ECON

11
Chapter 5: Demand and Consumer Behavior

Utility
• Denotes satisfaction
• How consumers rank different goods
and services
• The subjective pleasure or usefulness
that a person derives from consuming a
good or service
• A scientific construct that economists
use to understand how rational
consumers make decisions Law of Diminishing Marginal Utility
• “The property in any object to produce • States that the amount of extra or
pleasure or happiness to prevent pain, marginal utility declines as a person
evil, or unhappiness” (Bentham) consumes more and more of a good
• As one consumes more and more, the
Theory of Demand total utility will grow at a slower and
• It is assumed that people maximize their slower rate
utility • Marginal utility diminishes as more of a
• Consumers choose the bundle of good is consumed because of satiety
consumption goods that they most • Implies that the marginal utility curve
prefer must slope downward and that the total
• Consumer demand function is derived utility curve must look concave
from the assumption that people make
decisions that give them the greatest
utility or satisfaction

Marginal Utility

• Increment to an individual’s utility

• “Extra happiness” one gets from

consuming a good or service

• Denotes the additional utility from the

consumption of an additional unit of a

commodity



Total Utility

• Total utility of consuming a certain

amount is equal to the sum of the

marginal utilities up to that point

• The sum of all the marginal utilities that

were added from the beginning

• Total utility rises with consumption but
rises at a decreasing rate, showing
diminishing marginal utility


Equimarginal Principle • Cardinal utility is generally rejected since
• Fundamental condition of maximum utility does not ring up like numbers but
satisfaction or utility useful in special situations
• A consumer will achieve maximum
satisfaction when the marginal utility of Indifference Curves
the last dollar spent on a good is exactly • Indifference analysis asks about the
the same as the marginal utility of the substitution effect and the income effect
last dollar spent on any other good of a change in price
• “I should arrange my consumption so • Points on the curve represent
that the last dollar spent on each good is consumption bundles among which the
bringing me the same marginal utility” consumer is indifferent; all are equally
• EX. If Good A costs twice as much as desirable
Good B, then buy Good A only when its • Drawn as a bowl-shaped or convex to
marginal utility is at least twice as great the origin
as Good B’s • As you move downward and to the right
• This should be because if any one good of the curve, the curve become flatter
gave more MU per dollar, one will
increase his utility by taking money away
from other goods and spending more on
that good – until the law of diminishing
MU drove its MU per dollar down to
equality with that of any other goods

Marginal Utility of Income
• The common marginal utility per dollar
of all commodities in consumer
equilibrium
• Measures the additional utility that
would be gained if the consumer could Substitution Effect
enjoy an extra dollar’s worth of • When the price of a good rises,
consumption consumers will tend to substitute other
• MUgood1 = MUgood 2 goods for the more expensive good in
P1 P2 order to satisfy their desires more
inexpensively
Ordinal Utility • When consumers substitute less
• Under this approach, consumers need to expensive goods for expensive ones,
determine only their preference ranking they are buying a given amount of
of bundles of commodities satisfaction at a lower cost
• Can be stretched while always • EX. When coffee becomes a more
maintaining the same greater-than or expensive beverage, less coffee and
less-than relationship more tea or cola will be bought
• If the utility scale is stretched (ex.
doubled), it can be seen that all the Law of Substitution
numerators in the condition are changed • The scarcer a good, the greater its
by exactly the same amount so the relative substitution value; its marginal
consumer equilibrium condition still utility rises relative to the marginal
holds
 utility of the good that has become Income Elasticity
plentiful • Percentage change in quantity
• Substitution ratios or marginal rate of demanded divided by the percentage
substitution – as the size of the change in income
movement along the curve becomes • IE = % change in quantity demanded
very small, the closer the substitution % change in income
ratio comes to the actual slope of the • High income elasticities indicate that the
indifference curve demand for the goods rises rapidly as
• rate at which a consumer can give up income increases
some amount of one good in exchange • Low income elasticities denote a weak
for another good while maintaining the response of demand to increases in
same level of utility income
• The slope of the indifference curve is the
measure of the goods’ relative MU, or of
the substitution terms on which the
consumer would be willing to exchange
a little less of one good in return for a
little more of the other
• EX. As the amount of food you consume
goes up – and the quantity of clothing
goes down – food must become
relatively cheaper in order for you to be
persuaded to take a little extra food in
exchange for a little sacrifice of clothing

