Micro part 2.pdf

01/02/2022
1
THECONSUMERTHEORY
01
02
ConsumerPreferences
UtilityFunctions:SingleandMultipleGoods
03 ConstrainedConsumerChoice
Consumers spend their money on the bundle of products that gives them the most pleasure.
However, consumers must choose which goods to buy because their limited incomes prevent
them from buying everything that catches their fancy.
In addition, government rules restrict what they can buy (laws prohibit people from buying
drugs).
Consumers buy the goods that give them the most pleasure, subject to the constraints that they
cannot spend more money than they have nor can they spend it in ways forbidden by the
government.
THECONSUMERTHEORY

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The consumer behavior model is based on three premises:
1. Individual tastes or preferences determine the amount of pleasure people derive from
the goods and services they consume.
2. Consumers face constraints, or limits, on their choices.
3. Consumers maximize their well-being or pleasure from consumption subject to the
budget and other constraints they face.
THECONSUMERTHEORY
Market basket or bundle : a collection of goods and services that an individual might consume.
As a consumer, you choose among many goods.
• Should you have ice cream or cake for dessert?
• Should you spend most of your money on a large apartment or rent a single room and use the
money you save to pay for trips and concerts?
➔ You must allocate your money to buy a bundle of goods
How do consumers choose the bundle of goods they buy?
Let’s start by specifying the underlying assumptions in the economist’s model of consumer
behavior.
ConsumerPreferences

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Assumptions
1. Preferences are complete: The consumer is able to rank any two baskets.
For baskets A and B, for example, the consumer can state her preferences according to one of the
following possibilities:
• She prefers basket A to basket B (written A ≻ B).
• She prefers basket B to basket A (written B ≻ A).
• She is indifferent between, or equally happy with, baskets A and B (written A ≈ B).
ConsumerPreferences
Assumptions
2. Preferences are transitive : the consumer makes choices that are consistent with each other.
Suppose that a consumer tells us that she prefers basket A to basket B, and basket B to basket E.
We can then expect her to prefer basket A to basket E.
Using the notation we have just introduced to describe preferences, we can represent transitivity
as follows:
If A ≻ B and if B ≻ E, then A ≻ E
3. More is better: having more of a good is better for the consumer.
ConsumerPreferences

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OrdinalandCardinalRanking
• Ordinal ranking indicates whether a consumer prefers one basket to another, but does not
contain quantitative information about the intensity of that preference.
Example: the consumer prefers basket A to D because more is better
• Cardinal ranking is a quantitative measure of the intensity of a preference for one basket
over another.
Example: The consumer likes basket A twice as much as basket D
It is usually easy for consumers to answer a question about an ordinal ranking.
However, consumers often have more difficulty describing how much more they prefer one
basket to another.
ConsumerPreferences
Utilityfunction
A Utility function measures the level of satisfaction a
consumer receives from any basket of goods and services.
Example:
y : the number of hamburgers Sarah purchases each week,
U(y) : the level of satisfaction (or utility) that Sarah derives
from purchasing y hamburgers.
Sarah’s utility at point C is higher than it is at point B, and
her utility at point B is higher than her utility at point A
PreferenceswithaSingleGood

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MarginalUtility
Marginal utility : The rate at which total utility changes as
the level of consumption rises.
The additional satisfaction received from consuming more
of a good depends on how much of the good has been
already consumed.
Example:
MarginalUtility
The principle of diminishing marginal utility: After some point, as consumption of a good
increases, the marginal utility of that good will begin to fall.
Diminishing marginal utility reflects a common human trait. The more of something we
consume, whether it be hamburgers, candy bars, shoes, or baseball games, the less additional
satisfaction we get from additional consumption.
Example: The MU of the sixth hamburger you consume this week will be less than the MU of the
second hamburger ➔ your MU of hamburgers is diminishing

