Managerial Economics– Chapter 4 & 5- Consumer Choice &

Production
Session 3

Dr.Dimple Pandey
 Learning Objectives

 Consumer preference
 Utility
 The budget constraint
 Indifference curve and its properties
 Constrained consumer choice

 Production function – short run and long run

 Returns to scale
• Producers’ equilibrium
 Consumer Preferences-Introduction

 As a consumer you have to satisfy your unlimited wants with limited resources. We need to
priortise our wants on the basis of urgency and intensity of such wants and paying capacity
i.e income. Demand for a commodity is based on various factors such as income, tastes of
the consumers, price etc.
 Consumer Preferences

 A consumer faces choices involving many goods and must allocate his or her available
budget to buy a bundle of goods.

 Would ice cream or cake make a better dessert? Is it better to rent a large apartment
or rent a single room and use the savings to pay for concerts?

 How do consumers choose the bundles of goods they buy?

 One possibility is that consumers behave randomly and blindly choose one good or
another without any thought.

 Another is that they make systematic choices.

 To explain consumer behavior, economists assume that consumers have a set of tastes or
preferences that they use to guide them in choosing between goods.

 These tastes differ substantially among individuals.

 Properties of Consumer Preferences

 Completeness/Decisiveness

• When a consumer faces a choice between any two bundles of goods, only one of the following
is true. The consumer might prefer the first bundle to the second, or the second bundle to the
first, or be indifferent between the two bundles. Indifference is allowed, but indecision is not.
According to the assumption of decisiveness/completeness, the individual would act in one of
the following ways:
• Opt for pizza
• Opt for burger
• Opt for none of the two and walk out
 Properties of Consumer Preferences

 Transitivity

 If a is strictly preferred to b and b is strictly preferred to c, it follows that a must be

strictly preferred to c. Transitivity applies also to weak preference and indifference
relationships. In the above example, if the individual chooses pizza over burger,
burger over pasta, then the individual would prefer pizza over pasta too as per the
assumption of transitivity.

 According to Transitivity, preferences of an individual consumer are always

consistent.

 More is better

 All else being the same, more of a good is better than less. This is a nonsatiation
property.
 Consumer Preferences-Sellers want to know
Sellers have to take various important production decisions on the basis of consumers’ tastes and
preferences.

An insight into consumers’ buying behaviour and perception helps firms in identifying new
marketing variables such as product offering, pricing strategy etc.

The basis of consumers’ buying behaviour is the concept of utility.

 Introductory caselet: consumer demand for bottled water

• According to a study conducted by IKON Marketing Consultants India, an Ahmedabad-based

market research firm, the bottled water market in India is estimated to be INR 8,000 crores.
The bottled water market is growing at a compound annual growth rate (CAGR) of 19%,
which is expected to grow over four-folds by 2020.
• According to the report, consumers’ increasing awareness for health and safety, scarcity of
safe drinking water, and aggressive expansion by market players are the reasons behind the
expansion of the bottled water industry during the past decade.
 Introductory caselet: consumer demand for bottled water

• Because of an outburst of waterborne diseases, consumers have become concerned about their
health and safety. They do not mind spending on bottled water in spite of its higher per unit
cost against tap water. The awareness about the need for safe drinking water has spread even
in rural areas and small towns, which has aggravated the sale of bottled water all over the
country.
• Apart from this, factors, such as increased disposable income of consumers, growth of
organised retail, and focus on product extension and quality, may further stimulate the growth
of the industry.
 Utility as a Basis of Consumer Demand

• Utility can be defined as a measure of satisfaction received by a consumer on the consumption

of a good or service. Utility is a relative term which means that a product may give
satisfaction to one individual while be of no use to the other.
• Our consumer behavior model assumes that consumers can compare bundles of goods and
take the one with the greatest satisfaction.
 Total Utility (TU)

• Total utility is defined as the sum of the utility derived by a consumer from the different
units of a commodity or service consumed at a given period of time.
• If an individual consumes five units of a commodity X at a given period of time and derives
utility out of the consumption of each unit as U1, U2, U3, U4, and U5.
TU = U1 + U2 + U3 + U4 + U5
 Marginal Utility

• Marginal utility is defined as the utility derived from the marginal or additional unit of a
commodity consumed by an individual.
• Marginal Utility= TUn –TUn – 1
 Law of Diminishing Marginal Utility

• When an individual continues to consume more and more units of a commodity per unit of
time, the utility that he/she obtains from each successive unit continues to diminish.
• For example, the utility derived from the first glass of water is high, but with successive
glasses of water, the utility would keep diminishing.

