Business Economics

Session 3
Professor David Shepherd

Imperial College Business School

Consumer Theory:
Preferences, Constraints and Choices

Reading:
Pindyck and Rubenfeld, Chapters 3 & 4
Sexton, Chapters 4 &5

Imperial College Business School

Available Alternatives
Market basket (or bundle) Lists specific quantities of one or
more goods that a consumer might buy. To explain the theory
of consumer behavior, we will ask whether consumers prefer
one market bundle to another
Market Bundle

Units of Food

Units of Clothing

20

30

10

50

40

20

30

40

10

20

10

40

Consumer Preferences: Assumptions

Completeness: Preferences are assumed to be complete. In other
words, consumers can compare and rank all possible bundles. Thus, for
any two market bundles A and B, a consumer will either prefer A to B,
prefer B to A, or be indifferent between the two. Indifference means
that a person is equally satisfied with either bundle
Transitivity: Preferences are transitive. Transitivity means that if a
consumer prefers bundle A to bundle B and bundle B to bundle C, then
the consumer also prefers A to C. Transitivity implies consumer
consistency in consumer decision-making
More is better than less: Consumers always prefer more of any good
to less. In addition, consumers are never satisfied or satiated; more is
always better, even if just a little better

Consumer Preferences: Indifference Curves

The indifference curve

shows the bundles of goods
that give the same level of
utility (satisfaction)
The consumer prefers bundle E,
which lies above U1, to A, but
prefers A to H or G, which lie
below U1.

The Indifference Map

indifference map: a set of indifference curves showing the market
bundles between which a consumer is indifferent.

An indifference map is a set

of indifference curves that
describes a person's
preferences.
Higher indifference curves
show higher utility
Any bundle on indifference
curve U3, such as A, is
preferred to any bundle on
curve U2 such as B, which in
turn is preferred to any
bundle on U1, such as D.

Preferences and the Indifference Map

The indifference map is a mapping of
consumer preferences and it must satisfy
our assumptions about those preferences.
For example, if indifference curves U1 and
U2 intersect, our assumptions are violated.
According to this diagram, the consumer
should be indifferent between bundles A
and B, and A and D, and transitivity
therefore implies indifference between A
and D. But B should be preferred to D
because B has more of both goods.

So our assumptions imply indifference

curves can not intersect.

The Marginal Rate of Substitution in

Consumption
marginal rate of substitution: the amount of a good that a consumer is
willing to give up in order to obtain one additional unit of another good.
The magnitude of the slope of an
indifference curve measures the
consumers marginal rate of
substitution (MRS) between two goods.
In this figure, the MRS between
clothing (C) and food (F) falls from 6
(between A and B) to 4 (between B and
D) to 2 (between D and E) to 1
(between E and G)
Convexity. When the MRS diminishes
along an indifference curve, the curve
is convex. The assumption of convexity
implies that the more of one good the
consumer has ( food), the less willing
he or she is to give up the other good
(clothing) and vice versa

Budget Constraints
The indifference map shows how consumer preferences are ordered, but to
determine what a consumer will actually buy we need to know how much
income is available to spend and the prices of the goods. Income is limited and so
the consumer faces a budget constraint.
The budget constraint shows all combinations of goods for which the total
amount of money spent is equal to available income.
Suppose income is $80 and food and clothing are priced at $1 and $2
respectively. We can then calculate the bundles the consumer can afford to buy.
Market Bundles and the Budget Constraint

Market Bundle

Food (F)

Clothing(C)

Total Spending

40

$80

20

30

$80

40

20

$80

60

10

$80

80

$80

The Budget Line

A Budget Line
A budget line describes the
combinations of goods that can be
purchased given the consumers
income and the prices of the
goods.
Line AG (which passes through
points B, D, and E) shows the
budget associated with an income
of $80, a price of food of PF = $1
per unit, and a price of clothing of
PC = $2 per unit.
The slope of the budget line
(measured between points B and
D) is PF/PC = 10/20 = 1/2.

Changes in Household Income

Effects of a Change in Income
on the Budget Line
Income changes A change in
income (with prices unchanged)
causes the budget line to shift
parallel to the original line (L1).
When the income of $80 (on L1)
is increased to $160, the budget
line shifts outward to L2.
If the income falls to $40, the
line shifts inward to L3.

