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UTILITY AND
DEMAND
© 2003 Pearson Education Canada Inc.
7
CHAPTER
7-1
Household Consumption Choices
A household’s consumption choices are determined by:
 Consumption possibilities
 Preferences
• Consumption Possibilities: Budget Constraint
• The budget constraint refers to the limits imposed on household
choices by income, wealth, and product prices
• The choice set or opportunity set refers to the set of options that is
defined and limited by a budget constraint.
Choice Sets: An Example
Table 6.1Possible Budget Choices of a Person
Earning $1000 per Month After Taxes
Option
Monthly
Rent
Food
Other
Expenses
Total
Available?
A
$400
$250
$350
$1000
Yes
B
600
200
200
1000
Yes
C
700
150
150
1000
Yes
D
1000
100
100
1200
No
Budget Constraint and Opportunity Set for Trudee and
Mark
• Points A, B, and C are
each on the budget
constraint, meaning
that Trudee and Mark
have spent their
income.
• Point D does not spend
the entire $200 and
point E is unattainable
as it would cost more
than $200.
The Effect of a Decrease in Price on Trudee and
Mark’s Budget Constraint
• When the price of a
good decreases, in
this case Thai meals
fall from $20 to $10,
the budget constraint
swivels to the right,
increasing the
opportunities
available and
expanding choice.
The Basis of Choice: Utility
• Utility is the satisfaction, or reward, a product yields relative
to its alternative. It is the basis for choice.
• Marginal utility is the additional satisfaction gained by the
consumption or use of one more unit of something.
• Total utility is the total amount of satisfaction obtained from
consumption of a good or service.
Law of Diminishing Marginal
Utility
• The more of any one good consumed in a
given period, the less satisfaction (utility) is
generated by consuming each additional
(marginal) unit of the same good.
Allocation of Fixed Expenditures per Week Between
Two Alternatives
Frank’s utility maximizing decision between basketball games
and trips to the club.
Frank’s Total and Marginal Utility of Trips to the Club
Utility-Maximizing Rule
• A utility maximizing consumer allocates his
or her expenditures such that the marginal
utility per dollar spent on each activity is
equal:
MUx = MUy
Px
Py
Predictions of Marginal Utility Theory
•A Rise in the Price of Pop
Now suppose the price of pop rises.
We know that MUP/PP falls, so before the consumer changes the
quantities consumed, MUP/PP < MUM/PM.
To restore consumer equilibrium (maximum total utility) the consumer
decreases the quantity of pop consumed to drive up the MUP and
increases the quantity of movies consumed to drive down MUM. These
changes restore MUM/PM = MUP/PP.
7-11
POSSIBILITIES,
PREFERENCES,
AND CHOICES
© 2003 Pearson Education Canada Inc.
8
CHAPTER
8-12
Consumption Possibilities
•
The Budget Equation
–
–
We can describe the budget line by using a budget equation.
The budget equation states that:
–
•
Expenditure = IncomePPQP
+ PMQM = Y
QP = Y/PP – (PM/PP)QM
The term Y/PP is Lisa’s real income in terms of pop.
•
•
•
A household’s real income is the income expressed as a quantity of goods
the household can afford to buy.
Lisa’s real income in terms of pop is the point on her budget line where it
meets the y-axis.
The term PM/PP is the relative price of a movie in terms
of pop.
•
•
•
A relative price is the price of one good divided by the price of another good.
It is the magnitude of the slope of the budget line.
The relative price shows how many pops must be forgone to see an additional
movie.
8-13
Preferences and Indifference Curves
–An indifference curve is a
line that shows combinations
of goods among which a
consumer is indifferent.
–All the points above the
indifference curve are
preferred over the points on
the curve.
–And all the points on
the indifference curve are
preferred over the points
below the curve.
8-14
Preferences and Indifference Curves
–An indifference curve
above I1 is I2 . All the
points on I2 are preferred
to those on I1 .
–For example, point J is
preferred to either point
C or point G.
