Lecture03.pdf

# Household behavior and consumer choice Household behavior is centered on making constrained choices in both consumption and labor markets to maximize satisfaction, considering limitations imposed by income, wealth, and prices [7](#page=7). ## 1. Household budget constraint ### 1.1 The concept of the budget constraint A budget constraint defines the limits of a household's choices in output markets, influenced by income, wealth, expectations about future income, and product prices. The set of all available combinations of goods and services that a household can afford, given its income and prices, is known as the opportunity set [10](#page=10) [8](#page=8). * **Trade-offs and opportunity cost**: Households make choices by evaluating the value of one product against other goods and services they could purchase with the same money. The opportunity cost of a product is the value of the next best alternative that must be forgone due to limited resources [9](#page=9). ### 1.2 Components of the budget constraint The budget constraint can be generally represented by the equation: $$P_X X + P_Y Y = I$$ where: * $P_X$ is the price of good X [12](#page=12). * $X$ is the quantity of good X consumed [12](#page=12). * $P_Y$ is the price of good Y [12](#page=12). * $Y$ is the quantity of good Y consumed [12](#page=12). * $I$ is the household income [12](#page=12). The slope of the budget constraint is given by $-\frac{P_X}{P_Y}$ [12](#page=12). ### 1.3 Nominal versus real income * **Nominal income** is income measured in monetary terms [11](#page=11). * **Real income** represents the purchasing power of income, reflecting the actual quantity of goods and services a household can acquire given its nominal income and prevailing prices. It can be calculated as [11](#page=11): $$\text{Real income} = \frac{\text{Nominal income}}{\text{Price level}}$$ Real income increases when nominal income rises or when prices fall, and decreases when nominal income falls or prices rise [11](#page=11). ### 1.4 Changes in the budget constraint * **Price changes**: A decrease in the price of a product causes the budget constraint to rotate outwards, expanding the opportunity set and increasing available choices. Conversely, an increase in price rotates the budget constraint inwards, reducing opportunities [13](#page=13). * **Income/Budget changes**: An increase in budget shifts the budget constraint outwards (to the right), expanding the opportunity set and available choices. A decrease in budget shifts the constraint inwards (to the left), reducing opportunities [14](#page=14). ## 2. Utility as the basis of household choice ### 2.1 Utility and marginal utility * **Utility** is the satisfaction a household derives from consuming a product [16](#page=16). * **Marginal utility (MU)** is the additional satisfaction gained from consuming one more unit of a product [16](#page=16). * **Total utility** is the aggregate satisfaction from consuming a product [16](#page=16). ### 2.2 The law of diminishing marginal utility This law states that as a household consumes more of a particular product within a given period, the additional satisfaction (marginal utility) gained from each successive unit decreases, assuming all other factors remain constant (ceteris paribus) [16](#page=16). > **Tip:** This concept is fundamental to understanding why demand curves slope downwards. The declining marginal utility means consumers are willing to pay less for additional units of a good. **Example**: A table illustrating diminishing marginal utility for bar visits per week shows total utility increasing at a decreasing rate, and marginal utility falling with each additional visit [17](#page=17). ### 2.3 Diminishing marginal utility and demand Diminishing marginal utility directly explains the downward-sloping nature of demand curves. As the marginal utility of a good declines with increased consumption, consumers will only purchase more units if the price falls sufficiently [18](#page=18). ## 3. Indifference curves and preference maps ### 3.1 Indifference curves An indifference curve represents all combinations of two goods (X and Y) that yield the same level of total utility for a consumer. A consumer is indifferent between any bundles lying on the same indifference curve [20](#page=20). ### 3.2 Preference map A preference map is a collection of indifference curves. Higher indifference curves signify higher levels of utility [21](#page=21). ### 3.3 Slope of the indifference curve The slope of an indifference curve is negative and its absolute value decreases as consumption of good X increases (moving right along the curve). This can be expressed as: $$\frac{\Delta Y}{\Delta X} = -\frac{MU_X}{MU_Y}$$ where $MU_X$ and $MU_Y$ are the marginal utilities of goods X and Y, respectively [22](#page=22). ### 3.4 Marginal rate of substitution (MRS) The marginal rate of substitution ($MRS_{xy}$) is the rate at which a household is willing to exchange one unit of good Y for one unit of good X while maintaining the same level of utility. It is equal to the absolute value of the slope of the indifference curve [23](#page=23): $$MRS_{xy} = \frac{MU_X}{MU_Y}$$ The MRS is