Chapter 4: Theory of Consumer Behavior

Introduction

        This chapter revolves around the fundamental concept of utility or satisfaction to explain consumption and
demand behavior in the short-run. Graphs and tables lend support as tools of understanding and analysis. In
addition, the chapter illustrates the simple dynamics of these tools which can serve as a starting point in
understanding long-run consumption behavior.

Utility and Behavioral Factors

        Utility is defined as the satisfaction derived from the consumption of a commodity which determines
consumption and demand behavior. As such, it is the foundation of consumer's behavior.

        Figure 26 presents the underlying cultural, social, personal, and psychological factors that affect utility and
consumption behavior. Inter-factor combinations filter different patterns of consumption behavior down the line
(see arrows). Different consumption behaviors can stem from, say, variations within the cultural structure in
combination with the cross-sections of the other interlocking structures. In addition, the psychological factors
reflect Maslow's hierarchy of needs as influenced by said interfactor combinations.

Cultural Factors

       Cultural factors exert the broadest and deepest influence on consumer behavior.  Culture is one of the
most fundamental determinants of a person's wants and behaviors. While lower creatures are largely governed
by instinct; human behavior is largely learned. The child growing up in society learns a basic set of values,
perceptions, preferences, and behaviors through a process of socialization involving the family and other key
institutions.

        Some people, for example, would go for the music of Bach or Mozart while others would go crazy for
Gary Valenciano; toilet paper may be a common thing for the urban dwellers but could be an unusual thing for
the mountain people.

         Most human societies exhibit social stratification. More frequently, stratification takes the form of social
classes. Social classes show distinct product and brand preferences.
          Komiks tend to be the reading materials for the lower income classes while magazines and newspapers
are preferred by the middle and higher income classes.

        Values of individuals or peoples are highly influenced by the cultural environment.  An American or a
Western child is exposed to the values of achievement and success, progress, material comfort, efficiency, and
practicality. A Filipino child, on the other hand, is exposed to the values of hiya, pakikisama, social acceptance,
and smooth interpersonal relationships.

Social Factors

        A consumer's behavior is also influenced by social factors such as the consumer's reference groups, family,
and social roles and statuses.

        Reference groups are those groups that have a direct or indirect influence on the person's attitudes or
behaviors. A teenager buys shoes that are in accordance to the taste of his peer group while a more matured
person would prefer more durable or conservative shoes.

Cultural – Culture, Subculture, Social Class

Social – Reference groups, Family, Roles and statuses

Personal – Age and life-cycle stage, Occupation, Economic circumstances, Lifestyle, Personality and self-
concept

Psychological – Motivation, Perception, Learning, Beliefs and attitudes

        Members of the buyer's family can exercise a strong influence on the buyer's behavior. From the parents, a
person acquires an orientation toward religion, economics, personal ambitions, love. Husband-wife involvement
in purchases varies widely by product category. Husbands are more dominant in the purchases of insurances
and cars; while wives are more dominant in the purchases of washing machines and kitchen wares.

        A person's position in each group can be defined in terms of role and status. A role consists of the activities
a person is expected to perform according to the person around him or her. Each role carries a status reflecting
the general esteem accorded to it by society.

        The kind of clothing that a teacher or a teenager wears reflects their respective roles and statuses. A
company president, for example, will drive a Mercedes Benz, wear expensive clothes, and drink scotch or
whiskey.

Personal Factors

        A buyer's decisions are also influenced by personal outward characteristics such as: the buyer's age and life
cycle, occupation, economic circumstances, lifestyle, personality, and self-concept.

        People change the goods and services they buy over their lifetimes, Young single people have different
consumption needs from retirees; newly-married couples buy different kinds of furniture from older married
couples.
        A person's occupation has an influence on the goods and services he buys. A company president will buy
expensive clothes while a blue-collar worker will buy work clothes.

        A person's lifestyle and economic condition will affect the goods and services bought. The traditionalists
would buy different kinds of goods from those who would like to experiment; the sportsminded-type of persons
would prefer different kinds of goods from -those who are the stay-home types.

        A person's personality and self-concept will influence his or her buying behavior.

Psychological Factors

        A person's purchases are also influenced by psychological factors: motivation, perception, learning, and
beliefs and attitudes.

        Maslow's Theory of Motivation.  Abraham Maslow sought to explain why people are driven by particular
needs at particular times, Maslow's hierarchy of needs are: physiological needs, safety needs, social needs,
esteem needs, and self-actualization needs. A person will try to satisfy the most

important needs first. When a person succeeds in satisfying an important need, it will cease being a motivator
for the present time. And the person will be motivated to satisfy the next most important need.

        For example, a starving man (need 1) will not take an interest in going to a disco (need 3), nor in breathing
clean air (need 2). However, as each important need is satisfied, the next most important need will come into
play.
Self-actualization – self-development and realization

Esteem needs – self-esteem, recognition, status

Social needs – sense of belongingness, love

Safety needs – security, protection

Physical needs – hunger, thirst

        A motivated person is ready to act. How the motivated person acts is influenced by his perception and
learning of the situation. Two people may act quite differently because their perception and learning of a
situation may be different. One buyer may buy one brand of soft drinks while the second buyer buys another
brand.

        Perception can be defined as the process by which an individual selects, organizes, and interprets
information to create meaningful picture of the world. Learning, on the other hand, describes changes in an
individual’s  behavior arising from experience.

        Through perception and learning, people acquire their beliefs and attitudes. These in turn influence their
buying behavior If a consumer perceives and believes that Coke is the best soft drink, he or she will buy Coke.
A belief is a descriptive thought that a son holds about something, while an attitude a person's enduring
favorable and unfavorable cognitive evaluations, emotional feelings, and action tendencies toward some object
or ideas.

        To sum up, a consumer will buy a particular product, given an optimum budget, if he or she thinks and
believes that this product will give him or her the best value or utility.

