G IMPERF
4. Indifference curves are everywhere. We can construct an indifference curve starting from any point on
the diagram. This simply means that any two bundles of goods can be compared by the individual.
5. Indifference curves cannot cross-if they did, rational ordering would be violated. If indifference curves crossed, our postulate that more goods are better than
fewer goods would be violated. Exhibit A2 shows this point. The crossing of the indifference curves implies that points Y and Z are equally preferred because they both are on the same indifference curve as X. Consumption bundle though, represents more of both fish and breadfruit than bundle Z, so Y must be preferred to Z. Whenever indif- ference curves cross, this type of internal inconsistency (irrational ranking) will arise. So, the indifference curves of an individual must not cross.
The Consumer’s Preferred Bundle
Used together with the opportunity constraint of the indi- vidual, indifference curves can be used to indicate the most preferred consumption alternatives available to an in-
dividual. The ~~~~~ ~ ~ t u ~ i t ~ ~ o ~ s t r a ~ ~ ~ sepa- rates consumption are attainable from those
that are unattainable.
Assuming that Crusoe could produce only for himself, his consumption opportunity constraint would look like the production possibilities curves discussed in Chapter 2. What would happen if natives from another island visited Crusoe and offered to make exchanges with him? If a barter market existed that permitted Cmsoe to exchange fish for breadfruit at a specified exchange rate. his options would resemble those of the market constraint shown by Exhibit A3. First, let us consider the case where Crusoe inhabits a barter econ- omy in which the current market exchange rate is two fish to one breadfruit. Suppose that, as a result of his expertise as a fisherman, Crusoe specializes in this activity and is able to bring sixteen fish to the market per week. What consump- tion alternatives will be n to him? Because two fish can
EXHIBIT A 2
Indifference Curves
z=
( 7 , l O ) PI I I I 1
I6
If the indifference curves of an individual crossed, they would show the inconsistency pictured here. Points X and Y must be equally valued, since they are both on the same indifference curve (il). Similarly, points X and Z must be equally preferred, since they are both on the indifference curve (iJ. If this is true, Y and Z must also b e equally preferred, since they are both equally preferred to X. However, point Y represents more of both goods than Z, so Y has to be preferred to Z. W h e n indiffer- ence curves cross, this type of internal inconsistency always arises.
Addendum: Consumer Choice and Indifference Curves 167
,Market or budget constraint 8
market (or budget) constraint indicates that two fish trade for one breadfruit in this barter economy. If Crusoe pro- duces sixteen fish per week, he will trade eight fish for four breadfruit in order to move to the consumption bundle (eight fish and four breadfruit) that maximizes his level of satis- 4
16 Fish
I
faction.EXHIBIT A 3
Consumer Maximization in a Barter Economy
Suppose that the set of indifference curves shown here outlines Crusoe’s preferences. The slope of the
be bartered in the market for one breadfruit, Crusoe will be able to consume sixteen fish, or eight breadfruit, or any combination on the market constraint indicated by the line between these two points. For example, if he trades two of his sixteen fish for one breadfruit, he will be able to con- sume a bundle consisting of fourteen fish and one bread- fruit. Assuming that the set of indifference curves of Exhibit A3 outlines Crusoe’s preferences, he will choose to con- sume eight fish and four breadfruit. Of course, it will be possible for Crusoe to choose many other combinations of breadfruit and fish, but none of the other attainable combi- nations would enable him to reach as high a level of satis- faction. Because he is able to bring only sixteen fish to the market, it would be impossible for him to attain an indiffer- ence curve higher than i,.
Crusoe’s indifference curve and the market constraint curve will coincide (they will be tangent) at the point at which his attainable level of satisfaction is maximized. At that point (eight fish and four breadfruit), the rate at which Crusoe is willing to exchange fish for breadfruit (as indi- cated by the slope of the indifference curve) will be just equal to the rate at which the market will permit him to ex- change the two (the slope of the market constraint). If the two slopes differ at a point, Crusoe will always be able to find an attainable combination that will permit him to reach a higher indifference curve. He will always move down the market constraint when it is flatter than his indif- ference curve, and up if the market constraint is steeper.
