MICRO-ECONOMICS – I

Chapter One
Theory of Consumer Behavior
Consumer Behavior can be understood
in 3 steps.
1) Consumer‘s Preference- A consumer makes
choices by comparing bundle of goods.
2) Budget Constraints
3) Consumer Preference & Budget Constraint
together determine consumer choice 2
 Cont’’’’
Consumer Preference
Given any two consumption bundles, the consumer can
either decide that one of consumption bundles is strictly
better than the other, or decide that he is indifferent
between the two bundles.
Strict preference
• Given any two consumption bundles(X1,X2) and (Y1,Y2),if

(X1,X2)>(Y1,Y2) or if he chooses (X1,X2) when (Y1,Y2) is available

the consumer definitely wants the X-bundle than Y. 3
 Cont’’’’

Weak preference
• Given any two consumption bundles(X1,X2) and (Y1,Y2),if the
consumer is indifferent between the two commodity bundles or if
(X1,X2) (Y1,Y2,the consumer would be equally satisfied if he
consumes (X1,X2) or (Y1,Y2).

Completeness
• For any two commodity bundles X and Y, a consumer will prefer X to
Y, Y to X or will be indifferent between the two.

Transitivity
• It means that if a consumer prefers basket A to basket B and to basket
4
 Cont’’’

More is better than less

• Consumers always prefer more of any good to less and they are never
satisfied or satiated.
• However, bad goods are not desirable and consumers will always prefer
less of them.
UTILITY to describe the satisfaction or pleasure derived
The
from Conceptof of
the consumption Utility
a good or service.

• Utility is the level of satisfaction that is obtained by

consuming a commodity or undertaking an activity.

5
 Cont’’’

 The concept of utility is characterized with the following

properties:
• ‘Utility’ and ‘Usefulness” are not synonymous.
For example, paintings by Picasso may be useless
functionally but offer great utility to art lovers.
• Utility is subjective.
The utility of a product will vary from person to person. For
example, no-smokers do not derive any utility from cigarettes.
• The utility of a product can be different at different
places and time.
For example, the utility that we get from meat during fasting
is not the same as any time else.
6
 1.2. Approaches of Measuring Utility

There are two major approaches to measure or

compare consumer‘s utility:
The Cardinalist Theory
Neo classical economists argued that utility is
measurable like weight, height, temperature by
arbitrary unit of measurement called Utils in the
form of 1, 2, 3 etc.
• Hence, utility can be quantitatively measured.

7
 Assumptions of Cardinal Utility Theory
1. Rationality of Consumers. The main objective of the consumer is
to maximize his/her satisfaction given his/her limited budget or
income. Thus, in order to maximize his/her satisfaction, the
consumer has to be rational.
2. Utility is Cardinally Measurable. According to the cardinal
approach, the utility or satisfaction of each commodity is
measurable. Utility is measured in subjective units called Utils.
3. Constant Marginal Utility of Money. A given unit of money
deserves the same value at any time or place it is to be spent. A
person at the start of the month where he has received monthly
salary gives equal value to 1 birr with what he may give it after
three weeks or so.
4. Diminishing Marginal Utility (DMU). The utility derived from
each successive units of a commodity diminishes. In other
words, the marginal utility of a commodity diminishes as the
consumer acquires larger quantities of it. 8
 Total and Marginal Utility
Total Utility (TU) is the total satisfaction a consumer
gets from consuming some specific quantities of a
commodity at a particular time. As the consumer
consumes more of a good per time period, his/her
total utility increases.
Marginal Utility (MU) is the extra satisfaction a
consumer realizes from an additional unit of the
product.
 Marginal utility is the change in total utility that results
from the consumption of one more unit of a product.
 Graphically, it is the slope of total utility.

9
 To explain the relationship between TU and MU, let us
consider the following hypothetical example.

 The Total Utility first increases, reaches the

maximum (when the consumer consumes 6 units)
and then declines as the quantity consumed
increases.
 The marginal utility continuously declines (even
10
becomes zero or negative) as quantity consumed
 Law of Diminishing Marginal Utility
(LDMU)
 The law of Diminishing Marginal Utility states that as
the quantity consumed of a commodity increases per unit
of time, the utility derived from each successive unit
decreases, consumption of all other commodities
remaining constant.
 The extra satisfaction that a consumer derives declines as he/she
consumes more and more of the product in a given period of time.

11
 Equilibrium of a consumer
• The objective of a rational consumer is to maximize
total utility. As long as the additional unit consumed
brings a positive marginal utility, the consumer wants
to consumer more of the product because total utility
increases.
 The Case of One Commodity The equilibrium
condition of a consumer that consumes a single good
X occurs when the marginal utility of X is equal to its
market price.

12
solution

13
 Limitation of the Cardinalist approach

 The Cardinalist approach involves the following three weaknesses:

a. The assumption of cardinal utility is doubtful (utility is not objectively

measurable)

• because utility may not be quantified.

– Utility is a subjective concept, which cannot be measured objectively.

b. Utility cannot be measured absolutely (objectively).

• The satisfaction obtained from different commodities cannot be measured

objectively.

c. The assumption of constant MU of money is unrealistic

• because as income increases, the marginal utility of money changes.

14
 Assumptions of Ordinal utility

According to the Ordinalist school, utility is not measurable

in cardinal numbers rather the consumer can rank or
order the utility he derives from different goods and
services.

15
 Assumptions of Ordinal utility

1.The Consumers are rational: they aim at maximizing their

satisfaction or utility given their income and market prices.
2. Utility is ordinal: utility is not absolutely (cardinally)
measurable. Consumers are required only to order or rank
their preference for various bundles of commodities.
3. Diminishing Marginal Rate of Substitution (MRS):The
marginal rate of substitution is the rate at which a consumer is
willing to substitute one commodity (x) for another.
When a consumer continues to substitute X for Y the rate goes
decreasing and it is the slope of the Indifference curve.
4. The total utility of the consumer depends on the
quantities of the commodities consumed :
i.e., U=f (X1,X2,X3---Xn )
16
 Cont’’’

5. Preferences are transitive or consistent:

• It is transitive in the senses that if the consumer prefers

market basket X to market basket Y, and prefers Y to Z, and
then the consumer also prefers X to Z.
• When we said consistent it means that If market basket X is
greater than market basket Y (X>Y) then Y not greater than
X (Y not >Y).
 The ordinal utility approach is expressed or explained with
the help of indifference curves.
 Therefore, we call it indifference curve analysis 17
 Indifference set, Curve and Map
• Indifference Curve: When the indifference set or
schedule is expressed graphically, it is called an
indifference curve.
An indifference curve shows different combinations of
two goods which yield the same utility (level of
satisfaction) to the consumer. Indifference
Schedule/Indifference set
• .

