46 PA R T I INTRODUCTION AND BACKGROUND
A vertical demand curve is one for which the quantity demanded does
supply curve A curve showing
the quantity of a good that firms
are willing to supply at each
price.
marginal productivity The
impact of a one-unit change in
any input, holding other inputs
constant, on the firms output.
not change when price rises; in this case, demand is perfectly inelastic.
A horizontal demand curve is one where quantity demanded changes
infinitely for even a very small change in price; in this case, demand is
perfectly elastic.
Finally, the example here is a special case in which the demand for CDs
doesnt change as the price of movies changes. The effect of one goods
prices on the demand for another good is the cross-price elasticity, and
with the particular utility function we are using here, that cross-price
elasticity is zero. Typically, however, a change in the price of one good
will affect demand for other goods as well.
Supply Curves
The discussion thus far has focused on consumers and the derivation of
demand curves. This tells about only one side of the market, however. The
other side of the market is represented by the supply curve, which shows the
quantity supplied of a good or service at each market price. Just as the demand
curve is the outcome of utility maximization by individuals, the supply curve
is the outcome of profit maximization by firms.
The analysis of firms profit maximization is similar to that of consumer
utility maximization. Just as individuals have a utility function that measures
the impact of goods consumption on well-being, firms have a production func-
tion that measures the impact of firm input use on firm output levels. For ease,
we typically assume that firms have only two types of inputs, labor (workers)
and capital (machines, buildings). Consider a firm that produces movies. This
firms production function may take the form q K
L, where q is the
quantity of movies produced, K is units of capital (such as studio sets), and L is
units of labor (such as hours of acting time employed).
The impact of a one-unit change in an input, holding other inputs constant,
on the firms output is the marginal productivity of that input. Just as the
marginal utility of consumption diminishes with each additional unit of con-
sumption of a good, the marginal productivity of an input diminishes with
each additional unit of the input used in production; that is, production gener-
ally features diminishing marginal productivity. For this production function, for
example, holding K constant, adding additional units of L raises production by
less and less, just as with the utility function (of this same form), holding CDs
constant, consuming additional movies raised utility by less and less.4
This production function dictates the cost of producing any given quantity
as a function of the prices of inputs and the quantity of inputs used. The total
4
A good way to see this intuition is to consider digging a hole with one shovel. One worker can make
good progress. Adding a second worker probably increases the progress, since the workers can relieve each
other in shifts, but it is unlikely that progress doubles. Adding a third worker raises progress even less. By the
time there are four or five workers, there is very little marginal productivity to adding additional workers,
given the fixed capital (one shovel).