CONSUMER CHOICE AND BEHAVIOR Table 7.

Total Utility and Marginal

Utility Data for
UTILITY ANALYSIS Consuming Less Cholesterol Content
Food
• Utility – the sense of pleasure, or satisfaction,
Less Total Marginal
that comes from consumption Cholesterol Utility Utility
– Subjective – because it depends Content Food TU MU= TU/
Q Q
on taste or preferences

• Tastes – a consumer’s preference for different goods 0 0 -

and services 1 17.5
2 31
– Economists assume simply that tastes are given and 3 41.5
are relatively stable – that is, different people may 4 50
have different tastes but an individual’s tastes are 5 54
not constantly in flux. 6 54
7 45
The Law of Diminishing Marginal Utility

• Total utility – the total satisfaction a consumer derives

from consumption; it could refer either to the total utility
of consuming a particular good or the total utility from
all consumption
– Example: total utility is the total
satisfaction you got from consuming the five pieces
of chocolates.
• Marginal utility – the change in total utility derived
from a one-unit change in consumption of a good
– Example: marginal utility of the third piece of
chocolate that is the change in total utility resulting
from consuming that third piece of chocolate.
• Law of diminishing marginal utility – the more
of a good consumed per period, the smaller the
increase in total utility from consuming one more unit,
other things constant
Consumer Equilibrium
• Consumer Equilibrium is reached when utility is
maximized and the budget is completely spent.
• utility is maximized when the marginal utility of a
good divided by its price is identical for the last unit of
each good purchased.
The Utility-Maximizing Conditions
• Consumer equilibrium – The condition in which an
individual consumer’s budget is completely spent and
the last dollar/peso spent on each good yields the
same marginal utility; therefore, utility is maximized
1st Condition MUp = MUv
Pp Pv
Equi-Marginal Principle

– The marginal utility you derive from each additional 2nd Condition Total expenditure = Income/Budget
chocolate declines as your consumption increases. Income = (Pp x Qp)+(Pv x Qv)
Measuring Utility

• Units of Utility – called Utils

• Developing numerical values for utility allows us to be

more specific about the utility derived from
consumption

• Each individual has a uniquely subjective utility scale.

• Use ordinal ranking of preferences.

INDIFFERENCE CURVES AND UTILITY • Locus of points, each point representing combinations
MAXIMIZATION of the maximum amounts of goods and services that a
consumer can purchase given his/her level of income
• Indifference curve - shows all the combinations of and the prices of the commodities.
two goods that provide a consumer with the same total
satisfaction, or total utility. • Serves as a boundary between what combinations of
goods are feasible and what are not feasible.
(Possible UNITS OF UNITS • Represented by the equation (Income or Budget
Combination) CLOTHING OF Constraint)
POINTS FOOD
A 12 1 I = Px *Qx + Py *Qy
B 8 1.5
• Where I is income, Px is price of good X, Qx is
C 5 2.5
D 4 3.5 quantity of good X, Py is price of good Y, and Qy is
E 3 5.5 quantity of good Y

• Maximum amount of good X if all income is spent on

Properties of indifference curves good X

• Indifference curves reflect a constant level of utility; Qx = I/ Px

that is, the consumer is indifferent among consumption • Maximum amount of good Y if all income is spent on
combinations along an indifference curve. good Y
• Indifference curve slopes down Qy = I/Py
• Because of the law of diminishing marginal rate of GIVEN: INCOME = $20
substitution, indifference curves are bowed in toward
the origin Price of clothing per unit = $2

• Indifference curves do not intersect. Price of food per unit = $4

• Each curve in an indifference map represents a Slope of the budget line

different level of utility.
Negative ratio of prices = - Px/Py
• Curves further from the origin reflect higher levels of
• The budget line is negatively sloped because, given a
total utility
fixed level of income and prices of goods, if a
consumer wants to buy more of good X, then it is only
possible if some amounts of good Y will be given up.

Consumer equilibrium at the Tangency

• The consumer wants to select a combination of goods

on an indifference curve as far from the origin as
possible, but must stay on or within the budget line.

• Equilibrium occurs when the consumption bundle

selected is on the highest possible indifference

• The marginal rate of substitution, MRS, indicates

the maximum amount of one good a consumer is
willing to give up in order to get one more unit of
another good, while maintaining the same level of total
utility.

• The marginal rate of substitution equals the

slope of an indifference curve

BUDGET LINE

• Represents limit on consumer choices

 curvethat is tangent to the budget line. • Classification of factors of production: fixed factor and
variable factor.
INDIFFERENCE SCHEDULE FOR CLOTHING
AND FOOD – Fixed factor – remains constant regardless of the
volume of production
POINTS UNITS OF UNITS OF
CLOTHING FOOD – Variable factor – changes in accordance with the
A 12 1 volume of production
B 8 1.5
C 5 2.5 Production Function
D 4 3.5
E 3 5.5 • A model which shows the relationship between
quantities of various inputs used and the maximum
GIVEN: INCOME = $20 output that can be produced with those inputs, given a
Price of clothing per unit = $2
Price of food per unit = $4
certain state of technology during a given time period.

• It can be expressed in a table, graph, or an equation.

• It shows what is technically feasible when the firm

operates efficiently.

• Point C is the equilibrium point. It is where the

indifference curve is tangent with the budget line.

