Microeconomics I Lecture Notes 1 11

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Microeconomics I - Lecture notes 1-11
Microeconomics I. (Vysoká škola ekonomická v Praze)
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MICROECONOMICS I.
Kekebooks.vse.cz
Nicholson Walter and Christopher M. Snyder: intermediate Economics and Its application
Specian.p@gmail.com
Kekebooks.vse.cz …. Heslo: keke123, fnh01
GRADING
 Seminars 20
 Midterm 30 - 7th/8th week, computer
 Final 50
___________________________________
Chapter 1 - Nicholson and Snyder, Chapter 1 and 2 – specific instruction, handout 1 in INSIS
every week
The production possibility frontier (hranice produkčních možností)

 = shows the different combinations of two goods that can be produced from a fixed amount
of scarce resources. It also shows the opportunity cost of producing more of one good as the
quantity of the other good that cannot then be produced. The opportunity cost at two
different levels of production of a good can be seen by comparing points A and B. Inefficiency
(neefektivnost) is shown by comparing points B and C.
 10 units of food and 3 units of clothing can be made, or 4 units of food and 12 units of
clothing. Many other combinations of food and clothing can also be produced, and the graph
shows all of them. Any combination on or inside the frontier can be produced, but
combinations of food and clothing outside the frontier cannot be made because there are
not enough resources to do so.
An Econimic Way of Thinking

 We live in a world of scarcity and painful trade-offs (kompromisy)
 Scarcity (nedostatek) - resources are limited (are scarce) - Some combinations of food and
clothing (such as 10 units of food together with 12 units of clothing) are impossible to make
because resources are scare. We simply cannot have all of everything we might want.

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 Scarcity involves opportunity costs  That is, producing more of one good necessarily
involves producing less of something else - to znamená, že produkovat více z jednoho dobrého
znamená produkovat méně něčeho jiného
 For example, if this economy produces 10 units of food and 3 units of clothing per
year at point A, producing 1 more unit of clothing would ‘‘cost’’ one-half unit of food.
In other words, to increase the output of clothing by one unit means the production
of food would have to decrease by one-half unit.
 Incentives matter (motivace je důležitá) - thinking in terms of costs and benefits
 When people make economic decisions, they will consider opportunity costs. Only
when the extra (marginal) benefits from an action exceed (převyšují) the extra
(marginal) opportunity costs will they take the action being considered. Suppose,for
example, that the economy is operating at a place on its production possibility
frontier where the opportunity cost of one unit of clothing is one unit of food. Then
any person could judge whether he or she would prefer more clothing or more food
and trade at this ratio. But if, say, there were a 100 percent tax on clothing, it would
see massif you could get only one-half a unit of clothing in exchange for giving up
food—so you might choose to eat more and dress in last year’s apparel.
 Rational people make decisions based on (marginal) costs and benefits
 All costs are, in the end, opportunity costs - opportunity costs are increasing (not just money)
 Markets are a great medium of social coordination (extremely important for social
coordination) - markets in everything
 Markets are efficient, if they work well – if specific conditions are fulfilled - ekonomika
funguje neefektivně uvnitř hranice produkčních možnost
About Microeconomics
 Economics is a (social) science that largely proceeds through deducation from basic principles
(builds upon certain principles – staví na určitých principech)
o Mastering these principles will take you a long way - principles of Economics:
Mankiw, N. Gregory
 Language of modern economics is (in most cases) mathematics
 Economists works with models and they cares much more about prediction than description
SUMMARY:
 Economics is the study of allocating scarce resources among possible uses. Because resources
are scarce, choices have to be made on how they will be used. Economists develop
theoretical models to explain these choices.
 The production possibility frontier provides a simple illustration of the supply conditions in
two markets. The curve clearly shows the limits imposed (uložena) on any economy because
resources are scarce. Producing more of one good means that less of something else must be
produced. This reduction in output elsewhere measures the opportunity cost involved in such
additional production.
 The most commonly used model of the allocation of resources is the model of supply and
demand developed by Alfred Marshall. The model shows how prices are determined by
creating an equilibrium between the amount people want to buy and the amount firms are
willing to produce. If supply and demand curves shift(posouvají se), new prices are
established to restore equilibrium(obnovit rovnováhu) to the market.

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Positive & Normative Economics

 Positive – what is, a fact
o Statements about facts, how the world is
o It is "positively" true (or false)
o "An increase in price will reduce the quantity demanded." - Zvýšení ceny sníží
požadované množství.
 Normative - what should be, an opinion
o Statements of values, how the world ought to be
o Judgements of taste that cannot be scientifically tested
o "We should increase the minimum wage."
 Understanding the positive side of economics will also help you to assess (posoudit) the
normative side
Economic model for market

o "Identify the basic mechanism and throw away all unnecessary details."
o Comparative statics – compare different equilibrium (rovnováha) in different ways
o Endogenous(influence) and exogenous (not influenced) variables – endogenní a
exogenní proměnné
Equilibrium price - The price at which the quantity demanded by buyers of a good is equal to the
quantity supplied by sellers of the good.
_________________________________________________________
Structure of the course:
 1 – 4 lectures - CONSUMERS (HOUSEHOLDS)
 5 – 6 lectures - PRODUCERS (FIRMS)
 7 – 9 lectures - MARKET FOR GOODS (OUTPUTS)
 10 – 11 lectures - MARKET FOR FACTORS OF PRODUCTION (INPUTS) – consumers are selling
their labour
 12 lecture - MARKET FAILURE
___________________________________________________________________

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Chapter 2
Utility and Choice
 Model of a situation where a rational decision-maker chooses among alternatives
 We assume (předpokládáme) that all people’s behavior is rational
 Theory of choice is an abstract model of a situation where "you" (i.e. a rational decision-
maker) choose between alternatives
 The interaction of preferences and constraints (interace preference a omezení) that causes
people to make the choices they do
o Preferences = what you want (subjective) – wishes and desires
o Constraints = what you can afford (objective)
 Utility
o Utility is the pleasure, satisfaction, or need fulfillment that people get from their
economic activity
 The intuitive ‘’psychological’’ interpretation is only approximate (přibližná)
 The economists let people reveal (odhalit) their preferences through their
actions (people reveal their preferences through their behaviour)
o Can utility be measured?

 Cardinalist (cardinal view of utility - able to put a number on a utility – utility
can be measured – but this position is doubtful) and ordinalist (unable to do so –
most economists believe in this view – utility can’t be mesured) view
o Ceterus Paribus Assumption (CPA)

 = znamená podmínku (nebo předpoklad=assumption), že se při zkoumání
vlivu nějakého parametru (proměnné) na výsledek ostatní parametry nezmění
 CPA = holding all other factors constant so that only the factor being studied
is allowed to change!
 Reality is too complex to take everything into account (for us to take all
influences into account) – příliš složité brát vše v úvahu
 We isolate only the variables we consider interesting – oddělujeme pouze
důležité proměnné
o Simple model of choice - utility from consuming two goods

 Our primary interest will be in the ordinal perspective
 Setting:
For start, we assume that a person receives utility from consumption of two goods
"x" and "y"
E.g.: Robinson consumers cocoa nuts (x) and fish (y)
Utility function:
utility = U (x,y, or other things)
 Assumptions about Utility (preferences)

 Basic assumptions about preferences!:
 Preferences are complete - an individual is able to state (schopen
uvést) which of any two options is preferred (comparation between two
options)
 Preferences are transitive (přechodný) – (transitivity of preference
means 3 goods A,B,C) if A is preferred to B (I like A better than B), and B is
preferred to C, then A must be preferred to C – our choices can circle in
transitivity (přechod) – we can’t know the preferation

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More Is Better: Defining an Economic "Good"

 Economic good: something that yields positive benefits (přináší výhody) to the
consumer (MU>0)
 More of a ‘good’ is better:
if both x and y are goods  MU > 0
A .. no fish and no cocoa nuts, no x and y

X* = 3 cocoa nuts, Y* = 2 fish
Blue area up – all points need to better than in alternative A – you have more at least in
one of the product
Blue are down – lower utility than in A – we have less than in A
Indifference Curves (IC) – combinations of x and y

o An indifference curve shows all the combinations of goods or services that provide
(poskytuje) the same level of utility
o IC connects all the bundles of goods (svazky zboží) that have the same utility for a
person
P*Q = U ↑

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Meaning: The curve U1 shows the combinations of hamburgers and soft drinks that provide the same
level of utility to an individual. The slope of the curve shows the trades an individual will freely make.
For example, in moving from point A to point B, the individual will give up two hamburgers to get one
additional soft drink. In other words, the marginal rate of substitution is approximately 2 in this range.
Points below U1 (such as F) provide less utility than points on U1. Points above U1 (such as E) provide
more utility than U1.
Completeness (úplnost grafu) : A >_< B (A vetší, menší nebo rovná se B)
 E.. E is a bundle of goods preferred to A-D ….comparation between C and E (6 units of soup
and 4 units of bread) = means E is better than C (but C is equily better than E for consumer)
 C is the same as A
E > A, C is the same as A
 means E> A
 F is worse than C – everything inside is worse (under the IC)

 Behavior: you wold give up C for E, F is a bundle of goods worse than A-D
 Behavior: You would never voluntarily exchange bundle C for F
Marginal Rate of Substitution (MRS) – mezní míra substituce

o Is the rate at which a consumer is willing (ochotný) (is ready) to give up one good in
exchange for another good while maintaining the same level of utility – nahrazujeme
vzájemně statek X za statek Y, bez toho aby se změnil užitek
o MRS is the negative of the slope on an indifference curve
o Intuition: if you give up some y, the only way you can be as happy as before is
by getting more x
Change in utility = MUY * ∆Y + MUX * ∆ X
MU x
MRS =
MUy
∆Y
Slope = -
∆X
∆ Y MU x
- =
∆ X MUy
Př. If y = -1 and x = 1  MRS = 1
Marginal Utility (MU) – mezní užitek = U

o Marginal Utility of X is an increase in total utility gained by consumption of some
additional amount of X, other things reamaining the same
Diminishing Marginal Rate of Substitution – snížení MRS

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o MRS usually diminishes(diminišis) along an indifference curve moving from left to

right
o Consumers prefer balance in consumption  ‘’average’’ bundle G is preferred to
both A and D
o Convexity of the indifference curves
Meaning: The consumption bundle (spotřební balíček) G (four hamburgers, four soft drinks) is
preferred to either of the extreme bundles A and D. This is a result of the assumption of a diminishing
MRS (snížení MRS). Because individuals become progressively less willing to give up (jednotlivci jsou
postupně méně ochotní vzdát se) hamburgers as they move in a southeasterly (pohybují se v
jihovýchodním směru) direction along U1, the curve U1 will have a convex shape. Consequently (v
důsledku toho), all points on a straight line joining two points such as A and D will lie above U1. Points
such as G will be preferred to any of those on U1.  od G bude nová IC doprava nahoru (prochází
bodem G) – je to výhodnější z hlediska potravin

