CHAPTER FIVE

THEORY OF CONSUMER BEHAVIOUR

5.1 Introduction
5.2 Utility concepts
5.2.1 Total Utility (TU)
5.2.2 Average Utility (AU)
5.2.3 Marginal Utility (MU)
5.3 Relationship between TU and MU
5.4 Diminishing Marginal Utility
5.5 Utility measurement
5.5.1 Cardinal Approach to Consumer behaviour
5.5.2 Assumptions of cardinal utility analysis
5.1 Marginal utility and Marginal demand curve
5.2 Utility Maximisation/ Marshallian Equilibrum
5.3 Downward sloping Demand curve from Cardinal Approach
5.4 Criticisms of cardinal utility analysis
5.5 Consumer Surplus
5.6 Ordinal Approach to Consumer Behaviour (Indifference curve Explanation)
5.6.1 The Concept of Ordinal Utility
5.6.2 Assumptions of Ordinal Utility Approach
5.6.3 Indifference Curve
5.6.4 Indifference Map
5.7 Utility Maximization using Ordinal (Indifference curve) Analysis
5.8 Budget line

5.11Slope of the budget line

5.12 Changes in the budget line

5.13 Income Effect and Substitution Effect
5.14 Consumer Surplus Vs Producer’s Surplus
5.15 The Revealed Preference Hypothesis
5.1 INTRODUCTION
Consumer behavious rinvolves understanding the reason(s) why consumers react to changes in price
and other factors influencing demand and supply of a given commodity at a particular time, place
and value. Utility is generally defined as the satisfaction derived by a consumer from the
consumption of a particular commodity at a given point in time.
The theory of Consumer behaviour underscores the concept of utility on the basis of effective
demand, which is dependent upon consumer’s perception of their environment. Since the way we
perceive our environment differs, the resultant behaviour of the consumer is not expected to be the
same.
Generally, Economists believe that certain assumptions underline the theory of consumer
behaviour:
• Consumers are constrained by their budgets (income level);
• Consumers have different preferences;
• Consumers are rational;
• Consumers’ incomes are fixed and the products they buy, have fixed prices with market
certainty.
All these and other assumptions are perceived by various classical Economists, who viewed
utility by three major concepts: Total utility (TU); Average Utility (AU) and Marginal utility
(MU).

5.2UTILITY CONCEPTS
5.2.1Total Utility:This refers to the total satisfaction gained from consuming different quantities
of same commodity for a given period of time. It could be regarded as the overall satisfaction
obtained from consuming different units of a given commodity. Initially, TU rises faster as the
quantity consumed increases to a certain point of saturation where it begins to decline gradually
due to the law of diminishing Marginal utility.
 Fig. 15

5.2.2Average Utility (AU): This is the satisfaction derived per unit of a commodity consumed
by a consumer. It is the amount of satisfaction that an individual or household will gain from
consuming a unit of a given commodity, say X. The AU rises falls as the quantity consumed
increases but does not fall below the origin, due to the law of diminishing Marginal utility.
AU = Total Utility
Quantity consumed

Fig. 16: Average Utility

5.2.3Marginal Utility (MU): This refers to the additional satisfaction derived by the individual
or household from additional units of a given commodity consumed. Technically, MUrefers to
the change in total utility, resulting from a little more or a less of the commodity consumed.
Thus:
MU = Change in Total Utility __ ORdTU
Change in Quantity consumed dq
Ceteris paribus, it follows that as quantity consumed increases, the MU initially rises slowly and
then begins to falls faster to the extent that it declines below the origin, thus giving negative
values of utility (i.e. dissatisfaction). This is due to the law of diminishing marginal utility.

Fig. 17: Marginal Utility

5.2.4 RELATIONSHIP BETWEEN TU & MU

The satisfaction obtained from consuming a particular product increases to a point and, thereafter,
starts diminishing as the number of unit consumed increases. This diminishes until it reaches
saturation point, after which we have negative diminishing marginal utility. A tabular and
graphical representations of the total, marginal and diminishing marginal utilities can be shown
below,
Table 7: Schedule of TU and MU
No. of Units Total Utility (TU) Marginal Utility (MU)
(Bottles of Fanta) (Measured in Utils) (i.e Utility of each bottle)
0 0 0
1 10 10
2 18 8
3 25 7
 4 30 5
5 33 3
6 34 1
7 34 0
8 33 1

Fig. 17: The Relationship between TU &MU

Interpretation of the Graph:
From the table and graph above, marginal utility of the second bottle of Fanta is the total utility
of two bottles minus the utility of the first, it would be seen that the addition of all marginal
utilities equals total utility. The table also shows that as more and more bottles of Fanta are
consumed, less and less utility are enjoyed. This is what is known as diminishing marginal utility.
The law of diminishing marginal utility states that as the amount of a commodity consumed
increases, the marginal utility derived from the consumption of extra units diminishes.

Exercise:
Given the Utility Schedule of a consumer as below:

Utility of Comm. Total Utility Average Utility Marginal Utility

X consumed
1 25 25 -
2 34 A 10
3 45 15 6
 4 48 12 C
5 48 B 1
6 42 7 0
7 E 5.7 -2
8 38 4.75 D

i. Calculate the values of A, B, C, D & E and plot the TU, AU & MU

ii. Explain the relationship between TU, AU & MU.
iii. Explain the law of Diminishing Marginal Utility, using the above table.

DIMINISHING MARGINAL UTILITY

This classical law of consumer behaviour postulates the idea that the higher the consumption of
additional units of a commodity, the lesser the total satisfaction derived. Hence, Ceteris paribus,
the higher the addition to total quantities consumed, the lesser the marginal utility derived. Thus,
the law of diminishing Marginal utility states that, “holding the consumption of all other goods
constant, the marginal utility of good diminishes as consumption of that good increases”

5.4 UTILITY MEASUREMENT

5.4.1 CARDINAL APPROACH TO CONSUMER EQUILIBRIUM (MARSHALLIAN
APPROACH)
Human behaviour, in terms of rational conduct, by desiring to maximize pleasure and minimise
pain, underlies the consumer theory. The consumer tends to maximise his utility or benefit in the
utilization of his resources in such a way that he tries to use each of the units of his resources to
achieve the highest benefit while at the same time tends to bring the cost he incurs to the barest
minimum.
The cardinal analysis of utility looks at utility as "measurable” in the sense that value can be
attached to any unit of output consumed and the satisfaction, in utils, derived from it. It considers
a number of assumptions in its analysis.
5.4.2 ASSUMPTIONS OF CARDINAL UTILITY ANALYSIS
(i) Rationality: Consumers behave rationally by endeavouring to utilize his
resources to obtain the optimal consumption based on the existing price of the
commodity and the income of the consumer,
(ii) Cardinality: This assumes that the utility of each commodity is measurable, usually, in terms
of how much a consumer is willing to pay for the successive unit of commodity consumed.
(iii) Constant Marginal Utility of Money: This states that the (marginal) utility of money is
constant as a unit of measuring utility.
(iv) Diminishing Marginal Utility:This assumption holds that the greater the rate of consumption
of the commodity per unit of time, the lesser is the marginal utility derived from it.
The above assumptions enable us to understand the discussion of cardinal utility measurement.

