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 its 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
TU
MU

Q
TU

Relationship TU and MU graphically

Q
P
MU
MU
Q
0
TU
0
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
Consumer Equilibrium
As a rational consumer, you presumably seek to obtain
the greatest possible utility from your limited monthly
income.

On condition we dont 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. 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

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 consumers
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
Y
MRSXY

Py
Px
X
Y

Y P X P I y x
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 consumers
indifference map



MUy
MUx
ratio on substituti
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

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=MU
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 youll 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 X
2
. (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