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MarginalUtility
More may not always be better
Sarah may find that her total utility increases as she eats the
1st, 2nd , and 3rd hamburgers each week. For these hamburgers,
her MU > 0, even though it may be diminishing with each
additional hamburger she eats.
But at some point she will find that an additional hamburger
will bring her no more satisfaction. She might find that the
marginal utility of the 7th hamburger per week is zero, and the
marginal utility of the 8th or 9th hamburgers might even be
negative.
UtilityFunction
We can illustrate many of the most important aspects of consumer choice among multiple
products with a relatively simple scenario in which a consumer, Adam, must decide how much
food and how much clothing to purchase in a given month.
Let : x measure the number of units of food, and
y measure the number of units of clothing purchased each month.
Adam’s utility for any basket (x, y) is measured, in this case, by :
PreferenceswithMultipleGoods

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MarginalUtility
The marginal utility of any one good is the rate at which total utility changes as the level of
consumption of that good rises, holding constant the levels of consumption of all other goods.
In the case in which only two goods are consumed and the utility function is U(x, y), the marginal
utility of food (MUx) measures how the level of satisfaction will change (ΔU) in response to a
change in the consumption of food (Δx), holding the level of y constant:
MarginalUtility:Example
When the total utility from consuming a bundle (x, y) is , the marginal utilities are :
So, at basket A (with x = 2 and y = 8) :
• Adam realizes a level of utility of
• Marginal Utilities are
When the marginal utility is a positive number, the total utility will increase when more of the
good is consumed.

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IndifferenceCurves
Indifference curve is a curve connecting a set of
consumption baskets that yield the same level of
satisfaction to the consumer.
➔ The consumer would be equally satisfied with
(or indifferent in choosing among) all baskets
on that curve.
For example, Adam would be equally satisfied
with baskets A, B, and C because they all lie on the
indifference curve with the value U = 4.
IndifferenceCurves
Indifference curves properties :
1. When the consumer likes both goods (i.e., when MUx and MUy
are both positive), all the indifference curves have a negative
slope.
2. Indifference curves cannot intersect.
3. Every consumption basket lies on one and only one
indifference curve.
4. Indifference curves are not “thick.” (A thick indifference curve
contains baskets A and B with different utilities)

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TheMarginalRateofSubstitution
Marginal rate of substitution (MRS) is the rate at which the consumer will give up one good to
get more of another, holding the level of utility constant.
Example: a consumer’s marginal rate of substitution of hamburgers for lemonade is the rate at
which the consumer would be willing to give up glasses of lemonade to get more hamburgers,
with the same overall satisfaction.
TheMRS:Example
At point A, we can see that the consumer is ready to exchange
3 units of Good Y for one additional unit of Good X.
At this stage, the consumer’s Marginal Rate of Substitution
of X for Y is 3.
The MRS of X for Y represents the amount of Y which the consumer has to give up for the gain of
one additional unit of X so that his or her level of his or her utility (satisfaction) remains the same.
We assume that any of the five combinations in the table have the same level of utility.
For example, if the consumer goes from D to E, then the marginal rate of substitution becomes 1.
Combination Good X Good Y
A 2 10
B 3 7
C 4 5
D 5 3
E 6 2

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a) In the this figure, we have drawn an
indifference curve for a certain
consumer. Calculate an estimate of
her marginal rate of substitution,
MRS, in point A
b) Can we say anything about whether
point B is better or worse for the
consumer, as compared to point A ?
c) What about point C ?
Exercise
Solution

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Solution
ConstrainedConsumerChoice
TheBudgetConstraint
The budget constraint defines the set of baskets that a consumer can purchase with a limited
amount of income.
Example : Adam purchases only two types of goods, food and clothing.
The budget line indicates all of the combinations of food (x) and clothing (y) that Adam can
purchase if he spends all of his available income I on the two goods
Px x+ Py y = I
With : x be the number of units of food he purchases, Px the price of a unit of food,
y the number of units of clothing, Py the price of a unit of clothing.