5.4.3 MARGINAL UTILITY AND-MARGINAL DEMAND CURVE

Since a rational consumer will not pay more for a unit of a commodity than the value the unit of
it gives to him, it means that as each unit consumed, yields less and less utility. More units of
that commodity will only be bought if the price were lower i.e., more goods will be demanded
when the price falls, because utility enjoyed from increased consumption falls. See the below table
and graph for figurative and graphical expressions of the above rational conduct of the consumer.

Table 8: Marginal Utility and Marginal Demand Curve

No. of bottles Marginal utility Marginal Utility
of Fanta (Measured in (Measured in N worth
utils) (1 util = N1.00))
1 10 N10
2 8 N8
3 7 N7
4 5 N5
5 3 N3
6 1 N1
7 0 N0
Figure 18: A Graph showing Marginal Utility and Marginal Demand Curve

Analysis of the Graph

From the table and graph above, it can be observed that the more the quantity of good demanded
and consumed, the less the utility enjoyed. If utility enjoyed decreases as consumption increases, it
means that sellers can only encourage the buyers to buy more by reducing their prices. This is
how the law of demand, which states, "the lesser the price of a good, the quantity purchase”, is
derived. The marginal utility curve above thus has the same shape with the demand curve.
Therefore, the theory of utility serves as the bases of the theory of demand.

5.5 UTILITY MAXIMISATION OR EQUILIBRIUM (MARSHALLIAN APPROACH)

The major consideration for a consumer to obtain his maximum satisfaction under cardinal
analysis is that the consumer must examine the marginal utility per monetary unit, say, naira,
spent on each commodity. In the equi-marginal principle, it is expected that total utility is
maximised when the marginal utility (MU) per naira spent on each commodity is equal; or
again, total utility is maximised when the ratio of MU to price are equal for all commodities
under consideration.
A consumer will be in equilibrium when the MU of the various consumer that he consumed are
equal. Thus, a consumer will be in equilibrium at a point where the ratio of the mariginal utility
of consumers to it price, equals to the corresponding ratio of other consumers.
For example, given two commodities, say, A and B } with their respective MUs as MUa and
MUb and the corresponding prices as Pa and Pb, then utility maximization exists when:
MUA = MUB or MUA= PA
PA PB MUB PB

In general, MUA = MUB =… = MUN

PA PB PN

This equilibrium analysis has been attributed to Alfred Marshal, hence the Marshallian
Approach, because he looked at the analysis in partial equilibrium state. This is a type of
equilibrium in a particular market situation. This analysis bolds a number of assumptions as
in the above assumptions of cardinal analysis of utility maximisation and holds other
conditions in ceteris paribus state. The opposite of the partial equilibrium analysis is the
general equilibrium analysis which is credited to Walrus. It ignores the partial assumptions
and looks at all the markets collectively.

Table 9 : Figurative Expression of Cardinal Approach to Utility Maximisation (i-e.

the Consumer Equilibrium)

Qa Tux Mux Px MUX Qy TUY MUy PY MUy

PX PY
(Units) (Utils) (Utils) (N) Px (Units) (Utils) (Utils) (N) Py
1 120 120 20 6.0 1 80 80 12.00 6.7
2 230 110 19 5:8 2 150 70 10.90 6.4
3 330 100 18 5.6 3 210 60 10.50 5:7
4 420 90 17 5.3 4 260 50 10.00 5.0
5 500 80 16 5.0 5 300 40 09.50 4.2
:
6 570 70 15 4.7 6 330 30 09.00 3.3

Mathematical expression:
From the table, the budget line is as below
PxQx + PyQy = Y (income)
Possible combinations are:
Given that income is N9.
Explanation to the Table
• MUx = Optimal consumption of X
Px
• MUy = Optimal consumption of Y
Py
(3) From the assumption of utility, the price a consumer will be willing to pay upon the
consumption of every successive unit of a commodity reduces over time, hence the Pxand Py
schedules in the above table.

(4) The point of consumer equilibrium is shownatMUx= MUy

Px Py
At this point, the quantity or units consumed of X = 5; and that consumed of Y = 4.

5.6 DOWNWARD SLOPING DEMAND CURVE FROM CARDINAL APPROACH

From the above table, the price is put along the Y-axis if one of the products is plotted against its
corresponding quantity (Q) along the X-axis. The resultant curve is a downward sloping demand
curve; Let us use Qx against its price, Px to plotthe demand curve as the below figure 19.

Figure 19: Downward Sloping Demand Curve from Cardinal Approach

Analysis of the Graph
It needs –be noted "that -the same idea "of an expected reduced marginal demand price as "the" amount
of the commodity consumed increases, also exists in the determination of the above data in table
9 and the resultant graph 19.
The concept of consumer surplus is precipitated on the concept of DMU. No doubt, the consumer
will be willing to pay more for the first bottle of coke than for the second or third or fourth, etc. as
the case may be.

5.7 CRITICISMS OF (CARDINAL) UTILITY ANALYSIS

The cardinal utility or just utility analysis has been criticised over the ambiguity of measuring
utility. There is also the problem of inconsistency in the theory and its assumptions not very
realistic.
In other words; consumer surplus is a measure of the different between the value that a
consumer place on the consumption of a consumer and the amount he actually pays.

5.8CONSUMER SURPLUS (CS)

Under the rational behaviour, we have noted that a consumer may be willing to pay a lesser and
lesser price upon his successive consumption of a given commodity over a period of time. This
price he is willing to pay is called the marginal demand price. Situations might arise that a
consumer might get to the market and eventually find out that the price of the product is lesser
than what he was willing to pay per successive unit consumed. The difference between what he
was prepared to pay (i.e., his marginal demand price) and the lesser-actual price in the market is
called the consumer surplus (CS). It is enjoyed by the consumer. For example, let's say that you
bought a football match ticket to watch Enyimba FC Vs Rangers International during the
summer holiday for N1, 500, but you were expecting and willing to pay N2,000 for one ticket.
The N500 represents your consumer surplus.

Thus, CS tells us that the utility or welfare a consumer derives from consuming a product over a
period of time may outweigh the total utility of its monetary sacrifice or the price paid for it. It is
computed in terms of the difference between total welfare or total utility and the total
expenditure made over time.
While the total welfare is determined by the summation of the various marginal prices of the
product over time, the total expenditure is obtained by adding up the corresponding multiples of
the price and quantity consumed. Thus, the difference between the total welfare and the total
expenditure gives the CS.

Consumer surplus is based on the economic theory of marginal utility, which is the additional
satisfaction a person derives by consuming one more unit of a commodity. The satisfaction
varies by consumer, due to differences in personal preferences. According to the theory, the
more of a product a consumer buys, the less willing he/she is to pay more for each additional unit
due to the diminishing marginal utility derived from the product.

Consumer Surplus and Price Elasticity of Demand

Consumer surplus for a product is zero when the demand for the product is
perfectly elastic. This is because consumers are willing to match the price of
the product. When demand is perfectly inelastic, consumer surplus is infinite
because a change in the price of the product does not affect its demand. This
includes products that are basic necessities such as milk, water, etc.

Demand curves are usually downward sloping because the demand for a
product is usually affected by its price. With inelastic demand, consumer
surplus is high because the demand is not affected by a change in the price,
and consumers are willing to pay more for a product.

In such an instance, sellers will increase their prices to convert the consumer
surplus to a producer surplus. Alternatively, with elastic demand, a small
change in price will result in a large change in demand. It will result in a low
consumer surplus as customers are no longer willing to buy as much of the
product or service with a change in price.