Income Effect
• Real Income – actual quantity of goods
that your money income can buy
• When a price rises and money income is
fixed, real income falls because the Budget Line or Budget Constraint
consumer cannot afford to buy the same • Sums up all the possible combinations of
quantity of goods as before two goods that would exhaust the
• Change in the quantity demanded that consumer’s income
arises because a price lowers consumer • The slope of the budget line is the ratio
real income of price of Good A to price of Good B –
means that given certain prices, every
time a consumer gives up X units of
Good A, he can gain Y units of Good B









Equilibrium Position of Tangency
• A consumer is free to move anywhere
along the budget line
• Geometrically, the consumer is at
equilibrium where the slope of the
budget line is exactly equal to the slope
of the indifference curve
• Consumer equilibrium is attained at the
point where the budget line is tangent to
the highest indifference curve – at that
point, the consumer’s substitution ratio
is just equal to the slope of the budget
line Demand Shifts
• PA = substitution ratio = MUA • An increase in income tends to increase
PB MUB the amount individuals are willing to buy
of most goods
• Necessities tend to be less responsive
than most goods to income changes,
while luxuries tend to be more
responsive to income changes
• Inferior goods – purchases may shrink as
incomes increase because people can
afford to replace them with other, more
desirable goods
• The demand curve shows the quantity of
a good demanded responds to a change
in its own price but the demand is also
affected by the prices of other goods, by
consumer incomes, and by special
influences

Substitutes
Market Demand • Goods A and B are substitutes if an
• The market demand curve is the sum increase of price in the price of Good A
total of individual demands at each price will increase the demand for substitute
• The demand curve for a good for the good B
entire market is obtained by summing
up the quantities demanded by all the Complements
consumers • An increase in the price of Good A causes
• To obtain the total market demand a decrease in the demand for its
curve, we calculate the sum total of complimentary good B
what all the different consumers
consume at each price
• Market demand and supply curves are
labeled with uppercase letters (DD and
SS) while individual demand and supply
curved use lowercase letters (dd and ss)
 • Measures the extra value that
consumers receive above what they pay
for a commodity
• Economists use the consumer surplus
when they are performing a cost-benefit
analysis, which attempts to determine
the costs and benefits of a government
program
• Something should be free if its total
consumer surplus exceeds its costs



Independent Goods
• For which a price change for one has no
effect on the demand for the other

Paradox of Value
• “Diamonds are very scarce and the cost
of getting extra ones is high, while water
is relatively abundant and costs little in
many areas in the world”
• Total utility from water consumption
does not determine its price or demand
• Water’s price is determined by its
marginal utility by the usefulness of the
last glass of water
• The more there is of a commodity, the
less is the relative desirability of its last
little unit
• It is the large quantities that pull the
marginal utilities so far down and thus
reduce the prices of these vital
commodities

Consumer Surplus
• Consumers “receive more than they pay
for” as a result of the law of diminishing
marginal utility
• Consumers pay for each unit what the
last unit is worth
• The area between the demand curve
and the price lines is the total consumer
surplus
• Consumers pay the price of the last unit

for all units consumed so they enjoy a
surplus of utility over cost
Chapter 6: Production and Business Average Product
Organization • Equals total output divided by total units
of input
Productive capacity
• Determined by the size and quality of
labor force, by the quantity and quality
of the capital stock, by the nation’s
knowledge along with the ability to use
that knowledge, and by the nature of the
public and private institutions
• A modern economy has an enormously
varied set of productive activities

Production Function
• The relationship between the amount of
input required and the amount of output
that can be obtained
• Specifies the maximum output that can
be produced with a given quantity of
inputs
• Defined for a given state of engineering
and technical knowledge

