Theory of Consumer

Behavior
 Theory of Consumer Behavior
 Useful for understanding the demand side of the
market.
 Utility - amount of satisfaction derived from the
consumption of a commodity ….measurement
units  utils
 Utility concepts
 cardinal utility - assumes that we can assign values for
utility, (Jevons, Walras, and Marshall). E.g., derive 100
utils from eating a slice of pizza
 ordinal utility approach - does not assign values,
instead works with a ranking of preferences. (Pareto,
Hicks, Slutsky)
 Total utility and marginal utility
 Total utility (TU) - the overall level of
satisfaction derived from consuming a good
or service
 Marginal utility (MU) additional satisfaction
that an individual derives from consuming
an additional unit of a good or service.

TU
MU 
Q
 Total utility and marginal utility
Example (Table 4.1):
 TU, in general, increases with Q
Q TU MU  At some point, TU can start
falling with Q (see Q = 6)
0 0 ---
 If TU is increasing, MU > 0
1 20 20
 From Q = 1 onwards, MU is
2 27 7 declining  principle of
3 32 5 diminishing marginal utility 
As more and more of a good are
4 35 3 consumed, the process of
5 35 0 consumption will (at some point)
6 34 -1 yield smaller and smaller
additions to utility
7 36
30 -4
 Total Utility Curve
TU

35
Total utility(in utils)

30
25 Figure 4.1

20
15
10
5
Q
0 1 2 3 4 5 6
Quantity
 Marginal Utility Curve
MU
Marginal utility (in utils)

20
15
10

5
0 Q
1 2 3 4 5 6
-5
Quantity
Figure 4.2
 Consumer Equilibrium
 So far, we have assumed that any amount of
goods and services are always available for
consumption
 In reality, consumers face constraints
(income and prices):
 Limited consumers income or budget
 Goods can be obtained at a price
 Some simplifying assumptions
 Consumer’s objective: to maximize his/her
utility subject to income constraint
 2 goods (X, Y)
 Prices Px, Py are fixed
 Consumer’s income (I) is given
 Consumer Equilibrium
 Marginal utility per peso  additional utility
derived from spending the next peso on the
good

MU
MU per peso 
P
 Consumer Equilibrium
 Optimizing condition:
MU X MU Y

PX PY

 If
MU X MU Y

PX PY
 spend more on good X and less of Y
 Simple Illustration
 Suppose: X = fishball
Y = siomai

 Assume: PX = 2
PY = 10
 Numerical Illustration

Qx TUX MUX MUx QY TUY MUY MUy

Px Py
1 30 30 15 1 50 50 5
2 39 9 4.5 2 105 55 5.5
3 45 6 3 3 148 43 4.3
4 50 5 2.5 4 178 30 3
5 54 4 2 5 198 20 2
6 56 2 1 6 213 15 1.5
 2 potential optimum positions
 Combination A:  X = 3 and Y = 4
 TU = TUX + TUY = 45 + 178 = 223
 Combination B:  X = 5 and Y = 5
 TU = TUX + TUY = 54 + 198 = 252
 Presence of 2 potential equilibrium
positions suggests that we need to consider
income. To do so let us examine how much
each consumer spends for each
combination.
 Expenditure per combination
 Total expenditure = PX X + PY Y
 Combination A: 3(2) + 4(10) = 46

 Combination B: 5(2) + 5(10) = 60

 Scenarios:
 If consumer’s income = 46, then the optimum is
given by combination A. .…Combination B is
not affordable
 If the consumer’s income = 60, then the
optimum is given by Combination
B….Combination A is affordable but it yields a
lower level of utility
PRODUCTION and COSTS
Theory of Production and Costs
 Focus- mainly on the the firm.
 We will examine
 Its production capacity given available resources
 the related costs involved
 What is a firm?
 A firm is an entity concerned with the purchase and
employment of resources in the production of various
goods and services.
 Assumptions:
 the firm aims to maximize its profit with the use of resources
that are substitutable to a certain degree
 the firm is" a price taker in terms of the resources it uses.
 The Production Function
 The production function refers to the physical relationship
between the inputs or resources of a firm and their
output of goods and services at a given period of time,
ceteris paribus.

 The production function is dependent on different

time frames. Firms can produce for a brief or lengthy
period of time.
 Firm’s Inputs
 Inputs - are resources that contribute in the
production of a commodity.

 Most resources are lumped into three categories:

 Land,
 Labor
 Capital.
 Fixed vs. Variable Inputs
 Fixed inputs -resources used at a constant amount in
the production of a commodity.
 Variable inputs - resources that can change in quantity
depending on the level of output being produced.
 The longer planning the period, the distinction between
fixed and variable inputs disappears, i.e., all inputs are
variable in the long run.
Production Analysis with One Variable Input

 Total product (Q) refers to the total amount of output

produced in physical units (may refer to, kilograms
of sugar, sacks of rice produced, etc)
 The marginal product (MP) refers to the rate of change
in output as an input is changed by one unit, holding
all other inputs constant.

