Introduction to Microeconomics

Chapter 3: Theory of Consumer Behavior or Choice

Consumer is one who demands for products and services.

As one who chooses, desires, and purchases the goods, consumers have the power or the
command to dictate what is to be produced in the market. Such power is known as
consumer sovereignty. As demand comes from consumers, an increase in demand
generally results to increase in supply as consumer’s choice bring more profit to sellers.

Anything that satisfies needs, wants and desires of consumers in exchange for something
with value are known as goods. There are several classifications of goods depending upon
their characterization in relation to consumers.

In economics, there are two basic types of goods: tangible economic products or simply
products, which are all physical and concrete goods bought by consumers to satisfy their
longings, and intangible economic activities or simply known as services, which are all
undertakings and pursuits that fulfills the consumers in exchange for money or other things
with value.

The other classifications of goods are as follows:

Consumer Goods- these are goods that directly satisfy consumers. The three important
characteristics should be present in order for a good to be considered as consumer goods:
1. Yields direct satisfaction, 2. easily found in the market. 3. Bought to instantly satisfy
consumers.

Essential/ Necessity Goods- these are goods that satisfy the needs of consumers. These
are good which people cannot survive without.

Luxury Goods- these are goods that people can live without but are bought for pleasure,
comfort, and well-being.

Economic Goods- these are goods which are both useful and scarce.

Free Goods- these are goods so abundant that everyone can be satisfied without
necessarily paying anything during the consumption.

There are also instances when people pay for things yet they receive or experience
frustration or dissatisfaction or disappointment. Such are not called goods but rather
known as bads.

Consumers will always choose goods over bads. Moreover, the behavior of the consumers
shape the flow of the market of goods as to what will be produced and what will be obsolete
in time depending on how much satisfaction they gain from the use of the different goods
offered in the market. Also, the behaviors of the consumers depend on different scenarios
and constraints.
 Utility

It is assumed that consumption of any goods whether products or services give satisfaction
to consumers. In the field of economics, pleasure or satisfaction is measurable. As
customers consume bundle or combination of products and services, they receive happiness
or fulfillment and such is measured by utility. The unit of measurement for utility is called
utils. Utils will be measured through the concept of marginal utility which Is the amount of
additional satisfaction obtained by consumers for every additional unit of goods consumed.
In addition, the sum of all marginal utility or long run satisfaction is known as total utility.

The marginal utility of any good is the increase in the utility that the consumer gets from an
added unit consumed of that certain good. Generally, the goods consumed display
diminishing marginal utility. The concept suggests that: the more goods the consumer
gets, the marginal utility provided by an extra unit of such good becomes lower.

For economists and analysts, they have observed that consumers prefer a certain bundle of
goods versus another when the first chosen bundle provides more utilty than the rest of the
other bundles revealing the concept of cardinal utility or assigning numerical value for
preferences by means of descriptive explanation. Ranking the utility of goods as to first,
second, third and succeeding preference is known as the concept of ordinal utility.

Example:

Assume that Juan gets 10 utils after eating 10 pcs of fish balls and 5 utils after eating the
same number of squid balls. Then, he gets 8 utils after eating 8 more fish balls.

In the given scenario.

-cardinal utility explains that Juan was able to gain 5 utils for 10 pieces of squid balls, 10
utils and 8 utils for the two sets of 10 pieces of fish balls respectively.

- Ordinal utility clarifies that Juan prefers fish balls over squid balls as he was able to get
more satisfaction from the former.

The formula for the Overall total utility (TU):

TU= Tu1 + Tu2 + Tu3………..

The formula for marginal utility:

Mu= Change in Tu/ Change in Q

Or Mu= (Tu2-Tu1) / (Q2-Q1)

Budget Constraint

Everyone would want to have all his/her desires yet there will always be bounds on up to
what extent one will be able to acquire. One of which is budget constraint. Budget
constraint is the limit on the consumption bundles that a consumer can afford because of
limited budget. People spend less than what they desire because their spending is limited or
constrained by their income.
Example:

Assume that there are only two goods in the market: Tangible economic products and
Intangible economic services.

Suppose a person has:

A budget of P1000.00

A unit of product is worth P100.00

A unit of service is worth P200.00

Note: For ease in understanding budget constraint, it is better to create a budget constraint
table and a budget constrain curve.

Unit/s of Unit/s of Spending on Spending on Total Spending

Product Service Product Service
0 5 P0 P 1000 P 1000
2 4 200 800 P 1000
4 3 400 600 P 1000
6 2 600 400 P 1000
8 1 800 200 P 1000
10 0 1000 0 P 1000

Note:

Optimum Bundle is the combination of goods that gives the maximum satisfaction to
consumers that is within the bounds of their budget.

