Econ 200: Lecture 12

November 10, 2016

0. Learning Catalytics Session:
1. The social basis of preferences
2. Technology and Production
3. Short vs. Long Run in Production
4. Marginal Product of Labor
Why Would Social Influences Matter for Consumption?

In most standard economic models, people are assumed to make

choices independently of others.

Such ignore the social aspects of decision-making.

“The utility from drugs, crime, going bowling… depends on whether

friends and neighbors take drugs, commit crime, go bowling…”
Gary Becker and Kevin Murphy
in Social Economics: Market Behavior in a Social Environment

2
Examples of Social Influences on Demand
Celebrity endorsements

Consumers might believe:

• “The celebrity knows more about the product than I do”; or
• “By buying this product, I will become more like the celebrity.”

3
Examples of Social Influences on Demand
Network externalities
Sin which the usefulness of a product increases with the number of
consumers who use it.

Examples: Facebook; Blu-ray discs; AT&T cell phone service

Network externalities might result in market failure, if enough people

become locked into inferior products.

Example: QWERTY keyboards are designed to be slower to use than

alternatives, but almost all keyboards are QWERTY now.

4
Examples of Social Influences on Demand—cont.
Fairness
People like to be treated fairly, and prefer to treat each other fairly
even if it is bad for them financially.

Example: People tend to tip their servers, even if they never plan to
go back to the restaurant.

5
Testing Fairness in the Laboratory
Ultimatum game
Pairs are given $100.
Person A proposes a split of the money, say $75 for him, and $25 for
person B.
If B accepts, each get the money. If B rejects, neither gets any.

“Optimal” play: B should accept any split, hence A should offer B very
little.

Actual play: Non-even splits are often rejected; and people anticipate
this, tending to offer 50/50 splits.

6
Testing Fairness in the Laboratory
Dictator game
Same game, except B cannot reject.

“Optimal” play: give B nothing!

Actual play: 50/50 splits are still common!

7
Testing Fairness in the Laboratory—conclusions
The results from these laboratory games suggest that people strongly
value fairness.

However it may be the perception of fairness that people value.

And, when subjects are asked to perform tasks to earn the money,
they are more likely to keep as much as they believe they earned.

Conclusion: Care needs to be taken in interpreting artificial

laboratory experiments.

8
What’s Up with “Fuel Surcharges”?
As oil prices rose in 2008,
many firms introduced “fuel
surcharges.

By 2011, decreases in the

price of oil allowed supply
to expand, but demand also
increased.

Prices should rise or stay

the same.

The unnecessary “fuel surcharges” remained.

9
Is Our Theory Realistic?
Our theory of utility maximization suggests we should compare the
marginal utility per dollar spent on every item we buy.

But when you go grocery shopping, buying dozens of items, would

you really do this? Likely, no.

Behavioral Economist Richard Thaler: “No Econ would buy a larger

portion of whatever will be served for dinner on Tuesday because he
happens to be hungry when shopping on Sunday. Your hunger on
Sunday should be irrelevant in choosing the size of your meal for
Tuesday. An Econ would not finish that huge meal on Tuesday, even
though he is no longer hungry, just because he had paid for it. To an
Econ, the price paid for an item in the past is not relevant in making
the decision about how much of it to eat now.” (NYT 05/08/15)

10
Is Our Theory Useless?

Does this invalidate our theory? Traditional economists often answer

“no”, because:

1. Simplification = good
2. Predictive accuracy

(Thaler is not so optimistic, urges economists to recognize

importance of “supposedly irrelevant factors” in decision making.
E.G.: Retirement savings)

11
Firms and Technologies (CH 11)
The basic activity of a firm is to use inputs, for example
• Workers,
• Machines, and
• Natural resources
to produce outputs of goods and services.

We call the process by which a firm does this a technology.

If a firm improves its ability to turn inputs into outputs, we refer to this
as a positive technological change.

12
Firms and Technologies
We call the process by which a firm does this a technology.

If a firm improves its ability to turn inputs into outputs, we refer to this
as a positive technological change.

Technology: The processes a firm uses to turn inputs into outputs of

goods and services.

Technological change: A change in the ability of a firm to produce a

given level of output with a given quantity of inputs.

13
The Short and the Long Run in Economics
Economists refer to the short run as a period of time during which at
least one of a firm’s inputs is fixed.

Example: A firm might have a long-term lease on a factory that is too

costly to get out of.

In the long run, no inputs are fixed, the firm can adopt new
technology, and increase or decrease the size of its physical plant.

14
Fixed and Variable Costs
The division of time into the short and long run reveals two types of
costs:
Variable costs are costs that change as output changes, while
Fixed costs are costs that remain constant as output changes.

In the long run, all of a firm’s costs are variable, since the long run is
a sufficiently long time to alter the level of any input.