• In areas of the economy where
Law of Diminishing Returns
technology is changing rapidly
(computer software, biotechnology, • A firm will get less and less extra output
etc.), production functions may become when it adds additional units of an input
obsolete (out of date) soon after they while holding other inputs fixed
are used • Marginal product of each unit of input
• Concept of production function is a will decline as the amount of that input
useful way of describing the productive increases, holding all other inputs
capabilities of a firm constant
• As more of an input such as labor is
Total Product added to a fixed amount of land,
• Total physical product machinery, and other inputs, the labor
has less and less of the other factors to
• Designates the total amount of output
produced in physical units (bushels of work with. The land gets more crowded,
wheat, pairs of shoes, etc.) the machinery is overworked, and the
marginal product declines
Marginal Product • Diminishing returns are seen as a
concave or dome shaped total product
• Extra output produced by one (1)
curve
additional unit of that input while other
inputs are held constant • The law of diminishing returns is a widely
observed empirical regularity rather
• Crucial for understanding how wages
than a universal truth
and other factor prices are determined






Returns to Scale technologies are introduced because
• Effects of scale increases of inputs on the they increase profits of the innovating
quantity produced firms
• CONSTANT returns to scale denote a • Technological regress can occur when
change in all inputs that leads to a there are market failures
proportional change in output
• INCREASING returns to scale (economies
of scale) arise when an increase in all
inputs leads to a more-than-
proportional increase in the level of
output
• DECREASING returns to scale occur
when a balanced increase of all inputs
leads to a less-than-proportional
increase in total output

Short Run
• Period in which firms can adjust
production by changing variable factors

such as materials and labor but cannot
change fixed factors such as capital Productivity
• Factors that are increased in the short • A concept measuring the ratio of total
run are called variable factors output to a weighted average of inputs
• Factors that cannot be changed in the • Labor productivity calculates the
short run because of physical conditions amount of output per unit of labor
or legal contracts are called fixed factors • Total factor productivity measures
output per unit of total inputs
Long Run • Total factor productivity =
• Period sufficiently long that all factors output/index of all inputs
including capital can be adjusted • Labor productivity = output/unit of
labor
Technological Change
• When output is growing faster than
• Improves productivity and raises living inputs, this represents productivity
standards growth
• Process innovation occurs when new • Productivity grows because of
engineering knowledge improves technological advances, and of
production techniques for existing economies of scale and scope
products, from product innovation,
whereby new or improved products are Economies of Scale and Mass Production
introduced in the marketplace
• Important elements of productivity
• Technological change shifts the growth
production function upward
• If increasing returns to scale prevail, the
• Technological regress is not possible for larger scale of inputs and production
a well functioning market economy would lead to greater productivity
• Inferior technologies are unprofitable
and tend to be discarded in a market
economy, while more productive
Economies of Scope
• Occur when a number of different
products can be produced more
efficiently together than apart
• Specialization and division labor that
increase productivity as economies
become larger and more diversified

Aggregate Production Functions
• Relate total output to the quantity of
inputs
• Total factor productivity has been
increasing because of technological
progress and higher levels of worker
education and skill

































Chapter 7: Analysis of Costs Minimum Attainable Costs
• To attain the lowest levels of costs,
Firm’s Problem managers have to make sure the firm is
• The firm wants to maximize profit paying the least possible amount for
subject to a cost constraint necessary materials, engineering
• The firm wants to minimize cost subject techniques incorporated into factory
to an output constraint output, etc.
• It is facing given resources – prices of
factor inputs Marginal Cost
• It operates in 2 markets – goods and • Extra or additional cost of producing one
factor markets (1) extra unit of output
• △TC
Fixed Cost △Q
• Expenses that must be paid even if the • Slope of the TC curve
firm produces zero output
• “overhead” or “sunk costs”
• Consist of items such as rent, interest
payments on debts, etc.
• Do not change if output changes
• Amount that must be paid regardless of
the level of output

