d: Discuss the characteristics of consumer indifference curves.

More is preferred to less. Higher indifference curves represent greater absolute utility than lower curves.

Goods are substitutable. Therefore, indifference curves slope downward to the right.

The utility of a good declines the more of it you consume. Therefore, indifference curves are convex when viewed from below.

There are an infinite number of indifference curves.

Indifference curves cannot intersect.

e: Discuss the role of the consumption-opportunity constraint and the budget constraint in indifference curve analysis.

Consumers have budget constraints. These constraints separate the consumption opportunities that can be obtained from those that cannot be obtained. The optimal level of consumer satisfaction will be the tangency point between the budget constraint line and the highest obtainable indifference curve.

This analysis applies both in the cases of barter and an economy with money. In the money economy, the budget-constraint line applies. In a barter economy, the consumption –opportunity constraint line applies. This line indicates different bundles of goods that can be acquired (3 fish and 4 loaves of bread or 6 fish and 2 loaves of bread, etc.). In either case, it is the relative price of each good, which determines the slope of the line, and thus the optimal level of consumption of each good or bundle of goods.

f: Describe, and distinguish between, the income effect and the substitution effect.

The income effect: As the price of a good drops, your real income rises and you will consume more of that good (and other goods). The income effect occurs when the budget line shifts in or out.

The substitution effect: If a good becomes cheaper relative to other goods, you will consume more of that good. The substitution effect occurs when the price of one good relative to another increases.

Key point: Under the substitution effect, you will consume along the same indifference curve, whereas under the income effect, you will consume along a different indifference curve.

2.B: Costs and the Supply of Goods

a: Describe the principal-agent problem of the firm.

Principal-agent problem - the agent (management) may be working for different objectives than those of the principal (owner). The essence of the problem is that it is difficult or costly for the principal to monitor the actions of the agent. There is an incentive for the agent to "shirk".

b: Distinguish between (1) explicit costs and implicit costs, (2) economic profit and accounting profit, and (3) the short run and the long run in production.

Explicit costs are measurable cash flows for operating expenses. Implicit costs measure the opportunity cost of using a firm's assets. The opportunity cost of a machine or labor is the highest return available from an alternative use. Business owners must ask themselves, “what was the highest return available from the funds that we used to buy our latest machine?”

Economic profit includes both the explicit and implicit cost components of the firm, while accounting profit ignores implicit costs such as the opportunity cost of equity capital. Accounting profits are generally higher than economic profits. When the firm’s revenues are just equal to its costs (explicit and implicit, including the normal rate of return) economic profits will be zero.

In the short-run, it is difficult to alter production methods. The short-run is defined as that time period in which the size of plant and equipment cannot be changed. The length of the "Short-run" varies from industry to industry. The long-run allows the firm to change all of its production methods and resource uses. In the long-run, all resources are variable.

c: Define various types of costs, including opportunity costs, sunk costs, fixed costs, variable costs, marginal costs, and average costs.

Fixed costs, sometimes called sunk costs, remain unchanged in the short-run.

Average fixed costs are fixed costs divided by output. Average fixed costs decline as output increases.

Variable costs are costs (like wages and raw materials) that vary with output.

Average variable cost = variable cost divided by output.

Average total cost = total cost (fixed and variable) divided by the number of units produced.

Marginal cost is the cost of producing an additional unit of output. The marginal cost is the opportunity cost of the last unit produced.

d: State the law of diminishing returns and explain its impact on a company's costs.

The law of diminishing returns states that as more and more resources (such as labor) are devoted to a production process, they increase output but at an ever decreasing rate. For example, if an acre of corn needs to be picked, the addition of a second worker is highly productive. But if you already have 300 workers in the field, the productive capacity of the 301st worker is not near that of the second worker. At some point the workers begin bumping into one another.

e: Define economies and diseconomies of scale, explain how each is possible, and relate each to a company's long-run average total cost curve.

Are large firms more efficient than small firms? It depends on the industry.

Three reasons why unit cost declines as output or plant size increases:

Mass production,

Specialization of labor and machinery, and

Experience.

Economies of scale are present when unit costs fall as output increases. Diseconomies of scale are present when costs rise as output increases.

f: Describe the factors that cause cost curves to shift.

Changes in resource prices

Changes in taxes paid

Changes in regulations that increase costs

Improvements in technology that lower production costs

Each of these factors changes the marginal cost of a unit of output. Lower input prices, lower taxes, and better technology all lower the marginal cost for the firm. This will, in turn, lower the AVC and ATC.

2.C: Price Takers and the Competitive Process

a: Distinguish between price takers and price searchers.

Price takers have small output relative to the market. They can sell all of their output at the prevailing market price. However, if they set their output price higher than the market price, they would sell nothing. The term "price-taker market" means the same thing as "purely competitive market."

Price searchers have downward sloping demand curves. They can set their own prices, and the higher the price, the less they will sell.

b: Discuss the conditions that characterize a purely competitive market.

Pure competition assumes the following characteristics:

All the firms in the market produce a homogeneous product.

There are a large number of independent firms.

Each buyer and seller is small relative to the total market.

There are no barriers to entry or exit.

Producers must sell their product at the going market price or be shut out of the market. The market's (not the individual firm’s) supply and demand determines the price. Under pure competition, individual firms have no control over price. Thus, the firm’s demand schedule is perfectly elastic, horizontal.

c: Explain how and why price takers maximize profits at the quantity for which marginal cost = price = marginal revenue.

In the short run, a firm will continue to expand production until marginal revenue (MR) = marginal cost (MC). Marginal revenue (change in total revenue divided by change in output) is the revenue obtained from selling one more unit of output. In the pure competition case, since the market price is constant, the firm's marginal revenue is constant. This means the firm's marginal revenue curve is flat and overlapping the demand curve, so d = p = MR.