Consumer Choice, Demand and Utility

1
 Utility Analysis
 Utility
 Satisfaction derived from consumption

 Subjective

 Assumption
 Tastes are given
 Tastes are relatively stable
2
 Total Utility & Marginal Utility

 Total utility
 Total satisfaction

 Marginal utility
 Change in total utility from one-unit change in
consumption

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4
 The Law of Diminishing
Marginal Utility
 The more of a good consumed
 The smaller the increase in total utility
 Marginal utility from each additional unit
 Declines as more is consumed
 Disutility
 Negative marginal utility

5
 Measuring Utility

 Units of utility
 Each person has a unique subjective utility scale

 Two Approaches:
 Cardinal
 Ordinal
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 Utility Derived from Drinking
Water After Jogging Four Miles

7
 Total Utility and Marginal Utility You Derive from
Drinking Water after Jogging Four Miles
(a) Total utility (b) Marginal utility
80

Marginal utility
Total utility

60
40
40
20
20
0

0 1 2 3 4 5 1 2 3 4 5
Glasses (8-ounce) Glasses (8-ounce)
Total utility increases with each of the
first 4 glasses of water consumed but Marginal utility declines
by smaller and smaller amounts MU of the 5th glass is negative
The 5th glass causes TU to fall 8
9
 Utility Maximization Without
Scarcity

 Free good
 Increase consumption as marginal utility is positive

 Two free goods

 Until the marginal utility of each is 0
 Tastes, preferences
10
 Total and Marginal Utilities from
Tea and Rice
Tea Rice

Marginal Marginal
Consumed Total Marginal Utility per Consumed Total Marginal Utility per
per Week Utility Utility Rupee if per Week Utility Utility Rupee if
P=Rs. 8 P=Rs. 4

0 0 __ __ 0 0 __ __
1 56 56 7 1 40 40 10
2 88 32 4 2 68 28 7
3 112 24 3 3 88 20 5
4 130 18 2.25 4 100 12 3
5 142 12 1.5 5 108 8 2
6 150 8 1 6 114 6 1.5
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 Utility Maximization With
Scarcity
 Goods – not free
 Tastes, preferences
 Limited income

 Maximize utility
 Equilibrium
 Any affordable change will reduce utility 12
 Utility-Maximizing Conditions

 Equilibrium
 There is no way to increase utility by reallocating the
budget
 Last Rupee spent on each good yields the same marginal
utility
MU T MU R

pT pR
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Equi-marginal Principle of Utility

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Total and Marginal Utilities from Tea and Rice After
the Price of Tea Decreases from Rs.8 to Rs.6
Tea Rice
Marginal Marginal
Consumed Total Marginal Utility per Consumed Total Marginal Utility per
per Week Utility Utility Rupee if per Week Utility Utility Rupee if
P=Rs. 6 P=Rs. 4
0 0 __ __ 0 0 __ __
1 56 56 9.33 1 40 40 10
2 88 32 5.33 2 68 28 7
3 112 24 4 3 88 20 5
4 130 18 3 4 100 12 3
5 142 12 2 5 108 8 2
6 150 8 1.33 6 114 6 1.5
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 Marginal Utility and
the Law of Demand
 Max U; budget = Rs.40
 QT = 3; PT =Rs.8; one point on D curve
 (QR = 4 ; PR = Rs.4)
 Price of Tea drops to Rs.6, other things constant
 Max U; budget = Rs.40
 QT = 4; PT = Rs.6; second point on D curve
 (QR = 4 ; PR = Rs.4)
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 Demand for Tea Generated from
Marginal Utility

Rs.8 a
P=Rs.8, consumer equilibrium at
Q=3
6 b
MU per Rupee is the same for all
Price per Tea

goods consumed
4 P=Rs.6, consumer equilibrium at
Q=4
2 D

0 1 2 3 4 Tea per week 17

MUX
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Festive Offer Only FOR
TODAY!!!!!!!

1st Burger at Rs. 55

2nd Burger at Rs. 50
3rd Burger at Rs. 45
4th Burger at Rs. 40
5th Burger at Rs. 35
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 Consumer Surplus

– Value of a good purchased must at least

equal the P
 D curve
– Marginal valuation
 Consumer surplus
– Consumer bonus
– Value of total utility minus total spending
– Area under D, above P
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Consumer Surplus from Sub Sandwiches
Rs.8 At P=Rs.4:
•1st sub valued at Rs.7
7
Price per subs

•2nd sub valued at Rs.6

6 •3rd sub valued at Rs.5
5 •4th sub valued at Rs.4
4 •Willing to pay Rs.22 for 4 subs
3 •Pays only Rs.16 for 4 subs
•Consumer surplus
2
Rs.22-Rs.16 = Rs.6
1
D