Variable Cost
• Vary as output changes
• Include materials required to produce
output, production workers, etc.
• Begins at zero when q is zero
• Part of total cost that grows with output


Total Cost

• Represents the lowest total dollar

expense needed to produce each level of

output q

• Rises as q rises
• TC = FC + VC












Average Cost constant FC gets spread over more and
• Total cost divided by the total number of more units
units produced
• Sum of AFC and AVC Average Variable Cost
• AC = TC • AVC = VC/q
q • AVC first falls then rises
• Average cost falls lower and lower at
first Relation Between Average Cost and Marginal
• It reaches minimum then slowly rises Cost
• Total cost moves with variable cost while • MC < AC à pulling AC down (last unit
fixed cost remains the same produced costs less than the average
• U-shaped AC curve and aligns AC right cost of all the previous units produced)
below the TC curve from which it is • MC > AC à pulling AC up (last unit
derived produced costs more than the average
cost of all the previous units produced)
• MC = AC à AC is constant; at the bottom
of a U-shaped AC, MC = AC = minimum
AC














Link Between Production and Costs
• Factors that determine the cost curves
are factor prices and the firm’s
production function
• Prices of inputs are important
ingredients of costs
• Costs also depend on the firm’s
Average Fixed Cost technological opportunities
• Defined as FC/q • If technological improvements allow the
• As a firm sells more output, it can spread firm to produce the same output with
its overhead cost over more and more fewer inputs, the firm’s costs will fall
units
• AFC curve is a hyperbola, approaching
both axes: it drops lower and lower,
approaching the horizontal axis as the
Diminishing Returns and U-Shaped Cost Curves Least-Cost Rule
• Economists often draw cost curves like • Firms minimize their costs of production
the letter “U” • Firm should strive to produce its output
• For a U-shaped cost curve, cost falls in at the lowest possible cost and thereby
the initial phase, reaches a minimum have the maximum amount of revenue
point, and finally begins to rise left over for profits or other objectives
• In the short run, labor and material costs • Find least-cost combination:
are typically variable costs, while capital 1. Calculate marginal product of
costs are fixed each input
• In the long run, all costs are variable 2. Divide the MP of each input by
• The U-shaped cost curves are based on its factor price = marginal
diminishing returns in the short run product per dollar of input
• Increasing and then diminishing of the • Cost-minimizing combination of inputs
variable factor gives U-shaped marginal comes when the MP/dollar of input is
and average cost curves equal for all inputs
• If cost curves did not eventually turn up • A firm will minimize its total cost of
(U-shaped), perfect competition would production when the MP/dollar of input
break down. A firm with a cost curve is equalized for each factor of
that declines forever as more output is production (least-cost rule)
produced would dominate the industry • Marginal product of L
Price of L
= marginal product of A = …
price of A
• Least-cost rule states that the marginal
product of each dollar-unit of input must
be equalized
• If the marginal products per $1 of inputs
were not equal, you could reduce the
low MP/dollar input and increase the
high MP/dollar input and produce the
same output at lower cost
• A corollary of the least-cost rule is the
substitution rule
• Substitution rule: if the price of one
factor falls while all other factor prices
remain the same, firms will profit by
substituting the now-cheaper factor for
the other factors until the marginal
products/dollar are equal for all inputs

Numerical Production Function
• Production theory and costs analysis
have their roots in the concept of a
production function
• Shows the maximum amount of output
that can be produced with various
combinations of inputs
 • Shows the maximum output available Least-Cost Factor Combination for A Given
given engineering skills and technical Output
knowledge available at a particular time • The numerical production function
shows the different ways to produce a
given level of output
• EX. Combination A, the total labor and
land cost will be $20, equal to (1 x $2) +
(6 x $ 3)










