Microeconomics: Utility, Consumer Choice, Production, Costs, Demand & Perfect Competition

Roadmap

• Sequential overview repeatedly sign-posted in slides; useful to keep the “big picture” in mind while studying.

  • Part 1: Utility theory → consumer choice → demand.

  • Part 2: Substitution & income effects.

  • Part 3: Production, costs & profits (short run & long run).

  • Part 4: Market structures with emphasis on perfect competition.

Utility Concepts

• Utility (U): psychological measure of satisfaction from consuming goods/services.

• Total Utility (TU)

  • Cumulative satisfaction from all units consumed.

  • Table/graph for Alison’s bottled-water example supplied (10 bottles → TU_{10}=99 utils).

• Marginal Utility (MU)

  • Extra satisfaction from one additional unit.

  • Computed as MUn = TUn - TU_{n-1}.

  • Diminishes with quantity in the example (30 → 1 utils).

• Graphical representation

  • TU curve rises at a decreasing rate.

  • MU curve slopes downward; intersects horizontal axis where TU peaks.

Law of Diminishing Marginal Utility (DMU)

• Formal statement: For a given time period and constant tastes, MU from successive units of a good declines as total consumption rises.

• Significance

  • Explains downward-sloping individual demand curves.

  • Provides rationale for variety seeking, bulk discounts, progressive taxation, etc.

• Boundary conditions

  • Short time frame; goods are homogeneous; ceteris paribus (income, tastes held constant).

Consumer Choice Framework

• Objective: Maximize TU subject to constraints.

• Core assumptions about the consumer

  • Rational, complete & transitive preferences.

  • Knows prices; faces fixed money income.

  • Model often simplified to two goods: X and Y.

Utility-Maximizing Rule

• Allocate spending so that marginal utility per last dollar is equal across goods:
  \frac{MUX}{pX}=\frac{MUY}{pY}

• Rearranged: \frac{MUX}{MUY}=\frac{pX}{pY} (tangency of indifference curve & budget line in ordinal approach).

Numerical Illustration – Apples (X) & Oranges (Y)

• Income I=10\,; pX=1; pY=2 (initially).

• Table converts MU to MU/$ (decision variable).

• Sequential algorithm

  1. Spend first dollar where MU/$ is highest (orange, 12 utils/$).

  2. Update remaining income & next highest MU/$.

  3. Continue until I exhausted.

• Optimal bundle obtained when equality holds and budget is exactly spent.

• Pedagogical payoff: shows discrete version of equi-marginal principle.

From Utility Maximization to Demand

• If the price of oranges falls to 1 (slide experiment):

  • MU schedule unchanged; MU/$ for oranges doubles → consumer reallocates toward oranges.

  • Observed quantities yield two price-quantity pairs → individual demand point-plot.

  • At p_Y=2, Q* (from earlier table) = 4 oranges.

  • At p_Y=1, Q* = 6 oranges.

• Connecting all such pairs traces the downward-sloping demand curve.

Consumer Surplus Refresher

• Area under demand curve up to Q actually bought minus total expenditure.

• Graphically: region between demand curve and horizontal price line.

• Represents net benefit to buyers → welfare benchmark.

Decomposing a Price Change: Substitution & Income Effects

• Price change simultaneously alters

  1. Relative price \left(\frac{pX}{pY}\right) ⇒ Substitution Effect (SE).

  2. Purchasing power (real income) ⇒ Income Effect (IE).

• Formal definitions

  • SE: change in Q when relative price changes with utility held constant (Hicksian) or with real income adjusted to keep purchasing power constant (Slutsky).

  • IE: change in Q caused by change in real income holding relative prices constant.

• Outcomes by good type

  • Normal good: SE & IE work same direction → always downward-sloping demand.

  • Inferior good: IE opposite SE; usually SE dominates, still downward-sloping.

  • Giffen good: Rare case where negative IE outweighs SE; demand curve upward-sloping.

• Diagram (slide 23) depicts three panels illustrating decomposition.

Labor-Supply Application

• Choice between leisure (normal good) & labor hours.

• Wage ↑ ⇒ SE: labor relatively more rewarding → supply more hours.

• IE: higher real income permits more leisure (less labor) if leisure normal.

• Net labor-supply response ambiguous; can generate backward-bending curve.

Firms: Production Functions & Profit Concepts

• Firm transforms inputs (L, K) into output: Q = f(L,K).

• Economic Profit
  \pi = TR - (\text{Explicit} + \text{Implicit Costs})

• Explicit costs: observable outlays (wages, rent, materials).

• Implicit costs: opportunity cost of owner’s time & capital.

• Accounting profit ignores implicit costs ⇒ always ≥ economic profit.

• Slide table (Ruth’s Gourmet Soup)

  • TR =2000, Explicit =1160 ⇒ Accounting =840.

  • Implicit =265 ⇒ Economic =575 (still positive).

