Economic Theory Overview

Theory of Demand

• Total Utility: Overall happiness or satisfaction from all consumption.
• Marginal Utility: Additional utility gained from consuming one more unit of a good or service.

Diminishing Marginal Utility:

• The additional satisfaction decreases with each additional unit consumed:
• 1st unit increases utility by +20
• 2nd unit increases utility by +14
• 3rd unit increases utility by +6
• Reason for diminishing marginal utility is consumer satiation; can marginal utility be negative? Yes.

Examples of Diminishing Marginal Utility:

• Amusement park example: Satisfaction diminishes with a second visit, hence two-day passes are discounted based on this concept.

Graphs:

• Total utility graph: Parabolic (inverted).
• Marginal utility graph: Linear downward slope.
• Optimal utility is achieved at the peak where marginal utility is maximized before it becomes negative.

Optimizing Consumption:

• Consumer Optimum: Combination of goods/services maximizing utility within a budget constraint.
• Budget Constraint:
• I = Px * X + Py * Y (and more variables for additional goods).
• Higher income reduces constraints; lower income increases constraints.
• Maximum utility condition setup: $MU<em>x/P</em>x = MU<em>y/P</em>y$.

Consumer Choice Example:

• Identify optimal consumption where $MU/P = MU/P$ close to budget.

Price Changes and Effects:

• Substitution Effect: Buying more of a relatively cheaper good, less of expensive.
• Real-Income Effect: Change in purchasing power due to price changes, feeling similar to an increase in income.

Theory of Supply:

• Businesses make numerous decisions regarding labor, capital, etc. like a fast-food restaurant.

Calculating Profit and Loss:

• Total Revenue (TR): Revenue from goods/services sold.
• Total Cost (TC): Expenses incurred, with profit/loss defined as $Profit/Loss = TR - TC$.
• Explicit Costs: Tangible bills.
• Implicit Costs: Opportunity costs implied in business operations.
• Profit Types:
• Accounting profit excludes implicit costs: $Accounting \, Profit = Revenues - Explicit \, Costs$.
• Economic profit includes all costs: $Economic \, Profit = Revenues - All \, Costs$.
• Accounting profit can be negative even when economic is positive.

Production Function:

• Describes inputs to outputs relationship: $Q = f(K, L)$.
• Marginal Product (MP): Change in output per change in input, differentiating labor and capital:
• $MPL = Change \, in \, Q / Change \, in \, Labor$
• $MPK = Change \, in \, Q / Change \, in \, Capital$.

Diminishing Marginal Product: Increases from added inputs lead to slower output increases in the short run with fixed capital - more labor means adding less and less output.

Costs in the Short Run:

• Variable Costs (VC): Tied to output rates (e.g., labor, supplies).
• Fixed Costs (FC): Static costs unrelated to output.
• Total Costs (TC): $TC = VC + FC$.

Cost Curves:

• Marginal Cost (MC) intersects average variable cost (AVC) and average total cost (ATC) minima.
• Difference between ATC and AVC is average fixed costs (AFC).

U-Shaped Cost Curves:

• Arises from diminishing marginal products.
• Reaches a point where productivity declines, increasing costs.

Long Run Costs:

• Economies of Scale: Reduced ATC with increased production.
• Diseconomies of Scale: Increased ATC due to larger firm complexity.
• Constant Returns to Scale: ATC remains unchanged with production increases.

Competitive Pricing and Perfect Competition (Chapters 11+12):

• Characteristics of competitive markets (many buyers/sellers, homogenous goods, free market entry/exit).
• Firms act as price takers; demand determines revenue.

Profit Maximization for Firms:

• Firms can only make profits in the short run under competitive conditions.
• Profit max occurs when $MR=MC$; if MR > MC increase production, if MR < MC decrease production.

Long Run Adjustment:

• Economic profits converge to zero in perfect competition due to new entrants in response to positive profitability.
• Firms exit when losses occur.
• Shut down rule: Firms shut down if market price falls below AVC.

Monopoly Characteristics (Chapter 14):

• Single seller markets with barriers to entry, allowing for long-term profit sustainability.
• Types of barriers include control of resources, capital requirements, and economies of scale.

Government-Established Barriers:

• Licenses, patents, and copyrights serving to limit competition.

Monopolist Pricing and Output Decisions:

• Profit maximization for monopolists occurs where $MR=MC$; price set higher than MR due to downward perception of demand.
• Results in higher prices and inefficiencies compared to competitive markets.

Deadweight Loss:

• Occurs from monopolist decisions reducing total surplus and market efficiency compared to the equilibrium in perfect competition.

Solutions to Excessive Monopoly Power:

• Splitting monopolies, reducing barriers, regulating prices to limit monopolistic efficiency.

Monopolistic Competition:

• Free entry, numerous firms, and product differentiation characterize this structure, often requiring advertising for competition.
• Long-term economic profits are zero due to market ease of entry and escalating costs of advertising.