diminishing, meaning a household is more willing to give up Y for X when it has a lot of Y and little X, and less willing to do so when it has little Y and a lot of X [23](#page=23). ### 3.5 Shape of indifference curves The shape of indifference curves reflects a household's preferences: * Steeper indifference curves indicate higher preferences for good X and lower preferences for good Y [24](#page=24). * Flatter indifference curves indicate lower preferences for good X and higher preferences for good Y [24](#page=24). * **Perfect complements**: Indifference curves are L-shaped, indicating goods are consumed in fixed proportions (e.g., left and right shoes). The MRS is 0 or infinity [25](#page=25). * **Perfect substitutes**: Indifference curves are straight lines, indicating goods are perfectly interchangeable (e.g., two brands of the same basic product). The MRS is constant [25](#page=25). ## 4. Utility maximization ### 4.1 The utility maximization rule Consumers aim to choose a combination of goods that maximizes their utility while remaining within their budget constraint. This occurs at the point where the budget constraint is tangent to the highest attainable indifference curve [27](#page=27). At this tangency point, the slope of the budget constraint equals the slope of the indifference curve: $$-\frac{MU_X}{MU_Y} = -\frac{P_X}{P_Y}$$ This leads to the utility maximization rule: $$\frac{MU_X}{P_X} = \frac{MU_Y}{P_Y}$$ This condition implies that utility is maximized when the marginal utility per dollar spent on each good is equal across all goods [28](#page=28) [29](#page=29). ### 4.2 The diamond-water paradox The utility maximization rule helps explain the diamond-water paradox, where items with high use-value (like water) can have low exchange-value, and vice versa (like diamonds). Water has a low price ($P_X$) and high total utility but low marginal utility due to its abundance, while diamonds have a high price ($P_Y$) and low total utility but high marginal utility due to their scarcity [30](#page=30). ### 4.3 Applications of utility maximization * **Sugar tax**: A tax on sugar-sweetened beverages increases their price ($P_Y \uparrow$). This leads households to substitute towards less-taxed or untaxed alternatives (like $X$) to maximize utility, by increasing the marginal utility of the taxed good (leading to lower consumption) or reducing the marginal utility of the substitute good (leading to higher consumption) [31](#page=31). ### 4.4 Effects of budget and price changes on utility maximization * **Increase in budget**: For normal goods, an increase in the budget shifts the budget constraint outwards, allowing the consumer to reach a higher indifference curve. Both goods X and Y are consumed in larger quantities [32](#page=32). * **Decrease in budget**: For a normal good (X) and an inferior good (Y), a decrease in budget shifts the budget constraint inwards. Consumption of the normal good (X) decreases, while consumption of the inferior good (Y) increases [33](#page=33). * **Decrease in price**: When the price of good X decreases (and X and Y are normal goods), the budget constraint rotates outwards. The consumer moves to a higher indifference curve, increasing consumption of X and potentially decreasing consumption of Y [34](#page=34). ## 5. Income and substitution effects The total effect of a price change on the quantity demanded can be decomposed into two components: ### 5.1 Substitution effect This effect arises because a change in price alters the relative attractiveness of goods. When the price of a product falls, it becomes relatively cheaper, prompting consumers to substitute away from other goods and towards the cheaper one. For a price decrease, the substitution effect leads to increased consumption of the good whose price fell. For a price increase, it leads to decreased consumption [35](#page=35) [38](#page=38) [39](#page=39). ### 5.2 Income effect This effect stems from the change in purchasing power resulting from a price change. A price decrease effectively increases a household's real income, allowing for greater consumption of goods. For a price decrease, the income effect leads to increased consumption of normal goods. For a price increase, it leads to decreased consumption of normal goods [35](#page=35) [38](#page=38) [39](#page=39). ### 5.3 Effects for different types of goods * **Normal goods**: For normal goods, the income and substitution effects work in the same direction, leading to a downward-sloping demand curve. A price decrease leads to increased consumption due to both effects; a price increase leads to decreased consumption [38](#page=38) [39](#page=39). * **Inferior goods**: For inferior goods, the income and substitution effects work in opposite directions. The substitution effect (leading to increased consumption when price falls) dominates the income effect (leading to decreased consumption of the inferior good when real income rises), resulting in a downward-sloping demand curve [40](#page=40) [41](#page=41). * **Giffen goods**: For Giffen goods, the income and substitution effects work in opposite directions, but the income effect (leading to increased consumption of the Giffen