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Synopsis

Consumer Behavior

Utility is the power of an article to satisfy any human want for example food, cloth, shelter,cinema show and automobile all have utility as each item satisfies one or the other want of

ours. Utility is different from satisfaction. While satisfaction is what we attain, utility is thepower of an article to confer satisfaction and to satisfy some want. Utility is different fromusefulness. An article need not have necessarily good effect to have utility for example evenliquor and opium have utility for such persons who are its addicts. Utility is subjective and notobjective. Utility for the same article is different from person to person, place to place and timeto time.

In the utility that is derived from the last unit of consumption of an article. If, for example, aperson consumes three units of an apple, the utility of the third apple would be the marginalutility. Total utility by contrast, is the sum total of the utilities derived from all the units of anarticle (in this case the three units).

The law of diminishing marginal utility states that the amount of extra or marginal utility

declines as a person consumes more and more of a good.

Law Equi-Marginal utility theory states that a consumer having a fixed income and facing

given market prices of goods will achieve maximum satisfaction or utility when the marginal

utility of the last rupee spent on each good is exactly the same as the marginal utility of the last

rupee spent on any other good.(MuA/PA = MuB/PB..MuN/PN= MuM)

Consumer surplus is the difference between what a person would be willing to pay and what he

actually has to pay to buy a certain amount of a good.

Indifference curve analysis is an improvement over the utility analysis. Utility being subjective

cannot be measured. So the utility, approach by modern writers has been replaced by

indifference curve approach. This technique through a curve illustrates as to how a consumer is

indifferent between the two or more combinations of the two products.

Indifference Curves has following characteristics: it slopes down towards the right, it is convexto the origin, and the curves do not intersect each other, higher indifference curves indicate

higher level of utility.

A consumer is in equilibrium when he/she maximizes his/her utility, given income and market

prices. In other words, equilibrium is attained where the consumer reaches the highest possible

indifference curve given his/her budget constraint

Consumer equilibrium with ordinal measurement of utility is achieved at the point at which

the slope of the indifference curve is equal to the slope of the budget line,

The concept of value in use and value in exchange is explained with the help of Water-

Diamond Paradox. The essence of this paradox is that the goods that have more value in use

are to be priced less and the goods which have more value in exchange are to be priced more.

Modern approach to utility is expressed in terms of Price effect. Price effect can be furtherdecomposed into Substitution effect and income effect

Income effect, is assumed that the given income of the consumer remains the same and so the

prices of the two goods. But when, the income of consumer changes (upward or downward),

the aggregate satisfaction of the consumer would also change (upward or downward) provided

the prices remain the same.

A consumer re-arranges his purchases either due to the change in his income or due to a change

in the relative prices of the two goods. When income changes, it is known as the Income effect.

But when it is a change in the relative prices of the two goods, he/she changes to the lower

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priced good for the higher priced good. It is known as the substitution effect. He/she buys more

of an article that becomes cheaper and less of the article that is now dearer.

Theory of production

Production involves the transformation of resources or factor inputs into output of goods and

services. A firm with an objective of profit motive organizes resources and produces goods and

services. Profits refer to reward received in the form of revenue to the firm from the sale of the

output after deducting all the expenses that have been incurred by the firm in the production

process. Factor inputs are those inputs that participate in the production process and may be

classified into labor, land, capital, organization.

The time period during which at least one input is fixed is called short-run. In the long-run all

inputs are variable.

Law of diminishing returns states that, when one or more inputs are held constant, a variable

input is likely to have a marginal product that finally diminishes as the level of input increases.

Three Stages of Law of Variable Proportions

Stage I: In this stage Total Product (TP), increases at an increasing rate. The stage comes toan end when Average Product (AP) is Maximum and also AP = MP (Marginal Product). It is

the stage of Increasing Returns.

Stage II: In this stage AP and MP fall but TP increases. This stage is called the stage of

Diminishing Returns. In this stage a firm decides its level of production, when MP = 0 and TP

is Maximum.

Stage III: In this stage TP starts falling and slope of TP curve becomes negative. MP becomes

negative. This stage is called the stage of Negative Returns.

