Micro Economic Theory - Essay Example

Micro economic theory Economic activity of a firm in general is determined not only by consumption and consumer behavior but is also influenced by production and trade. Assumptions about consumer behavior that are made by the producers also play an important role in determining the guidelines based upon which a producer makes its choices. Production is measured in terms of the flow of inputs and outputs during a particular period (Guoqiang, 2006). Technology is vital in determining this production process because it will determine the combination of inputs in producing the output. A production plan made by a producer will comprise a list of selected outputs. All the production plans that are technologically feasible will be grouped together into one production possibilities set, which will describe all the patterns of inputs and outputs that the level of technology of the firm makes possible. Every production set will consist of two different kinds of possibilities. On the one hand are those production plans that may be feasible immediately and on the other, are those plans that may not be feasible on a short term basis but may eventually become possible (Guoqiang, 2006). The short term possibilities will include all input levels which are feasible based upon one restricting factor which is the time period and will be able to produce a particular level of output. This is represented as an isoquant which shows all the various input bundles that may be combined in order to produce one particular level of output. When a firm produces one output from two different kinds of output, for example one input may be labor while the other one may be the technology or machinery that is used in the process, a short term possibilities set will be derived on a different basis. In such a case, the isoquant will show the various combinations of the two different inputs that may be used in producing a specific level of output. For example, if y is the level of output produced, l is the amount of labor that is input and k is the amount of capital that is input, then the assumption which will be made is that labor can be varied within the short time period that is under consideration, however the machinery or capital remains fixed, then the production plans will be (y, -l, -k) and the short term possibilities set can be written as: Y(k’) = {(y,-l,-k) in Y: k = k’} A production plan will be considered technologically efficient if there is no way to produce any more of the output with the same inputs or to produce the same amount of output by using less inputs (Guoqiang, 2006). A set of a technologically efficient production plans can be described through the use of a transformation function T which I able to identify the maximal vectors of net outputs just as the production function is able to pick out the maximal scalar output as a function of the inputs. Thus the production function is a unique relationship between the inputs and the outputs. While TP is the total product output over a particular period of time, the AP or average product is defined as the total product divided by the quantity of labor that is sued, while the MP or marginal product of labor is the change in the total product divided by the amount of labor that is used. When curves are drawn for the average or marginal product, then the average product at any point on the total product curve will be equal to the slope of a straight line that is drawn from that point to that point on the TP curve. The marginal product between two points on the TP curve is equal to the slope of the TP curve between two points. However, in the production of most goods, it is not only one or two variables that will have to be considered. In many cases, several different variables/inputs are used. The law of diminishing returns states that as more and more units of variable inputs are added together with fixed input variables, then there will come a point where the level of return for each unit of the variable unit that is added will keep diminishing, therefore the marginal product keeps on decreasing (Salvatore 2006). This will therefore be a case of decreasing returns to scale, where the output is likely to keep decreasing as the scale of production is increased through the addition of more input variables, because as the scale of the production increases, the problem of managing the firm and of coordinating the various divisions and operations of the firm becomes difficult. Where the question arises of an innovative product being produced, for example such as the flat screen technology that is being produced by LG Philips, new and better production techniques are developed over a period of time. However, when such products are initially launched, there may be a large amount of sales, but there is the added danger of foreign imitators who want to rush in and try to seize some of the domestic and international market that is being created (Salvatore 2006). As a result, over a period of time, despite the fact that new and better production techniques produce a higher level of output, the expected degree of sales may not exist. As a result of such a product cycle model, the long term result is that the law of diminishing returns may start to apply rather than the desired profit maximization that is sought. The law of diminishing returns also begins to apply in terms of the demand and supply of the product. When the product is initially produced, there is a huge amount of demand because it is an innovative product. Since flat screen technology is a new technological innovation, it is to be expected that there will be a great deal of demand for the product. However the possibility of the initial demand being sustained is reduced in the long term. The reason for this is that when the demand is high, investors bring in heavy investment to produce