Microeconomics by Judy whitehead

"Theory of the Consumer"

Submitted by:

Amr Mohamed El-seraty

Economic department

Supervised by:

Dr. Ahmed Mandour

Professor of economics

Economic department

Faculty of economic studies and political science

Alexandria university

This was submitted for the second chapter of the course of advanced microeconomic theory

Alexandria, 2022
 Why do consumers respond to price changes in the way they do? Is it irrational
for consumers to spend more one some commodities when their prices fall but to
spend less on other commodities when they undergo a similar price reduction?
These are some of the important questions that we address in this chapter.

We should know how an individual consumer’s satisfaction changes as he or she

alters the amount consumed of a single product. The satisfaction a consumer
received from consuming that product is called utility. Total utility refers to the
total satisfaction derived from all the units of that product consumed. Marginal
utility refers to the change in satisfaction resulting from consuming one unit more
or one unit less of that product.

For example, the total utility of consuming 7 eggs a weak is the some total satisfaction
provided by all 7 eggs. The marginal utility of the seven eggs consumed is the addition to
total satisfaction provided by consuming that extra egg. Put another way, the marginal utility
of the seventh egg is the addition to total utility gained from consuming 7 eggs per week
rather than 6 per week.

The study of the economic behavior of the consumer is a prequel to the study of
demand for goods and services in the product market.

This is the utility theory that provide the foundation for the law of demand,
indicating how and why consumers respond in particular ways to the structure of
incentives and various other factors (price, income, tastes) in the market.

The individual consumer and utility maximization:

The concept of utility or satisfaction is central to the study of the consumer

behavior in the market.

The standard theory of the consumer follows the traditional deductive approach
using the scientific method of inquiry. This approach proceeds in a structured way
from assumptions, through the body of the theory to its testable conclusions.
 To study the consumer theory, we must first know the main assumptions
about it:

• The consumer is always assumed to be rational and to optimize with respect to

the given values for income and market price.
• Consumers plan to spend their income to attain the highest possible utility
( satisfaction ) within these parameters.
• In the traditional theory it is assumed that the consumer has full knowledge of
all the information relevant to his decision, that is he has complete knowledge
of all the available commodities, their prices, and his income.

In order to attain this objective, the consumer must be able to compare

the utility (satisfaction) of the various 'baskets of goods' which he can buy
with his income.

there are two basic approaches to the theory of utility

maximization (problem of comparison of utilities): The cardinal
theory and the ordinal theory. A third approach, the revealed
preference theory, is usually viewed as an addendum or upgrade
to the ordinal theory but may be considered a theory in its own
right.
As the study proceeds, it may be observed that all three approaches lead to the
same conclusion or testable hypothesis: that, normally, as the price
of a good falls, the quantity demanded increases. This becomes
known as the Law of Demand.

1. The Cardinal utility theory

The Cardinal utility theory is the oldest version of utility theory. Central to the
Cardinal theory is the concept of measurable utility. The assumption is that
 utility or satisfaction is measurable on a cardinal scale (scale with zero as the
origin), this measurement could be done by money or unit called Utils.

1.1 Assumptions of the Cardinal utility theory

• The consumer is rational. This implies that the consumer aims at the
maximization of utility given prices and income (as a constraint).
• Cardinal utility. The utility of each commodity is measurable. Utility is a
cardinal concept. The most convenient measure is money: the utility is
measured by the monetary units that the consumer is prepared to pay for
another unit of the commodity.
• The marginal utility of money is constant ( 𝑀𝑈 ̅̅̅̅̅ ) . This assumption is
necessary if money is to be used as a measuring rod, to prevent money
from becoming an ‘elastic’ ruler. It means that a unit of money (e.g. one
dollar) has the same utility to the holder no matter how much money the
holder possesses.
• There is diminishing marginal utility for a commodity.
• The total utility of a ‘basket of goods’ depends on the quantities of the
individual commodities. If there are n commodities in the bundle with
quantities x1, x 2, …, x., the total utility is:

U = f (x1, x2, …, xn)

In very early versions of the theory of consumer behavior it was assumed

that the total utility is additive1, For a basket comprising two goods x and y,
the total utility (U) for the consumer is the sum of the utilities gained from
the two goods. This may be expressed as: U = Ux + Uy

1
The additivity assumption was dropped in later versions of the cardinal utility theory. Additivity implies
independent utilities of the various commodities in the bundle, an assumption clearly unrealistic, and unnecessary
for the cardinal theory.
 1.2 Consumer equilibrium under the Cardinal theory
a. single commodity
Consider a single commodity (x), its price is (px), and the consumer
seeks to maximize the utility from consuming the commodity.
The maximation of utility — consumer equilibrium

Utility for the individual consumer depends on the quantity consumed of

commodity (x).

So:
The utility function for the consumer is expressed as:

𝑈 = 𝑓𝑄𝑥
On buying 𝑄𝑥 the consumer has an expenditure on good 𝑥 (𝐸𝑥) such that:

𝐸𝑥 = 𝑄𝑥 𝑃̅𝑥
The consumer’s objective is to maximize the difference between utility received
and the expenditure made on the good.

