Household Budget Constraint; Utility Analysis; Short Run Profit

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					      Household Budget Constraint; Utility Analysis;
            Short Run Profit Maximization




                          Class 4




Listokin                  Econ 1                       1
We have discussed market equilibrium, and elasticity of
demand without understanding how we choose among
preferences


           Up to now
           •   Demand and Supply vs Quantity Demanded and Quantity Supplied
           •   Use demand and supply to figure out the equilibrium price
           •   Understand that the market system maximizes surplus
           •   Recognize that demand can be less/more sensitive to price for
               different products

           •   Now, we will take price as given by adding a couple of assumptions




Listokin                                   Econ 1                                   2
Throughout the next bunch of lectures, we will assume
perfect competition and perfect knowledge


           Perfect Competition and Perfect Knowledge

           •   Industry with lots of small firms
           •   Producing almost identical – homogeneous – products
           •   No firm is large enough to have control over price
           •   Households know the quality of goods, they know their income

           •   Think of coffee shops in Berkeley
                – There are lots of them
                – They sell just about the same thing – consumers know what they are
                  getting
                – No coffee shop in Berkeley controls the market
                – They charge the market rate for a small coffee (about $1.50)



Listokin                                     Econ 1                                    3
Households must make lots of choice: how much to work,
how much to play, what goods to buy, how much to save for
later


           Determinants of Household Demand
           •   Price of the product
           •   Income available to the household
           •   The household’s accumulated wealth
           •   The prices of related products
           •   Household’s tastes and preferences
           •   The household’s expectations of future income, wealth and prices




Listokin                                   Econ 1                                 4
Why does the household have to make choices?



           Budget Constraint
           •   There is a limit to how much a household can buy, because of
               wealth, income and prices
           •   Households must choose among the choice set – the available
               options given the budget constraint




Listokin                                   Econ 1                             5
Budget Constraint Example



           Budget Constraint and Choices

     Possible Budget Choices of a Person Earning
     $1,000 Per Month After Taxes
     OPTION         RENT      FOOD         OTHER      TOTAL   AVAILABLE?
           A    $    400      $250            $350   $1,000     Yes
           B         600       200             200    1,000     Yes
           C         700       150             150    1,000     Yes
           D        1,000      100             100    1,200      No



Listokin                             Econ 1                                6
The budget constraint is reminiscent of the PPF



           Another Example
           •   This is the budget constraint when
               income equals $200 dollars per month,
               the price of jazz club visits is $10
               each, and the price of a Thai meal is
               $20.
           •   One of the possible combinations is 5
               Thai meals and 10 Jazz club visits per
               month.
           •   Income = Y = Pjazz*Qjazz + Pthai*Qthai
           •   $200 = $10 * Qjazz + $20 * Qthai



Listokin                                     Econ 1     7
There are combinations of goods that you just can’t have



           Thai and Jazz
           •   $200 income
           •   Jazz - $10
           •   Thai - $20



           •   Point E is unattainable given the
               current income prices.
           •   Point D does not exhaust the entire
               income available.



Listokin                                    Econ 1         8
A change in price of a good will have an effect on the budget
constraint and choice set



           Price Change
           •   A decrease in the price of Thai
               meals to $10 shifts the budget line
               outward along the horizontal axis.
           •   The decrease in the price of one
               good expands the consumer’s
               choice set.




Listokin                                    Econ 1              9
How do households choose from their choice set?


           Utility

           •   The satisfaction, or reward, a product yields compared to its
               alternatives.
           •   Marginal utility is the additional satisfaction gained by the
               consumption or use of one more unit of something.
                – Eating one orange gives me high levels of utility
                – The marginal utility I get from eating my 50th orange can be different
                  than the marginal utility I get from eating my 2nd orange




           •   The law of diminishing marginal utility - The more of one good
               consumed in a given period, the less satisfaction (utility) generated
               by consuming each additional (marginal) unit of the same good.


Listokin                                      Econ 1                                       10
Total utility increases at a decreasing rate, while marginal
utility decreases


                                       Total Utility and Marginal Utility of
                                       Trips to the Club Per Week
                                       TRIPS TO      TOTAL       MARGINAL
                                        CLUB         UTILITY      UTILITY
                                            1           12           12
                                            2           22           10
                                            3           28             6
                                            4           32             4
                                            5           34             2
                                            6           34             0




Listokin                      Econ 1                                       11
The goal is to maximize our utility while staying within the
budget constraint, so use marginal utility per dollar



           MU/P
           •   Since different options cost different amounts of money (P’s are
               different) we cannot just make decisions by choosing the options
               with highest marginal utility
           •   Figure out the option with the highest marginal utility per dollar
               spent on it – get the most “bang for the buck”
           •   Choose the option with the highest MU/P. If you have money left
               over, choose the option with the next highest MU/P… etc




Listokin                                   Econ 1                                   12
                            APPLES (Price = $1)
quantity      Total Utility   Marginal Utility    MU/Price
   0              0
   1              11                                              MU/$
   2              20
   3              26
                                                                  •Fill in the MU and MU/Price
   4              31
   5              35
   6              37                                              •What should you buy with an income
                           BOOKS (Price = $10)                    of $20?
quantity      Total Utility  Marginal Utility  MU/Price
   0               0
   1              50
   2              95
   3              135
   4              165
   5              180
   6              190
                          COFFEE (Price = $2)
quantity      Total Utility Marginal Utility MU/Price
    0                 0
    1              20
    2              36
    3              46
    4              54
    5              59
    6              60
       Listokin                                              Econ 1                                     13
Diminishing marginal utility helps to explain why demand
slopes down.



