1.3.1 Principles of Demand
1.3.2 Principles of Supply
1.3.3 Equilibrium, Surplus, and Shortage
1.3.3 Equilibrium, Surplus, and Shortage
1.3.4 Consumers, Producers, and Shifting Demand Curves
1.3.5 Consumers, Producers, and Shifting Supply Curves
1.3.6 Elasticity
1.3.7 Perfect Elasticity and Perfect Inelasticity
1.3.8 Demand and Consumers
1.3.9 Production Function, Inputs, and Marginal Product
Basic Economic Principles in Agribusiness
Overview
Principles of Demand
Learning Objectives
5a Understand basic concepts of economics and explain their significance.
5h Understand market price determination, demand, demand schedules, demand curves, supply, supply and demand relationships and shifters, and equilibrium.
Why Can We Not Get Enough of Organic?
Organic food is increasingly popular, not just in the United States, but worldwide. At one time, consumers had to go to specialty stores or farmers' markets to find organic produce. Now it is available in most grocery stores. In short, organic is part of the mainstream.
Organic food costs more than conventional food. Think about this: An organic Fuji apple could cost $1.99 a pound, while its conventional counterpart costs $1.49 a pound. The same price relationship is true for just about every organic product on the market. If many organic foods are locally grown, should they not take less time to get to market and therefore be cheaper because of the lowered transportation and storage costs? Turns out the forces that keep organic prices from being less than (or the same as) conventional food process has less to do with incurred costs and more to do with this section’s topic: demand.
This section introduces the economic model of demand and supply—one of the most powerful models in all of economics. The discussion here begins by examining how demand and supply determine the price and the quantity sold in markets for goods and services, and how changes in demand and supply lead to changes in prices and quantities. But our main focus here will be on demand.
An auction bidder pays thousands of dollars for a dress Whitney Houston wore. A collector spends a small fortune for a few drawings by John Lennon. People usually react to purchases like these in two ways: their jaw drops because they think these are high prices to pay for such goods OR they think these are rare, desirable items and the amount paid seems right. The amount paid for these items was determined by supply and demand, but more so by demand. In 1998, comic book artist Todd McFarlane paid $3,000,000 for Mark McGwire’s 70th Home Run Ball. No-one had ever paid so much for such an artifact. In fact, the next highest price paid for a baseball was, at that time, $805,000 for Babe Ruth’s 1933 All-Star Game Home Run Ball. But McFarlane’s demand determined what he was willing to pay—in addition to his net worth at the time.
When economists talk about prices, they are less interested in making judgments than in gaining a practical understanding of what determines prices and why prices change. Consider a price most of us contend with weekly: that of a gallon of gas. Why was the average price of gasoline in the United States $3.71 per gallon in June 2014? Why did the price for gasoline fall sharply to $1.96 per gallon by January 2016? To explain these price movements, economists focus on the determinants of what gasoline buyers are willing to pay and what gasoline sellers are willing to accept. As it turns out, the price of gasoline in June of any given year is nearly always higher than the price in January of that same year. Over recent decades, gasoline prices in midsummer have averaged about 10 cents per gallon more than their midwinter low. The likely reason is that people drive more in the summer, and are also willing to pay more for gas, but that does not explain how steeply gas prices fell between 2014 and 2016. Other factors were at work during those 18 months, such as increases in supply and decreases in the demand for crude oil.
Demand for Goods and Services
Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants—if you have no need or want for something, you won't buy it. While a consumer may be able to differentiate between a need and a want, from an economist’s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a baseball enthusiast has no effective demand for historical baseball artifacts unless their net worth allows for major cash expenditures that will not affect their ability to pay their usual bills.
What a buyer pays for a unit of the specific good or service is called price. The total number of units that consumers would purchase at that price is called the quantity demanded. A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant.
We can show an example from the market for gasoline in a table or a graph. Economists call a table that shows the quantity demanded at each price a demand schedule. The demand schedule shows that as price rises, quantity demanded decreases, and vice versa. We graph these points, and the line connecting them is the demand curve (D). The downward slope of the demand curve again illustrates the law of demand—the inverse relationship between prices and quantity demanded. In Table 1.3.1a, we measure price in dollars per gallon of gasoline. We measure the quantity demanded in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country).
Price (per gallon) | Quantity Demanded (millions of gallons) |
$1.00 | 800 |
$1.20 | 700 |
$1.40 | 600 |
$1.60 | 550 |
$1.80 | 500 |
$2.00 | 460 |
$2.20 | 420 |
A demand curve shows the relationship between price and quantity demanded on a graph. Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. Demand curves embody the law of demand: As the price increases, the quantity demanded decreases; and, conversely, as the price decreases, the quantity demanded increases.
Figure 1.3.1a is a demand curve with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical. Economics is not math.)
Table 1.3.1a shows the demand schedule and the graph in Figure 1.3.1a shows the demand curve. Demand schedule and demand curve are two ways to describe the same relationship between price and quantity demanded.
Attributions
Title Image: "Historical GDP growth of the United States" by GiovanniMartin16, Wikimedia Commons is licensed under CC BY-SA 4.0
Description: Historical GDP growth of the U.S. Between 1961 and 2015.
"Principles of Microeconomics for AP® Courses 2e" by Steven A. Greenlaw, David Shapiro, OpenStax is licensed under CC BY 4.0
Access for free at https://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/3-1-demand-supply-and-equilibrium-in-markets-for-goods-and-services
Principles of Supply
Instructor Ideas:
There is a lot of information in this ‘lesson’ of the textbook. Instructors could break up the lesson by having the class play the candy supply and demand game. There are many resources available about how to implement this active learning game in your classroom.
Learning Objectives
5a Understand basic concepts of economics and explain their significance.
5h Understand market price determination, demand, demand schedules, demand curves, supply, supply and demand relationships and shifters, and equilibrium.
Supply of Goods and Services
When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service.
A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants for refining into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours.
Economists call this positive relationship between price and quantity supplied the law of supply—a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied. The law of supply assumes that all other variables that affect supply are held constant. Like demand, we can illustrate supply using a table or a graph. The supply schedule and the supply curve are just two different ways of showing the same information.
A supply curve is a graphic illustration of the relationship between price—shown on the vertical axis, and quantity—shown on the horizontal axis. The supply curve (S) is created by graphing the points from the supply schedule and then connecting them. The upward slope of the supply curve illustrates the law of supply—that a higher price leads to a higher quantity supplied, and vice versa. Figure 1.3.2a illustrates the law of supply, again using the market for gasoline as an example. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.
The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply. In Figure 1.3.2a, as the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.
A supply schedule is a table that shows the quantity supplied at a range of different prices. As price rises, quantity supplied also increases, and vice versa. In Table 1.3.2a, we again measure price in dollars per gallon of gasoline, and we measure quantity supplied in millions of gallons.
Price (per gallon) | Quantity Supplied (millions of gallons) |
$1.00 | 500 |
$1.20 | 550 |
$1.40 | 600 |
$1.60 | 640 |
$1.80 | 680 |
$2.00 | 700 |
$2.20 | 720 |
Attributions
"Principles of Microeconomics for AP® Courses 2e" by Steven A. Greenlaw, David Shapiro, OpenStax is licensed under CC BY 4.0
Access for free at https://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/3-1-demand-supply-and-equilibrium-in-markets-for-goods-and-services
Equilibrium, Surplus, and Shortage
Learning Objectives
5a Understand basic concepts of economics and explain their significance.
5h Understand market price determination, demand, demand schedules, demand curves, supply, supply and demand relationships and shifters, and equilibrium.
5t Understand the role of agricultural economics and how they predict market movement.
Equilibrium—Where Demand and Supply Intersect
Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.
Figure 1.3.3a illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to Figure 1.3.1a (see Principles of Demand section). The supply curve (S) is identical to Figure 1.3.2a (see Principles of Supply section).
The demand curve (D) and the supply curve (S) intersect at the equilibrium point E, with a price of $1.40 and a quantity of 600. The equilibrium is the only price where quantity demanded is equal to quantity supplied. At a price above equilibrium like $1.80, quantity supplied exceeds the quantity demanded, so there is excess supply. At a price below equilibrium such as $1.20, quantity demanded exceeds quantity supplied, so there is excess demand.
Remember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross, designated by point E in Figure 1.3.3a , is called the equilibrium. The word equilibrium means “balance.” If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity.
The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). Economists call this common quantity the equilibrium quantity. At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price.
In Figure 1.3.3a, the equilibrium price is $1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the table where the quantity demanded and the quantity supplied are equal. Table 1.3.3a contains the same information as found in the Demand and Supply Curve (Figure 1.3.3a), but it is presented in tabular form.
Price (per gallon) | Quantity demanded (millions of gallons) | Quantity supplied (millions of gallons) |
$1.00 | 800 | 500 |
$1.20 | 700 | 550 |
$1.40 | 600 | 600 |
$1.60 | 550 | 640 |
$1.80 | 500 | 680 |
$2.00 | 460 | 700 |
$2.20 | 420 | 720 |
But let’s continue our discussion with the Supply and Demand Curve (Figure 1.3.3a). Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead of $1.40 per gallon, the price is $1.80 per gallon. The dashed horizontal line at the price of $1.80 in Figure 1.3.3a illustrates this above equilibrium price. At this higher price, the quantity demanded drops from 600 to 500. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.
Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from 600 to 680, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus.
With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will stimulate a higher quantity demanded. Therefore, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to fall toward the equilibrium.
Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line at this price in Figure 1.3.3a shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550.
