Utility Theory and the Downward Sloping Demand Curve.

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1 Tuesday Notes Utility Theory and the Downward Sloping Demand Curve. Five fundamentals of consumer choice 1. We make decisions purposefully and We are motivated and act based on rational self-interest. We make choices based on our preferences. 2. We face constraints. Limited income matched with Varying prices necessitates choice. 3. One good can be substituted for another. 4. Consumers must make decisions without perfect information. 5. The law of diminishing marginal utility applies. Implies that a consumer s marginal benefit falls with the rate of consumption (subjective), and thus the demand curve falls with the rate of consumption. The two effects of a price change: The substitution effect that part of change in the amount consumed that is the result of a good being cheaper or more expensive in relation to another good. The income effect the part of a change in the amount consumed that is the result of the consumer s real income being changed by the price change. Number of cookies consumed per week Total utility Marginal utility


3 General Theory of the Firm Organization of the Business Firm The Theory behind Supply (Producers) Firm an institution that hires factors of production and organizes them to produce and sell goods and services. Primary Goal of the firm Maximize profit Profit = total revenue total cost Firms organize production to: Minimize transaction costs Economies of scale - cost of producing falls as output rate rises Team production Three factors that promote firm efficiency Competition among firms for investment funds and customers Compensation and management incentives Threat of corporate takeover Short Run Production theory Output the production function is the technological relationship that exists between the quantity of inputs employed and the quantity of output produced. Inputs (factors of production) Land natural resources Labor- human resources Capital machines, building Entrepreneurial skills innovation Fixed inputs Machinery, buildings, land (cannot be varied in short run) Capital is the input most commonly considered fixed. Variable inputs Labor, materials (can be varied in the short run). Labor is the input most commonly considered variable.

4 Time Periods Short run is a time period short enough that at least one input is fixed. The firm cannot choose from among all possible production techniques. Long run is a time period sufficient for all inputs used in a productive process to be variable. We can choose from all possible production techniques. Total Product (TP) The maximum total output that can be produced from a given level of fixed and variable inputs. Average Product (AP) The average product of a variable factor of production is the total product divided by the amount of the variable input that is being used. This tells us the average amount of output that each unit of input enables us to produce. AP=TP/amount of input The Marginal Product (MP) of a variable factor of production is the change in total output that occurs when an additional unit of that factor is used. MP=ΔTP/Δ input The level of output at which marginal product reaches as maximum is called the point of diminishing marginal productivity. The law of diminishing marginal returns (or marginal returns), is that as more and more units of a variable resource are combined with a fixed amount of other resources, the use of additional units of variable will eventually increase output but only at a decreasing rate.

5 Example Variable input = number of workers (labor or L) Fixed input = a machine (capital or K) AP=TP/ (amount of input) column 5 Point of diminishing average productivity is between 9 and 12 units of output. MP of labor, MPL column 4 MP L = ΔΤP 2 workers TP 5 MP L 3(5-2) AP L 2,5(5/2) 3 workers TP 9 MP L 4(9-5) AP L 3(9/3) 4 workers TP 12 MP L 3(12-9) AP L 3(12/4) 5 workers TP 14 MP L 2(14-12) AP L 2,8 7 workers TP 13 MP L -2(15-13) AP L 1, Number of workers, L Units of fixed factor, K Total Product, TP Marginal Product of Labor, MP L Average Product of Labor, AP L =(2-0) 2=2/ =(5-2) 2,5=5/ =(9-5) 3,0=(9/3) , , , , units of labor increasing marginal returns 4-6 units of labor diminishing marginal returns 7 units of labor absolute diminishing returns