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2.přednáška
Indifference Curve Maps
o Shows the utility and individual obtains from all possible consumption bundles
o = infinite number of ICs in the map
o Every bundle of goods yields some level of utility (completeness)
o No bundle can yield (poskytnout) two different amounts of utility at the same time
(transitivity)
o Since every combination of goods must yield some level of utility, every point must
have one (and only one) indifference curve passing through it
 Indifference curves can never cross!
 Every bundle lies on exactly one indifference curve!
 Crossing ICs would be a violation of transitivity (porušování podmínky
přechodnosti preferencí)
Meaning: The positive quandrant is full of indifference curves, each of which reflects a different level
of ultility. Three such curves are illustrated. Combinations of goods on U3 are preferred to those on
U2, which in turn are preferred to those on U1. This is simply a reflection of the assumption that
more of a good is preferred to less, as may be seen by comparing points C, G, and H.
Well-behaved preferences
 Economists like to work with well-behaved preferences
 These fulfill not only assumptions:
o Completeness
o Transitivity
 But also
o The-more-the-better (nonsatiation=nenasycení, monotonicity)
o Convexity

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Specific Preferences I: Not all stuff is good

o Not all things have to be ‘goods’
o If you do not care about something it is "useless" or "neutral"
 Marginal utility of a neutral is 0
For x: =0
o If you dislike something it is "bad"

 Marginal utility of a bad is negative
For x: <0
 Indifference Analysis: ‘Bads’ and ‘Neutrals’:
1st graph  neutral good = useless good

2nd graph – an economic bad
Special Preferences II: Extreme Cases of Substitutability

o You do not really make a distinction (rozdíl) between some goods, they are the same
for you
 Perfect subtitutes
 e.g. Pepsi Cola and Coca-Cola = some people don’t see the difference
between them
 = the consumer doesn’t know the difference between two goods

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 The ratio does not have to be one-on-one

o Some goods, however, can be consumed only in fixed proportions (v pevných
poměrech) and one is not a substitute for the other at any rate
 Perfect complements
 e.g. left shoe and right shoe = need to use something together, none
of them can be substituted
 = we need both of goods, they cannot be substituted
 IC Maps for Perfect Substitutes and Perfect Complements:
1st graph – they are the same – MRS is constant, equal to 1 (MRS=1)
2nd graph – extra right shoes and extra left shoes are useless  both of them have to be together - IC
broken in the middle at point 1
Choices are Constrained

 The people's choices are always constrained (volby lidí jsou vždy omezené) – e.g. I want to
have Ferrari but I have no money
 The most general constraint is time - Constraint in terms of an income (příjem) or time
o However, in the basic model we will think in monetary terms of an income
(přemýšlíme o příjmu vyjádřeném v penězích)
o Budget constraint (rozpočtové omezení) = the limit that income places on the
combinations of goods that an individual can buy (hranice, kterou příjmy dosahují na
kombinace zboží, které jednotlivec může koupit)
 Affordability (dostupnost) is given by:
1. The goods’ prices
2. The consumer’s income
 Of the choices the individual can afford, he or she will choose the one that yields (poskytuje)
the most utility

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Budget Constraint: A case with Two Goods

 Two goods, two prices
 I (income) … dollars of income to spend on goods x and y
 Px … price of x
 Py … price of y
 Total expenditures = total amount of money = quantity of a good multiplied by its price
 The whole income will be spent on goods!!!
 Since both goods (and only these goods) provide more utility with increased consumption,
the consumer will spend his or her entire income on them
Budget constraint equation:
 when you spent all your money on goods = Budget Constraint

 below budget line (constraint) – when you do not spend all your money, you can buy goods, buy
you will have some money left
 above budget line – we do not have enough money to afford to buy the goods
 Negative slope of the budget constraint and the opportunity cost of x in terms of y  you
give up one thing for another thing, due to the prices (if you want more coconuts, you will
have no fish)

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Budget Constraint & Opportunity Cost
Solving for y:
I
y= ... intercept
Py
Px
- … Slope = relative price – how expensive something is in compare to something else
Py
_______________________________________________
Pro představu příklad:
Equality of MRS with the Ratio of Prices – rovnost MRS a racionálních cen
 Suppose the individual is currently consuming where MRS = 1
 Price of soft drinks (X) is 0.50$ and the price of hamburgers (Y) is 1$
o Price are exogenous variables
Px 0.50 1
 Price ratio: = =
Py 1 2
 The person could give up one hamburger (freeing 1$) and purchase one soft drink using 0.50$
 Since MRS = 1, the person would be just as happy as before but would now have an
additional 0.50$ to spend, which would enable him to increase utility (umožnit zvýšit užitek)
 The only way utility cannot be increased further is when MRS is equal to the price ratio (MRS
= price ratio)
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Utility Maximization
 If you are rational, from several options you will pick the best one
 The best option = a bundle of goods that yields the highest utility from all bundles available
 Choice as utility maximization
 Consumer sovereignty - the situation in an economy where the desires and needs of
consumers control the output of producers
 People know their own preferences best and make choices consistent with them

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 Utility Maximization in a Diagram:
 consider buying bundle A – it is affordable. But not all income spent  the best choice is, when
you spent your whole income  bundle A cannot be bought, because is not rational  rational
means when you spent all your income and you are not wasting your resources (money)
 bundle B – more rational – but not the best choice either, you spent your money, it costs more
money, but it is not going to make more satisfaction
 bundle D – very attractive, but it is not affordable

 bundle C – affordable, whole income spent, the highest possible satisfaction – prefferences are
well-behaved  the highest indifference curve U2  utility maximization = optimum = the best
possible situation

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 Bundle C: U2 is tangent to the budget line
 slope of BC = slope of IC = the optimum Necessary condition:

Px
=MRS
Py
Different Preferences Result in Differing Optima:
a) both goods
b) more coca-cola
c) consume only one good = corner solution
‘Bads’ and ‘Neutrals’ Will Not Be Purchased

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a) U2 I spend my money (=optimum consumption 10 beers), U1 I will not spend money (there is
not the optimum)
b) I want to achieve the more utility I can – I won’t spend money for what I dlislike, only for
chocolate, that I like U3
Extreme Cases of Substitutability Also Lead to Specific Optima
a) I will only buy coca-cola, it is cheaper then pepsi cola – If there is perfect substitution – more
utility per one crowd
b) U2 it is the best – the optimum at point E
Composite Good (CG) (kombinované zboží):

 = a Composite good is obtained by combining expenditures on several different goods, whose
relative prices do not change into a single good for convenience in analysis (Kombinované zboží
se získává kombinací výdajů na několik různých zboží, jejichž relativní ceny se nezmění v
jednoduché zboží pro pohodlí při analyse)
 Quantity measured in monetary units (množství měřené v peněžních jednotkách)
 This is a common graphing procedure that is used when many goods are involved but you
want to study one good 
foodstuffs

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SUMMARY:
 If people are to obtain the maximum possible utility from their limited incomes, they should
spend all the available funds and should choose a bundle of goods for which the MRS is equal
to the price ratio of the two goods. Such a utility maximum is shown graphically by a
tangency between the budget constraint and the highest indifference curve that this person’s
income can buy. - Aby lidé získali maximální možnou užitečnost z jejich omezených příjmů,
měli by vynaložit veškeré dostupné prostředky a zvolit si balíček zboží, pro který se MRS rovná
cenovému poměru obou výrobků. Takové užitné maximum je zobrazeno graficky vztahem
mezi rozpočtovým omezením a nejvyšší křivkou indiference, kterou mohou příjemci této
osoby koupit.
3.přednáška
Demand Curves
 Changes in income and prices lead to changes in people's choices
 We will use comparative statics in our discussion of "old" and "new" choices
 The final aim is the construction of an individual demand curve
Demand functions
 If we knew a person's preferences and all the economic forces that affect his or her choices,
we could predict how much of each good will be chosen
 a Demand function - how quantity demanded depends on prices, income and preferences
 = A representation of how quantity demanded depends on prices, income, and preferences
 "Demand function" and "demand curve" are not synonyms!!!
 Determinants of the quantity demanded:
o Prices of PX and PY
o Person's income (I)
o Person's preferences for X and Y
x = f (Px, Py, I, preferences)
Changes in Income

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 When person’s income increases, ceteris paribus, the quantity purchased of each good may
increase
 single solution (single optimum) you can choose

 Constraint show sizes of income
 income is the only thing that changes
 posun na BC2 a U2 means we have higher income  consumer has bigger bundle to consume
 Quantity demanded does not change when prices and income increase in the same proportion
Engel's Law
 One important generalization (zevšeobecnění) about consumer behaviour
 = Economic theory that the proportion of income spent on food decreases as income
increases, other factors remaining constant (teorie, že podíl příjmů vynaložených na jídlo se s
rostoucím příjmem snižuje, ostatní faktory zůstávají konstantní)
Normal Goods
 = A normal good is one that is bought in greater quantities as income increases (kupuje se ve
velkých množstvích, když příjem roste)
2 types of normal goods:

 If the quantity increases more rapidly than income the good is called a luxury good (luxusní)
as with good Y in the figure  luxuries
 If the quantity increases less rapidly than income the good is called a necessary good
(nezbytné) as with good X in the figure  necessities
Inferior Goods (méněcenné statky)

 = An inferior good is one that is bought in smaller quantities as income increases (it is a good
that people prefer to stay away from if they can afford it)
o As income increases form BC1 to BC2, the consumption of inferior goods decreases
 Goods such as Chinese soups, potatoes, secondhand clothes
 The higher income  the lower quantity I consume

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 we start in the optimum  income is increasing (higher income)  when you can afford to eat
something else than Yum yum soup
 CG – composite good
Engel Curve
 = engel curve shows consumption of x at various levels of income (ukazuje spotřebu statku x
v různých úrovních příjmu)
 Preferences and relative prices held constant
 Increasing for normal goods (necessities versus luxuries) ↑ m (I)  ↑ X (Qx)
 Decreasing for inferior goods ↑m ↓X
na x = Quantity
na y = income

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 Bends toward the Y-axis (ohyby směrem k ose Y) for necessities and towards X-axis for luxury
goods:
Changes in a Good's Price
 A change in the price of one good "rotates" the budget line
 The change involves moving to a new utility-maximizing choice on another indifference curve
with a different MRS
 new u-max choice
Y = vertical intercept  y= 1/Py – Px/Py * x (dosadíme za x=0)

When coffee gets cheaper , you can buy more coffee than icecream, or both  both options become
greater

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The lower the price  the greater the quantity !!!
Substitution Effect
 Change in quantity demanded, part 1: substitution effect (SE)
 = substitution of one good for another due to change in the relative price
 Results in a movement along (podél) an indifference curve!
o Consumption has to be changed to equate (vyrovnat) MRS the new price ratio of the
two goods
 If price increases, SE always works to decrease the quantity demanded (it works the other
way as well)
SE: P↑  X ↓
Př.