When the price is below equilibrium, there is excess demand—or a shortage. In other words, at the given price the quantity demanded—which has been stimulated by the lower price, now exceeds the quantity supplied—which had been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level.
Attributions
"Principles of Microeconomics for AP® Courses 2e" by Steven A. Greenlaw, David Shapiro, OpenStax is licensed under CC BY 4.0
Access for free at https://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/3-1-demand-supply-and-equilibrium-in-markets-for-goods-and-services
Consumers, Producers, and Shifting Demand Curves
Learning Objectives
5h Understand market price determination, demand, demand schedules, demand curves, supply, supply and demand relationships and shifters, and equilibrium.
5g Explain scarcity, types of resources, and desires of producers and consumers.
Review of Factors Affecting Demand
We defined demand as the amount of some product a consumer is willing and able to purchase at each price. This statement suggests at least two factors that affect demand: willingness to purchase and ability to purchase.
- Willingness to purchase suggests a desire, based on what economists call tastes and preferences. If you neither need nor want something, you will not buy it. If you really like something, you will buy more of it than someone who does not share your strong preference for it.
- Ability to purchase suggests that income is important. CEOs are usually able to afford better housing and transportation than college students, because they have more income.
But there are other important factors that affect demand: price of related goods and size of population making demands on the market.
- Prices of related goods can affect demand. Think of this way, if you need a new car, the price of a Subaru may affect your demand for a Ford.
- The size or composition of the population can affect demand. The more children a family has, the greater their demand for clothing. The more driving-age children a family has, the greater their demand for car insurance, and the less for diapers and baby formula.
These factors matter for both individual and market demand as a whole. In this section, we will take a closer look at each of these factors so to better understand how demand is affected with each.
How Does Income Affect Demand?
Let’s use income as an example of how factors other than price affect demand. Figure 1.3.4a shows the initial demand for automobiles as D0. At point Q, for example, if the price is $20,000 per car, the quantity of cars demanded is 18 million. D0 also shows how the quantity of cars demanded would change as a result of a higher or lower price. For example, if the price of a car rose to $22,000, the quantity demanded would decrease to 17 million, at point R.
The original demand curve D0, like every demand curve, is based on the ceteris paribus assumption that no other economically relevant factors change. Now imagine that the economy expands in a way that raises the incomes of many people, making cars more affordable. How will this affect demand? How can we show this graphically?
Return to Figure 1.3.4a. The price of cars is still $20,000, but with higher incomes, the quantity demanded has now increased to 20 million cars, shown at point S. As a result of the higher income levels, the demand curve shifts to the right to the new demand curve D1, indicating an increase in demand. Table 1.3.4a shows clearly that this increased demand would occur at every price, not just the original one.
Price | Decrease to D2 | Original Quantity Demanded D0 | Increase to D1 |
$16,000 | 17.6 million | 22.0 million | 24.0 million |
$18,000 | 16.0 million | 20.0 million | 22.0 million |
$20,000 | 14.4 million | 18.0 million | 20.0 million |
$22,000 | 13.6 million | 17.0 million | 19.0 million |
$24,000 | 13.2 million | 16.5 million | 18.5 million |
$26,000 | 12.8 million | 16.0 million | 18.0 million |
Now, imagine that the economy slows down so that many people lose their jobs or work fewer hours, reducing their incomes. In this case, the decrease in income would lead to a lower quantity of cars demanded at every given price, and the original demand curve D0 would shift left to D2. The shift from D0 to D2 represents such a decrease in demand: At any given price level, the quantity demanded is now lower. In this example, a price of $20,000 means 18 million cars sold along the original demand curve, but only 14.4 million sold after demand fell.
When a demand curve shifts, it does not mean that the quantity demanded by every individual buyer changes by the same amount. In this example, not everyone would have higher or lower income and not everyone would buy or not buy an additional car. Instead, a shift in a demand curve captures a pattern for the market as a whole.
In the previous section, we argued that higher income causes greater demand at every price. This is true for most goods and services. For some—luxury cars, vacations in Europe, and fine jewelry—the effect of a rise in income can be especially pronounced. A product whose demand rises when income rises, and vice versa, is called a normal good.
A few exceptions to this pattern do exist. As incomes rise, many people will buy fewer generic brand groceries and more name brand groceries. They are less likely to buy used cars and more likely to buy new cars. They will be less likely to rent an apartment and more likely to own a home. A product whose demand falls when income rises, and vice versa, is called an inferior good. In other words, when income increases, the demand curve shifts to the left.
Other Factors That Shift Demand Curves
Income is not the only factor that causes a shift in demand. Other factors that change demand include tastes and preferences, the composition or size of the population, the prices of related goods, and even expectations. A change in any one of the underlying factors that determine what quantity people are willing to buy at a given price will cause a shift in demand. Graphically, the new demand curve lies either to the right (an increase) or to the left (a decrease) of the original demand curve. Let’s look at these factors.
Changing Tastes or Preferences
From 1980 to 2021, the per-person consumption of chicken by Americans rose from 47 pounds per year to 97 pounds per year, and consumption of beef fell from 76 pounds per year to 59 pounds per year, according to the U.S. Department of Agriculture (USDA). Changes like these are largely due to movements in taste, which change the quantity of a good demanded at every price: that is, they shift the demand curve for that good, rightward for chicken and leftward for beef.
Changes in the Composition of the Population
The proportion of elderly citizens in the United States population is rising. It rose from 9.8% in 1970 to 12.6% in 2000, and it will be a projected 20% of the population by 2030 (per the U.S. Census Bureau). A society with relatively more children, like the United States in the 1960s, will have greater demand for goods and services like tricycles and day care facilities. A society with relatively more elderly persons, as the United States is projected to have by 2030, has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the demand curve.
Changes in the Prices of Related Goods
Changes in the prices of related goods such as substitutes or complements also can affect the demand for a product. A substitute is a good or service that we can use in place of another good or service. As electronic books, like this one, become more available, you would expect to see a decrease in demand for traditional printed books. A lower price for a substitute decreases demand for the other product. For example, in recent years as the price of tablet computers has fallen, the quantity demanded has increased (because of the law of demand). Since people are purchasing tablets, there has been a decrease in demand for laptops, which we can show graphically as a leftward shift in the demand curve for laptops. A higher price for a substitute good has the reverse effect.
Other goods are complements for each other, meaning we often use the goods together, because consumption of one good tends to enhance consumption of the other. Examples include breakfast cereal and milk; notebooks and pens or pencils, golf balls and golf clubs; gasoline and sport utility vehicles; and the five-way combination of bacon, lettuce, tomato, mayonnaise, and bread. If the price of golf clubs rises, the quantity demanded of golf clubs falls (because of the law of demand), but the demand for a complement good like golf balls decreases, too. Similarly, a higher price for skis would shift the demand curve for a complement good like ski resort trips to the left, while a lower price for a complement has the reverse effect.
Changes in Expectations about Future Prices or Other Factors that Affect Demand
While it is clear that the price of a good affects the quantity demanded, it is also true that expectations about the future price (or expectations about tastes and preferences, income, and so on) can affect demand. For example, if people hear that a hurricane is coming, they may rush to the store to buy flashlight batteries and bottled water. If people learn that the price of a good like coffee is likely to rise in the future, they may head for the store to stock up on coffee now. We show these changes in demand as shifts in the curve. Therefore, a shift in demand happens when a change in some economic factor (other than price) causes a different quantity to be demanded at every price. A shift in demand means that at any price (and at every price), the quantity demanded will be different than it was before.
Graphing Shift in Demand
We can use the demand curve to identify how much consumers would buy at any given price. Following is an example of a shift in pizza demand due to an income increase. This example is presented with steps taken to compose the graph so that you may learn how to create a demand curve.
Step 1. Draw the graph of a demand curve for a normal good like pizza. Pick a price (like P0). Identify the corresponding Q0. See an example in Figure 1.3.4b.
Step 2. Suppose income increases. As a result of the change, are consumers going to buy more or less pizza? The answer is more. Consumers will purchase larger quantities, pushing demand to the right, and causing the demand curve to shift right. Draw a dotted horizontal line from the chosen price, through the original quantity demanded, to the new point with the new Q1. Draw a dotted vertical line down to the horizontal axis and label the new Q1. Figure 1.3.4c provides an example.
Step 3. Now, shift the curve through the new point. You will see that an increase in income causes an upward (or rightward) shift in the demand curve, so that at any price the quantities demanded will be higher, as Figure 1.3.4d illustrates.
Summing Up Factors That Change Demand
Figure 1.3.4e summarizes six factors that can shift demand curves. The direction of the arrows indicates whether the demand curve shifts represent an increase in demand or a decrease in demand. Notice that a change in the price of the good or service itself is not listed among the factors that can shift a demand curve. A change in the price of a good or service causes a movement along a specific demand curve, and it typically leads to some change in the quantity demanded, but it does not shift the demand curve.
When a demand curve shifts, it will then intersect with a given supply curve at a different equilibrium price and quantity. In the next section, we will discuss shifts in supply curves.
Attributions
"Principles of Microeconomics for AP® Courses 2e" by Steven A. Greenlaw, David Shapiro, OpenStax is licensed under CC BY 4.0
Access for free at https://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/3-2-shifts-in-demand-and-supply-for-goods-and-services
Consumers, Producers, and Shifting Supply Curves
Instructor Ideas:
Assign a news article about supply and demand. Topics could be supply and demand of candy at Halloween, the Cabbage Patch Kid Riots of 1983, supply and demand of corn due to ethanol, the cream cheese shortage, or allow the students to do their own research.
