substitutes for a product.

Percent of Income: The larger the purchase is to one’s budget, the more sensitive consumers are to a price change, and the more elastic the demand curve. The percent of income spent on the good influences the elasticity of demand. Think of your annual expenditures on toothpicks or pencils.  If the price of those items increased, by say 20 percent, the quantity demanded would likely decrease very little due to your annual expenditures on the item. Spending $.60 instead of $.50 each year on toothpicks doesn’t dramatically change the quantity demanded. However for those items that make up a greater portion of our income, we are more responsive. If the price of a car increases by 20 percent, the quantity demanded is likely to decline significantly. In general, the greater percent of income spent on the good the more elastic it becomes, all else held constant.

Luxury or necessity: Those items that are a necessities in life are more inelastic than items that are a luxury.  Food in general, salt, and life saving medical care are examples of necessities and have lower price elasicities than luxury items such as: jewelry, yachts, or vacation travel.

Market definition: The broader the definition the fewer number of close available substitutes exist. If a single gas station in town raises its price, there are several other gas stations in town that sell a very similar product, thus the gas at a particular station tends to be elastic. However, if we look at the entire market for gas, there are few substitutes and the PED is inelastic.

Time period: The longer consumers have to adjust, the more sensitive they are to a price change and the more elastic the demand curve. In general, the price elasticity coefficient of demand is higher the longer a price change persists. The longer the time period, the more elastic a good becomes as more substitutes become available. If the price of gas doubled, car owners would still need to buy gas. But in time, they may choose to trade their larger vehicle in for one that is more fuel efficient or uses an alternative fuel, or even choose to move to a different apartment so that they are closer to work or able to use an alternative method of public transportation. In the short run, the elasticity of gas is estimated to be .2 while in the long run is .7.

How to Define the Short Run and the Long Run: The long run is the period of time necessary for consumers to make a full adjustment to a given price change, all other things held constant. The short run is any period that is less than the long run.

III. Cross-Price (or Cross) Elasticity of Demand (CPED) measures the responsiveness of the quantity demanded for one good to a change in the price of another good, ceteris paribus. It is measured as the percentage change in the quantity demanded for the first good that occurs in response to the percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the demand of new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be -20% ÷ 10% = 2.

IV. Income Elasticity of Demand (IED) measures the responsiveness of the quantity demanded for a good or service to a change in the income of the people demanding it, ceteris paribus. It is calculated as the ratio of the percentage change in the quantity demanded to the percentage change in income. For example, if in response to a 10% increase in income, the quantity demanded for a good increased by 20%, the income elasticity of demand would be 20% ÷ 10% = 2.

V. Price Elasticity of Supply (PES or E_s): a measure used in economics to show the responsiveness, or elasticity, of the quantity supplied of a good or service to a change in its price. The elasticity is defined as the percentage change in the quantity supplied divided by the percentage change in price.

When the coefficient is less than one, the supply of the good can be described as inelastic; when the coefficient is greater than one, the supply can be described as elastic. An elasticity of zero indicates that the quantity supplied does not respond to a price change: it is "fixed" in supply. Such goods often have no labor component or are not produced, limiting the short run prospects of expansion. If the coefficient is exactly one, the good is said to be unitary elastic.

The quantity of goods supplied can, in the short term, be different from the amount produced, as manufacturers will have stocks which they can build up or run down.

Classifying Supply Elasticity: Supply is elastic if a 1% increase in price elicits greater than 1% increase in the quantity supplied. Supply is perfectly elastic if the slightest reduction in price will cause quantity supplied to fall to zero. Supply is inelastic if a 1% increase in price elicits a less than 1% increase in the quantity supplied. Supply is perfectly inelastic if quantity supplied remains the same as price changes. If the percentage change in the quantity supplied is just equal to the percentage change in the price, then supply is unit-elastic.

Price Elasticity of Supply and Length of Time for Adjustment: The longer the time for adjustment, the more price-elastic is the supply curve. The reasons are (1) more firms are able to figure out ways to increase or decrease production in an industry, and (2) more resources can flow into (or out of) an industry through expansion (or contraction) of existing firms.

