MICROECONOMICS ASSIGNMENT 2 – Solutions

MAXIMUM 30 MARKS
DUE DATE: Monday, 19th October 2015, in class

Q1) Explain the meaning of utility. What is the difference between total utility and marginal utility? Use
graphs to explain your answer. (5 MARKS)

Utility is the satisfaction that a consumer derives by consuming a commodity. Utility is a subjective
concept and its perception varies among different individuals. In fact, the extent of desire for a
commodity by an individual depends on the utility that he associates with it. The theory of demand
assumes that people maximize their utility, which implies that consumers choose those goods and
services that give them the maximum level of satisfaction.

Total utility (TU) is defined as the aggregate utility derived by a consumer after consuming all the
available units of a commodity. Thus, it is the sum of all the utilities a consumer obtains from consuming
each individual unit of the various commodities. Contrary to this, marginal utility (MU) is the utility from
an additional unit of a commodity, over and above what had been consumed. The total utility graph is
concave due to the law of diminishing marginal utility. As a consumer increases his consumption of a
good, total utility increases at a decreasing rate. Thus the marginal utility falls as a consumer increases
his consumption and so the marginal utility curve is downward sloping. The two graphs are related
because if we sum the marginal utilities we will get the total utility.
Q2) Explain the law of diminishing marginal utility and give a numerical example. (5 MARKS)

The law of diminishing marginal utility states that as a consumer increases his consumption of a
commodity, the utility he obtains from successive units of the commodity decreases. This means that
the marginal utility falls as a consumer increases his consumption of a good. A simple example can
illustrate this concept. The table below gives the total utility and the marginal utility a consumer obtain
from drinking a glass of water.

Number of Total Marginal

Glasses Utility Utility
1 20 20
2 32 12
3 40 8
4 42 2
5 42 0

Evidently, when the consumer is parched the first glass of water gives him the highest level of
satisfaction. As he keeps drinking more glasses of water, his marginal utility diminishes. Total utility
increases but at a decreasing rate. The fifth glass of water does not give the consumer any added utility
as he is completely satiated.

Q3) What is the difference between the ordinal and the cardinal approach to consumer equilibrium. To
answer this question, explain each of the approaches and how consumer equilibrium is derived under
each approach. (10 MARKS)

The cardinal approach to utility theory is based on a number of assumptions. Firstly we assume that a
consumer is rational, and given his income constraints will always maximize his utility. Secondly, utility
can be measured in quantitative terms. Hence, a person may express the utility he derives from
consuming a bar of chocolate as 20 or 30 utils. In addition, consumers are able to compare and define
the difference in utilities between two or more commodities. For example, a consumer can compare the
utility he achieves from a chocolate or an apple, and can consume the item that maximizes his
satisfaction. Thus, it allows an individual to compare the 20 utils of satisfaction the bar of chocolate
gives, to the 10 utils of satisfaction from consuming an apple. For convenience utility can be expressed in
the monetary value that a consumer is willing to pay for the marginal unit of the commodity.

The aim of the consumer is to maximize his utility from consumption. The equimarginal principle is the
fundamental condition of utility maximization. It states that a consumer will achieve maximum
satisfaction or utility when the marginal utility of the last dollar spent on a good is exactly the same as
the marginal utility of the last dollar spent on any other good. This means that the ratios of the marginal
utilities of the individual commodities to their respective prices are equal for all commodities. This is the
condition that is necessary for consumer equilibrium and it is essential that this condition hold. This is
because if any good gave a higher marginal utility, consumers would switch consumption away from
other goods and spend more money on that good. This process would continue until the law of
diminishing marginal utility drove the marginal utility per dollar down and equaled the marginal utility of
the other goods. Similarly, if any good gave a lower marginal utility, consumers would buy less of that
good until the marginal utility of the last dollar spent on the good has risen to the level of the other
goods. The common marginal utility of all goods in consumer equilibrium is what is called the marginal
utility of income. The marginal utility of income measures the added utility that is gained if the
consumer could enjoy an extra dollar of consumption. The equimarginal principle, which is the
fundamental condition for consumer equilibrium, can be written in terms of the marginal utilities (MUs)
and prices (Ps) of different goods as follows:

The ordinal approach to utility, unlike the cardinal approach described above, cannot be measured in
quantitative terms. Rather, the consumer can compare the utility obtained from different commodities
and rank them in accordance with the satisfaction each commodity gives him. So for example, if we ask
an individual if they prefer a chocolate to an apple, they simply answer which one they prefer. There is
no need to quantify by how much one item is preferred to the other. Thus ordinal utility is
dimensionless, and it allows us to state that A is preferred to B, but we cannot determine by how much
it is preferred. All we can do is rank them relative to one another. To determine consumer equilibrium
under the ordinal approach, we need to use indifference curves and budget lines. Once this is done,
consumer equilibrium is where the indifference curve intersects the budget line.

