Summary
The Cost-Minimizing Input Combination
- 1. Firms will determine the optimal input combination using the cost-minimization rule: When a firm uses the cost-minimizing combination of inputs, the marginal product of labor divided by the wage rate is equal to the marginal product of capital divided by the rental rate.
The Time Value of Money
- 2. In order to evaluate a project in which costs or benefits are realized in the future, you must first transform them into their present values using the interest rate, r. The present value of $1 realized one year from now is $1/(1 + r), the amount of money you must lend out today to have $1 one year from now. Once this transformation is done, you should choose the project with the highest net present value.
The Economics of Information
- 3. Private information can cause inefficiency by distorting economic decisions and preventing mutually beneficial transactions from taking place. One problem is adverse selection, private information about the way things are. It creates the “lemons problem” in used-car markets, where sellers of high-quality cars drop out of the market. Adverse selection can be limited in several ways—through screening of individuals, through the signaling that people use to reveal their private information, and through the building of a reputation.
- 4. A related problem is moral hazard: individuals have private information about their actions, which distorts their incentives to exert effort or care when someone else bears the costs of that lack of effort or care. It limits the ability of markets to allocate risk efficiently. Insurance companies try to limit moral hazard by imposing deductibles, placing more risk on the insured.