Question

1. Explain marginal utility and diminishing marginal utility. Provide an example of each concept.

2. Explain the income effect and the substitution effect.

3. Provide me with one example of the endowment effect.

4. Explain economic profit and how it is “better” than accounting profit.

5. Provide me 3 examples of sunken costs.

6. Explain how American farmers have utilized the concept of economies of scale to increase profits.

Answer 1

The concept of Marginal utility is used widely in cardinal utility theory. According to the proponents of this theory utility or use of an item can be measured accurately through mathematical functions. Therefore given a function that represents total utility of a good for an individual, the change in total utility derived from the good, when the amount of good consumed increases by 1 unit is called marginal utility. For example, the additional satisfaction a person gets by watching another movie show, or purchasing a new dress, or simply by drinking 1 more unit of apple juice etc. In all these cases we are measuring the change (whether positive or negative) in existing satisfaction level from a good, if an additional unit is increased for consumption.

Diminishing marginal utility states that keeping other things constant the additional utility derived from the consumption of good diminishes as quantity of good consumed increases. In other words, as the amount of good consumed keeps on increasing it gives lesser and lesser satisfaction to the individual. For example, initially after a hectic week at work an individual enjoys taking a sauna bath. The first hour will give highest satisfaction to the individual as it relieves pain, in the next hour utility will be positive but lesser than first and so on till a point reaches (say 5 hours!) when the individual gets exhausted. The same good which was giving positive utility initially becomes disutility to the individual later on.

According to the law of demand, under ceteris paribus assumption when price increases demand for the good falls. This price effect is actually decomposed into income effect and substitution effect. When price of a good decreases it increases the real purchasing power of the consumer as the consumer can spend the dollar 'saved' on purchasing other good. This is called income effect.

Further if price of the good increases it makes the Individual move towards cheaper substitute of the good as the budget constrains the individual to spend more on purchasing the same quantity of good. This is called substitution effect.

Endowment effect makes an individual develop an inward bias for a good which they own in comparison to the good they do not own or possess. Such goods hold greater value (than the actual market value) to the individual due to their ownership. For example, a pen gifted by the teacher when the student tops the assignment in class holds more value to the student than any other pen. This student will not exchange it for the same or higher value pen because it is special. The student has earned it not through ordinary means but through an outstanding performance.

Economic profit takes into consideration the concept of opportunity cost or implicit cost, This is a better version than accounting cost because accounting costs are historical expenses which have been incurred during the course of business. While economic costs includes even those costs which was not incurred explicitly but would have incurred if the assets were not owned. For example a spare residential flat used for business purposes, or private car used for purchasing business supplies. These assets have alternative uses and would have earned rent. However an 'opportunity is lost' since they were engaged in carrying out business. So these are implicit costs which are part of economic costs.

Sunk costs are expenditure usually high value which have been incurred during setting up or preparation of business and no matter whether the business operations are continued or not they cannot be recovered. For example -

• Research and development cost
• Tilling up barren land for agriculture
• Infrastructure costs such as laying new railway tracks, setting up hydro or wind power plants.
• Costs incurred in spaceship programmes.

Economies of scale are benefits which arise solely due to expansion of production activity. This reduces cost of production as inputs can be purchased in bulk at lesser costs, fixed costs can be spread over large output etc.

For example, in agriculture small landholdings by individual farmers limit production and resource usage which does not lead to optimum output. However, with enlarged landholdings, different kinds of crops can be grown and mechanized equipment can be used in cultivation and harvesting stages.This reduces labor effort, ensures better productivity and leaves enough time for the farmer to engage in other agricultural allied activities. Also, usage of modern techniques reduces cost per unit of output and therefore increases overall profits.