Instructor could use this as a springboard for class discussion about the different scenarios that would affect supply and demand.
During instructor lead discussion using real world examples, students are hearing and using the vocabulary words and this offers more opportunity for students to understand and incorporate the vocabulary.
Learning Objectives
5h Understand market price determination, demand, demand schedules, demand curves, supply, supply and demand relationships and shifters, and equilibrium.
5g Explain scarcity, types of resources, and desires of producers and consumers.
How Production Costs Affect Supply
A supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris paribus—so that no other economically relevant factors are changing. If other factors relevant to supply do change, then the entire supply curve will shift. Just as a shift in demand will create a change in the quantity demanded at every price, a shift in supply means a change in the quantity supplied at every price.
In thinking about the factors that affect supply, remember what motivates firms: profits—the difference between revenues and costs.
A firm produces goods and services using combinations of labor, materials, and machinery, or what we call inputs or factors of production. A firm’s profits go up if it faces lower costs of production while the price for the good or service produced remains unchanged. When a firm’s profits increase, it is more motivated to produce output, since the more it produces the more profit it will earn. Take, for example, a messenger company that delivers packages around a city. The company may find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will find it can deliver messages more cheaply than before. Since lower costs correspond to higher profits, the messenger company may now supply more of its services at any given price. For example, given the lower gasoline prices, the company can now serve a greater area, and increase its supply. When costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. This is when the supply curve shifts to the right.
Conversely, if a firm faces higher costs of production, then it will earn lower profits at any given selling price for its products. As a result, a higher cost of production typically causes a firm to supply a smaller quantity at any given price. In this case, the supply curve shifts to the left.
Consider the supply for cars, shown by curve S0 in Figure 1.3.5a. Point J indicates that if the price is $20,000, the quantity supplied will be 18 million cars. If the price rises to $22,000 per car, ceteris paribus, the quantity supplied will rise to 20 million cars, as point K on the S0 curve shows.
Decreased supply means that at every given price, the quantity supplied is lower, so that the supply curve shifts to the left, from S0 to S1. Increased supply means that at every given price, the quantity supplied is higher, so that the supply curve shifts to the right, from S0 to S2.
We can show the same information from the supply curve in Figure 1.3.5a in table form, as in Table 1.3.5a.
Price | Decrease to S1 | Original Quantity Supplied S0 | Increase to S2 |
$16,000 | 10.5 million | 12.0 million | 13.2 million |
$18,000 | 13.5 million | 15.0 million | 16.5 million |
$20,000 | 16.5 million | 18.0 million | 19.8 million |
$22,000 | 18.5 million | 20.0 million | 22.0 million |
$24,000 | 19.5 million | 21.0 million | 23.1 million |
$26,000 | 20.5 million | 22.0 million | 24.2 million |
Now, imagine that the price of steel, an important ingredient in manufacturing cars, rises; this would cause production of a car to become more expensive. At any given price for selling cars, car manufacturers will react by supplying a lower quantity. We can show this graphically as a leftward shift of supply (refer back to Figure 1.3.5a), from S0 to S1, which indicates that at any given price, the quantity supplied decreases. In this example, at a price of $20,000, the quantity supplied decreases from 18 million on the original supply curve (S0) to 16.5 million on the supply curve S1, which is labeled as point L.
Conversely, if the price of steel decreases, producing a car becomes less expensive. At any given price for selling cars, car manufacturers can now expect to earn higher profits, so they will supply a higher quantity. The shift of supply to the right, from S0 to S2, means that at all prices, the quantity supplied has increased. In this example (refer back to Figure 1.3.5a), at a price of $20,000, the quantity supplied increases from 18 million on the original supply curve (S0) to 19.8 million on the supply curve S2, which is labeled M.
Other Factors That Affect Supply
In the example above, we saw that changes in the prices of inputs in the production process will affect the cost of production and thus the supply. Several other things affect the cost of production, too, such as changes in weather or other natural conditions, new technologies for production, and some government policies.
Changes in Weather
Changes in weather and climate will affect the cost of production for many agricultural products. For example, in 2014 the Manchurian Plain in Northeastern China, which produces most of the country's wheat, corn, and soybeans, experienced its most severe drought in 50 years. A drought decreases the supply of agricultural products, which means that at any given price, a lower quantity will be supplied. Conversely, especially good weather would shift the supply curve to the right.
New Technologies
The supply curve will shift to the right when a firm discovers a new technology that allows the firm to produce at a lower cost. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world used these Green Revolution seeds—and the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price.
Government Policies
Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about $8 billion per year from producers. Businesses treat taxes as costs. Higher costs decrease supply for the reasons we discussed above.
Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace. Complying with regulations increases costs. From the firm’s perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price.
A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government directly pays a firm or reduces the firm’s taxes if the firm carries out certain actions. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right.
Shift in Supply
We know that a supply curve shows the minimum price a firm will accept to produce a given quantity of output. What happens to the supply curve when the cost of production goes up? The following example that uses supply of pizza is presented with steps taken to compose the graph so that you may learn how to create a demand curve.
Step 1. Draw a graph of a supply curve for pizza. Pick a quantity (like Q0). If you draw a vertical line up from Q0 to the supply curve, you will see the price the firm chooses. Figure 1.3.5b provides an example.
Step 2. Why did the firm choose that price and not some other? One way to think about this is that the price is composed of two parts. The first part is the cost of producing pizzas at the margin: the cost of producing the pizza, including cost of ingredients (e.g., dough, sauce, cheese, and pepperoni), the cost of the pizza oven, the shop rent, and the workers' wages. The second part is the firm’s desired profit, which is determined, among other factors, by the profit margins in that particular business. If you add these two parts together, you get the price the firm wishes to charge. The quantity Q0 and associated price P0 give you one point on the firm’s supply curve, as Figure 1.3.5c illustrates.
Step 3. Now, suppose that the cost of production increases. Because the cost of production and the desired profit equal the price a firm will set for a product, if the cost of production increases, the price for the product will also need to increase. Perhaps cheese has become more expensive by $0.75 per pizza. If that is true, the firm will want to raise its price by the amount of the increase in cost ($0.75). Draw this point on the supply curve directly above the initial point on the curve, but $0.75 higher, as Figure 1.3.5d shows.
Step 4. Shift the supply curve through this point. When the cost of production increases, the supply curve shifts upwardly to a new price level. You will see that an increase in cost causes an upward (or a leftward) shift of the supply curve, so that at any price the quantities supplied will be smaller, as Figure 1.3.5e illustrates.
Summing Up Factors That Change Supply
Changes in the cost of inputs, natural disasters, new technologies, and the impact of government decisions all affect the cost of production. In turn, these factors affect how much firms are willing to supply at any given price.
Figure 1.3.5f summarizes factors that change the supply of goods and services. Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.
Because demand and supply curves appear on a two-dimensional diagram with only price and quantity on the axes, an unwary visitor to the land of economics might be fooled into believing that economics is about only four topics: demand, supply, price, and quantity. However, demand and supply are really “umbrella” concepts: demand covers all the factors that affect demand, and supply covers all the factors that affect supply. We include factors other than price that affect demand and supply by using shifts in the demand or the supply curve. In this way, the two-dimensional demand and supply model becomes a powerful tool for analyzing a wide range of economic circumstances.
Attributions
"Principles of Microeconomics for AP® Courses 2e" by Steven A. Greenlaw, David Shapiro, OpenStax is licensed under CC BY 4.0
Access for free at https://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/3-2-shifts-in-demand-and-supply-for-goods-and-services
Elasticity
Learning Objectives
5m Comprehend and apply elasticity; be able to calculate and interpret elasticity coefficients for price, cross-price, income, elastic ties of demand, and price elasticity of supply.
Price Elasticity
Both the demand and supply curve show the relationship between price and the number of units demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity demanded (Qd) or supplied (Qs) and the corresponding percent change in price. The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.
We can usefully divide elasticities into three broad categories: elastic, inelastic, and unitary (see Table 1.3.6a).
An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price.
Elasticities that are less than one indicate low responsiveness to price changes and correspond to inelastic demand or inelastic supply.
Unitary elasticities indicate proportional responsiveness of either demand or supply.
Because price and quantity demanded move in opposite directions, price elasticity of demand is always a negative number. Therefore, price elasticity of demand is usually reported as its absolute value, without a negative sign. The summary in Table 1.3.6a is assuming absolute values for price elasticity of demand.
| If... | Then... | And It Is Called... |
|---|---|---|
| % change in quantity > % change in price | Elastic | |
| % change in quantity = % change in price | Unitary | |
| % change in quantity < % change in price | Inelastic |
To calculate elasticity along a demand or supply curve economists use the average percent change in both quantity and price. This is called the Midpoint Method for Elasticity, and is represented in the following equations:
The advantage of the Midpoint Method is that one obtains the same elasticity between two price points whether there is a price increase or decrease. This is because the formula uses the same base (average quantity and average price) for both cases.
Calculating Price Elasticity of Demand
We calculate the price elasticity of demand as the percentage change in quantity divided by the percentage change in price. Let’s calculate the elasticity between points A and B and between points G and H, as Figure 1.3.6a shows.
First, apply the formula to calculate the elasticity as price decreases from $70 at point B to $60 at point A:
Therefore, the elasticity of demand between these two points is which is 0.45, an amount smaller than one, showing that the demand is inelastic in this interval. Price elasticities of demand are always negative since price and quantity demanded always move in opposite directions (on the demand curve). By convention, we always talk about elasticities as positive numbers. Mathematically, we take the absolute value of the result. Remember to interpret elasticities as positive numbers.