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Income Effect
 Change in quantity demanded, part II.: income effect (IE)

 Caused by a change in purchasing power (změna kupní síly) (change in real income)
 Normal goods: IE has same direction as SE (makes the total effect(TE) stronger)
 Inferior goods: IE has opposite direction than SE (weakness TE)
 Consumer will move to a new indifference curve that is consistent with this new puchasing
power
Increase in Price: Normal Good

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- Substitution effect  helpful line – symbolizes the new relative price, when it touches the old
indifference curve  we put a point A, that helps us with the substitution effect  movement from
E1 to A (Xe1 to Xa = means the substitution effect)
- new optimum on new BC and there is movement to U2  income effect (posune se doleva dolů)
SE & IE for a Normal Good: A summary

 Grounds for downward sloping demand curves (důvody klesajících křivek poptávky)
 If either SE or IE is large  ∆Q will be large (with a given price change)  steeply decreasing
demand curve
SE & IE for Inferior Goods:

 SE & IE work in opposite directions
Increase in Price: Inferior Good

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 Two effects go opposite to each other
Giffen's Paradox
 If we have
 an inferior good (necessary condition)
 IE stronger than SE
 Then
↑ P  ↑ Q (X)
 When the price of Irish potatoes rised (food for poor people), the consumption of potatoes
also increased  a case of increasing demand curve
 Potatoes were not only an inferior good but also had few substitutes and constituted
a large portion of Irish people’s income
 All Giffen goods are inferior goods, but not all inferior goods are Giffen goods!!!
 If an increase in a good's price leads people to consume more of the good  it is called
Giffen's paradox
X
Opakem je ORDINARY GOOD: ↑ P  ↓ Q (X)  individual demand curve is
decreasing
Relative Size of Substitution Effects

 With ski bindings (x) and skis (y), the SE of an increase in Px is zero

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SE = 0 for perfect complements

TE = IE
If you take the helpful line, you will see that you will still remain where you were, no change of slope
will change the tangency E1 = A (zero SE!)  SMALL SUBSTITUTION EFFECT
 SE, when it occurs, is very large for perfect substitutes  LARGE SUBSTITUTION EFFECT
Optimum E1  z E1 to A  SE completely rewards the consumption  you switch totally in tea cups,
from preferation of coffee cups (substitution of tea cups)  the new optimum E2¨
Changes in the Price of Another Good

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 Complements: goods that people ‘’consume’’ together – I tend to consume two things
together, they are complements but not perfect
o Observable relationship:
↑Py  ↓Qx (and the other way around – a naopak)
 Substitutes: are goods that are used for essentially the same purpose (not perfect
substitutes!) – zboží, které se pouužívá v podstatě pro stejný účel
o Observable relationship:
↑Py  ↑Qx (and the other way around)

one price going up, pushes me to a greater consumption of another good
Effect of a Decrease in the Price of x on the Demand for y: A Case of Substitutes
Optimal bundle of apples and oranges = E1  apples get cheaper (probably apple season), no change
in price of oranges  movement to New BL  new optimum is E2 Income effect pushes to consume
more apples  SE and IE = cross-effects!  total effect (TE) will be really small

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Construction of Individual Demand Curves

 An individual demand curve is a graphical representation of a relation between the price of a
good and the quantity of it demanded by a person
o All other factors (preferences, the prices of other goods and income) are held
constant!!! => CPA applies (ceteris paribus assumption)
 third optimum U3
Shape of the Demand Curve

 If a good X has close substitutes, an icrease in its price will cause a large decrease in the
quantity demanded as the substitution effect will be large
o The demand curve for a type of breakfast will be pretty flat
 If X has few substitutes, the substitution effect of a price increase or decrease will be small
and the demand curve will be relatively steep
o Water is an example
Shifts in Individual’s Demand curve

 An individual’s demand curve summarizes the relationship between the price of X and the
quantity demanded of X when all the other things that might affect demand are held
constant. The income and substitution effects of changes in that price cause the person to
move along his or her demand curve.
 If one of the factors (the priceof Y, income, or preferences) that we have so far been holding
constant were to change, the entire curve would shift to a new position.
 When income increases, people buy more X even if its price has not changed, and the
demand curve shifts outward:

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a) the effect on good X of an increase in income  if the good is normal good, an increase in income
causes more X to be demanded at each price. At P1, for example, the quantity of X demanded rises
from X1 to X2.
b) substitutes (coffee = x, tea = y)  An increase in the price of tea causes the individual to substitute
coffee for tea. More coffee (that is, good X) is demanded at each price than was previously the case.
At P1, for example, the quantity of coffee (x) demanded increases from X1 to X2.
c) complements – (coffee = x, cream = y)  An increase in the price of cream causes the demand
curve for coffee to shift inward. Because coffee and cream go together, less coffee (that is, good X)
will now be demanded at each price. This shift in the demand curve is shown in panel c —at P1, the
quantity of coffee demanded falls from X1 to X2.
Terminology
 A movement along a demand curve in response to a change in price is called change in
quantity demanded
 Increase or decrease in quantity demanded = The increase or decrease in quantity
demanded caused by a change in the good’s price. Graphically represented by the
movement along a demand curve. (posun podél poptávkové křivky!)
 A shift of a demand curecve is called change in demand
 Increase or decrease in demand = The change in demand for a good caused by
changes in the price of another good, in income, or in preferences. Graphically
represented by a shift of the entire demand curve. (posun celé poptávkové křivky!)
Consumer surplus (přebytek spotřebitele)

 = The extra value individuals receive from consuming a good over what they pay for it. What
people would be willing to pay for the right to consume a good at its current price.
 Consumer surplus = the difference between the maximal amounts a person would pay for a
good and what he or she actually pays
 In graphical terms, consumer surplus is given by the area below the demand curve and above
the market price

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 This concept is used to study the welfare effects of price changes (používá se ke studiu vlivů
změn cen na životní prostředí)
Consumer surplus and Utility

 consumer surplus provides a way of putting a monetary value on the effects that changes in
the marketplace have on people’s utility

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 The figure shows a person’s choices between a particular good (here again we use the T-shirt
example) and ‘‘all other’’ goods he or she might buy. The budget constraint shows that with a $7
price and a budget constraint given by line I, this person would choose to consume twenty T-shirts
along with $500 worth of other items. Including the $140 spent on T-shirts, total spending on all
items would be $640. This consumption plan yields a utility level of U1 to this person.
PRAVIDLA:
SE = substitution effect
SE ↑ (increase of quantity demanded) ↓ Px  ↑X ↓Y
Py constant, Px/Py changes  Px↓/Py (x is cheaper, so we buy more x)
For normal goods:

↑X  ↑ IE
m
IE = income effect ↓ Px  ↑
Px ↓
Real income of consumer
m..monetary income
Px…price decrease For inferior goods:
↓X  ↓ IE
(quantity demanded is
decreasing)
Normal good: TE = ↑SE + ↑IE  TE↑  Px↓ ↑X

TE = total effect (total change) = ordinary good
Inferior good: TE = ↑SE + ↓IE

Market Demand and Elasticity
 The market demand = the total quantity -ofmost inferiors:
a good or serviceSEdemanded
> IE  TE↑ all Px↓
by  ↑X
potential
buyers
- for Giffen good: SE < IE  TE (shares the direction with IE)  Px↓ ↓X

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 The market demand curve = the relationship between the total quantity demanded of a
good or service and its price, holding all other factors constant
Construction of the Market demand curve from Individual demand curves:
Shifts in the market demand curves

 To discover how some event might shift a market demand curve
o Find out how this event causes individual demand curves to shift
o Compare the horizontal sum of these new demand curves with the old demand curve
 Outcomes can be ambiguous
Přednáška 4.
Učebnice: NS Chapter 4 – the course skips chapter 5

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Elasticity
 = measure of the percentage change in one variable (proměnné) brought about by a 1
percent change in some other variable
 How quantity of x is sensitive to the good‘s price or to the real income  elasticity = kind of
sensitivity
 Unit-less measure of responsiveness = jednotková míra odezvy

 Avoids the problem of comparability = vyhýbá se probl=mům srovnatelnosti
 Goods are often measured in different units (steak is measured in grams while oranges are
measured in pieces)
 It can be difficult to make simple comparisons between goods when we are trying to
determine which is more responsive to change in price  we need to use elasticity to compare
them
 If we have the demand function, we need to concentrate on price of x  x = f(Px, Py, I,
preferences)
Price Elasticity of Demand

 The (own-) price elasticity demand is the percantage change in the quantity demanded of a
good in response to a 1 percent change in its price
X = quantity of x
Generally: ex, px < 0 (below zero)
 The price elasticity records how Q changes in percentage terms in response to a percentage
change in P
 Since P and Q have the same direction  Giffen paradox (ex, px > 0)
 Since P and Q typically move in opposite direction  elasticity will be negative
 For example, a value of eQ,P = -1 means that a 1 percent rise in price leads to a 1 percent
decline (pokles) in quantity, whereas a value of e Q,P = -2 means that a 1 percent rise in price
causes quantity to decline by 2 percent.
Values of the Price Elasticity of Demand

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 When eX,Px < -1, a price increase causes more than a proportional quantity decrease and the
curve is called elastic
 When e X,Px = -1, a price increase causes a proportional quantity decrease, and the curve is
called unit elastic
 When e X,Px > -1, a price increase causes less than a proportional quantity decrease, and the
curve is called inelastic
Price elasticity and Total Expenditures

 Total expenditures (celkové výdaje) on a good = are found by multiplying the goods price (P)
and the quantity purchased (Q=x)
 Total expenditures on a good:
Total expenditures on x = Px * x
 Elastic D: ↑P  ↓ total expenditures
 Inelastic D: ↑P  ↑ total expenditures
 Unit elastic D: ↑P  total expenditures remain the same with a price change
Demand Curves and Price Elasticity

 Elasticity may remain the same everywhere, but it may also be different at every point
(Elasticita může zůstat všude stejná, ale může se také lišit v každém bode)
 Elasticity for current prices (aktuální ceny, v běžných cenách):