8-15
Preferences and Indifference Curves
•Marginal Rate of Substitution
–The marginal rate of substitution, (MRS) measures the
rate at which a person is willing to give up good y (the good
measured on the y-axis) to get an additional unit of good x
(the good measured on the x-axis) and at the same time
remain indifferent (remain on the same indifference curve).
•The marginal rate of substitution is the ratio at
which a household is willing to substitute good Y for
good X.
•
MRS = MUx / MUy
–The magnitude of the slope of the indifference curve
measures the marginal rate of substitution.
8-16
Preferences and Indifference Curves
–A diminishing marginal rate of substitution is the
key assumption of consumer theory.
–A diminishing marginal rate of substitution is a
general tendency for a person to be willing to give
up less of good y to get one more unit of good x,
and at the same time remain indifferent, as the
quantity of good x increases.
–If the indifference curve is relatively steep, the MRS is high.
–In this case, the person would be willing to give up a large quantity
of y to get a bit more x.
–If the indifference curve is relatively flat, the MRS is low.
–In this case, the person would be willing to give up a small quantity
of y to get more x.
8-17
Preferences and Indifference Curves
–Figure shows the
diminishing MRS of
movies for pop.
–At point C, Lisa is
willing to give up 2 sixpacks to see one more
movie—her MRS is 2.
–At point G, Lisa is
willing to give up 1/2 a
six-pack to see one more
movie—her MRS is 1/2.
8-18
Preferences and Indifference Curves
•Degree of Substitutability
–The shape of the indifference curves reveals the degree of
substitutability between two goods.
–Figure shows the indifference curves for ordinary goods,
perfect substitutes, and perfect complements.
8-19
Predicting Consumer Behaviour
–The consumer’s best affordable
point (Consumer Utility-Maximizing
equilibrium):
Is on the budget line
Is on the highest attainable
indifference curve
Has a marginal rate of substitution
between the two goods equal to the
relative price of the two goods
–Here, the best
affordable point is C.
8-20
Predicting …
–Figure illustrates the price effect
and shows how a demand curve is
generated.
–Initially, the price of a movie is $6
and Lisa consumes at point C in part
(a) and at point A in part (b).
–The price of a movie then falls to
$3. The budget line rotates outward.
–Lisa’s best affordable point is now J
in part (a).
–In part (b), Lisa moves to point B,
which is a movement along her
demand curve for movies.
8-21
Predicting Consumer Behaviour
•
–
–
1.
2.
Substitution Effect and Income Effect
For a normal good, a fall in price always increases the quantity consumed.
We can prove this assertion by dividing the price effect into two parts:
Substitution effect:
– is the effect of a change in price on the quantity bought when the
consumer remains indifferent between the original situation and the new
situation.
Income effect:
– When a good is a normal good, the quantity consumed changes in the
same direction as the change in income.
8-22
Substitution Effect
When the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the
quantity demanded decreases.
When the price of a product falls, that product becomes more attractive relative to potential substitutes.
Income Effect
When the price of a good or service rises relative to income, people cannot afford all the things they
previously bought, so the quantity demanded decreases.
When the price of a product falls, a consumer has more purchasing power with the same amount of income
and is better off.
Predicting Consumer Behaviour
–The price of a movie falls from $6 to $3
and her budget line rotates outward.
–Lisa’s best affordable point is then J.
–We’re going to break the move from C to J
into two parts.
–The first part is the substitution effect,
and the second is the income effect.
8-24
Predicting Consumer Behaviour
–To isolate the substitution effect, we give
Lisa a hypothetical pay cut.
–Lisa is now back on her original indifference
curve but with a lower price of movies, and her
best affordable point is K.
–The move from C to K is the substitution effect.
–The direction of the substitution effect never
varies: a fall in price brings an increase in the
quantity bought.
–The substitution effect is the first reason why the
demand curve slopes downward.
8-25
Predicting Consumer Behaviour
–To isolate the income effect, we reverse
the hypothetical pay cut and restore
Lisa’s income to its original level (its
actual level).
–Lisa is on indifference curve I2 and her
best affordable point is J.
–The move from K to J is the income
effect.