more quantity of the product and the natural consequence of this is that the price of the product goes up and the demand falls, thereby reducing the profits that accrue to the manufacturer. Thus, another reason for such reduced long term demand is the demand and supply fluctuations in a market economy. Demange and Laroque(1999) have conducted a study to study stationary long run allocations using an overlapping generations model of social security with the impact of two variables being specifically taken into consideration, i.e, shocks to the productivity of labor and capital and demographic shocks. They have discovered an optimum level of stationary allocations and identified its properties, i.e, intergenerational transfers must be optimal, for if this is not met, then consumption between the young and old generations will be reallocated with labor and capital being fixed. They have further applied this to the competitive equilibrium that must be maintained in a market economy and they have been able to show that the relationship between the rational expectations equilibria and the conditional optima is comparable to the welfare theorems of standard economics. Therefore, there the determination of optimal stationary runs and its relationship with rational expectations must be taken into consideration while planning long term production output and determining long term possibilities. In the case of flat screen technologies, as stated in article – lots more capacity means a lower price for flat screens (Economist 2004), or in other words, a production glut which pushes supply up and thereby results in a fall in price. While the process of production may be technologically efficient as identified above, it may still result be subjected to the law of diminishing returns. The Aggregate Demand curve is the one that shows how a change in the price levels caused by a particular factor will change the aggregate expenditure on goods and services within the economy. The Short Run Aggregate Supply curve is a reflection of current changes in the economy. It is an upward sloping curve and is a reflection of two types of microeconomic markets (i) auction markets and (ii) posted price markets. The Long Run aggregate supply curve is a reflection of the long term relationship between price levels and output and is vertical. In the process of strategic planning and implementation, the factors of demand and supply will be strong determinants that will influence the financial decisions that must be made by any company. Financial factors that may influence demand and supply include foreign income, exchange rates, expectations about future outputs and future prices, the monetary and fiscal policy of the Government, changes in input prices, the expectation of possible inflation, changes in factor productivity, changes in excise and sales tax or changes in import prices. Therefore, such accounting information will be vital in influencing the demand and supply of a product. However, by utilizing the demand and supply theories that are a part of microeconomics and deriving the optimal production function that will maintain the input and output levels with a range that will maximize profits will help in strategic long and short term planning. The short term and long term production possibilities set will help to fix production at a level where the market is not glutted by supply which will drive the prices down. Moreover, microeconomics also offers input through the use of relevant formulae that explain how inflation, government regulations, import-export, etc can bring about profit maximization or losses. Therefore such theories are very helpful in implementing the kind of long term plans that will ensure optimal profit margins. Hence microeconomic theory is relevant in the case of flat screen technology. It illustrates how important it is to carefully assess the short term and long term production possibilities and how they will be impacted by the financial factors listed above which could cause changes in demand and supply. Such changes, not only in terms of short term demand and supply but also in terms of aggregate long term demand and supply will impact upon the level of profits that can be expected. While some factors can be easily anticipated and provision made for them, long term changes cannot be so easily anticipated. For instance, while it may be possible to make an accurate assessment about when Government may increase or decrease excise and/or sales tax, etc since there is usually press discussion about such issues, it is much more difficult to determine long term trends such as changes in currency exchange rates or fluctuations that may occur unexpectedly and cannot be intelligently predicted. Therefore, microeconomic theory is important in that it enables the establishment of a certain level of foresight in making economic decisions and helps to predict with a reasonable degree of accuracy how the factors of demand an supply are likely to impact upon profit maximization of a product and this a company can plan its long term production output on this bases. For example, the production of flat screen technology instruments must take into account, the factor of entry of foreign imitators of the product, glut in production of the product due to other companies joining in what appears to be a financially lucrative product and the impact of such production gluts upon demand and supply of the product. References: * Demange, Gabrielle and Laroque, Guy, 1999. “Social security and demographic shocks” Econometrica, 67(3): 527-543. * Economist article, 2004. “The Big Picture” The Economist , 24th July 2004. * Salvatore, Dominique, 2006. “Microeconomics theory and applications.”(4th edn) Oxford University Press. * Tian, Guoqiang, 2006. “Lecture notes: microeconomic theory.” Texas A&M University. [online] available at: * Read More