Economics of Satisfaction

Utility Theory
In economics, this refers to the satisfaction or
pleasure that an individual/consumer gets from
consuming a good/service. It can also be defined
as consumers' willingness to pay for goods or
services, whatever its price, to achieve
satisfaction.
Total Utility
The total satisfaction that a consumer derives
from the consumption of goods/services.
Utility is subjective. Different individuals can
get different levels of utility from the same
commodity
Util – the unit of satisfaction
Marginal Utility
Marginal Utility is defined as the
additional satisfaction that an individual
derives from consuming an extra unit of
goods/services.
Law of Diminishing Marginal Utility
Law of Diminishing Marginal Utility as the
consumer gets more satisfaction in the long
run, the consumer experiences a decline in
satisfaction. As more and more units of
products/goods are consumed, every
additional unit gives satisfaction with a
diminishing rate.
Unit Total Utility Marginal utility
0 - -
1 80 80
2 120 40
3 140 20
4 150 10
5 155 5
6 155 0
180

160
155 155
150
140 140

120 120

100

80 80

60

40 40

20 20
10
5
0 0
Candy 1 Candy 2 Candy 3 Candy 4 Candy 5 Candy 6
Negative Marginal Utility
While there are some
circumstances where there will
always be some marginal utility
to producing or consuming more
of a good, there are also
circumstances where marginal
utility can become negative
The Production Function
• The production function relates the maximum
amount of output that can be obtained from a given
number of inputs.
• Production function relates physical output of a production
process to physical inputs or factors of production.
• It is a mathematical function that relates the maximum
amount of output that can be obtained from a given number
of inputs – generally capital and labor.
• The production function, therefore, describes a boundary or
frontier representing the limit of output obtainable from each
feasible combination of inputs.
Firms
Firms use the production function to determine how
much output they should produce given the price of
a good, and what combination of inputs they should
use to produce given the price of capital and labor.
When firms are deciding how much to produce they
typically find that at high levels of production, their
marginal costs begin increasing. This is also known
as diminishing returns to scale increasing the
quantity of inputs creates a less-than-proportional
increase in the quantity of output.
The Law of Diminishing Returns
• The law of diminishing returns states that adding more of one
factor of production will at some point yield lower per-unit
returns.
• In economics, diminishing returns is the decrease in the marginal
output of a production process as the amount of a single factor of
production is increased, while the amounts of all other factors of
production stay constant.
• The law of diminishing returns states that in all productive
processes, adding more of one factor of production, while holding
all others constant (“ceteris paribus”), will at some point yield
lower per-unit returns. The law of diminishing returns does not
imply that adding more of a factor will decrease the total
production, a condition known as negative returns, though in fact
this is common.
Inputs and Outputs of the Function
In the basic production function,
inputs are typically capital and
labor and output is whatever good
the firm produces.
Capital
• Capital refers to the material objects necessary for
production. Machinery, factory space, and tools
are all types of capital.
• Economists assume that the level of capital is
fixed – firms can’t sell machinery the moment it’s
no longer needed, nor can they build a new
factory and start producing goods there
immediately. When looking at the production
function in the short run, therefore, capital will be
a constant rather than a variable.
Labor
• Labor refers to the human work that goes
into production. Typically economists assume
that labor is a variable factor of production; it
can be increased or decreased in the short
run in order to produce more or less output.
• The price of labor is the prevailing wage rate,
since wages are the cost of hiring an
additional unit of capital.
 Total, Marginal and Average
Product
Units of Total Product Marginal Average STAGES OF
PRODUCTION
Labor Input (TPL) Product Product (ON THE
(L) (MPL) (APL) BASIS OF
MPL)