Units of Commodity X Total Utility (TUx) Marginal Utility (MUx)

0 0 -
1 8 8
2 14 6
3 18 4
4 19 1
5 19 0
6 17 -2
 Cardinal Utility Approach - Neo Classical Approach
• Neo-classical economists believed that utility is cardinal or quantitative like other
mathematical variables, such as height, weight and temperature. They developed a unit of
measuring utility called utils.
• For example, according to the cardinal utility concept, an individual gains 12 utils from a
pizza and 9 utils from french fries.
• Cardinal utility if we know absolute numerical comparisons.
 Ordinal Utility Approach – modern economists Indifference
Curve Analysis

• According to the ordinal theory, utility is a psychological phenomenon like happiness,

satisfaction, etc. It is highly subjective in nature and varies across individuals. Therefore, it
cannot be measured in quantifiable terms.
• Most of our discussion of consumer choice holds if utility has only ordinal properties. We care
only about the relative utility or ranking of the two bundles.
• For example, a consumer may prefer ice-cream over soft drink. In such a case, ice-cream
would have 1st rank, while 2nd rank would be given to soft drink.
Cardinal vs Ordinal Utility Approach
 Ordinal Utility Approach – modern economists Indifference
Curve Analysis

• As per the ordinal utility approach, a consumer identifies several pairs of two commodities
which would provide him/her the same level of satisfaction. Among these pairs, he/she may
prefer one commodity over the other based on how he/she ranks them in order of utility. This
implies that utility can be ranked qualitatively and not quantitatively.
 Ordinal Utility Approach – Concepts

Meaning of Indifference Curve

• An indifference curve is the set of all bundles of goods that a consumer views as being equally
desirable, which yield the same level of utility to a consumer.
• The consumer is indifferent to any combination of two commodities if he/she has to make a
choice between them.
• When these combinations are plotted on the graph, the resulting curve is called indifference
curve. This curve is also called the iso-utility curve or equal utility curve.
 Ordinal Utility Approach – Indifference Curve Analysis

Indifference Schedule for Substitutes X and Y

Combin Units of Units of Total Utility

ation Commodity Commodity
Y X
a 25 3 U
b 15 5 U
c 8 9 U
d 4 17 U
e 2 30 U
 Ordinal Utility Approach – Marginal Rate of Substitution

• Marginal rate of substitution (MRS) refers to the rate at which one commodity can be
substituted for another commodity maintaining the same level of satisfaction and remaining on
the same indifference curve.
Diminishing MRS between X and Y

Indifferen Combinatio Change in Change in MRSy,x

ce points ns Y+X Y (ΔY) X (ΔX) (ΔY/ ΔX)
a 25 + 3 - - -
b 15 + 5 -10 2 -5.00
c 8+9 -7 4 -1.75
d 4 + 17 -4 8 -0.50
e 2 + 30 -2 13 -0.15

As the consumer moves from combination a to b on IC, he/she sacrifices 10 units of

commodity Y and gets 2 units of commodity X.
 Properties Of Indifference Curve

• ICs are negatively sloped and convex to the origin- As a consumer increases the
consumption of commodity X, he/she sacrifices some units of commodity Y in order to
maintain the same level of satisfaction.
• Higher IC represents higher satisfaction level
• ICs do not intersect
 Curvature of Indifference Curves

• Convex indifference curves reflect imperfect substitutes

• Straight-line indifferences curves reflect perfect substitutes, goods that are essentially
equivalent for the consumer
• Right-angle indifference curves reflect perfect complements, goods consumed only in fixed
proportions
 Concept of Budget Line

• A budget line, also called price line, represents various combinations of two commodities,
which can be purchased by a consumer at the given income level and market price. The
budget line is an important element of consumer behaviour analysis.