The Utility Function

        Utility is the technical term for satisfaction. There is a functional relationship between utility and
consumption as the need for the latter arises.

        This functional relationship assumes two (2) forms and is quantitatively defined as follows:

TU (Total Utility) = Function of Q

                               (Consumption)

                      MU= Δ(TU)   (Satisfaction from an additional unit of consumption)

        Figure 28 and Table 10 illustrate the aforementioned concepts with the consumption of water as an
example. The symbol for change carries u positive sign when the variable increases and a negative sign if the
variable decreases. As the consumption level increases, a positive marginal utility (MU) increases total utility
(TU), while the opposite is true when MU is negative. Moreover, marginal utility is also defined as the utility or
dissatisfaction from the last unit of consumption, depending on whether MU carries a positive or negative sign.
For example, the table shows that marginal utility (MU) is 2 which is the increase in total utility (TU) when
consumption increases from 5 to 6 units. This level of MU is simply the utility of the 6th or last unit of
consumption.

        But how does the behavior of the MU curve influence the behavior of the total utility (TU) curve and the
level of maximum satisfaction? Referring again to Figure 28 and Table 10 an additional unit of consumption
registers a positive change and, therefore, an increase in total utility (TU) so long as MU is positive. Eventually,
the TU curve registers a negative change and therefore, a decline where MU is negative. The consumer is only
willing to consume up to the point of maximum satisfaction from where an additional unit of consumption no
longer yields additional satisfaction. Beyond this point, the additional dissatisfaction (negative MU) that the
consumer begins to incur simply decreases total utility (TU) or satisfaction.

        Stating the concepts in concrete terms, the first glass of water is more satisfying than the second, although,
two glasses of water are more satisfying than one. One is willing to consume more glasses of water so long as
one gains additional and therefore, more satisfaction, but only up to the point where an additional glass is no
longer satisfying. Beyond this point, an additional glass of water becomes more and more dissatisfying leading
to a lower level of satisfaction from all the glasses of water consumed.

        But consumers behave differently with the same consumption of a good due to the varying influence of
cultural, social, personal, and psychological factors. Consumers who are very difficult to please would have
their total utility (TU) curve sharply skewed to the right (facing the graph) if we reconstructed Figure 28. It
takes more of additionally less satisfying units of consumption (Marginal Utility or MU) to add up and
maximize satisfaction (Point GM). In contrast, consumers who are very easy to please would have their TU
curve sharply skewed to the left as it only takes less of additionally more satisfying consumption units to
multiply satisfaction to the fullest.

        In conclusion, the diminishing marginal utility (MU) causes the total utility (TU) to decline eventually, for
which reason maximum consumption is only up to the point of maximum utility.
 

Consumption

The Indifference Curve

        The indifference curve together with the isocost in the next section is a useful tool for analyzing
consumption behavior on the utility theory. An indifference curve contains varying combination in the
consumption of commodities that yield the same level of total utility. An indifference curve illustrates this
property assuming two commodity items, which are shown in Figure 29 and Table 11, are food and clothing.

        The points along the indifference curve correspond to the different combinations of consumption of food
and clothing that yield the same level of their aggregate utility. Between any point to another along the curve,
an inverse relationship exists between the commodity units inasmuch as the utility foregone by consuming less
of one is regained 'by consuming more of the other. It is the equality between utility gained and utility foregone
that holds the total utility level from both commodity items constant.

        Between any two points along the indifference curve, the ratio between utility gained and utility foregone
is always equal to 1 and, therefore, constant. However, this is not true of the corresponding substitution between
the commodity items. The marginal rate of substitution (MRS) of food (Y-axis) to clothing (X-axis) in Table 11
is measured as follows which is simply how much food one has to give up to consume an additional unit of
clothing.

MRS = Δ Food Consumption

            Δ Clothing Consumption

Where:

 Δ = change

        Assume a continuous increase in clothing consumption and, therefore, a decrease in food consumption.
The marginal utility
(MU) of clothing  (       Δ util                  ) 

                                 Δ consumption

                                                                decreases while its marginal consumption or reciprocal    

                                (  Δ consumption  ) 

                                    Δ util

                                                               Increases due to the law of diminishing returns. On the other hand, the
marginal utility (MU)) of food consumption increases while the reciprocal decreases due to the opposite
influence of this law as consumption declines. Therefore, for every unit of utility foregone and then regained by
continuously decreasing food consumption and increasing clothing consumption, respectively, the following
relationship should hold true:

positive (Δclothing consumption is increasing)

negative (Δfood consumption is decreasing)

Therefore:

(MRS) = ( Δ Food )      (decreasing)

              (Δ Clothing)

        Figure 29 and Table 11 illustrate the foregoing relationship through the slope of the indifference curve.
The change in food consumption diminishes for every additional unit of clothing consumed.

The Law of Diminishing Marginal Utility and the Shape of the Curve
 

       Technically, the shape of the indifference curve is convex to the graph's point of origin due to the Law of
Diminishing Returns. To maintain overall satisfaction, one only has to give up less of a good with an increasing
marginal utility (MU) to be regained by more consumption of another with a decreasing MU. But practically
put, one becomes increasingly reluctant to give up a good (food for example) that becomes scarcer and
additionally more valuable (higher marginal utility or MU, in exchange for another (clothing) that becomes
more abundant and additionally less satisfying.
For Table 10 the Utility schedules, all you have to do to get the Total Utility, first you are going to add first the
first and second line , 6+7=13, then for the 3rd line, add the 1st, 2nd and the 3rd line 6+7+8=18. So to continue
to get the 4th line, just add 1st, 2nd, 3rd, and 4th, same with the the 5th up to 7th line.

So, for the 8th line it has been the reversed way if you could check it is decreasing part then the Total Utility is
28 then on the 9th level of Total Utility should be less 1 or 28-1=27 and so on.

