Consumer Behavior, Production & Market Structures Economics
Consumer Behavior: Utility & Indifference Curves
This unit explores how consumers make choices to maximize their satisfaction.
Key Concepts
Utility: The want-satisfying power of a commodity.
Cardinal Utility: Assumes utility can be measured numerically (e.g., in “utils”). This is the basis for the Marginal Utility Analysis.
Ordinal Utility: Assumes utility can only be ranked or compared (e.g., first, second, third preference). This is the basis for the Indifference Curve Analysis.
Law of Diminishing Marginal Utility (LDMU): As a consumer consumes more units of a specific commodity, the utility derived from each successive unit decreases.
Law of Equi-Marginal Utility: To maximize total utility, a consumer will distribute their fixed income among different goods so that the ratio of marginal utility to price of each good is equal (MU_A / P_A = MU_B / P_B = … = MU_n / P_n).
Indifference Curve Analysis
Indifference Curve (IC): A curve showing various combinations of two goods that give the consumer equal levels of satisfaction (utility).
Indifference Map: A group or collection of several indifference curves; a higher IC represents a higher level of satisfaction.
Properties of an Indifference Curve:
Slopes downwards to the right: This reflects the trade-off between the two goods (to get more of one, the consumer must give up some of the other).
Is convex to the origin: This is due to the Diminishing Marginal Rate of Substitution (MRS).
Never intersect: If they intersected, it would imply that a higher level of satisfaction is equal to a lower level, which is impossible.
Indifference Curve Analysis
Indifference Curve (IC): A curve showing various combinations of two goods that give the consumer equal levels of satisfaction (utility).
Indifference Map: A group or collection of several indifference curves, where a higher IC represents a higher level of satisfaction.
Properties of an Indifference Curve:
Slopes downwards to the right: This reflects the trade-off between the two goods (to get more of one, the consumer must give up some of the other).
Is convex to the origin: This is due to the Diminishing Marginal Rate of Substitution (MRS).
Never intersect: If they intersected, it would imply that a higher level of satisfaction is equal to a lower level, which is impossible.
Marginal Rate of Substitution (MRS): The rate at which a consumer is willing to give up one good for an additional unit of another good while remaining on the same indifference curve.
Consumer Equilibrium (Indifference Curve Approach): A consumer achieves maximum satisfaction when the budget line is tangent to the highest possible indifference curve. At the point of tangency, the slope of the indifference curve (MRS) equals the slope of the budget line (price ratio of the two goods): MRS_XY = P_X / P_Y.
Production Analysis and Cost
This unit explores the relationship between inputs (factors of production) and outputs, and the associated costs.
Key Concepts
Production Function: The technical relationship between a firm’s inputs (factors of production) and its maximum output. It is expressed as Q = f(L, K, E, T, …) where Q is output and L, K, E, T are inputs like labour, capital, land/enterprise, technology, etc.
Short Run: A period where at least one factor of production is fixed (usually capital or plant size) and others are variable (e.g., labour).
Long Run: A period long enough for all factors of production to be varied.
Short Run: Law of Variable Proportions
This law explains the behavior of output when only one input is varied while others remain fixed. It consists of three stages:
Stage I: Increasing Returns: Total Product (TP) increases at an increasing rate. Marginal Product (MP) increases and is maximum at the end of this stage. Average Product (AP) is also increasing.
Stage II: Diminishing Returns: TP increases at a diminishing rate and reaches its maximum. MP is positive but decreasing. AP is decreasing. The firm operates in this stage.
Stage III: Negative Returns: TP starts to fall. MP becomes negative.
Long Run: Returns to Scale
This explains the behavior of output when all inputs are varied simultaneously and proportionally.
Increasing Returns to Scale (IRS): Output increases by a greater proportion than the increase in inputs (e.g., inputs double, output triples). Caused by economies of scale (e.g., specialization).
Constant Returns to Scale (CRS): Output increases by the same proportion as the increase in inputs (e.g., inputs double, output doubles).
Decreasing Returns to Scale (DRS): Output increases by a lesser proportion than the increase in inputs (e.g., inputs double, output increases by 1.5 times). Caused by diseconomies of scale (e.g., management complexity).
Market structure refers to the characteristics of a market that influence the behavior and performance of firms that sell in that market. The structure is based on the number of sellers, nature of the product, and conditions of entry/exit.
Perfect Competition (PC)
Perfect competition is a theoretical market structure characterized by the complete absence of rivalry among individual firms.
Features of Perfect Competition
Large number of buyers and sellers: The number is so large that the output of a single firm is a negligible fraction of the total market supply.
Homogeneous product: The products offered by all firms are identical in quality, size, and features. They are perfect substitutes for each other.
Free entry and exit: Firms can enter or leave the industry without restrictions or special costs in the long run. This ensures that firms earn only normal profits in the long run.
Perfect knowledge: Both buyers and sellers have complete information about price, product quality, and market conditions.
Perfect mobility of factors of production: Resources (labour, capital) can move freely between firms and industries in response to price signals.
Absence of selling costs: Due to homogeneous products and perfect knowledge, firms typically do not spend on advertising or sales promotion.
Price and Output Determination
Firm is a price taker; industry is a price maker: The market determines the price where total market demand and total market supply intersect.
The individual firm accepts this price. The demand curve for a perfectly competitive firm is perfectly elastic (horizontal), which means Price (P) = Average Revenue (AR) = Marginal Revenue (MR).
Monopoly
Monopoly is a market structure where there is a single seller of a product with no close substitutes.
Features of Monopoly
Single seller, many buyers: The monopolist is the sole producer and controls the entire market supply. The firm is the industry.
No close substitutes: The product is unique, and its cross-elasticity of demand with other goods is zero or near-zero.
Barriers to entry: New firms cannot enter the market due to strong barriers (e.g., legal patents, government licenses, control over key raw materials, or huge capital requirements).
Monopolist is a price maker: The firm has considerable control over the price but cannot fix both price and quantity simultaneously. The demand curve for a monopolist is downward sloping (same as the industry’s demand curve).
Price and Output Determination
Profit maximization: The monopolist maximizes profit by producing the output where Marginal Revenue (MR) equals Marginal Cost (MC).
The price (AR) charged will be read from the demand (AR) curve at the profit-maximizing output level.
In the long run: Due to barriers to entry, a monopolist can continue to earn supernormal profits (AR > AC).
Relationship between AR and MR: Since the demand curve is downward sloping, the monopolist must lower the price to sell more units. Therefore, the MR curve lies below the AR curve (AR > MR).
Price Discrimination
Price discrimination occurs when a monopolist (or any firm with market power) charges different prices for the same product to different buyers or in different markets.
The monopolist may charge a lower price in the market with more elastic demand and a higher price in the market with less elastic (inelastic) demand.