AGEC 340 International Economic Development Part II: Microeconomics of Development Week 6February 17

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AGEC 340 International Economic
DevelopmentPart II Microeconomics of
DevelopmentWeek 6February 17-19

• Today
• Returndiscuss project topics sources
• Hand out Exercise 2 due this Thurs., Feb. 19th
• Start proper microeconomics
• a powerful way to explain peoples choices,
• particularly useful when looking over large
  numbers of people and long time periods

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Are low-income people inefficient?

• Why do the poor have low incomes?
• Do they use what they have inefficiently?
• or just have few resources?
• or is something else holding them back?
• Modern economics answers these questions in a
  very specific way!
• Here we will use farming as an example,
• but same logic applies to any kind of production

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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?

4
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.

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As a farmer turns labor into crops, what levels
of effort and yield might we see?
crop yields (bu/acre)
labor use (hrs/acre)
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This is our textbook production functionor
input response curve (IRC)
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The IRC defines a frontier of technical
efficiency
Qoutput
crop yields (bu/acre)
to produce above the the curve would be
technologically impossible
Technical efficiency holds everywhere along the
curve
to produce below the curve would be inefficient
labor use (hrs/acre)
Qinput
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But what point along the IRC will people choose?
Qoutput
point of maximum yields?
crop yields (bu/acre)
segment with steepest slope?
To predict a choice we need more information!
labor use (hrs/acre)
Qinput
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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 mXb
• Subtract PoQo and ? from both sides
• -PoQo -? - PiQi
• and then divide both sides by Po
• Qo ?/Po (Pi/Po)Qi (equation 2)

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We can graph this equation...
Qo
crop yields (bu/acre)
?/Po
The formula for this line is Qo ?/Po (Pi/Po)Qi
labor use (hrs/acre)
Qi
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but there are there are as many of these lines
as there are levels of profit.
Qo
crop yields (bu/acre)
?3/Po
Each line is Qo ?/Po (Pi/Po)Qi with the same
slope (Pi/Po), but a different intercept (?/Po)
?2/Po
?1/Po
labor use (hrs/acre)
Qi
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These lines are called iso-profit lines
Qo
crop yields (bu/acre)
?3/Po
?2/Po
Slope Pi/Po
?1/Po
labor use (hrs/acre)
Qi
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and we expect farmers will choose the point on
IRC with the highest profit level
This is the highest-possible level of profit
Slope Pi/Po
?/Po
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Because of diminishing returns, only one point
can be economically optimal.
Profits above ? are technically impossible
At the optimal point, the isoprofit line crosses
the IRC only once the isoprofit line is
tangent to the IRC
?/Po
Profits below ? are economically inefficient
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We can do a similar analysis for farmers choice
among outputs.
Qty. of Corn per farm
Holding all else constant!
Qty. of Beans per farm
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What combinations of outputs do we expect to see?
Qty. of Corn per farm
Qty. of Beans per farm
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What combinations of outputs do we expect to see?
Qty. of Corn per farm
A production possibilities frontier (PPF)
Qty. of Beans per farm
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We have a similar picture as before...
Qty. of Corn per farm
Technically impossible
Technically inefficient
Qty. of Beans per farm
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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)

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Graphing this equation we get
Qty. of Corn per farm
Iso-revenue lines, of slope -Pb/Pc
Qty. of Beans per farm
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which we can use to find the efficient point
Revenue ( profits) are highest the iso-revenue
line is tangent to the PPF
Qty. of Corn per farm
Qty. of Beans per farm
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To apply this to choice among inputs we can
again hold all other things constant (both
outputs and other inputs)
tractor or animal use (hp-hrs)
possible techniques to produce two tons of corn,
using one acre of land, etc.
labor use (person-hours)
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To apply this to choice among inputs we can
again hold all other things constant (both
outputs and other inputs)
tractor or animal use (hp-hrs)
An iso-quant
technically inefficient
technically impossible
labor use (person-hours)
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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)

