Class 5- Theory of Consumer Choice

8/10/2019 Class 5- Theory of Consumer Choice

1/33

Theory of Consumer Choice

How Consumers Make Choices under

Income Constraints?


2/33

Utility

Utility was thought of as a numeric measureof a personshappiness.

Bentham (1823, p. 3): 'By utility is meant that

property in any object, whereby it tends toproduce benefit, advantage, pleasure, good orhappiness . . . '

'Utility' is roughly synonymous with'satisfaction,' 'well-being,' 'welfare,''happiness,' 'pleasure,' etc.


3/33

the theory of consumer behavior has beenreformulated entirely in terms of consumerpreferences, and utility is seen only as a way

to describepreferences. A utility function is a way of assigning a

number to every possible consumptionbundle such that more-preferred bundles getassigned larger numbers than less-preferredbundles.


4/33

Two Approaches to Measure Utility

Cardinal Approach: Utility can be quantified.(Generally done by using money as measuringunit). Alfred Marshall is the proponent of

cardinal approach Ordinal Approach: It is based on ranking or

ordering satisfaction derived fromconsumption of goods and services. Ordinalnumbers are not quantifiable. R G D Allen, J RHicks, P A Samuelson


5/33

Total Utility and Marginal Utility

Marginal utility is the utility a consumerderives from the last unit of a consumer goodshe or he consumes (during a given

consumption period) Total utility is the total utility a consumer

derives from the consumption of all of theunits of a good or a combination of goodsover a given consumption period.


6/33

6

Total and Marginal Utility

of Listening to Digital Music Albums


7/33

7

Total Utility

of Listening to Digital Music Albums


8/33

The Law of Diminishing Marginal Utility

Over a given consumption period, the more of a good aconsumer has, or has consumed, the less marginal utility anadditional unit contributes to his or her overall satisfaction(total utility).

Alternatively, we could say: over a given consumptionperiod, as more and more of a good is consumed by aconsumer, beyond a certain point, the marginal utility ofadditional units begins to fall.

Marshall, The additional benefit which a person derivesfrom a given increase of his stock of a thing diminishes withevery increase of the stock that he already has.


9/33

Assumptions

1. Cardinal measurement of utility: Expressing utilitynumerically

2. Ceteris Paribus: Factors influencing consumption areconstant i.e. price, income, prices of related products,

taste, fashion, preferences etc.3. Rationality: Consumers are rational i.e. attempt to

maximize satisfaction.

4. Constant marginal utility of money

5. Continuity in consumption6. Homogeneity of products under consideration

7. Standard units of consumption


10/33

10

Marginal Utility

Listening to Digital Music Albums


11/33

11

Total and

Marginal Utility

of Downloadingand Listening

to Digital

Music Albums

Total utility ismaximized...

where marginalutility equals zero.


12/33

Utility Maximizing Rules A rational consumer would buy an additional unit

of a good as long as the perceived dollar value of

the utility of one additional unit of that good (say,

its marginal dollar utility) is greater than its

market price. The Two-Good Rule

MUI

MUH

--------- = ----------

$PI $PH


13/33

Utility Maximization under An

Income constraint Consumersspending is constrained by their incomes:

Income = Px Qx + Py Qy + Pw Ow + .+Pz Qz

While the consumer tries to equalize MUx/Px , MUy/Py, MUw/Pw,. and MUz/Pz , to maximize herutility and her total spending cannot exceed herincome.


14/33

14

Total and Marginal Utility from Consuming Music

Album Downloads and Sandwiches on an Income of

$26


15/33

15



$26


16/33

16



$26


17/33

17

Optimizing Consumption Choices

A consumers money income should be

allocated so that the last dollar spent on each

good purchased yields the same amount of

marginal utility (when all income is spent),

because this rule yields the largest possible

total utility.


18/33

18

Optimizing Consumption

Choices

The rule of equal marginal utilities per dollar spent

A consumer maximizes personal satisfaction when

allocating money income in such a way that the last

dollars spent on good A, good B, good C, and so on,yield equal amounts of marginal utility.


19/33

19

The rule of equal marginal utilities per dollar spent

Optimizing Consumption

Choices

MUof good A

Price of good A=

MUof good B

Price of good B

MUof good Z

Price of good Z= =...


20/33

20

How a Price Change Affects Consumer

Optimum

Recall from earlier table, Income = $26

Qd = 4MU

d

Pd36.5

5= = 7.3

Qs = 2

MUs

Ps

223= = 7.3


21/33

21


Optimum

Assume Price of Music Falls to $4

Qd = 4MU

d

Pd36.5

4= = 9.125

Qs = 2

MUs

Ps

223= = 7.3


22/33


23/33

23


Optimum

Consumption decisions are summarized in thelaw of demand

The amount purchased is inversely related to

price.

A consumers response to a price change

At higher consumption rate, marginalutility falls.


24/33

24

Digital Music Download Prices and

Marginal Utility


25/33

25


Optimum

The Substitution Effect

The tendency of people to substitute cheaper

commodities for more expensive commodities

The Principle of Substitution

Consumers and producers shift away

from goods and resources that become pricedrelatively higher in favor of goods and resources

that are now priced relatively lower.


26/33

26


Optimum

Purchasing Power

The value of money for buying goodsand services

Real-Income Effect

The change in peoplespurchasing power that occurswhen, other things being constant, the price of one

good that they purchase changes

When that price goes up (down), real income, orpurchasing power, falls (increases).


27/33

Diamond-Water Paradox

Diamond-water paradox the observation

that essential goods are often lower priced

than non-essential goods.

The price of a good is equal to the marginal

utility of the last unit consumed.

A person consumes many units of water. The

last unit of water consumed have a very lowmarginal utility.


28/33

A person consumes few diamonds. The last

diamond consumed has a high price and

provides high marginal utility.

Water is more valuable than diamonds in

terms of total utility, but diamonds have a

higher marginal utility, and thus a higher price.

Marginal utility, not total utility, determineshow much people are willing to pay.

Diamond-Water Paradox


29/33

Significance of the Law

Foundation to other laws i.e. law of demand,consumption etc.

Distinguishes between use value and

exchange value. For e.g. water- diamondparadox.

Used in public finance: Basis for progressive

taxation i.e. tax rate increasing with income. Support to socialism: Redistribution of incomein favor of poor.


30/33

Exceptions

Collections i.e. antiques

Consumption of intoxicants

Reading & writing Music and poetry


31/33

Limitations

Utility is not quantifiable

Ceteris Paribus may not always hold

Marginal utility of money is not constant Existence of indivisible goods and durables i.e.

TV, refrigerator etc.

Too many assumptions i.e. unrealistic


32/33

Consumer Surplus

The difference between what a consumer is

willing to pay for an addition unit of a good

and the market price that he/she actually pays

is referred to as consumersurplus.

The area between the demand curve and the

price (line) measures the total consumer

surplus.


33/33

Consumer Surplus

Price

D

Qx

0

P

Class 5- Theory of Consumer Choice

Documents

Transcript of Class 5- Theory of Consumer Choice