• A budget line is the locus of all commodity combinations that a consumer can purchase by
spending all his/her income.
 Concept of Budget Line
• If there are only two commodities X and Y. The
price of X is Px and that of Y is Py. Let Qx be
the quantity of commodity X and Qy be the
quantity of commodity Y, purchased by the
consumer with income M. Then, the budget
equation is represented as follows:

M = Px Qx + Py Qy

• The budget equation states that the total

expenditure of a consumer on various
combinations of commodities X and Y cannot
exceed his/ her money income M.
 Budget Line

A is not attainable as it represents a combination of

commodities beyond the individual’s income.

N is not desirable as at this point consumer can still buy more

of both commodities.
 Budget Line

Suppose Sam’s income to be spent on M and N is Rs 1000 per month. Price per unit of M is Rs
10 and that of N is Rs 20. Budget equation is______
Few possible combinations could be

Combination Quantity of M Quantity of N

A 0 50

B 20 40

C 40 30
Shifts in Budget Line
 Consumer Equilibrium Effects
• A consumer reaches a state of equilibrium when
he/she attains maximum total utility at the given
income level and market price of commodities. The
consumer is at
equilibrium at point E.
• As the IC2 curve is tangent to the budget line AB,
IC2 is the highest indifference curve that a
consumer can attain at the given income level and
market price

of commodities.
• At point E, the consumer consumes quantities OQx
of X and OQy of Y to yield maximum satisfaction.
Production
 Production Functions

 A firm uses a technology or production process to transform inputs or factors of

production into outputs.

 Inputs

 Capital (K) - land, buildings, equipment

 Labor (L) – skilled and less-skilled workers

 Materials (M) – natural resources, raw materials, and processed products

 Output

 It could be a service, such as an automobile tune-up by a mechanic, or a physical

product, such as a computer chip or a potato chip
 Production Functions
 The production function concept
 Maximum quantity of output that can be produced with different combinations of
inputs, given current knowledge about technology and organization
 A production function shows only efficient production processes because it gives the
maximum output.
 Production Function: q = f(L, K)
 Production function for a firm that uses only labor and capital
 q units of output (wrapped candy bars) are produced using L units of labor services
(hours of work by assembly-line workers) and K units of capital (number of
conveyor belts).
 Production Functions, Time and Variability of Inputs
 Short run: a period of time where at least one factor of production cannot be varied.
Inputs can be fixed or variable.
 Long run: period of time that all relevant inputs can be varied. Inputs are all
variable.
 Production Function-Uses

• Helps in making short-term decisions, such as optimum level of output.

• Helps in making long-term decisions, such as deciding the production level.
• Helps in calculating the least cost combination of various factor inputs at a given level of
output.
• Gives logical reasons for making decisions. For example, if price of one input falls, one can
easily shift to other inputs.
Total Product, Marginal Product, and Average Product of
Labor with Fixed Capital-Short-Run Production(capital is
fixed and labor is variable)
 Short-Run Production

The Effect of Extra Labor

 Output rises with labor until it reaches its maximum of 110 computers at 11 workers

 Average product of labor first rises and then falls as labor increases. Also, the marginal
product of labor first rises and then falls as labor increases.

 Average product may rise because of division of labor and specialization. Workers become
more productive as we add more workers. Marginal product of labor goes up, and
consequently average product goes up.

 Average product falls as the number of workers exceeds 6. Workers might have to wait to
use equipment or get in each other’s way because capital is constant. Because marginal
product of labor goes down, average product goes down too.
 Law of Diminishing Returns

• It explains that when more and more units of a variable input are employed at a given quantity
of fixed inputs, the total output may initially increase at an increasing rate and then at a
constant rate, and then it will eventually increase at diminishing rates.
• Let us understand the law of diminishing returns with the help of an example. Suppose an
organisation has fixed amount of land (fixed factor) and workers (variable factor) as the labour
in the short-run production. For increasing the level of production, it can hire more workers.
 Law of Diminishing Returns
Law of Diminishing Returns

Total Marginal Average Stages of Production

No.of Workers(L) Product(TPL) Product(MPL) Product(APL) (on the basis of MPL)
0 0 0 0
1 80 80 80
2 170 90 85
3 270 100 90 Increasing Returns
4 368 98 92
5 430 62 86
6 480 50 80
7 504 24 72 Diminishing Returns
8 504 0 63
9 495 -9 55
10 470 -25 47 Negative Returns

•We can see that MP of labour rises till 3 units of labour.