This means that, along the demand curve between point B and A, if the price changes by 1%, the quantity demanded will change by 0.45%. A change in the price will result in a smaller percentage change in the quantity demanded. For example, a 10% increase in the price will result in only a 4.5% decrease in quantity demanded. A 10% decrease in the price will result in only a 4.5% increase in the quantity demanded. Price elasticities of demand are negative numbers indicating that the demand curve is downward sloping, but we read them as absolute values.
Finding the Price Elasticity of Demand
Calculate the price elasticity of demand using the data in Figure 1.3.6a for an increase in price from G to H. Has the elasticity increased or decreased?
Step 1. We know that:
Step 2. From the Midpoint Formula we know that:
Step 3. So we can use the values provided in the figure in each equation:
Step 4. Then, we can use those values to determine the price elasticity of demand:
Therefore, the elasticity of demand from G to is H 1.47. The magnitude of the elasticity has increased (in absolute value) as we moved up along the demand curve from points A to B. Recall that the elasticity between these two points was 0.45. Demand was inelastic between points A and B and elastic between points G and H. This shows us that price elasticity of demand changes at different points along a straight-line demand curve.
Calculating the Price Elasticity of Supply
Assume that an apartment rents for $650 per month and at that price the landlord rents 10,000 units are rented as Figure 1.3.6b shows. When the price increases to $700 per month, the landlord supplies 13,000 units into the market. By what percentage does apartment supply increase? What is the price sensitivity?
We calculate the price elasticity of supply as the percentage change in quantity divided by the percentage change in price.
Using the Midpoint Method,
Again, as with the elasticity of demand, the elasticity of supply is not followed by any units. Elasticity is a ratio of one percentage change to another percentage change—nothing more—and we read it as an absolute value. In this case, a 1% rise in price causes an increase in quantity supplied of 3.5%. The greater than one elasticity of supply means that the percentage change in quantity supplied will be greater than a one percent price change.
Is the elasticity the slope?
It is a common mistake to confuse the slope of either the supply or demand curve with its elasticity. The slope is the rate of change in units along the curve, or the rise/run (change in y over the change in x). For example, in Figure 1.3.6a, at each point shown on the demand curve, price drops by $10 and the number of units demanded increases by 200 compared to the point to its left. The slope is –10/200 along the entire demand curve and does not change. The price elasticity, however, changes along the curve. Elasticity between points A and B was 0.45 and increased to 1.47 between points G and H. Elasticity is the percentage change, which is a different calculation from the slope and has a different meaning.
When we are at the upper end of a demand curve, where price is high and the quantity demanded is low, a small change in the quantity demanded, even in, say, one unit, is pretty big in percentage terms. A change in price of, say, a dollar, is going to be much less important in percentage terms than it would have been at the bottom of the demand curve. Likewise, at the bottom of the demand curve, that one unit change when the quantity demanded is high will be small as a percentage.
Thus, at one end of the demand curve, where we have a large percentage change in quantity demanded over a small percentage change in price, the elasticity value would be high, or demand would be relatively elastic. Even with the same change in the price and the same change in the quantity demanded, at the other end of the demand curve the quantity is much higher, and the price is much lower, so the percentage change in quantity demanded is smaller and the percentage change in price is much higher. That means at the bottom of the curve we'd have a small numerator over a large denominator, so the elasticity measure would be much lower, or inelastic.
As we move along the demand curve, the values for quantity and price go up or down, depending on which way we are moving, so the percentages for, say, a $1 difference in price or a one-unit difference in quantity, will change as well, which means the ratios of those percentages and hence the elasticity will change.
Attributions
"Principles of Microeconomics for AP® Courses 2e" by Steven A. Greenlaw, David Shapiro, OpenStax is licensed under CC BY 4.0
Access for free at https://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/5-1-price-elasticity-of-demand-and-price-elasticity-of-supply
Perfect Elasticity and Perfect Inelasticity
Learning Objectives
5m Comprehend and apply elasticity; be able to calculate and interpret elasticity coefficients for price, cross-price, income, elastic ties of demand, and price elasticity of supply.
Elasticity Extremes
There are three extreme cases of elasticity. The more usual extreme cases happen when elasticity equals zero or when it is infinite. A third case is that of constant unitary elasticity.
Infinite elasticity or perfect elasticity refers to the extreme case where either the quantity demanded (Qd) or supplied (Qs) changes by an infinite amount in response to any change in price at all. In both cases, the supply and the demand curve are horizontal as Figure 1.3.7a shows.
While perfectly elastic supply curves are for the most part unrealistic, goods with readily available inputs and whose production can easily expand will feature highly elastic supply curves. Examples include pizza, bread, books, and pencils. Similarly, perfectly elastic demand is an extreme example. However, luxury goods, items that take a large share of individuals’ income, and goods with many substitutes are likely to have highly elastic demand curves. Examples of such goods are Caribbean cruises and sports vehicles.
Zero elasticity or perfect inelasticity, as Figure 1.3.7b depicts, refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. While a perfectly inelastic supply is an extreme example, goods with limited supply of inputs are likely to feature highly inelastic supply curves; examples include diamond rings or housing in prime locations such as apartments facing Central Park in New York City. Similarly, while perfectly inelastic demand is an extreme case, necessities with no close substitutes are likely to have highly inelastic demand curves; this is the case of life-saving drugs and gasoline.
Constant unitary elasticity, in either a supply or demand curve, occurs when a price change of one percent results in a quantity change of one percent. Figure 1.3.7bc shows a demand curve with constant unit elasticity.
Using the midpoint method, you can calculate that between points A and B on the demand curve, the price changes by 66.7% and quantity demanded also changes by 66.7%. Hence, the elasticity equals 1. Between points B and C, price again changes by 66.7% as does quantity, while between points C and D the corresponding percentage changes are again 66.7% for both price and quantity. In each case, then, the percentage change in price equals the percentage change in quantity, and consequently elasticity equals 1. Notice that in absolute value, the declines in price, as you step down the demand curve, are not identical. Instead, the price falls by $8.00 from A to B, by a smaller amount of $4.00 from B to C, and by a still smaller amount of $2.00 from C to D. As a result, a demand curve with constant unitary elasticity moves from a steeper slope on the left and a flatter slope on the right—and a curved shape overall.
Unlike the demand curve with unitary elasticity, the supply curve with unitary elasticity is represented by a straight line, and that line goes through the origin. In each pair of points on the supply curve there is an equal difference in quantity of 30. However, in percentage value, using the midpoint method, the steps are decreasing as one moves from left to right, from 28.6% to 22.2% to 18.2%, because the quantity points in each percentage calculation are getting increasingly larger, which expands the denominator in the elasticity calculation of the percentage change in quantity.
Consider the price changes moving up the supply curve in Figure 1.3.7d. From points D to E to F and to G on the supply curve, each step of $1.50 is the same in absolute value. However, if we measure the price changes in percentage change terms, using the midpoint method, they are also decreasing, from 28.6% to 22.2% to 18.2%, because the original price points in each percentage calculation are getting increasingly larger in value, increasing the denominator in the calculation of the percentage change in price. Along the constant unitary elasticity supply curve, the percentage quantity increases on the horizontal axis exactly match the percentage price increases on the vertical axis—so this supply curve has a constant unitary elasticity at all points.
Attributions
"Principles of Microeconomics for AP® Courses 2e" by Steven A. Greenlaw, David Shapiro, OpenStax is licensed under CC BY 4.0
Access for free at https://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/5-2-polar-cases-of-elasticity-and-constant-elasticity
Demand and Consumers
Learning Objectives
5g Explain scarcity, types of resources, and desires of producers and consumers.
5k Discuss the role of the consumers and demand.
5l Comprehend and apply concepts of utility, satisfaction, and indifference curves.
5n Understand and be able to explain the law demand, law of diminishing returns, and supply and demand principles.
Consumer Choices
Information on the consumption choices of Americans is available from the Consumer Expenditure Survey carried out by the U.S. Bureau of Labor Statistics. Table 1.3.8a shows spending patterns for the average U.S. household in 2015. The first row shows income; after taxes and personal savings are subtracted, it shows that the average U.S. household spent $48,109 on consumption. The table then breaks down consumption into various categories. The average U.S. household spent roughly one-third of its consumption on shelter and other housing expenses, another one-third on food and vehicle expenses, and the rest on a variety of items, as shown. These patterns will vary for specific households by differing levels of family income, by geography, and by preferences.
Average Household Income before Taxes | $62,481 |
Average Annual Expenditures | $48.109 |
Food at home | $3,264 |
Food away from home | $2,505 |
Housing | $16,557 |
Apparel and services | $1,700 |
Transportation | $7,677 |
Healthcare | $3,157 |
Entertainment | $2,504 |
Education | $1,074 |
Personal insurance and pensions | $5,357 |
All else: alcohol, tobacco, reading, personal care, cash contributions, miscellaneous | $3,356 |
Total Utility and Diminishing Marginal Utility
To understand how a household will make its choices, economists look at what consumers can afford, as shown in a budget constraint (or budget line), and the total utility (or satisfaction) derived from those choices. In a budget constraint line, the quantity of one good is on the horizontal axis and the quantity of the other good on the vertical axis. The budget constraint line shows the various combinations of two goods that are affordable given consumer income.
Consider José's situation, shown in Figure 1.3.8a. José wishes to choose the combination that will provide him with the greatest utility, which is the term economists use to describe a person’s level of satisfaction or happiness with individual choices.
