Lynne Pepall

Article / Updated 03-26-2016

A firm with a given technology makes a choice about how much of each of the factors of production to use to make how much output — and pays the cost for doing so. The question for the firm is how to use its technology and choose its inputs in order to make its profits as large as possible. The way it does so is to choose its inputs in order to make the costs as small as possible. An example of how an economist looks at a technology. The technology shown in the figure is a specific form known as a Cobb-Douglas production function. If you're wondering why economists think this way, consider profit maximization. In the following equation, profit equals the difference between total revenue and total cost: A firm can determine what to make and how much to make, but it doesn't have any control over what consumers choose to buy. Therefore, it makes sense that economists model the things that the firm does control — its own costs — and so they assume that profit maximization is the same thing as cost minimization.

Article / Updated 03-26-2016

One way to think about consumption bundles and preferences on microeconomics is to think about all the possible choices. If you describe the set of possible choices in a diagram, you can see pretty easily which choices the consumer would prefer. For instance, this figure draws an indifference curve for all the consumption bundles for which Bob gets the same amount of utility. Two equivalent bundles, A and B, are marked. The shaded area shows the set of all possible points yielding higher utility than bundles A and B. Bob's preferred consumption bundle: Bundle C yields higher utility than A and B and would therefore be Bob's preferred consumption. He's now offered a bundle that offers more utility than these two — call it bundle C — and you translate this into microeconomist speak as follows: C > B, C > A This expression confirms that C is strictly preferred to B and A. In the figure, you can picture C as being a member of the set of points that are strictly preferred to A and B, and the area covered by that set is shaded. That relationship is strict preference, it can't include the indifference curve itself, because that would mean Bob gets at least as much utility from something we've already said yields more utility.

Article / Updated 03-26-2016

A budget constraint maps the relative availability of two goods to a fixed amount of resources, called M. In the consumer choice model, this means that you take account of an increase in income by moving the budget constraint away from the origin so that the new curve is parallel to the old, as shown here. Representing a change in income by shifting the budget constraint. You can look at this another way. If your income goes up and prices stay the same, you can afford to buy more goods. Alternatively, if your income stays the same but prices of goods all decline by the same percentage, you can afford more goods as well. Under either scenario your budget constraint shifts up parallel to the old. A shift in the budget constraint means that some bundles that the consumer desires are now either available where they hadn't been before (if the change is positive) or ruled out (if the change is negative).

Article / Updated 03-26-2016

Microeconomics is fundamentally about what happens when individuals and companies make decisions. The idea is to understand how those decisions are made and explore their consequences. What happens, for example, when prices of houses go up? Well, on the one hand, people are likely to buy fewer or smaller houses. On the other hand, developers may want to build more houses so that they can get more revenue. The result could be a lot of unsold houses! Then there will be pressure to get rid of those stocks of unsold houses, and that leads to lower prices. When does that process stop? At the limit, the only logical place to stop cutting the price is when exactly as much is sold as is available to sell. This point is called an equilibrium in the housing market — a place where supply and demand are equal. When people talk about market forces, they're talking about the outcome of all these decisions taken together. No vast impersonal power called "market forces" exists, just a lot of smaller entities — consumers and companies — making a lot of simple decisions based on signals that come from prices. That's really all market forces means. The way markets work seems so impersonal because every one of the smallest units — small companies and individuals — makes up just a tiny fraction of all the decisions taken. Even the biggest corporations or most powerful governments have limitations on their ability to influence the world. Microeconomics also looks at the exception to the rule when a decision-maker — a buyer or seller — is not so small and can influence market forces. All these small decision-makers do the best they can, given that ultimately they're acting with imperfect knowledge of a complicated world. People and companies can't know exactly how much they'll be earning next year or exactly how much they'll sell. They just look for ways of making decisions that give them the best chance of doing the best they can — which is about all anyone can ask for in an uncertain world.

Article / Updated 03-26-2016

One word that's central to microeconomics is decision. Microeconomics is ultimately about making decisions: whether to buy a house, how much ice cream to make, what price to sell a bicycle at, or whether to offer a product to this or that market, and so on. This is one reason why economists center their models on choice. After all, when you don't have options to choose from, you can't make a decision. Deciding to make something or to buy something is the starting point for microeconomics. To a microeconomist, decisions aren't right or wrong. Instead, they're one of the following: Optimal: Getting the best of what you want, given what's available. Sub-optimal: Getting less than the best. Of course, a model of decisions needs two sides: Consumers base their decisions on the value they get from choosing one option as opposed to another. Companies base their decisions on a measure of monetary benefit — revenue against costs. Microeconomists look at these decisions in several ways. Sometimes, you use a framework for making the best decision given some kind of constraint — budget, time, or whatever else constrains you — to show you how microeconomists look at individuals and companies separately. The famous supply and demand model shows you how different types of markets lead to different results. And game theory looks at how individuals or companies (or even other entities, such as governments) strategically interact with each other.