 
Then for Table 11, this is what you are going to do:

(MRS) = ( Δ Food )                           

              (Δ Clothing)

Example:     MRS =

                          = 56-46
                              1-2
                          = 10/-1

                           = -10

The answer is -10 and then that would fall under the second line since we could not do the first one since there
is nothing to deduct on its first line so that is why first line has no answer. all you have to do is put underline on
it.

The rest would also fall on negative numbers, and the results, you can see on Fig. 29 since it falls under
negative numbers.
Chapter 4: Theory of Consumer Behavior (Continuation)

Hierarchy of Indifference Curves

        As already mentioned, an indifference curve corresponds to a certain level of utility. Therefore, changing
the consumption levels of commodities at every point of combination along the curve leads to another
indifference curve and utility level. There is a hierarchy consisting of infinite indifference curves as there are
infinite levels of utility.

       In Figure 30, all points from curve I1 rise to curve I2 as the consumption levels of food and clothing
increase; and the opposite is true with a downward shift in the curve. The shift in the indifference curve follows
the direction of the upward sloping line from the point of origin of the graph indicating the consistency of
varying the quantity levels of both commodity items for all the points of combination along the curve. Hence,
no curve intersects another. Moreover, an indifference curve can be drawn from any point on the graph as there
are infinite levels of utility.
 

        However, it should be noted that the level of consumption and corresponding indifference curve vary in
direct proportion with the level of utility only up to a certain extent. Beyond this limit, the utility level; declines
despite the increase of overall consumption and a higher indifference curve due to the Law of Diminishing
Marginal Utility

The Budget Line and the Optimum Combination

        What is the optimum or best combination of consumption of the commodities within a budgetary limit?
The answer to this question lies in the relationship between the indifference curve which represents what the
consumer likes, and the budget line which limits affordability.

The Budget Line

        A budget line contains infinite points of combinations of the commodity items that the same budget can
buy at a given prices. The aforementioned statement is quantitatively expressed as follows, assuming food and
clothing as the commodities being purchased.

  

        Thus, the budget (B) is the total expenditure per food (f) and clothing (c).

An inversely proportional relationship exists between the two commodities along the budget line given the
budget and prices as constant. Figure 31 and Table 12 present a hierarchy of budget items where a directly
proportional relationship, however, exists between the levels of the budget line and the overall purchase
quantities of the commodity items. The point along every budget line that coincides with the straight line drawn
from the point of origin of the graph represents the same ratio of combination between the commodity units as
Table 12.
 

 
         Also illustrates. The difference between these points lies in the purchase quantities if the budget lines.
Thus, a bigger budget leads to a greater purchasing power and a higher budget line.

        Finally, the budget lines have two important properties. One property is the constant rate of substitution
between the commodity variables from any point to another along the budget line. The marginal rate of
substitution (MRS) assuming the examples given, is measured in absolute terms (i.e., disregarding the negative
sign) as follows:

Note: The percentage change in the budget is the same as the corresponding change in the quantity of each
commodity for the same combination. For example, a ratio of combination equal to 3 (see figures with
asterisks) yields 6 units of food and 2 units of clothing when the budget is P 500.00. They increase by 100% to
12 units and four (4) units respectively, when the budget likewise increases by 100% to 1,000.

           MRS =    ( Δ  food units purchased      )

                            Δ clothing units purchased

         The ratio is simply how much of the food purchase one has to give up to buy an additional unit of
clothing. This additional unit entails an additional expenditure equal to its price which is shifted from the
expenditure for food. The consumption of food foregone in shifting this amount to buy an additional unit of
clothing is the alternative meaning of the said rate of substitution and expressed as follows:

        MRS = Price of clothing

                     Price of food

        Since these prices are constant, the aforementioned ratio and, hence, the marginal rate of substitution
(MRS) between the commodities is likewise constant at any point of combination along the budget line. In
Table 12, the marginal rate of substitution of food to clothing is equal to 2.

        The other property exhibits the budget lines as parallel to one another in the hierarchy. Any budget line,
which corresponds to a budget level, exhibits the same marginal rate of substitution (MRS) between the
commodities so long as their prices and, hence, their price ratios are constant. This constancy should, therefore,
bring the budget lines as parallel to one another in the hierarchy where their levels vary in direct proportion to
the size of the budget.

“The Optimum Combination"

        The quantities of the commodities at any point along a budget line indicate purchasing capacity. This point,
together with the said purchase quantities coincides with that of an indifference curve and hence, meets the
latter's budget requirement. Simply put, the consumer can afford to have that much satisfaction.

        Figure 32 shows three of the infinite indifference curves that are strategically within the purchasing power
of the budget line. Indifference curve I2 is attainable at either points of intersection (A and B) with the budget
line as on any curve I3. On the other hand, I3 is attainable at the point where it is tangent to the budget line
(point A). Furthermore, no indifference curve about I3 is attainable with the same budget in the absence of any
point of coincidence.

        The question now is "which of the points along the budget line corresponds to an indifference curve that
yields the maximum satisfaction?" The budget yields the maximum level of satisfaction at the point where
 
it is tangent (Point A) to indifference curve It. This is the highest  indifference curve corresponding to the
highest level of satisfaction that the budget can afford.

        The concept of optimum combination implies that a consumer can increase the level of satisfaction, despite
a fixed income, by altering the consumption mix. For example, consumers minimize their consumption of
luxurious items in favor of the more basic ones during an economic crisis, This is inasmuch as the utility gained
by consuming more of the latter outweighs the former, thus, minimizing the decrease in real income and the
level of satisfaction. Furthermore, the aforementioned concept also helps make correct social decisions. For
example, a government project may be better off instead in generating income and employment among the
lower income groups as it contributes to a better mix of social benefits. This is inasmuch as every peso of
income generates greater marginal satisfaction among the lower income groups, thus, increasing aggregate
welfare.

