Jgard5000

Misconceptions of Neoclassical Theory

Aggregate Consumer Demand Curve

The aggregate consumer demand curve is the summation of the individual consumer demand curves. The aggregation process preserves only two characteristics of individdaul consumer prefereence theory continuity and homogeniety. [does this mean convexity does not survive aggregation] Aggregation introduces three additional non price determinants of demand - (1) the number of consumers (2) "the distribution of tastes among the consumers" and (3) "the distribution of incomes among consumers of different taste." Thus if the population of consumers increases ceteris paribus the demand curve will shift out. If the proportion of consumers with a stong preference for a good increases certeris paribus the demand for the good will change. Finally if the diistributuo of income changes is favor of those consumer with a strong preference for the good in quesiton the demand will shift out. It is important to remember that factors that affect individual demand can also affect aggregate demand. However, net effects must be considered. For example, a good that is a complement for one person is not necessary a complement for another. Further the strength of the relationship would vary among persons.

Problems with Aggregation

Aggregating individual consumer demand curves presents several problems.

Independence Assumption

First to sum the demand functions it must be assumed that they are independent - that is that one consumer's demand decisions are not influenced by the decisions of another consumer. Example, A is asked how many pairs of shoes he would buy at a certain price. A says at that price i would be willing and able to buy 2 pairs of shoes. B is asked the same question and says 4 pairs. Questioner goes back to A and says B is willing to buy four pairs of shoes, what do you think about that? A says if B has any interest in those shoes then i have none. Or A, not to be outdone by B says then i'll buy five pairs. And on and on.This problem can be eliminated by assuming that the consumers tastes are fixed in the short run. This assumption can be expressed as assming that each consumer is an independent idiosyncratic decision maker.

No interesting Properties

The third problem is the most serious. As David Kreps note is his tezt, A Course in Microeconomic Theory (Princeton 1990), “...total demand will shift about as a function of how individual incomes are distributed even holding total (societal) income fixed. So it makes no sense to speak of aggregate demand as a function of price and societal income." Since any change in relative prices affects a redistribution of real income the result is that there is a separate demand curve for every relative price. Kreps goes on to say, "So what can we say about aggregate demand based on the hypothesis that individuals are preference/utility maximizers? Unless we are able to make strong assumptions about the distribution of preferences or income throughout the economy (everyone has the same homothetic preferences for example) there is little we can say. ..” The strong assumptions are that everyone has the same tastes and that each person’s taste remain the same as income changes so each additional income is spent exactly the same way as all previous dollars. As Keen notes the first assumption amounts to assuming that there is a single consumer the second that there is a single good. Kleen further states that the implications for traditional economics that you cannt draw conclusions anout social welfare, there is no invisible hand and Adam Smith was wrong. Varian, a leading expert on microeconomic analysis reaches a more muted conclusion, "The aggregate demand function will in general possess no interesting properties..." However Varian went on to say," the neoclassical theory of the consumer places no restriction on aggregate behavior in general." Among other things this means the preference conditions (with the possible exception of continuity) simply don't apply to the aggregate function.Jgard5000 (talk) 23:26, 3 October 2009 (UTC)jgard5000 Does this mean that a good portion of microeconomic analysis is worthless? No. It means that it is useful as an approximation of aggregate consumer behavior and nothing more.

Market or aggregate demand is the summation of individual demand curves. In addition to the factors which can affect individual demand there are three factors that can affect market demand - cause the market demand curve to shift (1) the number of consumers, (2) the distribution of tastes among consumers, and (3) the distribution of income among consumers with different tastes. If all other factors are held constant an increase in the number of consumers will cause the demand for goods to increase. If tastes change among the population of consumers the demand for some goods will increase while the demand for other goods will fall. If the distribution of income changes in favor of consumers with a strong preference for a good then the demand for the favored good would increase.

Market Power and the PC firm

A fundamental assumption of traditional (neoclassical) theory is fims in a perfectly competitive market are price takers and face a perfectly elastic demand curve. However, the assumption of perfectly elastic demand curve and a negatively sloped demand curve are contradictory. As Kleen notes the market demand curve is the summation of the firm demand curves and that one cannot add flat line segements to derive a negatively sloped demand curve. If you add line segments all you get is one long line. One response to this criticism is taht the firm "perceive" the demand curve as perfectly elastic even though it is not. However, this response violates the assumption of perfect knowledge. It is impossible to fool someone with perfect knowledge. A second response is that the output of each frim is infinitely small and that each firm's demand curve is represented by a point on the market demand curve. This explanation shares the problems of flat firm demand curves - if you add together a bunch of points you end up with a point (point have no dimensions). The answer is provided by one of the leading neoclassical theorists. Varian states, the firm demand curve has a "little bit" of negative slope and that the market demand curve should be viewed simply as an approximation of aggregate demand. Of course, first approximations lack the mathemaical precision infused into the theory of teh firm by the mathematization of neoclassical micreconomics and undercuts some of the assumptions of welfare economics particularly.