In Figure 1.3.8a we show the quantity of T-shirts on the horizontal axis while we show the quantity of movies on the vertical axis. If José had unlimited income or goods were free, then he could consume without limit. However, José, like all of us, faces a budget constraint. José has a total of $56 to spend. The price of T-shirts is $14 and the price of movies is $7. Notice that the vertical intercept of the budget constraint line is at eight movies and zero T-shirts ($56/$7=8). The horizontal intercept of the budget constraint is four, where José spends of all of his money on T-shirts and no movies ($56/14=4). The slope of the budget constraint line is rise/run or –8/4=–2. The specific choices along the budget constraint line show the combinations of affordable T-shirts and movies.
Let’s begin with an assumption that José can measure his own utility with something called utils. It is important to note that you cannot make comparisons between the utils of individuals. If one person gets 20 utils from a cup of coffee and another gets 10 utils, this does not mean that the first person gets more enjoyment from the coffee than the other or that they enjoy the coffee twice as much. The reason why is that utils are subjective to an individual. The way one person measures utils is not the same as the way someone else does.
Table 1.3.8b shows how José’s utility is connected with his T-shirt or movie consumption. The first column of the table shows the quantity of T-shirts consumed. The second column shows the total utility, or total amount of satisfaction, that José receives from consuming that number of T-shirts. The most common pattern of total utility, in this example, is that consuming additional goods leads to greater total utility, but at a decreasing rate. The third column shows marginal utility, which is the additional utility provided by one additional unit of consumption.
The equation for marginal utility is:
Notice that marginal utility diminishes as additional units are consumed, which means that each subsequent unit of a good consumed provides less additional utility. For example, the first T-shirt José picks is his favorite and it gives him an addition of 22 utils. The fourth T-shirt is just something to wear when all his other clothes are in the wash and yields only 18 additional utils. This is an example of the law of diminishing marginal utility, which holds that the additional utility decreases with each unit added. Diminishing marginal utility is another example of the more general law of diminishing returns we learned earlier in the section on scarcity.
T-Shirts (Quantity) | Total Utility | Marginal Utility | Movies (Quantity) | Total Utility | Marginal Utility |
1 | 22 | 22 | 1 | 16 | 16 |
2 | 43 | 21 | 2 | 31 | 15 |
3 | 63 | 20 | 3 | 45 | 14 |
4 | 81 | 18 | 4 | 58 | 13 |
5 | 97 | 16 | 5 | 70 | 12 |
6 | 111 | 14 | 6 | 81 | 11 |
7 | 123 | 12 | 7 | 91 | 10 |
8 | 133 | 10 | 8 | 100 | 9 |
The rest of Table 1.3.8b shows the quantity of movies that José attends, and his total and marginal utility from seeing each movie. Total utility follows the expected pattern: it increases as the number of movies that José watches rises. Marginal utility also follows the expected pattern: each additional movie brings a smaller gain in utility than the previous one. The first movie José attends is the one he wanted to see the most, and thus provides him with the highest level of utility or satisfaction. The fifth movie he attends is just to kill time. Notice that total utility is also the sum of the marginal utilities.
Table 1.3.8c looks at each point on the budget constraint in Figure 1.3.8a, and it reveals José’s total utility for five possible combinations of T-shirts and movies.
Point | T-Shirts | Movies | Total Utility |
P | 4 | 0 | 81 + 0 = 81 |
Q | 3 | 2 | 63 + 31 = 94 |
R | 2 | 4 | 43 + 58 = 101 |
S | 1 | 6 | 22 + 81 = 103 |
T | 0 | 8 | 0 + 100 = 100 |
Calculating Total Utility
To aid your understanding of how these totals were derived, the following section was laid out in steps that can be taken when calculating utils. Let’s look at how José makes his decision in more detail.
Step 1. Observe that, at point Q (for example), José consumes three T-shirts and two movies.
Step 2. Look at Table 1.3.8b. You can see from the fourth row/second column that three T-shirts are worth 63 utils. Similarly, the second row/fifth column shows that two movies are worth 31 utils.
Step 3. From this information, you can calculate that point Q has a total utility of 94 (63 + 31).
Step 4. You can repeat the same calculations for each point on Table 1.3.8c, in which the total utility numbers are shown in the last column.
Notice that, for José, the highest total utility for all possible combinations of goods occurs at point S, with a total utility of 103 from consuming one T-shirt and six movies. (And remember that this may not be true for another individual.)
Choosing with Marginal Utility
Most people approach their utility-maximizing combination of choices in a step-by-step way. This approach is based on looking at the tradeoffs, measured in terms of marginal utility, of consuming less of one good and more of another. For example, say that José starts off thinking about spending all his money on T-shirts and choosing point P, which corresponds to four T-shirts and no movies, as Figure 1.3.8a illustrates. José chooses this starting point randomly as he has to start somewhere. Then he considers giving up the last T-shirt, the one that provides him the least marginal utility, and using the money he saves to buy two movies instead.
Table 1.3.8d tracks the step-by-step series of decisions José needs to make in order to find his utility-maximizing combination of choices (Key: T-shirts are $14, movies are $7, and income is $56).
Try | Which Has | Total Utility | Marginal Gain and Loss of Utility, Compared with Previous Choice | Conclusion |
Choice 1: P | 4 T-shirts + 0 movies | 81 from 4 T-shirts + 0 from 0 movies = 81 | – | – |
Choice 2: Q | 3 T-shirts + 2 movies | 63 from 3 T-shirts + 31 from 0 movies = 94 | Loss of 18 from 1 less T-shirt, but gain of 31 from 2 more movies, for a net utility gain of 13 | Q is preferred over P |
Choice 3: R | 2 T-shirts + 4 movies | 43 from 2 T-shirts + 58 from 4 movies = 101 | Loss of 20 from 1 less T-shirt, but gain of 27 from two more movies for a net utility gain of 7 | R is preferred over Q |
Choice 4: S | 1 T-shirt + 6 movies | 22 from 1 T-shirt + 81 from 6 movies = 103 | Loss of 21 from 1 less T-shirt, but gain of 23 from two more movies, for a net utility gain of 2 | S is preferred over R |
Choice 5: T | 0 T-shirts + 8 movies | 0 from 0 T-shirts + 100 from 8 movies = 100 | Loss of 22 from 1 less T-shirt, but gain of 19 from two more movies, for a net utility loss of 3 | S is preferred over T |
Decision Making by Comparing Marginal Utility
In order to give you a clear picture of how marginal utility is compared, the following provides steps for calculation. Think of it this way, José could use the following thought process (if he thought in utils) to make his decision regarding how many T-shirts and movies to purchase:
Step 1. From Table 1.3.8b, José can see that the marginal utility of the fourth T-shirt is 18. If José gives up the fourth T-shirt, then he loses 18 utils.
Step 2. He figures that foregoing the fourth T-shirt frees up $14 (the price of a T-shirt) for the purchase of the first two movies (at $7 each).
Step 3. José knows that the marginal utility of the first movie is 16 and the marginal utility of the second movie is 15. Thus, if José moves from point P to point Q, he gives up 18 utils from T-shirt purchase, but gains 31 utils from the movie purchase.
Step 4. Gaining 31 utils and losing 18 utils is a net gain of 13. This is just another way of saying that the total utility at Q (94 according to Choice Q in Table 1.3.8d) is 13 more than the total utility at P (81).
Step 5. Thus, for José, it makes sense to give up the fourth T-shirt in order to buy two movies.
José clearly prefers point Q to point P. Now repeat this step-by-step process of decision making with marginal utilities. José thinks about giving up the third T-shirt and surrendering a marginal utility of 20, in exchange for purchasing two more movies that promise a combined marginal utility of 27. José prefers point R to point Q. What if José thinks about going beyond R to point S? Giving up the second T-shirt means a marginal utility loss of 21, and the marginal utility gain from the fifth and sixth movies would combine to make a marginal utility gain of 23, so José prefers point S to R. However, if José seeks to go beyond point S to point T, he finds that the loss of marginal utility from giving up the first T-shirt is 22, while the marginal utility gain from the last two movies is only a total of 19. If José were to choose point T, his utility would fall to 100. Through these stages of thinking about marginal tradeoffs, José again concludes that S, with one T-shirt and six movies, is the choice that will provide him with the highest level of total utility. This step-by-step approach will reach the same conclusion regardless of José’s starting point.
A more systematic way of using this approach is accomplished by focusing on satisfaction per dollar. If an item costing $5 yields 10 utils, then it’s worth 2 utils per dollar spent. Marginal utility per dollar is the amount of additional utility José receives divided by the product's price.
If José wants to maximize the utility he gets from his limited budget, he will always purchase the item with the greatest marginal utility per dollar of expenditure (assuming he can afford it with his remaining budget). Table 1.3.8e shows the marginal utility per dollar for José's T shirts and movies.
