CONCEPT OF UTILITY • In Fig. 2.

1, units of ice-cream, are shown along

the X-axis and TU and MU are measured along
• Utility refers to want satisfying power of a
the Y-axis. MU is positive and TU is increasing
commodity. It is the satisfaction, actual or
till the 4th ice-cream. After consuming the 5th
expected, derived from the consumption of a
ice-cream, MU is zero and TU is maximum.
commodity. Utility differs from person- to-
person, place-to-place and time-to-time. In the • This point is known as the point of satiety or
words of Prof. Hobson, “Utility is the ability of the saturation point or the stage of maximum
a good to satisfy a want”. satisfaction.
• In short, when a commodity is capable of • After consuming the 6th ice-cream, MU is
satisfying human wants, we can conclude that negative (known as disutility, discommodity or
the commodity has utility. dissatisfaction) and total utility starts
diminishing.
How to Measure Utility?
• Disutility is the opposite of utility. It refers to
• the economists derived an imaginary measure,
loss of satisfaction due to consumption of too
known as ‘Util’.
much of a thing.
• Utils are imaginary and psychological units
Approaches in measuring Utility:
which are used to measure satisfaction (utility)
obtained from consumption of a certain quantity 1. Cardinal Approach or the Marginal Utility
of a commodity. Approach
• Alfred Marshall, suggested the measurement of • It's based on the cardinal counting numbers
utility in monetary terms. It means, utility can be like 1, 2, 3, 4.
measured in terms of money or price, which the
2. Ordinal Approach or the Indifference Curve
consumer is willing to pay.
Approach
• means ranking items under consideration
1. Total Utility (TU): from most satisfaction to the least
• Total utility refers to the total satisfaction Characteristics of Utility:
obtained from the consumption of all possible
The following are the important characteristic features of utility:
units of a commodity. It measures the total
satisfaction obtained from consumption of all 1. Utility has no Ethical or Moral Significance:
the units of that good.
• A commodity which satisfies any type of want,
2. Marginal Utility (MU): whether moral or immoral, socially desirable or
undesirable, has utility, i.e., a knife has utility as a
• Marginal utility is the additional utility derived household appliance to a housewife, but it has also a
from the consumption of one more unit of the utility to a killer for stabbing some body.
given commodity.
2. Utility is Psychological:
• In the words of Chapman, “Marginal utility is
addition made to total utility by consuming one • Utility of a commodity depends on a consumer’s
more unit of a commodity”. mental attitude and assessment regarding its power to
satisfy his particular want. Thus, utility of a
commodity may differ from person to person.
Psychologically, every consumer has his likes and
dislikes and everyone determines his own level of
satisfaction.
3. Utility is always Individual and Relative: Types of utility:
• Utility of a commodity varies in different situations 1. Form Utility:
in relation to time and place. Even the same
This utility is created by changing the form or shape
consumer may derive a higher or lower utility for the
of the materials. For example—A cabinet turned out
same commodity at different times and different
from steel furniture made of wood and so on.
places. For example—a person may find more utility
Basically, form utility is created by the
in woolen clothes during the winter.
manufacturing of goods.
4. Utility is not Necessarily Equated with Usefulness:
2. Place Utility:
• Utility simply means the ability to satisfy a want. A
• This utility is created by transporting goods from one
commodity may have utility but it may not be useful
place to another. Thus, in marketing goods from the
to the consumer. For instance—A cigarette has utility
factory to the market place, place utility is created.
to the smoker but it is injurious to his health.
Similarly, when food-grains are shifted from farms to
However, demand for a commodity depends on its
the city market by the grain merchants, place utility is
utility rather than its usefulness. Thus many
created.
commodities like opium, liquor, cigarettes etc. have
demand because of utility, even though, they are • Transport services are basically involved in the
harmful to human beings. creation of place utility. In retail trade or distribution
services too, place utility is created. Similarly,
5. Utility cannot be Measured Objectively:
fisheries and mining also imply the creation of place
• Utility being a subjective phenomenon or feeling of a utility. Place utility of a commodity is always more in
consumer cannot be expressed in numerical terms. So an area of scarcity than in an area of abundance.
utility cannot be measured cardinally or numerically.
