agec 340 – international economic development course slides for week 6 (feb. 16 & 18) the...
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AGEC 340 – International Economic Development
Course slides for week 6 (Feb. 16 & 18)
The Microeconomics of Development: Are low-income people “poor but efficient”?*
–This starts proper microeconomics: a powerful way to explain peoples’ choices, particularly useful when looking over large
numbers of people and long time periods
* If you’re following the textbook, this is in chapter 5, pages 87-102.
Are low-income people “inefficient”?
• Why do the poor have low incomes? –Do they use what they have “inefficiently”?
• Modern economics answers these questions in a very specific way!
For example,
• Why do farmers in a given place often use similar farming practices?
• Why do farmers in different places use such different farming practices?
How can we explain & predict production decisions?
• We can start by describing what is possible, – then ask what is technically efficient, and– finally ask what is economically efficient.
• With this approach we can understand differences and predict changes.
As a farmer turns labor into crops, what levels of effort and yield
might we see?
labor use (hrs/acre)
crop yields(bu/acre)
This is our textbook “production function”or “input response curve” (IRC)
The IRC defines a frontier of technical efficiency
labor use (hrs/acre)
crop yields(bu/acre)
to produce below the curve
would be inefficient
to produce above thethe curve would be technologically impossible
Qoutput
Qinput
But what point along the IRC will people choose?
labor use (hrs/acre)
crop yields(bu/acre)
point of maximum yields?
segment withsteepest slope?
Qoutput
Qinput
Every point along the curve is technologically efficient, but not all are economically efficient
• If producers want to maximize profit:
= PoQo - PiQi (equation #1)
• and then some algebra, to solve for Qo so we can draw a line like Y = mX+b:
Subtract PoQo and from both sides
-PoQo = - - PiQi
and then divide both sides by –Po:
Qo = /Po + (Pi/Po)Qi (equation #2)
We can graph this equation...
labor use (hrs/acre)
crop yields(bu/acre)
/Po The formula for this line isQo = /Po + (Pi/Po)Qi
Qo
Qi
… but there are there are as many of these lines as there are levels of profit.
labor use (hrs/acre)
crop yields(bu/acre)
2/Po
1/Po
3/Po
Each line isQo = /Po + (Pi/Po)Qiwith the same slope (Pi/Po), but a different intercept (/Po)
Qo
Qi
These lines are called “iso-profit” lines
2/Po
1/Po
3/Po
Slope = Pi/Po
Qo
Qilabor use (hrs/acre)
crop yields(bu/acre)
…and we expect farmers will choose the point on IRC with the highest profit level
Slope = Pi/Po*/Po
This is the highest-possiblelevel of profit
Because of diminishing returns, only one point can be economically optimal.
*/Po
Profits below* are economicallyinefficient
Profits above * aretechnically impossible
At the optimal point, the isoprofit line crosses the IRC only once:the isoprofit line is “tangent” to the IRC
We can do a similar analysis for farmer’s choice among outputs.
Qty. ofCorn perfarm
Qty. of Beansper farm
Holding all else constant!
Qty. ofCorn perfarm
Qty. of Beansper farm
What combinations of outputs do we expect to see?
Qty. ofCorn perfarm
Qty. of Beansper farm
A “production possibilitiesfrontier” (PPF)
What combinations of outputs do we expect to see?
We have a similar picture as before...
Qty. ofCorn perfarm
Qty. of Beansper farm
Technicallyinefficient
Technicallyimpossible
What is the economically efficient choice?
• First the assumption that producers will maximize profit:
= PcQc + PbQb (equation #1)
• and then some algebra, to turn equation #1 into the equation for a line on our graph:
Qc = /Pc - (Pb/Pc)Qb (equation #2)
Qty. ofCorn perfarm
Qty. of Beansper farm
Graphing this equation we get:
Iso-revenue lines,of slope = -Pb/Pc
which we can use to find the efficient point:
Qty. ofCorn perfarm
Qty. of Beansper farm
Revenue (& profits) are highest;the iso-revenue line is tangent to the PPF
To apply this to choice among inputs… we can again hold all other things constant
(both outputs and other inputs)tractor oranimal use(hp-hrs)
labor use(person-hours)
possible techniques to produce two tons of corn, using one acre of land, etc.
To apply this to choice among inputs… we can again hold all other things constant
(both outputs and other inputs)tractor oranimal use(hp-hrs)
labor use(person-hours)
An “iso-quant”
technicallyimpossible
technicallyinefficient
All points along the isoquant are “technically efficient”, but which is
economically efficient?
• In this case the assumption that producers maximize profit means minimizing costs:
C = PlabQlab + PtracQtrac (equation #1)
• and then some algebra, to turn equation #1 into the equation for a line on our graph:
Qtrac = C/Ptrac - (Plab/Ptrac)Qlab (equation #2)
Graphing this equation we get:
Iso-cost lines,of slope = -Plabor/Ptractor
tractor oranimal use(hp-hrs)
labor use(person-hours)
and again only one choice can minimize costs (or maximize profits)
Qtractors
Qlabor
“iso-quant”
iso-cost line(slope = -Plab/Ptrac)
So we have three kinds of diagrams...
