BAC 1-Basic Microeconomics Page 1 of 5

INITAO COLLEGE
P-2A Jampason, Initao, Misamis Oriental
2ND Semester, S.Y. 2023 – 2024
Bachelor of Science in Business Administration
Instructor: GROUPS 1-7
MR. FRENZ IAN Q. ESCALA

MODULE 5

Topic: Theory of Consumption Desired Learning Outcomes:

At the end of the week, the students should be able to;
 Identify the different factors that affect utility and consumption behavior
 Distinguish the relationship of income to substitution effects
In explaining consumer behavior, economics relies on the fundamental premise that people choose those goods and
services they value most highly. To describe the way consumers, choose among different consumption possibilities,
economists a century ago developed the notion of utility.

Utility – is defined as the satisfaction derived from the consumption of a commodity which determines consumption and
demand behaviour. It is the foundation of consumer’s behaviour.

Utility and Behavioral Factors

 Cultural Factors – Exert the broadest and deepest influence on consumer behaviour. A child growing up in society learns
basic set of values, perceptions, preferences, and behaviors through the process of socialization involving the family
and other key institutions. For example, toilet paper may be a common thing for the first world countries but could be a
rare commodity for the third world countries.
Values of individuals or peoples are highly influenced by cultural environment. An American or a Western child is
exposed to the values of achievement and success, progress, material comfort, efficiency, and practicality. A Filipino child,
on the other hand, is exposed to the values of hiya, pakikisama, social acceptance, and smooth interpersonal relationships.
 Social Factors – such as the consumer’s reference groups, family, and social roles and statuses.
Reference groups are those groups that have a direct or indirect influence on person’s attitudes or behaviors. A
teenager may buy shoes that are in accordance to the taste of his peer group, while a more matured person would prefer
more durable or conservative shoes. The kind of clothing that a person wears reflects his respective roles and statuses. A
company president, for example, will tend to drive a Mercedes Benz, wear expensive clothes and eat in posh restaurants,
 Personal Factors – buyer’s decisions are also influenced by personal outward characteristics such as the buyer’s age
and life cycle, occupation, economic circumstances, lifestyle, personality, and self-concept.
People change the goods and services they buy over their lifetime. Young single people have different consumption
needs from retirees. A person’s lifestyle and economic condition will affect the goods and services he buys. c; the sports-
minded type of person would prefer different kinds of goods as opposed to those who are the homebody type.
 Psychological Factors – person’s purchases are also influenced by psychological factors: motivation, perception,
learning, beliefs, and attitudes.
Maslow’s Theory of Motivation (Abraham Maslow) – based on the theory, a person will try to satisfy the most important
needs first. When a person succeeds in satisfying an important need, he will be motivated to satisfy the next most important
need.

The Utility Function

Utility is the technical term for satisfaction. There is a functional relationship between utility and consumption as the need for
the latter arises.
Total Utility (TU) – the total amount of satisfaction derived from consuming foods and services.
Marginal Utility (MU) – the additional satisfaction derived from consumption of additional goods and services. The
expression “marginal” is a key term in economics and always means “additional” or “extra.”

MU = ΔTU ΔTU= TU2 – TU1

Law of Diminishing Marginal Utility – states that the amount of extra or marginal utility declines as a person consumes
more and more of a good. To understand this law, first remember that utility tends to increase as you consume more of a
good. However, as you consume more and more, your total utility will grow at a slower and slower rate.

Table 3.1 Utility Schedule. Illustrate the concept of the law of diminishing marginal utility.
Consumption Total Utility Marginal Utility
0 0 -
1 7 7 MU1 = 7-0 = 7
2 13 6
3 18 5 MU2 = 13-7 = 6

MU3 = 18-13 = 5

MU4 = 22-18 = 4
 MU5 = 25-22 = 3

BAC 1-Basic Microeconomics Page 2 of 5

4 22 4
5 25 3
6 27 2
7 28 1
8 28 0
9 27 1
10 25 -2
11 22 -3
12 18 -4
13 13 -5
14 7 -6
15 0 -7
As we consume more of a good or service, total utility increase. The increment of utility from one unit to the next is the
“marginal utility” – the extra utility added by the last extra unit consumed. By the law of diminishing marginal utility, the
marginal utility falls with increasing levels of consumption.
In conclusion, the diminishing MU causes TU to decline eventually, for which reason, maximum consumption is only up to
the point of maximum utility.

CONSUMPTION
Indifference curve – contains varying combinations in the consumption of commodities that yield the same level of total
utility. This approach helps explain the factors that tend to make the responsiveness of quantity demanded to price – the
price elasticity of demand – large or small.
Indifference analysis asks about the substitution effect and the income effect of a change in price. By looking at these, we
can see why the quantity demanded of a good declines as its price rises.

Substitution Effect is an idea that when price increases or income decreases, consumers will replace expensive items with
cheaper alternatives. The substitution effect is not just limited to consumers. When companies outsource part of their
operations, they are using the substitution effect. Using cheaper labor in a different country of by hiring a third-party results in
a drop in costs.