According to Alfred Marshal: Consumer Surplus = Total Utility – (Price x

Quantity)
Producer’s Surplus: Is the surplus that a producer derives from a given output. It is the
difference between the revenue that he derives from the sale of the given output and the revenues
at which he was willing to produce the same output. That is, producer surplus is the difference
between the amount producers get for selling a good and the amount they want to accept for
that good.
Note: Total welfare (utility) is measured in naira. MU of money is constant at 1 util = N1.

Figure 20: Producer’s Surplus

From the graphical illustration above, the following points are worthy of note:
 Changes in the equilibrium price are directly related to producer surplus, other things
equal. As the equilibrium price increases, the potential producer surplus increases. As the
equilibrium price decreases, producer surplus decreases.

 Shifts in the demand curve are directly related to producer surplus. If demand increases,
producer surplus increases. If demand decreases, producer surplus decreases.

 Shifts in the supply curve are directly related to producer surplus. If supply increases,
producer surplus increases. If supply decreases, producer surplus decreases.

 Price elasticity of supply is inversely related to producer surplus. If supply is completely

elastic, it is drawn as a horizontal line, and producer surplus is zero. If supply is
completely inelastic, it is shown as a vertical line, and producer surplus is infinite.

5.9 Ordinal Approach to Consumer Equilibrium: Indifference CurveExplanation

5.9.1 Concept of Ordinal Utility
Ordinal utility relates to the ranking of utilities in the order of preference instead of the
measurement that cardinal utility postulates. It is otherwise called the indifference curveapproach to
utility analysis. This indifference curve approach has been viewed by many economists as
more appropriate for utility analysis than the cardinal approach for; such reasons as removing
the ambiguity of measuring utility. There is more element of consistency in the theory and its
assumptions are more realistic than those of cardinal.

5.9.2 Assumptions of Ordinal Utility Analysis

(1) Completeness: This refers to the knowledge of the consumer having full information
about the product he wants to consume in the areas of its price, its ability to satisfy his
wants "and also he considers the income he has at hand to satisfy the consumption of the
product(s).
He may, therefore, talk about preferring product A to B or B to A or neither A is preferred to B nor
B preferred to A; meaning he is indifferent between A and B.
(2) Non-Saturation: (greater quality of the product is preferred to less) This
assumption is shown with indifference curve(s) (ICs) that move farther away from the origin
 giving higher satisfaction in the consumption level. Thus higher or farther ICs from the
origin are preferred to closer one(s)to the origin.
(3) Consistency or transitivity: This relates to consistency and transitivity rules that
state that if product A is preferred to product B, and B is preferred to C, then A is preferred
to C. In this assumption, a consumer has a well-defined order or preference among
commodities.
(4) Continuity or Substitutability: This means that commodities are continuously and
infinitesimally divisible into sub-units. Thus, the consumer can vary the quantity of, say,
'two commodities consumed to any level in which he is indifferent.
(5) Optimality: This relates to a consumer rational behaviour in deferring and endeavour to
maximize his TU by choosing an optimal or preferred commodity bundle, among various
combinations of commodity bundles.

5.10 INDIFFERENCE CURVE (IC)

Concept of Indifference Curve
A curve that illustrates how a consumer is indifferent between the two or more combinations of
two products he consumes, such that he gets equal satisfaction from consuming the two
commodities.
Indifference curve is a locus of the various combinations of commodity bundles in which the
consumer is indifferent. This means that he chooses any one of them depending on his preference
for it at a given point in time. It shows possible combination of commodities that yields equal
satisfaction to the consumer.

Characteristics of Indifference Curve

These characteristics are based on the above assumptions of optimal approach to utility
analysis. Also, two products, say, X and Y, are considered in the consumption basket. These
characteristics are as follow:
1. An indifference curve is continuous and passes through every point in the
commodityspace. A commodity space is the area that can have the various combinations of the
two commodities under consideration.
 Any movement or a demand in this IC units to brings no change in his total commodity
satisfaction. Thus, an IC of a consumer is drawn on the basis of a consumer’s scale of preference
or any of the five combination A, B, C, D, E, on the aforesaid IC gives him the same satisfaction.
Thus, the consumer is indifferent among all points such as A, B, C, D, & E.

Fig. 21a:Continuity Axiom ofIndifference Curve

Fig. 21b:A typical Indifference Curve

2. An Indifference curve is downward sloping. This follows the experience of the

marginal rate of substitution (MRS) of product X and Y, and vice-versa, in the consumption
basket. Here, the consumption of more of X brings about lesser consumption of Y, and vice-
versa, and he obtains the same level of satisfaction. The relationship between X and Y is
negative or inverse or opposite. This is so, because when more of X is consumed, less of Y is
consumed, or vice-versa; hence opposite relationship.

Fig. 21c:A special type of Indifference Curve

Analysis of the Graph:

From the above graph, when X1 is consumed, Y1 is combined with it. But when the consumption of
X is reduced from XI to X2, Y was increased from Y1 to Y2.
(3) The farther away from the origin an IC is, the higher the level of satisfaction. Thus, as
noted in the assumptions, the farther ones are preferred to those closer to the origin.

5.11 INDIFFERENCE MAP

Fig. 22: Indifference Map

(4) IC is convex to the origin. This follows the inverse or negative relationship between the
combinations of the two commodities under consideration.

Fig. 23:Consumer Equilibrum

(5) Indifference curve do not intersect. This follows the law of consistency and transitivity
in that, the higher the IC, the lower his preference, so, there is no way the lower one(s) can cut or
intersect the higher one(s), and vice-versa.
Fig. 24: Indifference Curve do not intersect
(6) A number of indifference curves in a commodity space is called indifference map.

Fig. 25: Indifference Map

An indifference map is a diagram showing a set of two or more ICs. Any IC lying above and to
the right of another rep. a higher level of satisfaction. To the further away an IC from the origin,
the higher the level of satisfaction derived by the consumer and vice versa.
Therefore, any combination of X commodity x and Y on IC4 is preferred to any combination of
commodity X and Y on IC3, IC2 or IC1.
Table 11:
Combination Oranges Mangoes MRCS (O/M)
oranges for
mangoes
1 18 1 -
2 13 2 5:1
3 9 3 4:1
4 6 4 3:1
5 4 5 2:1
6 3 6 1:1
NB: MRs (D, M) = D in oranges
D in mangoes
MRS for combination 2 = 18 – 13 = 5
2–1 1
Combination 3 = 13 – 9 = 4
3–2 1
As the consumer possesses more of mangoes, he would be prepared to surrender less of oranges.
Thus, MRS keeps declining from 5:1 to 1:1

Fig.26:Analysis of Graph:
MRSx, y = X
Y
MRSx, y at point B = Y2 - Y1= Y2,1
X2 X1 X2,1
= Y1,Y2 = MUY
X1, X2 = MUX
Note: The amount lost in, say X, is gained in Y i.e., 1 unit.

