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Utility Analysis
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Utility
Utility refers to want satisfying power of acommodity.
In objective terms, utility may be definedas the amount of satisfaction derived froma commodity or service at a particular
time.
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Utility
Assumptions:
Utility can be measured.
Marginal Utility of money remains constant No change in income of the consumer, his
taste and fashion assumed to be constant
Independent marginal utility of each unit ofcommodity
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Utility
Characteristics:
Utility is subjective/not measurable
Utility is variable
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Marginal and Total Utility
Marginal Utility (MU) is the addition madeto the total utility by consuming onemore unit of a commodity.
Total Utility (TU)Total Utility refers to the total satisfaction
derived by the consumer from theconsumption of a given quantity of a good.
TU = Sum of all MU
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Assumptions of Law of Diminishing
Marginal Utility
Unit of consumption must be a standardone
Consumption must be continuous
Multiple units of the commodity should beconsumed
The tastes and preferences of the
consumer should remain unchangedduring the course of consumption
The good should be normal
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Exceptions to the law of
diminishing marginal utility Rare things (paintings, books etc.)
Initial units
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Criticism
Unrealistic assumptions
Cardinal measurement of utility is not
possible
MU of money is not constant
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Law of Equi-marginal Utility
A consumer has to distribute his/her
income in purchasing different
commodities in such a manner that the
utility derived from the last unit of each
commodity is equal for all commodities in
the consumption basket.
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Assumptions of Law of Equi-
marginal Utility
Consumer has a fixed income
Consumers purchase decision is based
on the prices of the different commodities
to be consumed
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Consumers Equilibrium
A consumer is in equilibrium when he
regards his actual behavior as the best
possible under the circumstances and
feels no urge to change his behavior aslong as circumstances remain unchanged.
Assumptions:
Rational consumer
Cardinal utility
MU of money = constant
Tastes are constant
Perfect knowledge
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Properties of Indifference Curves
Downward sloping
Higher indifference curves represent
higher satisfaction
Indifference curves can never intersect
Convex to the origin
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Superiority of Indifference Curve
Technique over Utility Analysis
Dispenses with cardinal measurement of
utility.
Studies combination of two goods instead
of one.
Provides a better classification of goods
into substitutes and compliments.
Explains law of diminishing marginal utility
without unrealistic assumptions.
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Criticism of Indifference Curve
Technique
Old wine in new bottle
Not realistic
Cardinal measurement implicit
Consumer is not rational
Combinations are not based on anyprinciple
Two goods model unrealistic
Limited analysis of consumers behavior
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Revealed Preference Theory
It analyses consumers preference for a
combination of goods on the basis of
observed consumer behavior in the
market.
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Choice Reveals Preference
A consumer buys a combination of two
goods either because he likes this
combination in relation to the others or
because this combination is cheaper thanthe others.
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Consumer Choice Under Risk and
Uncertainty
Traditional theory does not discussconsumer choice under risky situations orsituations which are uncertain.
THE BERNOULLI HYPOTHESISSt. Petersburg Paradox states that people
would be unwilling to make bets even at
better than 50-50 odds.Bernoulli resolved it by saying that MU of
money diminishes as income increases.
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The N-M Utility Index
The consumer is expected to maximize
utility and the utility of an event with
certainty must be defined by the
probability and expected utility.
It provides conceptual measurement of
cardinal utility under risky choices.
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Production Theory
Types of Input
Technology
Fixed Inputs
Variable Inputs
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Production Theory
Factors of Production
Land
Labour
Capital
Enterprise
Organization
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Production Function With One
Variable Input
The short run production function showsthe maximum output a firm can producewhen only one input can be varied.
In the short run producers have tooptimize with only one variable input.
Any change in the output can be
manifested only through a change in oneinput (variable proportion productionfunction).
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Production Function With One
Variable Input
The short run production function shows
the maximum output a firm can produce
when only one of its inputs can be varied,
other things remaining fixed.
Q = f( L, K (constant))
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Production Function With One
Variable Input
This implies that it is possible to substitute
some of the labor by capital.
As the units of the variable input are
increased, the proportion of use between
fixed and variable input also changes.
Short run production function is governed
by law of variable proportions.
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Average and Marginal Products of
Factor Inputs
TP (L) = f (K (constant), L)
TP (K) = f (L (constant), K)
AP (L) = TP/L
AP (K) = TP/K
MP (L) = delta TP/delta L
Average product is total product per unit of
variable input. Marginal product is the addition in total output
per unit change in variable input.
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Law of Variable Proportions
Law of variable proportions, states that
with increase in the quantity of the variable
factor, its marginal and average products
will eventually decline, other inputs
remaining unchanged.
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3 Stages of the Law of Variable
Proportions
Increasing Returns to the Variable Factor Diminishing Returns to the Variable Factor
Negative Returns to the Variable Factor
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Production Function With Two
Variable Inputs
In the long run all inputs are variable.
Firm has the option of selecting that
combination of inputs which maximizes
returns.
Case of Maruti
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Production Function With Two
Variable Inputs
Q (constant) = f (L, K)
An isoquant is the locus of all technically
efficient combinations for producing a
given level of output (different
combinations of two inputs that
correspond to the same level of output).
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Characteristics of Isoquants
Downward sloping (slope = - delta K /
delta L)
A higher isoquant represents a higher
output
Isoquats do not intersect
Convex to origin
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Marginal Rate of Technical
Substitution
It measures the reduction in one input,
due to unit increase in the other input that
is just sufficient to maintain the same level
of output.
MRTS (LK) = -delta K / delta L
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Elasticity of Substitution
It measures the percentage change in factor
proportions due to change in MRTS.
In perfect substitutes MRTS remains
constant.
In perfect compliments elasticity of
substitution is zero.
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ISOCOST LINES
It is the locus of points of all the different
combinations of labour and capital that a
firm can employ, given the total cost and
prices of inputs (different combinations ofinputs that a firm can procure given the
total funds).
Slope = w / r C = wL + rK
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Producers Equilibrium
Necessary condition is
slope of isoquant = slope of isocost line
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Expansion Path
Expansion path is the line formed by
joining the tangency points between
various isocost lines and the
corresponding highest attainableisoquants.
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Returns to Scale
Returns to scale refers to the degree by
which the level of output changes in
response to a given change in all the
inputs in a production system.
Constant Returns to Scale
Decreasing Returns to Scale
Increasing Returns to Scale
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Technical Progress and its
Implications
Neutral Technical Progress (changes in
marginal product of labour and capital are
same)
Labour Augmenting Technical Progress
(MP (L) increases faster than MP (K))
Capital Augmenting Technical Progress
(MP (K) increases faster than MP (L))
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Break Even Analysis
Breakeven point is the point where total
cost just equals the total revenue.
It is the point of no profit no loss.
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Graphical Method
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Algebraic Method
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Contribution Margin
It is the difference between price and
average variable cost.
It is that portion of the price of the
commodity produced by the firm that can
cover the fixed costs and contribute to
profits.
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PV Ratio
PV Ratio = Contribution / Sales
Margin of Safety = FC / PV Ratio
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Limitations of Break Even Analysis
It does not take into account possible
changes in costs over the time period
under consideration.
It does not keep any provision for changes
in the selling price.
It assumes that what ever is produced will
be sold.
Assumes constant market conditions.
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Numerical
Suppose Going On Batteries Ltd. Company
makes 10,000 batteries per month. It has
to pay Rs.2000 per month towards rent of
factory and Rs.5000 per month towardselectricity. It also incurs a cost of Re.0.05
per battery. It sells its batteries at Rs.4 per
piece. Find BEP.
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