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.
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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!
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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?
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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?
labor use (hrs/acre)
crop yields(bu/acre)
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This is our textbook “production function”or “input response curve” (IRC)
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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
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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
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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 = mX+b:
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...
labor use (hrs/acre)
crop yields(bu/acre)
/Po The formula for this line isQo = /Po + (Pi/Po)Qi
Qo
Qi
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… 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
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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)
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…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
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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
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We can do a similar analysis for farmer’s choice among outputs.
Qty. ofCorn perfarm
Qty. of Beansper farm
Holding all else constant!
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Qty. ofCorn perfarm
Qty. of Beansper farm
What combinations of outputs do we expect to see?
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Qty. ofCorn perfarm
Qty. of Beansper farm
A “production possibilitiesfrontier” (PPF)
What combinations of outputs do we expect to see?
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We have a similar picture as before...
Qty. ofCorn perfarm
Qty. of Beansper farm
Technicallyinefficient
Technicallyimpossible
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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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Qty. ofCorn perfarm
Qty. of Beansper farm
Graphing this equation we get:
Iso-revenue lines,of slope = -Pb/Pc
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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
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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 oranimal use(hp-hrs)
labor use(person-hours)
possible techniques to produce two tons of corn, using one acre of land, etc.
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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 oranimal use(hp-hrs)
labor use(person-hours)
An “iso-quant”
technicallyimpossible
technicallyinefficient
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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:
Iso-cost lines,of slope = -Plabor/Ptractor
tractor oranimal use(hp-hrs)
labor use(person-hours)
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and again only one choice can minimize costs (or maximize profits)
Qtractors
Qlabor
“iso-quant”
iso-cost line(slope = -Plab/Ptrac)
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So we have three kinds of diagrams...
Qo
Qi
Qo2
Qo1
Qi2
Qi1
IRC PPF Isoquant
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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
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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
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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
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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
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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)
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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)
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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 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
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• 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?
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…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)
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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)
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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
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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?
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
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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.
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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
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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?