Determinants of the Elasticity of Supply

Product type: The type of product impacts how quickly a producer is able to respond to a change in price. A manufacturing firm may be able to quickly adjust production levels with only minor adjustments in the equipment while other products such as apples require several years to establish a new orchard. Since child care services requires relatively few skills compared to those of a physician, the supply elasticity of child care services is more elastic than that of physician services. To provide more physician care would require years of medical training.

Time: Time is a key determinant of supply. In the case of apples and some other agriculture products, the immediate elasticity of supply is very inelastic, i.e., there are only so many apples available for sale today.  However, with time producers are able to respond to the increase in price, manufacturing firms can build new facilities, farmers can plant additional acres to the particular crop. Thus in time, the elasticity of supply becomes more elastic.

Production capacity: If a firm is already operating at full capacity, then to increase supply would require building additional facilities and purchasing new equipment. A firm that is operating at below full capacity can respond to a price increase quicker than a firm that is already at full capacity.

Input substitution (Flexibility and Mobility): As the price of a good increases, how easily can inputs that were used in the production of another good be switched over to producing the good with the higher price?

VI. Using Elasticities

A firm’s profit is determined by taking the total revenue minus the total cost. Total revenue is equal to the price each unit sells for times the quantity or number of units sold. One of the key decisions in business is determining what price to charge. We know from the law of demand, that as the price increases/decreases the quantity demanded decreases/increases, but the question is by how much? Does total revenue increase or decrease as we raise or lower the price? The answer is, as is often the case in economics, it all depends.

Let’s assume that the demand for a given product can be represented by the equation, price = 100 - 0.5(quantity). If the current price is $10 and the quantity demanded is 180, then a two dollar increase in the price reduces the quantity demanded by four units. But even though four units less are sold, the additional two dollars per unit sold increases the total revenue.

P = 100 - 0.5(Q)

P₁ = $10 Q₁ = 180               TR = $1,800

P₂ = $12 Q₁ = 176               TR = $2,112

If the price is $90, the quantity demanded is 20. Raising the price by two dollars decreases the quantity demanded by four units. In this case, the total revenue would decline when the price is increased.

P = 100 - 0.5(Q)

P₁ = $90 Q₁ = 20  TR = $1,800

P₂ = $92 Q₁ = 16  TR = $1,472

Understanding elasticities is critical when making pricing decisions in business. For example, Disneyland and Disneyworld offer a lower price for state residents. Since residents are closer and can go more often, their elasticity of demand is more elastic and total revenue for the company increases by decreasing the price. Nonresidents are less sensitive to price changes; vacationers that are required to travel a long ways will likely only go once during the year. Given that their demand is less elastic, the company makes greater profits by charging them a higher price.

If a company can divide their customers into different groups that have different elasticities, they are able to charge each group according their elasticity of demand. These groups may be by age, such as children rates or senior citizen discounts, or by geographical region, as shown in the example above.

Understanding cross price elasticities, businesses may reduce the price of a good below their actual cost. These loss leaders are priced to get the customers into the store and while purchasing that item, they also will purchase other items.

VII. Government: Tax Incidence

Governments can also use elasticities when determining the tax incidence or what portion of a tax is ultimately borne by the consumers and the producers. Governments often tax addictive substances such as alcohol and cigarettes since demand is relatively inelastic. The government justifies these sin taxes in two ways. Since these products can contribute to poorer health and additional medical costs that are often paid for by all citizens, it is appropriate to tax those individuals using the products. The second justification is that the demand for these products is inelastic so that imposing a tax significantly increases tax revenues.

Elasticities are used to determine how much of a tax is borne by the producer verses the consumer. For example, when a tax is imposed on cigarettes, producers are able to pass along most of the burden of the tax by raising the price. If the supply is more elastic than demand, then the producer will bear a greater burden of the tax.

 

Test Yourself: Elasticity

The Business Firm

I. The Business Firm

An institution that hires and organizes resources to produce and sell goods and services, a firm is an organization that brings together different factors of production, such as labor, land, capital and entrepreneurial skill to produce a product or service that it hopes can be sold for a profit. The entrepreneur is a residual claimant who makes profits and bears losses.