5.12Utility maximization using the ordinal (indifference curve) analysis

Utility maximization is the optimal level or point of consumption at which a consumer derives
the highest satisfaction from his given income over the consumption of some particular
commodity at a given point in time. Or again, it is the point at which the consumer obtains the
heist level of utility from the expenditure of fixed income by selecting from among all of the
various possible commodity combinations that particular bundle that he believes will provide
him the highest level of satisfaction.
From the below diagram, the point of utility maximization can be explained as follows. While
IC1 is attainable, it will give the consumer lower level of consumption at his given income. IC 3 is
not attainable with his given income but he desires to get there. IC 2 is the highest the consumer
can attain at his given income. His given income is shown by thebudget line AB. The point C at
which the IC2 is tangential to the budget line AB is thepoint of utilitymaximization.

Fig.27: Conditions for Utility Maximisation in Ordinal Analysis

These conditions can be listed as follows:
• Tangency: The point at which the budget line meets the indifference curve or vice-versa;
• Budget Constraint: The consumer has a limited or given income and his total consumption
is based on what this income can give him with the level of price(s) of the product(s).
NB:At point C:(Same Condition as Cardinal Approach)

5.13BUDGET LINE
AB in the above graph for utility maximization under ordinary approach is "the budget line. It is
the fixed income of the consumer, which gives him different levels of combination of X and -Y
in which he is indifferent based on Px and Py respectively.

Mathematical Expression of Utility Maximisation

LetPx = N5;Py= N4; given income (1) or AB =N100,
At point A, amount of Y consumed = AB = 100 = 25 units and the amount of X
consumed is 0. Py 4

At point B, amount of X consumed = AB = 100 == 20 units and the amount of Y

consumed is 0. Px5

At Point C, amount of X and Y consumed = AB=100

PxPy Px,Py

The quantities of X and Y bought at this point C vary according to preference of the consumer.
We emphasize here that at this point of utility maximization, MUx/MUy =Px/Py
Note: With the above given Px>Py, and the budget line, the amount consumed of X and Y in their
combination in the consumption basket can be obtained as follows. The initial formulation is as
follows,
AB (Budget Line) = PXX+ PyY, With the given Figures for Px = M5, Py = N4, and AB =
U100; substituting into the AB equation, 100 = 5(X) + 4(Y)
100 - 5X = 4Y. If, say, 10 units of X is bought, then we have 100- 5(10) = 4Y
50 = 4Y; Y= 12.5 units,
Example: Practice the determination of the amount of X consumed by giving a value to Y and
substitute into the AB equation and then solve for the unit of X that would be consumed.
If 5 units of Y is bought, then I have
AB = Py x + PyY
N100 = 5X + 4 x 5
100 = 5x + 20
80 = 5x
80/5 = x
x = 16 units

5.13.1 Slope of the budget line

The budget line is a line in commodity space which show different combination of the
commodity. The consumer can buy given his money income and the market prices of the two
commodity.
As noted above, in the case of two commodities in a consumption basket, you can either fully
consume one product, say X, and none of the other, say, Y, or you consume the second, say, Y,
and none of the first, say, X; or you consume both of them, say X and Y, at different proportions,
and yet receiving the same amount or level of satisfaction. The above analysis relates to one budget
line. The quantity of X or Y or the quantities of both of them that can be consumed are based on
their prices.In Mathematical notation, the budget line is represented thus:
Budget Line (BL) = Income (I) = XP + YP y --- (1). This is a case where all of the consumer's
income is spent on the consumption of commodities X and Y. From the above equation (1), when
only X is bought, we have income (1) = X Px—(2)
Quantity of X bought (X) = -----------------(3)
Also when only Y is bought, we have I = Y Py.........(4)
And the Quantity of X bought (i.e. Y) = I..............(5)
When both X and Y are bought, we have I - XPx + YPy……………. (6)
From equation (6), I-XPX = YPy...............................(7)
I – X-PyY.........................(8)
Px

I - X = Py ……………… (9)
Y Px
Let us assume that all the income (I) is spent, i.e. I - 0; hence from equation (9),
0 -X =Py - X =PY.
Y Px Y P
Since we cannot have negative commodities, then we have X = - Py,
Y Px
Thus, Py/ Pxis the slope of the budget line; and it is negatively (-ve) signed showing that it
is negatively sloped, hence a case of inverse relationship between the consumption of
commodity X to Y and vice versa.

5.13.2 Changes in the Budget Line (BL)

The-previous or above discussion on the budget line assumes constant income and prices. Let us
now look at the cases where the income of the consumer and the price of product X change. The
general conditions here arc that the budget line shifts upward or downward in the case of
increase or decrease in the income of the consumer. However, in the case of change in price of
commodity, we have the rotation of the budget line. These two cases can be both illustrated and
explained as follows:

Fig.28: The Case of Changes in Income (Shift in the Budget Line)

From the above graph, it is assumed that the prices of X and Y are held constant but the income
of the consumer changes. If the income decreases from I to I I, the budget line shifts downward
from AB to A1B1. On the other hand, if the income increases from I to I 2, the budget line shifts
from AB to A2B2. The downward shift in the BL from AB to A 1B1 is a case of lower level of
consumption while the upward shift from AB to A2B2 depicts a better and higher level of
consumption.

Fig. 29: The Case of Changes in the Price of X (Rotation of the BL)
From the above graph, it is assumed that the income of the consumer is held constant but the price
of one of the commodities changes. The price can fall or rise. Let us take the case of changes in
the price of X. If there is increase in price, it follows that fewer of it will be bought, hence, since
the price of Y is constant, this fewer X will be represented by the BL rotating downward or
leftward from AB to AC. The point A is retained in both cases because the same quantity of Y will
still be bought since its price does not change. On the other hand, if the price of X falls, more of it
will be bought, hence a new BL from AB to AD; a case of upward or rightward rotation of the
BL.In a general case, we say that the BL rotates around the X axis when there are changes in the
price of X, Also, the slope of the BL AC is steeper or higher than that of AB and thatof AB is
higher than that of AD.

In summary, if income (I) and Price of Y (PY) are held constant (fixed) and Px falls, the slope of the
BL becomes smaller (i.e., the curve becomes flatter and the quantity of X bought expands). On the
other hand, when Px rises, the slope of the BL becomes larger (i.e. the curve becomes steeper, and
quantity of X bought contrasts).

5.14 Income Effect and Substitution Effect

Our knowledge of the above rotation of the budget line, shift in the budget line, and equilibrium
level of consumption is to be applied in understanding this sub- topic. A consumer re-arranges
his purchases either due to the change in his income or due to a change in the relative prices of
the two commodities. When income changes, it is known as the income effect. But when it is a
change in the relative prices of the two commodity, a rational consumer changes to the lower
priced commodity =>This is known as the Substitution effect. Then he buys more of a
commodity that becomes cheaper and less of the commodity that is now dearer.
Thus from the graph below, the movement along the indifference curve IC 1 shows the
substitution effect. However, the movement from IC1 to IC2 shows the income effect.
Fig. 30: Graphical illustration of Income & Substitution Effect

Interpretation of the Graph:

• AB is the original Budget line, (ii) IC1 is the original IC. (iii) There is a fall in the price of
X, hence, we obtain a new budget line, AC. (iv) Point X is the initial equilibrium point
before the fall in Px, (v) Point Y is the new equilibrium point with the fall in the price of
X (a case of increase in real income), (vi) There is the assumption that real income is not
allowed, hence an imaginary budget line DE is drawn to allow the consumer stay at his
initial level of consumption along IC 1, (vii) With (vi), it means IC 1 must be tangential to
the imaginary budget line (BL) DE, and this is obtained at point Z Note that AC and DE
must be parallel (i.e A C || DE). (viii) The movement from the equilibrium point X to that
of Y is called the overall total effect. That is the purchase L6 Xi at the initial time to the
purchase of X2 at the final or new level of consumption. (ix) The movement from X to Z,
(movement along the same IC). by forcing the consumer to remain at his initial level of
consumption (AB) is called the Substitution Effect: i.e, the consumption of X3 instead of
X2 (x) The movement from the equilibrium position of Z to that of Y, where X2 instead
of X3 is purchased is called the Income Effect (a shift from IC 1 to IC2)., and also a shift
from budget line DE to that of AC takes place.
NOTE: A case of a rise in the price of X and the corresponding substitution and income effects
also exist.
5.15 CONSUMER’S SURPLUS vs PRODUCER’S SURPLUS
Consumer surplus is the difference between the value that a consumer place on the consumption
of a commodity and the amount he actually pays. In other words, the consumer is in surplus
when the actual market price is lower than the price the consumer is willing to pay i.e. his
marginal demand price. The concept of Consumer surplus is precipitated on the concept of
Diminishing Marginal Utility(DMU).
On the other hand, the Producer’s surplus is the difference between the revenue that he derives
from the sale of the given output and the revenue at which he is willing to produce and sell the
same output.

Fig. 31: Consumer’s surplus Vs Producer’s surplus

From the graph above, if the market price (MP) = N50, the consumer is willing to purchase the
first bottle at N80 and N60 for the second bottle because he derives greater utility from earlier
consumption. As illustrated, he would be ready to offer less for further bottles he consumes. But
he actually paid N50per bottle as market price, however, he is ready to pay as high as N80 for
the first consumption. So, the difference between what he pays and what he would be willing to
pay, rather than go without is his consumer’s surplus, marked by KLM while the Producer’s
Surplus is measured by LMO.

5.16 THE REVEALED PREFERENCE HYPOTHESIS

As pointed out earlier, the other aspect of the ordinal approach to consumer behavior is the
revealed preference hypothesis by Paul Samuelson. The revealed preference theory is premised
on the axiom, which states that by choosing a collection of goods in any one budget situation, the
individual consumer reveals his preference for that commodity.
Example: Other axioms of the revealed preference theory are: Rationality, Consistency and
Transitivity of choice.
From this graph the consumer prefers to choose bundles of commodity to the right of R on
segment RE. Therefore, the consumer will not be willing to choose any commodity that falls to
the left of R.

Fig. 32: Marginal Rate of Commodity Substitution

MARGINAL RATE OF COMMODITY SUBSTITUTION (MRCS):
Marginal Rate of Commodity Substitution (MRCS) shows how much of one product is
substituted for how much of another. In other words, it shows the consumption pattern of a
consumer in terms of the rate at which he is willing to substitute one product for another.

Summary
The theory of consumer behaviour demonstrates the rational human conduct of a consumer on
his decision in his consumption basket with his given level of scarce or limited income. He
behaves in such a way as to maximise his utility; and thus have a higher standard of living by
consuming as much product as possible from the same level of income instead of less at the
same income.
Both measurable (cardinal approach) and ordinal approach (indifference curve analysis) were
used to demonstrate this consumer behaviour. The topic also discussed how a consumer may
have surplus by actually paying lesser amount on the product consumed than his expected or
projected market demand price. This surplus brings about a greater utility/welfare for the
consumer.
 CHAPTER SIX
THEORY OF PRODUCTION
6.1 Introduction
6.2 Basic production concepts
6.2.1 Production function
6.2.2 Fixed and Variable inputs
6.2.3 Short run Vs Long run
6.2.4 Product Concepts
6.2.4.1 Total Product
6.2.4.2 Average Product
6.24.3 Marginal Product
6.3 Law of Diminishing Returns
6.4 Production Possibility Frontier
6.5 Production Analysis in the short run
6.6 Production Analysis in the Long run
6.6.1 Assumptions of short run production process
6.6.2 Isoquants
6.6.3 Characteristics of Isoquants
6.6.4 Marginal Rate of Technical Substitution (MRTS)
6.6.5 MRTS, MPk& MPL
6.6.6 Diminishing MRTS
6.6.7 Returns to scale (RTS)
6.6.7.1 A tabular display of Returns to scale
6.6.7.2 Diagrammatic illustration of RTS
6.7 Isocost
6.8 Equilibrium Long Run Analysis

6.1 Introduction
Production, in economics, involves the creation of utility for the satisfaction, of wants that can
be paid for. Production is the process by which raw materials are converted by a combination of
factors of production into a form acceptable to consumers. In the theory of consumersbehaviour,
individual consumer attempts to maximize his satisfaction given his income and the commodity
prices. But in the theory of production, the firm attempts to maximize profit, given the cost
outlay by the way in which it secures and combines resources and inputs.

Production, as a topic and an economic phenomenon, is very crucial to the understanding of

rational behaviour as a complement and a corollary to consumer behaviour. "While the consumer
behaves in line with maximising his utility with the given/limited income, the producer behaves in
response to maximising his benefit in terms of profit made from his production and supply of his
product to the market. These two economic agents, consumer and producer, concentrate on the
optimum benefit they are to derive from the utilisation of their limited resources,

There is, however, the difference between the short- and long-run situations in the production
process. This syllabus concentrates on the long-run situation. Thus, the behaviour of the
producer, under certain assumptions, in the long run situation, will be analysed accordingly. The
extent the amount of output produced responds to the inputs used in their production also
matters in the producer's decision. He reacts and responds to situations that would arise that
might lead him to get; in return, greater, lesser or the same proportionate output to the cost of
inputs employed in the production process. This reaction also leads to some decision by the
producer.

Production refers to creation of utilities/values which involves transformation of inputs into

outputs.

Basic Production Concepts:

6.2.1 Production Function: A technical relationship between the quantities of output as a
function of specific combination of inputs. For example, Qx is the output of Commodity X as a
function of Labour and Capital. Thus, Qx = f (L, K)
6.2.2 Fixed and Variable factors: Fixed factors are those factors of production whose
quantity cannot be varied or improved upon in the short run, while Variable factors are
those whose quantities can be varied or improved upon either in the short run or in the
long run.In the short run, Land is the fixed factor while labour, capital and entrepreneur
 are the variable factors of production. Note that in the long run, all factors of production
can be varied.

6.2.3 Short and long run: The short run refers to that period of production when some
factor inputs are fixed while others are variable. This changes in the output is caused
by changes in variable inputs while fixed factor remains constant. It usually marks the
early stages of production. On the other hand, Long run refers to that period of
production when all factors of production become variable.

6.2.4 Product Concepts:In the short run, we have 3 product concepts:

(i) Total product
(ii) Marginal product
(iii) Average product

6.2.4.1 Total Product (TP):This refers to the total volume of goods and services produced
and provided for exchange to take place. Ceteris paribus, the total product increases as
quantity of goods and services provided rises, based on the availability and effective
utilization of factors of production. T.P = AP x Labour

Fig. 33: Total Product

6.2.4.2 Average Product (AP): Thisrefers to the amount of commoditiesproduced per unit of
factor inputs, say land, capital, labour or entrepreneurial skill(s). Mathematically, it can be
obtained by dividing total product by the units of labour that produced the commodities
produced per period of time i.e. AP = TP/L. Graphically, the AP slowly increases as the
amount of factor inputs used increases to a certain point of saturation before it declines but not
below the origin.

