Consumer Theory

Purpose of theory of demand is to determine the various factors that affect demand.
Determinants:
1. Price of commodity
2. Other prices
3. Income
4. Tastes
5. Income distribution
6. Total population
7. Wealth
8. Government policy
Utility – wants satisfying power, value in use of a commodity is the satisfaction which we
get from the consumption of a commodity
Marginal utility – additional utility derived from additional unit of a commodity. Net addition
made to total utility by consumption of an extra unit of a commodity
Total Utility – sum of utility derived from different units of a commodity consumed, amount
of utility derived from the consumption of all units of a commodity which are at the disposal
of consumer
Marginal Utility Analysis – Alfred Marshall, explain how a consumer spends his income
on different goods and services so as attain maximum satisfaction
Assumption of utility analysis:
1. Based on cardinal concept
2. Measurable and additive of goods
3. MU of money is assumed to be constant
4. Hypothesis of independent utility
5. Consumer is rational
6. Has full knowledge of the availability of commodities and their tehnical
qualities
7. Possesses perfect knowledge of the choice of commodities
8. No substitutes
9. Utilities are not influenced by variations in their prices
10. Theory ignores complementary between goods
Law of Diminishing Marginal Utility – based on human wants, developed by H.H. Gossen
“Gossens First Law” and popularized by Prof. Alfred Marshall
Assumptions:
1. Tastes, preferences of customer remain constant
2. Income of the consumer also remain constant
 3. Units of the goods are identical or similar
4. Process of consumption is continuous
5. Units of goods are not very small in size
Importance:
1. Framing taxation policy by the government
2. Useful to consumer to regulate his expenditure
3. Useful to monopolist producer in fixing the prices of his products
4. Basis for law of demand
5. Differentiate value in use and value in exchange
Explanation to the graph:
- TU declines in positive rate but MU declines in negative rate
- TU rises by smaller amounts
- Negative slope of MU curve reflects the law of diminishing MU
- Saturation point is when the TU is unchanged
- MU declines from larger to smaller units
Limitations:
1. Different units consumed must be identical and the habit, taste, income remain
unchanged
2. Different units consumed should be standard units
3. Continuous consumption, no gap
4. Law does not apply to articles like gold, cash, money, music, hobbies
5. Shape of utility curve may be affected by presence or absence of articles which
are sub to it
Conclusion
Utility reflects the tastes of a particular individual, uniqueness to the individual and
reflects his or her own particular subjective preferences and perceptions. Utility remain
unchanged so long as the individual’s tastes remain the same.
Ordinal and Cardinal Approach
1. Cardinal Approach – utility can be measured by monetary units, uses utils which
help in understanding how much utility is derived from consumption of a product,
comparative study, preceded the ordinal approach, concave function, quantitative
measure
2. Ordinal Approach – utility is not measurement, but is an ordinal magnitude,
consumer need not know in specific units, it is needed for him to rank the various
commodities.
- Consumption can’t be measured, utility is used for grading/ranking of the product
depending on the preferences of the consumer, much less compared, conceptual
and practical, convex function, qualitative measure
Consumer Behavior
Concept:
- Study of how individual customers, groups or organizations; select, buy, use, and
dispose ideas, goods, and services to satisfy their needs and wants
- Refers to actions of the consumers in the marketplace
- “consumer behavior is the decision process and physical activity, which individuals
engage in when evaluation, acquiring, using or disposing of goods and services”
– Louden and Bitta
Nature of Consumer Behavior
1. Influenced by various factors:
- Marketing, Psychological, Situational, Social and Cultural
2. Consumer behavior is not static
3. Varies from consumer to consumer
4. Varies from region to region and country to country
5. Information on consumer behavior is important to marketers: Product
design/model, promotion of the product, positioning, pricing of the product,
packaging and place of distribution
6. Leads to purchase decision
7. Varies from product to product
8. Improves standard of living
9. Reflects status of a customer
Budget Line:
- A higher indifference curve shows a higher level of satisfaction than a lower one
- A consumer in his attempt to maximize satisfaction will try to reach the higher
possible indifference curve
- In pursuit of buying more and more goods, he will obtain more and nore satisfaction
Two constraints: (1) he has to pay the prices for the goods (2) he has a limited
money income with which to purchase the goods
- A budget line shows all those combinations of two goods
- Consumer can buy spending his given money income at their given prices
- Consumer budget states the real income or purchasing power of consumer from
which he can purchase certain quantitative bundles of two goods at given place
Key points for a budget line
1. Separates what is affordable from what is not
2. BL slopes downwards as more of one good can be bought by decreasing some
units of the other good
3. Bundles which cost exactly equal to consumers money income lie on the budget
line
 4. Bundles which cost less than the consumers money income shows under
spending, they lie inside the budget line
5. Bundles which cost more than consumers money income are not available to
consumer, they lie outside the budget line
Budget Set
- Includes all possible consumption bundles that someone can afford with given the
prices of goods and the persons income level. Budget set is bounded above by the
budget line