This objective function may be expressed as:

𝑀𝑎𝑥: 𝑈 − 𝑃̅𝑥 𝑄𝑥
The calculus of variations is used to precisely identify an optimum position. For
this, the partial derivative of the objective function with respect to 𝑄𝑥 must be set
equal to zero. Thus:

𝜕𝑈 𝜕 (𝑃̅𝑥 𝑄𝑥 )
− =0
𝜕𝑄𝑥 𝜕𝑄𝑥

Or:
 𝜕𝑈
− 𝑃̅𝑥 = 0
𝜕𝑄𝑥
Rearranging we obtain:
𝜕𝑈
= 𝑃̅𝑥
𝜕𝑄𝑥
Since:
𝜕𝑈
= 𝑀𝑈𝑥
𝜕𝑄𝑥
this gives:

𝑀𝑈𝑥 =𝑃̅𝑥

Hence, the consumer achieves equilibrium (maximum satisfaction) when the

incremental utility (marginal utility) (utility from the last unit) derived from a
commodity is just equal to the given price of that commodity.

The result is that,

…where the incremental (marginal) utility is greater than the price (𝑀𝑈𝑥 > ̅𝑃𝑥 )
the rational consumer buys more units of the commodity as the satisfaction from
that extra unit of the commodity is greater than the cost of the unit.

…Correspondingly, when the satisfaction derived from that extra unit of the
commodity is less than the price for that unit (𝑀𝑈𝑥 < ̅ 𝑃𝑥 ) , the rational
consumer buys less units of the commodity as the satisfaction from that extra unit
of the commodity is less than the cost of the unit.
b. Multiple commodities
The equilibrium condition for good x can be done similarly for any other good.
Hence, for good y, the equilibrium condition would be:

𝑀𝑈𝑦 = 𝑝̅𝑦
Since the marginal utility of a good is equal to the price of the good, then:
𝑀𝑈𝑥 𝑀𝑈𝑦
=1 & =1
𝑃̅𝑥 𝑝̅𝑦

Hence:
𝑀𝑈𝑥 𝑀𝑈𝑦
=
𝑃̅𝑥 𝑝̅𝑦
Extending to any number (N) of goods, the equilibrium condition requires the
equality of the ratios of the marginal utilities of the individual commodities to their
price. This is expressed as:
𝑀𝑈𝑥 𝑀𝑈𝑦
= = … = 𝑀𝑈 𝑁
= 𝑀𝑈 𝑜𝑓 𝑚𝑜𝑛𝑒𝑦
𝑃̅𝑥 𝑝̅𝑦 𝑃̅ 𝑁

Consequently, for any two goods, say, x and y, the equilibrium position can also be
written as:

𝑀𝑈𝑥 𝑃̅𝑥
=
𝑀𝑈𝑦 𝑝̅𝑦
….The implication is that the utility derived from spending an additional unit of
money must be the same for all commodities or customers can increase welfare by
spending more on some and less on others until equilibrium is achieved.
 1.3 Derivation of the demand curve — Cardinal theory

Consider the total utility curve of the consumer as

depicted in the following figure:

This is based on the basic assumption (axiom) of

diminishing marginal utility. As more of good x is
consumed, the total utility derived from x increases
but at a decreasing rate. This is because the
additional utility from every extra unit is less than
that from the previous unit. Eventually, there is an
additional unit consumed that adds nothing (zero) to
the consumer’s total utility. This occurs at the quantity
QT. This is the point of satiation. After this, the addition
to the total utility from an extra unit becomes negative (<0).
As a result, the total revenue curve begins to decline.

The marginal utility of good x (MUX) is the slope of the total utility function:

𝑈𝑥 = 𝑓(𝑄𝑥 )

Hence, if tangents are drawn to the total utility curve, these tangents
would continue to decrease in slope (i.e., get flatter) until the top of the
total utility curve (T) is reached, when the tangent would be horizontal,
having a slope of zero. This occurs at the quantity QT of commodity x.
Beyond this point, the slope of the tangents would become negative.
 Consequently, the relevant marginal utility (MU) curve, as measured by
the slope of the total utility curve of good x, keeps declining until it
reaches zero at the quantity QT and then becomes negative.

The demand curve

The equilibrium condition was
previously derived as:

𝑀𝑈𝑥 =𝑝𝑥
So: Along the marginal utility of x
curve, for every level of marginal
utility, there is a corresponding
equilibrium price of good x. Hence:

MUx1 = Px1

MUx2 = Px2

So MUxN = PxN

This means that marginal utility can

be replaced by price and so the
marginal utility curve can be
replaced by a curve relating price to
the quantity of commodity x.

It should be recognized that, since negative prices are not meaningful in

economics, the demand curve (AB) doesn’t fall below zero price. Then, the
demand curve represents only the positive portion of the commodity’s marginal
utility curve.
 Critique of the Cardinal theory:
The Cardinal theory led to a conclusion that generates the standard demand curve.
Nevertheless, the theory was not considered satisfactory particularly because of
some of its assumptions.

Three basic weaknesses of the Cardinal theory were identified:

1- The assumption of cardinal measurement of utility was deemed

unsatisfactory. The absolute measurement of satisfaction in an objective
way, either in Utils or in money, was unacceptable.
2- The assumption of constant marginal utility of money was judged to be
unrealistic. The view was held that, as income increases, the marginal utility
of money (utility of one dollar) falls.
3- The assumption of diminishing marginal utility for a good was challenged. It
could not be accepted that the ‘axiom’ was indeed a basic truth. It could only
be considered a psychological law, established by introspection, which must
be taken for granted.