18
Banana (Y)
10 A
Indifference

6
B Curve (IC)

C
2
D
1

1 2 4 7 Orange(X)

19
 Indifference Map:
• To describe a person’s preferences for all
combinations potato and meat, we can graph a set of
indifference curves called an indifference map.
• It is the entire set of indifference curves.
• Which reflects the entire set of tastes and
preferences of the consumer.
• A higher indifference curve refers to a higher level
of satisfaction and a lower indifference curve shows
lesser satisfaction.
• IC2 reflects higher level of utility than that of IC1.
• Any consumer has lots of indifference curves, not
just one. 20
Good B
Indifference map

IC3
IC2
IC1

Good A
Indifference Map: It is a set of indifference curves with
different levels of satisfaction 21
Properties of Indifference Curves(IC)

1. Indifference curves have negative slope (downward sloping to the right).

2. Indifference curves are convex to the origin.

3. A higher indifference curve is always preferred to a lower IC.

4. Indifference curves never cross each other (cannot intersect).

22
23
 Marginal Utility and Marginal rate of
Substitution
• it is possible to show the derivation of the MRS
using MU concepts.
• The is related to the MUxMU and the MUy is:
MRS X ,Y  X
MU Y
Proof:
• Suppose the utility function for two commodities
X and Y is defined as: U=f(x,y)
• Since utility is constant on the same indifference
U  f ( X ,Y )  C
curve:
24
• The total differential of the utility function is:
U U
dU  dX  dY  0
X Y

• since there is no change in utility for any

movement along the same indifference curve

MU X dX  MU Y dY  0

MU X dY
  MRS X ,Y
MU Y dX

25
 Cont’’’

26
 Special Indifference Curves

• Indifference curves are convex to the origin

and downward sloping.
• However, the shape of the indifference curve
reflects the degree of substitution between the
two commodity.
• The shape of an indifference curve might be
different if the relationship between two
commodities is unique. 27
 Cont’’’

• Perfect substitutes: are goods which can be

replaced for one another at a constant rate.
• Perfect complements: are goods which are to be
consumed jointly at a constant rate.
 If two commodities are perfect complements the
indifference curve takes the shape of a right
angle (L –shape).
• A useless good: A good example is outdated book
and food.
 since the outdated books are totally useless,
increasing their purchases does not increase
utility. 28
Cont’’’

29
 The Budget Line or the Price Line

• Indifference Curves only tell

us about consumer preferences for
any two goods but they cannot
show which combinations of the
two goods will be bought.

• The Budget Line- shows

various combinations of two
goods that a consumer can
purchase given his/her limited
income & prices of two
goods. 30
•
 Factors Affecting the Budget Line

Effects of changes in income

• If the income of the consumer changes (keeping the prices of the
commodities unchanged) the budget line also shifts (changes).

• Increase in income causes an upward shift of the budget line

that allows the consumer to buy more goods and services and

• Decreases in income causes a downward shift of the budget

line that leads the consumer to buy less quantity of the two goods.

• It is important to note that the slope of the budget line (the

ratio of the two prices) does not change when income rises
or falls. 31
M2/Py

M/Py
Where M2>M>M1

M1/Py

M1/PX M/PX M2/PX

Effects of change in income

32
 Cont’’’

Effects of Changes in Price of the commodities

We can notice that changes in the prices of the

commodities change the position and the slope of
the budget line. But, proportional increases or

decreases in the price of the two commodities

(keeping income unchanged) do not change the
slope of the budget line if it is in the same
direction.
33
Numerical Example
•A person has $ 100 to spend on two goods(X,Y) whose respective
prices are $3 and $5.
a)Draw the budget line.
b)What happens to the original budget line if the budget falls by
25%?
c)What happens to the original budget line if the price of X
doubles?
d)What happens to the original budget line if the price of Y falls to
4?
34
 Optimum of the Consumer
• A Rational Consumer tries to attain the highest possible
indifference curve, given the budget line. This occurs at the point
where the indifference curve is tangent to the budget line so that
the slope of the indifference curve ( MRS XY ) is equal to the
slope of the budget line (PX / P Y ).

MRS X ,Y  PX / PY

35
 Cont’’’’

36
 Mathematical derivation of equilibrium

 Suppose that the consumer consumes two

commodities X and Y given their prices and level of
money income M.
The objective of the consumer is maximizing his utility
subject to his limited income and market prices.
In utility maximization, the function that represents the
objective that the consumer tries too achieve is called the
objective function and the constraint that the consumer
faces is represented by the constraint function. 37
 Cont’’’’

MaximizeU  f ( X , Y )
Subject to PX X  PY Y  M

To solve the constrained problem; we use the

Lagrange Multiplier Method.
The steps involved are:
A)Rewrite the constraint function as follows:
M  PX X  PY Y  0  (  will have positive value) or
PX X  PY Y  M  0 ,  will have negative value
38
B) Multiply the constraint by Lagrange
multiplier

 ( M  PX X  PY Y )  0

  ( PX X  PY Y  M )  0
C) Form a composite function or the
Lagrange function:

  U ( X , Y )   ( M  PX X  PY Y )
  U ( X , Y )   ( PX X  PY Y  M )
39
D) The first order condition for maximum requires
that the partial derivatives of the Lagrange
function with respect to the two goods and the
 langrage
U multiplier
 U be equals to
 zero.
  PX  0 ;   PY  0 and  ( PX X  PY Y  M )  0
X X Y Y 

From the above equations we obtain:

U U
 PX and  PY
X Y

Therefore, substituting and solving for we

get the equilibrium condition:
40
 MU X MU Y
 
PX PY MU X PX

By rearranging we get: MU Y PY

E) The second order condition for maximum requires that

the second order partial derivatives of the Lagrange
function with respect to the two goods must be negative.