•Beyond this point, the MP of labour starts decreasing.
•After using the 8 units of labour, the MP of labour starts becoming negative.
 Law of Diminishing Returns

• The law of diminishing returns determines the optimum labour required to produce the
maximum output.
• stages 1 and 3 depict the increasing and negative returns, respectively. If an organisation is in
stage 1 of the production, more increase in labour is required to increase the production. If an
organisation is in stage 3, then it needs to reduce the labour to reduce production.
• Stage 2 provides information about the number of workers that needs to be employed for
reaching the maximum level of production. Thus, this stage is helpful in making important
business decisions.
 Long-Run Production

 In the long run, labor and capital are variable.

 The firm can substitute one input for another while

continuing to produce the same level of output, ͞q.

Isoquants: ͞q = f (L,K)

 An isoquant shows the efficient combinations of

labor and capital that can produce the same (iso)
level of output (quantity).
 output q is produced with the combination of
labor L and capital K.
 points a, b, c and d show the same level of
output, q = 24.
 Long-Run Production

Output Produced with Two Variable Inputs

 Isoquant Curves

• A technical relation that shows how inputs are converted into output is depicted by an
isoquant curve. It shows the optimum combinations of factor inputs with the help of prices of
factor inputs and their quantities that are used to produce the same output. There are only two
factor inputs, labour and capital, to produce a particular product. For example, for producing
100 calendars, 90 units of capital and 10 units of labour are used.
• The slope of the isoquant curve is the rate of substitution that shows how one input can be
substituted for another while holding the output constant. This is called marginal rate of
technical substitution (MRTS).
 Marginal Rate Of Technical Substitution
• The slope of the isoquant curve is the rate of substitution that shows how one input can be
substituted for another while holding the output constant.
• The marginal rate of technical substitution may be defined as the rate at which one factor is
substituted for another with output held constant.” The formula for calculating MRTS is as
follows:

MRTS of labour for capital, MRTS(L,K) = - ΔK/ΔL

where, ΔK = Change in capital

ΔL= Change in labour

• If ΔL units of labour are substituted for ΔK units of capital, then the increase in output due to
increase in ΔL should match with the decrease in output due to decrease in ΔK.
 Isoquant Curves

Combinations of two factor inputs

Labour Capital MRTS = - ΔK/ΔL
6 40
7 28 12:1
8 18 10:1
9 12 6:1
10 8 4:1
 Long-Run Production
How the Marginal Rate of Technical Substitution Varies Along
an Isoquant
 Isoquant Curves Properties
• Isoquant curves slope downwards: It implies that the slope of the isoquant curve is negative.
This is because when capital (K) is increased, the quantity of labour (L) is reduced or vice
versa, to keep the same level of output.
• Isoquant curves are convex to origin: It implies that factor inputs are not perfect substitutes.
• Isoquant curves cannot intersect each other: If the isoquants intersect each other, it would
imply that a single input combination can produce two levels of output, which is not possible.
• The higher the isoquant the higher the output: It implies that the higher isoquant
represents higher output. The upper curve of the isoquant produces more output than the curve
beneath. This is because the larger combination of input results in a larger output as compared
to the curve that is beneath it.
 Forms Of Isoquants
• Linear Iso-quant Curve- This curve shows the
perfect substitutability between the factors of
production. This means that any quantity can be
produced either employing only capital or only
labor or through “n” number of combinations
between these two.
• L-shaped isoquant- This is the case of perfect
complements. When the production isoquants are
L-shaped, only one combination of labour (L) and
capital (K) can be used to produce a given output.
The addition of more labour does not increase
output, nor does the addition of more capital
alone.
 Returns to Scale

