• How do producers decide:

  • which products to produce
  • in what quantity
  • using which resources
  • and for what price?

• Answers to these questions are building blocks for supply curves

• Nearly all goods must be produced before we can exchange & consume them

• Consumption is the destruction of value to gain utility

  • Consumption is the ultimate goal of all economic activity

• Production is the creation of value, by transforming lower-valued goods (resources, inputs, etc) into higher-valued goods (outputs, consumer products, etc)

• Consider a simple example — Robinson Crusoe stranded on a deserted island

• Anything he wants to consume, he must first produce

• Suppose on this tropical island, there is the potential to farm two goods:
  • Bananas
  • Coconuts

• Production possibilities frontier (PPF) displaying possible combinations of outputs

• Slope called marginal rate of transformation (MRT), or just call it marginal cost

• Increasing marginal cost: to produce more of a good, opportunity cost rises as he cultivates more plots of land

• Producing Bananas (x-axis), start with most productive plot first (B), then start cultivation on (A)

  • “Intensive margin”: producing more using first (most productive) plot
  • “Extensive margin”: bringing new plots into cultivation for production

• Imagine now there are many various plots of land, differing in quality

• So a more-fully curved PPF

• Imagine now there are many various plots of land, differing in quality

• So a more-fully curved PPF

• Again, increasing marginal cost with more production (worse land)

  • Producing more Bananas, (A→B), slope gets steeper
  • Producing more Coconuts, (A←B), slope gets flatter

• Based on his preferences, his productive & consumption optimum is point A (highest Indifference curve tangent to PPF)

• At this point: MRT⏟PPF slope=MRS⏟I.C. slope=pbpc⏟price line

• Now suppose he has the opportunity to trade with others

• Current market exchange rate is the slope of darker purple dashed line

• Now suppose he has the opportunity to trade with others

• Current market exchange rate is the slope of darker purple dashed line

• He will specialize in production of Bananas, produce more of them (A→B) to trade to get coconuts

  • B is his productive optimum

• He will trade at the market prices (slope of dark purple dashed line)

• He will trade at the market prices (slope of dark purple dashed line)
  • Sell (export) his specialized good, Bananas

• He will trade at the market prices (slope of dark purple dashed line)
  • Sell (export) his specialized good, Bananas
  • Buy (import) from others, Coconuts

• He will trade at the market prices (slope of dark purple dashed line)

  • Sell (export) his specialized good, Bananas
  • Buy (import) from others, Coconuts

• Allows him to reach higher indifference curve at point C, new consumption optimum

1. Trade is good
   • Reaches higher indifference curve, beyond PPF!

1. Trade is good

2. Specialization and Comparative advantage

   • specialize in producing whatever good you have the lower opportunity cost in
   • buy (import) everything else!
   • can be comparatively good at something, or comparatively bad at everything else!

• In modern market economies, most production takes place in a legal organization known as the firm

• It does not have to be this way, and for most of history it was not this way!

  • Craft guilds
  • Independent artisans
  • Independent contractors

• We'll assume "the firm" is the agent to model:

• So what do firms do?

• How would we set up an optimization model:

1. Choose: < some alternative >

2. In order to maximize: < some objective >

3. Subject to: < some constraints >

• Technology or a production function: rate at which firm can convert specified inputs (x1,x2,⋯,xn) into output (q) q=f(x1,x2,⋯,xn)

• We will assume just two inputs: labor l and capital k

• We will assume firms maximize profit (π)

• Not true for all firms

  • Examples: non-profits, charities, civic associations, government agencies, criminal organizations, etc

• Even profit-seeking firms may also want to maximize additional things

  • Examples: goodwill, sustainability, social responsibility, etc

• In economics, profit is simply benefits minus (opportunity) costs

• In economics, profit is simply benefits minus (opportunity) costs

• Suppose firm sells output q at price p

• In economics, profit is simply benefits minus (opportunity) costs

• Suppose firm sells output q at price p

• It can buy each input xi at an associated price pi

  • labor l at wage rate w
  • capital k at rental rate r

• In economics, profit is simply benefits minus (opportunity) costs

• Suppose firm sells output q at price p

• It can buy each input xi at an associated price pi

  • labor l at wage rate w
  • capital k at rental rate r

• The profit of selling q units and using inputs l,k is:

π=pq⏟revenues−(wl+rk)⏟costs

π=pq⏟revenues−(wl+rk)⏟costs

• The firm's costs are all of the factor-owner's incomes!
  • Landowners, laborers, creditors are all paid rent, wages, and interest, respectively

π=pq⏟revenues−(wl+rk)⏟costs

• Profits are the residual value leftover after paying all factors

• Profits are income for the residual claimant(s) of the production process (i.e. owner(s) of a firm):

  • Entrepreneurs
  • Shareholders

π=pq⏟revenues−(wl+rk)⏟costs

• Residual claimants have incentives to maximize firm's profits, as this maximizes their own income

• Entrepreneurs and shareholders are the only participants in production that are not guaranteed an income!

  • Starting and owning a firm is inherently risky!

• In markets, production must face the profit test:

  • Is consumer's willingness to pay > opportunity cost of inputs?

• Profits are an indication that value is being created for society

• Losses are an indication that value is being destroyed for society

• Survival in markets requires firms continually create value & earn profits

• So what do firms do?

1. Choose: < some alternative >

2. In order to maximize: < profits >

3. Subject to: < technology >

• We've so far assumed they maximize profits and they are limited by their technology

• What do firms choose? (Not an easy answer)

• Prices?

  • Depends on the market the firm is operating in!
  • Study of industrial organization

• Essential question: how competitive is a market? This will influence what firms (can) do

• Begin with one extreme case: "perfect competition"

  • Firms can choose to sell as much q∗ as they want
  • Firms are constrained to sell at the (exogenous) market price ˉp

• Appropriate for settings with many firms, each small relative to market

• After we find firm's optimal decisions in this market (and have Exam 2), we will then finally look at market equilibrium

• Put Supply and Demand together

• We've seen how consumers cause and respond to market changes

  • e.g. (Δpx, Δpy, Δm)

• We're about to explore how producers cause and respond to market changes

• Finally we can explain all of these market changes with Supply and Demand equilibrium models

• Discuss how markets work, why they are good & efficient, and when they fail

• Examine another extreme case: monopoly of a single seller

  • Appropriate for some markets

• "Imperfect competition": models of monopolistic competition & oligopoly

  • In latter case, firms act strategically, so we will need game theory

• Firms can choose both q∗ & p∗ to maximize π