 2
U 2
 2
U 2
  0 and  0
X 2
X 2
Y 2
Y 2

41
Example
A consumer consuming two commodities X and Y
has the following utility function . If the
price of the two commodities are 4 and 2
respectively and his/her budget is birr 60.
a) Find the quantities of good X and Y which will
maximize
Solution utility.
b)Find the
The Lagrange equation will be written asat optimum.
follows:
  XY  2 X   (60  4 X  2Y )

 Y  2   4  0 ……………………….. (1)
X

 X   2  0 …………………………… (2)
Y

42

 60  4 X  2Y  0 …………………… (3)

From equation (1) we get Y  2  4 and from equation (2) we get X  2 .Thus, we can get
Y 2 1
that X  and equation (2) gives as   X .
2 2
Y 2
By substituting X  in to equation (2) we get Y  14 and X  8.
2
MU X
MRS X ,Y 
MU Y
Y 2

X
After inserting the optimum value of Y=14 and X=8 we get 2 which equals to the price ratio of
PX 4
the two goods (   2) .
PY 2
43
Exercise 1

A consumer consuming two commodities X and Y has

the following utility function.

If the price of the two commodities are 3 and 4

respectively and his/her budget is birr 100.

i. Find the quantities of good X and Y which will

maximize utility.

ii. Total utility at equilibrium.

iii. Find the MRSxy at optimum point 44

 Effects of Changes in Income and Prices on Consumer‘s equilibrium

Changes In Income:
Income Consumption Curve and the Engel Curve
i. The case of normal goods
An increase in the consumer’s income (all other things
held constant) leads to an upward parallel shift of the
budget line.
 As a result a consumer moves to different
consumption level.
• The following figure shows this condition 45
 Since both X and Y increased as income increase this
shows the case of normal goods
Commodity Y

ICC

E3
Y3
E2

Y1 E1

X1 X3 Commodity X
46
• Income Consumption Curve (ICC) : is a locus of all points that

representing various combinations of the two commodities purchased

by the consumer at different levels of his income, all other things

remaining the same.

• Normal Good is a good whose demand increases with income increase.

• For normal good income effect is positive.

ii. The case of inferior goods

• Inferior good : is a good whose consumption decreases as income

increase.

• Engle curve will have a negative slop for inferior good as indicated in

the figure below 47

 the income –consumption curve when good y is inferior good

Y3
Y1
ICC

X1 X3 X

48
 the income –consumption curve when good X is inferior good

Y
ICC

Y3

Y1

X
X1 X3
49
• ICC is used to derive Engle Curve:

Engle Curve: is a line representing the relationship

between the equilibrium quantity purchased of a good
and the level of income.
• For normal goods Engle curve will have positive slope

• The Engle Curve shows the equilibrium (utility

maximizing) quantities of a commodity, which a
consumer will purchase at various levels of income;
(ceteries paribus) per unit of time. 50
In relation to the shape of the income-consumption and Engle
curves goods can be categorized as normal (superior) and
inferior goods.
• Thus, commodities are said to be normal, when the income
consumption curve and its Engle curve are positively sloped;
meaning that more of the goods are purchased at higher
levels of income.
• On the other hand, commodities are said to be inferior when
the income consumption curve and Engle curve is negatively
sloped, i.e. their purchase decreases when income increases.
51
 Effects of Price Change
Price Consumption Curve (PCC) and Individual Demand
Curve
• When one of the two commodity price changes while other
things remain unchanged the budget line will rotate.
• As a result the consumer will move to a new equilibrium
points.
• If we connect such equilibrium points that would occur at
different price level we get a line called Price Consumption
Curve (PCC)
52
The Effect of price change on Consumer’s Equilibrium

Y
L

PCC
E3
E2
E1

M M’ M’’ X

53
• PCC: is the locus of the utility-maximizing
combinations of products that result from
variations in the price of one commodity when
other product prices, the money income and other
factors are held constant.
• We use the PCC to derive the individual demand
curve for a particular commodity How ?
• By plotting PCC from commodity space to price
54
Commodity Y

PCC

Commodity X
Price of X
Px1
Px2
Individual
Px3 demand curve

X1 X2 X3
Commodity X
55
 Income and Substitution effects of a price change

• When price of one of the commodity changes, while other thing

remain unchanged, the budget line will rotate accordingly.
 This price change will brings two major effects,

A) Substitution

B) Income

A) Substitution effect:
• refers to the change in the quantity demanded of a
Commodity resulting exclusively from a change in its price
when the consumer’s real income is held constant. 56
56
• If a price of commodity X falls while Price Y and income of a
consumer remain unchanged.

• Commodity X will relatively be cheaper and this induces consumer to

substitute cheaper commodity (X) for more expensive one.

• If price falls (rises), the good becomes cheaper (more expensive) relative
to other goods; and consumers substitute toward (away from) the good.

B) The Income Effect:

• When price of commodity X decreases ( other things remain), the relative

purchasing power of consumer will increase, i.e., the real income will
increase (meaning a consumer can afford to buy more of the two
commodities with the existing income depending on the nature of the
57
commodity.
• As price falls (rises), the consumer’s purchasing power increases
(decreases).
• Since the set of consumption opportunities increases (decreases) as
price changes, the consumer changes the mix of his or her
consumption bundle.
• The income effect may be defined as the change in the quantity
demanded of a commodity exclusively associated with a change in
real income.
• The income effect is determined by observing the change in the
quantity demanded of a commodity that is associated solely with the
change in the consumer’s real income.
 The following figure will depict these two effects 58
Suppose the consumer is at equilibrium at point A consuming X1 unit of X

Suppose price of X falls while

other things remain unchanged
A
The budget line will shift from
AB to AB’
•A consumer move to a new
C
A B IC2 equilibrium point at point B
 
consuming X3 units
C IC1
 •The movement from A to B is
called Total Effect or Net effect
of price change
x2 B •The TE consists of SE and IE
x1
SE IE
x3 C’ B’
NE

Income and Substitution effect for a normal 59

 TE = Substitution effect + Income Effect
TE = SE + IE
How can we split these two effects?