–For Lisa, movies are a normal good.
–When her income increases, she sees more
movies—the income effect is positive.
–For a normal good, the income effect
reinforces the substitution effect and is the
second reason why the demand curve
slopes downward.
8-26
ORGANIZING
PRODUCTION
© 2003 Pearson Education Canada Inc.
9
CHAPTER
9-27
Profit
 The Firm’s Goal
– A firm’s goal is to maximize profit.
• Profit is the difference between total revenue and total
costs.
Profit = Total Revenue (TR) - Total Cost (TC)
Where Total Revenue is the receipts from the sale
of a product (P x q)
Economists measure profit based on an opportunity
cost measure of cost.
The Firm and Its Economic Problem
–A firm’s opportunity cost of producing a good is the best, forgone
alternative use of its factors of production, usually measured in dollars.
–Explicit costs are costs paid directly in money.
–Implicit costs are costs incurred when a firm uses its own capital or its owners’
time for which it does not make a direct monetary payment.
The implicit rental rate of capital is made up of:
– Economic depreciation
–is the change in the market value of capital over a given period.
– Interest forgone
–is the return on the funds used to acquire the capital
The opportunity cost of the owner’s labour spent running the business is the wage
income forgone by not working in the next best alternative job.
9-29
Calculating Total Revenue, Total Cost and
Profit For a Small Belt Firm
Technology and Economic Efficiency
–Technological efficiency occurs when a firm
produces a given level of output by using the least
amount of inputs.
–Economic efficiency occurs when the firm
produces a given level of output at the least cost.
–An economically efficient production process is also
technologically efficient.
–A technologically efficient process may not be economically
efficient.
9-31
OUTPUT AND
COSTS
© 2003 Pearson Education Canada Inc.
10
CHAPTER
10-32
Decision Time Frames
–The short run is a time frame in which the
quantity of one or more resources used in
production is fixed.
–For most firms, the capital, called the firm’s plant, is fixed in the
short run.
–Other resources used by the firm (such as labour, raw materials,
and energy) can be changed in the short run.
–The long run is a time frame in which the
quantities of all resources—including the plant
size—can be varied.
Short-Run Technology Constraint
•Product Schedules
–Total product is the total output produced in a given period.
–The production function or total product function is a numerical or
mathematical expression of a relationship between inputs and outputs.
–It shows units of total product as a function of units of inputs.
–The marginal product of labour is the change in total product
that results from a one-unit increase in the quantity of labour
employed, with all other inputs remaining the same.
–Marginal product is the additional output that can be produced by adding one
more unit of a specific input, ceteris paribus.
–The average product of labour is equal to total product
divided by the quantity of labour employed.
–The average product is the average amount produced by each unit of a variable
factor of production.
Law of Diminishing Returns
• The law of diminishing returns states that
when additional units of an input are added
to fixed inputs after a certain point, the
marginal product of the variable input
declines.
Production Function (Sandwich
Making)
Labor
Units
0
1
2
3
4
5
6
Total
Product
0
10
25
35
40
42
42
Marginal
Product
--10
15
10
5
2
0
Average
Product
--10.0
12.5
11.7
10.0
8.4
7.0
Short-Run Technology Constraint
–The total product curve is
similar to the PPF.
–It separates attainable
output levels from
unattainable output levels
in the short run.
Typical Production Function
• Marginal and average
product curves can be
derived from total
product curves.
• The marginal product of
labour is the slope of the
total product curve.
• Average product
follows marginal
product; it rises when
marginal product is
above it and falls when
marginal product is
below it.
Short-Run Cost
–To produce more output in the short run, the firm
must employ more labour, which means that it
must increase its costs.
–We describe the way a firm’s costs change as total
product changes by using three cost concepts and
three types of cost curve:
– Total cost
– Marginal cost
– Average cost
Short-Run Cost
•Total Cost
–A firm’s total cost (TC) is the cost of all resources
used.
–Total fixed cost (TFC) is the cost of the firm’s
fixed inputs. Fixed costs do not change with output.