0 - -

1 30 30 30 Increasing Return

2 55 25 27.5 Increasing Return

3 65 10 21.67 Increasing Return

4 70 5 17.5 Increasing Return

5 75 5 15 Diminishing return

6 75 0 12.5 Diminishing return

 TOTAL PRODUCT
80

70

60

50

40

OUTPUT 30

20

10

0
1 2 3 4 5 6

INPUT
 Marginal Product
35

30

25

20

15

OUTPUT
10

0
1 2 3 4 5 6

INPUT
IMPORTANCE OF THE LAW OF DIMINISHING
RETURNS
• It shows how cost of production vary with change in output when one
factors is fixed.
• It shows how producers substitute one factor of production from the
other when the relative price of factors changes and marginal
productivity remains unchanged.
• When the producer is expecting, increasing returns to the variety factor,
more of the variable factor should be added.
• The law explains why more capital is combined with a given amount of
goods in different countries
• It experiences decreasing return to be variable factor less variable
factor should be used.
• law of diminishing returns can be applied in all the fields,
namely, agriculture, mining manufacturing, etc.
 Cost of Production
Types of Costs
• Variable costs change according to the quantity of
goods produced;
• Fixed costs are independent of the quantity of goods
being produced.
• Total Costs is the sum of variable costs and fixed costs.
• Average Cost is the total cost divided by the number of
goods produced.
• Marginal cost is the change in total cost when another
unit is produced.
Firm
OUTPUT Total Fixed Total Variable Total Cost Marginal Cost
Cost Cost TFC+TVC=
- 50 - 50 -
1 50 10 60 10
2 50 15 65 5
3 50 22 72 7
4 50 28 78 6
5 50 31 81 3
6 50 32 82 1
Average cost is the total cost divided by the number of
quantity

AFC = Fixed Cost

Quantity

AVC = Variable Cost

Quantity

ATC = Total Cost

Quantity
Firm
OUTPUT Total Total Total Marginal Ave. Ave. Ave.
Fixed Variable Cost Cost Fixed Variable Total
Cost Cost Cost Cost Cost
- 50 - 50 - - - -
1 50 10 60 10 50 10 60
2 50 15 65 5 25 7.5 32.5
3 50 22 72 7 16.67 7.33 24
4 50 28 78 6 12.5 7 19.5
5 50 31 81 3 10 6.2 16.2
6 50 32 82 1 8.33 5 13.67
Profit
• The term “profit” may bring images of money
to mind, but to economists, profit
encompasses more than just cash. In general,
profit is the difference between costs and
revenue, but there is a difference between
accounting profit and economic profit.
• The biggest difference between accounting
and economic profit is that economic profit
reflects explicit and implicit costs, while
accounting profit considers only explicit costs
Accounting Profit
• Accounting profit is the difference between total monetary
revenue and total monetary costs, and is computed by using
generally accepted accounting principles. These consist of the
explicit costs a firm has to maintain production (for example,
wages, rent, and material costs). The monetary revenue is
what a firm receives after selling its product in the market.
• Accounting profit is also limited in its time scope; generally,
accounting profit only considers the costs and revenue of a
single period of time, such as a fiscal quarter or year.
• Accounting profit = total monetary revenue- total costs.
• 1,000,000-900,000= Accounting Profit = 100,000
Economic Profit
• Economic profit is the difference between total monetary
revenue and total costs, but total costs include both
explicit and implicit costs. Economic profit includes the
opportunity costs associated with production and is
therefore lower than accounting profit.
• Economic profit also accounts for a longer span of time
than accounting profit. Economists often consider long-
term economic profit to decide if a firm should enter or
exit a market.
• Economic profit = total revenue – (explicit costs + implicit
costs).
• Explicit cost: A direct payment made to
others in the course of running a business,
such as wages, rent, and materials, as
opposed to implicit costs, which are those
where no actual payment is made.
• Implicit cost: The opportunity cost equal
to what a firm must give up in order to use
factors which it neither purchases nor hires.
Example
1,000,000 Revenue 1,000,000 Revenue
Expenses:
Expenses: Labor - 300,000
Labor - 300,000 Rent – 120,000
Rent – 120,000 Equip – 200,000
Raw Ma. – 250,000
Equip – 200,000 Total = 870,000
Raw Ma. – 250,000 1,000,000 – 870,000
Total = 870,000 322,000 Wage
130,000-322,000
1,000,000 – 870,000 Opportunity Costs.
= 130,000 Accounting Profit. = -192,000 Economic Profit.