A
We can split these two effects by drawing an
imaginary budget line which is parallel to the
new budget line (AB’) and tangent to the
original IC1
C
P R IC2
Point Q represents imaginary
  equilibrium
Q IC1 The movement from P to Q and a
 resulting increase in demand by X1X2 is
substitution effect.

x2 B The movement from Q to R and

x1
SE IE
x3 C’ B’ increase in demand by X2X3 is
NE
due to income effect
60
• In the above case income effect and the
substitution effects operate in the same
direction – they reinforce each other.
• This is the case for a good called Normal
goods.
• But, not all goods are normal. Some goods
are called inferior goods.
61
Inferior good:
Is a good whose quantity demand decrease with income
increase.
• Is a good whose demand is negatively related to the
income of a consumer.
 For an inferior good, a decrease in the price of the
commodity,
– causes the consumer to buy more of it (the
substitution effect),
– but at the same time the higher real income tends the
62
Suppose the consumer is at equilibrium at point A consuming X1 unit of X

When price of X falls while other

things remain unchanged
Y The budget line will shift from
AB to AB’
A
•A consumer move to a new
R equilibrium point at point R
C
P consuming X2 units
Q2 •The movement from A to B is
Total Effect or Net effect of price
B’
change
B
X1 X2 X3 X
IE
NE Income, Substitution, and Net effect for an
inferior commodity 63
SE
The TE can be split into SE and IE by drawing imaginary budget
line CC’
Where: Point Q represents imaginary
X1X3= NE=Net effect equilibrium
X1X2= SE=Substitution effect
Y The movement from P to Q
X2 X3= IE=Income effect and a resulting increase in
A
demand by X1X3 is
substitution effect.
R
C
P
The movement from Q to R and
Q decrease in demand by X2X3 is
due to income effect.
B B’
As real income decreases
X1 X2 X3 X demand for inferior good
IE decreases
NE
64
SE
• In this case we observe that,
– the substitution effect still is more powerful
than the income effect (SE >IE)
– even though the income effect works against
the substitution effect, it does not override it.
– As a result the law of demand hold
– Hence, the demand curve for most inferior goods
is still negatively sloped.
 In very rare occasions, a good may be so
strongly inferior that the income effect
actually overrides the substitute effect.
• As a result the law of demand may be violated,
I.e., decline in the price of a good would lead to
a decline in the quantity demanded. 65
• In other words, price and quantity move
in the same direction which is against
the law of demand. Such goods are
called Giffen Goods.
Giffen goods: are goods whose demand
decreases as price of a commodity
decreases.
• That is, the quantity demanded is
directly related to the price
• The graph below shows the substitution
and income effect of Giffen goods
66
 Suppose the consumer is at equilibrium at point P
consuming X1 unit of X
Y When price of X falls while
A other things remain
R unchanged
IC2
C The budget line will shift
from AB to AB’ A consumer
P move to a new equilibrium
Q
point at point R consuming
IC1 X3 units
B’
B
X3 X1 X2
C’
X The movement from P to R
SE is Total Effect or Net effect
NE
of price change
IE Income, Substitution and net effects for a
67
Giffen good
The TE can be split into SE and IE by drawing imaginary budget line CC’

Y Point Q represents imaginary equilibrium

A
R The movement from P to Q and a
IC2 resulting increase in demand by X2X3 is
C substitution effect.
The movement from Q to R and
P decrease in demand by X1X3 is
Q due to income effect.
IC1 We observe that the income effect
B’
B C’ is greater than substitution effect.
X1 X2 X3 X The net effect is that as price fall
SE
NE demand for giffen good will also
decrease
IE
68
• The strong negative income effect
outweighs the substitution effect (
IE > SE)
• This reduces quantity demanded of
a giffen good
• Which means as price of a giffen
good decreases quantity demanded
will also decrease
• Which is against the law of demand
69
 The Slutsky Equation
• The change in relative prices makes the consumer to
consume more of the cheaper good-substitution effect.
• The increase in purchasing power due to the lower price
may increase or decrease consumtion of the good-income
effect.
• Generally, the Slutsky equation says that the total change in
demand is the sum of the substitution effect and the income
effect.
Numerical Example
• Suppose that the consumer has a demand function for good
X is given by
• Originally his income is $ 200 per month and the price of the
good is 5 per killogram.
• Therfore,his demand for good X will be per month.70
• Suppose that the price of the good falls to 4 per
kilogram. Therfore , the new demand at the new
price will be: per month.
• Thus, the total change in demand is 4.5 that is
32.5-28. When the price falls the purchasing
power of the consumer changes.
• Hence, in order to make the original consumption
of good X, the consumer adjusts his income.
• This can be calculated as follows:
• Subtracting the second equation from the first
gives:4-
71
• Therfore, new income to make the original
consumption affordable when price falls to 4
is:
• Hence, the level of income necessary to keep
purchasing power constant is

• The consumers new demand at the new price

and income will be :
• Therfore, the substitution effect will be:

• The income effect will be:

72
 The Consumer Surplus
• Demand curve shows the price that
consumers are willing to pay for various
quantity demanded.
• While consumers purchase goods and
services,
– they often pay less than what they
are willing to pay.
• the difference between what they are
willing to pay and what they actually
paid is considered as their surplus.

73
• Therefore, consumer surplus is the
difference between what a consumer is
willing to pay and what he actually pays.
• Graphically it is measured by the area
below the demand curve and above the
price level.
• More precisely it is the area of the
triangle above the price but below the
demand curve.

74
P

P1

CS
E

Pe

Q1 Q

75
 Numerical Example : Suppose the demand function of a
consumer is given by
a.Compute the consumer surplus when the priceof the good is 2
b.Compute the consumer surplus when the price ofthe good is 4
c. Compute the change in consumer surplus when the price
changes from 2 to 4.
Solution
When Price is zero the demand for quantity purchased will be
15 and when the demand for quantity is put to zero then the
price level will be 15. And finally, when we insert the given price
level 2 in the demand equation we get the level of qunatity
demanded that is 13.
• Hence, we can easily compute the area of the triangle that is
found above the given price level that is 2.
76
77
 Chapter two
CHOICE UNDER UNCERTAINITY

Most of the time risk and uncertainty are usually used

interchangeably, some people distinguish between the two.

