• How do producers decide:

  • which products to produce
  • in what quantity
  • using which inputs
  • and sold at what price?

• Answers to these questions are building blocks for supply curves

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

• Consumption is the using up of value to gain utility

  • Consumption is the ultimate goal of all economic activity

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

• Iron Ore $\to$ Steel $\to$ Buildings, Bridges, Ovens, Water Bottles

• Supply is actually Demand in disguise!

• An (opportunity) cost to buy (scarce) inputs for production because other people demand those same inputs to consume or produce other valuable things!

  • Price necessary to pull them out of other valuable productive uses in the economy!

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

• “Autarky”: complete self-sufficiency; no exchange with others

• Anything he wants to consume, he must first produce by himself

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

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

• Slope of PPF called “marginal rate of transformation” (MRT)

  • can just call it marginal cost

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

• So a more-fully curved PPF

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

• So a more-fully curved PPF

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

  • Producing more Bananas, $(A\to B)$, slope gets steeper
  • Producing more Coconuts, $(A\leftarrow B)$, slope gets flatter

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

• At this point: $$\underset{\text{PPF slope}}{\underset{}{MRT}}=\underset{\text{I.C. slope}}{\underset{}{MRS}}=\underset{\text{price line}}{\underset{}{\frac{p_b}{p_c}}}$$

  • MC = MB = price

• Now suppose he has the opportunity to trade with others

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

• Now suppose he has the opportunity to trade with others

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

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

  • B is his productive optimum

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

1. Trade is good

2. Specialization and exchange

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

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

  • A legal fiction for particular purposes

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

  • Craft guilds
  • Independent artisans
  • Independent contractors

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

• So what do firms do?

• How would we set up an optimization model:

1. Choose: < some alternative >

2. In order to maximize: < some objective >

3. Subject to: < some constraints >

• Technology or a production function: rate at which firm can convert specified inputs $(x_1,x_2,\cdots ,x_n)$ into output $\left(q\right)$ $$q=f(x_1,x_2,\cdots ,x_n)$$

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

• We will assume firms maximize profit $\left(\pi \right)$

• Not true for all firms

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

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

  • Examples: goodwill, sustainability, social responsibility, etc

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

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

• Suppose firm sells output $q$ at price $p$

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

• Suppose firm sells output $q$ at price $p$

• It can buy each input $x_i$ at an associated price $p_i$

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

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

• Suppose firm sells output $q$ at price $p$

• It can buy each input $x_i$ at an associated price $p_i$

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

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

$$\pi =\underset{revenues}{\underset{}{pq}}-\underset{costs}{\underset{}{(wl+rk)}}$$

$$\pi =\underset{revenues}{\underset{}{pq}}-\underset{costs}{\underset{}{(wl+rk)}}$$

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

$$\pi =\underset{revenues}{\underset{}{pq}}-\underset{costs}{\underset{}{(wl+rk)}}$$

• Profits are the residual value leftover after paying all factors

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

  • Entrepreneurs
  • Shareholders

$$\pi =\underset{revenues}{\underset{}{pq}}-\underset{costs}{\underset{}{(wl+rk)}}$$

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

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

  • Starting and owning a firm is inherently risky!

• In markets, production must face the profit test:

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

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

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

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

• So what do firms do?

1. Choose: < some alternative >

2. In order to maximize: < profits >

3. Subject to: < technology >

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

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

• Prices?

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

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

• Begin with one extreme case: “perfect competition”

  • Firms can choose to sell as much $q^{\ast }$ as they want
  • Firms are constrained to sell at the (exogenous) market price $\overline{p}$

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

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

• Put Supply and Demand together

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

  • e.g. $(\Delta p_x$, $\Delta p_y$, $\Delta m$)

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

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

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

• Examine another extreme case: monopoly of a single seller

  • Appropriate for some markets

• “Imperfect competition”: models of monopolistic competition & oligopoly

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

• Firms can choose both $q^{\ast }$ & $p^{\ast }$ to maximize $\pi$