Principles of Microeconomics

SS 16
LUMS
Fall-20
Capstone Case: Drugs, Crimes and Markets
• Each year, billions of dollars are devoted to curb drug smuggling
and drug-related crimes.
– Drug smugglers usually involved in organized crimes e.g., Mexican drug
cartels. Addicts finance their drug usage by engaging in petty crimes i.e.,
robberies etc.
• Standard operating procedure: Anti-narcotics teams burn illegal
drugs, commonly known as drug interdiction
– Let’s trace the impact of this policy using our supply-demand model.
• How does this policy impact equilibrium quantity and price of drugs? How
does this policy affect crime levels and robberies? Is this policy the optimal
solution to the problem of drug related crimes?
– Do we know something about the underlying nature of drug-demand?
What about drug-supply and structure of drug markets?
Capstone Case: Drugs, Crimes and Markets
• Demand for drugs is arguable close to being perfectly inelastic:
– An addict will do anything to get his dose!
• Drug supply is fairly inelastic, and drug interdiction reduces the
supply of drugs.
– Most drugs are made from plant-based substances, and these inputs are
not easily available.
• As a result, drug interdiction moves the new market equilibrium
to a significantly higher price and slightly lower quantity.
– The subsequent increases in total revenue from drug sales, implies more
money to finance/grow organized crime rackets!
– Obviously, total expenditure by addicts on drugs also increases, and this
is financed by increased levels of petty crimes!
– Leading to an overall increase in drug related crimes! What to do now?
 Overview-Producer Theory
• Modelling producers’ decisions in perfectly competitive market:
– No producer is large enough to influence market prices. Firms are price-
takers i.e., each firm can sell as much as it wants at the market price.
– Each firm produces (roughly) identical goods e.g., eggs, wheat, pencils.
– There is free entry and exit i.e., entering/exiting the market is easy.
• Primary objective of producers/firms is to maximize net profits:
– We need to understand how producers/firms in a perfectly competitive
market decide what quantity to produce.
• Application of the principle of optimization and thinking at the margin!
• A firm’s choice/decision problem consists of three components.
– Production Technology: How inputs are combined to make output e.g.,
some combination of seed, land, chemicals, machinery, labor and fuel to
grow potatoes. Guns, labor and equipment for a security company.
 Overview-Producer Theory
– Production Costs: How much it costs to produce unit of output i.e., cost
of doing business, and how costs behave as production levels are varied.
– Revenues: Price at which a unit of output can be sold in the market.
• Modelling each of these components will yield a set of decision
rules that govern optimal production levels of profit-maximizing
firms in different contexts (e.g., short-run and long-run)
– The same structure is utilized to derive optimal production decisions of
firms operating under other market structures (i.e., monopoly, oligopoly
and monopolistic competition) later on in our course.
– A study of these components also provides a blueprint, if you decide to
start you own business!
– In particular, for perfectly competitive firms, there is a close relationship
between nature of production technologies and behavior of production
costs.
 Production Technology: Inputs to Outputs
• Firms are entities that produce and sell goods or services in an
economy, and essentially combine inputs e.g., labor and capital
to create outputs (e.g., cheese and cars).
• The building blocks of the production process are:
– Factors of Production: Set of inputs available to a firm i.e., capital, labor
and raw materials etc.
– Technology: How firms can produce output from a set of inputs.
• Firms face technological constraints i.e., number of feasible approaches to
produce maximum amount of output from a given set of inputs.
• Relationship between the quantity of inputs used and quantity
of outputs produced is represented by a production function.
– Production function signifies an engineering relationship that describes
the optimal amount of input required to produce a given output.
 Short-Run Production Function
• Economists propose a clear distinction between short-run and
long-run production decisions in theory of the firm:
– Short-run is the period of time when only some of a firms’ inputs can
be varied i.e., at least one factor of production is fixed in the short-run
e.g., takes 1-2 years to change size of factory or develop an oil well.
– Long-run is the period of time wherein firms can change any input i.e.,
all factors of production can be varied in the long-run.
• For simplicity, we assume firms can employ only two factors of
production:
– Physical capital is a fixed factor of production — an input that cannot
change in the short run.
– Labor is a variable factor of production — an input that can change in
the short run.
 Short-Run Production Function
• At a given level of capital, we simply graph relationship between
output (Y-axis) and labor (x-axis).
– Marginal product is the change in total output associated with one more
unit of labor i.e., extra amount of output produced by an additional unit
of variable input.
– Mathematically, the marginal product of labor at any given level of labor
is equal to the slope of the production function at that point.
– The marginal product of labor increases with the first few workers due
to specialization.
• Workers develop specific skills that increases total productivity e.g. one digs
the hole and other moves away the excess mud.
– Due to the fixed amount of capital in the short run, extra output from an
additional unit of labor generally increases at a decreasing rate.
• Intuition: Keep on hiring more workers but only have one available machine
e.g. one shovel and many workers trying to dig a hole.
 Short-Run Production Function
• Law of Diminishing Returns: After a certain point, the marginal
product begins to decrease i.e., successive increases in inputs
produce less and less additional units of output.
– Graphically, production function become flatter.