The ulimate problem is that you simply cannot aggregate consumer indifference curves to generate a social utility function. The positions and values of the curves will constantly shift as you change relative prices.

If PC firms face a negatively sloped demand curve then the market demand curve is negatively sloped. The firm would also have a marginal revenue curve and would produce where MR = MC rather than where P = MC.

Market Evolution

The firm's demand curve would be highly elastic. As for the supply curve, under the standard assumptions the firm produces an infinitely small amount of product so it is futile to discuss the elatstiicy of a firm supply curve since each firm's supply curve is a point. If we assume that they produce a little bit of goods then we are left to guess whether the curve's elasticity since thereare no substantial barrieres to entry )just a little bit of market power) the supply curve would be higly elastic. So in Almost Perfect Competition we have a hghly elastic dmeand and supply curve which means that any change in price would prompt howevere with a near infinity of firms the rapid increase in production would reduce the number of firms extinction firms qiclly ievolve into a monopolo deffeiernt market structure - with the quiakest to respond being the more likeley to survive evolutionary eoconomics. It is reasonable to assume that the aggregate supply curve would also be highly elastic. The market would appear to be highly volatile with large swings in quantity demanded in response to small changes in price.

PC Firms have a "little" market power

Note that if a firm has market power, even a "little bit" then it faces a negatively sloped demand curve rather than the perfectly elastic curve assumed by PC theory = which means the firm would not produce where P equals marginal revenue but would follow the conventional rule produce where MR = MC. As Kreps notes in one of the leading texts on microeconomic theory "firms assume they have no market power when in fact they have a litte bit." Kreps, A Course in Microeconomic Theory (Princeton 1990) at 292. Kreps goes on to note that the perfectly competitive model should be viewed as a first approximation of firms that have and realize they have a small amount of market power." Kreps at 292. Again market power means that the firms face a negatively sloped and highly elastic demand curve it also means that there is a marginal revenue curve at the firm and industry level.

Marginal cost is NOT the cost of producing the "next" or "last" unit.

Marginal cost is not the cost of producing the "next" or "last" unit. —Preceding unsigned comment added by Jgard5000 (talk • contribs) 20:44, 11 August 2009 (UTC) Silberberg & Suen, The Structure of Economics, A Mathematical Analysis 3rd ed. (McGraw-Hill 2001) at 181. As Silberberg and Suen note the cost of the last unit is the same as the cost of the first unit and every other unit. In the short run increasing production requires using more of the variable input - conventionally assumed to be labor. Adding more labor to a fixed capital stock reduces the marginal product of labor because of the diminishing marginal returns. This reduction in productivity is not limited to the additional labor needed to produce the marginal unit - the productivity of every unit of labor is reduced. Thus the costs of producing the marginal unit of output has two components - the costs directly attributable to hiring the additional labor needed to produce the marginal unit (AC) and the increase in average costs for all units produced due to the “damage” to the entire productive process (∂AC/∂q)q. Id. Therefore, the correct formula is MC = AC + (∂AC/∂q)q. Id. Marginal costs can also be expressed as the cost per unit of labor divided by the marginal product of labor. See http://ocw.mit.edu/NR/rdonlyres/Economics/14-01Fall-2007/F4843AF1-1F54-46B5-A2BA-AE728225F274/0/14_01_lec13.pdf. MC = ∆VC∕∆q; ∆VC = w∆L; ∆L∕∆q the change in quantity of labor to affect a one unit change in output = 1∕MPL. Therefore MC = w∕MPL Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [12 Sept 2009].

In discussing marginal cost several things must be kept in mind. First, the behavioral assumption underlying the cost functions is that firms are profit maximizer/cost minimizers. Secondly, the cost functions show the minimum cost to produce a given output which means that the firm is using the optimum short run capital labor ratio. Third, in the short run a firm can increase production and conform to the cost minimizing assumption only by increasing the use of the variable input by an amount that produces the desired output at the minimum additional cost. Marginal cost is this minimum increase in cost attributable to an increase in output.Silberberg & Suen, The Structure of Economics, A Mathematical Analysis 3rd ed. (McGraw-Hill 2001) at 179. A firm could produce the marginal unit without "hiring" additional labor but to do so would violate the behavioral assumption of the model. Likewise a firm could hire more labor than was necessary to produce the marginal unit at minimum cost. In either case the marginal cost would increase by an extent exceeding the minimum increase necessary to produce the marginal unit. [edit]Economies of Scale

