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Distinguish between total utility and marginal utility
Discuss why marginal utility at first rises but ultimately tends to decline as a person consumes more of a good or service Explain why an individual’s optimal choice of how much to consume of each good or service entails equalizing the marginal utility per dollar spent across all goods and services
Shaila Srivastava 2
Describe the substitution effect of a price change on the quantity demanded of a good or service
Understand how the real-income effect of a price change affects the quantity demanded a good or service Evaluate why the price of diamonds is so much higher than the price of water even though people cannot survive long without water
Shaila Srivastava 3
One way of deriving the law of demand involves an analysis of the logic of consumer choice in a world of limited resources?
In this chapter we discuss what is called utility analysis.
Utility Theory Utility – The want-satisfying power of a good or service Utility Analysis – The analysis of consumer decision making based on utility maximization Util – A representative unit by which utility is measured Shaila Srivastava 5 .
Utility Theory Marginal Utility – The change in total utility due to a one-unit change in the quantity of a good or service consumed Change in total utility Marginal utility = Change in number of units consumed Shaila Srivastava 6 .
Graphical Analysis We can appreciate total and marginal utility by using graphical analysis. Shaila Srivastava 7 .
Total & Marginal Utility of Downloading & Listening to Digital Music Albums Shaila Srivastava 8 .
Total & Marginal Utility of Downloading & Listening to Digital Music Albums Shaila Srivastava 9 .
Total & Marginal Utility of Downloading & Listening to Digital Music Albums Shaila Srivastava 10 .
…where marginal utility equals zero.Total & Marginal Utility of Downloading & Listening to Digital Music Albums Total utility is maximized... Shaila Srivastava 11 .
Shaila Srivastava 12 .Graphical Analysis Observations – Marginal utility falls as more is consumed. – Marginal utility equals zero when total utility is at its maximum.
The High Cost of Certain Sources of Negative Marginal Utility Conventional wisdom says that it is impossible to put a price tag on happiness. What is the amount of compensation required for economic “bads?” Shaila Srivastava 13 . Economists usually attempt to attach dollar values to economic goods.
Diminishing Marginal Utility Diminishing Marginal Utility – The principle that as more of any good or service is consumed. its extra benefit declines – Increases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period. Shaila Srivastava 14 .
Shaila Srivastava 15 .Newspaper Vending Machines versus Candy Vending Machines How many people take more than one paper from the vending machine? Why not dispense candy the same way? The answer is found in the concept of diminishing marginal utility.
Optimizing Consumption Choices Consumer Optimum – A choice of a set of goods and services that maximizes the level of satisfaction for each consumer. subject to limited income – Law of Equi-Marginal Utility Shaila Srivastava 16 .
Algebraically. The consumer will maximize total utility from his income when the utility from the last rupee spent on each good is the same. (b).Consumer Optimum A consumer will be in equilibrium with a single commodity symbolically: MUx = Px The position of equilibrium will be reached when the marginal utility of each good is in proportion to its price and the ratio of the prices of all goods is equal to the ratio of their marginal utilities. Shaila Srivastava 17 . (c)…. (n) are various goods consumed. this is: MUa / Pa = MUb / Pb = MUc = Pc = MUn = Pn Here: (a).
(iii) Utility is cardinally measurable. (ii) Constant marginal utility of money.Assumptions of Law of Equi-Marginal Utility: (i) Independent utilities. The marginal utility of money remains constant to the consumer as he spends more and more of it on the purchase of goods. (iv) Every consumer is rational in the purchase of goods. Shaila Srivastava 18 . The marginal utilities of different commodities are independent of each other and diminish with more and more purchases.
00. consumers try to equate the marginal utility per dollar for the items being purchase 2. Shaila Srivastava 19 .Utility maximizing rule 1. When spending a limited amount of money. use utility maximizing theory to calculate how many of the following two products would be purchased assuming utility is to be maximized and all the money is to be spent. Given a budget of $26.
Algebraically. this is: MUa / Pa = MUb / Pb = MUc = Pc = MUn = Pn Shaila Srivastava 20 .
Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26 Shaila Srivastava 21 .
Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26 Shaila Srivastava 22 .
Total & Marginal Utility from Consuming Music Album Downloads &Sandwiches on an Income of $26 Shaila Srivastava 23 .
Optimizing Consumption Choices A consumer’s money income should be allocated so that the last unit of money spent on each good purchased yields the same amount of marginal utility (when all income is spent). Shaila Srivastava 24 . because this rule yields the largest possible total utility.
Shaila Srivastava 25 . good C.Optimizing Consumption Choices A little math – 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. yield equal amounts of marginal utility. and so on.
= Price of good A Price of good B Price of good Z Shaila Srivastava 26 .Optimizing Consumption Choices A little math – The rule of equal marginal utilities per dollar spent MU of good A MU of good B MU of good Z = = ...
