Decision Making Process of Consumers and Firms

Decision Making Process of Consumers and FirmsThe focus of this lecture is the decision making process. Students will learn about the consumer's purchasing pattern and firm's production process. Definitions of production and cost functions will be covered.

OBJECTIVES1. Understand topics about consumption possibilities.2. Define total and marginal utilities3. Analyze the utility maximization model.4. Differentiate between economic and accounting cost and profit.5. Understand the short run and long run production and cost functions.

TOPICSPlease read all the following topics.CONSUMPTION POSSIBILITIESUTILITYUTILITY MAXIMIZATION MODELINDIFFERENCE CURVEPRODUCTION PROCESSSHORT RUNLONG RUNECONOMIC PROFIT AND PROFIT MAXIMIZATION

Consumption PossibilitiesConsumers have choices in their purchases. These choices depends on their income level and price level of goods and services. Budget line shows various combinations of products which can be purchased with a given money income and knowledge of the prices of the products. This line tells us which purchases are affordable and which are not.

The budget line is constructed by putting the quantities of two products on the X-axis and Y-axis at a given income level. The horizontal intercept is the quantity of product A that can be purchased with quantity of product B equals to 0. The vertical intercept is the quantity of product B that can be purchased with quantity of product A equals to 0.

If a consumer X has an income of $7 to spend on Product A and B, with A's price = $1, and B's price = $0.5.

The budget line is illustrated below. The vertical intercept is at quantity of B = $7 / $0.5 = 14; The horizontal intercept is at quantity of A = $7 / $1 = 7.

Budget LineIf the price of Product A decreases, the maximum quantity of Product A ( when quantity of B is 0) increases at the same income level, pushing the budget line outwards. If the price of Product A increases, the maximum quantity of Product A decreases at this income level, pushing the budget line inwards towards the origin.

An increase in money income shifts the budget line outward to the right. Likely wise, a decrease in money income shifts the budget line inward to the left. In both cases, the slope of the line will not change.

If product's price is unchanged: A's price = $1, and B's price = $0.5, the following graph illustrate the budget lines at income level of $7, $10 and $14. These lines are parallel, indicating same slope.

The slope of this curve is determined by the ratio of the price of Product A divided by the price of the Product B.

Slope of the Budget line = Price of product A / Price of product B

This slope is negative as consumers must give up some of one good to obtain more of the other goods. The slope of the budget line shows the relative price of one product in terms of the other product - opportunity cost.

If a consumer's income is $7, and price of product A is $1, the following graph illustrated the budget line with price of B changing from $0.5 to $1. Notice that the slopes of the budget lines are different, indicating the price-ratio change.

UtilityUtility or total utility (TU) refers to the amount of total satisfaction a person gets from consumption of a certain item.

Marginal Utility (MU) refers to the extra utility a consumer gets from one additional unit of a specific product. MU = change in TU / change in Q

The law of diminishing marginal utility states: successive units of a product yield smaller and smaller amounts of marginal utility.

Example: If you can have a Big Mac for free, can you have an unlimited amount at one time? As you have the first Big Mac, you probably will have a very high satisfaction level. What about the satisfaction level when you are eating the second one, the third one, or the fourth one? Your satisfaction level from successive units of Big Macs will decline. In another words, your MU decreases. Eventually your MU will be zero and then even negative. Your TU may continue to increase until you have negative MU. Then your TU will decrease also. Although consumer wants in general are unlimited, wants for specific items can be fulfilled at one time. This means that to encourage additional consumption, price must fall. Diminishing marginal utility helps to explain the law of demand.

In the following table, you may see the relationship between total utility and marginal utility.

GOOD X (PRICE=$1) GOOD Y (PRICE = $2)

QUANTITYMarginal Utility

Total UTILITY

QUANTITYMarginal Utility

Total UTILITY

1 8 8 1 10 10

2 7 15 2 8 18

3 6 21 3 6 24

4 5 26 4 4 28

5 4 30 5 3 31

6 3 33 6 2 33

7 2 35 7 1 34

Adding MU from each unit together will give you your TU. On the other hand, Subtracting MU from the TU will yield the MU.For example,1. MU at Qx = 1 is 8, and Qx= 2, is 7, TU from the first and second units of X is 8+7 = 15.

2. TU of six units of X is 33, TU of five units of X is 30, MU of the sixth unit of X is 33-30 = 3. Since the change is quantity in this example is 1, the change in quantity can be neglected.