good when real income falls due to a price increase) dominates the substitution effect. This results in an upward-sloping demand curve, where a price increase leads to an increase in quantity demanded [42](#page=42) [43](#page=43). ## 6. Deriving the demand curve The demand curve for a good shows the relationship between its price and the quantity demanded, holding all other factors constant ($Q_d = f(p | \text{all other factors})$). By observing how the utility-maximizing quantity of a good changes as its price varies (ceteris paribus), a downward-sloping demand curve can be derived for most goods. The shape of the demand curve is influenced by the shape of the indifference curves, which reflect consumer preferences [45](#page=45). --- # The perfect market assumption This section outlines the foundational assumptions of perfect markets, which are critical for understanding various economic models [3](#page=3). ### 1.1 Core assumptions of a perfect market The perfect market assumption is a cornerstone of many economic models discussed within Part II of the course. It simplifies market dynamics by positing a set of ideal conditions. These assumptions are [3](#page=3): * **Perfect knowledge**: This assumption posits that all economic agents possess complete and instantaneous information. * Households are aware of the qualities and prices of all goods and services available in the market [3](#page=3). * Firms have access to all relevant information regarding wage rates, costs of capital, available technologies, and the prices of their outputs [3](#page=3). * **Perfect competition**: This assumption describes a market structure with a large number of participants. * There are many buyers and many sellers in the market [3](#page=3). * Each individual buyer and seller is small relative to the overall size of the market, meaning no single participant has the power to influence market prices [3](#page=3). * **Homogeneous products**: This assumption dictates that the products offered by different sellers are indistinguishable. * Outputs are identical and cannot be differentiated from one another [3](#page=3). ### 1.2 Role within the market system The perfect market assumption is a simplification used as a starting point for analyzing the market system. The broader overview of the market system includes [4](#page=4): * Household consumption, examined in lecture 3 (chapters 6 & 7) [4](#page=4). * Firm production, covered in lectures 3 & 4 (chapters 8 & 9) [4](#page=4). * Competitive input markets, discussed in lecture 4 (chapters 10 & 11) [4](#page=4). * General equilibrium, explored in lecture 5 (chapter 12) [4](#page=4). > **Tip:** Understanding the perfect market assumption is crucial because market imperfections and the role of government are discussed in later lectures (Lectures 5 to 8) as deviations from this ideal state. This guide focuses specifically on the ideal case before introducing complexities [4](#page=4). The perfect market assumption serves as a benchmark against which real-world market behaviour is often compared. Deviations from these assumptions lead to market imperfections. --- # Firms and the production process This topic examines the fundamental decisions and processes of profit-maximizing firms, focusing on their production choices, cost structures, and the relationship between inputs and outputs [57](#page=57). ### 3.1 The firm's role and decisions Firms are economic entities that demand inputs, engage in production, and produce outputs. They are driven by an incentive to maximize profits or minimize costs. Firms make three primary decisions [57](#page=57): 1. **Output quantity:** Determining how much of a product to supply [57](#page=57). 2. **Production method:** Choosing the technology to employ for production [57](#page=57). 3. **Input demand:** Deciding how much of each input to acquire [57](#page=57). ### 3.2 Profits and costs Profit is defined as the difference between total revenue and total cost [58](#page=58). $$Profit = Total Revenue - Total Cost$$ [58](#page=58). **Economic profit** accounts for both explicit and implicit costs, including the opportunity cost of resources [58](#page=58). $$Economic Profit = Total Revenue - Total Economic Cost$$ [58](#page=58). * **Total Revenue:** The total income a firm generates from selling its products, calculated as price per unit multiplied by the quantity of output sold [58](#page=58). * **Total Cost:** The sum of explicit costs (actual expenses) and implicit costs (opportunity costs) [58](#page=58). * **Total Economic Costs:** Explicit costs plus implicit costs [58](#page=58). A crucial aspect of economic cost is accounting for the opportunity cost of capital. This is incorporated by including a "normal rate of return" on capital in economic costs. The normal rate of return is the minimum return necessary to keep owners and investors satisfied, and for relatively risk-free firms, it approximates the interest rate on risk-free government bonds [59](#page=59). ### 3.3 Short run versus long run decisions The distinction between the short run and the long run is critical for firm decision-making [60](#page=60). * **Short Run:** A period where a firm operates with a fixed scale of operation, meaning some factors of production are fixed. In the very short run, all factors are fixed. During the short run, firms cannot enter or exit an industry [60](#page=60). * **Long Run:** A period where there are no fixed factors of production, allowing firms to adjust their scale of operations. In the long run, new firms can enter and existing firms can exit the industry [60](#page=60). ### 3.4 Factors influencing firm decision-making Firms make decisions based on three key elements [61](#page=61): 1. **Market price of output:** This influences potential revenues [61](#page=61). 