The Concept of Production

Production – entrepreneur must put together resources – land, labor, capital –and
produce a product people will be willing and able to purchase
Firm – entity concerned with the purchase and employment of resources in the production
of various goods and services
Assumptions:
- Firm aims to maximize its profit with the use of resources that are substitutable to
a certain degree
- The firm is “a price taker in terms of the resources it uses”
Production Function
- Deals with the maximum output that can be produced with a limited and given
quantity of inputs
- Dependent on different time frames
- Firms can produce for a brief or lengthy period of time
- Q=f(K,L,La) Q – output, K – capital, L – land and La – labour
Assumptions:
1. Perfect divisibility of both inputs and outputs
2. Limited substitution of one factor for another
3. Constant technology
4. Inelastic supply of fixed factors in the short run
The Laws of Production
Laws of Variable Proportions – relates to the study of input output relationship in the short
run with one variable input while other inputs are held constant
Laws of Returns Scale – relates to the study of input output relationship in the long run
assuming all inputs to be variable
Firm’s Inputs
- Inputs – are resources that contribute in the production of a commodity
- Most resources are lumped into 3 categories: land, labor and capital
Fixed vs. Variable Inputs
- Fixed Inputs – resources used at a constant amount in the production of a
commodity
Remain the same in short period
- Variable inputs – resources that can change in quantity depending on the level of
output being produced
In long run, all factors of production are varies
- The longer planning the period, the distinction between fixed and variable inputs
disappears
Theory of Production
- Production – process that creates/adds value or utility
- Inputs converted to outputs
- Production function means the functional relationship between inputs and outputs
in the process of production
- Technical relation which connects factors inputs used in the production function
and the level of outputs
Factors of production
- Land, labor, capital, organization
Various Concept of Production
Total Product
Average Product – ratio of total product and one variable inputs
Marginal Product – the rate of change of output as a result changes in one variable input
Law of Production Function
Laws of Variable Proportion – law of diminishing return (short run production function with
at least one input is variable)
Laws of return scales – long run production function with all inputs factors are variable
Law of Variable Proportion: Short run production function
- Explain short run production function
- Production function with at least one variable factor keeping the quantities of other
inputs as a fixed
- Show the input output relation when one inputs is variable
The Nature of Cost
Cost – value of money that has been used up to produce something, expenses faced by
the business in the process of supplying goods and services to consumer
Nature of Cost:
- Accounting cost which an entrep takes into account in making payments to the
various factors of production
- Explicit – payments to outside suppliers of inputs
- Implicit – costs are the imputed value of the entrp owns resources and services
- Salvatore “implicit costs are the value of owned inputs used by the firm in its own
production process”
Entrepreneurial Costs:
- Owners of firm are entitled to difference between revenues and costs, called profit
- If they incur opportunity costs for their time or other resources, cost ang tawag
From production to cost
- Production concepts examine the mount of inputs needed to produce given output
- Cost concept examine the cost of inputs needed to produce a given output, cost
concepts combine production concepts with input prices
Short run cost measures
- C = VC + F
Sunk Fixed Cost
- Expenditures that cannot be recovered
- Opportunity cost of capital is zero
Long Run Cost
- Firm adjust all its input so its cost of production is as low as possible
- LR fixed cost = 0
- LRTC = LRVC / C = VC
Types of Costs
Opportunity Cost – cost incurred for loosing next best alternative
Actual Cost – actual amount paid or incurred
Explicit cost – money expended to buy
Implicit Cost – cost of use of the self-owned resources of org that are used in prod
Direct Cost – directly attributable cost
Indirect Cost – not directly accountable to specific cost, not directly related to production
Historical Cost – original (actual) cost incurred at the time the asset was acquired
Replacement Cost – price an entity would pay to replace an existing asset
Fixed Cost – cost that remains unchanged irrespective of output level
Variable Cost – costs that vary depending on a company’s production volume; they raise
as prod increases and fall as prod decreases
Real cost – physical quantities of various factors used in producing commodity
Prime cost – direct cost of commodity in terms of materials and labors involved in its prod
excluding fixed cost, firm can decide the selling price to earn profit
Total Cost = TC = TVC + TFC, cost refers to the total expenses incurred in reaching a
particular level of output
Marginal cost – per unit cost of production, addition made to the total cost by producing
one more unit of output MCn = TCn – TCn-1
Average cost – total cost divided by total units of output AC = TC/Q, Q is quantity
produced
Average fixed cost – total fixed cost divided by total units of outputs = AFC = TFC / Q , Q
is number of units produced
Average Variable Cost – total variable cost divided by quantity produced, AVC = TVC / Q