Law of Diminishing Marginal Product Equal-Product Curve
• The marginal product of labor is the • Isoquant
extra production resulting from 1 • Analogous to the consumer’s
additional unit of labor when land and indifference curve
other inputs are held constant • Axes on the isoquant are two
• In the production function, marginal inputs/factors of production
product of labor can be found by • Convex to the origin because of the law
subtracting the output from the number of diminishing marginal productivity
on its right in the same row • As one input is increased while all other
• EX. When there are 2 units of land and 4 inputs are held constant, the marginal
units of labor, the marginal product of an product of the varying input will start
additional laborer would be 48=448-400 declining after some point
• Slope of the isoquant is the marginal rate
Law of Diminishing Returns of technical substitution – ratio of the
• As we increase one input and hold other MP of labor to the MP of land
inputs constant, the marginal product of • Technical recipe determines the
the varying input will, at least after some combinations of the two factors of
point, decline production able to produce same level
• EX. As the labor goes from 1 to 2 units, of output
the level of output increases from 200 to • Equal quantities
282 (or by 82 units) but the next dose of
labor adds only 64 units (or 346-282)
• Each unit of the variable factor has less
and less of the fixed factor to work with





Equal Cost Lines













• Given: prices of two factors of Least Cost Conditions
production 1. Ratio of marginal products of any two
• How much it will cost to produce a given inputs must equal the ratio of their
level of output factor prices
• Different combinations of the two inputs Substitution Ratio = Marginal product of labor
that can be used to produce the same Marginal product of land
level of output = slope of equal-product curve = price of labor
• If the price of one factor of production price of land
changes so that the ratio of the factor 2. MP of L = MP of A = …
prices are no longer the same, the equal Price of L Price of A
cost line will pivot

Least Cost Tangency
• Combining the equal-product and equal-
cost lines, the optimal or cost-
minimizing position of the firm can be
determined
• Point of tangency where the slope of the
equal-product curve matches the slope
of an equal-cost line and the curves are
just kissing
• Slope of equal cost curve = PL / PA
• Slope of a point of a curved line is the
slope of the straight line tangent to the
curve at the point
• For the equal-product curve, this slope is
a “substitution ratio” between the two
factors
• Depends upon the relative marginal
products of the two factors of
production MPL / MPA - just as the rate
of substitution between two goods
along a consumer’s indifference curve
Chapter 8: Analysis of Perfectly Competitive 4. Long run equilibrium condition
Markets price = minimum AC implies zero
profit condition in the LR due to
Behavior of a Competitive Firm free entry and exit
• Assume that competitive firm
maximized profits
• Perfect competition is a world of
atomistic firm who are price-takers

Profit Maximization
• Profits represent the amount a firm can
pay in dividends to the owners, reinvest
in new plant and equipment, etc.
• Activities mentioned increase the value
of the firm to its owners
Competitive Supply: P = MC
• Firms maximize profits because that
maximizes the economic benefit to the • The maximum profit comes at the
owners of the firm output where price = marginal cost
• Profit maximization requires the firm to • A competitive firm can always make
manage its internal operations additional profit as long as the price is
efficiently and to make sound decisions greater than the marginal cost of the last
in the marketplace unit
• Total profit is maximized when there is
Perfect Competition no longer any extra profit to be earned
• Perfect competition is the world of by selling extra output
price-takers • At the max profit point, the last unit
• A perfectly competitive firm sells a produced brings in an amount of
homogenous product revenue = cost per unit
• The firm is so small relative to its market • Marginal cost is the extra cost of
that it cannot affects the market price producing an additional output
but simply takes the price as given

• The firm’s segment of the demand curve
is only a tiny segment of the industry’s
curve

• The firm’s dd curve looks completely

horizontal or infinitely elastic

• The price for each unit sold is the extra

revenue that the firm will earn

• Perfect Competition Conditions:

1. Horizontal firm demand curve –

firm has no control or influence

over market price. It is a price taker,

atomistic, and sells a homogenous
• A firm will maximize profits when it
product
produces at that level where MC = P
2. Cost curves are U-shaped except

for AFC

3. Price = Marginal Revenue
Zero-Profit Point Firm and Market Supply
• At the profit-maximizing output, the firm • Quantity supplied will be determined by
has zero profits with total revenues = each firm’s marginal costs
total costs • Total quantity brought to market at a
• Zero-profit point is the production level given price will be the sum of the
at which the firm makes zero economic individual quantities that all firms supply
profits at that price
• At zero-profit point, P = AC so revenues • The market supply curve for a good in a
just cover costs PC market is obtained by adding
• A firm’s MC curve is also its supply curve horizontally the supply curves of all the
individual producers of that good
Shutdown Condition (P < min AVC)
• A firms should not necessarily shut down
if it is losing money. The firm should
minimize its losses / maximize its profits
• A firm must still cover its contractual
commitments even when it produces
nothing
• In the short run, firm must pay fixed
costs and the balance of the firm’s costs
are variable costs which would have zero
cost at zero production
• It would be better to continue Short-Run and Long-Run Equilibrium
operations with P = MC, as long as • Demand shifts produce greater price
revenue covers VC adjustments and smaller quantity
• Shutdown Point – revenues = variable adjustments in the SR compared to LR
costs (Alfred Marshall)
• P > SP then the firm will produce along • Short-run equilibrium – when output
its MC curve because it will lose money changes must use the same fixed
if it shuts down amount of capital
• P < SP the firm will produce nothing at all • Long-run equilibrium – when capital and
because by shutting down the firm will all other factors are variable and there is
only lose its fixed costs free entry and exit of firms into and from
• Shutdown Rule – the shutdown point the industry
comes where revenues just cover VC or • Free entry and exit – when there are no
where losses = FC. When price falls barriers (government regulations,
below AVC, the firm will maximize intellectual property rights, etc.) to entry
profits by shutting down and exit










Long-Run Industry Supply General Rules in Competitive Markets
• Horizontal SS supply curve • Demand rule – an increase in demand
• Upward sloping for a commodity (the supply curve being
• LR supply curve of industries using unchanged) will raise the price of a
scarce factors rises because of commodity; for most commodities, an
diminishing returns increase in demand will also increase the
• LR rising MC curve means that the LR quantity demanded
supply curve must be rising • Supply rule – an increase in supply of a
commodity (the demand curve being
constant) will generally lower the price
and increase the quantity bought and
sold

Constant Cost
• Production of many manufacturing
items can be expanded by merely
duplicating factories, machineries, and
labor




Long-Run for a Competitive Industry
• In the LR, all costs are variable, all
commitments become options again
• In the LR, firms will produce only when
price is at or above the zero-profit
condition where P = AC
• A critical zero-profit point below which
LR price cannot remain if firms are to
stay in business –– LR price must be
equal to or above total LR average cost Increasing Costs and Diminishing Returns
• In the LR, price in a competitive industry • As a result of diminishing returns, the
will tend toward the critical point where MC of producing good 1 increases as
revenues just cover full competitive good 1 production rises
costs • The higher the demand will increase the
• Below this critical price, firms would price of this good even in the long run
leave the industry until price returns to with identical firms and free entry and
LR Average Cost exit
• Above this price, new firms would enter
the industry, thereby forcing market
price back down to the LR equilibrium
price where all competitive costs are
covered
• LR Zero-Economic Profit – Zero-profit LR
price = P = MC = min LR AC

Fixed Supply and Economic Rent Shifts in Supply
• Some goods/productive factors are • If the law of downward sloping demand
completely fixed in amount, regardless is valid, increased supply must decrease
of price price and increase quantity demanded
• Pure Economic Rent – payment for the • An increased supply will decrease P most
use of such a factor of production when demand is inelastic
• When supply is independent of price, • An increased supply will increase Q least
the supply curve is vertical when demand is inelastic
• An increase in demand for a fixed factor
will affect only the price – quantity Pareto Efficiency
supplied is unchanged • An economy is efficient when it provides
• When tax is placed upon the fixed its consumers with the most desired set
commodity, the tax is completely paid by of goods and services, given the
the supplier – the consumer buys exactly resources and technology of the
as much of the good as before economy
• Pareto Efficiency – also called allocative
efficiency, Pareto optimality; occurs
when no possible reorganization of
production or distribution can make
anyone better off without making
someone else worse off; under
conditions of allocative efficiency, one
person’s satisfaction can be increased
only by lowering someone else’s utility
• Being on the PPF