Article / Updated 03-26-2016

In a two-good model, the budget line is a simple straight line whose slope is the ratio of prices. But if, for instance, a tax changes the cost of a good relative to others, that is tantamount to a price change, and you can use the shape of the budget line to think about how to analyze the effect of the tax. Before doing so, you have to be a bit more specific about the type of tax, because different taxes do different things to the shape of the budget line. You want to distinguish two types of tax (or their seemingly positive cousin, subsidies) that affect the constraint: Quantity taxes: A tax per unit of something bought. Examples are the tax that government levies on gasoline, expressed per gallon, or the "sin" taxes levied on certain goods, such alcohol and cigarettes per unit. These taxes, also called excise taxes, simply change the price paid for that quantity: If x1 is the quantity of unleaded gasoline, and the quantity tax is τ per unit, the price of a gallon is p1 + t, and you can treat the imposition of the tax as a price change. Ad valorem ("to the value of") taxes: Instead of being levied on a per unit quantity of the good, an ad valorem tax is levied as a percentage of the purchase price of the good. A common example is the sales tax. In the U.S., the sales tax varies according to jurisdictions within the country. For example, the sales tax in Chicago is 10.25% — consisting of 6.25% state, 1.25% city, 1.75% county, and 1% for the regional transportation authority. In Baton Rouge, Louisiana, the sales tax is 9%, consisting of 4% state and 5% local rate. If the pre-tax price of the good is p1, then the post-tax price is (1 + t) p1 where τ is the ad valorem rate of tax. For the 10.25% sales tax that a consumer pays in Chicago, t equals 0.1075 (convert the percentage to a decimal), and 1 + t is 1.1075. So the price of a good is 1.1075 times p. Again, you can treat the introduction of an ad valorem tax as being tantamount to an increase in the price of the good you're considering and manipulate the budget constraint to show it. In this case, the constraint would show the bundles of goods that can be consumed when the sale tax on good 1 is included in the post-tax price. An interesting case to consider is what happens when a tax is only levied on consumption of a good above a certain price. In Massachusetts, the sales tax of 6.25% is not levied on clothing that costs less than $175. Any individual clothing item that is more than $175 is taxable on the amount over the basic exemption. If you buy a $200 coat, $1.56 or 6.25% of the $25 taxable amount would be added to the price. So, the microeconomics question is: How do you look at this aspect using a budget constraint? The answer's easy: One slope of the line for purchases goes up to the threshold and then the line bends at that point (see the following figure). The effect on the budget constraint of a stepped tax. To make everything easier, think about the tax being levied on a quantity rather than a value tax. Suppose, for argument's sake, that the first item of clothing does not incur a tax, but the second does. Now, while you're deciding to buy a first item, the budget constraint is the constraint for x1 up to the point where x1 = 1. Here, the slope of the budget constraint is –p1/p2 as it was earlier. However, beyond x1 = 1, the slope changes to become –(p1 + t)/p2. As you can see, the budget line is steeper beyond the threshold. You can do the same type of graphing with subsidies, too. A subsidy, in this case, is just a negative tax, and so instead of adding it to the price you subtract it. Therefore, if good x1 is subsidized, the budget slope is –(p1 – t)/p2. Showing the effect of a subsidy on the budget constraint. Rationing also affects the budget line. If a good is rationed, one area of the budget set becomes unavailable at any price — the set is said to be truncated in economics-speak. To show this, cut a vertical line in above the maximum rationed consumption of good x1. To the left of the line, the budget set behaves as normal. To the right, where the maximum consumption is greater than the rationed amount — call it R for the moment — the set consists of goods that the consumer could afford, but can't get. Rationing truncates the budget constraint.

Article / Updated 03-26-2016

One thing you can say about the relationship between preferences and the budget constraint is about the principle of revealed preference. Utility isn't measured, but things about utility can be found out by observing consumer choices and inferring from their choices the impact of price changes on their utility or welfare. This somewhat back-to-front way of looking at things makes sense when you realize that economists know nothing about the consumer until he participates in a situation where inferences can be made regarding his behavior. For example, suppose the government levies a tax on a good. From the consumer's perspective, it is as though the price of the good has increased and the consumer will be made worse off and hence will not be happy about the tax. The government may try and compensate the consumer by transferring a rebate to him that's equivalent to the tax revenue collected. However, the principle of revealed preference tells us that the consumer will still be worse off under the tax and rebate scheme. This is shown in the following figure. When the consumer faces prices p1 and p2 and has an income M, the consumer optimizes by choosing the bundle (x1*,x2*). Now the government imposes a tax on good 1 so that the price becomes p1'= p1 +t. At the same time, the government offers the consumer a rebate R equal to the tax revenue it collects from the consumer. With this budget constraint, the consumer chooses the bundle (x1',x2'), and you have that (p1 +t) x1'+ p2 x2' = M + tx1' where the rebate R is equal to the tax revenue tx1' collected. Simplifying this expression, you can see that it is equivalent to p1x1' + p2 x2' = M. In other words, the bundle (x1',x2') lies on the original budget constraint but the consumer did not choose it. The consumer preferred (x1*,x2*). This tells you by revealed preferences that the consumer is on a higher indifference curve or level of utility with (x1*,x2*). The imposition of an income compensated tax still made the consumer worse off. Revealed preference and income compensated tax. To put revealed preference as simply as possible, if a consumer chooses a bundle of goods — call it A — over another bundle — B — given that both B and A are affordable, you can say that the consumer prefers A to B. In other words, the act of choosing the bundle A reveals that the consumer preference is for bundle A over bundle B. Until the consumer makes a choice, you don't really have a way of knowing her preferences for these bundles. Although you may be able to deduce the existence of A and B from what you know is available and affordable, you don't know a consumer's preference for sure. In the act of choosing to consume A rather than B, therefore, you gain information about a consumer's preferences that you didn't previously possess. Thus, you can infer that bundle A is preferred to B from the choice made by the consumer.