3 Shaila Srivastava 27 .5 = 7.How a Price Change Affects Consumer Optimum Recall from Table 20-1 Income = $26 Qd = 4 Qs = 2 MUd 36.3 = Pd 5 MUs 22 = Ps 3 = 7.
3 Shaila Srivastava 28 .5 = 9.How a Price Change Affects Consumer Optimum Assume Price of Music Falls to $4 Qd = 4 Qs = 2 MUd 36.125 = Pd 4 MUs 22 = Ps 3 = 7.
How a Price Change Affects Consumer Optimum Assume Price of Music Falls to $4 Now Result MUd MUs > Pd Ps Buy more downloads and MUd falls Shaila Srivastava 29 .
How a Price Change Affects Consumer Optimum Consumption decisions are summarized in the law of demand – The amount purchased is inversely related to price. A consumer’s response to a price change – At higher consumption rate. marginal utility falls. Shaila Srivastava 30 .
Digital Music Download Prices and Marginal Utility Shaila Srivastava 31 .
How a Price Change Affects Consumer Optimum The Substitution Effect – The tendency of people to substitute cheaper commodities for more expensive commodities Shaila Srivastava 32 .
How a Price Change Affects Consumer Optimum The Principle of Substitution – Consumers and producers shift away from goods and resources that become priced relatively higher in favor of goods and resources that are now priced relatively lower. Shaila Srivastava 33 .
How a Price Change Affects Consumer Optimum Purchasing Power – The value of money for buying goods and services Shaila Srivastava 34 .
Shaila Srivastava 35 . falls (increases).How a Price Change Affects Consumer Optimum Real-Income Effect – The change in people’s purchasing power that occurs when. other things being constant. or purchasing power. real income. the price of one good that they purchase changes – When that price goes up (down).
The Demand Curve Revisited Question – How is the demand curve derived? Answer – By presuming income. expectations. and the price of related goods are not changing as the price of the good changes Shaila Srivastava 36 . tastes.
– Diamonds are not essential to life but expensive.The Demand Curve Revisited Marginal utility. Shaila Srivastava 37 . total utility. and the diamond-water paradox – Water is essential to life but cheap.
The Diamond-Water Paradox Shaila Srivastava 38 .
the principle of substitution has applied to the services offered by several major airports. In recent years. people shift away from consuming items that become priced relatively higher in favor of items that are now priced relatively lower. Shaila Srivastava 39 . Many consumers of air travel are choosing to drive some distance before they depart to their ultimate destinations by plane.The Upside of Taking Off from a Less Convenient Airport According to the principle of substitution.
The Upside of Taking Off from a Less Convenient Airport Weighing relative marginal utilities and prices Opting to avoid hassles that reduce marginal utility Responding to price changes Shaila Srivastava 40 .
(i) Effect on fashions and customs: The law of equi-marginal utility may become inoperative if people forced by fashions and customs spend money on the purchase of those commodities which they clearly knows yield less utility but they cannot transfer the unit of money from the less advantageous uses to the more advantageous uses because they are forced by the customs of the country. Shaila Srivastava 41 . Limitations/Exceptions of Law of Equi-Marginal Utility: (ii) Ignorance or carelessness: Sometimes people due to their ignorance of price or carelessness to weigh the utility of the purchased commodity do not obtain the maximum advantage by equating the marginal utility in all the uses. then again the law may become inoperative. the operation of law may be impeded. (iii) Indivisible units: If the unit of expenditure is not divisible. (iv) Freedom of choice: If there is no perfect freedom between various alternatives.
The equal marginal rule also guides an individual in the spending of his saving on different types of assets. The law of substitution is applied to all problems of allocation of scarce resources. it is applied on the substitution of various factors of production to the point where marginal return from all the factors are equal. Shaila Srivastava 42 . the law of maximum satisfaction is meaningful general statement of how consumers behave.Importance of Law of Equi-Marginal Utility: Despite its limitation. In the theory of production. The law also guides an individual in the allocation of his time between work and leisure. The government can also use this analysis for evaluation of its different economic prices.
Law of diminishing marginal utility – Marginal utility ultimately declines as a person consumes more and more of a good or service.Summary Discussion of Learning Objectives Total utility versus marginal utility – Total utility is total satisfaction from consumption. – Marginal utility is the additional satisfaction from consuming an additional unit. Shaila Srivastava 43 .
Summary Discussion of Learning Objectives The consumer optimum – Occurs when the marginal utility per dollar spent on the last unit consumed is equalized The substitution effect of a price change – A person will substitute among goods by buying less of a good when its price increases. Shaila Srivastava 44 .
Shaila Srivastava 45 . Why the price of diamonds exceeds the price of water even though people cannot long survive without water – Marginal utility. determines how much people are willing to pay.Summary Discussion of Learning Objectives The real-income effect of a price change – A price change affects the purchasing power of an individual’s available income. not total utility.
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