2. **Available production techniques:** These determine the input requirements for a given output [61](#page=61). 3. **Market prices of inputs:** These directly affect production costs [61](#page=61). The **optimal production method** is defined as the technique that either minimizes costs for a specific output level or maximizes output for a given set of inputs [61](#page=61). ### 3.5 The production process and technology Production technology describes the quantitative relationship between the inputs a firm uses and the outputs it produces. Various types of production technologies exist [63](#page=63): * **Land-intensive technology:** Heavily reliant on land, often seen in agriculture [63](#page=63). * **Labor-intensive technology:** Emphasizes human labor in the production process [63](#page=63). * **Capital-intensive technology:** Relies significantly on capital (machinery, equipment) and can be labor- and/or land-saving [63](#page=63). * **Knowledge-intensive technology:** Utilizes knowledge and expertise, often leading to resource savings [63](#page=63). #### 3.5.1 Production functions A **production function** is a numerical, mathematical, or graphical representation of the relationship between inputs and outputs. It quantifies how much output can be produced given specific amounts of inputs [64](#page=64). > **Example:** A simple production function might show how many units of output (Total product) are produced by varying numbers of employees (input). > > | Employees | Total product | > | :-------- | :------------ | > | 0 | 0 | > | 1 | 10 | > | 2 | 25 | > | 3 | 35 | > | 4 | 40 | > | 5 | 42 | > | 6 | 42 | > [64](#page=64). #### 3.5.2 Marginal product **Marginal product** is the additional output generated by adding one more unit of a specific input, holding all other inputs constant (ceteris paribus) [65](#page=65). > **Example:** Continuing from the above, the marginal product of labor can be calculated: > > | Employees | Total product | Marginal product | > | :-------- | :------------ | :--------------- | > | 0 | 0 | - | > | 1 | 10 | 10 | > | 2 | 25 | 15 | > | 3 | 35 | 10 | > | 4 | 40 | 5 | > | 5 | 42 | 2 | > | 6 | 42 | 0 | > [65](#page=65). #### 3.5.3 Law of diminishing returns The **law of diminishing returns** states that when successive units of a variable input are added to fixed inputs, the marginal product of the variable input will eventually decline after a certain point. This law applies to every firm in the short run [66](#page=66). #### 3.5.4 Average product **Average product** measures the average output produced per unit of a variable factor of production. It is calculated by dividing total product by the quantity of the variable input used [67](#page=67). > **Example:** Calculating average product alongside total and marginal product: > > | Employees | Total product | Marginal product | Average product | > | :-------- | :------------ | :--------------- | :-------------- | > | 0 | 0 | - | - | > | 1 | 10 | 10 | 10.0 | > | 2 | 25 | 15 | 12.5 | > | 3 | 35 | 10 | 11.7 | > | 4 | 40 | 5 | 10.0 | > | 5 | 42 | 2 | 8.4 | > | 6 | 42 | 0 | 7.0 | > [67](#page=67). #### 3.5.5 Relationship between marginal and average product Marginal product and average product curves can be derived from total product curves [68](#page=68). * When the marginal product is above the average product, the average product rises [68](#page=68). * When the marginal product is below the average product, the average product falls [68](#page=68). * The average product reaches its maximum at the point where it intersects with the marginal product curve [68](#page=68). ### 3.6 Complementarity and productivity of inputs Inputs often work together in production, meaning they are **complementary**. For instance, capital and labor are complementary inputs. In agricultural production, capital, labor, and land are all complementary [69](#page=69). * Increasing capital can enhance the productivity of labor, leading to more output per worker [69](#page=69). * Similarly, increased labor and capital can boost the productivity of land, resulting in higher agricultural output per hectare [69](#page=69). ### 3.7 Technology choice and input substitution Inputs can often be substituted for one another to some extent [70](#page=70). * If labor becomes scarce and expensive, firms can adopt **labor-saving technologies** to substitute capital for labor [70](#page=70). * If land becomes scarce and expensive, farmers can implement **land-saving technologies**, substituting capital and labor for land [70](#page=70). The analysis of technology