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Lecture 5
Purpose
The purpose of this presentation is to give an
introduction to the theory of consumer behaviour.
Learning Objectives
At the completion of this presentation you should be
able to have an understanding of:
• Indifference Curves.
Where;
Mu= Marginal Utility
Tu= Total Utility
Calculating Marginal Utility
Theories of Utility
Starting at the origin (from the graph or table), we observe that each
of the first 5 units increases total utility (TU) but by a diminishing
amount. Total utility reaches a maximum with the addition of the
sixth unit and then decline. So in the graph and table above we find
that marginal utility (MU) remains positive but diminishes through
the first 5 units (while total utility increases but at a decreasing
rate).
Marginal utility is zero for the sixth unit (because that unit doesn’t
changes total utility). Marginal utility then becomes negative with
the seventh unit and beyond (because total utility is falling).
The Law of Diminishing Marginal
Utility
Total Utility
35
30
25
20 Total Utility
15
10
5
0
1 2 3 4 5 6 7 8
Marginal Utility
12
10
8
6 Marginal Utility
4
2
0
1 2 3 4 5 6 7
-2
-4
Utility Maximization Rule
Market basket A
is preferred to B.
Market basket B is
preferred to D.
Indifference Curves
Marginal rate of Technical
Substitution
P FF P C C I
The Budget Constraint
P FF P C C I
The Slope of the Budget Constraint
The Budget Line
As consumption moves along a budget line from the
intercept, the consumer spends less on one item and more
on the other.
The slope of the line measures the relative cost X2 and X1
= the negative of the ratio of the prices of the two goods.
That is Income over price Y=I/ Px
The slope indicates the rate at which the two goods can be
substituted without changing the amount of money spent.
The Slope of the Budget Line
UTILITY MAXIMISATION
Ordinalist Approach
PF
Clothing
(units per MRS
week)
40
At market basket A
the budget line and the
indifference curve are
PC
tangent and no higher
level of satisfaction
can be attained.
30 The ordinalist states
that the satisfaction
A which a consumer
20 At A:
MRS =Pf/Pc = .5 derives from the
consumption of
U2
product or service
Budget Line
cannot be measured
numerically.
0 20 40 80 Food (units per week)
Changes in Prices and the Budget
line
When price changes the budget line does not shift it
pivots.
Changes in Prices and the Budget
line
Price Price
increase decrease
of good of good Y
Y
Price
Price
decrease
increase of
of good x
good x
Changes in Income and the Budget
line
When income changes the budget line shift either inwards
or outwards.
Derivation of an Individual Demand
Curve
Consumer Surplus
Producer Surplus
Consumer and Producer Surplus
Calculating Consumer and Producer
Surplus
Class Exercise
Clarisse spends her income of $24 on two goods, W and
V. W sells for $3 and V sells for $2.
Draw the budget constraint to show how Clarisse can
spend her money on the two goods.
Calculate the slope of the budget line.
If the price of V reduces by $1 what will happen to the
budget line?
If the price of W increases by $1 what will happen to the
budget line?
Class Exercise
Formula: Quantity on any axis = Income/Price
W = $24/$3 = 8 units
V = $24/$2 = 12 units
Good V
12
8 Good W
Class Exercise
The slope of the line can be derived using two methods:
1. Quantities = change in good V(rise) / change in good W
(run)
= -12/8
= - 3/2
V = $24/$1
Good V= 24 units
24
12
8 Good W
END