–A fixed cost is any cost that a firm bears in the short run that
does not depend on its level of output. These costs are
incurred even if the firm is producing nothing. There are no
fixed costs in the long run.
–Total variable cost (TVC) is the cost of the firm’s
variable inputs. Variable costs do change with
output.
–A variable cost is any cost that a firm bears that depends on
the level of production chosen
Total Costs
Labor
Output
(workers/D)
0
1
2
3
4
5
0
4
10
13
15
16
Total
fixed cost
TFC
25
25
25
25
25
25
Total
variable cost
TVC
0
25
50
75
100
125
Total
cost
TC
25
50
75
100
125
150
Short-Run Cost
–Figure shows a firm’s
total cost curves.
–Total fixed cost is the
same at each output level.
–Total variable cost
increases as output
increases.
–Total cost, which is the
sum of TFC and TVC, also
increases as output
increases.
Short-Run Cost
• Marginal Cost
–
Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total
product (producing one more unit of output).
– Marginal costs reflect changes in variable costs.
–
In the short run, every firm is constrained by some fixed input that leads to diminishing
returns to variable inputs and that limits its capacity to produce. As the firm approaches
capacity, it becomes increasingly costly to produce more output. Marginal costs ultimately
increase with output in the short run.
–
Over the output range with increasing marginal returns, marginal cost falls as output
increases.
Over the output range with diminishing marginal returns, marginal cost rises as output
increases.
–
Declining Marginal Product Implies That Marginal Cost
Will Eventually Rise With Output
Short-Run Cost
•Average Cost
–Average cost measures can be derived from each
of the total cost measures:
–Average fixed cost (AFC) is total fixed cost per
unit of output.
–Average variable cost (AVC) is total variable cost
per unit of output.
–Average total cost (ATC) is total cost per unit of
output.
ATC = AFC + AVC
Total Costs; Marginal Cost; Average
Costs
L Outp. Total Total
Total Marginal Average Average Average
fixed C variable C
C
Cost fixed C variable C total C
TFC
TVC
TC
MC
AFC
AVC
ATC
0
1
2
3
4
5
0
4
10
13
15
16
25
25
25
25
25
25
0
25
50
75
100
125
25
50
75
100
125
150
6.25
4.17
8.33
12.50
25
6.25
2.50
1.92
1.67
1.56
6.25
5
5.77
6.67
7.81
12.5
7.5
7.69
8.33
9.38
Short-Run Cost
–The ATC curve is also Ushaped.
–The MC curve is very
special.
–Where AVC is falling,
MC is below AVC.
–Where AVC is rising, MC
is above AVC.
–At the minimum AVC,
MC equals AVC.
Short-Run Cost
•Shifts in Cost Curves
–The position of a firm’s cost curves depend on two
factors:
– Technology
– Prices of productive resources
Long-Run Cost
•Long-Run Average Cost Curve
–The long-run average cost curve is the relationship
between the lowest attainable average total cost and output
when both the plant size and labour are varied.
–The long-run average cost curve is a planning curve that
tells the firm the plant size that minimizes the cost of
producing a given output range.
–Once the firm has chosen that plant size, it incurs the costs
that correspond to the ATC curve for that plant.
Long-Run Cost
Figure 10.8 illustrates the long-run average cost (LRAC) curve.
Long-Run Cost
•Economies and Diseconomies of Scale
–Economies of scale are features of a firm’s
technology that lead to falling long-run average cost
as output increases.
–Diseconomies of scale are features of a firm’s
technology that lead to rising long-run average cost
as output increases.
–Constant returns to scale are features of a firm’s
technology that lead to constant long-run average
cost as output increases.
Long-Run Cost
Figure 10.8 illustrates economies and diseconomies of scale.
Long-Run Cost
–A firm experiences economies of scale up to some output
level.
–Beyond that output level, it moves into constant returns to
scale or diseconomies of scale.
–Minimum efficient scale is the smallest quantity of output
at which the long-run average cost reaches its lowest level.
–If the long-run average cost curve is U-shaped, the
minimum point identifies the minimum efficient scale output
level.