Synopsis

Consumer Behavior
Utility is the power of an article to satisfy any human want for example food, cloth, shelter,
cinema show and automobile all have utility as each item satisfies one or the other want of
ours. Utility is different from satisfaction. While satisfaction is what we attain, utility is the
power of an article to confer satisfaction and to satisfy some want. Utility is different from
usefulness. An article need not have necessarily good effect to have utility for example even
liquor and opium have utility for such persons who are its addicts. Utility is subjective and not
objective. Utility for the same article is different from person to person, place to place and time
to time.
In the utility that is derived from the last unit of consumption of an article. If, for example, a
person consumes three units of an apple, the utility of the third apple would be the marginal
utility. Total utility by contrast, is the sum total of the utilities derived from all the units of an
article (in this case the three units).
The law of diminishing marginal utility states that the amount of extra or marginal utility
declines as a person consumes more and more of a good.

Law Equi-Marginal utility theory states that a consumer having a fixed income and facing
given market prices of goods will achieve maximum satisfaction or utility when the marginal
utility of the last rupee spent on each good is exactly the same as the marginal utility of the last
rupee spent on any other good.(Mu
A
/PA = Mu
B
/P
B
..Mu
N
/P
N
= Mu
M
)
Consumer surplus is the difference between what a person would be willing to pay and what he
actually has to pay to buy a certain amount of a good.

Indifference curve analysis is an improvement over the utility analysis. Utility being subjective
cannot be measured. So the utility, approach by modern writers has been replaced by
indifference curve approach. This technique through a curve illustrates as to how a consumer is
indifferent between the two or more combinations of the two products.
Indifference Curves has following characteristics: it slopes down towards the right, it is convex
to the origin, and the curves do not intersect each other, higher indifference curves indicate
higher level of utility.
A consumer is in equilibrium when he/she maximizes his/her utility, given income and market
prices. In other words, equilibrium is attained where the consumer reaches the highest possible
indifference curve given his/her budget constraint
Consumer equilibrium with ordinal measurement of utility is achieved at the point at which
the slope of the indifference curve is equal to the slope of the budget line,
The concept of value in use and value in exchange is explained with the help of Water-
Diamond Paradox. The essence of this paradox is that the goods that have more value in use
are to be priced less and the goods which have more value in exchange are to be priced more.
Modern approach to utility is expressed in terms of Price effect. Price effect can be further
decomposed into Substitution effect and income effect
Income effect, is assumed that the given income of the consumer remains the same and so the
prices of the two goods. But when, the income of consumer changes (upward or downward),
the aggregate satisfaction of the consumer would also change (upward or downward) provided
the prices remain the same.
A consumer re-arranges his purchases either due to the change in his income or due to a change
in the relative prices of the two goods. When income changes, it is known as the Income effect.
But when it is a change in the relative prices of the two goods, he/she changes to the lower
priced good for the higher priced good. It is known as the substitution effect. He/she buys more
of an article that becomes cheaper and less of the article that is now dearer.


Theory of production
Production involves the transformation of resources or factor inputs into output of goods and
services. A firm with an objective of profit motive organizes resources and produces goods and
services. Profits refer to reward received in the form of revenue to the firm from the sale of the
output after deducting all the expenses that have been incurred by the firm in the production
process. Factor inputs are those inputs that participate in the production process and may be
classified into labor, land, capital, organization.
The time period during which at least one input is fixed is called short-run. In the long-run all
inputs are variable.
Law of diminishing returns states that, when one or more inputs are held constant, a variable
input is likely to have a marginal product that finally diminishes as the level of input increases.
Three Stages of Law of Variable Proportions
Stage I: In this stage Total Product (TP), increases at an increasing rate. The stage comes to
an end when Average Product (AP) is Maximum and also AP = MP (Marginal Product). It is
the stage of Increasing Returns.
Stage II: In this stage AP and MP fall but TP increases. This stage is called the stage of
Diminishing Returns. In this stage a firm decides its level of production, when MP = 0 and TP
is Maximum.
Stage III: In this stage TP starts falling and slope of TP curve becomes negative. MP becomes
negative. This stage is called the stage of Negative Returns.