3. Time Utility:
It cannot be measured directly in a precise manner.
Professor Marshall has however, unrealistically • Storing, hoarding and preserving certain goods over a
assumed cardinal measurement of utility in his period of time may lead to the creation of time utility
analysis of demand. for such goods e.g., by hoarding or storing food-
grains at the time of a bumper harvest and releasing
6. Utility Depends on the Intensity of Want:
their stocks for sale at the time of scarcity, traders
• Utility is the function of intensity of want. A want derive the advantage of time utility and thereby fetch
which is unsatisfied and greatly intense will imply a higher prices for food-grains. Utility of a commodity
high utility for the commodity concerned to a person. is always more at the time of scarcity. Trading
But when a want is satisfied in the process of essentially involves the creation of time utility.
consumption it tends to experience a lesser utility of
4. Service Utility:
the commodity than before. Such an experience is
very common and it is described as a tendency of • This utility is created in rendering personal services
diminishing utility experienced with an increase in to the customers by various professionals, such as
consumption of a commodity. In other words, the lawyers, doctors, teachers, bankers, actors etc.
more of a thing we have, the less we want it.
Approaches:
7. Utility is Different from Pleasure:
MARGINAL UTILITY OR THE CARDINAL APPROACH:
• A commodity may have utility but its consumption
Objective: to maximize satisfaction
may not give any pleasure to the consumer, e.g.,
Subject to: income and the prices of goods and services
medicine or an injection. An injection or medicinal
Assumptions:
tablet gives no pleasure, but it is necessary for the 1. Utility can be expressed in terms of cardinal numbers. The
patient. higher the number, the higher the satisfaction it represents.
2. Consumers are rational. They prefer more of a given good
8. Utility is also Distinct from Satisfaction: than less of it.
3. Consumers are given a set of income and prices are also
• Utility and satisfaction, both are though interrelated given. To maximize satisfaction, all income must be spent such
but they have not been considered as the same in a that savings must be zero.
strict sense.
Steps: It is also assumed that prices of both the commodities
are given and are constant.
1. Define the Utility Function
3.Non satiety
U= f (x,y,z,...nth)
Satiety means saturation. And, indifference curve theory
2. Set the consumer's budget equation
assumes that the consumer has not reached the point of
M= PxQx+PyQy+PzQz+...PnQn satiety. It implies that the consumer still has the
willingness to consume more of both the goods. The
3. Consumer's Equilibrium which is defined by the consumer always tends to move to a higher indifference
Utility Maximizing Rule (UMR). curve seeking for higher satisfaction.
UMR defines that MU/price of all goods and services 4. Ordinal utility: According to this theory, utility is a
consumed must be equal. psychological phenomenon and thus it is
UMR= MUx/Px=MUy/Py=MUz/Pz= ...MUn/Pn unquantifiable. However, the theory assumes that a
consumer can express utility in terms of rank.
4. Utility Maximizing Combination= combination of
goods and services that provides the greatest amount of Consumer can rank his/her preferences on the basis of
satisfaction. satisfaction yielded from each combination of goods.

Indifference Curve Analysis OR the Ordinal 5. Diminishing marginal rate of substitution: may be
Approach: Concept, Assumption and Properties defined as the amount of a commodity that a consumer
is willing to trade off for another commodity, as long
In microeconomics, indifference curve is an important as the second commodity provides same level of utility
tool of analysis in the study of consumer behavior. as the first one.
The concept of indifference curve analysis was first 6. Rational consumers: a consumer always behaves in a
propounded by British economist Francis Ysidro rational manner, i.e. a consumer always aims to
Edgeworth and was put into use by Italian economist maximize his total satisfaction or total utility.
Vilfredo Pareto during the early 20th century. However,
it was brought into extensive use by economists J.R. Properties of indifference curve
Hicks and R.G.D Allen. There are four basic properties of an indifference curve.