The Legal Organization of Firms: The basic organization of all firms can be thought of in terms of a few simple structures, the most important of which are the proprietorship, partnership, and the corporation.

Proprietorship: A business owned by one individual who makes the business decisions, receives all of the profits, and is legally responsible for all of the debts of the firm.

Advantages of Proprietorships: They are easy to form and to dissolve. All decision-making power resides with the sole proprietor. Its profit is taxed only once.

Disadvantage of Proprietorships: The proprietor faces unlimited liability. Proprietorships have limited ability to raise funds. Proprietorships normally end when the proprietor dies.

Partnership: A partnership is a business owned by two or more co-owners, partners, who share the responsibilities and the profits of the firm and are individually liable for all of the debts of the partnership.

Advantages of Partnerships: They are easy to form. Partnerships often help reduce the costs of monitoring job performance. They permit more effective specialization in occupations where, for legal or other reasons, the multiple talents needed for success are unlikely to be uniform across individuals. The income of the partnerships is treated as personal income and is subject only to personal taxation.

Disadvantages of Partnerships: The partners each have unlimited liability. Decision-making is generally more costly in a partnership than a proprietorship. Dissolution of the partnership is generally necessary when a partner dies or voluntary withdraws or when one or more partners wish to remove someone from the partnership.

Corporation: A legal entity that may conduct business in its own name just as an individual does. The owners of a corporation, called shareholders, own shares of the firm’s profits and have limited liability.

Advantages of Corporations: Owners of a corporation (the shareholders) enjoy limited liability. The law treats the corporation as a legal entity in and of itself; thus, the corporation continues to exist even if one or more owners of the corporation cease to be owners. Corporations are better able to raise large sums of financial capital.

Disadvantages of Corporations: The profits of the corporation are subject first to corporate taxation. If any after-tax profits are distributed to shareholders as dividends, such payments are treated as personal income to the shareholders and subject to personal taxation. Corporations are potentially subject to problems associated with the separation of ownership and control.

Corporate Financing Methods

Share of Stock: Stock is a legal claim to a share of a corporation’s future profits. If it is common stock, it incorporates certain voting rights regarding major policy decisions of the corporation. If it is preferred stock its owners are accorded preferential treatment in the payment of dividends.

Bond: A bond is a legal claim against a firm that usually entitles the owner of the bond to receive a fixed annual coupon payment, plus a lump-sum payment at the bond’s maturity date; bonds are issued in return for funds lent to the firm.

Reinvestment: Profits or depreciation reserves reinvested to purchase new capital equipment.

The Markets for Stocks and Bonds: The largest and most prestigious of these markets are the New York Exchange (NYSE) and the New York Bond Exchange, both located in New York City. More than 2,500 stocks are traded on the NYSE.

The Theory of Efficient Markets: The theory that all publicly available information is incorporated in the price of stocks leaving no forecastable profit opportunities. Stock prices thus follow a random walk where prices are said to move independently in securities markets and that there are no predictable trends that can be used to get rich quick.

Inside Information: Information about what is happening in a corporation that is not available to the general public. This information allows an investor to beat the market.

The objective of a firm is to maximize economic profit. Profit is limited by: market structure (We’ll look at market structures in the next unit.) and the technological (Technological doesn’t necessarily mean technology.) constraints of production. The firm is assumed to try to make the difference between total costs and total revenues as large as possible. This allows the firm to be better able to obtain financing and, thus, to grow.

Technology constraints: The quantity of output is limited by the productivity of inputs. These constraints are different depending on the time frame.

A firm’s production decisions depend on how those decisions affect economic profit. Economic profit = revenue minus opportunity cost. Economic profit is not the same as accounting profit because opportunity cost is not identical to accounting cost. Accounting profit is the difference between total revenues and explicit costs. Explicit costs are costs that business managers must take into account, because they must be paid. Economists are interested in both explicit and implicit costs. Implicit costs are costs managers do not necessarily have to take into account, such as the opportunity cost of owner-provided factors of production.

