Unit 4- Consumer and

Firm
Utility and Consumer
Decision Making
 What is Utility?
Utility refers to the total satisfaction or benefit from consuming a good
or service.

Economic theories based on rational choice usually assume that

consumers will strive to maximize their utility.

It is measured in ‘utils’.
 Marginal Utility
● Marginal utility (MU) is defined as the additional utility gained from the consumption of
one additional unit of a good or service.

No. of Units Total Utility Marginal Utility Kind of MU

1 10 10

2 18 8

3 24 6 Positive Utility
4 28 4

5 30 2

6 30 0 Zero Utility
7 28 -2
Negative Utility
8 24 -4
Law of Diminishing Marginal Utility
● The Law of Diminishing Marginal Utility was given by Alfred Marshall's.

● The Law of Diminishing Marginal Utility states that the consumers experience
diminishing additional utility as they consume more of a good or service during
a given period of time.
 Behavioral Economics
● The study of situations in which people make choices that do not
appear to be economically rational.

● Behavioral economics combines elements of economics and

psychology to understand how and why people behave the way
they do in the real world.
 Indifference Curve
● An indifference curve shows a combination of two goods in various
quantities that provides equal satisfaction (utility) to an individual.

● IC slopes downward: It slopes downward from left to right.

● IC is convex to the origin because of diminishing
marginal rate of substitution (MRS).
● IC curves never cut each other.
● Higher indifference curve represents more satisfaction.
● IC neither touches X-axis or Y-axis.
● IC need not be parallel to each other.
 MRS
● The marginal rate of substitution (MRS) is the amount of a good that a
consumer is willing to trade off for another. MRS is used in indifference
theory to analyze consumer behavior.
Budget Constraint
● A budget line shows combinations of two goods a consumer is able to
consume, given a budget constraint.

● An indifference curve shows combinations of two goods that yield equal

satisfaction.

● To maximize utility, a consumer chooses a combination of two goods at which

an indifference curve is tangent to the budget line.
 Technology,
Production and Cost
● Technology is the process a firm uses to turn inputs into outputs of
goods and services.

● A technological change is a change in the ability of a firm to produce

a given level of output with a given quantity of inputs.
 The Short Run and the Long Run
● Short run- The period of time during which at least one of a firm’s inputs is
fixed.

● Long run- The period of time in which a firm can vary all its inputs, adopt a
new technology and increase or decrease the size of its physical plant.

● Short run: Fixed costs are already paid and are unrecoverable (i.e. "sunk").

● Long run: Fixed costs have yet to be decided on and paid, and thus are not
truly "fixed."
Costs
● Total fixed costs are the sum of all consistent, non-variable expenses a
company must pay.
● Total variable cost (TVC) is that cost which changes as the level of output
changes.
● Total cost- The cost of all the inputs a firm uses in production.
 Implicit Costs and Explicit Costs
● An implicit cost, also called an imputed cost, implied cost, or notional cost, is
the opportunity cost equal to what a firm must give up in order to use a factor
of production. The costs in which there is no cash outlay, is known as Implicit
cost.

● The costs which involve outflow of cash due to the use of factors of production
is known as Explicit cost.
 The Production Function
● Production function is the maximum set of output(s) that can be produced
with a given set of inputs. Use of a production function implies technical
efficiency.

● The general production function formula is: Q= f (K, L), Here Q is the output
quantity, L is the labor used, and. K is the capital invested for the production of
the goods.
 Average Total Cost
● Average total cost is referred to as the sum total of all production costs
divided by the total quantity of output. In other words, the average cost is
the combination of total fixed and variable costs, which is divided by the total
number of units that are produced by the firm.
 Marginal Product of Labor
● The marginal product of labor (or MPL) refers to a company's increase in
total production when one additional unit of labor is added (in most
cases, one additional employee) and all other factors of production
remain constant.
● When MP is increasing, TP increases at an increasing rate.
● When MP is decreasing, but still positive, TP increases at decreasing
rate.
● When MP becomes negative, TP is declining.
 Law of Diminishing Returns
● The law of diminishing marginal returns is a theory in economics that predicts
that after some optimal level of capacity is reached, adding an additional factor
of production will actually result in smaller increases in output.

● For example, a factory employs workers to manufacture its products, and, at

some point, the company operates at an optimal level. With all other
production factors constant, adding additional workers beyond this optimal
level will result in less efficient operations.
Costs in the Long Run
● In the long run, all costs are variable. There are no fixed costs
in the long run.
● Thus, TC= VC and ATC=AVC.
● The long-run average cost curve shows the lowest cost at which a firm is able
to produce a given quantity of output in the long run, when no inputs are fixed.

● A firm experiences economies of scale, which means the firm’s long-run

average costs fall as it increases the quantity of output it produces.

● A long run average cost curve is known as a planning curve. This is

because a firm plans to produce an output in the long run by choosing a plant
on the long run average cost curve corresponding to the output.
End of Unit 4