One of best illustrations of relationship between marginal and average cost is freeway congestion example originally developed by Frank Knight and discussed by Silberberg and Suen on page The Structure of Economics. Assume that a section of freeway is our factory and that the objective is to move cars along the freeway at the minimum costs in terms of travel time. Assume also that an additional car entering the freeway when it is un-congested has no effect on the average travel time of the others cars already on the highway. Nor do the other cars affect the travel time of the additional vehicle. Finally assume that the travel time on the uncongested highway is 30 minutes. Now assume that there are ten cars traveling on the section of the highway and that ten cars is the point of capacity. The entry of the eleventh car immediately creates congestion increasing everyone’s travel time to 32 minutes. The question is what is the marginal cost in terms of travel time of the entry of the eleventh car onto the highway? The typical repsonse is that the marginal cost is the time spent by the eleventh car - 32 minutes - the cost of the last unit. This conclusion understates the cost of the entry of the additional car. After entry of the eleventh car the average time for each vehicle is 32 minutes. Thus the marginal cost of adding the 11 car is its own 32 minuted of travel time plus 2 extra minutes "imposed on each of the other ten cars' or 10 x 2 or 20 minutes for a total of 52 minutes.--Jgard5000 (talk) 21:29, 15 September 2009 (UTC)jgard5000. In plain language when the eleventh car enters the highway it presence intereferes with the use of the highway by the other ten drivers plus the presence of the other ten drivers interferes with the eleventh driveres use of the highway. This damage to the production process is precisely what happens when the additional labor is added to produce the marginal unit of output. The new worker creates "congestion" in the workplace that reduces the productivity of every worker. --Jgard5000 (talk) 20:13, 16 September 2009 (UTC)jgard5000 This is consistent with the mathematical expression of MC. The formula is MC = AC + (dAC/dq)q. In terms of the congested freeway MC equals the average cost of the eleventh car (32 minutes) plus the change in AC with respect to the ten cars times the number of cars (32 - 30) x 10 = 20) or MC = 32 + 20 = 52 minutes which conforms to the formula. It is important to understand the misleading nature of the statement the marginal cost is the cost of producing the last unit. In the freeway example the average cost of the last car is the same as the cost of all other cars or 32 minutes.--75.250.211.62 (talk) 11:35, 17 September 2009 (UTC)jgard5000 [edit]Perfectly Competitive Supply Curve

The portion of the marginal cost curve above its intersection with the average varaible cost curve is the supply curve for a firm operating in a perfectly competitive market. (te portion of the MC curve below its intersection with the AVC curve is not part of the supply curve becuase a firm would not operate at price below the shut down point) This is not true for firms operating in other market structures. For example, while a monopoly "has" an MC curve it does not have a supply curve. --Jgard5000 (talk) 11:50, 17 September 2009 (UTC)jgard5000 In a perfectly competitive market, a supply curve shows the quantity a seller's willing and able to supply at each price - for each price there is a unique quantity that would be supplied. The one-to-one relationship simply is absent in the case of a monopoly. With a monopoly there could be an infinite number of prices associated with a given quantity.--Jgard5000 (talk) 14:45, 17 September 2009 (UTC)jgard5000 It all depends on the shape and position of the demand curve and its accompanying marginal revenue curve.--Jgard5000 (talk) 14:48, 17 September 2009 (UTC)Jgard5000

Thirdly, it is important to underline that the marginal product is not, properly speaking, the contribution of the marginal unit by itself….The second man may very well produce nine or ten or eleven and still the total output increases only to eighteen because the first man reduces his output to nine, or eight or seven in the presence of the second. In our example, output increases from ten bushels to eighteen bushels when one adds the second man not because the second man only adds eight, but rather because his presence on the field makes the situation such that the total output of both men is eighteen. Notice that the contribution per man is reduced: the average product is actually nine. This may very well be how much each of the two laborers contributes. But this is not what interests us: what we wish to note is that by adding the second man, output was increased by eight. Thus, the marginal product of the second man is eight. But his actual contribution may be very different than this. [8]

Tax Incidence

If the demand curve is inelastic relative to the supply curve the tax will be disproportionatly borne by the buyer rather than the seller. If the demand curve is elastic relative to the supply curve the tax will be born disproportionatly by the siller.If PED = PES the tax burden split equally between buyer and seller. If PED > PES , buyer bears burden. If PES > PED the seller disproportionately bears the tax burden. The pass through fraction for buyers is PES/PES - PED. So if PED for cigarettes is -0.4 and PES is 0.5 then the pass through fraction to buyer would be calculated as follow:

PES/PES - PED

0.5/ 0.5 - (-.0.4) = 0.5/0.9 = 56%

56% of any tax increse would be "paid" by the buyer; 44% would be paid by the seller.

