Economics

Consumer Theory
Utility Theory

 Demand Curves arise from consumer preferences.

 Economists have developed several “axioms” that
describe “reasonable” preferences.

Axioms:
 Completeness

 Transitivity

 Continuity

 (Local) Non-Satiation / (Strict) Monotonicity

 Convexity
Utility Theory: Axioms

 Completeness: all combinations of goods can be

ranked by preferences
 Transitivity: If A is preferred to B and B is preferred to C, A
must be preferred to C
 Continuity: No “hard swerves”.
 (Local) Non-Satiation: More is preferred to less
 Convexity: Reasonable people prefer “balance”

 Completeness + Transitivity = Rationality (in the economic

sense)
 Demand and Supply Analysis:
Consumer Demand
Utility Theory: The Math

Utility function: Utility = U(Q1, Q2, Q3,…,QN)

 Variables are quantity consumed of goods 1 to N

 Quantity must be ≥ 0 for each good

 Utility is an ordinal scale

 An Indifference Curve

6
Consumer willing to give up 1 unit of Y to
obtain 1 extra unit of X
5

4
Good Y

3 Consumer willing to give up 1 unit of Y to

obtain 3 extra units of X
2

1 2 3 4 5 6 7 8 Good X
-2
 Budget Constraint

 Based on consumer’s income and the prices of the products.

 Budget line shows all combinations of both goods that will exhaust
the consumer’s income.

Income = $4,000
20
Units of Product Y

PX = $80
PY = $200

Opportunity set:
all affordable bundles

Units of Product X 50

-1
 Consumer’s Equilibrium Bundle

Income = $4,000 I0: Suboptimal; full income not

PX = $80 consumed, utility not maximized
PY = $200
I2: Utility > I1 but not affordable

20
Units of Product Y

12
I2
I1
I0
20 50
Units of Product X
-3
 Demand and Supply Analysis:
Consumer Demand
Substitution and Income Effects

Substitution effect always shifts consumption to more of Good X when

the price of Good X falls (always negative)

Total expenditure on the original bundle is now less than full income
(budget line shifts)
 Normal goods: Increase in income increases consumption of

Good X
 Inferior goods: Increase in income decreases consumption

of Good X
“Always” Price decrease, Quantity Increase
Giffen good: Suppose Price Decreases, the Quantity
Decreases (income effect) > Increases (substitution effect) Then QD falls
 Veblen Good

 Higher price increases desirability

  Price:  status
 High end designer/luxury goods
 Positively sloped demand curve for some individuals (within a
range)

*Not supported by the rules of consumer choice

(but Giffen good is)
 Economics

The Firm
 Demand and Supply
Analysis: The Firm
Economic Profit

Some key definitions:

Accounting profit = revenue – explicit costs

Economic profit = accounting profit – implicit costs
Implicit costs = return on owner capital + opportunity cost of
owner’s time
Normal profit: defined as economic profit = 0
Economic rent = surplus value when resource is in fixed supply, price >
amount required to sustain supply
Price, Marginal Revenue, Average Revenue

Total Revenue = P X Q
Price Average Revenue = TR/Q = Price
Marginal Revenue = ΔTR/ ΔQ

PM = Market Price = MR = AR
PM Demand

Quantity
LOS 15.b Calculate/Interpret/Compare Demand and Supply
CFAI p. 101 Schweser p. 64 Analysis: The Firm
Price, Marginal and Average Revenue

Sell 3 @ 60: TR = 180

PriceP rice
80
80
Sell 4 @ 50: TR = 200
70
70 MR for 4th Unit = 20
60
60 AR = Price
50
50

40
40

30
30
D
D

20
20

10
10
MR
00
1 2 3 4 5 6 7 8 Quantity
 Factors of Production
Land – location

Labor – skilled, unskilled, management

Capital – equipment, tools, buildings

Materials – productive inputs

LOS 15.d Calculate/Interpret Demand and Supply
CFAI p. 109 Schweser p. 68 Analysis: The Firm
Costs per Unit of Output

Average costs and marginal costs

Cost
Cost
ATC
ATC==AFC
AFC+ AVC
+ AVC
MC
MC
$6
$6

ATC
ATC

AVC
AVC
$3
$3
xx

$1
$1
AFC
AFC
xx
Shirts
Shirtsper
perday
day
00 10
10 20
20 30
30
LOS 15.e Determine/Describe Demand and Supply
CFAI p. 116 Schweser p. 72 Analysis: The Firm
Breakeven and Shutdown

Cost
MC

ATC
AVC
P1 Breakeven
Operate in SR,
P2 Shutdown in LR

Shutdown in SR and LR

Quantity
 Profit Maximization – Perfect Competition

To maximize profit:
Price MC = MR = Price
MC
Economic ATC Economic Loss when:
loss
Price < ATC
ATC*
P* MR = AR = D

Quantity
Q* Q* = Profit maximizing
output
LOS 15.f Describe Demand and Supply
CFAI p. 120 Schweser p. 76 Analysis: The Firm
Profit Maximization – Imperfect Competition

Profit is maximized at the output for which: MR = MC

Price Economic
Profit

P*
MC
ATC*

ATC D

MR
Quantity
Q*

-2
 Profit Maximization in the Long Run

Under perfect competition, the market price will be P2

in the long run as firms move to minimum efficient
scale
Price

1
C

2
C
AT

AT

6
C
5
C
3
C

AT
SR

SR

AT
4
AT

SR
LRATC

AT

SR
SR

SR
P1

P2 Q2 = minimum
efficient scale

Q1 Q2 Quantity