Efficiency of Competitive Equilibrium
• The allocation of resources by perfectly
competitive markets is efficient
• All markets are perfectly competitive
Backward-Bending Supply Curve and that there are no externalities
• Income and substitution effects (pollution, imperfect information)
• EX. When wage is higher: people work • MC curve = Supply curve
for less hours, instead of working 6 days • Demand curve is the horizontal sum of
a week, a person will only work for 3 and the identical individuals’ MU curves
have the other 3 days for vacation, etc. (downward slopping); MU curve =
Demand curve
• Intersection of SS and DD curves show
competitive competitive equilibrium
• At the point of intersection, producers
supply exactly what consumers want to
purchase at the equilibrium market price
• Economic Surplus – sum of the
consumer surplus which is the area
between the demand curve and the
price line and the producer surplus
which is the area between price line and
 supply curve; welfare or net utility gain Market Failures
from production and consumption of a • Imperfect Competition – when a firm
good – equal to the consumer surplus has market power in a particular market,
plus the producer surplus the firm can raise the price of its product
• Supply Surplus – includes rend and above its marginal cost; consumers buy
profits to firms of specialized inputs in less of such goods than they would
the industry and indicates excess of under perfect competition and
revenues over cost of production consumer satisfaction is reduced
• If MU = P = MC, then allocation is • Externalities – arise when some of the
efficient side effects of production or
• P = MU – consumers choose good consumption are not included in market
purchases up to the amount where P = prices; not all externalities are harmful.
MU; every person is gaining P utils of Some are beneficial such as the
satisfaction from the last unit of good externalities that come from knowledge-
consumed generating activities
• P = MC – as producers, each person is • Imperfect Information – the invisible-
supplying food up to the point where P = hand theory assumes that buyers and
MC of the last unit of good supplied (MC sellers have complete information about
being the cost in terms of the forgone the goods and services they buy and sell.
leisure needed to produce the last unit Firms are assumed to know about all the
of good; price then is the utils of leisure- production functions for operating in
time satisfaction lost because of working their industry and consumers are
to grow that last unit of good presumed to know about the quality and
• MU = MC – the utils gained from the last prices of goods
unit of good consumed exactly equal the
leisure utils lost from the time needed to
produce that last unit of good





















IMPORTANT EQUATIONS

Slope of the Budget Constraint: P1
P2

Equilibrium Condition (Equimarginal Principle): MU1 = MU2
P1 P2

Marginal Rate of Substitution; Slope of Indifference Curve: MU1 = P1
MU2 P2

Ratio of Output Price: P1
P2

Average Total Product: Total Product
Q of Input

Marginal Product: △ Total Product
△ Q of Input

Marginal Rate of Technical Substitution; Slope of Indifference Curve: MP1
MP2


Total Cost: Fixed Cost + Variable Cost (or) Average Cost x Quantity

Marginal Cost: △ Total Cost
△ Q of Output

Average Cost: Total CostQ
Q

Average Fixed Cost: Fixed CostQ
Q

Average Variable Cost: Variable CostQ
Q

Slope of Equal Cost Line: PInput 1
PInput2



Least-Cost: MPInput1 = MPInput2
PInput1 PInput2


Perfect Competition: Price = Marginal Revenue = Marginal Cost

Marginal Revenue: △ Total Revenue
Q produced

Supply Rule (Perfect Competition): Price = Marginal Cost

Profit Maximizing Rule: Marginal Revenue = Marginal Cost

Zero-Profit: Total Revenue - Total Cost = 0 (or) P = AC

Long Run Zero-Economic Profit: Zero-Profit LR P = P = MC = min LR AC