Law of Diminishing Marginal Utility - added satisfaction

declines as a consumer acquires additional units of a

given product.

MU of Product A MU of Product B
=
Price of A
Priceof B

Utility - is want-satisfying power. The utility of a good or

service is the satisfaction or pleasure one gets from
consuming it.

Income effect - is the impact that a change in the price of

a product has on a consumers real income and
consequently on the quantity demanded of that good.

Three characteristics of utility:

Substitution effect - is the impact that a change in a

products price has on its relative expensiveness and
consequently on the quantity demanded.

Utility and usefulness are not synonymous.

Utility is subjective.
Utility is difficult to quantify.

Total utility - is the total amount of satisfaction or

pleasure a person derives from consuming some specific
quantity
Marginal utility - is the extra satisfaction a consumer
realizes from an additional unit of that product. It is the
change in total utility that results from the consumption
of 1 more unit of a product.
a) As more of a product is consumed, total utility
increases at a diminishing rate, reaches a
maximum, and then declines.
b) Marginal utility, by definition, reflects the
changes in total utility. Thus marginal utility
diminishes with increased consumption, becomes
zero when total utility is at a maximum, and is
negative when total utility declines.

The theory of consumer behavior assumes that,

with limited income and a set of product prices,
consumers make rational choices on the basis of
well-defined preferences.
A consumer maximizes utility by allocating
income so that the marginal utility per dollar
spent is the same for every good purchased.
A downward-sloping demand curve can be
derived by changing the price of one product in
the consumer-behavior model and noting the
change in the utility-maximizing quantity of that
product demanded.
By providing insights on the income effect and
substitution effects of a price decline, the utilitymaximization model helps explain why demand
curves are down sloping.
The utility-maximizing rule and the demand
curve are logically consistent. Because marginal
utility declines, a lower price is needed to induce
the consumer to buy more of a particular
product.
The utility-maximization model illuminates the
income and substitution effects of a price
change. The income effect implies that a decline
in the price of a product increases the
consumers real income and enables the
consumer to buy more of that product with a
fixed money income. The substitution effect
implies that a lower price makes a product
relatively more attractive and therefore increases
the consumers willingness to substitute it for
other products.

Indifference Curve Analysis is the model of consumer

behavior that is based upon such ordinal utility rankings.
2 Main Elements: Budget Line and Indifference Curves
Budget Line (or, more technically, the budget constraint)
- is a schedule or curve showing various combinations of
two products a consumer can purchase with a specific
money income.

The
budget line has two other significant characteristics:
Utility-maximizing rule - To maximize satisfaction, the
consumer should allocate his or her money income so
that the last dollar spent on each product yields the
same amount of extra (marginal) utility.

Income changes - the location of the budget line

varies with money income. An increase in money
income shifts the budget line to the right; a
decrease in money income shifts it to the left.

Price changes - a change in product prices also

shifts the budget line. A decline in the prices of
both productsthe equivalent of an increase in
real incomeshifts the curve to the right.

Indifference curve - shows all the combinations of two

products A and B that will yield the same total
satisfaction or total utility to a consumer.

- Changing the price of one product shifts the budget line

and determines a new equilibrium point. A down sloping
demand curve can be determined by plotting the pricequantity combinations associated with two or more
equilibrium points.
PRODUCTION:
Economic costs are the payments a firm must make, or
the incomes it must provide, to attract the resources it
needs away from alternative production opportunities.
Those payments to resource suppliers are explicit
(revealed and expressed) or implicit (present but not
obvious).
A firms explicit costs are the monetary payments (or
cash expenditures) it makes to those who supply labor
services, materials, fuel, transportation services, and the
like. Such money payments are for the use of resources
owned by others.
A firms implicit costs are the opportunity costs of using
its self-owned, self-employed resources. To the firm,
implicit costs are the money payments that selfemployed resources could have earned in their best
alternative use.
Economic profit - is total revenue less economic costs
(explicit and implicit costs, the latter including a normal
profit to the entrepreneur).

Characteristics:

Indifference
indifference
more of one
total utility is

Curves Are Down sloping - An

curve slopes downward because
product means less of the other if
to remain unchanged.