Quantity of T-Shirts | Total Utility | Marginal Utility | Marginal Utility per Dollar | Quantity of Movies | Total Utility | Marginal Utility | Marginal Utility per Dollar |
1 | 22 | 22 | 22/$14=1.6 | 1 | 16 | 16 | 16/$7=2.3 |
2 | 43 | 21 | 21/$14=1.5 | 2 | 31 | 15 | 15/$7=2.14 |
3 | 63 | 20 | 20/$14=1.4 | 3 | 45 | 14 | 14/$7=2 |
4 | 81 | 18 | 18/$14=1.3 | 4 | 58 | 13 | 13/$7=1.9 |
5 | 97 | 16 | 16/$14=1.1 | 5 | 70 | 12 | 12/$7=1.7 |
6 | 111 | 14 | 14/$14=1 | 6 | 81 | 11 | 11/$7=1.6 |
7 | 123 | 12 | 12/$14=1.2 | 7 | 91 | 10 | 10/$7=1.4 |
From Table 1.3.8e, we notice that José starts with no purchases. If he purchases a T-shirt, the marginal utility per dollar spent will be 1.6. If he purchases a movie, the marginal utility per dollar spent will be 2.3. Therefore, José’s first purchase will be the movie. Why? Because it gives him the highest marginal utility per dollar and is affordable. Next, José will purchase another movie. Why? Because the marginal utility of the next movie (2.14) is greater than the marginal utility of the next T-shirt (1.6). Note that when José has no T- shirts, the next one is the first one. José will continue to purchase the next good with the highest marginal utility per dollar until he exhausts his budget. He will continue purchasing movies because they give him a greater “bang for the buck” until the sixth movie which gives the same marginal utility per dollar as the first T-shirt purchase. José has just enough budget to purchase both. This results in José purchasing six movies and one T-shirt.
A Rule for Maximizing Utility
This process of decision making suggests a rule to follow when maximizing utility. Since the price of T-shirts is twice as high as the price of movies, to maximize utility the last T-shirt that José chose needs to provide exactly twice the marginal utility (MU) of the last movie. If the last T-shirt provides less than twice the marginal utility of the last movie, then the T-shirt is providing less “bang for the buck” (i.e., marginal utility per dollar spent) than José would receive from spending the same money on movies. If this is so, José should trade the T-shirt for more movies to increase his total utility. If the last T-shirt provides more than twice the marginal utility of the last movie, then the T-shirt is providing more “bang for the buck” or marginal utility per dollar, than if the money were spent on movies. As a result, José should buy more T-shirts.
Notice that at José’s optimal choice of point S, the marginal utility from the first T-shirt, of 22 is exactly twice the marginal utility of the sixth movie, which is 11. At this choice, the marginal utility per dollar is the same for both goods. This is a tell-tale signal that José has found the point with highest total utility.
We can write this argument as a general rule: If you always choose the item with the greatest marginal utility per dollar spent, when your budget is exhausted, the utility maximizing choice should occur where the marginal utility per dollar spent is the same for both goods.
A sensible economizer will pay twice as much for something only if, in the marginal comparison, the item confers twice as much utility. Notice that the formula for the table above is:
Maximizing Utility
The general rule, , means that the last dollar spent on each good provides exactly the same marginal utility. In short, the general rule shows us the utility-maximizing choice, which is called the consumer equilibrium.
If José traded a dollar more of movies for a dollar more of T-shirts, the marginal utility gained from T-shirts would exactly offset the marginal utility lost from fewer movies. In other words, the net gain would be zero.
Products, however, usually cost more than a dollar, so José cannot trade a dollar’s worth of movies. The best he can do is trade two movies for another T-shirt, since in this example T-shirts cost twice what a movie does. If he trades two movies for one T-shirt, he would end up at point R (two T-shirts and four movies). Choice 4 in Table 1.3.8e shows that if he moves to point R, he would gain 21 utils from one more T-shirt, but lose 23 utils from two fewer movies, so he would end up with less total utility at point R.
There is another equivalent way to think about this. We can also express the general rule as the ratio of the prices of the two goods should be equal to the ratio of the marginal utilities. When we divide the price of good 1 by the price of good 2, at the utility-maximizing point this will equal the marginal utility of good 1 divided by the marginal utility of good 2.
Along the budget constraint, the total price of the two goods remains the same, so the ratio of the prices does not change. However, the marginal utility of the two goods changes with the quantities consumed. At the optimal choice of one T-shirt and six movies, point S, the ratio of marginal utility to price for T-shirts (22:14) matches the ratio of marginal utility to price for movies (of 11:7).
Measuring Utility with Numbers
This discussion of utility began with an assumption that it is possible to place numerical values on utility, an assumption that may seem questionable. You can buy a thermometer for measuring temperature at the hardware store, but what store sells a “utilimometer” for measuring utility? While measuring utility with numbers is a convenient assumption to clarify the explanation, the key assumption is not that an outside party can measure utility but only that individuals can decide which of two alternatives they prefer.
To understand this point, think back to the step-by-step process of finding the choice with highest total utility by comparing the marginal utility you gain and lose from different choices along the budget constraint. As José compares each choice along his budget constraint to the previous choice, what matters is not the specific numbers that he places on his utility—or whether he uses any numbers at all—but only that he personally can identify which choices he prefers.
In this way, the step-by-step process of choosing the highest level of utility resembles rather closely how many people make consumption decisions. We think about what will make us the happiest. We think about what things cost. We think about buying a little more of one item and giving up a little of something else. We choose what provides us with the greatest level of satisfaction. The vocabulary of comparing the points along a budget constraint and total and marginal utility is just a set of tools for discussing this everyday process in a clear and specific manner. It is welcome news that specific utility numbers are not central to the argument, since a good utilimometer is hard to find. Do not worry—while we cannot easily measure utils, by the end of the next module, we will have transformed our analysis into something we can easily measure: demand.
Attributions
"Principles of Microeconomics for AP® Courses 2e" by Steven A. Greenlaw, David Shapiro, OpenStax is licensed under CC BY 4.0
Access for free at https://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/6-1-consumption-choices
Production Function, Inputs, and Marginal Product
Learning Objectives
5f Discuss Different Types of Resources and Inputs.
5i Explain the production function relationship and give a working example of the production function.
5n Understand and be able to explain the law demand, law of diminishing returns, and supply and demand principles.
Quantity and Cost of Product for Production
We are going to explore the relationship between the quantity of output a firm produces, and the cost of producing that output. We previously discussed that the cost of the product depends on how many inputs are required to produce the product and what those inputs cost.
Production is the process (or processes) a firm uses to transform inputs (i.e., labor, capital, raw materials) into outputs (i.e. the goods or services) the firm wishes to sell. Consider pizza making. The pizzaiolo (pizza maker) takes flour, water, and yeast to make dough. Similarly, the pizzaiolo may take tomatoes, spices, and water to make pizza sauce. The chef rolls out the dough, brushes on the pizza sauce, and adds cheese and other toppings. The pizzaiolo uses a peel—the shovel-like wooden tool—to put the pizza into the oven to cook. Once baked, the pizza goes into a box (if it’s for takeout) and the customer pays for the good. What are the inputs (or factors of production) in the production process for this pizza? We can answer this question by looking at the firm’s production function.
Economists divide factors of production into several categories:
Natural Resources (Land and Raw Materials): The ingredients for the pizza were once raw materials. These include flour, yeast, and water for the dough; the tomatoes, herbs, and water for the sauce; the cheese; and the toppings. Other natural resources involved in pizza-making are wood or gas for the oven heating process; materials to make the containers that ingredients were transported in; even the electricity that the establishment uses while making the pizza. Also, it should not be forgotten that resources were employed to grow the agricultural products used, such as wheat and tomatoes; this means even the land utilized to produce the agricultural products would be included here.
Labor: When we talk about production, labor means human effort, both physical and mental. The pizzaiolo was the primary example of labor here. He, she, or they needs to be strong enough to roll out the dough and to insert and retrieve the pizza from the oven; they also need to know how to make the pizza, how long it cooks in the oven and a myriad of other aspects of pizza-making. The business may also have one or more people to work the counter, take orders, and receive payment.
Capital: When economists uses the term capital, they do not mean financial capital (money); rather, they mean physical capital, such as the machines, equipment, and buildings that one uses to produce a good. In the case of pizza, the capital includes the peel, the oven, the building, and any other necessary equipment (for example, tables and chairs).
Technology: Technology refers to the process or processes for producing the good. This does not include just any computers employed by the business. Think about how technology and technical knowledge is necessary for a pizza business. Someone has to possess the technical knowledge necessary for proper pizza making.
Entrepreneurship: Production involves many decisions and much knowledge, even for something as simple as pizza. Who makes those decisions? Ultimately, it is the entrepreneur, the person who creates the business, whose idea it is to combine the inputs to produce the outputs.
The cost of producing pizza (or any output) depends on the amount of labor capital, raw materials, and other inputs required and the price of each input to the entrepreneur. To better understand this information, let’s take a look at a production function.
Production Function
A production function is a mathematical expression or equation that explains the engineering relationship between inputs and outputs. The production function gives the answer to the question, how much output can the firm produce given different amounts of inputs?
Production functions are specific to the product. Different products have different production functions. The amount of labor a farmer uses to produce a bushel of wheat is likely different than that required to produce an automobile. Firms in the same industry may have somewhat different production functions, since each firm may produce a little differently. One pizza restaurant may make its own dough and sauce, while another may buy those items pre-made. A sit-down pizza restaurant probably uses more labor (to handle table service) than a purely take-out restaurant.
Inputs are fixed or variable.
Fixed inputs are those that can’t easily be increased or decreased in a short period of time. In the pizza example, the building is a fixed input. Once the entrepreneur signs the lease, the building should be used until the lease expires. Fixed inputs define the firm’s maximum output capacity. This is analogous to the potential real GDP shown by society’s production possibilities curve, i.e. the maximum quantities of outputs a society can produce at a given time with its available resources.
Variable inputs are those that can easily be increased or decreased in a short period of time. The pizzaiolo can order more ingredients with a phone call, so ingredients would be variable inputs. The owner could hire a new person to work the counter pretty quickly as well; therefore, human capital is considered a variable input.
Economists often use a short-hand form for the production function, where L represents all the variable inputs, and K represents all the fixed inputs:
Short Run and Long Run Production
The long run is the period of time during which all factors are variable. Once the lease expires for the pizza restaurant, the shop owner can move to a larger or smaller place.