Fig. 34: Average product

6.2.4.3 Marginal Product (MP): This refers to additional output(s) produced as a result of
additional factor inputs. Mathematically, MP can be calculated as below:
Marginal Product = Change in Total ProductOR dTP
Change in Qty Produced Dq

Graphically, the MP decreases as factor inputs increase. This is due to the law of Diminishing
Returns and Returns to Scale.
Fig. 35:Marginal product

RELATIONSHIP BETWEEN AVERAGE PRODUCT (AP), TOTAL PRODUCT (TP),

AND MARGINAL PRODUCT (MP).
- As production process begins, both AP, TP and MP risesbut TP rises faster.
- MP rises faster than AP and intercept AP at maximum and start to decline.
- When AP start falling, it is still above MP.
- TP is at maximum when MP is at zero.
- MP falls to negative, and both TP and AP declines.

Table 13: A typical Productivity Schedule is shown below:

Fixed Labour Total Average Marginal
Factor (Unit) Product Product Product
(Land) (TP) (AP) (MP)
10 10 30 3 -
10 20 80 4 5
10 30 150 5 7
10 40 240 6 9
10 50 200 4 4
10 60 180 3 2
10 70 150 2.5 -3
Required: From the table above, using appropriate scale, plot the TP, AP & MP and explain
the technical relationship if the production function of a typical production firm as: Q =

6.3 Law of Diminishing Returns

The law of diminishing returns states that as successive units of a variable factor of
production, say labour, is combined with a fixed factor, say land, will yield increase in output
produced to a certain extent at which the addition of more factor inputs will result in less
additional outputs produced.
From the Table 1 above, diminishing returns set in when TP falls from 240 units to 200 units;
While the AP falls from 6 units to 4 units and MP falls from 9 units to 4 units respectively
Thus, this law is the reason why all the product curves are n-shaped.

6.4 Production-Possibility Frontier (PPF)

Production possibility Frontier, also known as Production Possibility Curve (PPC) or
Production Possibility Boundary (PPB) may be described as a diagram or graph which shows
the locus of points in which a possible combination of different commodities can be produced
given every available land, labour, capital and entrepreneurial skills.
A production-possibility frontier shows the maximum number of alternative combinations of
goods and services that a society can produce at a given time when there is full utilization of
economic resources and technology. Thus, the PPC has a downward slope, which indicates
that there is an opportunity cost of producing more of one type of good at the expense of the
forgone alternative(s).
Table 14: Production possibilities
Possible Combination Commodity X Commodity Y
A 100 0
B 80 30
C 70 50
D 50 80
E 40 95
Using the above Table 14, the Production Possibility Curve (PPC) can be drawn as:

Fig: 36

The PPC points within the boundary such as X, Y, Zshows the combinations of Commodity X
and Y i.e. a case of under-utilization of productive resources while points outside the
Production Possibility Boundary, such as point F, shows the case of over-utilization of
productive resources while points B, C, D, and E are the PPC and indicates efficient use of
resources.
Appropriate application of PPC helps the government in making rational choice of what
commodities to specialize in its production while forgoing the production of other
commodities which the country does not have Absolute Cost Advantage and/or Comparative
Cost Advantage (For more details, refer to: Consumer Economics: A micro-perspective).

6.5 Production Analysis

6.5.1 Production Analysis in the Long Run –lsoquants

The areas covered in this section are broken down one after the other as follows.
6.5.1.1 Assumptions of Long-Run Production Process
(i) No fixed factor in the long run; rather, all factors are said to have varied. It is, therefore, a
case of multiple variable inputs.
(ii) The expectation of the producer is to minimize cost; and thus, combining the inputs
appropriately to meet this target.
(iii) With multiple inputs, the marginal product of any one input depends on the qualities of the
other. Thus, the inputs can be said to be interdependent,
(iv) Input choices must be made simultaneously.
Note:
(b) The multiple-input or "isoquant" model for determining optimal input choices leads directly
into the derivation of cost curves; and provides insights into cost relationships.
(c) The beginning of the analysis is the discussion of "lsoquants", which we now examine
as follows:

6.5.1.2 lsoquants
An isoquant is a curve/locus of points that shows the different combinations of the two inputs
producing the same level of output.
• This is a set of efficient input combinations that will produce a given level of output,
holding technology constant. All input combinations will lie on some isoquant if inputs
and outputs are infinitely divisible.
• An isoquant can also be defined as a curve showing all possible combinations of inputs
that are-capable of producing a certain quantity of output. For movement along an
isoquant, the level of output is unchanged but input ratio changes. This is similar to
the concept of indifference curve.
• For a two-quadrant case, two different varying inputs can be used to show an isoquant.
An example is as below:
Table 15: Production schedule
Combination K C
Unit of capital Unit of labour
W 50 15
X 40 20
Y 20 40
Z 10 25
From the graph, when capital decreases by 10, (i.e. from W to capital X), the labour increased by
5 units while the output remain the same (100 units).
Therefore,MRTS K,L = 50 – 40 = 10
20 – 15 5 = 2 UNITS
This implies that for every unit of labour, two units of capital can be deceased in order to
maintain output. Thus, as capital decreases and labour increases along an isoquant the amount of
capital that can be released for each added labour decreases.

Fig. 37: A typical Isoquant

Table 16: Tabular Data for the above Isoquant

Labour (units) 50 75 81 100 125
Capital (units) 131.2 87.5 81.0 65.6 52.5
Output (units) 81 81 81 81 81

Interpretation of the Graph and Table

With the various combinations of the varying units of inputs of labour and capital, the same level
of output, of 81 units, is produced. When the labour and capital inputs coordinates are plotted on
the two-quadrant diagram space, and a smooth negatively. sloping curve is drawn to show their
relationship, some of their combinations may: fall on the curve while others will fall outside the
curve (like the 50 labour and 131.2 capital and 75 labour and 87.5 capital). However, all the points
along the isoquant is an infinitesimal combination of labour and capital inputs to give the same
level of output (81 units) produced.

6.5.1.3Characteristics of Isoquants (Similar to Indifference Curve-IC -Properties)

(i) Isoquants have negative slope.
(ii) They are non-intersecting,
(iii) The higher the shift of isoquant upward (northeast), the greater the value. It is asimilar case to
indifference map.
(iv) They use cardinal scale of measurement.
MRTS, measures the rate at which one factor is substituted for another while the same output
level is obtained.
v. Isoquants shift when technology changes.
vi It is convex to origin.
vii Isoquants do not intersect

Fig. 38: Isoquants do not intersect

6.5.1.4 Marginal Rate of Technical Substitution (MRTS)

The marginal rate of technical substitution (MRTS) is the amount of an input (say, capital) that
can be replaced by one unit of another input (say, labour), such that output is held constant.
The MRTS is equal to the negative (or absolute) value of the slope of the isoquant.
 MRTS = K= slope of isoquant
L
i.e. MRTSK, L = - (K2-K1)/ (L2-L1)
Since, the scope of the isoquant reflects the rate at which one factor can be substituted to the
other, the MRTs explains that the scope of the isoquant decreases as we move downwards along
the isoquant. Thus the degree at which capital (K) is substituted for labour (L) diminishes along
the isoquant curve and is negative.
Thus MRTs L, K = - K
L
MRTs L, K = - K = Q/L = MPL
L Q/K MPK
Where MPL = Marginal product of labour
MPK = Marginal product of capital

