1. Copyright © 2002 by Thomson Learning, Inc. Chapter 1 Appendix Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-03-033652-X

2. Copyright © 2002 by Thomson Learning, Inc. Indifference Curve Analysis  Market Baskets are combinations of various goods.  Indifference Curves are curves connecting various market basket combinations of goods that make an individual equally happy.

3. Copyright © 2002 by Thomson Learning, Inc. Assumptions about Preferences  Persons can rank market baskets.  Rankings are transitive.  More is preferred to less.  The marginal rate of substitution is diminishing.

4. Copyright © 2002 by Thomson Learning, Inc. Indifference Curves and Indifference Maps

5. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.1 Indifference Curves Expenditure on Other Goods per Month (Dollars) 60 50 04050 Gasoline per Month (Gallons) QxQx U3U3 U2U2 U1U1 B2B2 B1B1

6. Copyright © 2002 by Thomson Learning, Inc.  The amount of expenditure on other goods that a person will give up in order to get an additional unit of another good is called the marginal rate of substitution. The Marginal Rate of Substitution

7. Copyright © 2002 by Thomson Learning, Inc. The Budget Constraint  The budget constraint is the combination of goods that can be afforded by a person.

8. Copyright © 2002 by Thomson Learning, Inc. The Budget Constraint in Algebraic Terms I = P x Q x +  P i Q i Where: I is income P i is the price of good i Q i is the amount of good i purchased

9. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.2 The Budget Constraint Expenditure on Other Goods per Month (Dollars) Expenditure on Gasoline per Month Expenditure on All Other Goods Except Gasoline per Month Gasoline per Month (Gallons) 100 60 040100 A F D C B QxQx

10. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.3 Consumer Equilibrium Expenditure on Other Goods per Month (Dollars) Gasoline per Month (Gallons) A E B U1U1 U3U3 U2U2 40 060QxQx

11. Copyright © 2002 by Thomson Learning, Inc. Equilibrium Condition P X = MB X

12. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.4 Changes in Income Expenditure on Other Goods per Month (Dollars) A A' B Q x per Month 0 B'

13. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.5 Changes in the Price of Good X Expenditure on Other Goods per Month (Dollars) A B '' B ' B0 Q x per Month

14. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.6 Income and Substitution Effects The Income Effect QxQx E' E1E1 150 50 100 6040 20 Expenditure on Other Goods per Month (Dollars) The Substitution Effect Gasoline per Month (Gallons) U2U2 U1U1 E2E2 45

15. Copyright © 2002 by Thomson Learning, Inc. The Law of Demand  The demand curve is downward sloping.  As the price rises the quantity demanded falls.

16. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.7 The Law of Demand D = MB Price Q x per Month0

17. Copyright © 2002 by Thomson Learning, Inc. Price Elasticity of Demand % Change in Quantity Demanded % Change in Price E D = QD/QDQD/QD P/PP/P =

18. Copyright © 2002 by Thomson Learning, Inc. Consumer Surplus  Net benefit that consumers obtain from a good.  Total benefit to consumers from obtaining a good, less the money they give up to get the good.

19. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.8 Consumer Surplus Price Q 1 A P B D = MB Market Price Consumer Surplus Gasoline per Month 0

20. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.9 The Work Leisure Choice U3U3 A E B Leisure Hours per Day 40 U2U2 U1U1 Income per Day 16240

21. Copyright © 2002 by Thomson Learning, Inc. Budget line for time allocation I = w(24 – L) Where: I is income W is wage L is the amount of time devoted to leisure

22. Copyright © 2002 by Thomson Learning, Inc. Analysis of Production and Cost  The Production Function is the expression of the maximum output obtainable from any combination of inputs.  The Short Run is the period of time in which some inputs cannot be changed.  The Long Run is the period of time in which all inputs can be changed.

23. Copyright © 2002 by Thomson Learning, Inc. Marginal Product  The increase in output associated with a one unit increase in an input is called the Marginal Product.

24. Copyright © 2002 by Thomson Learning, Inc. Isoquants  Isoquants are curves that show alternative combinations of variable inputs that can be used to produce a given amount of output.  The Marginal Technical Rate of Substitution is the amount of one input that can be given up with one additional unit of another input while keeping output constant.  It is the slope of the isoquant.

25. Copyright © 2002 by Thomson Learning, Inc. Isocost Lines Lines that show combinations of variable inputs that are of equal cost are called Isocost Lines C = P L L + P K K Where: C is the total cost P L is the price of labor (typically the wage) L is the units of labor employed P K is the price of capital (typically a rental price or an interest rate to reflect the opportunity cost of that capital) K is the units of capital employed

26. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.10 Isoquant Analysis Labor Hours per Month Monthly Output = Q 1 Machine Hours per Month Isocost Lines L* E K* 0

27. Copyright © 2002 by Thomson Learning, Inc. Cost Minimization Costs are minimized for every level of output where: MRTS KL = P K /P L

28. Copyright © 2002 by Thomson Learning, Inc. Cost Functions  Total Cost  Variable Cost  Average Cost  Average Variable Cost  Average Fixed Cost  Marginal Cost

29. Copyright © 2002 by Thomson Learning, Inc. Returns to Scale  Constant Returns to Scale  AC = MC  AC and MC are constant  Increasing Returns to Scale  AC < MC  AC is diminishing  Decreasing Returns to Scale  AC > MC  AC is increasing

30. Copyright © 2002 by Thomson Learning, Inc. Profit Maximization Assumption: All firms seek to maximize profits. Operationally that means that firms will set production where Marginal Revenue equals Marginal Cost; MC = MR.

31. Copyright © 2002 by Thomson Learning, Inc. Perfect Competition The situation where:  There are many buyers and sellers such that no one has market power.  The product being sold is homogenous.  There are no legal or economic barriers to entry.  Information is freely available. In such a case the market price is the Marginal Revenue to the firm and that firm will maximize profits where P = MC.

32. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.11 Short-Run Cost Curves and Profit Maximization under Perfect Competition Price and Cost Output per Month AVC min = F D = MR P E MC AC 0 Producer Surplus Q*

33. Copyright © 2002 by Thomson Learning, Inc. Short-Run Supply  Under perfect competition, Supply is the Marginal Cost curve emanating from the minimum of average variable cost

34. Copyright © 2002 by Thomson Learning, Inc. Producer Surplus  Producer Surplus is the difference between the market price and the minimum price for which the firm would sell the product. It is the area under the price line and above the marginal cost curve. It also represents the profit less fixed costs to the firm.

35. Copyright © 2002 by Thomson Learning, Inc. Normal and Economic Profit  Normal Profit is the opportunity cost of resources of owner-supplied inputs. The value of the firm owners’ time (typically measured by their next job opportunity) plus any other inputs provided by the owner(s).  Economic Profit is any profit to the firm that is above normal profit.

36. Copyright © 2002 by Thomson Learning, Inc. Long Run Supply  In the long run, economic profit is driven to zero under competition.  P = LRMC = LRAC min

37. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.12 Long-Run Competitive Equilibrium Price LRAC min = P LRMC LRAC D = MR Q* Output per Month 0

38. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.13 Long-Run Supply: The Case of A Constant-Costs Competitive Industry LRACmin = P Long-Run Supply Price Output per Year0

39. Copyright © 2002 by Thomson Learning, Inc. Figure 1A.14 A Perfectly Inelastic Supply Curve Supply Price Output per Year 0 Q1Q1

40. Copyright © 2002 by Thomson Learning, Inc. Price Elasticity of Supply % Change in Quantity Supplied % Change in Price E S = = QS/QSQS/QS P/PP/P