MICRO ECONOMICS

Micro Economics

Micro Economics

Part (A)

The law of diminishing returns deals with how output changes when one input is varied and the others are held constant. It is, therefore, a short run phenomenon--and does not hold in the long run. The law of diminishing returns deals with physical quantities; none of the components is measured in dollars. Output is measured in three ways: total physical product (TP), average physical product (AP) and--guess what--marginal physical product (MP). AP is TP divided by the quantity of variable input and MP is the change in TP divided by the change in the quantity of variable input.

The law of diminishing returns tells us that TP, AP and MP will all eventually decrease. Decreasing MP is of much greater importance to us than the others, as you will see later on. To grasp why TP eventually decreases, remember the example in class of the farm where we had fixed land and capital and varied labor. Eventually TP would have to decrease; otherwise we could just keep adding labor and be able to grow enough food for the whole world on our small farm.

We index cars by j = 0, 1, 2, which are, in that order, outside good, new car, and used car. We denote by d ? [0, 1] the probability characterizing the process of stochastic death.

In what follows, we describe the model and derive the equilibrium. We consider consumers' and firms' problem in partial equilibrium and then require full equilibrium by clearing all markets and formulating correct expectations on both sides of the market. For consumers' problem, this implies that, for now, consumers take the sequence of prices as given.



Part (B)

Next we use the production relationships explained above to derive short run cost schedules and cost curves. Cost schedules and curves show the cost of producing various levels of output. We want to end up with cost curves where the output is on the horizontal axis and the cost in dollars is on the vertical axis.

We will end up with a total of seven short run cost concepts: total cost (TC), total fixed cost (TFC), total variable cost (TVC), average total cost (ATC), average fixed cost (AFC), average variable cost (AVC) and marginal cost (MC). To get from production to cost, we use the production data above. The other ingredient we need is the price (or cost) of the inputs. We will use the total product data we used earlier (which is not the same as the numbers used in class). Assume the labor costs $5 per laborer and that the cost of the fixed inputs is $10. That's all we need to construct a total cost curve.

Rather than introduce budget lines for the two consumers, the Edgeworth box uses the concept of initial endowments. An initial endowment 'w' represents the amount of commodities X & Y individuals A & B have available before trade. The height of the Edgeworth box represents the total amount of commodity 'Y' available and the width of the ...