CONSUMER CHOICE

The Theory of Demand

Two major approaches to utility

KARDINAL- direct measuribility of

utility

Tools used:

- Total utility curve

- Marginal utility curve

ORDINAL- immeasurability of utility

Tools used: - Indifference analysis - Basic assumption: consumer

can rank market baskets (the most desired basket is ranked first)

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 quantity čit´s a subjective concept

Marginal utility = the extra satisfaction a person receives over a given period by consuming one extra unit of a good

Relationship of Total and Marginal Utility

The relationship between total and marginal utility can be expressed also graphically. The figure of total utility shows how the total utility depends on the amount of consumed good the ratio 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

Relationship TU and MU graphically

Q

P

MU

MU

Q0

TU0

1. Gossen´s 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

čUtility 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

Consumer Equilibrium

As a rational consumer, you presumably seek to obtain the greatest possible utility from your limited monthly income.

On condition we don´t have to pay anything for a good, the equlibrium level of consumption of that good would be the amount that brings us the highest total utility.

Equilibrium amount of a good will be bought than, as long as the marginal utility equals the price of that product:

MU = P

2. Gossen´s 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

Deriving of demand curve

The demand curve represents a relationship between the marginal utility of a good and the quantity consumed, other things beings equal

A higher price for a good reduces the consumer´s optimal consumption of that commodity, therefore for each price exists the quantity demanded corresponding the consumer optimum downward-sloping demand curve!

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 of substitution“   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 fixed prices).

The equation of budget line is:

The slope:

MUy

MUx

X

YMRSXY

Py

Px

X

Y

YPXPI yx

Consumer equilibrium

Represents that combination of goods purchases that maximizes utility subject to the budget constraint

Geometrically, the equilibrium can be described as that combination of goods corresponding to the point at which the budget line is just tangent to the highest attainable indifference curve in the consumer´s indifference map

MUy

MUxratioonsubstituti

Py

Px

Indifference analysis

A

TU=7

TU=4

TU=5

TU=1

TU=2

B

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

č 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)

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

Consumer surplus

Q

S

Q 0

RZ

D =M U

P 0

P

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 you´ll get, when the market price of good is 8

Eur and decide, how many units you will consume.

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

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

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 maximize

its 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