Hicks and Allen criticized Marshallian cardinal approach These properties are
of utility and developed indifference curve theory of 1. Indifference curve slope downwards to right
consumer’s demand. Thus, this theory is also known as
ordinal approach. • An indifference curve can neither be horizontal
line nor an upward sloping curve. This is an
• Indifference curve is a locus of all combinations of important feature of an indifference curve.
two goods which yield the same level of satisfaction
(utility) to the consumers. • When a consumer wants to have more of a
commodity, he/she will have to give up some of
• Since any combination of the two goods on an the other commodity, given that the consumer
indifference curve gives equal level of satisfaction, remains on the same level of utility at constant
the consumer is indifferent to any combination he income. As a result, the indifference curve
consumes. Thus, an indifference curve is also known slopes downward from left to right.
as ‘equal satisfaction curve’ or ‘iso-utility curve’.
• as explained by MRS x for y (marginal rate of
Assumptions of indifference curve substitution of x for y) which defines the
The indifference curve theory is based on few maximum amount of good y that will be given
assumptions. These assumptions are: up inorder to add up units of x, leaving TU
unchanged.
1. Two commodities. Thus, utility function is U = f (x,y)
2. It is assumed that the consumer has fixed amount of
money, all of which is to be spent only on two goods.
2. Indifference curve is convex to the origin Terms to be defined:
• As mentioned previously, the concept of 1. Income Consumption Curve: locus of the optimal
indifference curve is based on the properties of combinations of goods x and y as income is varied,
diminishing marginal rate of substitution. ceteris paribus.
• According to diminishing marginal rate of 2. Engel Curve: represents combinations of two goods, x
substitution, the rate of substitution of and y, at different income levels.
commodity X for Y decreases more and more
3. Price Consumption Curve: locus of the optimal
with each successive substitution of X for Y.
combinations of x and y as price of either x or y is
• Also, two goods can never perfectly substitute varied, ceteris paribus.
each other. Therefore, the rate of decrease in a
4. demand curve: equation/schedule/graph of quantities
commodity cannot be equal to the rate of
of goods or services consumers are willing and able to
increase in another commodity.
buy at all possible levels of price/u.t., ceteris paribus.
3. Indifference curve cannot intersect each other
Upward sloping engel curve means that the good under
• Each indifference curve is a representation of consideration is a normal good. If downward sloping, the
particular level of satisfaction. good is an inferior good.
• The level of satisfaction of consumer for any
given combination of two commodities is same
for a consumer throughout the curve. Thus,
indifference curves cannot intersect each other
for the following reasons:
• a. violation of the Utility Function
• b. violation of the Law of Transitivity
• Effects of a ΔM, c.p. →will shift the BRL either
• THE LAW OF TRANSITIVITY defines that to the right (due to increase in M) or to the left
consumers must be consistent in making (due to the decrease in M).
choices.
• Effects of a Δ in either the price of good X or
the price of good Y →will merely rotate the
BRL. Rotation inside if price increases and
rotation outside if price decreases.
4. Higher indifference curve represents higher level of
satisfaction
• Higher the indifference curves, higher will be
the level of satisfaction. This means, any
combination of two goods on the higher curve
give higher level of satisfaction to the consumer
than the combination of goods on the lower
curve.
• budget restraint line shows graphically the
combinations of two goods a consumer can buy
with a given budget.
THEORY OF PRODUCTION particular, it can opt for a new factory of any
technologically feasible size. However, once the
• Production is concerned with the nature of the
planning decision has been carried out— the plant built,
conversion process, i.e., how inputs are
machines purchased and installed, and so on—the firm
converted into output.
acquires fixed factors and it is operating in the short
• →involves the actual transformation of inputs run.”
into outputs OR it is the creation of goods and
We use three measures of production and productivity:
services. These are the Product Curves in the short run.
• The key concept in the theory of production is x= f(QL, QK)... Labor is VI and Capital is the FI
the production function.
1. Total product (total output). measures the total
• The production function shows the relation productivity of variable inputs applied to a fixed input.
between input changes and output changes.