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1.graf: Elasticity is different in each point on the graph  we charge the price of 8, then quantity be
zero  when price is high, the expenditures are very low  elastic
2.graf: total expenditures grow (when we drop price) – dropping prices leads to growing of total
expenditures and the demand need to be elastic  right part inelastic, in the middle elastic, left part
unitelastic
Price Elasticity and the Shape of the Demand Curve

 We often classify market demand curves by their elasticity
o For example, the market curve for medical services is inelastic since there is little
quantity response to change in price
o Opposite = candy bars
Price Elasticity and Time

 Long run price elasticity is generally greater than short run price elasticity
 People are more elastic, when they have more time to adapt

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Income Elasticity of Demand

 The income elasticity of demand = the percentage change in the quantity demanded of a
good in response to a 1 percent change in income
 Normal good: ex,I > 0  is positive, because increases in income lead to increases in
purchases of the good
 Luxury good: ex,I > 1  the purchase of the good increases more rapidly than income
 Necessity good: 0 < ex,I < 1  the purchase of the good increases less rapidly than income
 Inferior goods: : ex,I < 0  is negative
Cross-Price Elasticity of Demand

 The Cross-Price Elasticity of Demand = measures the percentage change in the quantity
demanded of a good in response to a 1 percent change in the price of another good
 eX,Py > 0 for substitutes

1. An increase in the price of one good will cause buyers to purchase more of the
substitute (if price of apples go up, people will consume more oranges)
 eX,Py < 0 for complements
o An increase in the price of one will cause buyers to buy less of that good and also less
of the good they use with it
Chapter 4
Uncertainty and Risk Aversion
Uncertainty (nejistota)
 In real-world things are often uncertain
Probability and expected value:

Probability
 The probability (p) that a repetitive event will happen is the relative frequency which an
event will occur (opakující se událost bude relativní četnost, s jakou událost nastane)
 Certain (určité) events: p = 1
 Impossible events: p = 0 – that the event will never ever happen

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 If n mutually exclusive outcomes are possible

o mutually exclusive = e.g. if it is going to rain or not = vzájemně se vylučující výsledky
 výroky 0 1 a pravděpodobnost
Př.
Games of Chance
 Game of chance:
o n mutually exclusive outcomes – we have 2 goods (vzájemně vylučující se)
o outcomes random – one of them is random
o probability of outcomes known
Př.  probability of 6 events  1/6 at each of event:
Expected Value
= The average outcome from an uncertain gamble (průměrný výsledek neurčitého hazardu)
 setting: lottery X
 prizes: x1 and x2
 probabilities of getting them: p1 and p2

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Fair Game
 Fair game (fair gamble) have an expected value of zero or cost their expected values (nebo
náklady na jejich předpokládané hodnoty)
 Refusal to participate in fair games = risk aversion (averze k riziku)
If we pay for the ticket 100,-  it’s fair game  if we pay more than / or less than/ 100,-  it is not
fair!!!
Games and Utility

 BEWARE! Monetary value of prizes (peněžní hodnota cen) does not matter per se (samo o
sobě), utility does (má význam pro užitnou hodnotu)
 Expected utility:
 Probability is given
 Utility = connected with outcomes, but not with probabilities!!!
Marginal Utility of Wealth (mezní užitek bohatství)

 Assumption: Diminishing marginal utility of wealth (DMU W)
 BEWARE! The cardinal concept of utility comes back to life here (but it is too difficult to do it
any other way in an intermediate course)
Risk Aversion
 Risk = variability of outcomes of some uncertain activity (variabilita výsledků některé nejisté
activity) (the bigger difference between 2 options  the more is risky for us)
 Risk aversion = The tendency of people to refuse to accept fair gambles
 Risk neutral = Willing to accept any fair gamble
 If 2 gambles have the same expected value, RA individuals will choose the one with lower risk

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Wealth – horizontal x
Utility – vertical y
Wealth is good, the more we have, it is better
MU of wealth must be diminishing
If we loose 1 000,-  larger change for us
 Fair gamble = 50 : 50
50 % probability that I win (WA + T), 50 % probability that I loose (WA - T)  ze vzorce
The addition line – shows the probable outcome (point B)
If the risk is bigger  possibilites are further away, bigger risk (line with point C) – for bigger prizes 
we always choose the least risk possibility

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Risk Aversion and Insurance

 RA (risk aversion) person is willing to pay to avoid the gamble
 Insurance = selling part of the risk to another person, when we pay him money for it
I am certain that I won’t be sick (point A) point D: If I will never ever be ill, my income will be large
 when I become ill (point A), smaller income  someone borrow me money (posun na W1) 
maximum insurance I am willing to pay = fair insurance
 Fair Insurance = insurance for which the premium is equal to the expected value of the loss
(očekáváná hodnota ztráty)
 BEWARE! You never get fair insurance (insurance is somewhere between the fair one and the
maximum one)
 Insurance company: high volume of operations decreases risk
Uninsurable Risks
 Private insurance companies can work only in relatively predictable areas and with sufficient
amount of information (Soukromé pojišťovny mohou pracovat pouze v relativně
předvídatelných oblastech a s dostatečným množstvím informací)
 some risks are too unique or difficult to evaluate (vyhodnotit)  uninsurable risks
o infrequent, unpredictable events (regulatory risks, political risks)
 Asymmetric information can take a form of hidden information about:

1) a type of agent: Adverse selection (nežádoucí výběr)
 A version of the principal agent model in which the agent’s type is private
information
2) behavior: Moral hazard - This moral hazard in people’s behavior means that
insurance against accidental losses of cash will not be available on any reasonable
terms.
 A version of the principal agent model in which the agent’s action is
private information
 asymmetric information = means one side is more informated than the other one (In a game with
uncertainty, information that one player has but the other does not)

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Přednáška 5.
Production
 Relations between inputs (land, something which I use) and outputs (products)
 Inputs  outputs
 Firm as a producer
o = any organization that turns inputs into outputs
o Many people – it’s pretty complex
o Single entity (agent) – black box
Production Function
 = the mathematical relationship between inputs and outputs  model of production
Two-Input Production Function
 A situation, where we use only two homogenious inputs (two enough for now, we can have
more inputs)
 Inputs: capital (K) and labor (L)
 how much staff you produce, it demends on how many inputs you will use
o the question: How much staff should be produced and with what combination of
inputs? (for example monthly) – kolik zaměstnanců má být zaměstnáno a jaká má být
kombinace vstupů
o What combination is the best combination for us? (we will find optimum)
Short Run and Long Run Production
 Some amount of time
 Time period: Short run X Long run (we can’t say exactly how much time it is for short or long
run)  BUT: don’t mix it!
 Variable inputs & fixed inputs
o Long run: all inputs are variable  we can change the quantity of some inputs
o Short run: at least one input is fixed!
 If we are talking about short run: we can fix the capital and labor can be changed

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Production in the SHORT RUN
Inputs: fixed K, variable L
Outputs: meals
 How the production depends on how many people cook  we have just chosen how many
people can cook
 The production function tell us: the more people we hire  the more meals they cook
 Assumption: all people have the same level of skills!
 Speed of increase is slowing down!  it is not necessary, that more people will cook more
meals (because it slowly run out)  the production function can start to slow!
Marginal Product
 = is the additional output that can be produced by adding one more unit of a particular input
while holding all other inputs constant
 Marginal (physical) product of an input:

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Law of Diminishing Returns
 = It says that, if other inputs are fixed, then the marginal product of the variable input must
eventually decline (poklesnout)
Average Product – not useful for economic analysis
 = is calculated by dividing total output by the number of units of input used to produce the
output
 for example per one person/per one hour
Total product (production function), Average product and Marginal Product

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 Graph 1: total product
o At first: convexity X then: concave function

o There is an inflection point (it’s mathematically importat, we will use this point for
finding the optimum)
 Graph 2:
o Worker number 4 will increase by 16 units! – if we calculate the slop of the function
(see on seminars later)
o Marginal – speed of growth!
o APL – how is it like this?

 If we have the production function and we have the graph for
example like this: q = f(Kfixed, L)
 Average: if we draw the straight line from origin (0), the slope will
show us
GENERAL CONDITION!  If the marginal value is bigger than average  the marginal contribution is
above the average! and the average grows up!  if is something below average function  then
the average function needs to go down!
 Není zde žádný další bod, díky kterému by se opět produkční funkce začala zvedat! – nikdy více se
to neděje, pouze jednou
Production in the LONG RUN

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Isoquant Maps
 = a contour map of a firm’s production function
 you may have different combination of inputs, that produce the same outputs
o For example: L1 = 1, K = 4  q1 = 4
o OR L2 = 5, K2 = 0  q2 = 4
o OR L3 = 2,5 K3 = 2  q3 = 4
 Isoquant
o = a curve that shows the various combinations of inputs that will produce the same
amount of output
o Resemblance to indifference curves, but magnitudes matter! – podobnost

s indif.křivkami, ale záleží na velikosti!
 remember that labor is horizontal!!
Marginal Rate of Technical Substitution (RTS)
o = the amount by which one input can be reduced when one more unit of another
input is added while holding output constant (= množství, o které může být jeden
vstup snížen, když je přidána další jednotka jiného vstupu, zatmco výstupní výstup je
konstantní)
o The negative of the slope of an isoquant

o RTS generally positive, diminishing
o We are intrested in the slope  technical substitution
o In some textbooks (MRTS)
∆ K = changes in capital input

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∆ L = changes in labor input
o You need to shutdown (vypnout) the machine, how many people can be substituted
for one machine?
o The slope is different in every point  if we already have many machines, than it’s
easier to substitute one machine for people X but if we have many people  it’s hard
to substitute them to machines
Returns to Scale
o = the rate at which output increases in response to proportional increase in all inputs
o If we change the size of outputs, what will happen?
o This topic opened up Adam Smith in the 18 th century – production of pins
o If we have manufacture with 2 workers and 2 machines, it will produced 1000 pins
(špendlíky)
 L1= 2, K1 = 2  q1 = 1000
o If we double inputs  outputs were growing much faster then inputs (but it’s not
necessary)
 L2 = 4, K2 = 4  q2 = 5000
 OR it can be also q2 = 1500 OR 2000 (all possibilities)
o Division of labor  specialization (rozdělení práce  specializace)

o Versus management costs! (náklady na správu)
 CONSTANT RETURNS TO SCALE:

 for example if we double the inputs, it double, too!
 Doubling the inputs will double the outputs!