 Total cost = Fixed cost +Variable cost

or, in symbols:
TC = FC + VC

15
Explicit and Implicit Costs
Recall that economists like to consider all of the opportunity costs of
an activity; both the explicit costs and the implicit costs.

Explicit cost: A cost that involves spending money

Implicit cost: A non-monetary opportunity cost

The explicit costs of running a firm are relatively easy to identify: just
look at what the firm spends money on.

The implicit costs are a little harder; finding them involves identifying
the resources used in the firm that could have been used for another
beneficial purpose.

16
Opening a Pizza Store
For example, suppose Jill quits her $30,000 a year job to start a
pizza store. She uses $50,000 of her savings to buy equipment—
furniture, etc.—and takes out a loan as well.
The items in red are explicit costs.
The items in blue are implicit costs.

Pizza dough, tomato sauce, and other ingredients $20,000

Wages 48,000
Interest payments on loan to buy pizza ovens 10,000
Electricity 6,000
Lease payment for store 24,000
Foregone salary 30,000
Foregone interest 3,000
Economic depreciation 10,000
Total $151,000

17
Opening a Pizza Store—continued
All of these implicit costs are real costs of Jill owning the pizza store,
even if they don’t require an explicit outlay of money.
Notice in particular Jill “charging herself” for the money she took out
of her savings, just like the bank charges for her loans.

Pizza dough, tomato sauce, and other ingredients $20,000

Wages 48,000
Interest payments on loan to buy pizza ovens 10,000
Electricity 6,000
Lease payment for store 24,000
Foregone salary 30,000
Foregone interest 3,000
Economic depreciation 10,000
Total $151,000

18
Production at Jill’s Restaurant
Jill’s restaurant turns its inputs (pizza ovens, ingredients, labor,
electricity, etc.) into pizzas for sale.

To make analysis simple, let’s consider only two inputs:

• The pizza ovens, and
• Workers

The pizza ovens will be a fixed cost; we will assume Jill cannot
change (in the short run) the number of ovens she has.

The workers will be a variable cost; we will assume Jill can easily
change the number of workers she hires.

19
Jill’s Production Function
Jill Johnson’s restaurant has a particular technology by which it
transforms workers and pizza ovens into pizzas.
As the number of workers increases, so does that number of pizzas
able to be produced.
This is the firm’s production function: the relationship between the
inputs employed and the maximum output of the firm.
Quantity of
Quantity of Quantity of Pizzas
Workers Pizza Ovens per Week
0 2 0
1 2 200
2 2 450
3 2 550
4 2 600
5 2 625
6 2 640

20
Worker Output at the Pizza Restaurant
Suppose Jill hires just one worker; what does that worker have to do?
• Take orders
• Make and cook the pizzas
• Take pizzas to the tables
• Run the cash register, etc.

By hiring another worker, these tasks could be divided up, allowing

for some specialization to take place, resulting from the division of
labor.
Two workers can probably produce more output per worker than one
worker can alone.

21
Marginal Product of Labor
Let’s look more closely at what happens as Jill Johnson hires more
workers.

Consider the marginal product of labor: the additional output a

firm produces as a result of hiring one more worker.

Quantity of Quantity of Pizza Quantity of

Workers Ovens Pizzas
0 2 0
1 2 200
2 2 450
3 2 550
4 2 600
5 2 625
6 2 640

22
Marginal Product of Labor
Let’s look more closely at what happens as Jill Johnson hires more
workers.

The first worker increases output by 200 pizzas; the second increases
output by 250.

Quantity of Quantity of Pizza Quantity of

Workers Ovens Pizzas
0 2 0
1 2 200
2 2 450
3 2 550
4 2 600
5 2 625
6 2 640

23
The Law of Diminishing Returns

Additional workers add to the potential output, but not by as much.

Eventually they start getting in each other’s way, etc., because there
is only a fixed number of pizza ovens, cash registers, etc.

Quantity of Quantity of Pizza Quantity of Marginal Product

Workers Ovens Pizzas of Labor
0 2 0 —
1 2 200 200
2 2 450 250
3 2 550 100
4 2 600 50
5 2 625 25
6 2 640 15

24
The Law of Diminishing Returns

This is the law of diminishing returns: at some point, adding more

of a variable input to the same amount of a fixed input will cause the
marginal product of the variable input to decline.

Quantity of Quantity of Pizza Quantity of Marginal Product

Workers Ovens Pizzas of Labor
0 2 0 —
1 2 200 200
2 2 450 250
3 2 550 100
4 2 600 50
5 2 625 25
6 2 640 15

25
Graphs of Output and Marginal Product of Labor
The output curve
flattening out and the
decreasing marginal
product curve both
illustrate the law of
diminishing returns.

26