Article / Updated 03-26-2016

Economists are often accused of treating firms too simply. By disregarding differences in organizational behavior, technology, or place, and by treating firms more simply as a kind of black box that takes inputs in and creates outputs from them, are economists painting a misleading picture that makes firms interchangeable and ignores important differences between them? Economists are interested in how the profit motive affects what a firm would do, first and foremost. When they understand that, they can start to look at how firm behavior differs across different industries or markets. The economist looking at a firm makes simplifications for two reasons: You can't build a model without placing some restrictions on your model. If you rule nothing out, you rule anything in, and before you know it you've reenacted the Lewis Carroll story about the map so accurate that it has to be as big as the kingdom it maps. You want to compare common features of firms, without focusing on all those details, so that you can zero in on the ones that are most important to building a model of a market.

Article / Updated 03-26-2016

When investigating the effect of a price change, a good place to start is by thinking about what the change will do to the behavior of a representative consumer. Indifference curves excel in this situation! Start at a given equilibrium to get a sense of what is happening before you make changes. In this case, the plot shown is an equilibrium with well-behaved indifference curves and a standard budget constraint, and at the consumer optimum, the price ratio equals the marginal rate of substitution between goods x1 and x2. A parallel shift in the budget constraint simulates a change in income. Now, imagine some situation that affects your income calamitously (such as losing your job, getting a new job that doesn't pay as much, or a national economic disaster like that affecting Greece). The details don't matter; the important thing is that it reduces your income. Starting at the equilibrium, you can draw in a new budget constraint, one that's parallel to the original one, but to the left of it. Of course, this means that the original equilibrium level of utility is now unattainable, and so you, as the representative consumer, react by reducing your consumption of goods x1 and x2. The parallel shift makes the old optimal choice unavailable, given the new constraint MNEW. Suppose instead that just one price changes (remember, you can treat x1 and x2 as though x1 is the good you're interested in and x2 represents all other goods). This is an interesting situation, because the effect on your purchasing opportunities isn't due to an overall fall in income, but to the relative price effect whereby x1 is now more expensive relative to the price of all other goods available. This situation is where indifference curves fully unpack their awesome power.

Article / Updated 03-26-2016

Total utility (the amount of utility gained in total from consuming something) is a useful concept, but economists far more commonly look at how utility changes as consumption at the margin changes. For that, they use the concept of marginal utility: the utility that is gained from consuming one extra unit of a good. The concept of the marginal unit is one of the most important concepts in the economics toolkit. Economists use it to analyze pretty much all production and consumption decisions. For instance, firms optimize their production based on the relationship between marginal revenue and marginal cost. For a consumer, the concept of marginal utility is key in looking at consumption decisions. But what is this mysterious marginal unit? The marginal unit is defined as only the last, incremental unit of something, whether that be cost, benefit, utility, or revenue. Suppose that chocoholic Ray is looking at six bundles of chocolate bars, each containing one more chocolate bar than the preceding bundle. The table describes the utility gained by Ray from consuming the different bundles. Ray's Total and Marginal Utility from Consuming Chocolate Bars Bar of Chocolate Total Utility Marginal Utility 1 5 5 2 11 6 3 16 5 4 19 3 5 19 0 6 17 –2 Ray's preferences can be described by the points on this utility function, and an extra column is added, which tells only the gain (or loss!) in utility from consuming an extra bar of chocolate. This is the marginal utility obtained from only the incremental last extra unit of chocolate, which does not include the utility from the consumption of the other bars in favor of looking just at what happens to Ray's utility as he consumes that last extra unit. The table uses cardinal measures of utility, so you can see what happens with some simple numbers. Suppose Ray gets 5 units of utility from his first bar. The second bar is even more enjoyable than the first and he gets 6 units of utility from it. The third, however, is starting to cause icky chocolate tummy and he gets less utility from that, and the fourth is really not giving all that much more utility. By the time he's on to the fifth he's feeling queasy and not so much enjoying it as suffering it. The following figure plots the table, and, as you can see, utility rises to a peak level — what economists call satiation — and then becomes disutility. Peak utility is found somewhere between the fourth and fifth bars (and we hope that these are fun-sized rather than full-sized bars). Assuming Ray is economically rational (and doesn't have any other constraints), he stops eating there. Ray's total and marginal utility functions for chocolate. Don't confuse marginal utility with the marginal rate of substitution (MRS is the slope of the indifference curve). Marginal utility is the gain in utility associated with an extra unit of something, whereas MRS tells you how much of one thing you have to give up in order to get an extra unit of something else.