choice and cost minimization is further explored using isoquants and iso-cost lines, which are discussed in more detail in appendix chapter 7 (for self-study) [70](#page=70). > **Example:** The cost-minimizing technology for producing 100 pairs of shoes can change based on input prices. > > Consider two scenarios: > > **Scenario 1: Price of Labor ($P_L$) = 1 euro, Price of Capital ($P_K$) = 1 euro** > > | Technology | Units of Capital (K) | Units of Labor (L) | Total Cost (if $P_L=1€, P_K=1€$) | > | :--------- | :------------------- | :----------------- | :-------------------------------- | > | A | 2 | 10 | 12 euros | > | B | 3 | 6 | 9 euros | > | C | 4 | 4 | 8 euros | > | D | 6 | 3 | 9 euros | > | E | 10 | 2 | 12 euros | > > In this scenario, **Technology C** (4 units of capital, 4 units of labor) minimizes costs at 8 euros [72](#page=72). > > **Scenario 2: Price of Labor ($P_L$) = 5 euros, Price of Capital ($P_K$) = 1 euro** > > | Technology | Units of Capital (K) | Units of Labor (L) | Total Cost (if $P_L=5€, P_K=1€$) | > | :--------- | :------------------- | :----------------- | :-------------------------------- | > | A | 2 | 10 | 52 euros | > | B | 3 | 6 | 33 euros | > | C | 4 | 4 | 24 euros | > | D | 6 | 3 | 21 euros | > | E | 10 | 2 | 20 euros | > > When labor becomes more expensive, **Technology E** (10 units of capital, 2 units of labor) becomes the cost-minimizing choice at 20 euros. This demonstrates substituting capital for labor as labor's price increases [73](#page=73). ### 3.8 Productivity differences Differences in agricultural production systems observed across various parts of the world, such as between the US and Vietnam, can be attributed to a complex interplay of factors including technology, input availability and prices, labor costs, land use, and institutional frameworks [74](#page=74). --- # Household choice in input markets This topic examines how households make decisions in input markets, primarily concerning labor supply and saving, by analyzing trade-offs and the influence of economic variables [49](#page=49) [50](#page=50) [54](#page=54). ### 7.1 Labor supply decisions Households face constrained choices when deciding on their labor supply. Key decisions include whether to work, how much to work, and what type of job to accept. These decisions are influenced by factors such as job availability, market wage rates, household members' skills, and available time [49](#page=49). #### 7.1.1 Alternatives to wage work and opportunity cost The alternatives to working for a wage are broadly categorized into leisure activities (like sleeping, reading, or watching TV) and unpaid work (such as gardening, cooking, or sewing). The opportunity cost of engaging in wage work is the forgone leisure time or the value of the nonmarket production that could be achieved through unpaid activities. Therefore, households face a trade-off between working for a wage, enjoying leisure, and undertaking unpaid work [50](#page=50). #### 7.1.2 The price of leisure The concept of "buying" more leisure involves reallocating time away from work. For every hour of leisure a household chooses to consume, it gives up one hour of potential wages. Consequently, the market wage rate acts as the price of leisure [51](#page=51). #### 7.1.3 Marginal utility and labor supply The decision between work and leisure is based on comparing the marginal utility of leisure relative to its price (the wage rate) with the marginal utility of other goods and services relative to their respective prices [52](#page=52). #### 7.1.4 Labor supply curve and its determinants The labor supply curve illustrates the relationship between the quantity of labor supplied and the wage rate. The shape of this curve is determined by how households respond to changes in the wage rate, which can be explained by two effects [52](#page=52): * **Income effect**: An increase in the wage rate leads to higher income. With more income, households can afford to consume more of all goods, including leisure, which can lead to a reduction in labor supply [52](#page=52). * **Substitution effect**: An increase in the wage rate raises the opportunity cost of leisure, making it more expensive. This encourages households to substitute away from leisure towards work, thereby increasing labor supply [52](#page=52). > **Tip:** The overall shape of the labor supply curve (upward or downward sloping) depends on which of these two effects is dominant. #### 7.1.5 Shapes of the labor supply curve * **Upward-sloping labor supply**: In this case, labor supply increases as the wage rate rises. This occurs when the substitution effect dominates the income effect [53](#page=53). * **Downward-sloping labor supply**: Here, labor supply decreases as the wage rate rises. This happens when the income effect dominates the substitution effect [53](#page=53). ### 7.2 Household saving decisions Changes in interest rates significantly impact household behavior in capital markets through income and substitution effects [54](#page=54). * **Income effect on saving**: An increase in interest rates boosts future household income, allowing households to save less for future expenses, thus reducing capital