Short-Run Production

• Time horizons: at least one fixed factor in SR (usually capital).

Product Measures

• Total Product (TP), Average Product (AP), Marginal Product (MP):
  APL = \frac{TP}{L}, \quad MPL = \frac{\Delta TP}{\Delta L}

• Law of Diminishing MP: beyond some point, adding variable input to fixed input lowers MP.

• Graph: MP intersects AP at AP’s maximum.

Short-Run Cost Measures

• TC = TFC + TVC

• ATC = \frac{TC}{Q}, \; AFC = \frac{TFC}{Q}, \; AVC = \frac{TVC}{Q}

• MC = \frac{\Delta TC}{\Delta Q} (equals \Delta TVC/\Delta Q).

• Geometrical relationships

  • MC intersects AVC & ATC at minima.

  • ATC is vertical sum of AFC + AVC; U-shape arises from spreading TFC and diminishing returns.

• Cost-curve shifts

  • ↑ variable-factor price ⇒ upward shift of AVC, ATC, MC.

  • ↑ fixed-factor price shifts ATC & AFC but not MC.

Long-Run Production & Costs

• All inputs variable; firms choose cost-minimizing input mix.

• Cost-minimization condition
  \frac{MPK}{pK}=\frac{MPL}{pL} \quad\text{or}\quad \frac{MPK}{MPL}=\frac{pK}{pL}

• Principle of Substitution: when relative input prices change, firms substitute toward cheaper input.

• LRAC Curve

  • “Saucer” shape: economies of scale (EOS) ↓ section, minimum efficient scale at Q_M, diseconomies ↑ section.

• Return to Scale linkage

  • IRS ⇒ EOS; CRS ⇒ constant LRAC; DRS ⇒ diseconomies.

• Relation to SRATC

  • LRAC is lower envelope of SRATC family; no SR curve can dip below it.

Market Structure Spectrum

• Perfect Competition ← Monopolistic Comp. ← Oligopoly ← Monopoly.

• Market Power: ability to influence market price; zero in perfect competition.

Perfect Competition Fundamentals

• Many firms, identical product, price-taking, perfect information, free entry/exit.

• Firm’s demand is perfectly elastic (horizontal) at market price p.

Revenue Identities for Price-Taker

• TR=pQ

• AR=\frac{TR}{Q}=p

• MR = \frac{\Delta TR}{\Delta Q}=p (constant).

Firm Behaviour in Short Run (PC)

1. Produce or Shut Down?

   • If p < \min AVC ⇒ shut down, loss =TFC.

   • If p \ge \min AVC ⇒ produce where p=MC.

2. Profit-Maximizing Output

   • Condition: p=MC (also =MR).

   • Supply curve = MC above AVC.

• Industry SR supply = horizontal sum of individual MC segments.

• Short-run equilibrium can involve profits, breakeven, or losses (≠ shutdown) depending on price relative to ATC.

Long-Run Adjustments & Equilibrium (PC)

• Free entry if p>\min ATC; exit if p<\min ATC.

• Long-run equilibrium requirements

  1. p=MC (profit maximization).

  2. p=\min ATC (zero economic profit; break-even).

• Firm operates at minimum LRAC (productive efficiency).

Efficiency & the Invisible Hand

• Allocative Efficiency: MC = MV (marginal value) ensured because p=MC and consumers’ p reflects MV.

• Productive Efficiency: Long-run PC drives firms to least-cost technology.

• Dynamic aspect: super-normal profits attract entry, fostering innovation (creative destruction); price signals reallocate resources.

Key Equations & Numerical References (Alphabetical)

• Accounting profit: \pi_A = TR - \text{Explicit}.

• Economic profit: \pi_E = TR - (\text{Explicit}+\text{Implicit}).

• Marginal Cost: MC = \frac{\Delta TC}{\Delta Q}.

• Marginal Product: MP = \frac{\Delta TP}{\Delta L} (if labor varied).

• Marginal Revenue (PC firm): MR=p.

• Marginal Utility rule: \frac{MUX}{pX}=\frac{MUY}{pY}.

• Profit-maximization (PC): p=MC.

• Shut-down criterion: p<\min AVC.

Practical & Ethical Implications

• DMU underlies rational drug dosage, progressive taxes, and diminishing joy in material accumulation.

• Perfect competition serves as normative benchmark for antitrust & regulatory policy.

• Recognition of implicit costs crucial for realistic entrepreneurial decision making.

• Creative destruction emphasizes ethical trade-off between short-run job losses and long-run growth.

Suggested Readings & Multimedia

• Textbook: Chapter 6 (utility & demand), 7.1–7.4 (costs), 8–9 (perfect competition), 12.1.

• Supplementary videos linked in slides for visual learners (MU graphs, production functions, SR decision rules).

These bullet-point notes capture all definitions, laws, numerical examples, formulas, and conceptual linkages presented across the 81-slide transcript. They are structured to serve as a standalone study guide for exam preparation.