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 INCREASING RS:
 DECREASING RS:
Law od Diminishing Returns and Returns to Scale
o Beware! Decreasing returns to scale ≠ law of diminishing returns

o Returns to scale = when all inputs are varied by a given proportion (všechny vstupy
se mění v určitém poměru)
o Law of diminishing returns = one input varies, others fixed  applies to all
production functions
Substitutability of Inputs – nahrazení vstupů

 Perfect substitutes (for example shall and benzina)
 Perfect complements (only work when they are together)

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 Fixed-proportion production function = a production function in which the inputs must be

used in a fixed ratio to one another (vzájemně pevný poměr)
Changes in Technology
 Technological progress  it changes production function!
o We can do more with the same level of inputs!  we have much more outputs 
changes the production function
 q1  it’s given
 Q1‘  new technology  we need lower number of inputs
 Technical progress = a shift in the production function that allows a given output level to be
produced using fewer inputs (=posun ve výrobní funkci, která umožňuje, aby daná výstupní
úroveň byla produkována s použitm méně vstupů)
Chapter 7:
COSTS

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Basic Concepts of Costs
 Competitive price of a good reflects its opportunity costs (if we have perfectly competitive
markets) – konkurence schopná cena zboží náklady příležitosti (pokud máme dokonale
konkurenční trhy)
 Opportunity cost = the cost of a good as measured by the alternative uses that are forgone
(vypuštěny) by producing the good
 Accounting cost X economic cost
o It is not the same!

o Accounting cost = the concept that inputs cost what was paid for them
o Economic cost = the amount required to keep an input in its present use; the amount
that it would be worth in its next best alternative use (=částka potřebná k uchování
vstupu v současném použit; částka kolik by stálo nejlepší jiné alternativní využit)
 What we have in economic cost – the value of resource we are using in the
second best use we can put it to (what would someone be willing to pay)
 EC: what the resouce would be worth in its second-best use
 Revenue = income from selling a firm’s product; defined as price times quantity sold
(definované jako ceny prodaného množství)
 Explicit costs = are out-of-pocket costs for a firm - for example, payments for wages and
salaries, rent, or materials.
 Implicit costs = are the opportunity cost of resources already owned by the firm and used in
business - for example, expanding a factory onto land already owned.
Labor Costs
 Labor services (worker-hours)  hourly wage rate (w)
 Wage rate (w) = the cost of hiring one worker for one hour = mzdové sazby
o 1 hour for example for 150 CZK = wage rate

o Reflects workers‘ OC (opportunity costs)  competitive wage rate
o Usually explicit  like accountants, economists regard the payments to labor as an
explicit cost
Capital Costs

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 Capital services (machine-hours)  hourly rental rate (v)
 Rental rate (v) = the cost of hiring one machine for one hour = nájemné
o Is determined by opportunity costs

o What someone else would be willing to pay for use of the machine (instead of you)
 Actual historical price paid = sunk cost (=expenditure that once made cannot be recovered –
výdaje, které se kdysi uskutečnily a nelze je získat zpět)
 Machine owned by the firm  implicit cost
A Simple two-input model
 Model:
o Two inputs: L (labor hours) and K (machine hours)

o Input market perfectly competitive
o One type of output
 Cost and Revenues:

o Total (economic) costs
o Total revenue = the revenue is given by a market price multiplied by the quantity of
how much thing I sold
o Economic profits (π) = the difference between a firm’s total revenues and its total
economic costs

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Přednáška 6.
Costs in the Long Run
Cost-Minimizing Input Choice
 Setting: Production aim: output level q1
 How to minimize costs?
 Cost minimization
 In the long run, all inputs are variable
 Isocost line = a set of input bundles each of which costs the same amount
 All combinations of K and L that are required to produce q 1
 Assumption: input prices are given  we can connect all the combinations of input
that costs the same
Example: we have TC1 = 10 000  we can divide it in L=30, K=0 or K=20, L=15  we
can choose different techniques which costs the same
 Slope is given by the ratio of input prices (not the same like budget line!!!)
Input Choice & Cost Minimization

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 we have a certain projective target  with the given technology

 q1 = our production aim
 TC3 – cost is too high
 TC2 – lower cost with the same prices of input
 TC1 – the lowest cost that we can have with the same prices of input  optimum
minimization E  optimal combination of labor and kapital  we reach our target
 At E the isoquant is tangent to TC1
Cost minimization:
RTS and Marginal Products

 RTS as a ratio of marginal products
 For cost minimizing combination:
Expansion Path
 Expansion path = set of cost-minimizing input combinations a firm will choose to produce
various levels of output (when the prices of inputs are held constant)  final test

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S = combination of inputs with the q1  minimizing

q2 = costs will grow, new miminum costs that we can reach at T
U = cost minimizing input bundle given the production target q3
 then we get the expansion path E
Cost Curves
 Expansion path = how minimum-cost input use grows when q expands
 the best you can do is to get to the curve TC
 Cost curves:
Total, Average, and Marginal Costs

 Tangent to TC  marginal costs

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 Total cost
 Average cost = total cost divided by output (a common measure of cost per unit)
 Marginal cost = the additional cost of producing one more unit of output
 the logic is the same as production earlier
Costs and Returns to Scale

 when inputs doubles, ouputs doubles also
 Shapes of the total cost curve:

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 The shape of the total cost curve depends on the nature of the production function.
 Panel a represents constant returns to scale: As output expands, input costs expand
proportionately.
 Panel b and panel c show decreasing returns to scale and increasing returns to scale, respectively.
 Panel d represents costs where the firm has an ‘‘optimal scale’’ of operations.
 Average and marginal returns to scale:
 The average and marginal cost curves shown here are derived from the total cost curves in
previous graphs. The shapes of these curves depend on the nature of the production function.
Costs and Constant Returns to Scale

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Shifting the Cost Curves

Shifts in Cost Curves
 = change in economic conditions that affects the expansion path will also affect the firm’s
cost curves
Changes in Input Prices

 A change in the price of an input  rotates isocosts  alters (mění) expansion path (EP)
 e.g. a rise in wage rates
TC1’ > TC1
 Increase in wages  increase in costs

 Extent of the shift?:
o 1) How important labor is in production
o 2) How successful the firm is in substituting other inputs for labor
Technological Innovation

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 = technological change alters the firm’s production function  isoquants will be different, the
production will change
 Isoquant maps shifts  firms’s EP changes
 Unbiased improvements shift isoquants toward the origin
 the same outputs as before with the same costs (posun q1,q2,q3 níž)  but prices are lower!
 Technological change biased toward the use of one input will:

o Alter isoquant maps
o Shift expansion paths
o Affect the shape and location of cost curves
 e.g. workers become more skilled, this only improves productivity of labor
 Economies of scope = reductions in the costs of one product of a multiproduct firm when the
output of another product is increased
Costs in the Short Run

Holding Capital Input Constant
 Capital input held constant at K0
 Law of diminishing returns applies
q2 – the only point I can be at is the amount of L 1
(in short run) STC (q1) > LTC (q1) (in long run)
STC (q2) = LTC (q2)

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Short run = the period of time in which a firm must consider some inputs to be fixed in making its
decisions
Long run = the period of time in which a firm may consider all of its inputs to be variable in making its
decisions
Total Cost in the Short Run

 Fixed costs (fixed, but not free, we still need to pay for it) verus variable costs (variable input,
with the quantity variable iw will change the production)
 Fixed costs = costs associated with inputs that are fixed in the short run
 Variable costs = costs associated with inputs that can be varied in the short run
TC in the short run:
If FC > 0  STC (q=0) > 0
Per-Unit Short-Run Cost Curves

 Short run average cost
 Short run marginal cost
 the relationship between marginal and average variables holds again

 when SMC < SAC, average cost is falling
 when SMC > SAC, average cost increases

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 Average variable cost
 Average fixed cost
STC VC FC
= +
q q q
STC = ∆VC + ∆FC

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Chapter 8 :
Profit Maximization and Supply in the Short Run
The Nature of Firms
 Assumption: Firm’s decisions are made by a single dictatorial manager who rationally pursues
the goal of maximizing economic profit
Definition of Profits
 Firm maximizes economic profit
 Economic profits (π):
 What level of output will generate the largest profit?
Total Cost, Total Revenue, and (Short-Run) Profit
Total revenues  TR = qB * P(market)
Profit Maximization

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 maximum is paralel to horizontal axis  at this point the slope = 0
 At the profit maximizing level of output, marginal revenue is equal to marginal cost
Marginal Revenue of a Price-Taking Firm

 A price taker = an agent whose decisions have no effect on the prevailing market price of a
good
o For a price taking firm, MR = P (MC)
 Marginal revenue = the extra revenue a firm receives when it sells one more unit of output

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Přednáška 7.
Supply Decisions of a Price-Taking Firm
Short-Run Profit Maximization
 law of dimishing returns to scale
π
= AR - AC
q
Average cost (AC)
Average revenue (AR)
π
AR > AC  >0
q
Firm’s Short-Run Supply

 Firm’s short-run supply curve as quantity-price relationship
 Firm’s short-run supply curve = the relationship between price and quantity supplied by a
firm in the short run
 price taker  fixed cost (sunk cost)

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 AVCmin = shutdown price

 shutdown price = the price below which the firm will choose to produce no output in the
short run. Equal to minimum average variable cost!
q* > 0 iff TR ≥ VC:

P * q ≥ VC
VC
P≥
q
P ≥ AVC
 under AVCmin  no output is produced  the firm’s producing no units of output (fialové) (our
loss is equal to fixed cost, but loss is smaller than shutdown)
PRICE TAKER:  in test

P = MR
MR = MC
Perfect Competition
Assumptions of perfect competition:

1. profit maximizing firms & rational consumers
2. a large number of buyers and sellers
3. no barriers to entry and exit
4. homogeneous product
5. perfect factor mobility
6. perfect information
7. zero transaction costs
8. no externalities etc..
 first 4 are important  in final test

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 buyers and sellers are all price takers!
Short-Run Market Supply Curve
 Short-run market supply curve = the relationship between market price and quantity
supplied of a good in the short run
 Market supply is a horizontal sum of individual firms’ supply
 Firm A – profit maximizing output q

 when we sum up horizontally two quantities of firm A and firm B  we get market price
Supply Response & Time

 Supply response = change in quantity of output if demand conditions change
o SR: no firms enter or exit the market (you are stuck on where you are)
o LR: new firms may enter the market (also new market)
Short Run Price Determination
 buyers and sellers are the same  we choose p1 in perfect competition: MR = AR = P

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Reasons for a Shift in a Demand or Supply Curve (Normal Good)
Short-Run Supply Elasticity

 = the percentage change in quantity supplied in the short run in response to a 1 percent
change in price
Effects of Demand Shifting

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The Long Run

 Long run supply responses are more flexible
1. LR cost curves reflect greater input flexibility
2. Firms can enter and exit the market in response to profit opportunities
Equilibrium Conditions
 Equilibrium price = the price at which the quantity demanded by buyers of a good is equal to
the quantity supplied by sellers of the good
 Perfectly competitive equilibrium = LR situation where no firm has an incentive (pobídka) to
change its behavior
1. Firms choose the profit maximizing level of output
2. No firm is motivated to enter or to leave the market
 implication: firms’ economic profit must be 0
Profit Maximization in the Long Run
Since for a price taker P = AR = MR

And profit maximization requires MR = MC
P = MC is the first equilibrium condition
 first equilibrium condition = determines the firm’s output choice and its choice of inputs
Entry and Exit

 Free entry in the LR
 π > 0 attract new firms into the industry
 π < 0 cause firms to leave the industry
 Entry: SR market supply curve shifts outward (směrem ven)  P decreases
 Until π = 0
 Exit: SR market supply curve shifts inward  P increases
 Until π = 0
Long-Run Equilibrium
 Assumption: identical cost curves
 Second equilibrium condition: in the LR equilibrium all firms earn π = 0, i.e.

