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Day 6 Review: Micro

Law of Diminishing Marginal Utility

Utility Maximizing Rule

Explicit and Implicit Costs

Short Run Cost Curves

Law of Diminishing Marginal Returns

Long Run Cost Curves

Economies and Diseconomies of Scale

MES

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Individual Choice

What consumers decide to purchase depends on their personal preferences and priorities.
No two people will make exactly the same decisions.
The concept of consumer equilibrium puts each person in charge of his/her own satisfaction.
The objective is to maximize their satisfaction but to stay within their budget.

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Law of Diminishing Marginal Utility

Although consumer wants in general are insatiable, wants for specific commodities can be fulfilled. The more of a specific product that consumers obtain, the less they will desire more units of that product.
Utility is a subjective notion in economics, referring to the amount of satisfaction a person gets from consumption of a certain item.
Marginal utility refers to the extra utility a consumer gets from one additional unit of a specific product. In a short period of time, the marginal utility derived from successive units of a given product will decline.

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Utility

Total utility

Total satisfaction from a specific quantity.

Marginal utility

Extra satisfaction from an additional unit.

Law of diminishing marginal utility

Explains downward sloping demand.

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Definitions:

Law of Diminishing Marginal Utility: As successive units of a particular good are consumed, the additional utility to the consumer declines.

Total Utility vs. Marginal Utility: Total utility will increase until marginal utility = zero, at which point additional consumption will result in a decline in total utility.

Total utility

Marginal utility

Scoops of ice cream

1 2 3 4 5

-2

Mr. Kelly at Sebastian Joe’s

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Theory of Consumer Behavior

An economic explanation for how different consumers allocate their money income among different goods and services:

Rational Behavior

Consumers try to get the "most for their money" to maximize their total utility

Preferences

Consumers have clear cut preferences and can determine how much marginal utility they get from consuming more units of a product

Budget Constraint

All consumers face a budget constraint, therefore must make decisions about what they buy based on their limited budget

Prices

Every product has a price, so consumers must weigh their purchasing decisions based on their marginal utility from consumption and the price of the goods they consume

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P_A

MU_A

MU_B

P_B

Utility Maximization Rule (DRAW):

Utility Maximization Rule:

To maximize satisfaction, a consumer should allocate his or her money income so that the last dollar spent on each product yields the same amount of extra utility. Marginal Utility per $ should be equal for each product you buy!

Interpretation: If a consumer gets more MU/$ for good A than good B, he should consumer more of A and less of B. As he consumes more A MU_Awill decrease. As he consumes less of good B MU_B will increase. When MU_A/P_A and MU_B/P_Bare equal, the consumer is consuming just the right amount of A and B.

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Explicit & Implicit Costs

Explicit costs are payments to nonowners for resources they supply. What accountants track.

Examples:

Rent for factory space and mall kiosks.
Cost of company cars/trucks.
Salaries (highly skilled watchmakers).
Factory utilities (electricity, security system, water (we have a bathroom).
Chinese manufacturers of bands, motors, glass, hands, etc.

Implicit costs are the money payments the self-employed resources could have earned in their best alternative employments. Implicit costs can include money! Not included by accountants – only economists.

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Normal vs. Economic Profit

Normal Profits are considered an implicit cost because they are the minimum payments required to keep the owner’s entrepreneurial abilities self-employed. Sometimes called: Zero Profit.

Economic or Pure Profits are total revenue less all costs (explicit and implicit including a normal profit).

The GOAL is Economic Profit. We will still stay in business at a Normal Profit, but leave the industry (shutdown point) if we cannot make at a minimum a normal profit.

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Short Run vs. Long Run

The short run is the time period that is too brief for a firm to alter its plant capacity (physical space). The plant size is fixed in the short run. Short‑run costs, then, are the wages, raw materials, etc., used for production in a fixed plant. Variable: Labor (most questions – cut/hire workers or shifts for 24/7 production).
The long run is a period of time long enough for a firm to change the quantities of all resources employed, including the plant size. Long‑run costs are all costs, including the cost of varying the size of the production plant. All long run costs are variable.

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Production Costs:�Short-Run�

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Remember: Law of Diminishing Marginal Utility (consumer, not producer)?

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New: Law of Diminishing Marginal Returns (producer, not consumer).

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Short Run & Law of Diminishing Returns

Short‑run production reflects the law of diminishing returns that states that as successive units of a variable resource (say, labor) are added to a fixed resource, beyond some point the product attributable to each additional resource unit will decline.

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The law of diminishing returns assumes all units of variable inputs—workers in this case—are of equal quality. Marginal product diminishes not because successive workers are inferior but because more workers are being used relative to the amount of plant and equipment available.

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Draw The Cost Curves:

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Shifting Curves

Cost curves will shift if the resource input prices change or if technology or efficiency change.

Examples:

Cheaper rent, electricity (utilities), and labor will lower our costs.
More expensive rent, utilities, and labor will raise our costs.
Shifting Marginal Cost
More

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Production Costs:�Long-Run

ALL COSTS ARE VARIABLE�

In the long‑run, all production costs are variable. Long-run costs reflect changes in plant size and industry size (expand or contract).

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�Long Run�Economies & Diseconomies of Scale

Shape of Curve: Economies or diseconomies of scale exist in the long run – NOT in the short run. Law of Diminishing Returns only in the Short Run with fixed costs.

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Economies of Scale

Economies of scale or economies of mass production explain the downward sloping part of the long‑run ATC curve. As plant size increases, long-run ATC decrease.
Reasons:
1. Labor and managerial specialization is one reason for this.
2. Ability to purchase and use more efficient capital goods also may explain economies of scale.
3. Other factors may also be involved, such as design, development, or other “start up” costs such as advertising and “learning by doing.”

Getting better/more efficient/more productive.

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Diseconomies of Scale

Diseconomies of scale may occur if a firm becomes too large as illustrated by the rising part of the long‑run ATC curve.
For example, if a 10 percent increase in all resources result in a 5 percent increase in output, ATC will increase.

Reasons:

Distant management (Corporate HQ, Home Office)
Worker alienation (no direct connection with the business, unlike cozy start-ups).
Rising costs of management (raises, bonuses, retirement & health care plans).
Problems with communication and coordination.

Constant returns to scale will occur when ATC is constant over a variety of plant sizes.

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Minimum Efficient Scale (MES)

The concept of minimum efficient scale defines the smallest level of output at which a firm can minimize its average costs in the long run.
1. The firms in some industries realize this at a small plant size: apparel, food processing, furniture, wood products, snowboarding, and small-appliance industries are examples.
2. In other industries, in order to take full advantage of economies of scale, firms must produce with very large facilities that allow the firms to spread costs over an extended range of output. Examples would be: automobiles, aluminum, steel, and other heavy industries. This pattern also is found in several new information technology industries.

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MES

Lowest Point (Q1)
Graph A

Large and small firms can compete (clothing, food industries).

Graph B

Few large firms. Auto, airline, heavy industry and high tech (microchips) sector.

Graph C

Large numbers of small producers (concrete).

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Multiple Choice Answers

1.b

2.b

3.d

4.b

5.b

6.b

7.d

8.c

9.b

10.d

11.d

12.c

13.c

14.d

15.b

16.b

17.b

18.c

19.c

20.c

21.c

22.c

23.a

24.d

25.b

26.c

27.c

28.a

29.c