UNIT.

LAW OF DIMINISHING (For understanding marginal graph better)

Assuming the wage rate in a small fast-food restaurant is fixed. The following table shows the
marginal product of labor for the fast-food restaurant, where MP (marginal product of labor) is
the number of hamburgers produced per hour.

Labor Output Marginal Product of Labor

1 10 10
2 25 15
3 45 20
4 55 10
5 62 7
6 69 4
Here, the input increases with every worker. However, the Marginal Product of Labor (MP)
denotes the additional units produced by each worker. The first worker can produce 10
hamburgers per hour. The second worker will add 15 hamburgers because both workers will
specialize in one task in particular. The third worker will add an extra 20 hamburgers.

However, the fourth worker will only add 10 more hamburgers. The 5th will add merely 7 units of
output per hour. Why so?

It is because the workspace is limited (numbers of ovens, etc.), adding the fourth worker will
increase output but will decrease the MP. That is why we need optimization for maximizing profit
and minimizing cost.

ANALYTIC MODELS IN MICROECONOMICS

1-LIMITED OPTIMIZATION

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If you are attempting to maximize the objective function, typical constraints might involve time,
money, and resources. The amounts of these things are limited, and these limits also place limits
on the best possible value of the objective function.

Target is maximizing profit or benefit and minimizing cost. Choices depend on constraints.
Limited optimization shows the balance points between limits and targets.

Example: A farmer has a Ç meter fence. His budget is sufficient only for a Ç meter fence. He
needs a corral for his animals. The perimeter of the corral should be equal to Ç meter.

Perimeter= L (length). W (width)

The perimeter is Ç and the farmer should try to maximize the length and width of the corral.

Ç= 2L+2W

2L+2W< or = to Ç

EXAMPLE:

Advertisement budget Additional sale by TV adv Add. sale by Radio adv.

Spending 100.000 to TV advertising adds 25.000 units additional sale which is seem the most
beneficial option.

If we spend 90.000 to TV and 10.000 to radio it makes 24.750+1.900=26.650

If we spend 80.000 to TV and 20.000 to radio it makes 24.000+3.600=27.600

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If we spend 70.000 to TV and 30.000 to radio it makes 22.750+5.100=27.850

We should consider the marginal effect for benefit maximization. After 70.000 spending for TV
advertisement the marginal benefit of TV advertisement is going to decrease.

10.000 more spending for tv advertisement after 60.000 (60.000-70.000) total tv advertisement
spending has an effect of:

(22.750-21.000)/10.000=0.175 sale increase per TL

If we make the same calculation for 70.000 (70.000-80.000):

(24.000-22.750)/10.000= 0.125-piece sale increase per TL

If we keep TV advertisement as 70.000 TL and spent the next 10.000 for radio advertisement;

(5.100-3.600)/10.000= 0.150-piece sale increase per TL

The marginal effect of radio advertisement is bigger than marginal effect of TV advertisement. If
we increase radio advertisement from 30.000 to 40.000;

(6.400-5.100)/10.000= 0.130 which is 0.175 for TV advertisement.

We can optimize spendings for maximizing benefit by calculating marginal effect.

BALANCE ANALYSIS

Excess demand occurs when the quantity demanded exceeds the quantity supplied. In this
situation, the market price is below the equilibrium price. And, when the mechanism works, the
price will rise towards its new equilibrium.

P1=2 TL

Pe(Equilibrium price)=4 TL

QS1=100

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Qe(Equilibrium quantity)= 200

Qd1= 300

P1 is under the equilibrium price. Only QS1 is supplied with cheaper price that is 2 TL.

There is an extra demand with price 2 that is between QS1-Qd1

We can calculate excess demand as:

D(E)= QD1-QS1

D(E)= 300-100= 200 pieces.

EXCESS SUPPLY

When the price increases, supply increases. Since the exact demanded amount with higher price
is not exactly known some part of the supply may have excess amount.

Qd= 100

Q*=250

Qs=350

P*=3 TL

P2=4 TL

Excess supply= Qs-Qd= 350-100=250

Example 1. A baker posts a sale price of $2 per loaf of bread.

At this price, he is willing to sell up to 300 loaves of bread (per day), but consumers are willing to
buy only 200.

We say that quantity supplied and quantity demanded (at the price of $2) are 300 and 200 and
write

S($2)=300 and D($2)=200.S($2)=300 and D($2)=200.

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Excess supply is then

ES($2)=S($2)−D($2)=300−200=100.

Example 2. A baker posts a sale price of $1 per loaf of bread.

At this price, he is willing to sell up to 100 loaves of bread (per day), while consumers are willing
to buy 250.

We say that quantity supplied and quantity demanded (at the price of $1) are 100 and 250 and
write

S($1)=100 and D($1)=250.S($1)=100 and D($1)=250.

Excess demand is then

ED($1)=D($1)−S($1)=250−100=150.

In the real world, the baker may not know precisely how many loaves of bread he's willing to sell
at each price.

The Principle of Diminishing Marginal Utility

What is Utility?

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When an individual consumes goods and services, the satisfaction gained or lost from
consumption is called utility. Consumer preferences are defined by the consumption bundles
that consumers face. A collection bundle is a bundle that maximizes the consumer’s total utility,
given the consumer’s budget constraints. One unit of utility is known as a util.

Marginal utility refers to the utility gained from the consumption of an additional unit of a good
or service.

The principle of diminishing marginal utility is illustrated here as the total utility increases at a
diminishing rate with additional consumption. It is evidenced by figures D, E, and F having
decreased marginal utility. Therefore, the principle of diminishing marginal utility indicates that
each additional unit of consumption adds less to the cumulative utility than the previous unit.

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An indifference curve is a contour line where utility remains constant across all points on the line.
Each point on an indifference curve represents a consumption bundle, and the consumer is
indifferent among all consumption bundles on the indifference curve. In our example, the
consumer yields 250 utils.

The Optimal Consumption Bundle

In the graph below, point A illustrates the tangency condition the utility curve has with the
budget line constraint.

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The tangency condition between the indifference curve and the budget line indicates the optimal
consumption bundle when indifference curves exhibit typical convexity.

Marginal rate of Substitution

The marginal rate of Substitution is one the major pillars on which the hypothesis of Indifference
curves stands. The marginal rate of substitution of X to Y is the maximum amount of Y good
which the consumer is ready to sacrifice or pay for one additional unit of X good holding utility
constant.

MRSX for Y =𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑋

Or = ∆𝑌 ∆𝑋

In table 2, As consumer moves from Combination A to combination B , He sacrifices 4 units of Y

for 1 additional unit of X, utility remains constant. So here Marginal rate of substitution of X for Y
is 4:1 which means he is ready to sacrifice 4 units of Y good for 1 additional unit of X good.
Similarly as he moves from combination B to C to D and to E , This rate becomes 3:1, 2:1 and 1:1.