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TheBudgetConstraint
Since the budget constraint permits a consumer to buy baskets both on and inside the budget
line, the equation for the budget constraint is :
Example:
If the income Y = $50, p1 = $1, and p2 = $2, Lisa can buy
any bundle in the opportunity set (the shaded area) including
points on the budget line L, which has a slope of -½.
TheBudgetConstraint

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TheBudgetConstraint
Exercise

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Solution
Solution

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Solution
OptimalChoice
Optimal choice is the consumer choice of a basket of goods that
• maximizes satisfaction (utility) while
• allowing him to live within his budget constraint.
An optimal consumption basket must be located on the budget line ➔ all income will be spent
The optimal choice problem for the consumer is expressed like this :

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OptimalChoice
Adam has an income of I = $800 per month,
the price of food is Px = $20 per unit, and
the price of clothing is Py = $40 per unit.
The budget line has a vertical intercept at y = 20,
indicating that if he were to spend all his income on
clothing, he could buy 20 units of clothing each
month.
The horizontal intercept at x = 40 shows that
Adam could buy 40 units of food each month
if he were to spend all his income on food.
The slope of the budget line is Δy/Δx = −Px/Py = −1/2.
OptimalChoice
Three of Adam’s indifference curves are shown
as U1, U2, and U3.
To maximize utility while satisfying the budget
constraint, Adam will choose the
basket that allows him to reach the highest
indifference curve while being on or inside
the budget line.
➔ That optimal basket is A
Any other point on or inside the budget line will
leave him with a lower level of utility.

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OptimalChoice
At the optimal basket A, the budget line is just
tangent to the indifference curve U2.
This means that :
BL slope = indifference curve slope
• The slope the BL is Δy/Δx = −Px/Py
• The slope of the indifference curve is
−MUx/MUy = −MRSx,y
The optimal basket A, requires that
OptimalChoice
The optimal basket A is said to be an interior optimum ➔ an optimal basket at which a consumer
will be purchasing positive amounts of all commodities.
At an interior optimal basket, the consumer chooses commodities so that the marginal utility per
dollar spent on each commodity is the same.
➔ The extra utility per dollar spent on good x is equal to the extra utility per dollar spent on
good y.

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The table below show the quantities, prices and marginal utilities of two goods; fudge and coffee,
which Tony purchases.
Tony spends all his money and buys only these two goods.
In order to maximize his utility, should Tony purchase more fudge and less coffee, purchase more
coffee and less fudge , or maintain his current consumption? Explain
Exercise1
Exercise2

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A consumer measures his satisfaction with the separate consumption of two goods X and Y.
The following table shows, for each of the goods, the value of the total utility as a function of the quantity consumed, with:
• x and y: respectively, the number of units of goods X and Y
• Ux and Uy: respectively, total utility of X and total utility of Y
1. Define, calculate and plot on the same graph the total and marginal utilities of goods X and Y
2. The consumer who allocates all of his income I to the purchase of goods X and Y, wants to maximize his satisfaction.
Given that Px=Py=2dhs and I=18dhs, what combination of quantities of the two goods should this consumer choose?
3. Define the optimal choices of the consumer knowing that Px =2dhs and Py =3dhs and that the income is successively
equal to 15dhs and 9dhs
Exercise3
x 0 1 2 3 4 5 6
Ux 0 10 18 24 28 30 30
y 0 1 2 3 4 5 6
Uy 0 12 23 32 39 43 43
A consumer has a budget of 12dhs which he must divide between two goods X and Y.
The price of each unit of X is 2dhs, that of each unit of Y is 1dh.
The marginal utilities are given in the following table:
1. Define the marginal utility of a good
2. Define the equilibrium conditions of the consumer
3. What will be the consumer's equilibrium for I=12dhs?
4. If the price of X decreases, what will be the consumer's reaction?
Exercise4
Unit of products X and Y 1st 2nd 3rd 4th 5th 6th 7th 8th
MUx 16 14 12 10 8 6 4 2
MUy 11 10 9 8 7 6 5 4