Isoquants are convex to the origin (sloping downwards) implying that the marginal product of

all inputs is positive and the slope of each isoquant is referred to as marginal rate of technical

substitution at each point on the isoquant.

The marginal rate of technical substitution of labor for capital (MRTS) is the amount by which

the input of capital can be reduced when one additional unit of labor is employed, as a result of

which output remains constant.

Returns to scale, a long-run analysis where a firm has an option to change its scale or size of

operation. Constant, increasing, decreasing returns to scale refers to a situation where output

changes respectively, by the same, by a larger and by a smaller proportion than the inputs.

Increasing returns to scale are due to specialization and division of labor and from employing

specialized machinery. Decreasing returns to scale arise due to increase in the scale of

operation as a result of which it becomes difficult to manage the firm and coordinate its

operations. In reality, most of the firms or industries exhibit near-constant returns to scale.\

Isocost line represents the units of labor and capital that can be employed by the producer

given the budget and prices of the factor of production. In other words it is the budget line of

the producer.

The point at which the slope of isoquant is equal to the slope of the isocost line is technically

referred to as Least cost combination or Maximization of output subject to cost constraint.

The locus of least combination is known as expansion path.

The locus of the points of isoquants where the marginal products are zero form the ridge lines.

The upper ridge line implies that the marginal product (MP) of capital is zero and the lower

ridge line implies that the marginal product (MP) of labor is zero.

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Production techniques are only technically efficient inside the ridge lines. Outside the ridge

lines the marginal products of the factors are negative and the methods of production are

inefficient, since they require more quantity of both the factors for producing a given level of

output.

Theory of cost

Cost functions are derived from the production function, which explains the technically

efficient method of producing a good at any one time. The time factor is important in the

theory of Cost. Based on the variability of factor inputs costs are distinguished as short-run

costs and long-run costs.

Costs may be classified as explicit costs and implicit costs. Explicit costs are actual

expenditures of the firm to hire or purchase factor inputs. Implicit costs are those which refer to

the value of the inputs owned and employed by the firm in its own production process. The

opportunity cost of a firm in employing any input is what the input could earn in its best

alternative use. Costs also may be classified as private costs which are incurred by individuals

and firms and social costs are those incurred by the society as a whole.

The short-run in the production process is that some inputs are fixed and some are variable. As

a result of this costs are further classified into fixed costs and variable costs.

Costs in the short-run may be classified as fixed, variable and total costs. Total fixed costs

(TFC) + total variable costs (TVC) = total costs (TC). The shape of the TVC curve in the cost

function is similar to the law of diminishing returns. Average fixed cost (AFC) = TFC/Q,

where Q is output. Average variable cost (AVC) = TVC/Q. Average total cost (ATC) = TC/Q

and also ATC = AFC+AVC. Marginal cost (MC) is equal to change in TC or in TVC per-unit

change in output. The AVC, ATC and MC curves initially will fall and then rise and therefore

they are U shaped. AVC and MC move inversely to the AP Land MPL respectively. The AVC

and ATC are given by the slope of a line from origin to the TVC and TC curves. MC is given

by the slope of the TC and TVC curves.

The horizontal line of TFC, represents a fixed cost, AFC is a rectangular hyperbola depicting decreasing

fixed cost per unit as output increases.

The logic behind the shape of both TVC and AVC curves is the law of variable proportions. According to

the law of variable proportions, in the beginning of the process of production when variable factor is

combined with the fixed factor, TVC increases at an decreasing rate and AVC falls. Beyond the optimal

combination of fixed and variable factors, TVC increases at an increasing rate and AVC rises.

To a TVC curve which initially increases at a decreasing rate and finally increases at a increasing rate,

AVC is U-shaped.

Given AC = AFC + AVC, implies that AVC is a part of AC.

AVC and AC are U-shaped, reflecting the law of variable proportions

average fixed cost tends to decline with the expansion in the level of output.

MC curve can be derived between two points on the TC or TVC curve by the slope of the linejoining the two points. As output increases, the value of the slope declines continuously till

point and rise thereafter.

The shape of the MC curve basically reflects the law of variable proportions.

To a TVC curve which initially increases at a decreasing rate and finally increases at a

increasing rate, marginal cost curve assumes U-shape.

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