A firm’s opportunity costs are divided into explicit costs and implicit costs.

Explicit cost (money costs) is the amount a firm pays for its needed factors of production (land, labor, capital, entrepreneurship).

Implicit cost is the value of foregone opportunities. A firm incurs implicit cost when it uses its own capital and uses its owner’s time or financial resources. They represent a firm’s opportunity cost of using its own resources or those provided by its owners without a corresponding cash payment.

Implicit rental rate is the forgone income from using your assets, rather than renting them to other firms. The implicit rental rate of capital is made up of economic depreciation and implicit interest.

Economic depreciation is the change in the market price of a piece of capital over a given time period, what you lose by not doing something else with that piece of capital. This is an opportunity cost. It is not the same as accounting depreciation, which involves using a number of conventional rules to determine the loss of value in a piece of capital over time.

Implicit Interest: The funds tied up in capital goods could have been invested in other things that yield a return (e.g. interest income). This is an opportunity cost.

Cost of the owner's resources: the income that the owner could have earned in the best alternative job. Normal profit is the expected return for supplying entrepreneurial ability.

Rent: Economic rent is a payment for the use of any resource over and above its opportunity cost. It can be viewed as a payment to resource owners in excess of what would be necessary to call forth that amount of the resource.

Determining land rent: Rent is determined by the demand for land interacting with a fixed supply of land.

Economic rent to labor: Pure economic rents can explain part of the difference between the extraordinary earnings of highly successful musicians and average musicians. Part of the wages of superstars consists of economic rents because they would work for less than they earn.

Economic rents and the allocation of resources: Economic rents allocate resources to their highest valued uses. Those who can most efficiently use the resources offer the highest payment.

Interest: Interest is the payment for current rather than future command over resources, the cost of obtaining credit, and the return paid to owners of capital.

Interest and Credit: Variations in the rate of annual interest that must be paid for credit depend on the following factors.

Length of Loan: In some cases, the longer the loan will be outstanding, other things being equal, the greater will be the interest rate charged.

Risk: The greater the risk of non-repayment of the loan, other things being equal, the greater the interest rate charged.

Handling Charges: The larger the amount of the loan, the smaller the handling (or administrative) charges are as a percentage of the total loan and, other things being equal, the lower the interest rate.

Real Versus Nominal Rates: The market rate of interest expressed in terms of today’s dollars is the nominal interest rate. The real rate of interest is obtained by subtracting the anticipated rate of inflation from the nominal rate of interest.

The Allocative Role of Interest: Interest is a price that allocates loanable funds (credit) to consumers and to business. Investment or capital projects with rates of return higher than the market rate of interest in the credit market will be undertaken. The interest rate, thus, allocates loanable funds to industries whose investments yield the highest returns and where resources will be the most productive.

Present Value: the value of a future amount expressed in today’s dollars; the most that someone would pay today to receive a certain sum at some point in the future

Interest Rate: the amount of money paid per year to savers as a percentage of the amount saved

 

Average and Marginal Physical Product: Average physical product is total product divided by the variable input. Marginal physical product is the change in total product that occurs when there is a one-unit change in the variable input.

Diminishing Marginal Returns: The law of diminishing returns is the observation that successive increases in a variable factor of production such as labor, added to fixed factors of production, will reach a point beyond which the extra or marginal product that can be attributed to each additional unit of the variable factor of production will decline. In other words, when more and more of a variable resource is added to a given amount of a fixed resource, the resulting change in output will eventually diminish and could become negative.

 

Short-Run Costs to the Firm: In the short run some inputs are fixed and some are variable and thus total costs consist of fixed and variable costs. Also, total costs include both explicit and implicit costs.

Total Fixed Costs: Costs that do not vary with output.

Total Variable Costs: Costs that vary with the rate of production.

Short-Run Average Cost Curves:

Average Fixed Costs (AFC): Total fixed costs divided by number of units produced.

Average Variable Costs (AVC): Total variable costs divided by number of units produced.

