Utility Analysis Class

8/3/2019 Utility Analysis Class

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Utility Analysis


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Utility

Utility refers to want satisfying power of acommodity.

In objective terms, utility may be definedas the amount of satisfaction derived froma commodity or service at a particular

time.


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Utility

Assumptions:

Utility can be measured.

Marginal Utility of money remains constant No change in income of the consumer, his

taste and fashion assumed to be constant

Independent marginal utility of each unit ofcommodity


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Utility

Characteristics:

Utility is subjective/not measurable

Utility is variable


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Marginal and Total Utility

Marginal Utility (MU) is the addition madeto the total utility by consuming onemore unit of a commodity.

Total Utility (TU)Total Utility refers to the total satisfaction

derived by the consumer from theconsumption of a given quantity of a good.

TU = Sum of all MU


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Assumptions of Law of Diminishing

Marginal Utility

Unit of consumption must be a standardone

Consumption must be continuous

Multiple units of the commodity should beconsumed

The tastes and preferences of the

consumer should remain unchangedduring the course of consumption

The good should be normal


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Exceptions to the law of

diminishing marginal utility Rare things (paintings, books etc.)

Initial units


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Criticism

Unrealistic assumptions

Cardinal measurement of utility is not

possible

MU of money is not constant


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Law of Equi-marginal Utility

A consumer has to distribute his/her

income in purchasing different

commodities in such a manner that the

utility derived from the last unit of each

commodity is equal for all commodities in

the consumption basket.


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Assumptions of Law of Equi-

marginal Utility

Consumer has a fixed income

Consumers purchase decision is based

on the prices of the different commodities

to be consumed


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Consumers Equilibrium

A consumer is in equilibrium when he

regards his actual behavior as the best

possible under the circumstances and

feels no urge to change his behavior aslong as circumstances remain unchanged.

Assumptions:

Rational consumer

Cardinal utility

MU of money = constant

Tastes are constant

Perfect knowledge


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Properties of Indifference Curves

Downward sloping

Higher indifference curves represent

higher satisfaction

Indifference curves can never intersect

Convex to the origin


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Superiority of Indifference Curve

Technique over Utility Analysis

Dispenses with cardinal measurement of

utility.

Studies combination of two goods instead

of one.

Provides a better classification of goods

into substitutes and compliments.

Explains law of diminishing marginal utility

without unrealistic assumptions.


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Criticism of Indifference Curve

Technique

Old wine in new bottle

Not realistic

Cardinal measurement implicit

Consumer is not rational

Combinations are not based on anyprinciple

Two goods model unrealistic

Limited analysis of consumers behavior


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Revealed Preference Theory

It analyses consumers preference for a

combination of goods on the basis of

observed consumer behavior in the

market.


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Choice Reveals Preference

A consumer buys a combination of two

goods either because he likes this

combination in relation to the others or

because this combination is cheaper thanthe others.


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Consumer Choice Under Risk and

Uncertainty

Traditional theory does not discussconsumer choice under risky situations orsituations which are uncertain.

THE BERNOULLI HYPOTHESISSt. Petersburg Paradox states that people

would be unwilling to make bets even at

better than 50-50 odds.Bernoulli resolved it by saying that MU of

money diminishes as income increases.


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The N-M Utility Index

The consumer is expected to maximize

utility and the utility of an event with

certainty must be defined by the

probability and expected utility.

It provides conceptual measurement of

cardinal utility under risky choices.


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Production Theory

Types of Input

Technology

Fixed Inputs

Variable Inputs


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Production Theory

Factors of Production

Land

Labour

Capital

Enterprise

Organization


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Production Function With One

Variable Input

The short run production function showsthe maximum output a firm can producewhen only one input can be varied.

In the short run producers have tooptimize with only one variable input.

Any change in the output can be

manifested only through a change in oneinput (variable proportion productionfunction).