Isoquants are convex to the origin (sloping downwards) implying that the marginal product of
all inputs is positive and the slope of each isoquant is referred to as marginal rate of technical
substitution at each point on the isoquant.
The marginal rate of technical substitution of labor for capital (MRTS) is the amount by which
the input of capital can be reduced when one additional unit of labor is employed, as a result of
which output remains constant.
Returns to scale, a long-run analysis where a firm has an option to change its scale or size of
operation. Constant, increasing, decreasing returns to scale refers to a situation where output
changes respectively, by the same, by a larger and by a smaller proportion than the inputs.
Increasing returns to scale are due to specialization and division of labor and from employing
specialized machinery. Decreasing returns to scale arise due to increase in the scale of
operation as a result of which it becomes difficult to manage the firm and coordinate its
operations. In reality, most of the firms or industries exhibit near-constant returns to scale.\
Isocost line represents the units of labor and capital that can be employed by the producer
given the budget and prices of the factor of production. In other words it is the budget line of
the producer.
The point at which the slope of isoquant is equal to the slope of the isocost line is technically
referred to as Least cost combination or Maximization of output subject to cost constraint.
The locus of least combination is known as expansion path.
The locus of the points of isoquants where the marginal products are zero form the ridge lines.
The upper ridge line implies that the marginal product (MP) of capital is zero and the lower
ridge line implies that the marginal product (MP) of labor is zero.
Production techniques are only technically efficient inside the ridge lines. Outside the ridge
lines the marginal products of the factors are negative and the methods of production are
inefficient, since they require more quantity of both the factors for producing a given level of
output.

Theory of cost
Cost functions are derived from the production function, which explains the technically
efficient method of producing a good at any one time. The time factor is important in the
theory of Cost. Based on the variability of factor inputs costs are distinguished as short-run
costs and long-run costs.
Costs may be classified as explicit costs and implicit costs. Explicit costs are actual
expenditures of the firm to hire or purchase factor inputs. Implicit costs are those which refer to
the value of the inputs owned and employed by the firm in its own production process. The
opportunity cost of a firm in employing any input is what the input could earn in its best
alternative use. Costs also may be classified as private costs which are incurred by individuals
and firms and social costs are those incurred by the society as a whole.
The short-run in the production process is that some inputs are fixed and some are variable. As
a result of this costs are further classified into fixed costs and variable costs.
Costs in the short-run may be classified as fixed, variable and total costs. Total fixed costs
(TFC) + total variable costs (TVC) = total costs (TC). The shape of the TVC curve in the cost
function is similar to the law of diminishing returns. Average fixed cost (AFC) = TFC/Q,
where Q is output. Average variable cost (AVC) = TVC/Q. Average total cost (ATC) = TC/Q
and also ATC = AFC+AVC. Marginal cost (MC) is equal to change in TC or in TVC per-unit
change in output. The AVC, ATC and MC curves initially will fall and then rise and therefore
they are U shaped. AVC and MC move inversely to the AP
L
and MP
L
respectively. The AVC
and ATC are given by the slope of a line from origin to the TVC and TC curves. MC is given
by the slope of the TC and TVC curves.
The horizontal line of TFC, represents a fixed cost, AFC is a rectangular hyperbola depicting decreasing
fixed cost per unit as output increases.
The logic behind the shape of both TVC and AVC curves is the law of variable proportions. According to
the law of variable proportions, in the beginning of the process of production when variable factor is
combined with the fixed factor, TVC increases at an decreasing rate and AVC falls. Beyond the optimal
combination of fixed and variable factors, TVC increases at an increasing rate and AVC rises.
To a TVC curve which initially increases at a decreasing rate and finally increases at a increasing rate,
AVC is U-shaped.
Given AC = AFC + AVC, implies that AVC is a part of AC.
AVC and AC are U-shaped, reflecting the law of variable proportions
average fixed cost tends to decline with the expansion in the level of output.

MC curve can be derived between two points on the TC or TVC curve by the slope of the line
joining the two points. As output increases, the value of the slope declines continuously till
point and rise thereafter.
The shape of the MC curve basically reflects the law of variable proportions.
To a TVC curve which initially increases at a decreasing rate and finally increases at a
increasing rate, marginal cost curve assumes U-shape.
The marginal cost curve has a distinguishing and important relationship with the Average
Cost:
Marginal Cost is below Average Cost, when Average Cost is falling
Marginal Cost is above Average Cost, when Average Cost is rising.
Marginal Cost is equal to Average Cost, when Average Cost is neither falling nor rising.
Marginal Cost Curve intersects Average Cost Curve at its minimum point.

The firms long-run decisions are called planning decisions. Decision-making in the process of
production is crucial because a wrong decision will lead to higher production costs and less
profits. The long-run cost curves are very important because they help in careful choice of a
production technology.
The production function of a firm along with the prices of factor inputs which the firm has to
pay for them determines the firms cost curves, represents the functional relationship between
production functions and cost curves.
Economies of scale may be defined as reduction in the firms per unit costs that are associated
with the use of large plants to produce large volume of output. It implies that the average cost
declines as the scale of production increases and marginal cost is less than an average cost
(MC<AC). Economies of scale can be further classified as Real economies of scale and
Pecuniary economies of scale. Further economies of scale be sub classified as Internal and
External economies of scale.

Diseconomies of scale may be defined as increase in the firms per unit costs that are
associated with the use of large plants to produce large volume of output. Diseconomies of
scale arise when a large organization tries to compete in a changing market. Thus, a
diseconomies of scale represents a situation when the marginal cost is greater than average cost
(MC>AC).
Economies of Scope involve process innovation or product diversification.