2. Average product measures output per-worker-
• → It also shows the maximum amount of output employed or output-per-unit of capital.
that can be obtained by the firm from a fixed
quantity of resources. APL = TPL/QL
The production function is expressed as: 3. Marginal Physical Product of Labor is the change
in output from increasing the number of workers used by
• X = f (a, b, c,...nth) one person, or by adding one more machine to the
• Where X is output (which is the dependent production process in the short run.
variable) and a, b, c ...nth are inputs, MPPL = ΔTPL/ ΔQL
respectively.
Factors influencing the behavior of APL:
Business firms operations:
For increasing average product: Economies of sizes and
1. The Short-Run: defined as a time too short that can't scales
allow the firm to vary all its inputs. Therefore, the short-
run refers to the period of time over which one (or more) 1. Division of labor
factor(s) of production is (are) fixed.
2. Specialization of labor
X= f (FI , VI)
3. Technology
• Fixed inputs are inputs the sizes of which do not
For decreasing average product: Diseconomies of sizes
vary with outputs. eg. land, labor, capital,
and scales
buildings
1. mangement failure in delegating authorities to
• Variable inputs are inputs which vary with
subordinates as the business firms become
outputs eg. raw materials, electricity, water...
bigger with employment of more manpower.
2. The Long-Run: a time period too long that allows the
Law of Diminishing Returns (LDR)
firm to vary all inputs used in the production process.
• In the short run, the law of diminishing returns
is defined as the period over which all factors of
states that as more units of a variable input are
production can be varied, within the confines of existing
added to fixed amounts of capital, the change in
technology. In the long-run all factors are variable.
total output will first rise and then fall
x = f (VI, VI)
• Diminishing returns to labour occurs when
discussed by the Theory of Isoquants. In the language of marginal product of labour starts to fall. This
R. G. Lipsey and C. Harbury: “The long-run is the means that total output will be increasing at a
period that is relevant when a firm is either planning to decreasing rate.
go into business or to expand, or contract, its entire scale
of operation. The firm can then choose those quantities
of all factors of production that seem most suitable. In
Stages of Production
To simplify the interpretation of a production function, it
is common to divide its range into 3 stages.
• Stage 1 Stage of Increasing or Positive Returns
• Satge 2 Stage of Declining or Diminishing
Returns
• Stage 3 Stage of Negative Returns Theory of Isoquants:

Stage 1 (from the origin to point B) the variable input is Definition and Meaning:
being used with increasing output per unit, the latter The word 'iso' is of Greek origin and means equal or
reaching a maximum at point B (since the average same and 'quant' means quantity. An isoquant may be
physical product is at its maximum at that point). defined as:
Because the output per unit of the variable input is
improving throughout stage 1, a price-taking firm will • "A curve showing all the various combinations
always operate beyond this stage. of two factors that can produce a given level of
output. The isoquant shows the whole range of
Stage 2, output increases at a decreasing rate, and the alternative ways of producing the same level of
average and marginal physical product both decline. output".
However, the average product of fixed inputs (not
shown) is still rising, because output is rising while fixed • The modern economists are using isoquant, or
input usage is constant. In this stage, the employment of "ISO" product curves for determining the
additional variable inputs increases the output per unit of optimum factor combination to produce certain
fixed input but decreases the output per unit of the units of a commodity at the least cost.
variable input. The optimum input/output combination Isocost Lines/Outlay Line/Price Line/Factor Cost Line:
for the price-taking firm will be in stage 2, although a
firm facing a downward-sloped demand curve might find • A firm can produce a given level of output using
it most profitable to operate in Stage 1. efficiently different combinations of two inputs.
For choosing efficient combination of the inputs,
Stage 3, too much variable input is being used relative to the producer selects that combination of factors
the available fixed inputs: variable inputs are over
which has the lower cost of production. The
utilized in the sense that their presence on the margin information about the cost can be obtained from
obstructs the production process rather than enhancing it.
the isocost lines.
The output per unit of both the fixed and the variable
input declines throughout this stage. At the boundary Explanation:
between stage 2 and stage 3, the highest possible output
• An isocost line is also called outlay line or price
is being obtained from the fixed input.
line or factor cost line. An isocost line shows all
Long Run Production With Variable Inputs: the combinations of labor and capital that are
available for a given total cost to-the producer.