Dynamics

        The world is not static and so is consumption which can change due to the consumer or the goods
themselves.

        Prices can change to make goods relatively cheap or costly. Figure 33 shows that budget line B2 is
relatively steep as the same budget can now buy more of cheaper food but less of costlier clothing (higher
Marginal Rate of Substitution or MRS) from the initial consumption mix at point  A along budget line B1. The
consumer then adjusts to point B to maximize satisfaction by buying what is cheaper in exchange for what is
costlier. Originally consuming less food and more clothing at point  A is now beyond the budget (B2). The
consumer is worse-off either as the game budget can only buy less of costlier if only to maintain the food
consumption at point A.

        Relative preference can also change the consumption mix as Figure 34 illustrates. Indifference curve I2 is
now steep relative to I1 as the consumer shifts preference from food to clothing. The MRS of I2 is higher as the
consumer is now willing to give up more food in exchange for clothing which has become more valuable. This
change of relative preference can happen in the real world when corporate advertising bamboozles consumers
with new designs that appeal to vanity. Thus, the consumer adjusts to point B to buy more of additionally more
satisfying clothing in exchange for food. The consumer is worse-off remaining at point A, consuming more
food and less clothing which are now less valuable and more valuable, respectively. The indifference curve can
be drawn through this point is below I2.

        The preceding section shows that a consumer can attain a combination in consumption that yields the
highest level of satisfaction possible from a given or fixed income assuming market prices constant. But what
spending process conceptually attains this objective and what is its optimum result? The crux of the process is
how the consumer spends his income from the first peso to the last.

        Every additional peso spent should yield the highest marginal utility possible. It therefore follows that the
consumer tends to spend more on the commodity that gives this advantage. If this commodity is sugar, the
consumer spends more for it but only up to the point where the utility gained from the last peso spent is exactly
the same as in any other commodity. This equality is inevitable since the marginal utility of sugar should
decline as more of it is consumed. The same process continues up to the last peso of the budget with the other
commodities having their turns in yielding the said utility advantage for marginal spending.

        A condition where the utility gained from the last peso spent on each commodity is not the same as in any
other commodity effects the aforementioned process. Assume an inequality where the marginal utility of sugar
is less than that of butter. The consumer can increase his level of satisfaction by consuming more butter and less
sugar as the utility gained from the former outweighs the utility foregone from the latter. The net effect, of
course, is, a net increase in satisfaction. However, the process of trading off sugar for more butter stops at the
point where the marginal utility from the last peso spent on one is the same as on the other. This is inasmuch as
the utility gained for butter declines as more of it is consumed while the utility foregone for sugar increases as
less of it is consumed.

        The ultimate result is a condition of equality and maximum satisfaction where the utility gained or
marginal utility from the last peso spent on one commodity is the same as in any other commodity. This can be
restated quantitatively as follows:

             MU of Commodity Y        =       MU of Commodity X

             Price of Commodity Y              Price of Commodity X

        This is the optimum condition at the equilibrium point of the indifference curve and the budget line where
their Marginal Rates of Substitution (MRS) are equal. Along a budget line, how much the consumer
additionally spends on one good is alternatively the same as the other, given a fixed budget. Along an
indifference curve, the utility gained by consuming more of one good equals utility foregone by consuming less
of the other. It follows that the additional peso spent on one yields the same utility as the other.

        Furthermore, the principle can be a tool to explain shifts in consumption mix due to changes in relative
prices and preferences as in Figures 33 and 34. The consumer in Figure 33 additionally spends more on cheaper
food with more purchasing power in exchange for costlier clothing (points A to B) to create a net increase in
satisfaction. Likewise, the consumer additionally spends on products that are more satisfying than the others.
But substitution is not indefinite and up to the condition due to the Law of Diminishing Returns. Going beyond
this optimum point makes additional spending on the products now less satisfying the others making the
consumer worse-off.

Income and Substitution Effects

        How does consumer equilibrium change with the price of a commodity item? Assume two not-so-close
substitutes, food and clothing where the price of the latter is assumed to decrease. With the change in price,
food shares in the potential increase in the consumption of clothing. The potential increase in the consumption
of both commodities, if realized. is called income effect. However, the consumer is not only contented to realize
this effect as the new condition allows optimization by substituting more clothing for food. This potential
substitution, if realized, is called substitution effect.

        Substitution effect results in a net gain in satisfaction since an additional peso is better spent on cheaper
and more units of clothing instead of the costlier units of food.

        In particular, a decrease in the price of clothing means more consumption, and, hence, from the last peso
spent more satisfaction. In effect, the marginal utility advantage of consuming more clothing instead of food
leads the consumer to substitute the former for the latter until the equi-marginal condition is fully met.

        Figure 35 illustrates the income and substitution effects resulting from the decrease in the price of one
commodity. The budget line fans out to the right, indicating a decrease in the price of clothing and no change in
the price of food. The change of equilibrium from point A to point C can be dichotomized into the two effects.
The movement from point A to point B is the income effect illustrating a proportional increase in the
consumption of both commodities (i.e.no change in their ratio). On the other hand, the movement from point B
to point C is the substitution effect illustrating an increase in the consumption of clothing as a substitute for
food. The decrease in the consumption ratio of food to clothing as equilibrium shifts from point A to point C
already indicates this substitution effect.

        Finally, the greater is the change in price, the greater is for both effects. But the closer substitute products
are, the greater is the substitution effect which offsets the income effect on consumption. Consider the extreme
case of a good without substitutes. Consumers have no choice but to buy less of other goods to pay for the same
costlier volume of this good and bear the income effect of its higher price in full, in the absence of alternatives.
In contrast, consumers could avoid this loss of purchasing power if they shifted to cheaper substitutes without
being worse-off, assuming perfect substitution. In between the two extremes, the greater is the substitution
effect, the more it influences consumption over income effect.