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 Summary:
1. P = MC because firms are profit maximizers & price takers
2. P = AC because market forces (tržní síly) in LR cause π = 0
Long-Run Supply: The Constant Cost Case

 Constant cost case = entry and exit have no effect on the cost curves of firms
 price is driven up  output is growing

 in final test!
 Long-run elasticity of supply = the percentage change in quantity supplied in the long run in
response to a 1 percent change in price
CONSUMER AND PRODUCER SURPLUS

Consumer Surplus
 Consumer surplus = measures economic welfare from the buyer’s side
o = willingness to pay for a good minus the market price
o = the extra value individuals receive from consuming a good over what they pay for
it. What people would be willing to pay for the right to consume a good at its current
price.
Producer Surplus
 Producer surplus = the amount a seller is paid for a good minus the seller’s costs
o Benefit to sellers participating in a market

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o = the extra value producers get for a good in excess of the opportunity costs they
incur by producing it. What all producers would pay for the right to sell a good at its
current market price.
Consumer & Producer Surplus

 Economically efficient allocation of resources (output level Q1) = an allocation of resources
in which the sum of consumer and producer surplus is maximized. Reflects the best
(utilitymaximizing) use of scarce resources
o Utility maximizing use of scarce resources
 competitive equilibrium E – crossing S and D
Short-Run Producer Surplus

 Short-run producer surplus
o S-curve’s positive slope reflects the diminishing returns to variable inputs
o P > MC at all output levels, except q*
 i.e. ‘‘intramarginal’’ units of output generate incremental profits
Long-Run Producer Surplus

 Long-run producer surplus
o S-curve increases because firms experience increasing input costs
o Firms have π = 0 and no fixed costs  SR producer surplus does not exist
o Surplus translated into inputs’ rents
o Described by David Ricardo  Long-run profits earned by owners of low-cost firms.
May be capitalized into the prices of these firms’ inputs.

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Přednáška 8.
Not competitive:
Application: Tax Incidence
Quantity (or Per Unit) Taxes
 A tax rate (daňová sazba) t places a wedge between the price paid by buyers Pb, and the
price received by sellers Ps
Quantity Taxes
 Even with a tax, the market clears
 Quantitites are the same  how taxes are – it matters
 Beware! Both equations are independent of whether the tax is levied on sellers or on buyers
(obě rovnice jsou nezávsilé na tom, zda je daň vybírána prodávajícím či kupujícím)
 Who carries the tax burden? – kdo nese daňové zatžení
 Tax incidence (theory) = the study of the final burden of a tax after considering all market
reactions to it
Quantity Taxes and Tax Incidence
 When we are more flexible  less tax will be

 Paied by sellers – the burden of the sellers (daňová zatžení prodávajících)

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 the tax burden falls on both the buyer and the seller (břemeno daně spadá jak na kupujícího, tak
prodávajícího)
Deadweight Loss and Own-Price Elasticities

 Tax in a competitive market:
↓quantity traded (obchodované množství)  ↓CS+PS (consumer and producer surplus)
 Deadweight loss (DWL = náklady mrtvé váhy), or excess burden (nadměrné zatžení)
 Deadweight loss = inefficiency created in the market, due to demand and surplus issues that
have a negative impact (dopad) on a society
 = also known as excess burden or allocative inefficiency, is a loss of economic
efficiency that can occur when equilibrium for a good or a service is not
achieved
 = losses of consumer and producer surplus that are not transferred to other
parties
 DWL is illustrated by the demand curve above, supply curve below, and
quantity
 The most common reasons for DWL is government actions such as taxes or
supply controls
↑ elasticity of S or D  ↑DWL (deadweight loss)
Chapter 11:
Monopoly
 No competition on seller’s side
 The only one in the market  it has the substitution power on the market
Monopoly
 = a market with the only one producer
 A single firm faces the entire market demand curve
 Price maker – we use our power to determine the prices to our advantage
o The monopoly must make the decision of how much to produce
o The monopoly's outup decision will completely determine the good's price on market
Causes of Monopoly
 Barriers to entry
o Source of all monopoly power
o = factors that prevent new firms from entering a market (faktory, které brání vstupu
nových firem na trh)
 Two general types of barriers to entry (ZT!):
1) Technical barriers to entry – one large firm instead of many firms
 Primary technical barrier – diminishing average cost over a broad range of
output levels (e.g. network industries – investment to networks, it costs a
lot)

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 A large firm is more efficient than a small one

 A large firm could drive out competitors by price cutting – all of them
will go bankrupt
 Natural monopoly = a firm that exhibits diminishing average cost
over a broad range of output levels (firma, která vykazuje snižující se
průměrné náklady v širokém rozsahu výstupních úrovní)
 Other technical barriers:
o Special knowledge of a low-cost method of production
o Ownership of a unique resource
o Possession of a unique managerial talents (vlastnictví
jedinečného manažerského talentu)
2) Legal barriers to entry – legal actions (interventions) by the government – may

prohibit the other firms, on the market can be only our firm
 Administrative monopoly is created by legal action (created by law)
 The government can award an exclusive license (výhradní licence) or
franchise (povolení)
o For reasons like "ensuring quality standards" – zajištění
standardů kvality
 Monopoly on certain intellectual property (like industrial technology)
can be awarded through a patent (monopol na určité duševní
vlastnictví může být udělen prostřednictvím patentu)
o Patent makes innovation profitable, encourages technical
advancement/progress (podporuje technický pokrok)
Profit Maximization of Monopoly (both types)

 Monopoly maximizes profits:
MR = MC
 A firm that is not a price taker faces a downward-sloping demand curve for its products
 Monopoly has to reduce the selling price in order to sell more goods! (difference between
monopoly profit and profits at competitive markets)  the only way how to sell good is to
make good cheaper (than we can sell more stuff)
MR < P
Examples:
 Q1 = 4, P1 = 250 000  TR1 = 1 mil.
 Q2 = 5, P2 = 200 000  TR2 = 1 mil.

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 because MC = 0
 profit maximization and price determination in a monopoly market:
Revenue and Price Elasticity
Marginal Revenue and Price Elasticity

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If the MC = 0  the price elasticity of demand in this area needs to be 0 too
If we go to the left, MR > 0  the higher part of demand will be elastic and the other part will be
inelastic
Marginal Revenue Curve

 Demand curve = average revenue curve (AR = P)
 Marginal revenue curve (mezní/vedlejší příjem) – shows revenue yielded by the last unit sold
o Based od D-curve
o If D-curve shifts, MR-curve also shifts
 Marginal revenue Curve & Demand Curve:
 left elastic, right inelastic

 Natural monopoly – you will never go to the inelastic curve
Natural Monopoly
 Natural monopoly = diminishing AC over a broad range of output levels
o Optimal number of firms in the industry is one!
Profit Maximiziation and Price Determination: Natural Monopoly

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MR – falling faster than AR (average revenue curve)

Decreasing MC  it draw the average cost (AC) down  it may happen that AC can at on point start
increasing:
1) optimum output: MR = MC  intersection shows us what the optimum output is going

to be! – how much we should produce
2) from the intersection we will go vertically up and the intersection the vertical line and AR
(D) is the optimal price at we can sell the products  when we reach the demand curve
(P*,Q*)
3) the intersection of the vertical line and AC means the average costs!
 Between points 2 and 3, there is a profit!  P - AR = π/Q
 long run economic profit (which is called monopoly rent in long

run)
Administrative Monopoly
 Administrative monopoly = based on an exclusive license, or patent
o Permitted number of firms in the industry is one!
Profit Maximiziation and Price Determination: Administrative Monopoly

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 MC is increasing, AC is increasing also in a competitive market due to the shape of MC!!

 MR = MC – the optimum output
 The highest part that we can sell (D a Q* intercept) – red point
 Profit – above ACQ*
Monopoly Power & Monopoly Rents

 Monopoly power = ability to raise price above marginal cost
 Monopoly rents = profits a monopolist earns in the long run
No Supply Curve for a Monopoly

 No single curve can capture the monopolist’s supply decision! = NO SUPPLY
 each demand curve is a unique profit-maximizing opportunity
 supply decision is based on MR rather than demand directly
 monopoly does not have a single supply curve:
What’s Wrong with Monopoly

 Perfectly competitive, constant cost industry as a benchmark – konkurenceschopné odvětví
s konstatními náklady jako měřítkem
o Monopoly distorts the resource allocation (narušuje přidělování zdrojů) – makes us to
lose the resources

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o Monopoly restrict their production to maximize profits (monopoly omezují výrobu,

aby maximalizovali zisk)
 output is too low, some mutually beneficial transactions are missed (vzájemně
prospěšné transakce chybí)
Effects of Monopoly on Allocation and Distribution
Graph:
 DWL = deadweight loss (náklady mrtvé váhy) – output reduced from Q** to Q*
 Simply case: MC = AC
 Economic rent for monopoly = transfer from consumers (there has to be point M on the D
curve)
 DWL = we will make the market smaller than it is  if we want to reduce DWL, we could, but
we will have smaller profit
 Misallocated resources

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Monopoly profits depend on the relationship between the demand and average cost curves
Natural Monopoly and Public Policy

Objections to Profit-Maximizing Natural Monopoly (námitky k maximalizaci zisku)
 Fairness objection (námitka spravedlnosti) = the producer earns a monopoly rent
 Efficiency objection (námitka účinnosti) = the price is above marginal cost, resulting in DWL
Fairness and Efficiency: Natural Monopoly

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Regulation Eliminating Monopoly Profit
 target is monopoly rent