Uncertainty: refer to a situation when there are more than possible

outcomes to a decision and where the probability of each specific
outcome is not known.
 Cont’’’d
 Risk: refers to a situation where there are more than one
possible outcome to a decision and the probability of each
specific outcome is known or can be estimated.
 Certainty: refers to a situation where there is only one
possible outcome to a decision and this outcome is known
precisely.
 Sources of uncertainty and risks
 Production risk: weather, pests, diseases, equipment
breakdowns, etc.
 Market or price risk: volatility in input and output
prices due to demand fluctuations, time lags
 Financial risk: unexpected variability of returns that
determines farm’s ability to pay the cash obligations in a
timely manner, possibility of losing some or all of the
original investment
 Legal risk: possibility of being sued (by customer,
worker, etc.), fined, penalized for violating a law or
regulatory
 Sources of uncertainty and risks
 People risk: human sources of risk includes the four D’s (death,
divorce, disability and disagreement)

 Technological risk: evolution of new production techniques,

technological innovations due to R & D, may make fixed past
investments obsolete

 Economic risk: our future income are uncertain (our earnings can
go upward, we can be promoted, demoted or even lose our jobs,
economic policy risks), health, political, human beings themselves
(acting out of professional code of ethics), etc. risks.
 Cont’’’d
We need two measures to describe and compare risk
choices. These measures are:

Expected value: is the weighted average of all possible

payoffs/outcomes that can result from a decision under
the various state of nature.

It measures the value that we would expect on average. We

can express as E(X) = P1X1 + P2X2
 Cont’’’d
 Variability: is the extent to which possible outcomes of an
uncertain event may differ.

 We measure variability by recognizing that large differences

between actual and expected value imply greater risk.

Standard deviation (sd)

The one with the lower/smaller standard deviation is less risky and
hence is preferred and vise versa.
 Different preference towards risk

 A risk averse person: is a person preferring a certain income to a

risky income with the same expected value. For a risk averse
person losses are more important than gains.

Thus, the MU of income diminishes as income rises.

 A risk neutral person: is a person indifferent between a certain

income and an uncertain income with the same expected value.
For this person, the MU of income is constant.
 Cont’’’d
 A risk loving person: -is a person preferring a risky income to a
certain income with the same expected value.

 NB: Expected utility E(U) is the sum of the utilities associated

with all possible outcomes, weighted by the probability that each
outcome will occur.
 Reducing risk

 Consumers and managers commonly reduce risk in various ways.

The major ones are diversification, insurance and obtaining more
information
 Diversification: - reducing risk by allocating resources to a variety
of activities whose outcomes are not closely related –“Don’t put all
your eggs in one basket.”
 Insurance: - If the cost of insurance is equal to the expected loss,
risk averse people will buy enough insurance to recover fully from
any losses they might suffer.
 The value of information: - people often make decisions based on
limited information. If more information were available, one could
make better predictions and reduce risk.
 87
Chapter Three
3.1.Theory of Production

Main contents
Theory of production
 88
3.1 Introduction: Definition and basic concepts

• Production means creation of utility for sales.

• Production may be defined as the act of creating those
goods/services which have exchange value for sale (not
for personal consumption).
• It is the act of transforming tangible and intangible raw
materials into final products
• Inputs or factors of production: land, labor, capital and
Entrepreneurship
• Production Function 91
– It is a purely technical relationship which connects
factors (inputs) to products (outputs) at any particular
time period.
– It also shows the maximum quantity of output that can
be produced from the given amount of variable inputs
for a given technology
– the relationship between quantity of inputs used to
make a good and the quantity of output of that good.
 90
Fixed Vs variable inputs

• Fixed inputs are those inputs whose quantity can not

readily be changed when market conditions indicate
that an immediate change in output is required.
• For example, It takes long time to buy new
machineries, to plant them and use for production.
• Buildings, machineries and managerial personnel are
examples of fixed inputs
 Cont’’’d 93
• Variable inputs are those inputs whose quantity
can be changed almost instantaneously in response
to desired changes in output.
• That is, their quantity can easily be diminished
when the market demand for the product decreases
and vise versa.
• The best example of variable input is unskilled
labor.
 Short run Vs. long run period of production
94
• Short run refers to that period of time in which the quantity of at
least one input is fixed.
– is that time period which is not sufficient to change the
quantities of all inputs,
– Some firms can change the quantity of all their inputs with in a
month while it takes more than a year to change the quantity of
all inputs for another type of firms.
• Long run is that time period (planning horizon) which is
sufficient to change the quantities of all inputs.
– Thus there is no fixed input in the long -run
94
 Production in the short run: Production with one variable input

• Production with one variable input (while the others are fixed) is
obviously a short run production
• Assumption of short run production analysis

1. Perfect divisibility of inputs and outputs

– factor inputs and outputs are so divisible that one can hire/
produce, a fraction of labor, a fraction of manager and fraction
of output.
2. Limited substitution between inputs
– Factor inputs can substitute each other up to a certain point,
beyond which they can not substitute each other
3. Constant technology
93
 Short-run production function
• Q = f (L) K - being constant, where
– Q is the quantity of production (Output)
– L is the quantity of labor used, which is variable,
&K is the quantity of capital (which is fixed)

Combination A B C D E F G H
s
Quantity of 0 1 2 3 4 5 6 7
Labour
Capital 4 4 4 4 4 4 4 4

Total 0 1 3 6 8 9 9 8
output
 Total Product(TP), Marginal Product(MP) and Average Product(AP)

• Total product (TP): is the total amount of output that can

be produced by efficiently utilizing a specific combination
of labor and capital.
• The total product curve, thus, represents various levels of
output that can be obtained from efficient utilization of
various combinations of the variable input, and the fixed
input.
• It shows the output produced for different amounts of the
95
variable input (example, labor).
 Marginal Product (MP)

• The marginal product is the additional to the total product attributable

to the addition of one unit of the variable input to the production
process.
• when variable input (labor) changes by ∆L, the change in out put per
worker or marginal product of labor, denoted as MPL is calculated as
TP dTP
MPL  or MPL 
L dL

• MPL measures the slope of the total product curve at a given point.
• In the short run, the MP of the variable input first increases reaches its
maximum and then tends to decrease to the extent of being negative.
• As we continue to combine more and more of the variable inputs with
the fixed input, the marginal product of the variable input increases
initially and then declines.
96
 Average Product (AP)

• The AP of an input is the ratio of total output to

the number of variable inputs used .

totalprodu ct TP
APlabour  
numberof L L
• The average product of labor first increases with the
number of labor (i.e. TP increases faster than the increase
in labor), and eventually it declines. 97
The relationship between TP, MP and AP function of a variable
input

• When MPL = APL, Slope of APL is zero (APL is at

its maximum).