• The law of returns to scale explains the proportional change in output with respect to
proportional change in inputs.
• The assumptions of returns to scale are as follows:
– The firm is using only two factors of production that are capital and labour.
– Labour and capital are combined in one fixed proportion.
– Prices of factors do not change.
– State of technology is fixed.
 Increasing Returns to Scale

It is a situation in which output increase by a greater proportion than increase in factor inputs. For
example, to produce a particular product, if the quantity of inputs is doubled and the increase in
output is more than double, it is said to be an increasing returns to scale. When labour and capital
are doubled from 2 to 4 units, output increases more than double, that is, from 50 units to 120
units. This is increasing returns to scale, which occurs because of economies of scale.
 Constant Returns to Scale

A constant return to scale implies the situation in which an

increase in output is equal to the increase in factor inputs.

For example in the case of constant returns to scale, when

the inputs are doubled, the output is also doubled. When

labour and capital are doubled from 2 to 4 units, output

also doubles from 50 units to 100 units. This is constant

returns to scale.
 Diminishing Returns to Scale
Diminishing returns to scale refers to a situation in
which output increases in lesser proportion than
increase in factor inputs. For example, when capital
and labour are doubled, but the output generated is
less than double, the returns to scale would be termed
as diminishing returns to scale. When labour and
capital are doubled from 2 to 4 units, output increases
less than double that is from 50 units to 80 units. This
is diminishing returns to scale. Diminishing returns to
scale is due to diseconomies of scale, which arises
because of the managerial inefficiency.
 Iso-Cost Curves
• An isocost show all combinations of factors that cost the same amount.
• The algebraic equation of linear iso-cost line is as follows:

C = PL×L + PK×K
Where,
PL = Price of labour
PK = Price of capital
• For example, a producer has a total budget of ₹ 120, which he wants to spend on the factors of
production, namely, X and Y. The price of X in the market is ₹ 15 per unit and the price of Y
is ₹ 10 per unit.
 Iso-Cost Curves
Combinat Units of X Units of Y Total
ions expenditure
A 8 0 120
B 6 3 120
C 4 6 120
D 2 9 120
E 0 12 120

Isocosts and isoquants can show the optimal combination of factors of production to produce the
maximum output at minimum cost.
 Producer’s Equilibrium

• Producer’s equilibrium implies a situation in which a producer maximises his/her profits.

Thus, he /she chooses the quantity of inputs and output with the main aim of achieving the
maximum profits.
• Least cost combination is that combination at which the output derived from a given level of
inputs is maximum or at which the total cost of producing a given output is minimum.
 Producer’s Equilibrium

• Suppose a producer wants to produce pencils with a total expenditure of ₹ 1500. The factors
of production to produce pencils involve labour and capital. He can hire 30 units of labour
with no capital or 20 units of capital with no labour. However, for producing pencils, he wants
to have the optimum combination of both the factors

The optimum combination is depicted by point E,

where 10 units of capital and 15 units of labour are
used. At point E, isoquant curve IQ is tangent to iso-
cost line AB.
 Let’s Sum Up

• Utility can be defined as a measure of satisfaction received by a consumer on the consumption

of a good or service.
• The law of diminishing marginal utility states that as the quantity consumed of a commodity
continues to increase, the utility obtained from each successive unit goes on diminishing,
assuming that the consumption of all other commodities remains the same.
• An indifference curve is the set of all bundles of goods that a consumer views as being equally
desirable, which yield the same level of utility to a consumer.
• A budget line represents various combinations of two commodities, which can be purchased
by a consumer at the given income level and market price.
 Let’s Sum Up

• Production Functions. A production function summarizes how a firm combines inputs such as
labor, capital, and materials to produce output using the current state of knowledge about
technology and management.
• Production function with one variable input-Short run
– Law of Diminishing Returns
– Increasing, Diminishing and Negative Returns to the Variable Factor

• Production function with two variable inputs-Long run

– Isoquants
– MRTS
– Returns to Scale
– Isocost
 Let’s Sum Up

Consumer Equilibrium Effects Producer’s Equilibrium-Long Run