Subject: SS-AE-I-12 Applied Economics

Week: 12
Topic: Socioeconomic Impact Study: Consumers and Suppliers
Consumer and Household
Total Utility and Diminishing Marginal Utility
To understand how a household will make its choices, economists look at what
consumers can afford, as shown in a budget constraint line, and the total utility or
satisfaction derived from those choices. In a budget constraint line, the quantity of one
good is measured on the horizontal axis and the quantity of the other good is measured
on the vertical axis. The budget constraint line shows the various combinations of two
goods that are affordable given consumer income.
The most common pattern of total utility, as shown here, is that consuming additional
goods leads to greater total utility, but at a decreasing rate. The third column shows
marginal utility, which is the additional utility provided by one additional unit of
consumption. This equation for marginal utility is:
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑈
𝑀𝑈 =
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄
Notice that marginal utility diminishes as additional units are consumed, which means that
each subsequent unit of a good consumed provides less additional utility. This is an
example of the law of diminishing marginal utility, which holds that the additional utility
decreases with each unit added.
Another way to look at this is by focusing on satisfaction per peso. Marginal utility per
peso is the amount of additional utility a person receives given the price of the product.
𝑀𝑈
𝑀𝑈/𝑃 =
𝑃
Supplier’s Production
We will begin by describing the technology available for producing output. Technology
summarizes the feasible means of converting raw inputs, such as steel, labor, and
machinery, into an output such as an automobile. The technology effectively summarizes
engineering know-how. Managerial decisions, such as those concerning expenditures on
research and development, can affect the available technology. In this chapter, we will
see how a manager can exploit an existing technology to its greatest potential.
To begin our analysis, let us consider a production process that utilizes two inputs, capital
and labor, to produce output. We will let K denote the quantity of capital, L the quantity of
labor, and Q the level of output produced in the production process. Although we call the
inputs capital and labor, the general ideas presented here are valid for any two inputs.
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However, most production processes involve machines of some sort (referred to by
economists as capital) and people (labor), and this terminology will serve to solidify the
basic ideas.
The technology available for converting capital and labor into output is summarized in the
production function. The production function is an engineering relation that defines the
maximum amount of output that can be produced with a given set of inputs.
Mathematically, the production function is denoted as:
Q= F(K,L)
that is, the maximum amount of output that can be produced with K units of capital and L
units of labor
Short Run Vs. Long Run Decisions
In the short run, some factors of production are fixed, and this limits your choices in
making input decisions. For example, it takes several years for automakers to develop
and build new assembly lines for producing hybrids. The level of capital is generally fixed
in the short run. However, in the short run automakers can adjust their use of inputs such
as labor and steel; such inputs are called variable factors of production. The short run is
defined as the time frame in which there are fixed factors of production.
The long run is defined as the horizon over which the manager can adjust all factors of
production. If it takes a company three years to acquire additional capital machines, the
long run for its management is three years, and the short run is less than three years.

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