• When MPL < APL, Slope of APL is negative (APL

falls)
• When MPL> APL, APL increases

• When MPL=0, TPL is at its maximum

 Hypothetical Example

•
 Cont’’’

•
 Production function in the short run
product
Total

TP
St
ag
e

I
Stage I
I III

e
ag
Figure 2.1: St

APL

L1
L0
0 MPL Unit of labor used

101
 The law of diminishing marginal returns (LDMR): short –run
law of production
• The LDMR states that as the use of an input increases (with other
inputs being fixed), a point will eventually be reached at which the
resulting additions to output decreases.
• The law of decreasing returns states that:

– As a firm uses more of a variable input, with a given quantity

of fixed inputs, the marginal product of the variable input
eventually decreases.
• Reason: a decrease in the proportion of fixed capital to be combined
with increasing units of a variable input
• The LDMR is in the short run (at least one input is fixed) and it starts
102
where the Marginal product starts to decline.
Stages of Production and the Efficient Region of Production in
the short-run
• At this level it is not possible to determine the specific number of
the variable input (labor) that the firm should employ
• However, it is possible to determine ranges over which the
variable input (labor) should be employed.
• Stage I – ranges from the origin to the point of equality of the APL
and MPL.
• Stage II – starts from the point of equality of MPL and APL and
ends at a point where MP is equal to zero.
• Stage III – covers the range of labor over which the MPL is
negative or TP is decreasing. 103
• The question: which stage of production is efficient and
preferable?
• To answer the question, let us follow elimination method.
• Obviously, a firm should not operate in stage III
– because in this stage additional units of variable input are contributing negatively to
the total product or (MP of the variable input is negative)
• because of over crowded working environment i.e., the fixed input is over
utilized.

• Stage I is also not an efficient region of production though the

MP of variable input is positive.
– The reason is that the variable input (the number of workers) is too small
to efficiently run the fixed input; so that the fixed input is under utilized
(not efficiently utilized)
• Thus, the efficient region of production is stage II.
– additional inputs are contributing positively to the total product and MP of
successive units of variable input is declining (indicating that the fixed input is
104
being optimally used).
 Long run Production: Production with two
variable inputs
• we have completed our analysis of the short-run production function. Now we
turn to the long run analysis of production.
• Remember that long run is a period of time (planning horizon) which is
sufficient for the firm to change the quantity of all inputs. For the sake of
simplicity, assume that the firm uses two inputs (labor and capital) and both are
variable.
• The firm can now produce its output in a variety of ways by combining different
amounts of labor and capital. With both factors variable, a firm can usually
produce a given level of output by using different combinations of labor and
capital.
• In this section, we will see how a firm can choose among combinations of labor
and capital that generate the same output. To do so, we make the use of isoquant.
So it is necessary to first see what is meant by isoquants and their properties.
 Isoquants

• An isoquant is a curve that shows all possible efficient

combinations of inputs that can yield equal level of output.
• If both labor and capital are variable inputs, the production
function will have the following form.
Q = f (L, K)
• Given this production function, the equation of an isoquant, where
output is held constant at Q is
Q = f (L, K)
• Thus, isoquants show the flexibility that firms have when making
production decision: they can usually obtain a particular output 106
(q)
 Isoquant curve

• A standard isoqunat curve

Isoquant (Q0)

X
 Isoquant maps

• An isoquant map is a set of isoquants.

• Each isoquant represents a different level of output and
the level of out puts increases as we move up and to the
right.
• The following
Capital
figure shows isoquants and isoquant map.
3

q3
2
q2
1
q1

1 3 6
Labor
 Prosperities of isquants

Isoquants have the same properties as indifference curves.

1. Isoquants slope down ward. Because isoquants denote efficient combination

of inputs that yield the same output, isoquants always have negative slope.

2. The further an isoquant lays away from the origin, the greater the level of
output it denotes. Higher isoquants (isoquants further from the origin)
denote higher combination of inputs and outputs.

3. Isoquants do not cross each other. This is because such intersections are
inconsistent with the definition of isoquants.

4. Standard isoquant curves are convex to the origin….due to diminishing

marginal rate of technical substitution

5. Isoquants must be thin. If isoquants are thick, some points on the isoquant
109
will become inefficient.
 Special Shapes of isoquant Curves

• Isoquants can have different shapes (curvature) depending

on the degree to which inputs can subistitute each other.
1-Linear isoquants
Isoquants would be linear when labor and K

capital are perfect substitutes for each

other. In this case the slope of an isoquant 10

is constant. As a result, the same output

can be produced with only capital or only 8
q=100

labor or an infinite combination of both.

12 15 L

110
 Input-output isoquants
K •To produce q1 level of output there
is only one efficient combination of
labor and capital (L1 and K1).
•Output cannot be increased by
q3 keeping one factor (say labor)
q2 constant and increasing the other
K2
(capital).
K1
q1
• To increase output (say from q1 to
L
q2) both factor inputs should be
L1 L2 increased by equal proportion.

