Firm and Household Decisions

Firm and Household Decisions
• Input and output

markets cannot be
considered separately
or as if they operated
independently.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Partial Equilibrium Analysis
• Partial equilibrium analysis is

the process of examining the
equilibrium conditions in
individual markets, and for
households and firms,
separately.
General Equilibrium
• General equilibrium is the

condition that exists when all
markets in an economy are in
simultaneous equilibrium.
Efficiency
• In judging the performance of an

economic system, two criteria used
are efficiency and equity (fairness).
• Efficiency is the condition in

which the economy is producing
what people want at the least
possible cost.
General Equilibrium Analysis
• To examine the move from partial to

general equilibrium analysis we will
consider the impact of:
• a major technological advance, and
• a shift in consumer preferences.
Cost-Saving Technological Change
• Technology improvements made it possible to

produce at lower costs in the calculator industry.
• As new firms entered the industry and existing firms

expanded, output rose and market prices dropped.
• A significant technological change in

a single market affects many
markets:
• Households must adjust to changing
prices
• Labor reacts to new skill requirements
and is reallocated across markets
• Capital is also reallocated
A Shift in Consumer Preferences
• To examine the effects of a change in one market on other

markets, we will consider the wine industry in the 1970s.
Production and Consumption of Wine in the United States, 1965–1980
U.S.
PRODUCTION IMPORTS TOTAL CONSUMPTION
(MILLIONS OF (MILLIONS OF (MILLIONS OF PER CAPITA
YEAR GALLONS) GALLONS) GALLONS) (GALLONS)
1965 565 10 575 1.32
1970 713 22 735 1.52
1975 782 40 822 1.96
1980 983 91 1073 2.02
Percent change, + 74.0 +810.0 + 86.6 +53.0
1965–1980
Source:
Source: U.S. Department of Commerce, Bureau of the Census, Statistical Abstract of the United States,
States, 1985, Table 1364, p. 765.
Adjustment in an Economy
with Two Sectors
• This graph shows the

initial equilibrium in an
economy with two
sectors—wine (X) and
other goods (Y)—prior
to a change in
consumer preferences.
with Two Sectors
• A change in consumer
preferences causes an
increase in the demand
for wine, and,
consequently, a
decrease in the demand
for other goods.
with Two Sectors
• A higher price creates a

profit opportunity in
sector X.
• Simultaneously, lower
prices result in losses in
industry Y.
with Two Sectors
• As new firms enter

industry X and existing
firms expand, output
rises and market prices
drop. Excess profits
are eliminated.
with Two Sectors
• As new firms exit

industry Y, market price
rises and losses are
eliminated.
Wine Production is an
Increasing-Cost Industry
Land in Grape Production in the United States and in California Alone,
1974 and 1982
NUMBER OF VINEYARDS NUMBER OF ACRES
United States
1974 14,208 712,804
1982 24,982 874,996
Percent change +75.8 +22.8
California
1974 8,333 607,011
1982 10,481 756,720
Percent change +25.8 +24.7
Source:
Source: U.S. Department of Commerce, Bureau of the Census, Census of Agriculture (1974 and 1982), 1, part 51.
Formal Proof of a
General Competitive Equilibrium
• This section explains why perfect

competition is efficient in dividing
scarce resources among alternative
uses.
• If the assumptions of a perfectly

competitive economic system hold, the
economy will produce an efficient
allocation of resources.
The Efficiency of Perfect Competition
• The three basic questions in a

competitive economy are:
1. What will be produced? What
determines the final mix of output?
2. How will it be produced? How do
capital, labor, and land get divided up
among firms?
3. Who will get what is produced? What
is the distribution of output among
consuming households?
• As we will see, in a perfectly

competitive economic system:
1. resources are allocated among firms
efficiently,
2. final products are distributed among
households efficiently, and
3. the system produces the things that
people want.
Pareto Efficiency
• Pareto efficiency, or Pareto

optimality, is a condition in which no
change is possible that will make some
members of society better off without
making some other members of society
worse off.
• This very precise concept of efficiency

is known as allocative efficiency.
Efficient Allocation of Resources:

• Perfectly competitive firms have incentives to
use the best available technology.
• With a full knowledge of existing technologies,
firms will choose the technology that
produces the output they want at the least
cost.
• Each firm uses inputs such that MRPL = PL.