TPL
MPL 
L
 Total vs. Marginal Product
 Total Product (TPx) = total amount of output
produced at different levels of inputs
 Marginal Product (MPx) = rate of change in output as
input X is increased by one unit, ceteris paribus.

TPX
MPX 
X
Production Function of a Rice Farmer
Units of L Total Product Marginal Product
(QL or TPL) (MPL)
0 0 -
1 2 2
2 6 4
3 12 6
4 20 8
5 26 6
6 30 4
7 32 2
8 32 0
9 30 -2
10 26 -4
Q

QL

0 L
 QL

32
30
26 QL
Total product

20

12

2
L
0 1 2 3 4 5 6 7 8 9 10

Labor

FIGURE 5.1. Total product curve. The total product curve shows the behavior of total product vis-a-vis an input
(e.g., labor) used in production assuming a certain technological level.
 Marginal Product
 The marginal product refers to the rate of change in
output as an input is changed by one unit, holding all
other inputs constant.
 Formula:

TPL
MPL 
L
 Marginal Product
 Observe that the marginal product initially increases,
reaches a maximum level, and beyond this point, the
marginal product declines, reaches zero, and
subsequently becomes negative.
 The law of diminishing returns states that "as the
use of an input increases (with other inputs fixed), a
point will eventually be reached at which the resulting
additions to output decrease"
 Law of Diminishing Marginal Returns

 As more and more of an input is added (given a

fixed amount of other inputs), total output may
increase; however, as the additions to total
output will tend to diminish.
 Counter-intuitive proof: if the law of
diminishing returns does not hold, the world’s
supply of food can be produced in a hectare of
land.
 Average Product (AP)

 Average product is a concept commonly associated

with efficiency.
 The average product measures the total output per
unit of input used.
 The "productivity" of an input is usually expressed in terms
of its average product.
 The greater the value of average product, the higher the
efficiency in physical terms.
 Formula: TPL
APL 
L
TABLE 5.2. Average product of labor.
Total product of Average product of
Labor (L) labor (TPL) labor (APL)
0 0 0
1 2 2
2 6 3
3 12 4
4 20 5
5 26 5.2
6 30 5
7 32 4.5
8 32 4
9 30 3.3
10 26 2.6
 Relationship between Average and
Marginal Curves: Rule of Thumb
 When the marginal is less than the average, the
average decreases.
 When the marginal is equal to the average, the
average does not change (it is either at maximum
or minimum)
 When the marginal is greater than the average,
the average increases
 Relationship between Average and Marginal
Curves: Example of Econ 11 Scores
 When the marginal score (new exam) is less than
your average score, the average decreases.
 When the marginal score (new exam) is equal to
the average score, the average does not change.
 When the marginal score (new exam) is greater
than your average score, the average increases.
AP,MP

At Max AP,
MP=AP

Max MPL
Max APL

APL

0 L1 L2 L3 L
MPL
 TP

TPL

0 L1 L2 L3 L
Stage I Stage II Stage III
MP>AP MP<AP
AP,MP AP increasing AP decreasing
MP<0
AP decreasing
MP still positive

APL

0 L1 L2 L3 L
MPL
 Three Stages of Production
 In Stage I
 APL is increasing so MP>AP.
 All the product curves are increasing

 Stage I stops where APL reaches its maximum at

point A.
 MP peaks and then declines at point C and beyond,
so the law of diminishing returns begins to manifest
at this stage
 Three Stages of Production
 Stage II
 starts where the APL of the input begins to decline.
 QL still continues to increase, although at a
decreasing rate, and in fact reaches a maximum
 Marginal product is continuously declining and
reaches zero at point D, as additional labor inputs are
employed.
 Three Stages of Production
 Stage III starts where the MPL has turned
negative.
 all product curves are decreasing.
 total output starts falling even as the input is
increased
 COSTS OF PRODUCTION
 Opportunity Cost Principle - the economic cost of an
input used in a production process is the value of
output sacrificed elsewhere. The opportunity cost of
an input is the value of foregone income in best
alternative employment.
 Implicit vs. Explicit Costs
 Explicit costs – costs paid in cash
 Implicit cost – imputed cost of self-owned or self employed
resources based on their opportunity costs.
 7 Cost Concepts (Short-run)
1. Total Fixed Cost (TFC)
2. Total Variable Cost (TVC)
3. Total Cost (TC=TVC+TFC)
4. Average Fixed Cost (AFC=TFC/Q)
5. Average Variable Cost (AVC=TVC/Q)
6. Average Total Cost (AC=AFC+AVC)
7. Marginal Cost (MC= ∆AVC/∆Q
 Short Run Analysis