supply. Conversely, a decrease in interest rates reduces future income, prompting households to save more and increasing capital supply [54](#page=54). * **Substitution effect on saving**: An increased interest rate raises the opportunity cost of consuming today, encouraging households to consume less and save more. A decreased interest rate lowers this opportunity cost, leading households to consume more and save less [54](#page=54). > **Tip:** Empirical evidence suggests that saving tends to increase as the interest rate rises, indicating that the substitution effect is generally stronger than the income effect on saving behavior [54](#page=54). #### 7.2.1 Financial capital market The financial capital market is where suppliers of capital (households that save) and demanders of capital (firms seeking to invest) interact [54](#page=54). --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Perfect market assumption | This refers to a theoretical market structure characterized by perfect knowledge, perfect competition, and homogeneous products, where individual buyers and sellers have no influence on prices. | | Household budget constraint | A limit on the choices an individual or household can make regarding consumption, imposed by their income, wealth, expectations, and product prices. It defines the set of affordable combinations of goods and services. | | Opportunity cost | The value of the next-best alternative that must be foregone when a choice is made. In consumption, it is the value of other goods and services that could have been purchased with the same amount of money. | | Nominal income | Income measured in terms of currency, without accounting for changes in the price level or inflation. It represents the monetary amount earned. | | Real income | Income adjusted for inflation, representing the actual purchasing power of a household. It reflects the quantity of goods and services that can be bought with the earned income. | | Utility | The satisfaction or benefit that a consumer derives from the consumption of a good or service. It is a measure of happiness or well-being. | | Marginal utility | The additional satisfaction gained from consuming one more unit of a product. It is the change in total utility resulting from a one-unit increase in consumption. | | Law of diminishing marginal utility | This economic principle states that as a consumer consumes more of a particular good or service, the additional satisfaction gained from each subsequent unit decreases, assuming all other factors remain constant. | | Indifference curve | A graphical representation showing all combinations of two goods that provide a consumer with the same level of satisfaction or utility. | | Preference map | A collection of indifference curves, where each curve represents a different level of utility. Higher indifference curves indicate higher levels of utility for the consumer. | | Marginal rate of substitution (MRS) | The rate at which a consumer is willing to give up one good in exchange for another while maintaining the same level of utility. It is represented by the absolute value of the slope of an indifference curve. | | Utility maximization | The economic principle that consumers aim to choose the combination of goods and services that provides them with the greatest possible utility, given their budget constraints. | | Profit | The financial gain of a business, calculated as the difference between total revenue and total cost. It represents the earnings after all expenses have been accounted for. | | Economic profit | Profit calculated by subtracting both explicit and implicit costs (including opportunity costs) from total revenue. It is a measure of a firm's true profitability. | | Explicit costs | Actual monetary outlays or direct expenses incurred by a firm in its operations, such as wages, rent, and raw materials. | | Implicit costs | Opportunity costs that arise from the use of resources already owned by the firm. These are not direct cash payments but represent the potential income foregone by using resources in one way rather than another. | | Production function | A mathematical or graphical expression that describes the relationship between the quantity of inputs used by a firm and the maximum quantity of output that can be produced with those inputs. | | Marginal product | The additional output produced as a result of adding one more unit of a specific input, while keeping all other inputs constant. | | Law of diminishing returns | A principle in economics stating that as more variable inputs are added to fixed inputs, the marginal product of the variable input will eventually decrease. | | Average product | The total output produced divided by the quantity of a specific variable input used. It represents the output per unit of that input. | | Income effect | The change in consumption of a good or service that results from a change in a consumer's purchasing power due to a change in price. | | Substitution effect | The change in consumption of a good or service that occurs when its price changes, leading consumers to substitute it for relatively cheaper alternatives or vice versa, while keeping utility constant. |