           Diminishing Marginal Utility and Demand
           •   Marginal utility falls with each additional
               unit, so people are not willing to pay as
               much for the additional units

           •   Increase in P means a decrease in
               MU/P at every quantity, so to maximize
               utility, we will decrease quantity




Listokin                                     Econ 1          14
Why does supply slope up?



           Firms Supply Decisions
           •   Assume: Firms want to maximize profits
           •   Profit = Total Revenue – Total Costs
           •   Total costs include explicit costs and opportunity costs (implicit)




Listokin                                    Econ 1                                   15
Total costs should include opportunity costs



           Total Cost
           •   Opportunity cost of capital:
                – Machine costs $10,000
                – $10,000 could earn 5% elsewhere
           •   So…
                – Include $500 per year as an implicit cost


           •   Opportunity cost of labor
                – You pay yourself $30,000
                – You could earn $40,000 elsewhere
           •   So…
                – Include $10,000 per year as an implicit cost

Listokin                                      Econ 1             16
Firms must decide (1) how much stuff to make; (2) how to
make that stuff; (3) how much input is needed to make that
stuff



           Firm Decision Making
           •   Short-run decisions
                – Technology and technique is fixed
                – New firms don’t enter competition; Old firms don’t leave
                – Decision: How much to produce?


           •   Long-run decisions
                – Technique and technology can be changed
                – New firms can enter, old firms
                – Decision: How to produce?




Listokin                                     Econ 1                          17
The production function or total product function is an
equation that shows the relationship between inputs and
outputs.


           The production process
           •   You take some capital and some labor, put them into the “black box”
               of the firm, and out comes hamburgers! Or widgets! Or textbooks.
           •   How much labor does it take to make a hamburger? How much
               capital?

           •   Some technologies require lots of labor, some lots of capital




Listokin                                    Econ 1                                   18
Marginal product is the additional output that can be
produced by adding one more unit of a specific input

           Sandwich Shop

                 Production Function
                                     (2)              (3)          (4)
                      (1)      TOTAL PRODUCT       MARGINAL    AVERAGE
                 LABOR UNITS    (SANDWICHES       PRODUCT OF   PRODUCT
                 (EMPLOYEES)      PER HOUR)         LABOR      OF LABOR

                     0               0                            

                     1              10                10        10.0
                     2              25                15        12.5
                     3              35                10        11.7
                     4              40                 5        10.0
                     5              42                 2         8.4
                     6              42                 0         7.0

Listokin                                 Econ 1                           19
Total product increases at a diminishing rate – the law of
diminishing returns



                       Law of Diminishing Returns




                       45
                       40
                       35                                                                     15
       Total product




                       30



                                                                           Marginal Product
                       25
                                                                                              10
                       20
                       15
                                                                                              5
                       10
                       5
                       0                                                                      0
                            0   1    2    3    4    5     6   7                                    0   1    2    3    4    5     6   7
                                    Number of employees                                                    Number of employees

Listokin                                                          Econ 1                                                                 20
What happens when there is more than one input?



           Inputs
           •   Capital and labor can be complements
           •   Combinations of capital and labor depend on the
               technology/technique used

                Inputs Required to Produce 100 Diapers
                Using Alternative Technologies
                                      UNITS OF         UNITS OF
                 TECHNOLOGY
                                     CAPITAL (K)       LABOR (L)
                       A                   2              10
                       B                   3               6
                       C                   4               4
                       D                   6               3
                       E                  10               2
Listokin                                  Econ 1                   21
To maximize profit, it helps to minimize costs



           Figure out the low cost technology
           • Bullets
           Cost-MinimizingChoice Among Alternative
           Technologies (100 Diapers)
                             (2)          (3)            (4)               (5)
               (1)        UNITS OF     UNITS OF     COST WHEN         COST WHEN
           TECHNOLOGY    CAPITAL (K)   LABOR (L)   PL = $1 PK = $1   PL = $5 PK = $1
                A             2           10            $12              $52

                B             3            6               9              33
                C             4            4               8              24
                D             6            3               9              21
                E            10            2             12               20
Listokin                               Econ 1                                          22
Next week




           •   Continue working on the supply curve (Chapter 7)
           •   Problem set due tomorrow night!




Listokin                                  Econ 1                  23
Sentence



           Title
           •   Bullets




Listokin                 Econ 1   24