0 1 2 3 4 5 6 7 8 Subs per
month
When P drops to Rs.3, consumer surplus increases by Rs.4 21
 Market D and
Consumer Surplus
 Market D curve
– Horizontal sum of individual D curves
– Total quantity demanded, per period, by all consumers, at
various prices
 Consumer surplus for the market
– Amount consumers are willing to pay minus amount they pay
– Net benefit for consumers
– Economic welfare
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 Summing Individual Demand Curves to Derive
Market Demand for Sub Sandwiches
(a) You (b) Sandy (c) Crains (d) Market demand
for subs
$6 $6 $6 $6
Price

4 4 4 4 dY+dS+dC=D

2 2 2 2

dY dS dC

0 2 4 6 0 2 4 0 2 0 2 6 12
Subs per month
Market demand curve is the horizontal sum of individual demand curves 23
Market Demand and Consumers Surplus

Consumer surplus at a price of

Rs.2 is shown by the blue area.

Price per unit If the price falls to Rs.1, consumer

surplus increases to include the
green area.

At a zero price, consumer surplus

increases to the entire area under
the D curve.
Rs.2
1 D

0 Quantity per period

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 Ordinal Approach-Indifference
Curves and Utility Maximization

 Indifference curve
– Combinations of goods
– Same total utility
– Slope downward to right
– Convex to origin

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 An Indifference Curve
An indifference curve (I) shows all
combinations of two goods that
10
provide a particular consumer with
Rice per week 8 a the same total utility.

Indifference curve:
5 • negative slope
4 b • convex to origin
3 c
2 d
I

0 1 2 3 4 5 10
Tea per week 26
Indifference Curves and
Utility Maximization

 Marginal rate of substitution MRS

– Willingness to trade
– Slope of indifference curve
 Law of diminishing MRS
– Diminishing slope of I curve

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 Indifference Curves and
Utility Maximization

 Indifference map
– Graphical representation of consumer’s tastes
– Each I: different utility levels
– The further indifference curve from origin
• The higher the utility
• More of both goods

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 An Indifference Map
Indifference curves I1 through
10 I4 are examples from a
consumer’s particular
Rice per week

indifference map.

Indifference curves farther

5 from origin depict higher
I4 levels of utility.
I3
I2
I1
A line intersects each higher
indifference curve, reflecting
more of both goods.
0 5 10
Tea per week 29
Indifference Curves Do Not Intersect

If indifference curves crossed (i)

every point on I and every point on
Rice per week

I’ would have to reflect the same

k level of utility as i.

j k: more Tea and Rice than

i
j; higher utility than j
I’
I

0 Tea per week

Indifference curves cannot intersect 30
X2

31
 A Budget Line
 The budget line
– Combinations of goods
– Able to buy
– Consumption possibilities
frontier
 Slope of budget line:
 A Budget Line
Budget line: all combinations of Tea and Rice that
10 can be purchased at fixed prices with a given income.
Rice per week

Slope = -pT / pR = -Rs.8/Rs.4 = -2

5
Slope = -2: the price of 1 Tea is 2 Rice.

0 5 10
Tea per week 33
Indifference Curves and Utility
Maximization
 Consumer equilibrium at the tangency
– Maximize utility
– Indifference curve tangent to budget line
pT 
MRS   MU
pR  MU R

T

MU T  pT pR
MRS 
MU R 
34
 Utility Maximization
10 A consumer’s utility is maximized at
point e, where indifference curve I2 is
Rice per week

a
tangent to the budget line.

5
e
4
I3
I2
I1

0 3 5 10
Tea per week 35
36
Other Shapes of Indifference Curves

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Indifference Curves and Utility
Maximization
 Effects of a change in price
– Derive the D curve

1. Income effect

2. Substitution effect

38
 Effect of a Drop in the Price of Tea
(a) (b)
10
Rice per week

Price per Tea

5 e
e” Rs.8
4 e”
e 6
I I” D

0 3 4 5 6.67 0 3 4
Tea per week Tea per week

A reduction in the price of Tea rotates A drop in price of Tea increases

the budget line rightward. quantity demanded.
The consumer is back in equilibrium
at point e” along the new budget line. 39
 Substitution and Income Effects of a Drop in the
Price of Tea from Rs.8 to Rs.4
10
A reduction in the price of Tea moves the
Rice per week

consumer from e to e*.

C Substitution effect: e to e’; consumer’s reaction

e*
5 to a change in relative prices along the
e
4 original indifference curve.
I*
e’
Income effect: e’ to e*; moves the
I
consumer to a higher indifference
curve at the new relative price ratio.
0 3 4 5 F 10
Tea per week
Substitution Income 40

effect effect
41
Price Consumption Curve

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Income Consumption Curve (ICC)

Good x is inferior good 43

ICC for Necessity and Luxury

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ICC for Perfect Substitutes and Perfect Complements

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 Engel Curve (EC)

X is necessity X is Luxury X is Inferior

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Questions???

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