This starts proper microeconomics : a powerful way to explain peoples’ choices,

1. AGEC 340 – International Economic DevelopmentCourse 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.

2. 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

3. 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.

5. As a farmer turns labor into crops, what levels of effort and yield might we see? crop yields (bu/acre) labor use (hrs/acre)

6. This is our textbook “production function”or “input response curve” (IRC)

7. 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

8. 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

9. 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)

10. 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

11. … 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

12. 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

13. …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

14. 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

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

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

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

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

19. 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)

20. Graphing this equation we get: Qty. of Corn per farm Iso-revenue lines, of slope = -Pb/Pc Qty. of Beans per farm

21. 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

22. 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)

23. 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)

24. 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)

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

26. and again only one choice can minimize costs (or maximize profits) Qtractors “iso-quant” iso-cost line (slope = -Plab/Ptrac) Qlabor

27. So we have three kinds of diagrams... Qo Qo2 Qi2 IRC PPF Isoquant Qi Qo1 Qi1

28. 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

29. The lines’ slopes are fixed by market values;they show the “relative prices” or what is economically desirable to produce Qo Qo2 Qo2 Qi2 Qi2 iso-profit lines (slope = Pi/Po) iso-revenue lines (slope = -Po1/Po2) iso-cost lines (slope = -Pi1/Pi2) Qi Qi Qo1 Qo1 Qi1 Qi1

30. The combination gives us the profit-maximizing combination of all inputs & all outputs highest profit Qo Qo2 Qo2 Qi2 Qi2 highest revenue lowest cost Qi Qi Qo1 Qo1 Qi1 Qi1

31. 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.

32. 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)

33. With relative price lines and technological-possibilities 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)

34. 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.

35. 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

36. 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...

37. …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)

38. 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 (slope=Pl/Pc) iso-revenue (-Pb/Pc) iso-cost (-Pl/Pm) Qty. of labor (hours/acre) Qty. of beans (bushels/acre) Qty. of labor (hours/acre)

39. 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)

40. …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 slope=Pl’/Pt Qty. of labor (hours/acre) Qty. of labor (hours/acre)

41. 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)

42. 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)

43. 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?