       But how would one distinguish income from substitution effect if price of clothing increased instead? A
reconstruction of the graph will illustrate income effect as the proportional decrease in the consumption of both
goods; whereas substitution effect is consuming more food and less of clothing because of the latter's increase
in price and, hence, lower marginal utility.
UTILITY AND DEMAND

Derivation of the Demand Curve

There is a potential consumption for a certain commodity item given its market price and the income of its
potential consumer. This potential consumption is also called demand which is the quantity that the consumers
are willing to buy. Moreover, as to how much of the given income is allocated for the product depends on the
influences of the other nonprice factors of demand such as population, taste or preference and speculation.
Therefore, the potential demand or a product at varying price levels and given a certain degree of influence of
the nonprice factors, determines its demand curve.

         Figure 36 illustrates the derivation of the demand curve from the indifference curve and budget Iino. A
continuous but constant decrease in the price of product B shifts the budget line to the right at an increasing
pace. As a result. potential consumption and, hence, demand increases in the same manner leading to a demand
curve which is convex to the of origin of the graph. In retrospect, the inverse  relationship that exists between
price and quantity of demand results from the income and substitution effects.

        Furthermore, a reconstruction of Figure 36 can illustrate the varying effects of the nonprice factors on
consumption and demand. A change in taste or preference can change demand through a change in the quantity
combination of items with the same budget size. For example, a much stronger preference for product B can
create instead a steeper indifference curve where the consumption of product A foregone in order to consume an
additional unite of product B is more. This results to more e consumption of product B at every given price
level, thus, shifting the demand curve to the right. On the other hand, price speculation can change demand
through a change in the budget size. For example, an increase in population requires a bigger budget and shifts
the budget line upward, thus, increasing consumption at every price level and shifting the demand curve to the
right.

Consumer Surplus

        The peso value that the consumer is willing to pay for certain volume of a commodity is less than the peso
value of the benefit from its consumption. This also means that the utility units foregone in paying for the
commodity item are less than the utility unit* gained from their consumption, The net benefit from the
exchange is called consumer's surplus or additional purchasing power.

        In Figure 37, the consumer is willing to pay P10 for 1 unit but P9 for 2 units of the commodity. But the
market dictates that the consumer only pays P9 for 2 units as well as for the earlier or 1st unit when consuming
all of the 2 units of the commodity. Therefore, paying P9 instead of P10 for the earlier or first unit with 2 units
of consumption creates a consumer's surplus of P1. This is simply the difference between the consumption gains
of P10 for the 1st unit and P9 for the 2nd unit and the sacrifice made from the purchase of the quantities equal
to P9 for each of the 1st and 2nd units.
Chapter 5: Theory of Production

Introduction

        The theory of production is an analysis of output— input relationship.  As such, discussions touch on the
relation of output to the size, combination, and efficiency of resources. In turn, this output function serves as a
tool in analyzing cost-output relationship in the next chapter. The fundamental concepts in this chapter are the
Law of Diminishing Returns and Returns to Scale which explain the output function in different resource
conditions.

Production Function

        Plant size and the efficiency of its re- t, sources (land, labor, and capital) determine plant capacity
(maximum output). Resources are fixed in the short-run which is generally described as a period when
conditions have not changed yet. But as plant size and resource efficiency change in the long-run, so is
production capacity. In addition, material inputs change with output regardless of the time frame i.e., within
fixed or changing plant capacity.

Description

        Different plant sizes and resource combinations determine different levels of resource efficiency and
production capacities. The production function only illustrates one side of this combination but drives home the
fundamental concept of Diminishing Returns. As a practical model and tool of analysis, its one-variable-
resource assumption basically reflects on dynamics in a multi-resource condition.

        In particular, the production function in Figure 39 and Table 13 illustrate how variations in a certain
resource (e.g. labor) change the Total Product (TP) or output, e assuming the other resource (e.g. capital)

fixed. Product or output is seen from the point of view of the variable resource, which is labor in the example,
although the virtual outcome of both resources. The purpose is to show how simple variations in resource
combination alter resource efficiency and output.

        In the same figure, Total Product (TP) or output rises with more labor inputs in the first two stages but
eventually declines in the last stage. The Marginal Product influences this trend and is defined as the product
due to the additional or last unit of the variable resource input and measured as follows:
                                MP= ΔQ

                                          ΔI

where:

        MP = Marginal Product or Output

        QP = Total Product or Output

           I = Resource Input

          Δ = Change

        For example in Table 13 the 2nd unit of labor yields an additional output of 5 which is actually the
Marginal Product (MP) of using 2 units of the resource. In turn, this additional product (MP) increases TP from
5 to 10 because of that 2nd or last unit of labor. But, the 7th unit of labor has a negative product or an MP of (3)
which decreases TP from 24 to 21.

        At stage 1, every additional input of labor churns out a bigger chunk with a higher Marginal Product (MP)
to accelerate the %tal Product (TP). At Stage 2, additional input churns out a smaller chunk with a lower MP to
still increase but decelerate TP. MP continues to decline to negative .levels at Stage 3 where additional labor
input has negative returns and decreases T.

Table 13

Production Function

 
 
 
 

        Lastly, Average Product (AP) is output per unit of the variable resource input and measured as follows:

                AP= Q

                         I

         In Figure 39, AP follows the trend of MP following the law of averages. In other words, a change in MP
(ΔQ)   causes the AP ratio  ( Q)  to change in the same direction.  
  ΔI                                    I                                  

The decline in TP at the last stage obviously decreases AP but only to the level of zero. There is no such thing
as a negative output, although, a negative MP simply means a decrease in output.