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A consumer has an income of 1400dhs per month which he uses entirely for the consumption of two goods X and Y.
The unit price of Y is Py=100. It is also known that if the consumer bought 6 units of Y, his income would allow him to
buy an additional 2 units of X.
1. Give the general form of the budget equation
2. Calculate the price of X, Px
Let U1 and U2 be two indifference curves belonging to the indifference map of this consumer assumed to be known:
• The equation of curve U1 is: (x+2)(y+2)=36
• The equation of curve U2 is: xy+2x+2y=77
3. Graph the two curves
4. State the definition of the MRSxy and give for each indifference curve an equation allowing to calculate this rate
at each point of the curve
5. What is the optimal combination of the two goods, for the utility levels U1 and U2?
Exercise5
PRODUCTION&COSTTHEORY
01
02
CostsofProduction
ProductionandCostrelationship
03 TheVariousMeasuresofCost
04 EconomiesandDiseconomiesofScale

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TheMarketForcesofSupplyandDemand
• Supply and demand are the two words that economists use most often.
• Supply and demand are the forces that make market economies work.
➔ Modern microeconomics is about supply, demand, and market equilibrium
• According to the Law of Supply:
Firms are willing to produce and sell a greater quantity of a good when the price of
the good is high. This results in a supply curve that slopes upward.
• The Firm’s Objective :
The economic goal of the firm is to maximize profits.
CostsofProduction
TotalRevenue,TotalCost,andProfit
• Total Revenue : The amount a firm receives for the sale of its output.
• Total Cost : The market value of the inputs a firm uses in production.
• Profit is the firm’s total revenue minus its total cost.
Profit = Total revenue - Total cost
CostsofProduction

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TotalRevenue,TotalCost,andProfit
A firm’s cost of production includes all the opportunity costs of making its output of goods
and services.
Opportunity cost includes both explicit costs and implicit costs :
• Explicit costs are input costs that require a direct outlay of money by the firm. For
example, payments for wages and salaries, rent, or materials
• Implicit costs are input costs that do not require an outlay of money by the firm.
• For example, a factory may close down for the day in order for its machines to be
serviced. The explicit cost to repair the machines is $10,000. However, the factory has lost
a whole days output which has cost it $50,000 in lost production (implicit cost).
CostsofProduction
EconomicProfitversusAccountingProfit
• Economic profit:
Economists measure a firm’s economic profit as total revenue minus total cost,
including both explicit and implicit costs.
• Accounting profit:
Accountants measure the accounting profit as the firm’s total revenue minus only the
firm’s explicit costs.
• When total revenue exceeds both explicit and implicit costs, the firm earns
economic profit.
CostsofProduction

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EconomicProfitversusAccountingProfit
• Economic profit is smaller that accounting profit.
• Economists include all opportunity costs when analyzing a firm.
Economic Profit = Total Revenue – Total Cost
• Accountants measure only explicit costs
Accounting Profit = Total Revenue – Explicit Cost
CostsofProduction
CostsofProduction

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Typesofbusinessfirms
• A business firm is an organization, owned and operated by private individuals, that
specializes in production
• A sole proprietorship : A firm owned by a single individual
• A partnership : A firm owned and usually operated by several individuals who share in the
profits and bear personal responsibility for any losses
• A corporation :
- Owned by those who buy shares of stock and whose liability is limited to the amount of
their investment in the firm
- Ownership is divided among those who buy shares of stock
- Each share of stock entitles its owner to a share of the corporation’s profit
ProductionandCost
Productionfunction
• Production is the process of combining inputs to make outputs
• Firms must incur costs when buy inputs to produce the goods and services that
they plan to sell.
• The production function shows the relationship between quantity of inputs
used to make a good and the quantity of output of that good.
ProductionandCost

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Productionfunction
• Marginal Product
The marginal product of any input in the production process is the increase in
output that arises from an additional unit of that input.
ProductionandCost
Example: Marginal product of labor (MPL) is the change in total product (ΔQ)
divided by the change in the number of workers hired (ΔL)
Tells us the rise in output produced when one more worker is hired
ΔL
ΔQ
MPL =
ProductionandCost

