Download Tuesday Notes Utility Theory and the Downward Sloping Demand

Tuesday Notes
Utility Theory and the Downward Sloping Demand Curve.
Five fundamentals of consumer choice
1. We make decisions purposefully and
 We are motivated and act based on “rational self-interest”.
 We make choices based on our preferences.
2. We face constraints.
 Limited income matched with
 Varying prices necessitates choice.
3. One good can be substituted for another.
4. Consumers must make decisions without perfect information.
5. The law of diminishing marginal utility applies.
 Implies that a consumer’s marginal benefit falls with the rate of consumption
(subjective), and thus the demand curve falls with the rate of consumption.
The two effects of a price change:

The substitution effect – that part of change in the amount consumed that is the result
of a good being cheaper or more expensive in relation to another good.

The income effect – the part of a change in the amount consumed that is the result of
the consumer’s real income being changed by the price change.
Number of cookies consumed
per week
Total utility
Marginal utility
0
0
0
1
10
10
2
18
8
3
24
6
4
28
4
5
30
2
6
30
0
7
28
-2
General Theory of the Firm
Organization of the Business Firm
The Theory behind Supply (Producers)
Firm – an institution that hires factors of production and organizes them to produce and sell goods and
services.
Primary Goal of the firm


Maximize profit
Profit = total revenue – total cost
Firms organize production to:



Minimize transaction costs
Economies of scale - cost of producing falls as output rate rises
Team production
Three factors that promote firm efficiency



Competition among firms for investment funds and customers
Compensation and management incentives
Threat of corporate takeover
Short Run Production theory
Output – the production function is the technological relationship that exists between the quantity of
inputs employed and the quantity of output produced.
Inputs (factors of production)




Land – natural resources
Labor- human resources
Capital – machines, building
Entrepreneurial skills – innovation
Fixed inputs – Machinery, buildings, land (cannot be varied in short run)
Capital is the input most commonly considered fixed.
Variable inputs – Labor, materials (can be varied in the short run). Labor is the input most commonly
considered variable.
Time Periods


Short run – is a time period short enough that at least one input is fixed. The firm cannot
choose from among all possible production techniques.
Long run – is a time period sufficient for all inputs used in a productive process to be
variable. We can choose from all possible production techniques.
Total Product (TP)
The maximum total output that can be produced from a given level of fixed and variable inputs.
Average Product (AP)
The average product of a variable factor of production is the total product divided by the amount of
the variable input that is being used. This tells us the average amount of output that each unit of input
enables us to produce.
AP=TP/amount of input
The Marginal Product (MP) of a variable factor of production is the change in total output that occurs
when an additional unit of that factor is used.
MP=ΔTP/Δ input
The level of output at which marginal product reaches as maximum is called the point of diminishing
marginal productivity.
The law of diminishing marginal returns (or marginal returns), is that as more and more units of a
variable resource are combined with a fixed amount of other resources, the use of additional units of
variable will eventually increase output but only at a decreasing rate.
Example
Variable input = number of workers (labor or L)
Fixed input = a machine (capital or K)
AP=TP/ (amount of input) column 5
Point of diminishing average productivity is between 9 and 12 units of output.
MP of labor, MPL column 4
MPL= ΔΤP
2 workers
TP 5
MPL
3(5-2)
APL
2,5(5/2)
3 workers
TP 9
MPL
4(9-5)
APL
3(9/3)
4 workers
TP 12
MPL
3(12-9)
APL
3(12/4)
5 workers
TP 14
MPL
2(14-12)
APL
2,8
7 workers
TP 13
MPL
-2(15-13)
APL
1,86
1
Number of
workers, L
2
Units of fixed
factor, K
3
Total Product,
TP
Marginal Product
of Labor, MPL
5
Average Product
of Labor, APL
0
1
0
0
0
1
1
2
2=(2-0)
2=2/1
2
1
5
3=(5-2)
2,5=5/2
3
1
9
4=(9-5)
3,0=(9/3)
4
1
12
3
3,0
5
1
14
2
2,8
6
1
15
1
2,5
7
1
13
-2
1,86
0-3 units of labor – increasing marginal returns
4-6 units of labor – diminishing marginal returns
7
4
units of labor – absolute diminishing returns