The short run is the period of time during which at least some factors of production are fixed. During the period of the pizza restaurant lease, the pizza restaurant is operating in the short run, because it is limited to using the current building, which means the owner can’t choose a larger or smaller building.
To better understand short run production, let’s consider the example of lumber production: cutting with a two-person crosscut saw to create the product of lumber.
Since by definition capital is fixed in the short run, the following production function can be used:
OR
This equation simply indicates that since capital is fixed, the amount of output (e.g. trees cut down per day) depends mainly on the amount of labor employed (e.g. number of lumberjacks working). We can express this production function numerically as Table 1.3.9a below shows. Note that TP in Table 1.3.9a is referring to Total Product—the amount of output produced with a given amount of labor and a fixed amount of capital; and MP refers to Marginal Product—the additional output of one more worker.
# Lumberjacks | 1 | 2 | 3 | 4 | 5 |
# Trees (TP) | 4 | 10 | 12 | 13 | 13 |
MP | 4 | 6 | 2 | 1 | 0 |
In this example, one lumberjack using a two-person saw can cut down four trees in an hour. Two lumberjacks using a two-person saw can cut down ten trees in an hour.
Marginal Product and Production
Mathematically, Marginal Product is the change in total product divided by the change in labor:
In Table 1.3.9a, since 0 workers produce 0 trees, the marginal product of the first worker is four trees per day, but the marginal product of the second worker is six trees per day. This happens because of the nature of the capital the workers are using. A two-person saw works much better with two people than with one. Suppose we add a third lumberjack to the story. What will that person’s marginal product be? What will that person contribute to the team? Think about it this way: if another person is added to the team the productivity of the two-person team could be more efficient because someone else could oil the tools, supply water, relieve someone for a break.
It may be that as we add workers, the marginal product increases at first, but sooner or later additional workers will result in decreasing marginal product. In fact, there may eventually be no effect or a negative effect on output. This is called the Law of Diminishing Marginal Product and it’s a characteristic of production in the short run. Consider the difference between Total Product and Marginal Product when more lumberjacks are added, as shown in Figure 1.3.9c.
Diminishing marginal productivity is very similar to the concept of diminishing marginal utility that we previously discussed. Both concepts are examples of the more general concept of diminishing marginal returns.
Attributions
"Principles of Microeconomics for AP® Courses 2e" by Steven A. Greenlaw, David Shapiro, OpenStax is licensed under CC BY 4.0
Access for free at https://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/7-2-production-in-the-short-run
Price vs Cost
Instructor Ideas:
The vocabulary in this lesson of the textbook is very important for continued student success in this class.
Instructor could facilitate a vocabulary game to help students review the terms. Students could compete individually or in teams.
Learning Objectives
5j Accurately calculate price vs cost, total price, total cost, marginal price, and marginal cost.
Total Cost
We’ve explained that a firm’s total costs depend on the quantities of inputs the firm uses to produce its output and the cost of those inputs to the firm. The firm’s production function tells us how much output the firm will produce with the given amounts of inputs. However, if we think about that backwards, it tells us how many inputs the firm needs to produce a given quantity of output, which is the first thing we need to determine total cost.
For every factor of production (or input), there is an associated factor payment. Factor payments are what the firm pays for the use of the factors of production. From the firm’s perspective, factor payments are costs. From the owner of each factor’s perspective, factor payments are income. Factor payments include:
- raw materials prices for raw materials,
- rent for land or buildings,
- wages and salaries for labor,
- interest and dividends for the use of financial capital (loans and equity investments),
- and profit for entrepreneurship. (Profit is the residual, what’s left over from revenues after the firm pays all the other costs. While it may seem odd to treat profit as a “cost,” it is what entrepreneurs earn for taking the risk of starting a business.)
A cost function is a mathematical expression or equation that shows the cost of producing different levels of output. What we observe in Table 1.3.10a is that the cost increases as the firm produces higher quantities of output. This is pretty intuitive, since producing more output requires greater quantities of inputs, which cost more dollars to acquire.
Q | 1 | 2 | 3 | 4 |
Cost | $32.50 | $44 | $52 | $90 |
The origin of these cost figures comes from the production function and the factor payments. In Table 1.3.10b we find that the number of Widgets produced increases when the number of workers increases.
Workers (L) | 1 | 2 | 3 | 3.25 | 4.4 | 5.2 | 6 | 7 | 8 | 9 |
Widgets (Q) | 0.2 | 0.4 | 0.8 | 1 | 2 | 3 | 3.5 | 3.8 | 3.95 | 4 |
We can use the information from the production function to determine production costs. What we need to know is how many workers are required to produce any quantity of output. If we flip the order of the rows, we “invert” the production function so it shows .
Widgets (Q) | 0.2 | 0.4 | 0.8 | 1 | 2 | 3 | 3.5 | 3.8 | 3.95 | 4 |
Workers (L) | 1 | 2 | 3 | 3.25 | 4.4 | 5.2 | 6 | 7 | 8 | 9 |
Obviously, the owner does not wish to produce a fraction of a Widget and must have the figures for whole Widget production. In Table 1.3.10d the numbers have been altered to determine whole Widget production.
Widgets (Q) | 1 | 2 | 3 | 4 |
Workers (L) | 3.25 | 4.4 | 5.2 | 9 |
Suppose widget workers receive $10 per hour. Multiplying the Workers row by $10 (and eliminating the blanks) gives us the cost of producing different levels of output. Table 1.3.10e reveals the extra step taken to calculate the totals used in Table 1.3.10a.
Widgets (Q) | 1.00 | 2.00 | 3.00 | 4.00 |
Workers (L) | 3.25 | 4.4 | 5.2 | 9 |
× Wage Rate per hour | $10 | $10 | $10 | $10 |
= Cost | $32.50 | $44.00 | $52.00 | $90.00 |
Of course, wage per hour is not the only input necessary to create Widgets. Therefore, we must consider other factors that go into the cost of production.
Average and Marginal Costs
The cost of producing a firm’s output depends on how much labor and physical capital the firm uses. A list of the costs involved in producing cars will look very different from the costs involved in producing computer software or haircuts or fast-food meals.
We can measure costs in a variety of ways. Each way provides its own insight into costs. Sometimes firms need to look at their cost per unit of output, not just their total cost. There are two ways to measure per unit costs. The most intuitive way is average cost—the cost on average of producing a given quantity. Average cost is the total cost divided by the quantity of output produced: . If producing two widgets costs a total of $44, the average cost per widget is per widget.
The other way of measuring cost per unit is marginal cost. Marginal cost is the cost of each individual unit produced OR the cost of producing one more unit of output.
Mathematically, marginal cost is the change in total cost divided by the change in output: . If the cost of the first widget is $32.50 and the cost of two widgets is $44, the marginal cost of the second widget is $44 - $32.50 = $11.50. In Table 1.3.10f we find the labor cost of producing each widget with average and marginal costs displayed. Note that the marginal cost of the first unit of output is always the same as the total cost.
Q | 1 | 2 | 3 | 4 |
Total Cost | $32.50 | $44.00 | $52.00 | $90.00 |
Average Cost | $32.50 | $22.00 | $17.33 | $22.50 |
Marginal Cost | $32.50 | $11.50 | $8.00 | $38.00 |
Fixed and Variable Costs
We can break down costs into fixed and variable costs. Total costs are the sum of fixed plus variable costs.
Fixed costs are the costs of the fixed inputs (e.g. capital). Because fixed inputs do not change in the short run, fixed costs are expenditures that do not change regardless of the level of production. Whether you produce a great deal or a little, the fixed costs are the same. One example is the rent on a factory or a retail space. Once you sign the lease, the rent is the same regardless of how much you produce, at least until the lease expires. Fixed costs can take many other forms: for example, the cost of machinery or equipment to produce the product, research and development costs to develop new products, even an expense like advertising to popularize a brand name. The amount of fixed costs varies according to the specific line of business: for instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed.
Variable costs are the costs of the variable inputs (e.g., labor). The only way to increase or decrease output is by increasing or decreasing the variable inputs. Therefore, variable costs increase or decrease with output. We treat labor as a variable cost, since producing a greater quantity of a good or service typically requires more workers or more work hours. Variable costs would also include raw materials.
Let's consider a barber shop example, as shown in Table 1.3.10g. The fixed costs of operating the barber shop, including the space and equipment, are $160 per day. The variable costs are the costs of hiring barbers, which in our example is $80 per barber each day. The first two columns of the table show the quantity of haircuts the barbershop can produce as it hires additional barbers. The third column shows the fixed costs, which do not change regardless of the level of production. The fourth column shows the variable costs at each level of output. We calculate these by taking the amount of labor hired and multiplying by the wage. For example, two barbers cost 2 x $80 = $160. Adding together the fixed costs in the third column and the variable costs in the fourth column produces the total costs in the fifth column. For example, with two barbers the total cost is $160 + $160 = $320.
Labor | Quantity | Fixed Cost | Variable Cost | Total Cost |
1 | 16 | $160 | $80 | $240 |
2 | 40 | $160 | $160 | $320 |
3 | 60 | $160 | $240 | $400 |
4 | 72 | $160 | $320 | $480 |
5 | 80 | $160 | $400 | $560 |
6 | 84 | $160 | $480 | $640 |
7 | 82 | $160 | $560 | $720 |
At zero production, the fixed costs of $160 are still present. As production increases, we add variable costs to fixed costs, and the total cost is the sum of the two. Figure 1.3.10a graphically shows the relationship between the quantity of output produced and the cost of producing that output.