Table 17: Isoquant combination

Labour (units) 30 40 49 60 70
Capital (units) 80 60 49 40 34.3
Output (units) 49 49 49 49 49

6.5.1.5 MRTS, MPK and MPL

The marginal rate of technical substitution (MRTS) equals the ratio of marginal products of labour
and capital.
i.e., MRTS = MPL
MPK
Example
Let output = Q = K ½ L ½
From our above Table 5, on Isoquants, as labour increases from 75 to 76, holding capital constant at
87.5 units, out increases from 81 to 81.55.
i.e. Q= (87.5) 1/2 (76) ½ 81.55
The additional units of labour increases output by 0.55 units. Thus, the MPlisapproximately
0.55. Also, as capital decreases from 87.5 to 86.5, holding labour constant at 75 units, the output
decreases from 81 to 80.55.
i.e. Q = (86.5)1/2 (75) ½ = 80.55.
The MPk is approximately 0.45. The MRTS at the second point is approximately L22
according to the ratio of marginal products
. i.e. MRTS =MPL= 0.55
MPK 0.45 = 1.22
This obeys the law of diminishing returns/law of variable proportion which states that “as more and
more of a variable factor (say labour or capital) is added to a fixed factor (say land), the production
yields less and less returns”.

Exercise: Given the Production function as: Q = 5L 0.7 K 0.3 where L =2 and K = 5.

Calculate: (i) Total Product (ii) AverageProduct (iii) Marginal Product

6.5.1.6 Diminishing MRTS

The MRTS is assumed to diminish along an isoquant as the K/L -ratio decreases. This is deduced
from the convexity of the isoquant.

6.6.2: Returns toScale

This indicates the relationship between a proportionate change in all inputs and the resulting change
in output. It is a long run phenomenon.
6.6.2.1: A Tabular Display of Returns to Scale
Change in output relative toReturns to scale
Proportionate change in all inputs
Outputs >inputs Increasing
Outputs = inputs constant
Outputs<inputsdecreasing
6.6.2.2: Diagrammatic Illustration of Returns to Scale
The diagrams for increasing-, constant- and decreasing-returns to scale are presented below. We
need to note here that production function is a firm's technology at a point in time; and that as a
firm increases its scale of operation by varying the level of inputs, these three possible responses of
output to changes in input occur. These are that:
• A doubling of all inputs, say, labour and capital, may lead to more than a doubling of
output. This is the case of increasing returns to scale.
• Output may increase by a smaller proportion than each of the inputs so that doubling
all inputs may lead to less than doubling of output; a case of decreasing returns to scale.
• A doubling of the inputs may lead to a doubling of output. Hence, output may
increase exactly the same proportion as the inputs. This is called constant returns
toscale.
The below diagrams now show the three cases of returns to scale:

Fig. 39: (a) Constant Returns to scale

Fig.40: (b) Increasing Returns to Scale
The higher to the origin an isoquant lies, the higher the level of output. The family of
isoquant is called an Isoquant Map.

Fig. 41 (c) Decreasing Returns to Scale

Another form of showing the returns to scale is as below:

Fig 42: Returns to Scale

Interpretation of theGraph: The curve of the increasing returns to scale is indicating that output
increases each time there is a variation in the combination of the variable inputs, hence more of the
curvature towards output axis.
The constant returns to scale is 45 degrees to the input and output axes respectively, hence
indicating the same proportionate relationship, thus represents the constant returns to scale,
The decreasing returns to scale is depicted by the curve pointing or tending towards the input axis
more than the output axis; thus indicating greater inputs combination resulting in lesser output
produced.

6.6.3 Isocost
A line which shows various combinations of the factor inputs that firm can buy with a given
level of expenditure at given factor prices.
This is a line showing the alternative combination of the factors a firm could buy for a given
monetary outlay in order to produce a given level of output. It is an analysis of cost minimizing
decision or choice, which is the corollary of optimum output production. The diagrammatic
relationship is as follows.
Therefore, the isocost depends on two factors:
• Price of factors of production and
• The total expenditure which the firm wants to make on the two factors of
production.
ILLUSTRATION

Fig. 43:Isocost
Example:
Suppose that the price of labour per unit employed is N50 and N100 for each unit of capital
employed. And that the firm wishes to spend N800 on the inputs. The question now is What
combination of labour and capital can be purchased for N800?
Solution:
With N800, the firm can either but (800/50) = 16 units of labour or N800/100 = 80 units of capital
or a combination of K and L.
This is the point at which the isoquant is tangent to the isocost line e.g. at point A & B.
Analysis of the Graph: Line AB is the isocost line. At point "A” all the income of the producer
was used to purchase the capital factor at the factor market price (Pk). On the other hand, at point
B, only the labour factor was purchased at the factor market-ruling price (PL). But at point C, some
quantity of labour (Li) and capital (Ki) were combinelypurchased in the production process.
The implication of this is that it is only at points A and B that either of the two factors can be
purchased in the production process; but at every other point in-between them, the two factors
must be purchased collectively to produce a given level of output. The decision point, however, is
that the quantity of either or both of the factor to be purchased is informed by the least cost that is
needed to produce the same level of output.

6.7 Equilibrium Long-run Production

Itis the combination of the isocost and isoquant that brings about the equilibrium long run
production of the firm. The isocost line relationship with the isoquant line is diagrammatically
shown as below:

Fig. 44:Equilibrium long run production

Interpretation of the Graph:
The tangency point between an isoquant and the isocost line is the least cost method of producing a
given level of output. From our above diagram, it is the combination of k1L1 giving a tangency at
point A that is the least cost for producing 200 units of the output at IS1, say, commodity X, under
consideration. There is also an equilibrium point at B where L2 and K2 combinations of labour and
capital inputs were used to produce-300 units of commodity X.
But mathematically, the firm is in equilibrium where
MRTS L,K = K= MPL = w
L MPK r
Where:
w = reward for labour (wages and salaries)
r = reward for capital (interest)

Note:
1. The Isoquant (IS) in production is likened to the Indifference curve (IC) in the theory
of utility. This is so, because the value or amount at any point of the curve is equal though
the combination of either amount of factors of production or commodities consumed
changes.
2.The Isocost (ISO) in production is .likened to the budget line in utility theory due
to the limited monetary value they respectively represent in both cases.
In representing isoquants graphically, we may show the real output or use our ordering system such
as q1, q2 q3, q4 given that q4> q3> q2>q1. Or we can use actual numbers, 100, 200, 300,4007as the
case maybe.

6.8 Summary
The theory of Consumer behaviour and Production can be compared and contrasted with some
salient points as reviewed below:
INDIFFERENCE CURVE VS ISOQUANT
An Isoquant shows equal level of product while an indifference curve shows equal level of
satisfaction at all points.
• An Indifference curve represents satisfaction which cannot be measured in physical units. In
the case of an isoquant the product can be measured in physical units.
•Secondly, on an indifference map one can only say that a higher indifference curve gives more
satisfaction than a lower one, but it cannot be said how much more or less satisfaction is being
derived from one indifference curve as compared to the other, whereas one can easily tell by how
much output is greater on a higher isoquant in comparison with a lower isoquant.
•An isoquant is a locus of combinations of two inputs which give the same level of output.
An indifference curve is also a locus of combinations of two commodities which gives the same
level of utility.
•Indifference curve takes all those commodity bundles among which the consumer gets the same
utility.
In case of isoquants, it takes all those capital and labour combinations which produce the same
output.