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Graphing this equation we get
tractor or animal use (hp-hrs)
Iso-cost lines, of slope -Plabor/Ptractor
labor use (person-hours)
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and again only one choice can minimize costs (or
maximize profits)
Qtractors
iso-quant
iso-cost line (slope -Plab/Ptrac)
Qlabor
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So we have three kinds of diagrams...
Qo
Qo2
Qi2
IRC
PPF
Isoquant
Qi
Qo1
Qi1
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The curves are fixed by nature and technology
they show the frontier of what is
technologically possible to produce
Qo
Qo2
Qi2
impossible
impossible
inefficient
inefficient
inefficient
impossible
Qi
Qo1
Qi1
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The lines slopes are fixed by market
valuesthey show the relative prices or what
is economically desirable to produce
Qo
Qo2
Qi2
Qo2
Qi2
iso-profit lines (slope Pi/Po)
iso-revenue lines (slope -Po1/Po2)
iso-cost lines (slope -Pi1/Pi2)
Qi
Qo1
Qi
Qo1
Qi1
Qi1
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The combination gives us the profit-maximizing
combination of all inputs all outputs
highest profit
Qo
Qo2
Qi2
Qo2
Qi2
highest revenue
lowest cost
Qi
Qo1
Qi
Qo1
Qi1
Qi1
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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
• For example, if the value of labor is 5/hr and
  the value of corn is 2.50/bushel, then the
  barter exchange ratio between them is 2
  bushels/hour.
• The price ratio or relative scarcity of two
  things does not depend on whether they are sold
  for cash.

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Profit-maximizing production choices depend only
on relative prices or exchange ratios
Qty. of corn (bu/acre)
Qty. of corn (bu/acre)
Qty. of machinery (hp/acre)
iso-cost line slope -Pl/Pm (machines exchanged
for labor)
iso-profit line slope Pl/Pc (corn exchanged
for labor)
iso-revenue line slope -Pb/Pc (corn exchanged
for beans)
Qty. of labor (hours/acre)
Qty. of beans (bushels/acre)
Qty. of labor (hours/acre)
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With relative price lines and technological-possi
bilities curveswe can predict the
profit-maximizing combination of all inputs
all outputs.
Qty. of corn (bu/acre)
Qty. of corn (bu/acre)
Qty. of machinery (hp/acre)
Qty. of labor (hours/acre)
Qty. of beans (bushels/acre)
Qty. of labor (hours/acre)
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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.

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Putting the two ideas together...

• with technical efficiency
• a curve, representing whats 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

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What happens when prices change?

• 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...

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which graph(s) change?
Qty. of corn (bu/acre)
Qty. of corn (bu/acre)
Qty. of machinery (hp/acre)
Qty. of labor (hours/acre)
Qty. of beans (bushels/acre)
Qty. of labor (hours/acre)
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We need to see where labor enters the picture...
Qty. of corn (bu/acre)
Qty. of corn (bu/acre)
Qty. of machinery (hp/acre)
iso-profit (slopePl/Pc)
iso-revenue (-Pb/Pc)
iso-cost (-Pl/Pm)
Qty. of labor (hours/acre)
Qty. of beans (bushels/acre)
Qty. of labor (hours/acre)
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and ask what would be changed bymore abundant
(lower-priced) labor
Qty. of corn (bu/acre)
Qty. of machinery (hp/acre)
slope of isoprofit line Plabor/Pcorn
slope of isocost line -Plabor/Ptractors
Qty. of labor (hours/acre)
Qty. of labor (hours/acre)
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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?
Qty. of corn (bu/acre)
Qty. of machinery (hp/acre)
old slope Pl/Pc
new slope Pl/Pc
old slope Pl/Pt
new slopePl/Pt
Qty. of labor (hours/acre)
Qty. of labor (hours/acre)
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Now, higher profits lower costs could be
reached if farmers move along the IRC
isoquantto a different technique, that was not
optimal before.
Qty. of corn (bu/acre)
Qty. of machinery (hp/acre)
higher profits
more labor use, more corn production
lower costs
more labor use, less machinery
Qty. of labor (hours/acre)
Qty. of labor (hours/acre)
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In this way we can explain (and predict) how
farmers respond to changing prices
Qty. of corn (bu/acre)
Qty. of machinery (hp/acre)
a new price ratio
old optimum
a new price ratio
a new optimum
a new optimum
old optimum
Qty. of labor (hours/acre)
Qty. of labor (hours/acre)
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Conclusions

• 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 everyones already maximizing their
  profits, how can things improve?