As far as the condition for maximization of consumer satisfaction is concerned, moving from a barter economy to a money income economy changes little. Exhibit A4 shows this point. Initially, the price of fish is $1, and the price of breadfruit is $2. The market therefore permits an
exchange of two fish for one breadfruit, just as was the case in Exhibit A3. In Exhibit A4, we assume that Crusoe has a fixed money income of $16. At this level of income, he confronts the same market constraint (usually called a get co~§traint in an economy with money) as in Exhibit A3. Given the product prices and his income, Crusoe can choose to consume sixteen fish, or eight breadfruit, or any combination indicated by a line (the budget constraint) connecting these two points. Given his preferences, Crusoe will again choose the combination of eight fish and four breadfruit if he wishes to maximize his level of satisfaction. As was true for the barter econ- omy, when Crusoe maximizes his satisfaction (moves to the highest attainable indifference curve), the rate at which he is willing to exchange fish for breadfruit will just equal the rate at which the market will permit him to exchange the two goods. Stated in more technical terms, when his level of satisfaction is at a maximum, Crusoe’s marginal rate of substitution of fish for breadfruit, as in- dicated by the slope of the indifference curve at E,, will just equal the price ratio (P,/P,, which is also the slope
of the budget constraint).
What will happen if the price of fish increases? Ex- hibit A4 also answers this question. Since the price of breadfruit and Crusoe’s money income are constant, a higher fish price will have two effects. First. it will make Crusoe poorer, even though his money income will be un- changed. His budget constraint will turn clockwise around point A, illustrating that his consumption options are now more limited-that is, his real income has declined. Sec- ond, the budget line will be steeper, indicating that a larger number of breadfruit must now be sacrificed to obtain an additional unit of fish. It will no longer be possible for Crusoe to attain indifference curve i,. The best he can do is indifference curve i,, which he can attain b
the bundle of five fish and three breadfruit.
I
168 C H A P T E R 7 Consiirnrr Choice und E l a ~ t i c i ~
Suppose that Crusoe’s income is $16 per day, the price of fish (fF) is $1, and the price of breadfruit (PJ is $2. Thus, Cru- soe confronts exactly the same price ratio and budget constraint as in Exhibit A3. Assuming that his preferences are un- changed, he will again maximize his satisfaction by choosing to consume eight fish and four breadfruit. What will happen if the price of fish rises to $27 Crusoe’s consumption opportunities will be reduced. His budget Constraint will turn clockwise around point A, reflecting the higher price of fish. His fish consumption will decline to five units. (Note: Because Crusoe’s real income has been reduced, his consumption of breadfruit will also decline.)
Using the information supplied by Exhibit A4, we can now locate two points on Crusoe’s demand curve for fish.
When the price of fish was $1, Crusoe chose eight fish;
when the price rose to $2, Crusoe reduced his consump- tion to five (see Exhibit A5). Of course, other points on Crusoe’s demand curve could also be located if we consid- ered other prices for fish.
The demand curve of Exhibit A5 is constructed on the assumption that the price of breadfruit remains $2 and that
-
Crusoe’s money income remains constant at $16. If either of these factors were to change, the entire demand curve for fish, shown by Exhibit A.5. would shift.
The indifference curve is a useful way to show how a person with a fixed budget chooses between two goods. In the real world, of course, people have hundreds, or even thousands, of goods to choose from, and the doubling of only one price usually has a small impact on a person’s overall consumption and satisfaction possibilities. In our
EXHIBIT A 5 Crusoe’s Demand
As Exhibit A 4 shows, when the price of fish is $1, Crusoe chooses eight units. When the price of fish increases to $2, he re- duces his consumption to five units. This gives us two points on Crusoe’s demand curve for fish. Other points on the de- mand curve could be derived by confronting Crusoe with still other prices of fish. (Note: Crusoe’s money income [$16] and the price of breadfruit [$2] are unchanged in this analysis.)
!
I
le example, the twofold increase in the price of fish s Crusoe much worse off, because he spends a large rtion of his budget on the item.
In the text, we indicated that, when the price of a product rises, the amount consumed will change as a result of both an income effect and a substitution effect. Indifference curve analysis can be used to separate these two effects. Exhibit A6 is similar to Exhibit A4. Both exhibits show Crusoe’s re- sponse to an increase in the price of fish from $1 to $2 when money income ($16) and the price of breadfruit ($2) are held constant. Exhibit A6, however, breaks down his total response into the substitution effect and the income effect.