Indifference Curves Are Convex to the Origin

o

The slope of an indifference curve at

each point measures the marginal rate of
substitution (MRS) of the combination of
two goods represented by that point. The
slope or MRS shows the rate at which the
consumer
who
possesses
the
combination must substitute one good
for the other (say, B for A) to remain
equally satisfied.

In general, as the amount of B increases,

the marginal utility of additional units of
B decreases. Similarly, as the quantity of
A
decreases,
its
marginal
utility
increases.

Pure Profit=Total Revenue Economic cost

An economic profit is not a cost because it is a return in

excess of the normal profit that is required to retain the
entrepreneur in this particular line of production.

Indifference Map - whole series of indifference curves.

Each curve reflects a different level of total utility and
therefore never crosses another indifference curve.
Short run - is a period too brief for a firm to alter its plant
capacity, yet long enough to permit a change in the
degree to which the fixed plant is used.
Long run is a period long enough for it to adjust the
quantities of all the resources that it employs, including
plant capacity.

- An
indifference map is a set of indifference curves. Curves
farther from the origin indicate higher levels of total
utility. Thus any combination of products A and B
represented by a point on I4 has greater total utility than
any combination of A and B represented by a point on I3,
I2, or I1.
- The consumer is in equilibrium (utility is maximized) at
the point on the budget line that lies on the highest
attainable indifference curve. At that point the budget
line and indifference curve are tangent.

Explicit costs are money payments a firm makes

to outside suppliers of resources; implicit costs
are the opportunity costs associated with a firms
use of resources it owns.
Normal
profit
is
the
implicit
cost
of
entrepreneurship. Economic profit is total
revenue less all explicit and implicit costs,
including normal profit.
In the short run, a firms plant capacity is fixed;
in the long run, a firm can vary its plant size and
firms can enter or leave the industry.

Total product (TP) is the total quantity, or total output,

of a particular good or service produced.

 Marginal product (MP) is the extra output or added

product associated with adding a unit of a variable
resource, in this case labor, to the production process.

Marginal Product =

Average variable
cost (AVC) for any
output level is

changetotal product
changelabor input

Average product (AP), also called labor productivity, is

output per unit of labor input.

Average product =

Total product
Unitsof labor

Law of Diminishing Returns It states that as successive

units of a variable resource (say, labor) are added to a
fixed resource (say, capital or land), beyond some point
the extra, or marginal, product that can be attributed to
each additional unit of the variable resource will decline.

calculated by dividing total variable cost (TVC) by that

output (Q)

TP, goes through three phases: It rises initially at an

increasing rate; then it increases, but at a diminishing
rate; finally, after reaching a maximum, it declines.
MP is the slope of the total- product curve. Where total
product is increasing at an increasing rate, marginal
product is rising. Similarly, where total product is
increasing but at a decreasing rate, marginal product is
positive but falling. When total product is at a maximum,
marginal product is zero. When total product declines,
marginal product becomes negative.
AP, it increases, reaches a maximum, and then
decreases as more and more units of labor are added to
the fixed plant. Where marginal product exceeds average
product, average product rises. And where marginal
product is less than average product, average product
declines.

Marginal cost (MC) - is the extra, or additional, cost of

producing one more unit of output.

Fixed costs - are those costs that in total do not vary with
changes in output.

The relationship of the marginal-cost curve to the

average-total-cost and average-variable-cost curves. The
marginal-cost (MC) curve cuts through the average-totalcost (ATC) curve and the average-variable-cost (AVC)
curve at their minimum points. When MC is below
average total cost, ATC falls; when MC is above average
total cost, ATC rises. Similarly, when MC is below average
variable
cost,
AVC
falls;
when
MC is above
average
variable
cost,
AVC rises.

Variable costs - are those costs that change with the

level of output. They include payments for materials,
fuel, power, transportation services, most labor, and
similar variable resources.
Total cost - is the sum of fixed cost and variable cost at
each level of output.
Average fixed cost (AFC) for any output level is found by
dividing total fixed cost (TFC) by that output (Q).

MC=

ChangeTC
changeQ