consumer choice (1)

7/31/2019 Consumer Choice (1)

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CONSUMER CHOICE

The Theory of Demand


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CARDINAL APPROACH TO UTILITY

Utility = satisfaction consumers receive from items

they require, activities they engage in, or services

they use

Total utility = total satisfaction enjoyed from

consuming any given quantityits a subjective

concept

Marginal utility = the extra satisfaction a person

receives over a given period by consuming one extra

unit of a good


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Relationship of Total and Marginal Utility

The relationship between total and marginal utility can beexpressed also graphically. The figure of total utility shows howthe total utility depends on the amount of consumed good theratio represents than the slope of total utility curve.

Quantity of good consumed Total utility Marginal utility

0 0

1 4 4

2 7 3

3 9 2

4 10 1

5 10 0

Q

TUMU

Q

TU


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Relationship TU and MU graphically

Q

P

MU

MU

Q0

TU0


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1. Gossens law

The law of diminishing marginal utility the amount of

extra or marginal utility declines as a person

consumes more and more of a good

Utility tends to increase as you consume more of a

good, however, according to the law of diminishing

marginal utility, your total utility will grow at a slower

and slower rate


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Consumer Equilibrium

As a rational consumer, you presumably seek to obtainthe greatest possible utility from your limited monthlyincome.

On condition we dont have to pay anything for a good,the equlibrium level of consumption of that good wouldbe the amount that brings us the highest total utility.

Equilibrium amount of a good will be bought than, aslong as the marginal utility equals the price of thatproduct:

MU = P


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2. Gossens law

The law of equal marginal utilities per

dollar/euro.. = equimarginal principle

- to maximize utility, consumer must equalize

the marginal utility per euro spent on each

good

(MU of income)

Py

MUy

Px

MUx


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Deriving of demand curve

The demand curve represents a relationship betweenthe marginal utility of a good and the quantity

consumed, other things beings equal

A higher price for a good reduces the consumersoptimal consumption of that commodity, therefore for

each price exists the quantity demanded

corresponding the consumer optimum downward-

sloping demand curve!


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ORDINAL APPROACH TO UTILITY

INDIFFERENCE CURVES

A graph of various market baskets

that provide a consumer with equal

utility

Different individual will naturally rank

market baskets differently

Main characteristics:

convex to origin represents the

law ofsubstitution

downward-sloping

there is always an infinite number

of curves

they never intersects mutually

THE BUDGET CONSTRAINT

Budget line = represents all

alternative combinations of

two goods that consumer

can afford considering his

fixed income (assuming fixedprices).

The equation of budget line

is:

The slope:

MUy

MUx

X

YMRSXY

Py

Px

X

Y

YPXPI yx


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Consumer equilibrium

Represents that combination of goods purchases that

maximizes utility subject to the budget constraint

Geometrically, the equilibrium can be described asthat combination of goods corresponding to the point

at which the budget line is just tangent to the highestattainable indifference curve in the consumersindifference map

MUy

MUx

ratioonsubstitutiPy

Px


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Indifference analysis

A

TU=7

TU=4

TU=5

TU=1

TU=2

B


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DERIVING THE DEMAND CURVE

Kept other things constant, when the price of X has increased, it will mean that

the less of that product you can afford with your income

graphically it means the change of the budget line slope it becomes

steeper and therefore will touch different indifference curve (representing lower

level of utility) each price corresponds other optimal point and therefore

different quantity of good demanded, in that way we can construct the demand

curve (individual)


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CONSUMER SURPLUS

= the gap between the total utility of a good and its total

market value

The surplus arises because we receive more than

we pay for, it is rooted in the law of diminishing

marginal utility

we pay for each unit what the last unit is worth but

by the law of diminishing marginal utility the earlier

units are worth more to us than the last thus, we

enjoy a surplus of utility on each of these earlier units


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Consumer surplus

Q

S

Q0

RZ

D=MU

P0

P


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Tasks:

1. Can be TU positive and MU negative at the same time? Draw graphs and explain.

2. Knowing following dates:

a) Draw the graphs of TU and MU curves.

b) Calculate, how high consumer surplus youll get, when the market price of good is 8Eur and decide, how many units you will consume.

3. Px = 120 Eur and Py = 80 Eur. Graphically show, what will happen when Px hasincreased by 18 Eur and at the same time Py by 12 Eur. Use the tools ofindifference analysis.

4. Your function of TU is: TU = 10X X2 . (where X is quantity of good consumed perweek).

a) Write the equation of MU and decide, at what level of consumption start TU decrease?

b) Derive and draw TU and MU curves.

c) Assume Px = 6 Eur. By what level of consumption of good X will household maximizeits utility, knowing, that the ratio MU/P for all other goods = 1)?

Q 1 2 3 4 5 6 7

TU 20 36 48 56 60 60 58

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