MODULE 2 Republic of the Philippines Surigao del Sur State Bniversity nue ) Cantilan Campus, Surigao del Sur ‘Website: www.sdssu.edu.gov.ph Department of Business Management A Learning Module SIC Prepared by: JONILYN G. AZARCON Instructor Basic Microeconomics (BAC1)MODULE 2 DISCLAIMER This module is a compilation of the works from international sources, manuals, and books from different authors and will be used for educational purpose only. Due recognition is given to the authors who are the sources of some parts found in this module. The compiler/owner does not claim copyrights to any part taken from other sources, Basic Microeconomics (BAC1) 2MODULE 2 [57 srson tren ofconsmer Botan & Intended Learning Outcomes Al the end of the chapter, the student is expected to: # Identity the theory of consumer behavior # Understand the utility function * Discuss the law diminishing marginal utity Introduction: This chapter revolves around the fundamental concept of utility or satisfaction fo explain consumption and demand behavior in the short-run. Graphs and tables lend support as tools of understanding and analysis, In addition, the chapter illustrates the simple dynamics of these tools which can serve as a starting point in understanding long-run consumption behavior. Utility and Behavioral Factors Utilty is defined as the satisfaction derived from the consumption of a commodity which determines consumption and demand behavior. As such, itis the foundation of consumer's behavior. Figure 1 presents the underlying cultural, social, personal and psychological factors that affect utility and consumption behavior. Inter-factor combinations fier diferent patterns of consumption behavior down the line. Different consumption behaviors can stem from, say, variations within the cultural stucture in combination with the cross-sections of the other interlocking structures, In addition, the psychological factors reflect Maslow’s hierarchy of needs as influenced by said inter factor combinations. Personal Cultural Social Psychological ‘Age and ife-cycle Reference stage Motivation Culture groups Occupation + cami | >| Perception + Buyer Economic Subculture Roles and circumstances ‘earning statues Betis and Lifestyle atttudes Social class Personality and self concept Figure 1 Model of Factors Influencing Behavior Basic Microeconomics (BAC1) 3MODULE 2 Maslows’s Theory of Motivation. Abraham Maslow sought o explain why people are driven by particular needs at particular times. Maslow’s hierarchy of needs are: physiological needs, safety needs, social needs, esteem needs and self-actualization needs. A person will try to satisfy Cs the most important needs first. When a person rac succeeds in satisfying an important need, it will cease being a motivator for the present time. And the person will be motivated to satisfy the next Psychological most important need. For example, a starving man (need 1) will not take an interest in going to a disco ( need 3), nor in breathing clean air (need 2). However, as each important need is satisfied, the next most important need will come into play. 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: This fimetional relationship assumes two forms and is quantitively defined as follows: TU (Total Utility) = Function of Q ( Consumption) ‘MUS A (TU) (Satisfaction from an additional unit of consumption) AQ Basic Microcconomies (BAC1) 4MODULE 2 Table2 Utility Schedule ‘Consumption Total Utility Marginal Utility 1 7 7 2 13, 6 3 18 5 4 22 4 5 25 3 6 27 2 7 28 1 8 28 0 9 27 A 10 25 2 " 22 3 12 18 4 13, 13, 5 14 7 6 15 0 7 Figure 3 Utility Curves Figure 3 and Table 2 illustrate the aforementioned concepts with the consumption of water as an example. The symbol for change carries a positive sign when the variable increases and a negative sign if the variable decreases. As the consumption level increases, a positive marginal utility (MU) increases total utility (TU), while the opposite is true when MU is negative. Moreover, marginal utility is also defined as the utility or dissatisfaction from the last unit of consumption, depending on whether MU carries a positive or negative sign. Basic Microcconomies (BAC1) 5MODULE 2 For example, the table shows that marginal utility (MU) is 2 which is the increase in total utility(TU ) when consumption increases from 5 to 6 units. This level of MU is simply the utility of the 6" or last unit of consumption. But how does the behavior of the MU curve influence the behavior of the total utility (TU) curve and the level of maximum satisfaction? Answer: Referring again to Figure 3 and Table 2 an additional unit of consumption registers a positive change and therefore, an increase in total utility so long as MU is positive. Eventually, the TU curve registers a negative change and therefore, a decline where MU is negative. Consumption The Indifference Curve The indifference curve together with the isocost in the next section is a useful tool for analyzing consumption behavior on the utility theory. An indifference curve contains varying combination in the consumption of commodities that yield the same level of total utility. An indifference curve illustrates this property assuming two commodity items, which Figure 3 and Table 3 are food and clothing, Table 3 Indifference Schedule Food Consumption ‘Clothing Consumption Marginal Rate of Substitution 56 1 - 46 2 (10) 7 3 O) 29 4 (8) 22 5 @ 16 6 ©) 1 7 ©) 8 8 (4) 5 9 3) 3 10 (2) 2 " ” Basic Microeconomics (BAC1) 6MODULE 2 Figure 4 Indifference Curve The marginal rate of substitution (MRS) of food (Y axis) to clothing (X axis) in Table 3 is measured as follows which is simply how much food one has to give up to consume an addit nal unit of clothing. MRS ~_A Food Consumption A Clothing Consumption Figure 4 and Table 3 illustrate the foregoing relationship through the slope of the indifference curve. The change in food consumption diminishes for every additional unit of clothing consumed. The Law of Diminishing Marginal Utility and the Shape of the Curve ‘Technically, the shape of the indifference curve is convex to the graph’s point of origin due to the Law of Diminishing Returns. To maintain overall satisfaction, one only has to give up less of a good with an increasing Marginal Utility (MU) to be regained by more consumption of another with a decreasing MU, But practically, one becomes increasingly reluctant to give up a good (food in the example) that becomes scarcer and additionally more valuable (higher MU), in exchange for another (clothing) that becomes more abundant and additionally less satisfying. In practical terms,one is only willing to forego less and less of one good in exchange for more and more of another as the former becomes relatively scarce and more valuable and the latter relatively abundant and less valuable. Basic Microcconomies (BAC1) 7MODULE 2 z Let's have an Activity Lesson 1:Activity 1 Case Study!!! Substitution between Domestic and Foreign Goods Substitution between domestic and foreign goods and services has reached an all-time high in the worlds today and is expected to continue to increase sharply in the future, For homogencous products such as a particular grade of wheat and steel,and for many industrial products with precise specifications such as computer chips, fiber optics and specialized machinery, substitutability between domestic and foreign products is almost perfect. Here, small price difference can lead quickly to large shifts in sales from domestic to foreign sources and vice versa, Even for differentiated products, such as automobiles and motor cycles, computers and copiers, watches and cameras, films and TV programs, soft drinks and cigarettes, soaps and detergents, commetcial and military aircrafts and most other products that are similar but identical, substitutability between domestic and foreign products is very high and rising. Despite the quality problems of the past, U.S.- made automobiles today are highly substitutable for Japanese and European automobiles, and so are most other products. Furthermore, with many parts and components imported from many nations and with production facilities and sales around the world often exceeding sales at home, even the distinction between domestic and foreign products is fast becoming obsolete, Should a Honda Accord produced in Ohio be considered American? What about a Chrysler minivan produced in Canada? Is a Kentucky Toyota or Mazda which uses nearly 50% of imported Japanese parts American? It is clearly becoming more and more difficult to define what is an American