111
 Kinked isoquants
• This assumes limited substitution between inputs.
• Inputs can substitute each other only at some points.
• The isoquant is kinked and there are only a few alternative
combinations of inputs to produce a given level of output.
• These isoquants are also called linear programming isoquants or
activity analysis isoquants.
K

A
12

7 B

C
5
3 1 3 5 9
D

L
112
 Smooth, convex isoquants

• This shape of isoquant assumes continuous substitution of capital and

labor over a certain range, beyond which factors cannot substitute each
other.
• Traditional economic theory mostly adopted the continuous isoquants
because they are mathematically simple to handle by the simple rule of
calculus, and they are approximation of the more realistic isoquants.
• This type of isoquant is the limiting case of the kinked isoquant when
the number kink is infinite.
• From now on we use the smooth and convex isoquants to analyze the
long run production.
113
 Smooth Isoquant…
•The slope of the isoquant decrease
Smooth Isoquant
K
as we move from the top (left) to the
right (bottom) along the isoquant.
∆K=4

• This indicates that the amount by

∆L=1

∆K=2 ∆K=1/2
which the quantity of one input
∆L=1
Q (capital)can be reduced when one
∆L=1

L extra unit of another inputs(labor)is

used ( so that out put remains
constant) decreases as more of the
114
latter input (labor)is used.
Marginal Rate of Technical Substitution (MRTS)
• A marginal rate of technical substitution is the rate at
which factors can be substituted at the margin without
altering the level of output. More precisely, marginal rate
of technical substitution of labour for capital may be
defined as the number of units of capital which can be
replaced by one unit of labour, the level of output
remaining unchanged. The concept of marginal rate of
technical substitution can be easily understood from the
Table below.
Table of Marginal Rate of Technical Substitution
Factor Combinations Units of Labour (L) Units of Capital MRTS of L for
(K) K

A 1 12 —

B 2 8 4

C 3 5 3

D 4 3 2

E 5 2 1
Returns to Scale (Production with all Variable Inputs)
In the short run, some factor inputs can be varied while the others
remain fixed. But in the long run, time is sufficient enough to vary all
the factor inputs. In other words, no input or factor is fixed in the long
run. When all factor inputs can be varied, keeping their proportion
constant, it is called a change in the scale of operations. The
behaviour of output consequent to such changes in the quantities of all
factor inputs in the same proportion (i.e., keeping the factor proportions
unaltered) is known as ‘returns to scale’. Alternatively when all the
factors required for production of a commodity are increased in a given
proportion the scale of production increases and the change caused in
return (output) is called return to scale. In such a situation, three types
• Increasing Returns to Scale. It occurs when output
increases by a greater proportion than the proportion of
increase in all the inputs.
• Constant Returns to Scale. It happens when output
increases by the same proportion as of inputs increase.
• Diminishing Returns to Scale. It occurs when output
increases by a smaller proportion than the proportion of
in input increases.
Reasons for Increasing and Decreasing Returns
• Reasons for operation of increasing returns to scale are:

• Greater division of labour and specialisation which increases

productivity.
• Use of more productive specialised machinery.

Reasons for operation of diminishing returns to scale are:

The main reason for operation

of diminishing return to scale is difficulty in management and
coordination when scale of operation becomes bigger and bigger.
 Equilibrium of the firm:
Choice of optimal combination of factors of production

• In our previous discussion we have said that an isoquant

denotes efficient combination of labor and capital
required to produce a given level of out put.
• But, this does not mean that the monetary cost of
producing a given level of out put is constant along an
isoquant.
• Thus, isoquant shows only technically efficient
combinations of inputs, not economically efficient
120
 Cont…
To determine the economically efficient input combination, the
following simplifying assumptions hold true:
Assumptions
1. The goal of the firm is maximization of profit (p=TR-TC)
Where P-Profit, R-revenue and C-is cost outlay.
2. The price of the product is given and it is
equal to .
3. The prices of inputs are given (constant).
PX

4. Price of a unit of labor is and that of capital is equal.

121
 Isocost line
• Dear learner, do you remember what the budget line
denotes?
• Isocost lines have most of the same properties as that of
budget lines, an isocost line is thewlocus points denoting
all combination of factors that a firm can purchase with a
given monetary outlay, given prices of factors.
• Suppose the firm has amount of cost out lay (budget) and
prices of labor and capital are “W”and “r” respectively.
122
The equation of the firm’s isocost line is given as:
 Chapter four
THEORY OF COSTS OF PRODUCTION

• Explain different ways of measuring private costs

• Cost functions both in the short run and long run.

• Explain the relationship between short run

production function and short run cost function.

123
 Basic concepts
• To produce goods and services, firms need factors of production or
simply inputs.
• To acquire these inputs, they have to buy them from resource suppliers.

• Cost is, therefore, the monetary value of inputs used in production of an

item.
• We can identify two types of cost of production: social cost and private
cost.
• Social cost: is the cost of producing an item to the society.

• It is a cost realized due to the fact that most resources used for
production purpose are scarce and some production process, by their
nature, emit dangerous chemicals, bad smell, etc to surrounding society.
124
 Cont…
• Private cost: This refers to the cost of producing an item
to the individual producer.
• It is the cost that the beer factory incurs to produce the
beer, in our example:
 Private cost of production can be measured in two ways:

• Economic cost
• Accounting cost

125
 Economic cost
In economics the cost of production to the individual producer includes the cost
of all inputs used for the production of the item.
• The actual or out- of- pocket expenditures that the firm incurs to purchase
these inputs from the market are called explicit costs.
• But, the producer can also use his/ her own inputs which are not purchased
from the market for the production purpose.
• For example, the producer may use his/ her own building as a production
place, he/she may also manage his firm by himself instead of hiring another
manager, etc.
• Since these inputs are used for the production purpose, their value has to be
estimated and included in the total cost of production
• The estimated costs of these non- purchased inputs are called implicit costs.
126
 Cont…

• Thus, in economics the cost of production includes the

costs of all inputs used in the production process whether
the inputs are purchased from the market or owned by
the firm himself that is:
• Economic cost: Explicit cost plus Implicit cost
• Accounting Profit= Total profit - Accounting cost
• Economic Profit =Total profit - Economic cost
• A firm’s economic profit equals total revenue minus
total cost. 127
 Cont…

Accounting Cost
• For accountant, the cost of production includes
the cost of purchased inputs only.
• Accounting cost is the explicit cost of production
only.
• An explicit cost is a cost paid in money.