Changes in Prices
Effects of a Change in Price on
the Budget Line

A change in the price of one

good (with income unchanged)
causes the budget line to
rotate
When the price of food falls
from $1.00 to $0.50, the
budget line rotates outwards
from L1 to L2.
However, when the price
increases from $1.00 to $2.00,
the line rotates inwards from L1
to L3.

Consumer Choice
Maximizing Consumer Satisfaction
The consumer aims to achieve maximum satisfaction from consumption (utility maximization).
The choice must satisfy two conditions: it must be located on the budget line and it must give
the consumer the most preferred combination of goods and services.
The consumer chooses bundle A
where the budget line and
indifference curve U2 are
tangential.

No higher level of satisfaction

(e.g., bundle D) can be attained,
given the consumers income and
for any other bundle on the
budget line the consumer would
reach a lower level of satisfaction
(a lower indifference curve)
At point A, the MRS between the
two goods equals the price ratio:
MRS = Pf / Pc = 1 / 2

The Impact of a Price Change: Normal Goods

Income and Substitution Effects: Normal Good
A decrease in the price of food has
both an income effect and a
substitution effect.
The consumer is initially at A, on
budget line RS.
When the price of food falls,
consumption increases by F1F2 as the
consumer moves to B.
The substitution effect F1E (associated
with a move from A to D) changes the
relative prices of food and clothing but
keeps real income (satisfaction)
constant.
The income effect EF2 (associated with
a move from D to B) keeps relative
prices constant but increases
purchasing power.
Food is a normal good because the
income effect EF2 is positive.

The Impact of a Price Change: Inferior Goods

Income and Substitution Effects: Inferior Good
The consumer is initially at A on
budget line RS.
With a decrease in the price of food,
the consumer moves to B.
The resulting change in food
purchased can be broken down into
a substitution effect, F1E (associated
with a move from A to D), and an
income effect, EF2 (associated with
a move from D to B).
In this case, food is an inferior good
because the income effect is
negative.
However, because the substitution
effect exceeds the income effect,
the decrease in the price of food
leads to an increase in the quantity
of food demanded.

Individual and Market Demand

Summing Individual Demands to Obtain a Market Demand Curve
The market demand curve is
obtained by summing individual
consumers demand curves,
such as DA, DB, and DC.
At each price, the quantity of
coffee demanded in the market
is the sum of the quantities
demanded by each consumer.
At a price of $4, for example, the
quantity demanded by the
market (11 units) is the sum of
the quantity demanded by A (no
units), B (4 units), and C (7
units).

Marginal Consumption Benefits

Given the relative prices of food and cloth, the consumer
reaches his or her most preferred position by consuming at the
point where MRS = PF/PC . The MRS can be thought of as
measuring the marginal benefit the consumer obtains from the
consumption of the last unit each product purchased and the
relative price is the cost of obtaining that unit.
Using this interpretation , we can then say that satisfaction is
maximized when the marginal benefitthe benefit associated
with the consumption of one additional unit of foodis equal
to the cost of obtaining that unit.

Marginal Consumption Benefits and the

Demand Curve
The vertical height of the demand
curve shows the max prices
consumers would pay to obtain
additional units of output. These
price valuations reflects the
perceived marginal benefits.
The demand curve is downwardsloping because increased
consumption of the product
implies that additional units are
valued less highly

P1

The downward slope of the

demand curve reflects
diminishing MRS. As the
consumer has more of this
product, additional units are
valued less highly and the
consumer will only buy them if
the price is lower

D (marginal benefit)
Q

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Consumer Surplus
Consumer surplus Difference between what a consumer
is willing to pay for a good and the amount actually paid.
Consumer surplus is the total
benefit from the
consumption of a product,
less the total cost of
purchasing it.
Here, the consumer surplus
associated with six concert
tickets (purchased at $14 per
ticket) is given by the yellowshaded area:
$6 + $5 + $4 + $3 + $2 + $1 =
$21

Consumer Surplus and the Demand Curve

For the market as a
whole, consumer surplus
is measured by the area
under the demand curve
and above the line
representing the purchase
price of the good.
Here, the consumer
surplus is given by the
yellow-shaded triangle
and is equal to
1/2 ($20 $14)
6500 = $19,500.