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Variable Input

The short run production function shows

the maximum output a firm can produce

when only one of its inputs can be varied,

other things remaining fixed.

Q = f( L, K (constant))


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Variable Input

This implies that it is possible to substitute

some of the labor by capital.

As the units of the variable input are

increased, the proportion of use between

fixed and variable input also changes.

Short run production function is governed

by law of variable proportions.


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Average and Marginal Products of

Factor Inputs

TP (L) = f (K (constant), L)

TP (K) = f (L (constant), K)

AP (L) = TP/L

AP (K) = TP/K

MP (L) = delta TP/delta L

Average product is total product per unit of

variable input. Marginal product is the addition in total output

per unit change in variable input.


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Law of Variable Proportions

Law of variable proportions, states that

with increase in the quantity of the variable

factor, its marginal and average products

will eventually decline, other inputs

remaining unchanged.


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3 Stages of the Law of Variable

Proportions

Increasing Returns to the Variable Factor Diminishing Returns to the Variable Factor

Negative Returns to the Variable Factor


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Production Function With Two

Variable Inputs

In the long run all inputs are variable.

Firm has the option of selecting that

combination of inputs which maximizes

returns.

Case of Maruti


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Production Function With Two

Variable Inputs

Q (constant) = f (L, K)

An isoquant is the locus of all technically

efficient combinations for producing a

given level of output (different

combinations of two inputs that

correspond to the same level of output).


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Characteristics of Isoquants

Downward sloping (slope = - delta K /

delta L)

A higher isoquant represents a higher

output

Isoquats do not intersect

Convex to origin


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Marginal Rate of Technical

Substitution

It measures the reduction in one input,

due to unit increase in the other input that

is just sufficient to maintain the same level

of output.

MRTS (LK) = -delta K / delta L


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Elasticity of Substitution

It measures the percentage change in factor

proportions due to change in MRTS.

In perfect substitutes MRTS remains

constant.

In perfect compliments elasticity of

substitution is zero.


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ISOCOST LINES

It is the locus of points of all the different

combinations of labour and capital that a

firm can employ, given the total cost and

prices of inputs (different combinations ofinputs that a firm can procure given the

total funds).

Slope = w / r C = wL + rK


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Producers Equilibrium

Necessary condition is

slope of isoquant = slope of isocost line


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Expansion Path

Expansion path is the line formed by

joining the tangency points between

various isocost lines and the

corresponding highest attainableisoquants.


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Returns to Scale

Returns to scale refers to the degree by

which the level of output changes in

response to a given change in all the

inputs in a production system.

Constant Returns to Scale

Decreasing Returns to Scale

Increasing Returns to Scale


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Technical Progress and its

Implications

Neutral Technical Progress (changes in

marginal product of labour and capital are

same)

Labour Augmenting Technical Progress

(MP (L) increases faster than MP (K))

Capital Augmenting Technical Progress

(MP (K) increases faster than MP (L))


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Break Even Analysis

Breakeven point is the point where total

cost just equals the total revenue.

It is the point of no profit no loss.


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Graphical Method


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Algebraic Method


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Contribution Margin

It is the difference between price and

average variable cost.

It is that portion of the price of the

commodity produced by the firm that can

cover the fixed costs and contribute to

profits.


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PV Ratio

PV Ratio = Contribution / Sales

Margin of Safety = FC / PV Ratio


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Limitations of Break Even Analysis

It does not take into account possible

changes in costs over the time period

under consideration.

It does not keep any provision for changes

in the selling price.

It assumes that what ever is produced will

be sold.

Assumes constant market conditions.


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Numerical

Suppose Going On Batteries Ltd. Company

makes 10,000 batteries per month. It has

to pay Rs.2000 per month towards rent of

factory and Rs.5000 per month towardselectricity. It also incurs a cost of Re.0.05

per battery. It sells its batteries at Rs.4 per

piece. Find BEP.


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Utility Analysis Class

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