Inefficient Bundle is the combination of goods which does not provide maximum
satisfaction to as the budget of the consumers has not yet been maximized.

Infeasible Bundle is the combination of goods which does not provide satisfaction at all
because the bundle is beyond the budget that the consumer can afford.

There are Four Factors that can affect Budget Constraint curve. These are:

1. Income- An increase in income increases the budget that can be used for purchase,
thus a shift in the budget constraint line to the right, thereby exhibiting increase in the
bundles that the consumer can choose from. A decrease in income leads to
decrease in budget shifts the budget constraint line to the left, shrinking the possible
bundles that can provide optimum satisfaction to consumers.
2. Supply of Goods- An increase in the supply of goods does not affect the budget and
a decrease in supply also does not affect the budget line.
3. Price of Goods- An increase in the price of goods in effect decreases the budget as
the consumer will be bounded by tighter constraint, therefore, shifting the budget
constraint line to the left. A decrease in the price of goods in effect increases the
 bundle of goods that the consumer can afford, thus, shifting the budget constraint line
to the right.
4. Savings- An increase in savings decreases the available budget to be used for
consumption, thus, shifting the budget constraint line to the left. A decrease in money
to be kept for savings allows the consumers to have increase in budget, thus, gaining
more bundles for consumption to consumers.

Indifference Curve

Indifference is the feeling of unconcern or disinterest in things. Consumers come to the

point where in the combination of goods may have varying bundles yet can provide the same
level of satisfaction. Indifference Curve shows the different consumption bundles that give
the consumers same level of satisfaction.

The consumer’s preferences are depicted by indifference curves which display the
combinations of French fries and chicken nuggets that provide same or equal level of
satisfaction for consumers. Marginal rate of substitution displays the willingness of
consumers to trade one good for another. In the given example, MRS is the rate tolerable to
consumer to change from point A to point B to achieve the same level of satisfaction.

Chapter 4: Optimum Choice

Optimization of Profit

The ultimate goal of the firms is maximum profit. Economists study industrial organization to
analyze the reasons and motives of how firms come up with decisions on prices and
quantities that depend on varying market conditions they confront. Optimization of profit is
the detailed explanation of what lies behind the supply curve and the comprehensive
understanding of why firms behave differently on diverse situations and market conditions.

Production Function

Production refers to any economic activity that utilizes the four factors of production to
produce an output that can directly satisfy consumers. The output may be in the form of a
product or service. In simple terms, production is the process of converting inputs into
outputs. Inputs are supplies and services utilized to create goods. While, outputs are
innumerable advantageous goods that rise from production activities and are either directly
consumed or used for further production

The decision on how many workers are to be hired and how much output is to be produced
is the concern of production function. Production Function is the correlation between quantity
of inputs used to make goods and the quantity output of such goods.

Example:

In production function, inputs are transferred in outputs.

Output basket = f( fabric , plastic thread, worker, paint, etc.)

The slope of the production function is rise over run. It means that there is a change in
output for every additional input of any of the factors of production being reviewed.

In simpler terms, the slope of the production function is the marginal product, which is the
increase in the output that arises from an additional unit of input, of any of the factors of
production being studied. As there is increase in input, the marginal product declines and the
production function becomes relatively flat. Diminishing marginal product, which is the
property whereby the marginal product of an input regresses as the amount of the input
rises, is very evident.

ILLUSTRATION

Suppose Mr. Noel, the owner of a basket factory, has the following data:

No. of Output ( # of Marginal Cost of Cost of Total Cost of

Workers baskets made Product of Factory Workers Inputs ( Cost of
per day) Labor Factory + Cost of
workers)
0 0 - P 100 P0 P 100
1 60 60 P 100 P 200 P 300
2 110 50 P 100 P 400 P 500
3 150 40 P 100 P 600 P 700
4 170 20 P 100 P 800 P 900
5 180 10 P 100 P 1000 P 1100

NOTE:

The formula for Marginal Product of Labor:

MPL= Change in Quantity/Change in labor or =(Q2-Q1)/(L2-L1)

The formula for Total Cost of Inputs”

TC= cost of factory + cost of workers or any other inputs used in the
problem/production

Production Costs

Costs are the amounts that firms pay to buy inputs used in production. In the formula:

Profit= Total Revenue- Total Cost

The ultimate goal of the firm which is a profit will only be achieved if the amount the firms
received from the sale of its output known as total revenue is greater than the market value
of the inputs a firm utilized in production called total cost.

