2: Consumer and Producer Behavior · 5 min read
2: Consumer and Producer Behavior
Utility Theory
Utility measures satisfaction or happiness derived from consumption. Total utility is cumulative satisfaction from all units consumed. Marginal utility is additional satisfaction from consuming one more unit.
The law of diminishing marginal utility states that marginal utility decreases as consumption increases, holding other factors constant. The first slice of pizza provides significant satisfaction; subsequent slices provide progressively less.
If marginal utility per dollar is higher for good A than good B, the consumer should buy more A and less B. This reallocation increases total utility until marginal utilities per dollar equalize. This principle derives the downward-sloping demand curve.
Indifference Curves and Budget Constraints
Indifference curves show combinations of two goods providing equal satisfaction. Consumers are indifferent between points on the same curve. Higher curves represent greater utility. Indifference curves slope downward (giving up one good requires more of another to maintain satisfaction), are convex (diminishing marginal rate of substitution), and cannot intersect.
The marginal rate of substitution (MRS) is the rate at which a consumer willingly trades one good for another while maintaining utility. MRS equals the absolute value of the slope of the indifference curve. Diminishing MRS explains the convex shape.
Budget constraints show affordable combinations given income and prices. The budget line has slope equal to the negative price ratio (-P₁/P₂). Changes in income shift the budget line parallel. Changes in prices rotate the budget line around the intercept of the unchanged good.
Income and substitution effects decompose consumer responses to price changes. The substitution effect (always negative for price increases) represents movement along an indifference curve toward the relatively cheaper good. The income effect represents the shift to a different indifference curve due to changed purchasing power.
For normal goods, income and substitution effects reinforce each other; demand curves slope downward. For inferior goods, effects oppose each other; demand curves typically still slope downward unless the income effect dominates. Giffen goods (theoretical inferior goods with dominant income effects) would have upward-sloping demand curves.
Production and Costs
The production function relates inputs to outputs. Short-run production has at least one fixed input. Long-run production allows all inputs to vary.
Total product (TP) is total output from given inputs. Marginal product (MP) is additional output from one more unit of variable input. Average product (AP) is total output divided by units of variable input.
The law of diminishing marginal returns states that as variable input increases with fixed input constant, marginal product eventually declines. This occurs because the variable input has less of the fixed input to work with. Note that total product may continue increasing while marginal product declines.
The relationship between marginal and average product follows a mathematical rule. When MP exceeds AP, AP rises. When MP falls below AP, AP falls. MP intersects AP at AP's maximum.
Average fixed cost (AFC) equals FC divided by output; it declines continuously as output increases. Average variable cost (AVC) equals VC divided by output; it typically U-shaped. Average total cost (ATC) equals TC divided by output or AFC plus AVC; also U-shaped. Marginal cost (MC) equals the change in TC from one additional unit of output.
The relationship between marginal cost and average costs mirrors the MP/AP relationship. When MC is below ATC, ATC falls. When MC exceeds ATC, ATC rises. MC intersects ATC at ATC's minimum point. The same relationship applies between MC and AVC.
Long-run costs allow adjustment of all inputs. The long-run average cost (LRAC) curve envelopes short-run average cost curves. Firms choose plant sizes to minimize average cost at expected output levels.
Economies of scale occur when LRAC declines as output increases. Sources include specialization, bulk purchasing, and spreading fixed costs. Diseconomies of scale occur when LRAC rises as output increases. Sources include coordination problems, communication difficulties, and bureaucratic inefficiencies. Constant returns to scale occur when LRAC remains constant.
The minimum efficient scale is the smallest output at which LRAC is minimized. Industries with large minimum efficient scales tend toward fewer, larger firms. Industries with small minimum efficient scales accommodate many firms.
Profit Maximization
Profit equals total revenue minus total cost. Economic profit includes opportunity costs (implicit costs) that accounting profit ignores. Normal profit (zero economic profit) means the firm earns just enough to cover all costs including opportunity costs.
The profit-maximizing rule is to produce where marginal revenue equals marginal cost (MR = MC). At quantities below this point, producing more adds more to revenue than to cost. At quantities above this point, producing more adds more to cost than to revenue.
In the long run, firms exit if price falls below average total cost. Economic losses signal that resources should move to higher-valued uses. Entry and exit drive economic profits toward zero in competitive markets.
Finished reading?
Lock it in with a quick 2: Consumer and Producer Behavior quiz.