The long run is the lengthy period of time during with all
Just as there are infinite number of isoquants,
inputs can be varied. There are no fixed input in the long
there are infinite number of isocost lines, one for
run. All factors of production are variable inputs.
every possible level of a given total cost. The
We now analyze production function by allowing two greater the total cost, the further from origin is
factors say labor and capital to very while all others are the isocost line.
held constant. With both factors are variable, a firm can
produce a given level of output by using more labor and
less capital or a greater amount of capital and less labor
or moderate amounts of both. A firm continues to
substitute one input for another while continuing to
produce the same level of output.
THEORY OF COSTS 4 PER UNIT COSTS
ECONOMIC COST is defined in terms of the cost of the these are main costs divided by quantity
foregone or sacrificed alternative.
1. Average cost = TC/Q
• it is the total cost of choosing one action over
2. Average Variable Cost = VC/Q
another. It includes the accounting cost and the
opportunity cost/ implicit cost 3. Average Fixed Cost = FC/ Q
ACCOUNTING COSTS 4. Marginal Cost = ΔTC/ΔQ
• Accounting costs, also known as explicit costs,
are costs that involve money being spent.
Examples include rent, interest payments and
utility bills
Costs are obligations made by the firm in its operations.
• Explicit Costs: out-of-pocket or actual
expenditures made by the business firms.
Usually, these are paid to the non-owners of the
firm and are recorded in the firm's financial
statements.
• Implicit Costs: these are costs of self-owned or
self-employed resources. No actual monetary
payments are usually made.
Economic costs = Explicit + Implicit Costs
Accounting costs = Explicit Costs only
COSTS IN RELATION TO THE BUSINESS FIRMS
OPERATIONS:
A. COSTS IN THE SHORT RUN Economies of Scale is defined as a fall in the long run
B. COSTS IN THE LONG RUN average costs because of an increased scale of
production. This basically means the cost of production
Costs in the Short Run per unit reduces as you produce more units. Reducing
the cost per unit of production is the most significant
• In the Cost Theory, there are two types of costs
advantage of achieving economies of scale.
associated with production – Fixed Costs and
Variable Costs. Examples of Internal Economies of Scale
• In the short-run, at least one factor of production 1. Technology
is fixed, so firms face both fixed and variable
costs. The shape of the cost curves in the short 2. Buying Power
run reflect the law of diminishing returns. 3. Financial or capacity of big firms in acquiring credit
MAIN COSTS IN THE SR Examples of External Economies of Scale
1. Total Cost = Fixed Cost + Variable Cost 1. Transportation
2. Variable Cost = Total Cost - Fixed Cost 2. Skilled Labor/ Specialization of labor
3. Fixed Cost = Total Cost - Variable Cost
Causes of Diseconomies of Scale The Market Structures
1. Workers: difficulty in managing large number of work Traditionally, the most important features of market
force structures are:
2. Supply chain: difficulty in coordinating informations 1. The number of firms (including the scale and extent of
across factories and countries. foreign competition)
Examples of Diseconomies of Scale 2. The market share of the largest firms (measured by the
concentration ratio)
1. Poor Communication: due to ineffective flow of
communications between departments/ divisions/ head 3. The nature of costs (including the potential for firms
offices/ subsidiaries. to exploit economies of scale and also the presence of
sunk costs which affects market contestability in the
2. Coordination: difficult to coordinate operations when
long term)
firms are large.
4. The degree to which the industry is vertically
3. Management Inefficiency: the loss of management
integrated - vertical integration explains the process by
efficiency that occurs when firms become large and
which different stages in production and distribution of a
operate in uncompetitive markets. This include
product are under the ownership and control of a single
overpaying for resources, such as paying managers
enterprise.
salaries higher than needed to secure their services and
excessive waste of resources. A good example of vertical integration is the oil
industry, where the major oil companies own the rights
4. Motivation: The low motivation of workers in large
to extract from oilfields, they run a fleet of tankers,
firms results in lower productivity, as workers may feel
operate refineries and have control of sales at their own
they are just another cog in the machine.
filling stations.