We always show the fixed costs as the vertical intercept of the total cost curve; that is, they are the costs incurred when output is zero so there are no variable costs. You can see from the graph that once production starts, total costs and variable costs rise.
While variable costs may initially increase at a decreasing rate, at some point they begin increasing at an increasing rate. This is caused by diminishing marginal productivity, which we discussed earlier as “Production in the Short Run.” As the number of barbers increases from zero to one in the table, output increases from 0 to 16 for a marginal gain (or marginal product) of 16. As the number rises from one to two barbers, output increases from 16 to 40, a marginal gain of 24. From that point on, though, the marginal product diminishes as we add each additional barber. For example, as the number of barbers rises from two to three, the marginal product is only 20; and as the number rises from three to four, the marginal product is only 12.
To understand the reason behind this pattern, consider that a one-man barber shop is a very busy operation. The single barber needs to do everything: say hello to people entering, answer the phone, cut hair, sweep, and run the cash register. A second barber reduces the level of disruption from jumping back and forth between these tasks, and allows a greater division of labor and specialization. The result can be increasing marginal productivity. However, as the shop adds other barbers, the advantage of each additional barber is less, since the specialization of labor can only go so far. The addition of a sixth or seventh or eighth barber just to greet people at the door will have less impact than the second one did. This is the pattern of diminishing marginal productivity. As a result, the total costs of production will begin to rise more rapidly as output increases. At some point, you may even see negative returns as the additional barbers begin bumping elbows and getting in each other’s way. In this case, the addition of still more barbers would actually cause output to decrease, as the last row of Table 1.3.10g shows.
This pattern of diminishing marginal productivity is common in production. As another example, consider the problem of irrigating a crop on a farmer’s field. The plot of land is the fixed factor of production, while the water that the farmer can add to the land is the key variable cost. As the farmer adds water to the land, output increases. However, adding increasingly more water brings smaller increases in output, until at some point the water floods the field and actually reduces output. Diminishing marginal productivity occurs because, with fixed inputs (land in this example), each additional unit of input (e.g. water) contributes less to overall production.
Average Total Cost, Average Variable Cost, Marginal Cost
The breakdown of total costs into fixed and variable costs can provide a basis for other insights as well. The first five columns of Table 1.3.10h duplicate the previous table, but the last three columns show average total costs, average variable costs, and marginal costs.
Labor | Quantity | Fixed Cost | Variable Cost | Total Cost | Marginal Cost | Average Total Cost | Average Variable Cost |
1 | 16 | $160 | $80 | $240 | $15.00 | $15.00 | $5.00 |
2 | 40 | $160 | $160 | $320 | $3.33 | $8.00 | $4.00 |
3 | 60 | $160 | $240 | $400 | $4.00 | $6.67 | $4.00 |
4 | 72 | $160 | $320 | $480 | $6.67 | $6.67 | $4.44 |
5 | 80 | $160 | $400 | $560 | $10.00 | $7.00 | $5.00 |
6 | 84 | $160 | $480 | $640 | $20.00 | $7.62 | $5.71 |
These new measures—average total costs, average variable costs, and marginal costs—help us to analyze costs on a per-unit (rather than a total) basis and are reflected in the curves in Figure 1.3.10b.
We can also present the information on total costs, fixed cost, and variable cost on a per-unit basis. We calculate average total cost (ATC) by dividing total cost by the total quantity produced. The average total cost curve is typically U-shaped. We calculate average variable cost (AVC) by dividing variable cost by the quantity produced. The average variable cost curve lies below the average total cost curve and is also typically U-shaped. We calculate marginal cost (MC) by taking the change in total cost between two levels of output and dividing by the change in output. The marginal cost curve is upward-sloping.
Average total cost (sometimes referred to simply as average cost) is total cost divided by the quantity of output. Since the total cost of producing 40 haircuts is $320, the average total cost for producing each of 40 haircuts is $320/40 = $8 per haircut. Average total cost starts off relatively high, because at low levels of output total costs are dominated by the fixed cost. Mathematically, the denominator is so small that average total cost is large. Average total cost then declines, as the fixed costs are spread over an increasing quantity of output. In the average cost calculation, the rise in the numerator of total costs is relatively small compared to the rise in the denominator of quantity produced. However, as output expands still further, the average cost begins to rise. Average cost curves are typically U-shaped, as Figure 1.3.10b shows. At the right side of the average cost curve, total costs begin rising more rapidly as diminishing returns come into effect.
We obtain average variable cost when we divide variable cost by quantity of output. For example, the variable cost of producing 80 haircuts is $400, so the average variable cost is $400/80 = $5 per haircut. Note that at any level of output, the average variable cost curve will always lie below the curve for average total cost, as Figure 1.3.10b shows. The reason is that average total cost includes average variable cost and average fixed cost. Thus, for Q = 80 haircuts, the average total cost is $8 per haircut, while the average variable cost is $5 per haircut. However, as output grows, fixed costs become relatively less important (since they do not rise with output), so average variable cost sneaks closer to average cost.
Average total and variable costs measure the average costs of producing some quantity of output. Marginal cost is somewhat different. Marginal cost is the additional cost of producing one more unit of output. It is not the cost per unit of all units produced, but only the next one (or next few). We calculate marginal cost by taking the change in total cost and dividing it by the change in quantity. For example, as quantity produced increases from 40 to 60 haircuts, total costs rise by 400 - 320 = 80. Thus, the marginal cost for each of those marginal 20 units will be 80/20 = $4 per haircut. The marginal cost curve is generally upward-sloping, because diminishing marginal returns implies that additional units are more costly to produce. In Figure 1.3.10b, we can see small range of increasing marginal returns in the figure as a dip in the marginal cost curve before it starts rising.
Where do marginal and average costs meet?
The marginal cost line intersects the average cost line exactly at the bottom of the average cost curve—which occurs at a quantity of 72 and cost of $6.60 in Figure 1.3.10b. The reason why the intersection occurs at this point is built into the economic meaning of marginal and average costs. If the marginal cost of production is below the average cost for producing previous units, as it is for the points to the left of where MC crosses ATC, then producing one more additional unit will reduce average costs overall—and the ATC curve will be downward-sloping in this zone. Conversely, if the marginal cost of production for producing an additional unit is above the average cost for producing the earlier units, as it is for points to the right of where MC crosses ATC, then producing a marginal unit will increase average costs overall—and the ATC curve must be upward-sloping in this zone. The point of transition, between where MC is pulling ATC down and where it is pulling it up, must occur at the minimum point of the ATC curve.
This idea of the marginal cost “pulling down” the average cost or “pulling up” the average cost may sound abstract, but think about it in terms of your own grades. If the score on the most recent quiz you take is lower than your average score on previous quizzes, then the marginal quiz pulls down your average. If your score on the most recent quiz is higher than the average on previous quizzes, the marginal quiz pulls up your average. In this same way, low marginal costs of production first pull down average costs and then higher marginal costs pull them up.
The numerical calculations behind average cost, average variable cost, and marginal cost will change from firm to firm. However, the general patterns of these curves, and the relationships and economic intuition behind them, will not change.
Lessons from Alternative Measures of Costs
Breaking down total costs into fixed cost, marginal cost, average total cost, and average variable cost is useful because each statistic offers its own insights for the firm.
Whatever the firm’s quantity of production, total revenue must exceed total costs if it is to earn a profit. As we previously discussed, fixed costs are often sunk costs that a firm cannot recoup. In thinking about what to do next, typically you should ignore sunk costs, since you have already spent this money and cannot make any changes. However, you can change variable costs, so they convey information about the firm’s ability to cut costs in the present and the extent to which costs will increase if production rises.
Why are total cost and average cost not on the same graph?
Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output produced. We measure these costs in dollars. In contrast, marginal cost, average cost, and average variable cost are costs per unit. In the Barbershop example, we measured them as dollars per haircut. Thus, it would not make sense to put all of these numbers on the same graph, since we measure them in different units ($ versus $ per unit of output). It would be as if the vertical axis measured two different things.
In addition, as a practical matter, if they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis, compared to the values for total cost, fixed cost, and variable cost. Using the figures from the previous example, the total cost of producing 40 haircuts is $320. However, the average cost is $320/40, or $8. If you graphed both total and average cost on the same axes, the average cost would hardly show.
Average Profit
Average cost tells a firm whether it can earn profits given the current price in the market. If we divide profit by the quantity of output produced, we get average profit—the firm’s profit margin. Expanding the equation for profit gives:
However, note that:
Thus:
This is the firm’s profit margin. This definition implies that if the market price is above average cost, average profit and total profit will be positive. If the market price is below average cost, profits will be negative. We can compare this marginal cost of producing an additional unit with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit—or not. Thus, marginal cost helps producers understand how increasing or decreasing production affects profits.
A Variety of Cost Patterns
The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs, but low marginal costs. Consider, for example, an internet company that provides medical advice to customers. Consumers might pay such a company directly, or perhaps hospitals or healthcare practices might subscribe on behalf of their patients. Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that the company must undertake before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information. In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation. If the website is popular, however, a large rise in the number of visitors will overwhelm the website, and increasing output further could require a purchase of additional computer technology and/or the patrol for additional computer scientists.
For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to transport workers to homes of customers and some rakes and shovels.
Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine equipment maintenance, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment.
Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself.
Attributions
"Principles of Microeconomics for AP® Courses 2e" by Steven A. Greenlaw, David Shapiro, OpenStax is licensed under CC BY 4.0
https://openstax.org/books/principles-microeconomics-ap-courses-2e/pages/7-3-costs-in-the-short-run