The Law of Diminishing Returns

        The production function shows that stretching the use of variable resources against the limits of fixed
resources decreases additional product (MP). This is the Law of Diminishing Returns which is basically due to
the limits of a fixed plant size. In Figure 39, the use of more labor inputs beyond Stage 1 strains the fixed input
of capital and makes both resources less efficient as they complement each other. Furthermore, having too much
of one resource and too little of another can even result in a resource imbalance that decreases production
capacity with a negative Marginal Product (MP) at Stage 3.

        Stretching resource use to the point of imbalance or overusing breeds counterproductive conditions which
directly cause diminishing or even negative returns. The saying, Too many cooks spoil the broth," applies to
production.

        Suppose you have a small party at home for which you hired a temporary cook in addition to your
mainstay. Obviously, two cooks are better than one which technically means that Total Product (TP) increases
with more resource inputs, But, more cooks how begin to overuse the same kitchen facility and breed
counterproductive conditions like confusion, delays, and mishandling of tools. As a result, the additional cook is
not as efficient as the regular cook when the latter does the regular kitchen chores alone. Technically, this
means that the Marginal Product (MP) decreases despite the increase in TP. Neither is every cook as efficient as
any one of them when doing the regular kitchen chores alone with the decrease in their Average Product (AP).

        Finally, what would happen if nine additional cooks were hired for the party? Perhaps, the said
counterproductive conditions would be so impinging on work that no cook can do the job unless with a bigger
kitchen facility. Technically, this is the condition of Stage 3 where output decreases despite more resource
inputs.

The Lessons of Diminishing Returns

        The Law of Diminishing Returns has three important lessons. First, the size of a resource, given the rest as
fixed, should not go beyond its product-maximizing point. This means that the maximum labor inputs in Figure
39 should only correspond to the end of Stage 2 where output is maximized to determine plant capacity. Beyond
this stage, resource imbalance and diminishing returns are at their worst as production capacity (maximum
output) decreases with a bigger but overtaxed plant.

        Therefore, the other lesson is that plant capacity can only increase with more ref sources combined unless
technology changes. Figure 40 shows that all the points of TPI move upward and rightward to form the higher
production function curve TP2. As both capital and labor increase, so is plant capacity from points A and B.
From these two lessons can be drawn the third that resources are basically complementary. Differently put, a
resource is as indispensable as any other in production.

The Isoquant-lsocost Model

      This model illustrates more dynamically how different plant sizes and resource combinations determine
different levels of resource efficiency and plant capacity. As a dynamic tool of analysis, it also factors in the
cost and budgetary limits of production.

The Isoquant

        Theoretically, there are infinite combinations of resource inputs which determine the same plant capacity
(maximum output). In a two-variable-resource system, these combinations form the product indifference curve
or isoquant. Figure 41 and Table 14 present an isoquant with capital and labor as resource inputs. Between one
point and another along the curve, an inverse relationship exists between the resources as the capacity foregone
by using less of one is regained by using more of the other (see arrows). It is the equality between capacity
foregone and gained that holds production capacity constant regardless of resource combination.
        But resource input foregone is not necessarily equal to resource input gained to maintain plant capacity and
their rate of substitution is not even constant along the curve. Their Marginal Rate of Substitution (MRS) is
defined as how much of one resource is given up in order to use an 'additional unit of the other, given a fixed
capacity. To use the isoquant in Figure 41, the MRS of Capital (K) to Labor (L) is measured as follows.

        MRS = ΔY axis

                   ΔX axis

        MRS = ΔK

                    ΔL

where additionally:

          Δ = Change

        Table 14 shows that less and less of capital inputs (K) are given up in order to use an additional unit of
labor (L) as MRS decreases down the line. In Figure 41, the shortening length of the downward pointing arrow
represents K given up while the rightward pointing arrow represents additional L used. Thus, the shortening
vertical arrow decreases as a ratio of the horizontal arrow which is actually the trend of the MRS as L
substitutes K. In addition, this trend shapes the isoquant as convex to the graph's point of origin.

The Isoquant and Diminishing Returns

        The Law of Diminishing Returns influences the behavior of the Marginal Rate of Substitution (MRS) as
the latter shapes the isoquant.

        In the same example, Marginal Product of Labor   (ΔQ)       decreases from more use
                                                                                  ΔL
while that of capital  (ΔQ)       increases from less use and the opposite effect of diminishing returns.
                               ΔK              

        It follows that more labor inputs (L) are needed to produce an additional unit of outputs as the increasing
inverse of its decreasing marginal product   (ΔL)       indicates. But, it also follows that less
                                                                                        ΔQ    
capital inputs (K) are only given up to reduce output by the same unit as the decreasing inverse of its marginal
product (ΔK)    also indicates.
                             ΔQ        

        To go back to their MRS formula (ΔK)     more labor is used (ΔL) to regain the same output foregone
                                                         ΔL

by giving up less and less of capital inputs (ΔK). Thus, the MRS ratio decreases as labor substitutes capital.
 

        To drive home the point, less capital is given up in exchange for more and more of labor as the former
becomes more efficient from less use while the latter becomes less efficient from more use. To stress the point,
an efficient resource cannot be given up in exchange for an inefficient one to maintain output.
Hierarchy of Isoquants

        A hierarchy of isoquants is an array of isoquants which correspond to different levels of resource inputs
and plant capacity. In Figure 42, all the points of Q1 move upward to form the higher isoquant Q2 as more
capital and labor combined increases plant capacity. This overall change is actually the upward and rightward
shift in the production function curve in Figure 40 where all resources increase plant size and capacity.

        In addition, there is an infinite number of isoquants as there are infinite levels of plant capacity in the
hierarchy. This means that any point in the graph is a resource combination of an isoquant. The isoquants shown
in the graph are just two of the infinite number in the hierarchy.

          Again, the assumption of infinity serves o highlight relevant tendencies in reality. For example,
technological research can the possibility of designing a plant that is neither too small nor too big for a certain
market size.