 Total fixed cost (TFC) is more commonly

referred to as "sunk cost" or "overhead cost."
 Examples: include the payment or rent for land,
buildings and machinery.
 The fixed cost is independent of the level of
output produced.
 Graphically, depicted as a horizontal line
 Short Run Analysis
 Total variable cost (TVC) refers to the cost
that changes as the amount of output produced
is changed.
 Examples - purchases of raw materials, payments to
workers, electricity bills, fuel and power costs.
 Total variable cost increases as the amount of output
increases.
 If no output is produced, then total variable cost is zero;
 the larger the output, the greater the total variable cost.
 Short Run Analysis
 Total cost (TC) is the sum of total fixed cost
and total variable cost

 TC=TFC+TVC

 As the level of output increases, total cost of the

firm also increases.
 Total Costs of Production
Total Total
Units of Total Fixed Variable Total Marginal Average
Labor Product Cost Cost Cost Cost Cost
L TPL TFC TVC TC MC AC
0 0 100 0 100 - -
1 6 100 30 130 30 130
2 10 100 50 150 20 75
3 12 100 60 160 10 53.3
4 13 100 65 165 5 41.25
5 15 100 75 175 10 35
6 19 100 95 195 20 32.5
7 25 100 125 225 30 32.14
8 33 100 165 265 40 33.12
9 43 100 215 315 50 35
10 55 100 275 375 60 37.5
Pesos

TC
(Total Cost)

TVC
(Total Variable Cost)

TFC
(Total Fixed Cost)

0 Q
“TOTAL” COST CURVES
Pesos

AFC=TFC/Q.
As more output is produced, the
Average Fixed Cost decreases.

AFC
(Average Fixed Cost)

0 Q
Pesos The Average Variable
Cost at a point on the
TVC curve is measured by
the slope of the line from
the origin to that point. TVC
(Total Variable Cost)
AVC=TVC/Q

Minimum AVC

0 q1 Q
Pesos
TVC
Inflection (Total Variable Cost)

point

0 q1 Q

MC
(Marginal Cost)

q1
Pesos

The Average Variable Cost is U

shaped. First it decreases, reaches a
minimum and then increases.

AVC
(Average Variable Cost)

Minimum AVC

0 q1 Q
Pesos The Marginal Cost curve passes
through the minimum point of
the AVC curve.
MC (Marginal Cost)
It is also U-shaped. First it
decreases, reaches a minimum AVC
and then increases. (Average Variable Cost)

Minimum AVC

0 q1 Q
Pesos MC

AC

AVC

AFC

0 q1 Q

The “PER UNIT” COST CURVES

Table 5.4 Average Cost of Production

(Q) (TC) (AC)

0 100 -
1 130 130.00
2 150 75.00
3 160 53.33
4 165 41.25
5 175 35.00
6 195 32.50
7 225 32.14
8 265 33.13
9 315 35.00
10 375 37.50
 Table 5.5 Average Variable Costs of Production

Total Product Total Variable Cost Average Variable Cost

(Q) (AVC) (AVC)
0 0 0
1 30 30.0
2 50 25.0
3 60 20.0
4 65 16.3
5 75 15.0
6 95 15.8
7 125 17.9
8 165 20.6
9 215 23.9
10 275 27.5
 LTC LTC
All inputs are variable in the long
run. There are no fixed costs.
Long Run Total Cost

Q
Total Product

LONG-RUN TOTAL COST CURVE

 The LAC
 The LAC curve is an envelop curve of all
possible plant sizes. Also known as “planning
curve”
 It traces the lowest average cost of producing
each level of output.
 It is U-shaped because of
 Economies of Scale
 Diseconomies of Scale
COST

LAC

SAC1

SAC2

0 Q

LONG-RUN AVERAGE COST CURVE

COST

LAC
SAC1

0 Q
q0
 Building a larger sized plant (size 2)
will result in a lower average cost of
COST producing q0

LAC
SAC1

SAC2

0 Q
q0
 Likewise, a larger sized plant (size
COST 3) will result to a lower average
cost of producing q1

SAC1 LAC
SAC2
SAC3

0 Q
q0 q1
 Economies and Diseconomies of Scale

 Economies of Scale- long run average cost

decreases as output increases.
 Technological factors
 Specialization

 Diseconomies of Scale: - long run average cost

increases as output increases.
 Problems with management – becomes costly,
unwieldy
COST

LAC

SAC1

SAC2

Economies of Scale Diseconomies of Scale

0 Q1 Q

LONG-RUN AVERAGE COST CURVE

 LONG-RUN AVERAGE and MARGINAL COST CURVES

LMC
COST

SMC2
LAC

SAC2
SMC1 SAC1

0 Q1 Q
 LAC and LMC
 Long-run Average Cost (LAC) curve
 is U-shaped.
 the envelope of all the short-run average cost
curves;
 driven by economies and diseconomies of size.

 Long-run Marginal Cost (LMC) curve

 Also U-shaped;
 intersects LAC at LAC’s minimum point.