Solution: given income = $20

• (5 units of clothing x $2) + (2.5 units of food x
$4) = $20
• At equilibrium the slope of the indifference
curve, MRS, equals the slope of the budget line, minus
the ratio of the prices of the two goods.
• The MRS also equals minus the marginal utility
of the good on the horizontal axis divided by the
marginal utility of the good on the vertical axis.
• That is, in equilibrium,
MUx/MUy = -Px/Py or
MUx/Px = MUy/Py
(Equi-marginal principle)
THE THEORY OF PRODUCTION AND COSTS
Theory of Production
• Production is the transformation of inputs into outputs.
• Inputs in production are also called factors of
production.
Short-Run versus Long-Run
• Short-run – some factors of production cannot be
changed (fixed factors)
• Long-run – all factors can be changed.
PRODUCTION CONCEPTS
Total Product
• Total amount of goods and services produced
• As the number of an input increases, total
product also increases
Average Product
• Output produced per unit of an input employed
• Total Product/ number of input (labor)
• Measures the productivity of labor in terms of
how much on average each worker can perform.
Marginal Product
• The extra product or output produced by adding an
extra unit of an input while holding other inputs fixed.
• Change in total product/ change in input
THREE STAGES OF PRODUCTION
Increasing Marginal Return
• As more inputs are added in production, total product
increases at an increasing rate so marginal product
increases.
Diminishing Marginal Return
• As more inputs are added in production while holding
other inputs fixed, total product increases but at a
decreasing rate so marginal product declines.
Negative Marginal Return
• As more inputs are added in production, total
product decreases so marginal product becomes
negative.
Diminishing Marginal Product
• Diminishing marginal product is the property whereby
the marginal product of an input declines as the
quantity of the input increases.
• Example: As more and more workers are hired at a
firm, each additional worker contributes less and less
to production because the firm has a limited amount of
equipment.
Marginal Product= Additional Output / Additional
Input
Relationship Between Average Product and Marginal
Product
• When the MP is greater than AP, the average product
increases as labor increases.
• When the MP is equal to AP, the average product is
constant.
• When MP is less than the AP, the average product will
fall as labor input increases.
A Firm’s Profit
Profit is the firm’s total revenue minus its total cost.
Profit = Total revenue - Total cost
Total Cost includes all of the opportunity costs of
production
TWO TYPES OF COSTS
Explicit Costs
- Costs firms pay for the inputs
- Actual cash payments for resource purchases
- Costs recorded by accountants
- i.e. wages, rent, interest, insurance, taxes, etc.
Implicit
- Measured by what the owner’s could have earned
have they worked and invested in their next best
alternative.
- Opportunity costs of the owner’s time and capital
- Require no cash payments and no entry in the firm’s
accounting statement
Normal Profit
- Is the profit when economic profit is zero.
- Gives the minimum amount that one has to make to
cover the explicit as well as the implicit costs.
Jerry was a computer programmer who earned $50,000
a year. He decided to go into business. He invested
$100,000 of his savings (which had been earning7% in a
money market fund) into the business. In the first year,
his business had $200,000 in revenues and $120,000 in
explicit costs. How much was his accounting profit?
What about his economic profit?
Fixed and Variable Costs
• Fixed costs are those costs that do not vary with the
quantity of output produced.
• Variable costs are those costs that do change as the
firm alters the quantity of output produced.
• Short Run vs. Long Run Costs
TC = TFC + TVC
 Relationship between marginal cost and marginal
product

• Marginal cost is the key to decision making in

the short run

• Changes in marginal cost reflect changes in

marginal product of the variable input.

• Marginal cost falls when the marginal product of

the variable resources increases and rises when the
Total-Cost Curve... marginal product of the variable resources declines,
i.e. when diminishing marginal returns set in.

Average Costs

• Average costs can be determined by dividing the firm’s

costs by the quantity of output produced.
• The average cost is the cost of each unit of product
produced.

Average Fixed Costs

(AFC)= FC/output

Average Variable Costs

(AVC)= VC/output

Average Total Costs

(ATC) = TC/output

ATC = AFC + AVC The Relationship between Marginal Cost and

Average Cost
Marginal Cost
• If marginal cost lies below average cost, it pulls
• Marginal cost (MC) measures the amount by which
average cost down so average cost decreases; if
total cost rises when the firm increases production by
marginal cost lies above, it pulls average cost up so
one unit.
average cost increases.
• Marginal cost helps answer the following question:
• If the marginal cost curve intersects both the average
- How much does it cost to produce an additional unit
variable cost curve and the average total cost curve
of output?
from below, the average variable cost and average
total cost are at their minimum level.

Three Important Properties of Cost Curves

• Marginal cost eventually rises with the quantity of

output.
 - Law of Diminishing Marginal Returns

• The average-total-cost curve is U-shaped.

• The marginal-cost curve crosses the average-total-

cost curve at the minimum of average total cost.

Costs in the Long Run

• For many firms, the division of total costs between

fixed and variable costs depends on the time horizon
being considered.
– In the short run some costs are fixed.
– In the long run fixed costs become variable costs.

COST IN THE LONG RUN

Long run Production

• The long run is best thought of as a planning horizon.

• Firms plan in the long-run, but they produce in the
short-run.
• In the long run, all inputs that are under the firm’s
control can be varied and the firm could expand in
terms of its size or scale of production.
• The appropriate size, or scale, for the plant (firm)
depends on how much output the firm will produce.