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HARAMAYA UNIVERSITY COLLEGE OF BUSINESS
AND ECONOMICS DEPARTMENT OF PUBLIC
ADMNISTRATION AND DEVELOPMENT
MANAGEMENT ASSIGNMENT OF
MICROECONOMICS
GROUP 3 MEMBERS ID
BERISO GEDA 1566/17
FAKRUDIN SABIT 1750/17
FIRAOL DECHU 1790/17
GETU KEBEBEW 1848/17
HANAN RIJAN 8893/17
KEYREDIN ABDULSELAM 8004/17
KANKU ABDULGAFAR 8973/17
TEMAM AHMED 2405/17
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Chapter 1: Theory of Consumer Behavior and Demand
The theory of consumer behavior forms the bedrock of microeconomics, explaining how rational
individuals make choices to maximize their satisfaction given their constraints. The core of this
theory rests on the concepts of preferences, utility, and the budget constraint.
Consumer Preferences
Consumer preferences allow an individual to rank different consumption bundles. The theory is
built on three key axioms that ensure rationality in decision-making:
1. Completeness: For any two commodity bundles X and Y, a consumer will prefer X to
Y,Y to X or will be indifferent between the two.
2. Transitivity: This ensures consistency. It means that if a consumer prefers basket A to
basket B and to basket C, then the consumer also prefers A to C
3. More is Better (Non-satiation): Consumers always prefer more of a good to less. This
ensures that the consumption bundles will always lie on the budget line, not inside the
budget set.
Utility and Indifference Curves
Utility is the numerical score representing the satisfaction a consumer gets from a given
consumption bundle. While Total Utility (TU) is the overall satisfaction, Marginal Utility (MU)
is the additional satisfaction gained from consuming one more unit of a good. The principle of
Diminishing Marginal Utility states that as consumption of a good increases, the MU derived
from each successive unit declines.
Indifference Curves (ICs) are graphical representations of all consumption bundles that yield
the same level of total utility to the consumer. Thus, the consumer is indifferent between any
points on a single curve.
Characteristics of Indifference Curves:
Downward Sloping: Due to the non-satiation assumption; to maintain the same utility
level, increasing one good requires decreasing the other.
Convex to the Origin: This reflects the Diminishing Marginal Rate of Substitution
(MRS). The MRS is the amount of one good a consumer is willing to give up to gain one
additional unit of another good, while keeping utility constant. As a consumer consumes
more of good X, they are willing to give up less of good Y to get even more X.
Higher Curves Mean Higher Utility: Bundles on ICs further from the origin are
preferred because they represent greater quantities of both goods.
Indifference Curves Cannot Intersect: If they did, it would violate the transitivity
assumption, leading to a logical inconsistency.
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The Budget Constraint
While preferences show what a consumer wants, the budget constraint shows what a consumer
can afford. It represents all possible combinations of goods (X and Y) a consumer can purchase
given their income (I) and the prices of the goods(Px,Py).
The equation for the budget line is:
The slope of the budget line is determined by the ratio of the prices and represents the rate
at which one good can be traded for another in the market. A change in income causes a parallel
shift in the budget line, while a change in the price of one good causes a rotation (change in the
slope).
Consumer Equilibrium
A rational consumer aims to choose the consumption bundle that provides the highest possible
level of utility while remaining within their budget constraint. This point, known as the
consumer equilibrium or optimum, occurs where the highest attainable indifference curve is
tangent to the budget line.
At the point of tangency, the slope of the indifference curve (MRS) is equal to the slope of the
budget line (price ratio):
This condition can be rearranged to state that the consumer maximizes utility when the marginal
utility per dollar spent is equal across all goods:
The graph illustrates that point E is
the optimal choice, as it is on the
highest IC (IC2) that is still
affordable (tangent to the budget line
(BL1). Points A and B are affordable
but provide less utility (IC1), while
(IC3) is unattainable given the budget
constraint.
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Deriving the Demand Curve
The individual demand curve for a good (for example, Good �) is derived by observing how the
consumer’s optimal consumption of Good � changes as its price (�ₓ) changes, while keeping
income and the price of Good � constant.
1 Price Consumption Curve (PCC): By connecting the consumer equilibrium points as �ₓ
changes, we trace out the PCC.
2Demand Curve: The information from the PCC (price–quantity pairs) is then plotted on a
separate diagram to derive the downward-sloping demand curve.
Income and Substitution Effects
When the price of a good falls, the change in consumption is due to two simultaneous effects:
1. Substitution Effect (SE): The good has become relatively cheaper compared to other
goods. The consumer substitutes the relatively more expensive good with the now
cheaper good. This effect is always negative (an increase in quantity demanded for a
price fall).
2. Income Effect (IE): The consumer's real income (purchasing power) has increased
because their money can now buy more.
For Normal Goods, the IE is positive (increases demand).
For Inferior Goods, the IE is negative (decreases demand).
For Giffen Goods (a special type of inferior good), the negative IE is so strong
that it outweighs the positive SE, leading to a positive slope for the demand curve.