The reduction in the consumption of fish solely because of the substitution (price) effect, holding Crusoe’s real income (level of utility) constant, can be found by constructing a line tangent to Crusoe’s original indifference curve (i,), and having a slope indicating the higher price of fish. This line (the broken line in Exhibit A6), which is parallel to Crusoe’s actual budget constraint (the line containing point E*), re- flects the higher price of fish. It is tangent to the original in- difference curve i,, so Crusoe’s real income is held constant.
As this line indicates, Crusoe’s consumption of fish would
fall from eight to seven, due strictly to the fact that fish are now more expensive. This move from E , to F is a pure sub- stitution effect.
Real income, though, has actually been reduced. As a result, Crusoe will be unable to attain point F on indif- ference curve i,. The best he can attain is point E,, which decreases his consumption of fish by another two units to five. Since the broken line containing F and the budget constraint containing E, are parallel, the relative price of fish and breadfruit is held constant as Crusoe moves from F to E2. This move from F to E, is thus a pure income ef- fect. (Note: Because the consumption of both goods drops in this move, when income falls but the prices do not change, both goods must be normal goods.) This re- duction in the consumption of fish (and breadfruit) in the move from F to E , is due entirely to the decline in Cru- soe’s real income.
Indifference curve analysis highlights the assumptions and considerations that enter into consumer decisions. The logic of the proof that there is an inverse relationship be- tween the price and the amount demanded is both elegant and reassuring. It is elegant because of the internal consis- tency of the logic and the precision of the analysis. It is re- assuring because it conforms with our expectations, which are based on the central postulate of economics-that in- centives matter in a predictable way.
. ._.._
. . ... . .
. . . . . . . -. ~ . . . . . . - .- -- ... .- . . . . . _ .
emand and supply interact to determine the market price of a product. In the preceding chapter, we showed that the demand for a product reflects the strength of consumer desire for that product. In thls chapter, we will
L U S an ciie cost of producaon. Ttie Iesourca needed 10 produce one good could be used to produce ocher
goods instead. As Thomas Sowell asserts in the quotation that begins this chapter. the cost to society of anything is the value that it has in alternative uses. The market for resources makes that cost clear to producers. The maker of soccer balls, for example, must compete against producers of other goods when purchasing the machines. materials. and labor needed to produce the balls. In turn, the firm incurs costs as these resources are purchased.
Costs carry an important message: they tell producers the value of the resources In the production of other things. Further, the message comes with an important incentive attached. If the per-unit cost of producing a good exceeds i t 5 pnce. producers will suffer losses. Under these conditions, they are unlikely to continue supplying the good because doing so will reduce their income and wealth. Thus, supply and the cost of production are closely linked. For example, a producer who faces a cost of
$1,500 to produce a high-quality TV set is unlikely to continue supplying the sets for very long if their market price is $1,000.
In the long run, firms will continue to supply a good only if they can sell it for a price that covers their per-unit cost.
In this chapter, we will lay the foundation for a detailed investigation of the links between costs, business output, and market supply. What do economists count as costs, and why? How do costs guide the owners and managers of firms in a market economy? Why are costs important to managers, even when they personally do not pay those costs? We will discuss these and related questions in this chapter.
T
The business firm is an entity designed to organize raw materials, labor, and machines with the goal of producing goods andlor services. Firms (1) purchase productive resources from households and other firms, (2) transform them into a different commodity, and (3) sell the transformed product or service to consumers.
Every society, no matter what type of economy it has, relies on business firms to organize resources and transform them into products. In market economies, most business firms choose their own price, output level, and methods of production. They reap the benefits of sales revenues, but they also must pay the costs of the resources they use. In socialist countries, governments often set the selling prices of goods and services and constrain the actions of business firms in various other ways. Firms typically do not pay all their bills from their revenues, and they are often not allowed to keep revenues that exceed costs. In any case, the business firm is the entity used to organize production in capitalist and socialist economies alike. In this chapter, we will focus on the organization and behavior of firms in a market economy.
In
In capitalist countries, most firms are privately owned. Owners risk their wealth on the success of the business. If the firm is successful and earns profits, these financial gains go to the owners. Conversely, if the firm suffers losses, the owners must bear the conse- quences. Because the owners receive what remains after the revenue of the firm is used to pay the contractual costs, they are called resid~al claimants.