automobile even after the American Automobile Labeling Act of 1992, which requires all automobiles sold in the United States to indicate what percentage of the car’s parts are domestic or foreign. Indeed, one could even ask if the question is relevant in a world growing more and more interdependent and globalized. Source: “Honda’s Nationality Proves Troublesome for Free-Trade Pact” The New Times, October 9, 1992;"Want a USS. Car? Read the Label, “The New York Times, September 18, 1994, and “Want to Buy American?"U.S. News and World Report, October 10, 1994, Questions: (Write your responses on the following questions below with a minimum of 250 words) 1. What promotes substitution in this reading? How? 2. Explain and illustrate how substitution promotes consumers welfare. References: -Pagoso et.al Introductory Microeconomics, Third Edition nnlaw, 2018, Principles of Microeconomics 2e- for AP Courses, - https://www slideshare.net/TheY oungIndianEconomists/theory-of-consumer-behaviour Basic Microeconomics (BAC1) 8MODULE 2 = DeSeraaay Intended Learning Outcomes Atthe end of the chapter, the students is expected to ‘* Describe the function of production ‘© Discussing the law diminishing returns Analyze the production function in short and long run Introduction: Production theory is the study of production, or the economic process of producing outputs from the inputs. Production uses resources to create a good or service that are suitable for use or exchange in a market economy. This can include manufacturing, storing, shipping and packaging. Some economist define product broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production, Production is a process and such it occurs through time and space. Because it is a flow concept, production is measured as a “rate of output per period of time”. There are three aspects to production processes: 1. The quantity of the good or service produced. 2. The form of the good or service created. 3. The temporal and spatial distribution of the good or service produced. Production is a process of combining various material inputs and immaterial inputs (plan, know-how) in order to make something for consumption (the output). It is the act of creating output,a good or service which has value and contributes to the utility of individuals. Production Function. Input" | Production | -——»_ output Function * Ineconomics, a 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. Basic Microeconomics (BAC1) 9MODULE 2 Factor of Production ‘* Economic resources are the goods or services available to individuals and businesses used to produce valuable consumer products. © The classic economic resources include land, labor and capital. Entrepreneurship is also considered am economic resource because individuals are responsible for creating businesses and moving economic resources in the business environment. ‘+ These economic resources are also called the factors of production. The factors of production describe the fimetion that each resource performs in the business environment. ‘Table 4 Product Function Labor Total Product/Output | Marginal Product | Average Product (Man Hours) (Units) (Units) i 5 3 2 10 5 Stage 1 3 16 6 353 a 2 5 52 3 24 3 a5 Stage 2 6 24 0 a 7 21 @ 3 8 16 I © 2 Stage 3 9 10 © TI 10 5 | G) 05 1 2 oO 02 Stage 4 2 0 @ 0 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: MP= AQ al Where: MP = Marginal Product or Output Qp = Total Product or Output 1 =Resource Input A = Change For example in Table 4 and the 2"! unit of labor yields an additional output of 5 which is actually the Marginal Product (MP) of using 2units of the resource. In turn, this additional product (MP) increases TP fiom 5 to 10 because of that 2" or last unit of labor. But, the 7" unit of labor has negative product or an MP of (3) which decreases TP from24 to 21 Basic Microeconomics (BAC1) 10MODULE 2 Total Product or Output (TP), it refers to the total volume of goods produced during a specified period of time. Average Product (AP) is output per unit of the variable resource input and measured as follows: AP=Q 1 The Law of Diminishing Returns The production function shows that stretching the use of variable resources against the limits of fixed resources decreases additional product (MP). This is the Law of Diminishing