 AC = Preg  small DWL
Regulation Eliminating Monopoly Inefficiency

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MC = Preg  no DWL ! BUT AC > MC  economic loss (and we don’t want to cancel production of
monopoly, because we need water and electricity  not easy case!)
 Two-Tier Pricing Systems
 Monopoly is permitted to charge some users a high price and charge "marginal" users a low
price
 Under this system, monopoly profits balance the losses (monopolní zisky vyvažují ztráty)
9.přednáška
Price Discrimination

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 Price discrimination = identical units of output are bsold at different prices

o Open new profit opportunities
Targets for Price Discrimination
 Opportunities for profit increase:

I. The remaining consumer surplus (zbývající přebytek spotřebitele)
II. The possibility of mutually beneficial trades otherwise lost to DWL (deadweight loss)
(možnost oboustranně prospěšných obchodů jinak náklady mrtvé váhy)
Types of Price Discrimination

 1st- degree (perfect) price discrimination = each unit of output is sold at a different price
according to a buyer’s willingness to pay
o Selling each unit of output for the highest price obtainable. Extracts all of the
consumer surplus available in a given market (rozšiřuje veškerý spotřebitelský
přebytek dostupný na daném trhu)
nd
 2 - degree price discrimination = the price paid by a buyer varies with the quantity
demanded by the buyer
o 6x  10/q (per unit)
o 60x  8/q
o  same prices for everyone
rd
 3 - degree price discrimination (market separation) = price differs across buyer groups
o Different prices for different individuals
Price Discrimination – Conditions

 The conditions that enable (umožnit) price discrimination:
1) Ability to determine consumers’ willingness to pay
2) Ability to prevent arbitrage between different buyers  means somebody will buy
product for a low price and he will resell (přeprodat) it for the higher price
 Monopolies want always to price discriminate – but it is not always possible
Market Separation
 Consumers separated into two (or more) categories  different prices
o More inelastic demand, higher WTP  ↑P
o e.g., textbook publishers
Price Discrimination in a Separated Market

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MR1 falling faster than demand (AR1= D1)

AR1=D1 – foreigners -
AR2=D2 – Czech – low willingness to pay  M2 falling faster than demand (AR2=D2)
Price P1 and Q1 - foreigners
P2 and Q2 – Czech
 Different prices to Czech people and to foreigners
 3rd degree price discrimination
 If two markets are separate, a monopolist can maximize profits by selling its product at different
prices in the two markets.The firm would choose that output for which MC=MR in each of the
markets. The diagram shows that the market that has a less elastic demand curve is charged the
higher price by the price discriminator.
Perfect Price Discrimination

 = 1st- degree price discrimination
 = all consumer surplus is appropriated by the monopoly (veškerý přebytek spotřebitele je
přisouzen monopolu)
 No DWL  means no economic efficiency (efektivnost)
 0 consumer surplus
D = MR decrasing!!! (not D=AR like usual)

 the lowest price is equal to MC of production (Pmin=MC)
 bigger profit than usual  situation is efficient, no consumer surplus
Recommended: Chapter 5 z učebnice!!!! To the test

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Chapter 5
Game Theory
Učebnice str.175-209
 viz prezentace v pc na ploše
Chapter 12
Imperfect Competition
Games of Strategy
 Perfect competition = parametric interaction (in perfect competition there is no value in
strategic consideration) – actions of firms determine market situation, parameters of decision
making
 Monopoly = decision, no strategy (for monopoly the profit maximization is also a question of
a decision, not strategy)
 With oligopoly:
o = a market with few firms but more than one
1) there are competitors (other rational, profit-maximizing firms)
2) individual firms influence the parameters of the common situation (jedinotlivé
firmy ovlivňují parametry běžné situace)
 interaction becomes strategic
Pricing of Homogenous Goods

 Setting: Market, low number of firms, a single homogenous good
 General assumptions:
o Demanders are price takers
o No transaction or information costs
o Fixed number of identical firms
  Single equilibrium price
Competitive Outcome
 One extreme: firms compete in setting prices (firmy soutěží při stanovování cen)  it leads
to competitive outcome
o P = MC (a firm will produce where price equals marginal costs)
o Resembles perfect competition (připomíná dokonalou konkurenci)
o  Bertrand model = An oligopoly model in which firms simultaneously (současně,
zároveň) choose prices
Perfect Cartel Outcome

 The other extreme: firms act in unison as a cartel (firms as a group may act as a cartel,
coordinate their decision – podniky jednají jako kartel)
o Deal made about outputs and profit shares (podíly na zisku)
o Perfect cartel = achieves the highest possible profit
o  Collusion model
Pricing Under Imperfect Competition

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 Qc and Pc perfect competition outcome

 yellow triangle DWL
 Market equilibrium under imperfect competition can occur at many points on the demand curve.
In this figure, which assumes that marginal costs are constant over all output ranges, the equilibrium
of the Bertrand game occurs at point C, also corresponding to the perfectly competitive outcome. The
perfect-cartel outcome occurs at point M, also corresponding to the monopoly outcome. The
equilibrium of the Cournot game might occur at a point such as A.
Nash Equilibrium
 Best response = strategy that produces the highest payoff for a player given what the other
player is doing (strategie, která produkuje největší výnos pro hráče, daného tm, co dělá
druhý hráč)
 Nash equilibrium = set of strategies, one for each player, that are each best responses against
one another (‘’mutual best response’’ - vzájemné)
Duopoly
 Duopoly = only two firms in the industry
 Cournot model = a duopoly where each firm decides on the level of output, taking the other
firm’s output as given (přičemž výstup druhé firmy je daný)
o named after French mathematician
Cournot model

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 = An oligopoly model in which firms simultaneously choose quantities

 Let’s star with a monopoly, we already know it
 Assume:
o Zero costs
o Inverse demand curve: P = 120 – Q
 Monopolist’s Output Choice
Cournot Duopoly
 Now let’s bring in a second firm…  Cournot model
o Firm A chooses its output level (qA) assuming the output of firm B (qB) is fixed
o Market output:
o Demand for A’s product:
 For profit maximizing output, MRA = MCA
 Beware! The optimum output of A depends on the output of B
is a best-response function (or reaction function)

 how much one firm will produce given what the other firm produces
Cournot Duopoly: Best-Response Functions

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 Equilibrium – expectations are correct
 Firm B, being identical with A, has a symmetrical B-R function:
Cournot Equilibrium
 Nash equilibrium of the Cournet model (‘Cournet-Nash Equilibrium’)
o Each firm makes the correct assumption about what the other firm will produce
o P & π above PC level, below monopoly level
Collusion
 C-N equilibrium profits – not the largest that the firms can earn in total
 Agreement to reduce output  increase in profits
o There are profit incentives (ziskové pobídky) for both firms to cooperate by lowering
their output
o Making such an agreement is called collusion (koluze, tajná dohoda) and firms are
called cartel
o A collusion is unstable due to its prisoner’s dilemma, cheating is being the dominant
strategy (koluze je nestabilní kvůli dilematu vězňů, podvádění je dominantní strategií)
10.přednáška

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Collusion
 C-N equilibrium profits – not the largest that the firms can earn in total (π > 0 in Nash
equilibrium)
 Agreement to reduce output  increase in profits
 For the firms there is motivation to colleague
Cournot Duopoly with Isoprofit Curves
 C – equilibrium  only stable point

 Isoprofit = the same profit (like isocost)  πA  unstable situation
 B – another isoprofit curve πB
 Different combinations of good of two firms which has the same equilibrium
 Monopoly point – crossing the end of RFA and qA
 Closer the isoprofits are to monopoly point  means that the bigger profit you get
 For B – monopoly point is on the other end of RF B and qB
Collusion Increases Profits for Both Firms
 Instead of MA and MB 60 – we will cut monopoly profit in half and we divide it to each firm to
30
Collusion
 Profit incentives to cooperate by lowering output (ziskové pobídky spolupracovat snížením
výstupu)
  collusion (tajná dohoda), cartel
 Beware! The firms cannot do worse by colluding than without it
Is a cartel stable?

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 Each firm has a profit incentive to cheat by increasing its output according to its B-R
function
o Cheating in cartel is the dominant strategy (strategy, that rational producer always
chooses)  collusion is unstable
o Prisoner’s dilemma:
 Payoff Matrix – show all the possibilities that may come out of the game
 A – player A (red numbers – profits of A)
 B is going to hold agreement – A will cheat, because it is better for it
 Dominant strategy – in whatever B is doing, A will always be cheating –
always it is better (and it works also in opposite way) (=best response to all of
the other player’s strategies)
 Cournot-Nash Equilibrium – difficult to cooperate a trust to each other –
both firms will cheat
Cheating is More Profitable Than Cooperating
 30x30 situation – not the best response

 B keeps the deal  A will produce 45, it is our best response (B will produce 30)
The Order of Play

 Cournot model – firms choose their output levels simultaneously (současně, zároveň)
o Competition as a simultaneous game
o Output levels as the strategic variables
 What if A choose its output level first and then firm B responds?
o Firm A is then a leader (moves first), firm B is a follower (moves second)
o Competition as a sequential game
o Output levels remain the strategic variables
Stackelberg Oligopoly

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 Sequential games with a leader and a follower are von Stackleberg games
 Stackleberg equilibrium = subgame-perfect equilibrium of the sequential (následující) version
of the Cournot game
 Sequential games can be solved using backward induction (we want to solve it from the end
– depends on response of the other side (B-the follower), on this response we choose the
action, we use the response for our advantage, quantity to our advantage!)
 Question: what is the best response of the follower, firm B?
Answer: choose 
 Firm A knows this, anticipates B’s reaction
 The leader makes a profit at least as large as its C-N equilibrium profit
Stackelberg Oligopoly:
o Leader may choose qA,C  B the other point

o Increase of output  push the follower to choose a higher output  form S to C
o Follower produce less, leader produce more (uses the advantage of being a leader)
o Different than Cournot-Nash Model! (there are the same firms, in here there is
leader, who has better options and follower)
Price Competition
 What if firms copete using price-setting strategies?
o Games in which firms use only price strategies and play simultaneously are Bertrand
games (price strategy – at Cournot model there we are talking about quantity)
Bertrand Games

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 Bertrand model = An oligopoly model in which firms simultaneously choose prices (two firms
in industry, the same like Cournot model)
 Assumptions:
o Each firm’s MC is constant at level ‘c’
o Homogeneous output
o Firms simultaneously set their prices
o No capacity constraint for the firms (žádné omezení capacity = capacity constraint =
a limit to the quantity a firm can produce given the firm’s capital and other available
inputs)
 Nash equilibrium where P = MC, i.e. P = c
 Proof, part I:
 suppose one firm sets its price higher than another firm’s price
 then the higher-priced firm would have no customers
 therefore, at an equilibrium, all firms must set the same price
 Proof, part II:
 Suppose the common price set by all firms is higher than marginal cost c
 then one firm can just slightly lower its price and sell to all the buyers,
thereby increasing its profit
 hence, the only common price which prevents undercutting is equal to c
(this is the only Nash equilibrium = the Nash equilibrium of thissecond-stage
game is for firms to choose the price at which quantity demanded exactly
equals the total capacity built in the first stage)  PA = PB = c (capacity)
 with using backward induction:

 PA = PB > c (there is not Nash equilibrium, because total sales fall
short of capacity. At least one firm (say, firm A) is selling less than its
capacity. By cutting prices lightly, firm A can increase its profits by
selling up to its capacity, qA)
 PA = PB < c (there is not Nash equilibrium, because at this price, total
quantity demanded exceeds total capacity, so firm A could increase
its profits by raising prices lightly and still selling q A)
Bertrand Paradox
 Nash equilibrium of the Bertrands model is the same as the perfectly competitive outcome
o P = MC, π = 0
  Bertrand Paradox – could competition be so tough (těžké) with only two firms in the
market?
 Beware! Paradox is not very general – sensitive to assumptions (citlivé na předpoklady)
o E.g. assumption of no capacity constraints
Chapter 13:

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Input Markets I: Pricing

Demand for Inputs
Marginal Productivity Theory of Input Demand
 Input prices are also determined by the forces of supply and demand
o Firms: demand side, households: supply side!!! (other than usual)
o Theory of input demand relies on (spolehá na) Ricardo’s theory of marginal
productivity
Profit-Maximizing Behavior: Inputs

 π – max: hire more of any input ‘I’ until 
 MEK, MEL = marginal expense of hiring capital a labor (marginal expense = marginal factor
cost)
 Also often called marginal factor cost (MFC) (like marginal cost) = additional cost of hiring
one input (capital of labor)
Profit-Maximizing Behavior and the Hiring of Inputs

 MRK, MRL = extra revenue from hiring an additional unit of capital, labor
o π-max:
Price-Taking Behavior
 Price taking in the input market:
v…rental rate
w…wage rate
Marginal Revenue Product

 Marginal revenue product of labor and capital (MRL, MRK) is the extra revenue obtained from
selling the output produced by hiring an extra worker or machine
 Marginal product (MP) is how much output the additional input can produce
 Marginal revenue (MR) is the extra revenue obtained from selling an additional unit of
output
A Special Case – Marginal Value Product

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 If the firm is also a price taker in the goods market, MR = P

 Then,
 conditions for profit maximization
Marginal Value Product

 Marginal value product (MVP) of capital and labor is a special case of marginal revenue
product in which the firm is a price taker in the output market
o For price taker in both input and output market therefore:
Changes in Input Prices: Short Run

 SR: fixed capital and variable labor (we use law of the diminishing returns from previous
lectures!)
 Labor will exhibit diminishing marginal physical productivity  decreasing MVPL
Changes in Input Prices: Single Variable Input Case:
11./12. přednáška

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……………………………..
Decrease in Price of Labor (Long Run)
Graf:
From E to A  substitution effect
Relative prices influence the firm’s decisions
Shift to q2  point F = new equilibrium
Less capital, less labor  OE output effect (from A to F)
Firm does not have the budget!!!
Decrease in Price of Labor: Output Choice

Graf:
MC decrease
Price remains the same  increase in output (there will be the outcome(=output) effect)
Firm’s Demand for Labor: A summary

 A fall in the wage rate will cause the firm to hire more labor:
o 1. The firm will substitute the now relatively cheaper labor for other inputs (SE)
o 2. ↓w ↓MC, so the π-max firm ↑q which requires hiring more labor (OE)
o When is the SE and OE weaker and stronger in textbook!!!
Input Supply
Allocation of Time
 People must choose how to allocate their available fixed time between work and other
activities
 We can divide time in work and other activities
Labor Supply and Wages

 For individuals, wages represent the opportunity cost of not working at a paying job
o Individuals will balance the rewards from working against the psychic benefits of
other, nonpaid activities – leisure (everything what is not paid – e.g. sleeping)
A Simple Model of Time Use

 Assume:
o Two users of time: (paid) work and leisure (nonpaid)
o U = U(C,H)
 C = consumption of market goods
 H = amount of leisure time
 indifference map – based on the utility function here
 The opportunity cost of leisure = the real wage rate determined in the market, i.e., the
consumption given up
o An extra hour of leisure costs one hour’s wage (w)
Utility From Leisure and Work

Graf:
Constraint
 Enjoy up to 24 hours of leisure by not working  horizontal intercept
 Working, you can spend up to 24 * w on consumption  vertical intercept
 Slope of the constraint = - w

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Utility-Maximizing Choice of Leisure and Work

Graf:
A = optimum  slope of indifference curve is the same like slope of the constraint
Substitution Effect of a Change in Wage (w)

 Substitution effect of the change in w
o ↑w  ↑OC of leisure (bigger opportunity costs of leisure)  causes an individual
to work more
Income Effect of a Change in Wage (w)

 Income effect of a change in w
o If leisure is a normal good, higher income will increase the demand for it  ↑w will
cause an individual to work less
Substitution & Income Effect: Increase in Wage

Graf:
Individual Labor Supply

 Beware! It is very likely that an increase in the wage will result in more labor supplied in the
market, but this does not have to hold for an individual’s labor supply
Individual Labor Supply: Subtitution Effect May Not Always Prevail

Graf:
Individual supply curve is increasing
People with very low wages and a lot leisure
Market Supply Curve for Labor

 A market supply curve: horizontal sum of the individual supply curves
o Increasing (most probably)
o 1. If SE generally exceeds IE, most individual labor supply curves will have positive
slopes
o 2. Rising wage will induce people to enter the labor force
Equilibrium in An Input Market

Equilibrium in the Labor Market
Graf:
Shifts in Demand and Supply

 Any factor that shifts the firms’ underlying production function will shift its input …………….
 ……………….
Chapter 14:
Input Markets II: Capital and Time
Time Periods and the Flow of Economic Transactions
 Let us get rid of the continuity of time and divide it into ‘periods’
 Transactions can occur across periods
o Durable goods = they work for more than one period of a time
o Borrowing/lending money = actions that consider time periods
Supply of Loans

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Individual Savings
 Saving frees up resources
o  investment goods (capital)
o We save the resources and somebody will use it for investments
Two-Period Model of Saving

 Setting: Two periods, utitlity maximizing consumer (I am saving to maximize my utility)
 C1 … consumption this year
 C2 … consumption next year
 Y … income this year (next year  zero income!  I = 0)
 Saved income earns interest (at a real interest rate, r) (real interest rate is always positive!)
Vzorec:
The Utility-Maximizing Savings Decision

Graf:
C2 … future consumption
Budget constraint  Y*(1+r) (whole income saved)
He could spend Y, but he spends C1*
Substitution Effect of a Change in r
Discounting
 Transactions that take place at different times cannot be compared directly
 ……………………………….
 No inflation!!!
Single-Period Discounting
 Two period model:
o A dollar invested today will grow by a factor of (1+r) next year
o the present value of a dollar that will not be received until next year is vzorec dollars
 Present value =
Present Value and Economic Motives

 Modification of a firm’s objective: maximize the present value of all future profits
 For individuals, present value enters the utility maximization decision through the budget
constraint
 Individuals also discount the future: incorporated in U-f
Utility-Maximizing Decision: Income in Both Periods

Graf:

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I) Input Markets
Firms' demand for capital and loans

 The profit maximizing firm will rent additional capital equipment up to the point at which
marginal revenue product of the equipment is equal to the real rate on the equipment
 V = MRk
Rental Rate and Interest Rate

 The per-period rate that firms have to pay to rent the equipment will be determined by the
average costs that the rental firms have to carry
 Costs of the equipment are:
o Borrowing costs are the explicit or implicit opportunity costs for the funds tied up to
the equipment
o Depreciation costs reflect the wear and tear
o Depreciation (d) and borrowing (=interest) costs ®, price of the equipment rented (P)
… rental rate (v)
 V = d*P+r*P = (d+r)*P
Ownership of capital equipment

 Firms that own equipment are really in two businesses
o They produce goods
o The lease capital equipment to themselves
o The implicit rates they pay for leasinf capital equipment are the same as for a firms
that rents such equipment
Determination of the Real Interest Rate

 The supply of loans is assumed to be an upward sloping function of the interest rate

Microeconomics I Lecture Notes 1 11

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Microeconomics I Lecture Notes 1 11

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Microeconomics I - Lecture notes 1-11

Microeconomics I. (Vysoká škola ekonomická v Praze)

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The production possibility frontier (hranice produkčních možností)

An Econimic Way of Thinking

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Positive & Normative Economics

Economic model for market

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o Can utility be measured?

o Ceterus Paribus Assumption (CPA)

o Simple model of choice - utility from consuming two goods

 Assumptions about Utility (preferences)

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More Is Better: Defining an Economic "Good"

A .. no fish and no cocoa nuts, no x and y

Indifference Curves (IC) – combinations of x and y

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Completeness (úplnost grafu) : A >_< B (A vetší, menší nebo rovná se B)

 F is worse than C – everything inside is worse (under the IC)

Marginal Rate of Substitution (MRS) – mezní míra substituce

Change in utility = MUY * ∆Y + MUX * ∆ X

Př. If y = -1 and x = 1  MRS = 1

Marginal Utility (MU) – mezní užitek = U

Diminishing Marginal Rate of Substitution – snížení MRS

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o MRS usually diminishes(diminišis) along an indifference curve moving from left to

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Specific Preferences I: Not all stuff is good

o If you dislike something it is "bad"

 Indifference Analysis: ‘Bads’ and ‘Neutrals’:

1st graph  neutral good = useless good

Special Preferences II: Extreme Cases of Substitutability

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 The ratio does not have to be one-on-one

 IC Maps for Perfect Substitutes and Perfect Complements:

Choices are Constrained

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Budget Constraint: A case with Two Goods

Budget constraint equation:

 when you spent all your money on goods = Budget Constraint

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Budget Constraint & Opportunity Cost

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 Utility Maximization in a Diagram:

 bundle D – very attractive, but it is not affordable

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 Bundle C: U2 is tangent to the budget line

 slope of BC = slope of IC = the optimum Necessary condition:

‘Bads’ and ‘Neutrals’ Will Not Be Purchased

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Extreme Cases of Substitutability Also Lead to Specific Optima

Composite Good (CG) (kombinované zboží):

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x = f (Px, Py, I, preferences)

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 single solution (single optimum) you can choose

2 types of normal goods:

Inferior Goods (méněcenné statky)

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