In a market economy, the property right of owners to the residual income of the firm plays a very important role: it provides owners with a strong incentive to organize and structure their business in a manner that will keep the cost of producing output low (relative to its value). The wealth of these residual claimants is directly influenced by the success or failure of the firm. Thus, they have both the authority and a strong incentive to see that resources under their direction are used efficiently and directed toward production of goods that are valued more highly than their costs.
. i
~esiduai ~laimants Individuals who personally receive the excess, if any, of revenues over costs. Residual claimants gain if the firm's costs are reduced or revenues increase.
171
172 C H A P T E R 8 Costs and the Sirpph of Goods
am ~ r ~ d ~ ~ ~ i ~ n A production process in which employees work together un- der the supervision of the owner or the owner’s repre sentative.
Working at less than the ex- pected rate of productivity, which reduces output. Shirking is more likely when workers are not monitored, so that the cost of lower output falls on others.
P~incipa~-agent p r o ~ i e ~ The incentive problem that occurs when the purchaser of services (the principal) lacks full information about the cir- cumstances faced by the seller (the agent) and cannot know how well the agent performs the purchased services. The agent may to some extent work toward objectives other than those sought by the principal paying for the service.
There are two ways of organizing productive activity: contracting and t ~ a ~ tion, in which workers are hired by a firm to work together under the supervisi
owner, or the owner’s representative-a manager. Most business firms use both contract- ing and team production.
In principle, all production could be accomplished solely through contracting. For example, a builder might have a house built by contracting with one person to pour the concrete, another to construct the wooden part of the house, a third to install the roof- ing, a fourth to do the electrical wiring, and so on. No employees would have to be in- volved in such a project. More commonly though, goods and services are produced with some combination of contracting and the use of team production by employees of a firm.
Why do firms use team production? If contracting alone is used to produce some- thing, the producer must, for each project, (1) determine what needs to be produced and how, given the circumstances, current technology, and prices, (2) search out reliable suppliers, and (3) negotiate and enforce the contracts. The entrepreneur who wants to produce by this method must have specialized knowledge in a variety of areas and must devote a great deal of time and effort to the planning and contracting processes.
Not many people have the expertise or the time to perform all these tasks by themselves except on a small scale. Team production for certain tasks can be more practical and less costly.
Accordingly, a builder with multiple projects is likely to hire knowledgeable, experi- enced workers to plan the construction process, purchase materials, and build the struc- tures. The builder will then contract with others to obtain materials and more specialized labor services.
The firm can reduce many of the transaction costs associated with contracting by using team production. Team production, however, comes with another set of problems.
Team members-the employees working for the firm-must be monitored and given incentives to avoid shirking, or working at less than the expected rate of productivity.
Taking long work breaks, paying more attention to their own conveni results, and wasting time when diligence is called for are examples of s
will shirk more when the costs of doing so are shifted to other team members, including the owners of the firm. Hired managers, even including those at the top, must be monitored and given incentives to avoid shirking.
Imperfect monitoring and imperfect incentives are al oblem with team production. It is part of a larger class of what economists cal
A person taking a car to an auto mechanic confronts this problem. The mechanic wants to get the job done quickly and make as much money on it as possible. The car owner wants to get the job done quickly also, but wants the problem fixed in a lasting way, at the lowest possible cost. Because the mechanic typically knows far more about the job than the customer, it is hard for the customer to monitor the mechanic’s work. There is a possibil- ity, therefore, that the mechanic may charge a large amount for a “quick fix” that will not last.
The owner of a firm is in a similar situation. It is often difficult to monitor the performance of individual employees and motivate them in a way that will encourage high productivity. Nonetheless, the ability of the firm to use resources effectively and succeed in a competitive market depends crucially upon resolving these problems. To keep costs low and the value of output high, a firm must discover and use an incentive structure that motivates managers and workers, and discourage5 shirking. The problem extends all the way to the top.
Even top-level executives hired to manage a firm do not have the same objectives as owners-who care mainly about profit maximization-unless, of course, the managers are the owners. So the judgments of executives, too, are influenced by what is in their personal best interests. They want perks, personal job security, and other benefits that may not be consistent with profit maximization for the firm. The problem becomes more serious as firms grow larger and acquire more managers and employees. Ultimately, it is the job of the owners, as residual claimants, to develop an incentive structure to mini- mize the principal-agent problem. For the owner, the saying “the buck stops here” al- ways applies.