The Theory of Consumer Behavior

The Elasticity of Demand

The Costs of Production

Non-Accounting Costs (opportunity costs)

Terms and Concepts

 The demand curve is down sloping from left to right. It depicts the inverse relationship between price and quantity-demanded. The supply curve is up sloping from left to right. It depicts the direct relationship between price and quantity-supplied.

At the equilibrium price quantity-demanded is equal to quantity-supplied. A surplus will occur if the firm sets price above equilibrium and a shortage occurs if a firm sets price below equilibrium. In an efficient market price exhibits a strong tendency towards equilibrium because firms will raise price when shortages occur and lower price when surpluses occur.

Shifts in demand are caused by changes in taste, income, prices of other goods, expectations and the number of consumers. For example, a rise in the price of a substitute good will cause demand to shift to the right (increase) as in the graph below (from D to D+). Equilibrium price increases when demand shifts right.

Shifts in supply are caused by changes in technology, factor costs, profitability of alternative opportunities, expectations and the number of sellers. For example, a decrease in the cost of materials will cause  supply to shift to the right (increase) as in the graph below. Equilibrium price decreases when supply shifts right.

When public policy causes an interference with equilibrium price the market will exhibit surpluses  or shortages. A minimum wage that is set above the equilibrium wage rate will cause unemployment (a surplus of workers looking for jobs) as in the graph below. Rent Control will produce a housing shortage if the rent ceiling is below the equilibrium rent level.

  In the model of a market economy presented by standard economic theory, the consumer is considered perfectly rational and possessing perfect information. Additionally, we are told that s/he operates from a position of consumer sovereignty. The concept of consumer sovereignty implies that producers are bound to produce goods that satisfy consumer wants. Additionally, consumers will act to maximize their satisfaction by consuming goods such that the added satisfaction (marginal utility) per dollar from one good is equal to the added satisfaction per dollar received from any other of the consumer's purchases.    

               Ed =     Chg in Q/Average Q   

                            Chg in P/Average P

     P         Qd

    $5          1

      4          3                                  Ed =  2/2 =     1     =  4.55

                                                               1/4.5     .22

  The demand for the product in the example above is elastic, that is the Ed > 1 meaning that consumers are very responsive to changes in price. A 1 percent rise in price will cause a 4.6 percent fall in quantity-demanded. Demand for a product is inelastic if Ed < 1.

  If demand for a good is elastic then a rise in price will lower total revenue while a decrease in price will increase total revenue. An inelastic demand will result in the opposite effect on total revenue for a given change (increase or decrease) in price - a decrease in P causes a decrease in TR and an increase in P causes an increase in TR.

The Short Run

    The Law of Diminishing Marginal Returns occurs in the short-run period of time when some inputs are fixed. This results in the inevitable rise in marginal costs after some point  in the process of increasing output. Capacity is limited by the amount of plant and equipment in operation at a moment in time.

 Calculate the marginal cost in the following production function. Assume the only variable input is labor which costs $100 a day.

  workers     Output  MPP     MC    TFC      TVC    TC             ATC

   per day      

          1          100        --        --     $200      $100  $300     $300/100 = $3       

          2          120       20                  200        200    400      400/120  =   3.33

          3          135       15                  200        300    500      500/135  =   3.70

          4          140         5                  200        400    600      600/140  =   4.29

     MC =  chg in Total cost/chg in output 

              The marginal cost of the output contributed by the fourth worker is:

                             a. $5

                             b. $6.67

                             c. $20

   Ans: c   ($20 = $100 / 5 units). The fourth worker costs $100 and adds 5 units to production. Those 5 units therefore cost $20 each, i.e., MC = $20. 

  If the product sells for $20, how many workers would the employer want to hire? She would hire up to the 4th worker who contributes 5 x $20 = $100 to the company revenue, while adding exactly $100 in costs per day. When the wage of the worker equals the value of the worker's contribution then the employer hires no more workers. 

   Why does Marginal Cost cut ATC at its minimum point? Remember AFC always falls as output increases while AVC turns up after some level of output. You can calculate AFC and AVC from the schedule above.  The clue to the answer is in the relative change in AFC and AVC as output is increased in the short run.  This also helps to understand why average total cost is U-Shaped.

  Where does a firm want to produce in the short run? At the minimum point of their ATC curve.

The Long Run

  The long run is a period of time when all inputs are variable. So, a producer can choose any plant size. Costs can increase with plant size (diseconomies of scale), decrease with plant size (economies of scale) or remain constant (constant returns to scale).   

  The long run average total cost curve can therefore have a positive slope, a negative slope or be a straight line. It is characteristically portrayed as U-Shaped as larger plant sizes are believed to inevitably lead to bureaucratic inefficiencies.                         

  Where does a firm want to produce in the long run? On the lowest ATC curve -- the most efficient plant size.   

   The foregone income from an alternative use of a capitalist's investment is an opportunity cost that must be considered when s(he) makes an economic decision.

marginal utility

short run

consumer sovereignty

equilibrium price

economies of scale

law of diminishing marginal returns

economic costs

accounting costs

opportunity costs

external costs

money as a medium of exchange

barter versus a money economy

causes of shifts in supply and demand

effects on equilibrium price and quantity of shifts in S & D