The Total Effect of a price change is the sum of the Substitution Effect and the Income Effect.
The analysis of these effects using Indifference Curves provides a rigorous microeconomic
foundation for the Law of Demand.
Elasticity of Demand
Responsiveness of consumer to change in one of the factors that affect demand(price, income, …)
Law of Demand shows direction of change
Elasticity measures degree/extent of changeThree Elasticity Measures:
Price Elasticity: Price → Quantity relationship
Cross Elasticity: Price of Y → Quantity of X relationship
Income Elasticity: Income → Quantity relationship
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Chapter 2: Theory of Production
This chapter shifts focus from the consumer to the producer, analyzing how inputs are
transformed into outputs and the costs associated with this process.
The Production Function
A production function is a technical relationship that specifies the maximum output (Q) that
can be produced from any given combination of inputs (Labor L, Capital K, Land N,
Technology T):
The time horizon is crucial in production analysis:
Short Run: A period where at least one factor of production is fixed (usually capital, K).
Production changes only through changes in variable inputs (usually labor, L).
Long Run: A period long enough for all factors of production to be variable.
Short-Run Production: Law of Diminishing Returns
In the short run, we observe the relationship between output and a single variable input (Labor,
L), while holding Capital (K) constant.
The Law of Diminishing Marginal Returns states that as more units of a variable input (e.g.,
labor) are added to a fixed input (e.g., capital), the marginal product of the variable input will
eventually decline.
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Short-Run Cost of Production
Production decisions are inextricably linked to the costs incurred. In the short run, total cost
(TC) is divided into fixed and variable costs.
Total Fixed Cost (TFC): Costs that do not vary with the level of output (e.g., rent,
insurance).
Total Variable Cost (TVC): Costs that change as output changes (e.g., raw materials,
labor wages)
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Chapter 3 The Theory of Costs of Production
1. Introduction and Fundamental Cost Concepts
The theory of costs examines the relationship between the resources consumed by a firm and its
resulting output level. Costs are categorized based on their nature and the time horizon.
Key Cost Distinctions
Opportunity Cost: The value of the best alternative forgone when a choice is made. This
is the foundation of economic decision-making.
Explicit Cost (Accounting Cost): Direct, monetary payments made to external parties
(wages, rent, utilities).
Implicit Cost: Non-monetary costs; the cost of resources owned and used by the firm
itself (e.g., owner’s salary forgone, implicit interest on owner-invested capital).
Economic Cost: The sum of Explicit Cost and Implicit Cost. Economists use this
measure for profit determination and efficient resource allocation.
2. Short-Run Cost Analysis
The short run is defined as a period where at least one factor of production (typically capital or
plant size) is fixed, while other inputs (labor, raw materials) are variable.
Total Costs in the Short Run
Total Cost (TC) is the sum of two components:
1. Total Fixed Cost (TFC): Costs that are constant regardless of output level (Q).
2. Total Variable Cost (TVC): Costs that
vary directly with the output level.
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3. Relationship between Production and Cost (The U-Shape)
The characteristic U-shape of the short-run cost curves
(AVC, ATC, MC) is a direct consequence of the Law of
Diminishing Marginal Returns (LDMR).
When the Marginal Product (MP) of the
variable input is rising, the firm is experiencing
increasing returns, meaning output is being
produced more efficiently. Consequently, the
Marginal Cost (MC) falls.
When the Marginal Product (MP) begins to
fall (LDMR sets in), efficiency decreases, and
the cost of producing each additional unit, MC,
rises.
Cost curves are therefore the inverse reflection of the
productivity curves.
4. Long-Run Cost Analysis
In the long run, all inputs are variable. The firm can change its plant size, technology, and scale
of operation. There are no fixed costs.
Long-Run Average Cost (LRAC)
The LRAC curve, often called the Planning Curve, shows the minimum average cost of
producing any given level of output when the firm is free to choose the optimal plant size. It is
graphically represented as the envelope curve tangent to the minimum points of all possible
short-run ATC curves.
Economies and Diseconomies of Scale
T he U-shape of the LRAC is determined by returns to scale:
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Modern Theory of Cost
Modern research often suggests a flatter, L-shaped LRAC curve rather than a strictly U-shaped
one. This reflects that while economies of scale are powerful, technological and managerial
advances (e.g., IT systems) often enable firms to counter internal diseconomies effectively,
maintaining near-constant low costs even at very large scales of operation.
5. Summary and Strategic Importance
Aspect Short Run Long Run
Inputs Some fixed, some variable All variable
Cost Type Fixed and Variable (TFC, TVC) Only variable costs
Shape Cause Law of Diminishing Returns Economies/Diseconomies of Scale
cost behavior is critical for firm efficiency and profitability:
Optimal Decisions: Cost analysis (especially MC) is essential for setting the profit-
maximizing output level and guiding long-term expansion plans.
Pricing: Costs set the lower bound for pricing decisions and inform strategic pricing
models.
Planning: The LRAC helps management choose the optimal plant size for future demand.
Policy: Cost data is vital for governments when designing tax, subsidy, or regulatory
policies that impact production efficiency.
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