Price Changes and Consumer Surplus

When the market price is lower consumers are better off because they can buy more
units a cheaper price. Can we get a money measure of how much they gain from a
price fall, or how much worse off they would be if the price went up. One way is to
examine how consumer surplus changes.
Price

At P1 consumer surplus = a b P1

a
P1
P2

At P2 consumer surplus = a c P2
The price fall generates an
increase in consumer surplus

b
c

CS = P1 b c P2
D (marginal benefit)
Quantity

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End of Session 3

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Business Economics
Session 4
Professor David Shepherd

Imperial College Business School

23

Production Choices and Production Costs

Reading:
Pindyck and Rubenfeld, Chapters 6 & 7
Sexton, Chapter 11

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The Production Process

Units of output are produced when firms use labour and capital and a
given technology in production processes which involves the
transformation of inputs into outputs
The inputs are raw materials, components and energy

The outputs are the products that come out of the production process
The firms production costs are the total of all costs incurred in the
production process, including the costs associated with the use of labour
and capital as well as the cost of materials

To determine the behaviour of production costs we need to examine the

nature of the production process and how labour and capital costs
influence the production decision

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The Technology of Production

The Production Function:
Q = f (L, K) A
Production Periods

Short run Period of time during which quantities of one or more of

the factors of production cannot be changed. The fixed factors are
usually taken to be capital and technology
Long run Period during which all of the factors of production can
be changed. In the log run all of the productive factors are variable

Labour and Capital Productivity

Q = f(L,K)A
The marginal product of labour is the extra output produced by an
extra unit of labour, holding capital constant
Q

= MPL

The marginal product of capital is the extra output produced by and

extra unit of capital, holding labour constant

= MPK

Production with Variable Capital and Labour

Production with Two Variable Inputs
LABOR INPUT
CAPITALI
NPUT

20

40

55

65

75

40

60

75

85

90

55

75

90

100

105

65

85

100

110

115

75

90

105

115

120

Isoquant
a curve showing all possible
combinations of inputs that
yield the same output

The Isoquant Map

Isoquant map Mapping of a number of isoquants, used to
describe a production function.
A set of isoquants, or isoquant
map, describes the firms
production function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D),
to isoquant q2 (75 units per
year at points such as B) and
to isoquant q3 (90 units per
year at points such as C and
E).

The Marginal Rate of Technical Substitution

Marginal Rate of Technical Substitution (MRTS) is the amount by which one
input can be reduced when an extra unit of the other input is used, so that
output remains constant.
Isoquants are downward sloping
and convex. The slope at any
point measures the MRTS,
which shows the terms on which
the firm can replace capital with
labor (or vice versa) while
maintaining the same level of
output.
MRTS= (K/)
On isoquant q2, the MRTS falls
progressively:

2/1

=2

1/1

=1

(2/3)/1 = 2/3
(1/3)/1 =1/3

MRTS = Change in capital input/change in labor input

= K/L (for a fixed level of q)

Production Functions: A Special Case

Isoquants When Inputs Are Perfect Substitutes

When the isoquants are

straight lines, the MRTS is
constant. Thus the rate at
which capital and labor can
be substituted for each other
is the same no matter what
level of inputs is being used.
Points A, B, and C represent
three different capital-labor
combinations that generate
the same output q3.

Production Functions: Another Special Case

Isoquants When Inputs Can Only Be Used In Fixed-Proportions
When the isoquants are Lshaped, only one combination
of labor and capital can be
used to produce a given
output (as at point A on
isoquant q1, point B on
isoquant q2, and point C on
isoquant q3). Adding more
labor alone does not increase
output, nor does adding more
capital alone.

The fixed-proportions
production function describes
situations in which methods
of production are limited.

Production with Variable Capital and Labour:

Returns To Scale
Returns to scale is a term to describe the rate at which output rises
as inputs are both increased in the same proportion
Increasing returns to scale Situation in which output more than
doubles when all inputs are doubled
Constant returns to scale Situation in which output doubles
when all inputs are doubled
Decreasing returns to scale Situation in which output less than
doubles when all inputs are doubled

Returns To Scale on the Isoquant Map

When a firms production process exhibits

constant returns to scale as shown by a
movement along line 0A in part (a), the
isoquants are equally spaced as output
increases proportionally.

However, when there are increasing

returns to scale as shown in (b), the
isoquants move closer together as
inputs are increased along the line.