The marginal value of each input to each firm
is just equal to its market price.
Efficient Distribution of Outputs Among

Households:
• Within the constraints imposed by income
and wealth, households are free to choose
among all the goods and services available
in output markets. Utility value is revealed in
market behavior.
• As long as everyone shops freely in the
same markets, no redistribution of final
outputs among people will make them better
off.
Producing What People Want

—the Efficient Mix of Output:
• Society will produce the

efficient mix of output if all
firms equate price and
marginal cost.
The Key Efficiency Condition: Price
Equals Marginal Cost
If PX > MCX, society gains value by producing more X

If PX < MCX, society gains value by producing less X
The value placed on Market-determined value of

good X by society resources needed to produce a
through the market, or marginal unit of X. MCX is equal
the social value of a to the opportunity cost of those
marginal unit of X. resources: lost production of other
goods or the value of the resources
left unemployed (leisure, vacant
land, etc).
Efficiency in Perfect Competition
• Efficiency in perfect competition follows from a weighing of values by
both households and firms.
The Sources of Market Failure
• Market failure occurs when resources

are misallocated, or allocated
inefficiently. The result is waste or lost
value. Evidence of market failure is
revealed by the existence of:
• Imperfect markets
• Public goods
• Externalities
• Imperfect information
Imperfect Markets
• Imperfect competition is an industry in

which single firms have some control
over price and competition.
• Imperfectly competitive industries give

rise to an inefficient allocation of
resources.
Imperfect Markets
• Monopoly is an industry composed

of only one firm that produces a
product for which there are no close
substitutes and in which significant
barriers exist to prevent new firms
from entering the industry.
Imperfect Markets
• In all imperfectly competitive industries,

output is lower—the product is
underproduced—and price is higher
than it would be under perfect
competition.
• The equilibrium condition P = MC does not
hold, and the system does not produce the
most efficient product mix.
Public Goods
• Public goods, or social goods are

goods and services that bestow
collective benefits on members of
society.
• Generally, no one can be excluded from
enjoying their benefits. The classic
example is national defense.
Public Goods
• Private goods are products produced

by firms for sale to individual
households.
• Private provision of public goods fails. A
completely laissez-faire market will not
produce everything that all members of a
society might want. Citizens must band
together to ensure that desired public
goods are produced, and this is generally
accomplished through government
spending financed by taxes.
Externalities
• An externality is a cost or benefit

resulting from some activity or
transaction that is imposed or bestowed
on parties outside the activity or
transaction.
• The market does not always force
consideration of all the costs and benefits of
decisions. Yet for an economy to achieve
an efficient allocation of resources, all costs
and benefits must be weighed.
Imperfect Information
• Imperfect information is the absence

of full knowledge concerning product
characteristics, available prices, and so
forth.
• The absence of full information can lead to
transactions that are ultimately
disadvantageous.

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Firm and Household Decisions

• Input and output

• Partial equilibrium analysis is

• General equilibrium is the

• In judging the performance of an

• Efficiency is the condition in

• To examine the move from partial to

• a shift in consumer preferences.

• Technology improvements made it possible to

• As new firms entered the industry and existing firms

• A significant technological change in

• To examine the effects of a change in one market on other

• This graph shows the

• A higher price creates a

• As new firms enter

• As new firms exit

• This section explains why perfect

• If the assumptions of a perfectly

• The three basic questions in a

• As we will see, in a perfectly

• Pareto efficiency, or Pareto

• This very precise concept of efficiency

Efficient Allocation of Resources:

• Each firm uses inputs such that MRPL = PL.

Efficient Distribution of Outputs Among

Producing What People Want

• Society will produce the

If PX > MCX, society gains value by producing more X

The value placed on Market-determined value of

• Market failure occurs when resources

• Imperfect competition is an industry in

• Imperfectly competitive industries give

• Monopoly is an industry composed

• In all imperfectly competitive industries,

• Public goods, or social goods are

• Private goods are products produced

• An externality is a cost or benefit

• Imperfect information is the absence

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