Income Effect is the change in the consumption of goods based on income. This means consumers will generally spend
more if they experience an increase in income, and they may spend less if their income drops.
For Example:
 If the price of meat increases, then the higher price may encourage consumers to switch to alternative food sources,
such as buying vegetables.
 However, with the higher price of meat, it means that after buying some meat, they will have lower spare income.
Therefore, consumers will buy less meat because of this income effect.
o If a good like a diamond increases, there will be little substation effect because there are no alternatives to
diamonds. However, a higher price of diamonds will lower demand because of the income effect.

Real Income means the actual quantity of goods that your money income can buy. When a price rises and money income is
fixed, real income falls because the consumer cannot afford to buy the same quantity of goods as before.

Table 3.2 Example of choice of goods

which give consumers the same utility.
Apples Bananas
14 20
10 26
9 41

Figure 3.2 Indifference Curve Map

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Budget Line – shows the combination of goods that can be afforded with your current income.
Figure 3.3 Budget Line with Income of P40

The consumer will move along this budget line until reaching the highest attainable indifference curve. At this point, the
budget line will touch, but not cross and indifference curve. Hence, equilibrium (Figure 3.4) is at the point of tangency, where
the slope of the budget line exactly equals the slope of the indifference curve.

Equimarginal Principle: The fundamental condition of maximum satisfaction or utility. It states that a consumer will achieve
maximum satisfaction or utility when the marginal utility of the last peso spent on a good is exactly the same as the marginal
utility of the last peso spent on any other good.
Figure 3.4

Consumer Surplus is the difference between what the

consumer pays and what he would have been willing to pay.
Example: If you would be willing to pay P100 for a movie
ticket, but the ticket costs P80. In this case, your consumer
surplus is P20.

Producer Surplus is the difference between the

price a firm receives and the price it would be willing
to sell it at.
Example: If a firm would sell a good at P5, but the
market price is P8, the producer surplus is P3.

MODULE 6
 BAC 1-Basic Microeconomics Page 4 of 5

Topic: Theory of Production Desired Learning Outcomes:

At the end of the week, the students will be able to;
 Explain the relationship between production function and marginal product
 Explain the law of diminishing returns and its effect to the economy
The theory of production is an analysis of output-input relationship.
PRODUCTION FUNCTION

Production refers to the transformation of inputs into outputs.

An input is a resource that a firm uses in its production process for the purpose of creating a good or service.
Output is the good, product or service produced.
The relationship between the quantity of output and the quantities of inputs is called the production function. It is a
technical relation which connects factors inputs used in the production function and the level of outputs.
One very simple example of a production function might be Q=K+L, where Q is the quantity of output, K is the amount of
capital, and L is the amount of labor used in production. This production function says that a firm can produce one unit of
output for every unit of capital or labor it employs. From this production function we can see that this industry has constant
returns to scale - that is, the amount of output will increase proportionally to any increase in the amount of inputs.

Marginal Product – product due to the additional or last unit of the variable resource input.

The Law of Diminishing Returns – states the use of variable resources against the limits of fixed resources or describes
the tendency at some point for each succeeding addition to output to become smaller as the firms add succession units of
variable input to some fixed inputs.
Table 4.1 Production Function
Labor Total Product/ Marginal Average Stage
(Man Hours) Output Product (Units) Product
(Units)
1 5 5 5 Stage 1
2 10 5 5
3 16 6 5.3
4 21 5 5.2 Stage 2
5 24 3 4.5
6 24 0 4
7 21 -3 3 Stage 3
8 16 -5 2
9 10 -6 1.1
10 5 -5 0.5 Stage 4
11 2 -3 0.2
12 0 -2 0
The TP or output rises with more labor inputs in the first two stages but eventually declines in the last stage. The marginal
product influences this trend and is defined as the product due to the additional or last unit of the variable resource input and
measured as follows:
ΔQ
MP= MP = Where: MP = Marginal Product or Output I = Resource Input
ΔI
Qp = Total Product or Output Δ = Change

At Stage 1, every additional input of labor churns out a bigger chunk with a higher MP to accelerate the TP. At Stage 2,
additional input churn out a smaller chunk with a lower MP to still increase but decelerates TP. MP continues to decline to
negative levels at Stage 3 where additional labor input has negative returns and decreases TP.
Q
Average Product (AP) – is output per unit of the variable resource input and measured as follows: AP =
I
Two Important Lessons of Diminishing Returns:
1. Size of a resource, given the rest as fixed, should not go beyond its product-maximizing point.
2. Plant capacity can only increase with more resources combined unless technology changes.

Returns to Scale - measures how output changes relative to resource inputs in the long run and indicate how overall
resource efficiency changes with plant size.
Because decisions take time to implement, and because capital and other factors are often very long-lived, the reaction of
production may change over different time periods. The short run is a period in which variable factors, such as labor or
material inputs, can be easily changed but fixed factors cannot. In the long run, the capital stock (a firm’s machinery and
factories) can depreciate and be replaced. In the long run, all inputs, fixed and variable, can be adjusted.

Technological change refers to a change in the underlying techniques of production, as occurs when a new product or
process of production is invented or an old product or process is improved. In such situations, the same output is produced
with fewer inputs or more output is produced with the same inputs. Technological change shifts the production function
upward.
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