Utility Maximization ModelThe theory of consumer behavior uses the law of diminishing marginal utility to explain how consumers allocate their incomes. The utility maximization model is built based on the following assumptions:

1. Consumers are assumed to be rational, trying to get the most value for their money. 2. Consumers’ incomes are limited because their individual resources are limited. They face a budget constraint.3. Consumers have clear preferences for various goods and services, thus they know their MU for each successive units of the product.4. Every item has a price tag. Consumers must choose among alternative goods with their limited money incomes.

The Utility Maximization rule states: consumers decide to allocate their money incomes so that the last dollar spent on each product purchased yields the same amount of extra marginal utility. The algebraic statement is that consumers will allocate income in such a way that:MU of product A / price of A = MU of product B / Price of B = MU of product C / price of C = etc.

It is marginal utility per dollar spent that is equalized. As long as one good provides more utility per dollar than another, the consumer will buy more of that good; as more of that product is bought, its MU diminishes until the amount of MU per dollar just equals that of the other products.

As the income increases, total utility increases also. Therefore, higher income groups in our society usually enjoys more products and have higher total utility levels.

An Example

GOOD X (PRICE=$1) GOOD Y (PRICE = $2)

QUANTITY MU MU/P TL UTILITY QUANTITY MU MU/P TL UTILITY

1 8 8 8 1 10 5 10

2 7 7 15 2 8 4 18

3 6 6 21 3 6 3 24

4 5 5 26 4 4 2 28

5 4 4 30 5 3 1.5 31

6 3 3 33 6 2 1 33

7 2 2 35 7 1 0.5 34

BY FOLLOWING UTILITY MAXIMIZATION RULE:

MUx / Px = MUy / Py

X Y     Mu/P

A 4 1           5

B 5 2           4

C 6 3           3

D 7 4           2

INCOME: TOTAL UTILITY

A: X=4, Y=1, $1x4+$2x1 = $6 26+10=36

B: X=5, Y=2, $1x5+$2x2 = $9 30+18=48

C: X=6, Y=3, $1x6+$2x3 = $12 33+24=57

D: X=7, Y=4, $1x7+$2x4 = $15 35+28=63

In the following example, it illustrated the consumption possibilities of this consumer under various income levels at fixed prices of Good X and Y.

Indifference CurveIndifference Curves show all combinations of two products which will yield the same level of satisfaction or utility to the consumer.

An indifference map refers to successive indifference curves where each entails a different level of utility.

As one moves away from the origin on the map, the level of utility increases. The consumer’s utility-maximizing combination of two goods will occur on the highest attainable indifference curve. That is where the budget line is tangent to an indifference curve, which is the highest attainable level of utility. Budget line shows various combinations of two products which can be purchased with a given money income and knowledge of the prices of the two products. An increase in money income shifts the budget line outward to the right; a higher level of utility will be attainable.

Production ProcessThe majority of firms has one objective: profit maximization. In order to obtain maximum profit, the firms must make many decisions. One of these is the decision of how to produce a given quantity of output. This decision depends on the relationship between a firm’s output and costs, which in turn depends on the time frame. There are two periods:

1. The short run.2. The long run.

Short Run is the time period that is too brief for a firm to alter at least one input, and the quantities of the other inputs can be varied. Variable inputs are those for which it is possible to change the quantity used in the short run. Fixed inputs are those whose amount cannot be changed in the short run. The plant size is usually fixed; labor and raw materials are usually variable in the short run. Long Run is the time period long enough for a firm to change the quantities of all resources employed. Plant size, labor and all other resources are variable in the long run.

There is no uniform amount of time dividing the short run from the long run for all industries. Short run period is usually longer in the heavy industries than in the light industries. Short run decisions are easily reversed, but the long run decisions are not easily reversed. Sunk costs should be disregarded in the decision making process. They have already been incurred and cannot be recovered. An example of a sunk cost is the past cost of a failed research and development project.

Short RunTo increase output in the short run, a firm must increase the amount used of a variable input. Three relationships are crucial in this period. (Assuming labor is the only variable input in the following discussion.)Total Product (TP or Q) is the total amount of output produced. Marginal Product (MP) of labor is the increase in output resulting from a one-unit increase in labor employed. Average Product (AP) of labor equals total output divided by the amount of labor employed.

When the marginal product of labor curve rises, the firm experiences increasing marginal returns, that is the marginal product of an additional worker exceeds the marginal product of the previous worker. At this time, the rate of increase in total product is accelerating. When the marginal product of labor curve falls, the firm experiences diminishing marginal returns, that is, the marginal product of an additional worker falls short of the marginal product of the previous worker. This is when the total product grows at a diminishing rate. As the marginal product continues to decrease, it will eventually become zero, then negative. This is when the total product declines. The law of diminishing returns states that as successive units of a variable resource are added to a fixed resource, the marginal product of the variable input eventually diminishes, assuming all units of variable inputs- workers in this case are of equal quality.

