Overview of the Major Issues in Micro Economics



Overview of the Major Issues in Micro Economics

Production is limited by the factors of production – the land, labour, capital and entrepreneurship – that are available and by the state of technical knowledge.

A. Given these factors, the amount that can be produced is limited.

B. The share each person receives of total production depends on the factors of production they own. (Note that in our society, people own their own labour and human capital. People earn an income by selling labour time to firms. Firms do not own the labour of their workers.)

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To obtain the maximum output from the economy, it must be efficient.

A. Productive efficiency requires that we obtain the most output from our inputs. The economy is productively efficient when it produces in the PPF.

B. Allocative efficiency is the production of the right combination of goods. An economy that produced only shirts but no pants would be rather interesting, but not allocatively efficient.

Short-run supply and demand result in allocative efficiency

A. The demand curve reflects the willingness to pay of each individual for another unit of the good.

Economists call this the marginal benefit of another unit of production. But remember that an additional $1 is likely to give more benefit to an impoverished student than to Bill Gates.

B. The supply curve reflects what must be given up, that is the marginal cost, of another unit of a good

C. When price and quantity stabilize at the point that demand and supply intersect, then what must be given up is equated to what people are willing to give up. Marginal Benefit equals Marginal Cost. Allocative efficiency results.

Allocative efficiency achieved when an equilibrium price and quantity are established in a competitive market.

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The theory of the firm lets us see what lies behind the supply curve and lets us see how productive efficiency as well as allocative efficiency are achieved.

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A. In the short-run, by definition, at least one factor of production is fixed in quantity. Fixed costs per unit decline as output increases, resulting in an initial decline in total costs per unit (ATC). Eventually the input from additional variable units results in a smaller addition to output. Diminishing returns set in. Diminishing returns cause the cost of one more unit, marginal costs, to rise. Rising marginal costs eventually pull up ATC and the average variable costs AVC.

B. Firms maximise their profits by increasing output so long as the revenue received from selling one more unit is greater than the addition to costs of producing one more unit. In the competitive firm, so long as the price is greater than the marginal cost. As a result, the firm’s profit maximising output (or loss minimising output) can be found by following the marginal cost curve.

(It is really the addition to revenue marginal revenue which must be greater than marginal cost. In a competitive industry where firms have no control over price the marginal revenue and price are the same. They are not the same if the firm has some control over the price it charges.)

ALLOCATIVE EFFICIENCY is achieved by equating MC what must be given up with the price, what people are willing to give up.

C. If the price is greater than ATC then the firm will make a profit. Total revenue will be greater than total costs. If the price is less than ATC the firm will make a loss. Total revenues will be less than total costs.

D. The firm will produce at a loss in the short-run, so long as the loss is smaller than the loss if it shut-down. If the price is greater than the minimum average variable costs, then the loss will be less than the fixed costs. All the costs that could be avoided in the short-run are covered.

In the long-run, the number of firms will adjust so that firms earn neither profits nor losses.

A. If the price is greater than ATC, profits are greater than zero, and firms will enter the market. As more firms enter, the market price falls and profits fall.

The supply curve is the sum of all the MC curves of the firms in the industry. As more firms enter the industry, the quantity produced at each price increases, because more MC curves are added to the industry supply

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[pic]This firm finds that the price at which it can sell its output falls as more firms are attracted into the industry by the high price. P1 > ATC. As the price falls, it reduces production by moving down the MC curve. Pushing to produce units that add a lot to costs no longer adds to profits because the price is lower. When P = ATC, firms no longer have a reason to enter the market, so the price will tend to stay at that level, so long as nothing changes economic conditions.

B. If the price is less than ATC, profits are less than zero. Firms are making losses. As a result, in the long-run firms will leave the market. As firms leave, the market price rises. As the price rises, the firm can profitably expand output.

Firms will continue leaving the market until the price has risen to minimum ATC, and firms are just covering all their costs (including forgone opportunities on capital and labour).

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C. In the long-run price just equals minimum ATC. Firms earn no more in this industry than they do in any other industry. They earn just enough to stay in the industry – so the consumer is getting the product at the lowest price possible.

Productive efficiency has been achieved. Each firm is operating where costs per unit are at a minimum. Inputs per unit of output are at a minimum, so output per input is at a maximum.

D. The pursuit of profit by firms results in an efficient economy. In the short-run, firms maximise their profits by producing where price equals MC. What people are willing to give up equals what must be given up to produce the good. Allocative efficiency is achieved in the short-run.

In the long-run, firms also achieve productive efficiency. Price equals minimum average total costs. Each firm not only produces where MC = price, they also tend to produce at the ideal output, where unit costs are as low as possible.

In the long-run poorly run firms will be driven out of business. If a firm can’t get its unit costs down to the industry minimum, it will make losses in the long-run and will shut-down.

If a firm is more efficient than the typical firm in the industry (and other firms can’t figure out what its doing to keep its costs down) then that firm can make extra profits even in the long-run.

On average, the typical firm will just break even.

E. As usual, efficiency results only in certain circumstances. First we are talking about firms in a competitive industry. No one can set the price, the market sets it. Firms are free to enter or exit the industry in response to the prices. Firms are free to decide how much to produce. No one sets a quota.

All costs of producing the good are paid by the firm. All benefits are enjoyed by the consumer.

If the production process has a negative impact on the environment the unregulated competitive industry will not achieve an efficient result. The true costs in the industry are higher than the firm’s cost. If an environmentally responsible firm decides to use a more costly production method that reduces the environmental cost, that firm will go out of business in the long-run. If the responsible firm’s costs are greater than the industry average, then its minimum ATC will be greater than the long-run equilibrium price, and in the long-run it will make a loss.

Only if the government forces all firms to use the environmentally superior method, can any firm that uses is survive in the long-run. The polluters are not nasty selfish people. In a competitive industry, firms are forced to use the cheapest methods to survive. That is good if they are forced to use the best technology, but not if they are forced to use a technology that is hard on the environment.

Firms will also find that if most other firms use low cost child labour or provide poor working conditions, they will also have to do so as well, or they will go out of business. Responsible, moral business people with foresight may well welcome regulation, because they will end up with the same profits after the long-run adjustment, and they can operate with a clearer conscience. They need everybody to be regulated to be good, before they can survive by being good.

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