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

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 the the curve would be technologically impossible Q output Q input

But what point along the IRC will people choose? labor use (hrs/acre) crop yields (bu/acre) point of maximum yields? segment with steepest slope? Q output Q input

Every point along the curve is technologically efficient, but not all are economically efficient If producers want to maximize profit:  = P o Q o - P i Q i (equation #1) and then some algebra, to solve for Q o so we can draw a line like Y = mX+b: Subtract PoQo and  from both sides -P o Q o = -  - P i Q i and then divide both sides by –P o : Q o =  /P o + (P i /P o )Q i (equation #2)

We can graph this equation... labor use (hrs/acre) crop yields (bu/acre)  /P o The formula for this line is Q o =  /P o + (P i /P o )Q i QoQo QiQi

… 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 /P o  1 /P o  3 /P o Each line is Q o =  /P o + (P i /P o )Q i with the same slope (Pi/Po), but a different intercept (  /Po ) QoQo QiQi

These lines are called “iso-profit” lines  2 /P o  1 /P o  3 /P o Slope = P i /P o QoQo QiQi labor use (hrs/acre) crop yields (bu/acre)

…and we expect farmers will choose the point on IRC with the highest profit level Slope = P i /P o  */P o This is the highest-possible level of profit

Because of diminishing returns, only one point can be economically optimal.  */P o Profits below  * are economically inefficient 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

We can do a similar analysis for farmer’s choice among outputs. Qty. of Corn per farm Qty. of Beans per farm Holding all else constant!

Qty. of Corn per farm Qty. of Beans per farm What combinations of outputs do we expect to see?

Qty. of Corn per farm Qty. of Beans per farm A “production possibilities frontier” (PPF) What combinations of outputs do we expect to see?

We have a similar picture as before... Qty. of Corn per farm Qty. of Beans per farm Technically inefficient Technically impossible

What is the economically efficient choice? First the assumption that producers will maximize profit:  = P c Q c + P b Q b (equation #1) and then some algebra, to turn equation #1 into the equation for a line on our graph: Qc =  /P c - (P b /P c )Q b (equation #2)

Qty. of Corn per farm Qty. of Beans per farm Graphing this equation we get: Iso-revenue lines, of slope = -P b /P c

which we can use to find the efficient point: Qty. of Corn per farm Qty. of Beans per 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 or animal 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 or animal use (hp-hrs) labor use (person-hours) An “iso-quant” technically impossible technically inefficient

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 = P lab Q lab + P trac Q trac (equation #1) and then some algebra, to turn equation #1 into the equation for a line on our graph: Q trac = C/P trac - (P lab /P trac )Q lab (equation #2)

Graphing this equation we get: Iso-cost lines, of slope = -P labor /P tractor tractor or animal use (hp-hrs) labor use (person-hours)

and again only one choice can minimize costs (or maximize profits) Q tractors Q labor “iso-quant” iso-cost line (slope = -P lab /P trac )

So we have three kinds of diagrams... Qo Qi Qo2 Qo1 Qi2 Qi1 IRC PPFIsoquant

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 inefficient 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 = P i /P o ) iso-revenue lines (slope = -P o1 /P o2 ) iso-cost lines (slope = -P i1 /P i2 ) Qi Qo2 Qo1 Qi2 Qi1

The combination gives us the profit-maximizing combination of all inputs & all outputs Qo Qi Qo2 Qo1 Qi2 Qi1 Qi 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 line slope = P l /P c (corn exchanged for labor) iso-revenue line slope = -P b /P c (corn exchanged for beans) iso-cost line slope = -P l /P m (machines exchanged 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=P l /P c ) iso-revenue (-P b /P c ) iso-cost (-P l /P m )

and ask what would be changed by more 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 = P labor /P corn slope of isocost line = -P labor /P tractors

…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 = P l ’/P c new slope=P l ’/P t Qty. of corn (bu/acre) Qty. of labor (hours/acre) Qty. of machinery (hp/acre) Qty. of labor (hours/acre) old slope = P l /P c old slope = P l /P t

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 lower costs 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 optimum a new optimum old optimum a new optimum a new price ratio a new price 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?