Output with Fixed Capital:

Diminishing Marginal Labour Productivity
Holding the amount of
capital fixed at a particular
level (say 3) we can see that
each additional unit of
labour generates less and
less additional output. In
other words, the marginal
product of labour declines as
output rises when K is held
constant

Labour and Capital Costs

In the long run the firm can alter both its capital and labor inputs
and move to a different scale of production
To determine the best combination of labor and capital the firm
needs to look at the cost of labor relative to the cost of capital
The cost of a unit of labor is the market wage rate w
If capital is purchased, the cost of using that capital is the interest
rate cost of the money used to buy it, plus any depreciation cost.
If capital is rented, the cost is the rental cost.
If capital markets are efficient we would expect the rental cost and
user cost of capital to be the same
So we think of the cost of capital in general as r which is either
the rental cost or the interest plus depreciation cost

Producing at Minimum Cost

Firms will want to produce output at the lowest possible cost. How does
a firm select the capital and labour inputs to produce a given output at
minimum cost?
Leaving material costs to one side just for the moment, the firm has to
consider the productivity of the labor and capital it could use in the
production process and the cost of hiring those inputs
The total cost C of producing a given quantity of output is the sum of
the labour cost and the capital cost:

C= w L + r K
This information can be combined with the isoquant map to determine
the input choice associated with any quantity of output
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The Isocost Line

The total cost of producing any quantity of output depends on the
wage rate and the quantity of labour used and the cost of capital
and the quantity of capital used
C= w L + r K
The total cost equation can be re-arranged as

K = C/r (w/r)
For a given value of C, this equation is called the isocost equation,
or the isocost line, because it shows the different combinations of
L and K which generate the same cost C

The isocost line has a slope of K/L = (w/r)

The slope is therefore the ratio of the wage rate to the cost of
capital

The Cost Minimizing Input Choice

Isocost lines describe the
combination of inputs
that cost the same
amount to the firm
Isocost curve C1 is tangent
to isoquant q1 at A and
shows that output q1 can
be produced at minimum
cost with labor input L1
and capital input K1
Other input
combinations-L2, K2 and
L3, K3-yield the same
output but at higher cost.

Input Substitution When Input Prices Change

Facing an isocost curve
C1, the firm produces
output q1 at point A
using L1 units of labor
and K1 units of capital.
When the price of
labor is higher, relative
to the price of capital
the isocost curve is
steeper and output q1
is produced at point B
on isocost curve C2
using less labour and
more capital.

Production Costs
Units of output are produced by firms using labour and capital in a
production process which involves the transformation of inputs into
outputs
The firms production costs are the total of all costs incurred in the
production process
These costs include capital costs, labour costs, and the cost of obtaining
materials, components and energy. They also include the costs associated
with the time and money that the owners of the firm have put into the
business
The behaviour of production costs depends on the cost of hiring the inputs
used and their productivity
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Direct and Indirect Costs

Most of the costs incurred in production are direct costs. These are costs
which involve a direct outlay of money by the firm when it buys or hires
inputs
The firm may also incur implicit costs. These are costs which do not involve
an outlay of money, but which should still be included as part of the firms
production costs
If the owners the firm invest time and money in the business and do not
take a direct money payment there is still an opportunity cost incurred,
because a return on that time and money could have been obtained by
investing it elsewhere. That alternative return is the implicit cost incurred
and it should be included in production costs, to get an accurate figure of
the true cost of doing business.

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Short-Run Production Costs

The short run is defined as a period of time during which some of the
inputs to the production process are fixed
The fixed inputs are the firms capital inputs (machinery, equipment,
establishment size, etc.) and the available technology (production methods
and know-how)
During the short run, the firm can alter production only by changing the
amount labour employed and the use of materials, energy, etc
The inputs that can be changed are the firms variable inputs
This means that the firms production costs in the short run can be
classified as either fixed costs or variable costs
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Average Costs
Total Costs are the sum of fixed costs and variable costs
TC = FC + VC
Average Cost is total cost per unit of output produced
AC= TC/Q
Average Fixed Cost is fixed cost per unit of output produced
AFC = FC/Q
Average Variable Cost is variable cost per unit of output produced
AVC = VC/Q
And the components of average total cost are:
AC = AFC + AVC
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Marginal Cost
Marginal Cost shows how production costs change as output changes
Marginal cost is defined as the change in total cost arising from the
production of an extra unit of output
MC = TC/Q
In the short run, capital costs are fixed, which means that they do not
change when output changes
The only cost component that changes in the short run is variable cost and
hence marginal cost is equivalent to the change in variable cost incurred
when output expands
MC = VC/Q
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Marginal and Average Cost:

A Numerical Example

Rate of
Output
(Units
per Year)

Fixed
Cost
(Dollars
per Year)

Variable
Cost
(Dollars
per Year)

Total
Cost
(Dollars
per Year)

Marginal
Cost
(Dollars
per Unit)

Average
Fixed Cost
(Dollars
per Unit)

Average
Variable Cost
(Dollars
per Unit)

Average
Total Cost
(Dollars
per Unit)

(FC)
(1)

(VC)
(2)

(TC)
(3)

(MC)
(4)

(AFC)
(5)

(AVC)
(6)

(ATC)
(7)

50

50

--

--

--

50

50

100

50

50

50

100

50

78

128

28

25

39

64

50

98

148

20

16.7

32.7

49.3

50

112

162

14

12.5

28

40.5

50

130

180

18

10

26

36

50

150

200

20

8.3

25

33.3

50

175

225

25

7.1

25

32.1

50

204

254

29

6.3

25.5

31.8

50

242

292

38

5.6

26.9

32.4

10

50

300

350

58

30

35

11

50

385

435

85

4.5

35

39.5

--

The Components of Marginal Cost

MC includes all of the firms costs that vary with output
In the short run, capital costs are fixed, which means that they do not
change when output changes
The behaviour of marginal cost depends only on the behaviour of the
variable cost components, which are primarily the costs of labour, and
materials and components and energy
If material and component costs are the same for each unit produced, this
component of MC is constant
But what about labour costs?

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Labor Costs and Marginal Cost

When output rises by Q, the extra labor cost incurred is the unit input cost of
labor (the wage rate w) times the number of extra labor units (L) needed to
produce that extra output. Ignoring material costs, the change in variable cost
when output rises (i.e. Marginal Cost) is the same as the change in labor cost
and hence VC/ Q = w L/ Q
The extra labor needed to obtain an extra unit of output is L/Q
We have already defined the Marginal Product of Labor as MPL = Q/L and so
L/Q = 1 / MPL. The implication is that MC is determined by the behavior of
MPL
MC = VC/ Q = w L/ Q = w (1/MPL) = w / MPL
In the short run, with K fixed, it is usual to suppose that it becomes increasingly
difficult for the firm to utilize extra labor efficiently and that MPL eventually
declines as output rises and more labor is employed. This means that even if
material costs per unit of output remain constant, the diminishing marginal
productivity of labor must eventually cause marginal cost to rise as output rises

The Firms Short- Run Cost Curves

In (a) total cost TC is
the vertical sum of
fixed cost FC and
variable cost VC.
In (b) average total
cost ATC is the sum
of average variable
cost AVC and
average fixed cost
AFC.
Marginal cost MC
crosses the average
variable cost and
average total cost
curves at their
minimum points.

Unit Costs: Key Information

Unit Costs

MC

MC rises as
production expands in
the short run
ATC

MC cuts ATC at
the minimum
point on the ATC
curve

ATC falls and then

rises as
production
expands in the
short run

Output per period

50

Long Run vs Short Run Decisions

The Inflexibility of Short-Run Production
When a firm operates in
the short run, its cost of
production may not be
minimized because of
inflexibility in the use of
capital inputs.
Output is initially at level
q1, (using L1, K1).
In the short run, output q2
can be produced only by
increasing labor from L1 to
L3 because capital is fixed
at K1.
In the long run, the same
output can be produced
more cheaply by
increasing labor from L1 to
L2 and capital from K1 to
K2.

Long Run vs Short-Run Cost Curves

The Relationship Between Short-Run and Long-Run Cost
The long-run
average cost curve
LAC is the envelope
of the short-run
average cost curves
SAC1, SAC2, and
SAC3.
With economies and
diseconomies of
scale, the minimum
points of the shortrun average cost
curves do not lie on
the long-run average
cost curve.

Profits and Production Again

If the firm knows how much output it can sell at any given price it can
calculate total revenue, average revenue and marginal revenue at any
output level
If the firms knows what its costs conditions would be at any output level it
can calculate total cost, average cost and marginal cost
Armed with this revenue and cost information, the firm should be able to
determine the production level; at which it would maximise profits
In practice, the outcome of this decision-making process depends on the
nature of market conditions, which determine whether the firm is a price
taker or a price setter

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End of Session 4

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