Average Total Costs (ATC): Total costs divided by number of units produced sometimes called average per-unit total costs.

Marginal Cost: The change in total costs due to a change in production of one unit, i.e., change in total cost divided by change in output. When the marginal physical product (MPP) rises MC will fall. When MPP falls (the point of diminishing marginal returns) MC will begin to rise.

Relationship Between Average and Marginal Costs: When marginal costs are less then both average total costs and average variable costs, the latter two are falling. Conversely, when marginal costs are greater than both average total costs and average variable costs, the latter two are rising. Finally, marginal cost will equal both average total costs and average variable costs at their respective minimum points.

Minimum Cost Points: The marginal cost curve intersects the minimum point of the average total cost curve and the minimum point of the average variable cost curve.

Relationship Between Diminishing Marginal Returns and Cost Curves: Short-run firm cost curves reflect the law of diminishing marginal returns. Given a constant price of a variable input, MC declines as long as marginal product of the variable resource goes up. At the point of diminishing marginal returns, MC will reach a minimum. MC will then rise as the marginal product of the variable input declines. The result is an MC curve that slopes down, hits a minimum, and slopes up. The ATC curve and AVC curve are similarly affected. They will have a U shape in the short run.

Long Run Cost Curves: In the long run, all factors of production are variable. Long-run curves are sometimes called planning curves, and the long run is sometimes called the planning horizon.

Long-Run Average Cost Curve: This curve is the locus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices, also, the planning curve.

Why the Long-Run Average Cost Curve is U-shaped: The reason it is U-shaped is economies of scale that occur when output increases lead to decreases in long-run average costs. Constant returns to scale is a situation in which the long-run average cost curve of a firm remains flat, or horizontal, as output increases. Diseconomies of scale occur when increases in output lead to increases in long-run average costs.

Economies of Scale: exist when the average cost of production by one firm becomes smaller as the rate of output increases

Reasons for Economies of Scale

Specialization: As a firm’s scale of operation increases, the opportunities for specialization in the use of resource inputs also increase.

Dimensional Factor: Large-scale firms require proportionately less input per unit of output simply because certain inputs do not have to be physically doubled in order to double the output.

Improved Productive Equipment: The larger the scale of the enterprise, the more the firm is able to take advantage of larger-volume (output capacity) types of machinery.

Why a Firm Might Experience Diseconomies of Scale: One of the basic reasons that a firm could expect to run into diseconomies of scale is that there are limits to efficient functioning of management. Also, as more workers are hired a more than proportionate increase in managers and staff people may be needed causing increased costs per unit.

Minimum Efficient Scale: The lowest rate of output per unit time period at which average costs reach a minimum for a particular firm.

Cost Concepts (PDF)

III. The analysis of short-run production is most concerned with the connection between the amount of product generated by a firm and the quantity of the variable input used. This gives rise to three related product notions: total product, marginal product and average product.

    Total, Marginal and Average Product

	Labor (workers/day)	Total (toys/day)	Marginal (toys/1 more unit)	Average (toys/worker)
A	0	0
B	1	4	4	4
C	2	10	6	5
D	3	13	3	4.33
E	4	15	2	3.75
F	5	16	1	3.20

 

Total product is the total output produced.

Total Product Curve

 

 

 

 

 

 

 

 

 

Marginal product is the increase in total product from a one-unit increase in an input.

Marginal Product Curve

 

 

 

 

 

 

 

 

 

Marginal product is measured by the slope of the total product curve.

Increasing marginal returns occur when the marginal product of an additional worker exceeds that of the previous worker.

Decreasing marginal returns occur when the marginal product of an additional worker is less than that of the previous worker.

Law of Diminishing Returns: As a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes.

 

Average product of an Input is the total product divided by the quantity of an input.

Average Product Curve

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Physical Product

Total Product

Total Product Curve

Marginal Product

Marginal Product Curve

Average Product

Average Product Curve

Total Product and Marginal Product

Total Product and Average Product

Average Product and Marginal Product

 

Money-Minded: Investing in the Stock Market

 

 

Test Yourself: The Business Firm