An indifference curve is defined as the locus of the various combinations of the two goods that give the
same satisfaction to the consumer, i.e. the consumer is indifferent between consuming say 1 unit of
food or 6 units of clothing. All points on an indifference curve yield the same level of satisfaction and so
they are equally desired by the consumer. The shape of the indifference curve is convex because of the
law of substitution, which states that as we increase consumption of one good, the slope of the
indifference curve or the substitution ratio becomes smaller. This means that as a good becomes less
scarce, its relative substitution value falls. An indifference map shows a family of indifference curves,
each showing different utility levels. A consumer’s budget line or budget constraint shows all the
possible combinations of the goods that a consumer can buy given the price of the good and his income.
The slope of the budget line is the ratio of the two prices. Geometrically consumer equilibrium is the
point where the slope of the budget line (ratio of price of goods) is exactly equal to the slope of the
indifference curve (ratio of the two marginal utilities). At equilibrium, the consumer’s substitution ratio
is equal to the slope of the budget line and so all marginal utilities are proportional to their prices. The
figure below graphically depicts the consumer equilibrium as the point where the budget line is tangent
to the highest indifference curve.
Q4) Assume that the demand for travel over a bridge takes the form

Y =1,000,000 - 50,000P,

where Y is the number of trips over the bridge and P is the bridge toll (in dollars).

a. Draw the demand curve for travel over a bridge. (2 MARKS)

Step1 Rewrite the demand function in the form:

P = 20 – 0.00002Y

This is because when we draw a demand curve, the price is the dependent variable depicted on
the y-axis, while the quantity is the independent variable on the x-axis.

Step2  Find the intercept values

When P=0, Y= 1,000,000  when the toll is free, the number of trips is 1,000,000.
When Y=0, P= 20  when the price of the toll is $20, no one uses the bridge.

Step 3  Draw the demand curve for travel.

b. Calculate the consumer surplus if the bridge toll is $0, $1, and $20. (3 MARKS)

The consumer surplus is the amount that buyers are willing to pay for a good minus the amount
they actually pay for it. It measures the benefit that buyers receive from a good as the buyers
themselves perceive it. Consumer Surplus can be calculated as the area under the demand curve
above the price paid for the good.

The consumer surplus when the toll is free is the full area under the whole demand curve i.e.
the area of the triangle and is $10,000,000. This is because at no cost, 1,000,000 trips will be
made. At a price of $20, no trips will be made and so there will be no consumer surplus. When
the price of the toll is $1, 950,000 trips will be demanded. Thus the consumer surplus will be the
 area under the demand curve above the price line of $1, i.e. $9,025,000. Essentially this is the
area of the triangle labeled, A, shown in the diagram below. It is evident that the lower the price
of the toll, the higher will be the consumer surplus enjoyed by those using the bridge to travel.

c. Assume that the cost of the bridge is $1,800,000. Calculate the toll at which the bridge owner
breaks even. What is the consumer surplus at the breakeven toll? (3 MARKS)

Breakeven toll can be calculated by equating the revenue generated to the cost of the toll. The
revenue is calculated as follows:

Revenue = Price * quantity = 1,000,000P – 50,000 P2

Break even  Revenue = Cost  1,000,000P – 50,000 P2 = 1,800,000

Rearranging and simplifying we get a simple quadratic equation  P2 - 20P = 36

Solving this we get P=$2 or P=$18. This means that there are two prices at which the bridge
owner can breakeven. At $2, the numbers of trips demanded are 900,000 and at $18 only
100,000 trips are made. In both cases the revenue generated is $1,800,000.

The consumer surplus when the price is $18 is $ 100,000 (0.5*100,000*(20-18)) and the
consumer surplus when the price is $2 is $8,100,000 (0.5*900,000* (20-2)). The owner is thus
indifferent between the two toll prices, while the consumer will enjoy a higher consumer surplus
if the toll price is $2.