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Productionfunction
• Diminishing marginal product
Diminishing marginal product is the property whereby the marginal product of an
input declines as the quantity of the input increases.
Example: As more and more workers are hired at a firm, each additional worker
contributes less and less to production because the firm has a limited amount of
equipment.
ProductionandCost
© 2007 Thomson South-Western
Figure 2 Hungry Helen’s Production Function
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
0 1 2 3 4 5 6 7
Number of Workers Hired
Quantity of output

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Productionfunction
• Diminishing returns to labor
When the marginal product of labor is decreasing
• There are diminishing marginal returns to labor
• Output rises when another worker is added so marginal product is positive
• But the rise in output is smaller and smaller with each successive worker
Law of diminishing (marginal) returns states that as we continue to add more of any one input
(holding the other inputs constant)
• Its marginal product will eventually decline
ProductionandCost
30
90
130
161
184
196 Total Product
DQ from hiring fourth worker
DQ from hiring third worker
DQ from hiring second worker
DQ from hiring first worker
increasing
marginal returns
diminishing
marginal returns
Units of Output
Number of Workers
6
2 3 4 5
1

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FromtheProductionFunctiontotheTotal-CostCurve
The relationship between the quantity a firm can produce and its costs determines
pricing decisions.
The total-cost curve shows this relationship graphically.
ProductionandCost
© 2007 Thomson South-Western
Figure 2 Hungry Helen’s Total-Cost Curve
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160
Total
Cost
Quantity
of Output
(cookies per hour)

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FixedandVariableCosts
Costs of production may be divided into fixed costs and variable costs.
• Fixed costs are those costs that do not vary with the quantity of output
produced.
• Variable costs are those costs that do vary with the quantity of output produced.
• We can calculate total, marginal and average costs of production
THEVARIOUSMEASURESOFCOST
Totalcosts
• Total fixed costs
Cost of all inputs that are fixed in the short run
• Total variable costs
Cost of all variable inputs used in producing a particular level of output
• Total cost
Cost of all inputs—fixed and variable
TC = TFC + TVC

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TheFirm’sTotalCostCurves
TC
0
Dollars
135
195
255
315
375
$435
30 90 130 161
Units of Output
184 196
TFC
TVC
AverageCosts
• Average fixed cost (AFC)
Total fixed cost divided by the quantity of output produced
• Average variable cost (AVC)
Total variable cost divided by the quantity of output produced
• Average total cost (ATC)
Total cost divided by the quantity of output produced
Q
TFC
AFC =
Q
TVC
AVC =
Q
TC
ATC =

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MarginalCost
Increase in total cost from producing one more unit or output
Marginal cost is the change in total cost (ΔTC) divided by the change in output (ΔQ)
ΔQ
ΔTC
MC =
• Tells us how much cost rises per unit increase in output
• Marginal cost for any change in output is equal to shape of total cost curve
along that interval of output
MarginalCost

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AverageAndMarginalCosts
CostCurvesandTheirShapes
The average total-cost curve is U-shaped
• At very low levels of output average total cost is high because fixed cost is spread
over only a few units.
• Average total cost declines as output increases.
• Average total cost starts rising because average variable cost rises substantially.
• The bottom of the U-shaped ATC curve occurs at the quantity that minimizes
average total cost. This quantity is sometimes called the efficient scale of the firm

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CostCurvesandTheirShapes
Relationship between Marginal Cost and Average Total Cost
• Whenever marginal cost is less than average total cost, average total cost is falling.
• Whenever marginal cost is greater than average total cost, average total cost is
rising
• The marginal-cost curve crosses the average-total-cost curve at the efficient scale.
• Efficient scale is the quantity that minimizes average total cost.
Exercise
Quantity 1 20 40 60 80 100
Cost 30 40 60 80 130 220

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