From the seller.producer's perspective the formula is -PED/(PES -PED)

-(-0.4)/[0.5 -(-0.4)]

0.4∕.9

44%

Advertising Elasticity of Demand

Advertising elasticity of demand measures the change demand induced by a change in advertising.[41] Advertising and demand although traditionally considered as being positively related to demand for the good that is subject of the advertising campaign can be inversely related if the advertising is negative. For example, the Coke versus Pepsi blind taste test ads.

Calculating AED

AED is calculated using the same formula as any demand elasticity - AED = %∆Q/%∆A = (∆Q/∆A) X (A/Q)[42]

Applications of AED

AED can be used to make sure advertising expenses are in line. The rule of thumb combines the PED and AED.

The rule is A/PQ = -(AED/PD)

To quote Pindyck and Rubinfeld, "to maximize profit, the firms advertising to sales ratio should be equal to minus the ratio of the advertising and price elasticities of demand."[43]

As noted by Pindyck and Rubinfeld, firms should advertise heavily if there AED is high - they get a lot of bang for their advertising buck or if their PED is low - a low PED implies high markups so for every added sales there is significant profit.[44]

===Estimating Point Elasticities==== Chiang & Wainwright, Fundamental Methods of Mathematical Economics 4th ed. Page 192-93. McGraw-Hill 2005

PED can also be expressed as (dQ/dP)/Q/P or the ratio of the marginal function to the average function for a demand curve Q = f( P).[1] This relationship provides an easy way of determining whether a point on a demand curve is elastic or inelastic. The slope of a line tangent to the curve at the point is the marginal function. The slope of a secant drawn from the origin through the point is the average function. If the slope of the tangent is greater than the slope of the secant (M > A) then the function is elastic at the point. [2]If the slope of the secant is greater than the slope of the tangent then the curve is inelastic at the point.[3] If the tangent line is extended to the horizontal axis the problem is simply a matter of comparing angles formed by the lines and the horizontal axis.[4] If the marginal angle is numerically greater than the average angle then the function is elastic at the point. If the marginal angle is less than the average angle then the function is inelastic at that point. If you follow the convention adopted by economist and plot the independent variable on the vertical axis and the dependent variable on the horizontal axis then the marginal function will be dP/dQ and the average function will be P/Q meaning that you are deriving the reciprocal of elasticity. Therefore opposite rules would apply. The tangency line slope would be dP/dQ and the slope of the secant would be the numerical value P/Q. This method is not limited to demand functions it can be used with any functions. For example a linear supply curve drawn through the origin has unitary elasticity (if you use the method the marginal function is identical to the slope). If a linear supply function intersects the y axis then the marginal function will be less than the average and the function is inelastic at any point and becomes increasingly inelastic as one moves up the curve.[5] With a supply curve that intersects the x axis then the slope of the curve will exceed the slope of the secant at all point meaning that the M > A the slope is elastic and will become increasingly elastic as one moves up the slope.[6] Again this assumes that the dependent variable is drawn on the Y axis. It is possible to consider the combined effects of two or more determinant of demand. The steps are as follows: PED = (∆Q/∆P) x P/Q. Convert this to the predictive equation: ∆Q/Q = PED(∆P/P) if you wish to find the combined effect of changes in two or more determinants of demand you simply add the separate effects: ∆Q/Q = PED(∆P/P) + YED(∆Y/Y)[12]

Remember you are still only considering the effect in demand of a change is two of the variables. All other variables must be held constant. Note also that graphically this problem would involve a shift of the curve and a movement along the shifted curve. Finally elasticity is dependent on time, place and circumstance. Dowling, Introduction to Mathematical Economics 3rd ed. ( McGraw-Hill 1980) at 112. ^ Dowling, Introduction to Mathematical Economics 3rd ed. ( McGraw-Hill 1980) at 5. If YED is negative (YED < 0) the good is sometimes referred to as an inferior good as opposed to normal goods ( 0 < YED < 1) and superior goods (1 < YED). ^ Perloff, Microeconomics Theory & Applications with Calculus (Pearson 2008) ^ In discrete terms it would be (∆Q/∆Y)(Y/Q). ∆Q/∆Y is the slope of the function Q = f(Y). ^ Samuelson & Marks, Managerial Economics 4th ed. (Wiley 2003) at 97.