Marginal product diminishes not because successive workers are inferior but because more workers are being used relative to the amount of plant and equipment available. For example, a doctor’s office has only one doctor and several assistants. This office is getting very busy; so more assistants are hired. The number of patients served by this office cannot increase without limit. Eventually, the additional assistant will not be able to increase the number of patients in this office. It is not because this extra assistant is inferior, but because there is only one doctor in this office. Doctor may be considered as fixed resource, while assistants can be considered variable resources.

The average product increases when the marginal product exceeds the average product. The average product falls when the marginal product is smaller than the average product. The average product is at its maximum and does not change when the marginal product equals the average product. This is the usual relationship between average and marginal variables. If your GPA or grade point average is 3.0, by getting A (4.0) in this class, you can increase your GPA. GPA is the average variable; your grade of each class is the marginal variable. A marginal variable which is greater than the average variable will increase the average variable, a smaller than average marginal variable will lower the average variable.

Short Run CostsTotal Cost (TC) is the cost of all the productive resources used by the firm. It can be divided into two separate costs in the short run. Total Fixed Cost (TFC) is costs of firm’s fixed resources; TFC does not vary with changes in short-run output. Total Variable Cost ( TVC) are costs of firm’s variable resources, TVC does vary with changes in output.

TC = FC + VCAverage Total Cost (ATC) is the total cost per unit of output. Average Fixed Cost (AFC) is the total fixed cost per unit of output. Average Variable Cost (AVC) is the total variable cost per unit of output. ATC = TC / Q; AFC = FC / Q; AVC = VC / Q.ATC = TC / Q = (FC + VC) / Q = (FC / Q) + (VC/Q) = AFC + AVC

Marginal Cost (MC) is the increase in total cost resulting from a one-unit increase in output. Marginal decisions are very important in determining profit levels.

All curves are U-shaped, except the AFC curve. The AFC curve is downward sloping because the fixed costs are spread over output. As output increases, the AFC decreases. Marginal cost is a reflection of marginal product and diminishing returns. When diminishing returns begin, the marginal cost will begin its rise. The MC is related to AVC and ATC. These costs will fall as long as the marginal cost is less than either average cost. As soon as the MC rises above the average, the average will begin to rise. Once again, you can think of the GPA example. MC curve cuts the ATC and AVC curves at their minimums.

The shapes of a firm’s cost curves are determined by the technology it uses. MC is at its minimum at the same output for which MP is at its maximum; AVC is at its minimum at the same output for which AP is at its maximum. A technological advance that increases productivity shifts the product curves upward and cost curves downward. If a technological advance requires that more capital and less labor be used, at low levels of output the ATC curve shifts upward and at higher levels of output the ATC curve shifts downward. Cost curves will shift if the resources’ prices changes. For example, an increase in minimum wage will shift the MC, AVC and ATC upward as labor is a variable resource. An increase in fixed cost shifts the AFC and ATC upward but does not shift MC and AVC.

Long RunLong Run Costs

Long run production costs include all costs after plant and industry size are allowed to change (expand or contract). The long run ATC curve shows the least per unit cost at which any output can be produced after the firm has had time to make all appropriate adjustments in its resources.

When long run ATC falls as output level increases, there are economies of scale.

When long run ATC rises as output level increases, there are diseconomies of scale.

When long run ATC remains constant as output level increases, there are constant returns to scale.

Bank mergers in the 1980s occurred with the expectation that economies of scale would result. But several recent studies conclude that these mergers have not reduced costs significantly. Economies of scale do not always occur as expected.

Profit MaximizationEconomic profits (EP) are defined as the difference between total costs (TC) and total revenue (TR). EP = TR – TC

Total revenue (TR) is the price multiplied by the quantity sold. TR = Price X Quantity

Total costs include both implicit and explicit costs. In another words: payments to owners (Normal profit) and non-owners for their resources are both included in the total cost. Economic profit is different from accounting profit because accounting profit does not account for implicit costs. Therefore, total cost should include cost from labor (wage), capital (interest), land (rent), and entrepreneurial ability ( normal profit).

TC = explicit cost + implicit cost = FC + VC (in the short run period)TR = Price X QuantityEP = TR – TC

Producers will choose the lowest cost production method in their production process. Within their production capabilities, they may also choose the most profitable product to produce. Their goal is to maximize their economic profit.