The Isocost Curve and Its Hierarchy

        Theoretically, there are infinite combinations of production resources that a given budget can buy. In a
two-variable-resource system, these combinations form the isocost curve. Figure 43 based on Table 15
illustrates the isocost curve with capital and labor as resource inputs. Between one point and another along the
curve, one resource is given up in exchange for the other because of a fixed budget.

        The same figure and table show that each budget is split between the resources at varying purchase
combinations. But as resource prices and their ratio are constant, so is the marginal rate of substitution down the
curve. Marginal Rate of Substitution (MRS) is defined as how much of one resource should be given up in order
to buy an additional unit of the other, given a fixed budget. The MRS of capital (K) to labor (L) in the example
is computed as follows:

                  MRS= ΔY axis

                           ΔY axis 

           

                 MRS= ΔK
                           ΔL
Chapter 5: Theory of Production(Continuation)

Productivity

        This section discusses the dynamics of resource efficiency as it affects production. Succeeding chapters
will also highlight its impact on the firm's competitiveness and survival.

Concepts

       Productivity is the efficiency and, therefore, the power of inputs to produce. This section confines
discussions to resource inputs which are basic to production. Productivity is measured as output per unit of
input which is illustrated below.

       Productivity = Q/I

       where:

          Q = Output

           I = Input

        According to that part of the input referred to, productivity is of two forms. Average productivity is the
efficiency of inputs taken as a whole and measured as their average output as in the foregoing formula. On the
other hand, Marginal productivity is the efficiency of additional inputs and the measures of its average output
which is also illustrated below.

        Marginal Productivity =  ΔQ/ΔI

          where additionally:   

                                    Δ = Change
        In the production function in Figure 39, the Average Product (AP) of labor measures its average efficiency
while Marginal Product (MP) measures its marginal efficiency.

Advantages

        Productivity improvement means more output per unit of input or with the same total input as the increase
in the efficiency ratio (Q/I) indicates. It also means less input for the same total or unit of out ut as the decrease
in the ratio's inverse (I/Q) indicates.

        Therefore, efficiency is not a matter of size. A bigger plant is not necessarily more efficient than its smaller
counterparts. To use a simple analogy, a class may best the rest in a school fund drive by the sheer number of
soliciting members. But the most efficient class has the biggest amount solicited by every member which
reflects on individual initiative.

        However, productivity is not an end but i a means to compete and survive in the free market. In Figure 39,
plant use is most efficient at the turning points of the MP and AP curves i.e. before diminishing returns. But, the
limited output at these points not necessarily make production more competitive and profitable. Instead, an
overall improvement in resource efficiency is economically viable but only when additional output is also more
than proportionate to the additional cost of efficiency. Overall efficiency improvement shifts the TP, MP, and
AP curves upward in Figure 39. If economically viable, said improvement not only increase scale but also
reduces unit cost to improve competitiveness and profit.

        The profitable improvement in overall resource efficiency in the foregoing is categorized as an increase
in Economic Efficiency. This form of efficiency is measured as output per monetary unit of input with the latter
expressed as monetary cost in the basic productivity ratio (Q/I). Therefore, economic efficiency balances or
reconciles the effects of two other types of productivity. Technical Efficiency capitalizes on the output while
Cost Efficiency gives emphasis to the cost of inputs.

        Usually, output and cost are mutually conflicting to attain economic efficiency. Thus, the technical
efficiency of a machine is not necessarily profitable if it is too costly. To strike a balance, its additional
monetary returns should outstrip its cost. However, technological advancement can optimize both output and
cost to readily fit the picture of economic efficiency. For example, computers have become more powerful and
cheaper to do more work at lower cost.

Relative Resource Efficiency

        Production resources are complementary not only in function but also in efficiency. A better machine also
enables its operator to work faster or the other way around. Resources do not become more internally efficient
at the same time, but, every improvement contributes to the overall productivity picture.

        In addition, the time lag between productivity improvements can alter the optimum combination of
resources. For example, replacing old machines with modern and more efficient ones improve work and shifts
the TP, AP, and MP upward. But, plant expansion (long-run) favors the use of more efficient capital than less
efficient labor. The shift is economically efficient since every peso of labor given up that is additionally  spent
for capital, yields a net increase in output.

Basic Ways to Improve Resource Efficiency

        How much a plant overall efficiency can be improved to increase output depends on the amount of wasted
resources and time that could otherwise be used productively. But to reiterate, technical efficiency is only
economically viable when also profitable, i.e. its additional returns outweigh the additional cost of efficiency.

        One way to improve the plant's overall resource efficiency or productivity is to change the nature of the
resource through innovation. One example is work specialization which concentrates instead of diffuses
efficiency on job requirements. Thus, a worker in a car assembly plant does more in tightening bolts than with
other jobs like mounting wheels. Another example is the advancement in hardware technology for the electronic
information industry. Hardware such as computers have become cheaper and more powerful as more
intelligence substitutes physical mass or matter. Smaller and cheaper microchips can now do more work at
lower cost because of the wonders of human intelligence. In both examples, the same resources have more
power to produce because of internal efficiency.

        Another way to improve resource efficiency is to change the external condition of resources such as the
organization of work. A simple example is increasing the number of customers served in a drug retail outlet by
temporarily re-assigning to augment the sales group during peak hours. This set-up minimizes imbalances in
work distribution and labor idle time.
        Another external change that can improve resource efficiency is a more balanced resource combination.
Increasing the size of constraining resources also makes the constrained resources more efficient and minimizes
diminishing returns. For example, investment in an irrigation system (capital) enables the rice farmer to plant
and harvest three times a year with the same land area. But without irrigation, capital is at a minimum and land
is only productive once a year.

The last but not the least way to improve plant overall resource efficiency is by using esource-saving
technology For example, computers have become more powerful and cost-efficient and resource combination in
industrialized economies favors their use to save on scarce and costly labor resources.