5. Principal-Agent Problem: This problem is caused
5. The extent of product differentiation (which affects
because the size and complexity of most large firms
cross-price elasticity of demand)
mean that their owners often have to delegate decision
making to appointed managers, which can lead to 6. The structure of buyers in the industry (including the
inefficiencies. possibility of monopsony power)
6. Complacency: Some economists argue that with large 7. The turnover of customers (sometimes known as
and uncompetitive markets, firms tend to become "market churn") – i.e. how many customers are prepared
complacent because of their size to switch their supplier over a given time period when
market conditions change. The rate of customer churn is
Long Run Cost and It’s Types
affected by the degree of consumer or brand loyalty and
1. Long Run Total Cost: the influence of persuasive advertising and marketing

• Long run Total Cost (LTC) refers to the

minimum cost at which given level of output can
be produced.
2. Long Run Average Cost:
• Long run Average Cost (LAC) is equal to long
run total costs divided by the level of output.
3. Long Run Marginal Cost:
• Long run Marginal Cost (LMC) is defined as
added cost of producing an additional unit of a
commodity when all inputs are variable.
The Four Types of Market Structures Characteristics:
1. Perfect Competition (1) all firms maximize profits,
(2) oligopolies can set prices,
describes a market structure, where a large number of
(3) there are barriers to entry and exit in the market,
small firms compete against each other. In this scenario,
(4) products may be homogenous or differentiated, and
a single firm does not have any significant market
(5) there is only a few firms that dominate the market.
power. As a result, the industry as a whole produces the
socially optimal level of output, because none of the
4. Monopoly: “mono” means one and “poly” for seller.
firms have the ability to influence market prices.
a market structure where a single firm controls the entire
Characteristics: market. In this scenario, the firm has the highest level of
market power, as consumers do not have any
(1) Many “small” sellers alternatives. As a result, monopolists often reduce output
(2) there is free entry and exit to the market, to increase prices and earn more profit.
(3) all firms sell completely identical (i.e. homogenous)
goods Characteristics:
(4) Firms are price takers and the industry is the price (1) the monopolist maximizes profit,
maker (2) it can set the price,
(5) No price and no non-price competition (3) there are high barriers to entry and exit (which are
(6) Mobility of resources: switching from one production large amount of capital requirements, control of the
line to another production line in order to minimize inputs used to manufacture unique goods or services,
losses in the operation. operation has to be franchised and product has to be
patented.)
2. Monopolistic Competition (4) there is only one firm that dominates the entire
refers to a market structure, where a large number of market.
firms compete against each other. However, unlike in eg. ALCOA as monopoly and monopsony market
perfect competition, the firms in monopolistic structure
competition sell similar, but slightly differentiated
products (Heterogenous products). This gives them a Regulations under monopoly
certain degree of market power which allows them to 1. Price control: government to set the maximum price
charge higher prices within a certain range. on the basis of the equality between MC and the DD.
effects:
Characteristics: a. Reduction in the price
(1) many “large” sellers b. Increase output production
(2) there is free entry and exit to the market c. Reduction in the profit
(3) firms sell differentiated products
(4) consumers may prefer one product over the other 2. Imposing per unit tax
(5) There is price and non-price competition effects:
(6) Excess capacity: firms inputs are under utilized as a. Increase price as the burden of paying taxes is
they consider the production levels of the many passed on to the consumers in the form of a higher
competing firms in the industry. price.
b. Reduction the Qd
3. Oligopoly: “oligo” literally means few and “poly” c. Reduction in the profit
means sellers. d. affects MC
a market structure which is dominated by only a small 3. Imposition of a lump sum tax which is a tax collected
number of firms. This results in a state of limited during the production cycle of the business firm. A tax
competition. The firms can either compete against each which cannot be passed on to the consumers.
other or collaborate. By doing so they can use their effects:
collective market power to drive up prices and earn more a. no effect on MC
profit. b. no effects on price, quantity and revenue
c. Profit is reduced by the amount of lump tax
collected .