Qo
Qi
Qo2
Qo1
Qi2
Qi1
IRC PPF Isoquant
The curves are fixed by nature and technology; they show the “frontier” of what is technologically possible to produce
Qo
Qi
Qo2
Qo1
Qi2
Qi1
inefficientinefficient
impossible impossible
impossible
inefficient
The lines’ slopes are fixed by market values;they show the “relative prices” or what is
economically desirable to produce
Qo
Qi
Qo2
Qo1
Qi2
Qi1
iso-profit lines(slope = Pi/Po)
iso-revenue lines(slope = -Po1/Po2)
iso-cost lines(slope = -Pi1/Pi2)
Qi
Qo2
Qo1
Qi2
Qi1
The combination gives us the profit-maximizing combination of all inputs & all outputs
Qo
Qi
Qo2
Qo1
Qi2
Qi1Qi
Qo2
Qo1
Qi2
Qi1
highest profit
highest revenue
lowest cost
Does profit maximization apply only to “modern” farmers?
• No! We can do the same analysis using “values” (in any units) instead of prices.– the “values” cancel out, and the “price ratios” become
a barter ratio at which the goods would be traded
Profit-maximizing production choices depend only on relative prices or exchange ratios
iso-profit lineslope = Pl/Pc
(corn exchanged for labor)
iso-revenue lineslope = -Pb/Pc
(corn exchanged for beans)
iso-cost lineslope = -Pl/Pm
(machinesexchanged for labor)
Qty. of corn(bu/acre)
Qty. of labor (hours/acre)
Qty. of corn(bu/acre)
Qty. of beans(bushels/acre)
Qty. of machinery(hp/acre)
Qty. of labor (hours/acre)
With relative price lines and technological-possibilities curves
we can predict the profit-maximizing combination of all inputs & all outputs.
Qty. of corn(bu/acre)
Qty. of labor (hours/acre)
Qty. of corn(bu/acre)
Qty. of beans(bushels/acre)
Qty. of machinery(hp/acre)
Qty. of labor (hours/acre)
We expect that farmers will try to be...
• technically efficient on the curves
• economically efficient
at the point of highest profit:–highest profit along the IRC,–highest revenue along the PPF,– lowest cost along the isoquant.
Putting the two ideas together...
• with “technical efficiency” – a curve, representing what’s physically
possible for a producer to do• and “economic efficiency”
– a line, representing relative values • we get a specific prediction about what
people are likely to choose
• In developing countries, rapid population growth and few nonfarm job opportunities means that the number of people needing to work on farms rises;
• If nothing else changes, labor becomes more abundant and its price goes down...
What happens when prices change?
…which graph(s) change?
Qty. of corn(bu/acre)
Qty. of labor (hours/acre)
Qty. of corn(bu/acre)
Qty. of beans(bushels/acre)
Qty. of machinery(hp/acre)
Qty. of labor (hours/acre)
We need to see where labor enters the picture...
Qty. of corn(bu/acre)
Qty. of labor (hours/acre)
Qty. of corn(bu/acre)
Qty. of beans(bushels/acre)
Qty. of machinery(hp/acre)
Qty. of labor (hours/acre)
iso-profit(slope=Pl/Pc) iso-revenue
(-Pb/Pc)
iso-cost (-Pl/Pm)
and ask what would be changed bymore abundant (lower-priced) labor
Qty. of corn(bu/acre)
Qty. of labor (hours/acre)
Qty. of machinery(hp/acre)
Qty. of labor (hours/acre)
slope of isoprofit line= Plabor/Pcorn slope of isocost line
= -Plabor/Ptractors
…in both cases the lines become less steep (a lower ratio, so a smaller slope)
At the new prices, is the old choice still optimal?
new slope = Pl’/Pc
new slope=Pl’/Pt
Qty. of corn(bu/acre)
Qty. of labor (hours/acre)
Qty. of machinery(hp/acre)
Qty. of labor (hours/acre)
old slope = Pl/Pc
old slope = Pl/Pt
Qty. of corn(bu/acre)
Qty. of labor (hours/acre)
Qty. of machinery(hp/acre)
Qty. of labor (hours/acre)
more labor use, more corn production
more labor use,less machinery
higher profits
lowercosts
Now, higher profits & lower costs could be reached if farmers move along the IRC & isoquant
to a different technique, that was not optimal before.
Qty. of corn(bu/acre)
Qty. of labor (hours/acre)
Qty. of machinery(hp/acre)
Qty. of labor (hours/acre)
In this way we can explain (and predict) how farmers respond to changing prices:
old optimuma new optimum
old optimum
a new optimum
a newprice ratio
a newprice ratio
In summary…
• Using these three simple diagrams helps you do the math on how an optimizing person would respond to change
• Many studies find that real farmers do usually respond in these ways
• Next week… if everyone’s already maximizing their profits, how can things improve?