128
 Cost functions
• Cost function shows the algebraically the relationship between
the cost of production and various factors which determine it.
• The cost of production depends on the level of output
produced, technology of production, prices of factors, etc.
hence; cost function is a multivariable function. Symbolically,
C = f (x, t, pi)
Where c- is total cost of production
x - is the amount of output
T – is the available technology of production.
Pi – is the price of input
• Graphically, cost functions can be illustrated by using a two-
dimension diagrams.
129
 Short run vs. long run costs
• Economics theory distinguishes between short run
costs and long run costs.
• Short run costs are the costs over a period during
which some factors of production (usually capital
equipments and management) are fixed.
• The long- run costs are the cost over a period long
enough to permit the change of all factor of
production. 130
 Short run costs
• In the traditional theory of the firm, total costs are split into two
groups: total fixed costs and total variable costs:
TC = TFC + TVC
Where – TC is short run total cost
TFC is short run total fixed cost
TVC is short run total variable cost
• By fixed costs, we mean a cost which doesn’t vary with the level
of output. The fixed costs include:
– Salaries of administrative staff
– Expenses for building depreciation and repairs
– Expenses for land maintenance
– The rent of building used for production , etc 131
• All the above costs are regarded as fixed costs because :
– these costs are unavoidable, and
– the firm can avoid fixed costs only if he / she shuts down the
business stops operation.
• Variable costs, on the other hand, include all costs which directly
vary with the level of output. The variable costs include:
– The cost of raw materials
– The cost of direct labor
– The running expenses of fixed capital such as fuel, electricity
power, etc.
• All these costs are regarded as variable costs because their amount
depends on the level of output.
• If the firm produces zero output, the variable cost is zero.
132
 Total Fixed Cost (TFC)

• TFC is denoted by a straight line parallel to the output axis.

• The point of intersection of the TFC line with the cost axis
(vertical axis) shows the amount of the fixed.
C

TFC
$100

133
 Total Variable Cost (TVC)

• The total variable cost of a firm has an inverse s- shape.

– The TVC has an inverse s-shape due to the law of diminishing
marginal returns.
• The shape indicates the law of variable proportions in
production.
• Graphically, the TVC looksTVC
the following.
C

134
 Total Cost (TC)

• The total cost curve is obtained by vertically adding the

TFC and the TVC i.e., by adding the TFC and the TVC at
each level of output.
• The shape of the TC curve follows the shape of the TVC
curve. i.e. the TC has also an inverse S-shape.
• TC curve doesn’t start from the origin as that of the TVC
curve.
• The TC curve starts from the point where the TFC curve
intersects the cost axis. 135
 Total Cost curve
• The TC and TVC curves has an inverse S- shape. The vertical distance between them (TFC)

is constant.

TC

TVC

TFC

TFC

136
 Per Unit costs
• Average fixed cost (AFC): is found by dividing the TFC by the
level of output.
TFC
AFC 
Q

• Graphically, the AFC is a rectangular hyper parabola.

• The AFC curve is continuously decreasing curve, but decreases at
a decreasing rate and can never be zero.
• Thus, AFC gets closer and closer to zero as the level of output
increases, because a fixed amount of cost is being divided by
increasing level of output. 137
• Average variable cost (AVC)
• The AVC is similarly obtained by dividing the TVC with
the corresponding level of output.
TVC
AVC 
X

• Graphically, the AVC at each level of output is derived

from the slope of a line drawn from the origin to the
point on the TVC curve corresponding to the particular
level of output.
138
 Average total cost (ATC) or simply, Average cost (AC)

• ATC (or AC, now on) is obtained by dividing the TC by the

corresponding level of output. It shows the amount of cost
incurred to produce each unit of successive outputs.
TC
Or equivalently, AC 
Q
TVC  TFC
AC 
Q
= AVC + AFC

TVC TFC
 
Q Q

• Thus, AC can also be given as the vertical sum of AVC and AFC.

139
 Marginal Cost (MC)

• The marginal cost is defined as the additional cost that the firm
incurs to produce one extra unit of the output. One thing to be noted
here is that, the additional cost that the firm incurs to produce the
10th unit of output is not equal to the additional cost of producing the
1000th unit. They would be equal if the TC curve is straight line.
• To sum up, the MC is the change in total cost which results from a
unit change in output i.e. MC is the rate of change of TC with respect
to output, Q or simply MC is the slope of TC function and given by

140
 Cont’’’’
•

143
 Hypothetical total, average and marginal costs

Q TFC TVC TC= AFC= AVC= ATC=TC/ MC=∆TC/∆Q

TFC+TVC TFC/Q TVC/Q Q=AFC+A
VC
0 60 0 60 - - - -

1 60 30 90 60 30 90 30

2 60 40 100 30 20 50 10

3 60 45 105 20 15 35 5

4 60 55 115 15 13.75 28.75 10

5 60 75 135 12 15 27 20

6 60 120 180 10 20 30 45

142
 Cost functions
•

TFC  100 AVC 

TVC

3Q 3  2 Q 2 10 Q 2
 3Q  2 Q  10
Q Q
TVC  3Q  2Q  10Q
3 2
TC 3Q 3  2 Q 2 10 Q 100 100
ATC   3Q 2  2 Q 10 
TFC 100 Q Q Q
AFC   dTC
9 Q 2  4 Q 10
Q Q MC 
dQ

143
 Graph of average cost curves

• TC, AC, AVC and MC curves

•The AVC curve reaches its cost

MC
AC

AVC
minimum point at Q1 output and
AC reaches its minimum point at
Q2.
AFC

• The vertical distance between AC Q1 Q2

output
and AVC (AFC) decrease
continuously as out put increases.

•The MC curve passes through the

144
 The relationship between AVC, ATC and MC

• ATC = AVC + AFC,

• Both AVC and ATC are U – shaped, reflecting the law of variable proportions
• The minimum of ATC occurs to the right of the minimum point of the AVC ( see
the above figure) this is due to the fact that ATC includes AFC which
continuously decreases as the level of output increases.
• After the AVC has reached its lowest point and starts rising, its rise is over a
certain range is more than offset by the fall in the AFC, so that the ATC
continues to fall (over that range) despite the increase in AVC.
• However, the rise in AVC eventually becomes greater than the fall in AFC so that
the ATC starts increasing.
• The AVC approaches the ATC asymptotically as output increases.

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Thank you so much!