NOTE:

In the given formula: Profit= Total Revenue- Total Cost

There is gain in profit when the result is positive

There is loss in profit when the result is positive

 There is break even in profit when the result is equal.

In economics, the fundamental concept of opportunity cost matters in production.

There are two kind of cost: implicit cost and explicit cost. Implicit cost is the cost spent on
inputs that do not require an outlay of money by the firm. Explicit cost, on the other hand, is
the cost that the firms spent on inputs requiring an outlay of money. With the given premises,
there is a difference between economic profit and accounting profit. Economic profit
considers all costs including both explicit and implicit costs. Whereas, accounting profit
only includes cost with actual money outlay or explicit costs.

Illustration

Economic Profit
Revenue Implicit Cost Accounting Profit
Explicit Cost Explicit Cost

Notice that economic profit is smaller than accounting profit because economics consider all
costs including opportunity cost. For a business to be considered as cost-effective in
economics, the total revenue should cover not only the explicit cost but all costs including
the implicit costs and opportunity costs.

A firm’s costs show its production process. The total costs of the firms can be divided
between fixed cost and variable cost. Fixed costs are constant and do not change
regardless whether the firm increases or decreases its outputs produced. Variable costs
are varying costs that moves as the firm adjusts its amount of outputs manufactured. From
the total cost of the firm, two significant and associated measures are obtained. Average
total cost is the total cost divided by the quantity of output produced. It measures the mean
or standard cost that the company incurs in the production of outputs. Marginal cost is the
quantity by which total cost increases if output rises by 1 unit. It is the change in total cost in
relation to change in output.

Note: Cost analysis is very important in understanding the behavior of firms in terms of
their decisions in the production of outputs.

Summary of the Various measures of Costs, Revenue and Profit

Term Description Formula

Explicit Cost Cost that requires outlay of ---
money
Implicit Cost Cost that does not ---
requires outlay of money
Fixed Cost Cost that do not vary with ---
output produced
Variable Cost Cost that vary with output ---
produced
Total Cost Market value of all factor TC= FC + VC
inputs used in production
Average Fixed Cost Fixed cost per unit output AFC= FC/Q
Average variable Cost Variable cost per unit AVC= VC/Q
 output
Average Total Cost Total cost per unit output ATC= TC/Q
Marginal Cost Increase in total cost from MC= Δ TC/ Δ Q
an extra unit in production Or
or Change in total cost TC2-TC1/Q2-Q1
divided by change in
quantity output
Total Revenue Total income gained by TR= Price X Quantity
quantity multiply by price
Total Profit Total Revenue minus Total TP= TR-TC
Cost
Marginal Revenue Increase in total revenue Δ TR/ Δ Q
from an extra unit in Or
production or Change in TR2-TR1/Q2-Q1
total revenue divided by
change in quantity output
Marginal Profit Increase in total profit Δ P/ Δ Q
from an extra unit in Or
production or Change in P2-P1/Q2-Q1
total profit divided by
change in quantity output

Illustration:

Noel’s bakery specializes on producing the best tasting muffin. The following are the costs
incurred for every given output produced for an hour. Price per piece at P 2.00. Complete
the table using the formulas above.

Qty FC VC TC AFC AVC ATC TR TP MC MR MP

0 2.00 0
1 2.00 1.00
2 2.00 1.80
3 2.00 2.40
4 2.00 2.80
5 2.00 3.20
6 2.00 3.80
7 2.00 4.60
8 2.00 5.60
9 2.00 6.80
10 2.00 8.20
11 2.00 9.80
12 2.00 11.60
13 2.00 13.60
14 2.00 15.80
NOTE:

- There is no variable cost when the quantity output is equal to zero.

- Total cost increases as there is increase in output
- The average fixed cost eventually declines as the amount of output increases.
- The average variable cost declines but eventually rises as the production continues.
- Notice that there is increasing marginal product before the occurrence of decreasing
marginal product.

Optimum Profit s established when the price-output combination yields maximum amount
of profit. In addition, it is the situation when the firms provide the least amount of input yet
obtains the maximum amount of profit. There is optimum profit if total revenue exceeds total
cost. Also, when marginal revenue is equal to marginal cost, firms achieve optimum profit.

Economies of scale is also known as increasing returns to scale. It is the situation where
more units are produced with less per unit cost in the production of outputs. Long-run
average total cost declines as the amount of outputs rise.

Diseconomies of scale is also known as decreasing returns to scale. It is the situation

where an increase in the level of outputs produces increase in per unit cost of production.
Long-run average total cost rises as the amount of outputs rise.

Constant returns to scale is the situation where per unit cost or an output is at the same
amount as inputs. Long-run average total cost stays the same as the amount of outputs
rise.