Iso-quant Curve Indifference Curve

Iso-quant curves related with Indifference curves are related with
production theory. the theory of Consumer behaviour.
 It shows the various combinations of It shows the various combinations of
two inputs that yields the same level two commodities that yields equal
of output at a particular period of time satisfaction to a consumer at a
particular time.
Iso-quant curve show constant levels These curves show the constant level
of output which can be measured. of satisfaction which cannot be
measured.
Iso-quant represents combination of Indifference curve represents
two factors, say Capital and Labour. combination of two good, say /
commodity X and commodity Y.
Its slope is influenced by the Marginal Its slope is influenced by the Marginal
Rate of Technical Substitution Rate of Commodity Substitution
(MRTS) between factor (MRCS) between commodities.
inputscombined.

MARGINAL UTILITY VS MARGINAL PRODUCT

MARGINAL UTILITY

The concept of Marginal Utility and Marginal Product has some similarities and conceptual
differences. While the former is used in the theory of Consumer behaviour, the latter is used in
the theory of Production.
The concept of marginal utility is used by economists to determine how much of an item
consumers are willing to purchase.Economists use the idea of marginal utility to gauge how
satisfaction levels affect consumer decisions while the idea of Marginal Product measures the
additional output produced as a result of additional inputs added to production. Marginal utility
is useful in explaining how consumers make choices to get the most benefit from their limited
budgets. Marginal utility can be positive, negative or zero. It is positive when consuming more
than one unit of an item brings more satisfaction. It becomes zero marginal utility when
consuming more of an item brings no added satisfaction and it is negative when too much of the
item has been consumed that it now becomes harmful.
The formula for the determination of marginal utility is the “change in total utility/change in
units.
Quantitatively, their computations seem to be similar. Thus:
 MU = Change in Total Utility
Change in Quantity Consumed
Marginal product on the other hand which can also be termed marginal physical productivity of
an input is the change in output resulting from employing one more unit of a particular input
when the quantities of other inputs are kept constant. The concept of marginal product simply
states that once an input (factor of production) is changed either by a decrease or an increase, a
change in output or production occurs.
The marginal product of a given input is expressed as MP=change in Y/change in X. Change in
Y represents the change in a firm’s input(probably by one unit) while change in X is the change
in the firm’s output as a result of added or reduced input.
Quantitatively, MP = Change in Total Product
Change in Quantity Produced
Comparatively, the two economic terms above are similar in terms that:
1. Both are economic measuring terms.
2. They are both used to measure results or responses(marginal utility measures
consumer satisfaction while marginal product measures productivity results.
3. Both concepts gauge the reaction resulting from change(the addition or
subtraction) in one or more units(level of satisfaction when more units of an item is consumed
and level of production when a unit of input is added or subtracted)
4. They are both also used to determine market behaviour.
Along with these similarities, they also have some major dissimilarities.
5. Marginal utility deals with consumers while marginal product deals with factors
of production.
6. Marginal utility is determined by an addition of units while marginal product can
be determined by addition or subtraction of input.
LAW OF DIMINISHING MARGINAL UTILITY VS LAW OF DIMINISHING
RETURNS

The law of diminishing marginal utility states that as a consumer consumes successive units of a
commodity to a point where the consumption of an additional unit yield less satisfaction. In other
words, it states that the satisfaction derived from consuming successive units of a commodity
will diminish as the total consumption of the commodity increases. That is, the total utility
increases as more of a commodity is consumed but increases at a diminishing rate
On the other hand, the law of diminishing returns, also called the principle of diminishing
marginal productivity is an economic law stating that if one input in the production of a
commodity is increased while all other input are held fixed, a point will eventually be reached at
which additions of the input yield lesser outputs. Hence, Economists used the law of diminishing
returns to predict that as population expanded in the world, output per head would fall to the
point where the level of misery would keep the population size from increasing further.
Conclusively, the law of diminishing marginal utility is a demand side theory and the law of
diminishing returns is a supply side theory.

Fig. 46
MARGINAL RATE OF COMMODITY SUBSTITUTION (MRCS) VS MARGINAL
RATE OF TECHNICAL SUBSTITUTION (MRTS)

Marginal Rate of Commodity Substitution (MRCS)

In Micro- Economics, the Marginal Rate of Commodity Substitution (MRCS) is the rate at which
a consumer can give up some amount of one good in exchange for another good while
maintaining the same level of utility (satisfaction).

Alternately, the Marginal Rate of Commodity Substitution (MRCS) is the amount of a

commodity that a Consumer is willing to consume in relation to another good as long as the new
good is equally satisfying. It is used in indifference theory to analyze consumer behaviour. The
MRCSx,y is calculated between two goods placed on an indifference curve, displaying a
comparison of utility for each combination of “good X” and “good Y”.
In order to better understand the concept of marginal rate of substitution, we need to know that
there are goods that can be substituted for each other and still provide same satisfaction. This is
where the concept comes in. MRS refers to the amount of good A that is substitutional for good
B to give same utility.
The indifference curve mentioned earlier is a sloping curve where each point along it represents
quantities of good X and good Y that you would be happy substituting for one another. It is
important to note that the slope of the indifference curve is very key in the analysis of marginal
rate of substitution. At any given point along the indifference curve, the MRS is the slope of the
indifference curve at that point.
The marginal rate of substitution can either increase or diminish. If it increases, the indifference
curve will be concave to the origin. This is not common as it means that a consumer would
consume more of good X for the increased consumption of good Y and vice versa. Usually,
marginal substitution rates diminishes meaning a consumer chooses the substitute in place of
another good rather than simultaneously consuming more of each goods.

Marginal rate of technical substitution(MRTS).

The marginal rate of technical substitution is an economic theory that illustrates the rate at which
one factor must decrease so that the same level of productivity can be maintained when another
factor is increased. The MRTS reflects the give and take between factors of production such as
capital and labor, that allows a firm to maintain a consistent or constant output.
For better understanding, the MRTS shows the rate at which you can substitute one input such as
labor for another such as capital without effecting any change in output.
The graphical representation of marginal rate of technical substitution shows the various
combinations of two inputs(factors of production) that would result in the same level of output.
The formula for the calculation of MRTS is
MRTS(L,K)=-change in L/change in K =MP(l)/MP(k)
Here:
K is capital
L is labor
MP= marginal products of each input
Change in K/Change in L= amount of capital that can be reduced when labor is increased(typical
analysis)
These above terms are similar in various ways:
 Both the MRS and MRTS are used to show or reflects comparison between
items(commodities or factors of production)
 They both deal with increase and decrease of goods or input. This means that in each,
the level of consumption of one good or input has to decrease for the other to
increase.
 The changes effected by decrease or increase in both results in constant output or
utility. There is no resulting change from the increase or decrease made.
As there are similarities, differences are also evident in the terms.
 Marginal rate of technical substitution differs from marginal rate of commodity
substitution because MRTS is focused on producer equilibrium while MRS is focused on
consumer.
 MRTS deals with factors of production(input) while MRS deals with quantities of goods
or commodities for consumption.