Returns which is basically due to the limits of a fixed plant size, Having too much of one resource and too little of another can even result in a resource imbalance that decreases production capacity with a negative Marginal Product at Stage 3. The Law of Diminishing Returns has three important lessons: First, the size of a resource, given the rest as fixed, should not go beyond its product-maximizing point. Second, plant capacity can only increase with more resources combined unless technology changes. Third, that resources are basically complementary. Relationship Between Different Products Between AP and MP « When MP > AP, AP Increases, When MP < AP, AP Decreases | When MP = AP, AP is Maximum Between TP and MP * When TP Increases at Inereasing Rate, MP Increases, * When TP Increases at Decreasing Rate, MP Decreases * When TP is Maximum, MP is 0 © When TP Decreases, MP is Negative Analysis of Production Function: Short Run * In the short run at least one factor be fixed in supply but all other factors are capable of being changed. * Reflects ways in which firms respond changes in output (demand). © Can increase or decrease output using more or less of some factors. Increase in total capacity only possible in the long run. Basic Microeconomics (BAC1) uMODULE 2MODULE 2 How much does the quantity of Q change, when the quantity of L is increased? Units of K Employed Output Quantity (Q) 8 37 60 83 96 107 117 127 128 7 42 64 78 90 101 110 119 120 6 37 52 64 73 82 90 97 104 Q ; ae 4 24) 3 17 29 41 52 58 64 69 73 2 8 18 29 39 47 52 56 52 1 4 8 14° 20 27 24 ~~ 21 17. 1 2 3 4 5 6 7 8 Units of L Employed Analysis of Production Function: Long Run ‘* The long run is defined as the period of time taken to vary all factors of production, Y By doing this, the firm is able to inetease its tofal capacity — not just short term capacity Y Associated with a change in the scale of production Y The period of time varies according to the firm and the industry. Basic Microcconomies (BAC1) BMODULE 2 How much does the quantity of Q change, when the quantity of both L and K is increased? Units of K Employed Output Quantity (Q) 8 37 60 83 96 107 117 127 42 64 78 90 101 1 120 37 52 64 73 82 97 104 31 47 «#58 82 89 95 24 39 67 73 79 85 52 58 64 69 73 39447 «+52 56 52 20.27 24 2117 4 2 a 4 & 6 r 8 Units of L Employed. Ano rkaon The Isoquant Theoretically, there are infinite combinations of resource inputs which determine the same plant capacity (maximum output). In a two-variable-resource system, these combinations form the product indifference curve or isoquant, Table 5 present an isoquant with capital and labor as resource inputs. Marginal Rate of Substitution (MRS) is defined as how much of one resource is given up in order to use an additional unit of the other, given a fixed capacity. MRS = AY axis AX axis MRS= AK AL ‘Table 5 Isoquant Labor Input | Capital Input Marginal Rate of Substitution A Capital / A Labor T 30 = 2 26 4 3 22.5 33 4 10.5 3 5 7 23 6 15 2 7 is 13 8 2 1 9 2 05 10 2 0 Table 5 shows that less and less of capital inputs (K) are given up in order to use an additional unit of Labor (L) as MRS decreases down the line. Basic Microeconomics (BAC1) 4MODULE 2 g Let's try what you have learned! Lesson 2:Activity 1 Problem Solving. Direction: Complete the table. Show the solution, Labor Input TP MP ‘AP 1 6.00 2 9.00 3 14.00 4 17.00 5 22.00 6 27.00 7 29.00 8 25.00 9 16.50 10 10.00 ul 6.00 2 3.00 13 1.00 14 0.00 Complete the table of MRS for this Production Isoquant, Show the solution, Labor Input Capital Input MRS T 37.00 2 43.00 4 36.00 6 17.75 7 9.25 9 21.00 10 16.50 ul 15.75 14 3.00 16 12.00 Basic Microcconomies (BACI)MODULE 2 References: Some of the concepts and ideas were adopted from or inspired by the following books which are highly recommended reading: - Greenlaw,et.al., Principles of Microeconomics 2¢, openStax = Pagoso,etsal, Intoductory Microeconomics, Third Edition = http:/www.darshan.ac.in/Upload/DIET/Documents/CE/Theory%200f%20production_05012015_060 332AM.pdf -hitps://www.slideshare.net/salasvelasco/microeconomics-production-theory ~ https:/www.slideshare.net/geetsrivastava/production-function-26663899%next_slideshow=I -https://www slideshare.net/tanveerabbott/production-function-15871760 Basic Microeconomics (BAC1) 16