        To illustrate the foregoing, the isocost curve in Figure 47 becomes steeper from to as the game budget can
now buy more of cheaper capital. On the other hand, the isoquant QI flattens to Q, (lower MRS) as only less of
the increasingly efficient capital is now given up to use an additional unit of labor to maintain plant capacity.

Maintaining combination at point A with more efficient and cheaper capital now requires a smaller budget
below isocost curve Bat but results in a bigger capacity. Aside from the obvious reason of cost, more efficient
capital produces more at this original point. But optimum resource combination is now at point B despite the
same budget at with more of cheaper and more efficient capital in exchange for labor to further increase output
to Q3.

Trends in Computer Technology

       Trends in computer techn010ß' in the U.S. demonstrate how deeper the use of capital can crowd out scarce
labor and impact overall resource efficiency. In particular, manufacturing sectors that use computers

heavily substitute the technology for labor as the former accumulates faster than the latter. These sectors added
computers at the annual rate of 20% in contrast to 3% for labor hours from 1973 to 1991. One reason is the
decline in computer prices relative to capital prices as a whole as the former cheapened by 17% while the latter
became costlier by 2% per year from 1975 to 1996.

        As a result, labor productivity rose by 5.7% annually in the 1990's from just 2.8% before 1973 when
computers were not widely used yet. In contrast, manufacturing sectors that do not use computers heavily even
experienced a slowdown to 2.6% from 3.1%, respectively.
     
        However, the technology only has a dramatic impact on output in the computer producing sector. This
manufacturing sector continually produces faster and better computers even at lower costs. For the other sectors
that use computers heavily, computer technical efficiency is yet to surface in overall production as productivity
improvements only reflect the substitution of cheaper capital for labor. Total Factor Productivity (TFP) in the
computer-producing sector increased by 3.4% per year in the 1990's. In comparison, the other computer using
sector only gained 1.2% per year in the same period.

        In conclusion, the use of more powerful and cheaper computers breaks the impasse of the limitation of
labor resources to increase output in first world countries.

Returns to Scale and Productivity

        Returns to scale measures how output changes relative to resource inputs in the long-run and indicates how
overall resource efficiency changes with plant' size. Plant expansion either conditions or stifles resource
efficiency depending on plant size and condition. Returns to scale is measured as follows:

            R= %(ΔQ)

                 %(ΔI)

                                      where:

                                      R = Returns to Scale

                                      Q = Output

                                       I = Resource Input

                                      Δ= Change

                                     % = Percentage

        Resource efficiency (Q/ I) increases when R is greater than 1 because Q increases faster than I. The
opposite is true when R is less than one.
        To capture the effect of plant expansion on resource efficiency, the measure assumes the same percentage
of use of plant capacity and excludes the distorting effect of diminishing returns. Otherwise, the measure can
misrepresent, say, a decline in plant efficiency from overusing resources as due to expansion.

        Therefore, the measure of R truly reflects the relation between size and efficiency only when the degree of
plant use is constant. Assume a simple case of plant expansion with no effect on efficiency yet i.e., constant
returns to scale. This expansion is like enlarging your photo with the same body proportions. Therefore, output
increases proportionally with resource inputs in the production function for the same capacity use. In Figure 48,
all the points of TPI move upward to form the new production function TP2. Full use of plant capacity, for
example, results in the same output-input ration at point B2 as at BJ following the proportion line. The same is
true at the threshold of diminishing returns at points Al and A2. Average Product (AP) and, therefore, overall
resource efficiency remains the same despite plant expansion. R has a value of 1 with proportional increases in
plant size and capacity.

        But underusing the bigger plant capacity at point in the foregoing distorts the meaning of R with the
opposite effect of diminishing returns. R is now less than 1 with a lower Average Product (AP) (B1 to A2) not
because of returns to scale but because of less efficient rate of plant use.

        Table 16 summarizes the different stages of plant expansion in relation to over all resource efficiency. The
first stage has increasing returns to scale with R greater than 1. Output increases faster than resource inputs as
the latter become more and more efficient. The second stage has constant returns to scale with R equal to 1.
Output increases as fast as resource inputs as the efficiency of resource inputs is constant. The third stage has
decreasing returns to scale with R less than 1. This time, output lags behind resource inputs as the latter become
less and less efficient. The last stage has negative returns to scale with R that is less than zero or negative. At
this stage, output decreases despite plant expansion as resources become more and more inefficient.

Reasons for Returns to Scale

        The early part of plant expansion conditions resources specialization and division of labor and increases
returns to scale. This stage is characterized by the efficiency of size or Economies of Scale. In a small plant, a
resource may be assigned different functions because no job is extensive enough to be its monopoly. But, large
scale production enables resources to concentrate instead of diffuse efficiency on job requirements. For
example, a worker in a big garment factory is more efficient sewing hemlines than doing the same to the whole
dress.

        But, further expansion breeds the problem of control and decreases returns to scale. This stage is
characterized by the decreasing efficiency or even the inefficiency of size which is also called Diseconomies of
Scale. The reason is that the problem of control makes coordination and directing difficult because of delays,
decision lapses, or even inaction.

        One factor that affects decision-making and control is communication. The longer time it takes to process
and transmit information through long organizational channels causes delays in decision-making and control.
On the other hand, miscommunication due to the growing complexity of information distorts decisions and
control. Installing electrical lines in the wrong places in a building construction project is an example of a
wrong decision. To reset the lines according to specification still results in cost inefficiency because of job
duplication.

        The problem of decision-making and control also stems from the difficulty of monitoring and handling
large volume of complex information that requires decisions. For one, a large organization has more
management levels and the higher the level, the more abstract is management's view of organizational
problems. Failure to detect the critical factors lurking behind this abstraction simply leads to impractical
decisions and loss of control. On the other hand, the volume and complexity of information may be too much
for management to handle which can lead to managerial paralysis and even loss of control.