CONSUMER CHOICE THEORY THE MARGINAL UTILITY THEORY Week

CONSUMER CHOICE THEORY THE MARGINAL UTILITY THEORY Week 7

Cardinal Utility Approach to demand theory Assumptions: The consumer is rational The utility of each consumer is measurable Constant marginal utility of money Diminishing marginal utility Total utility of a ‘basket of goods’ depends on the quantities of commodities consumed by the individual. • There is well defined preference • • • – Consistency – transitivity

The utility theory of demand • Economists believe that utility is measurable • The satisfaction people derive from their consumption activities. • It is also defined as the power in objects which normally produces satisfaction. • People allocate their income to maximize their satisfaction or total utility Chapter 5: Demand: The Benefit Side of the Market Slide 3

Utility – Utility is the benefit or satisfaction that a person gets from the consumption of a good or service. – Total utility is the total benefit that a person gets from the consumption of a good or service. Total utility generally increases as the quantity consumed of a good increases. – Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed.

Diminishing marginal utility – There is a general tendency for marginal utility to decrease as the quantity of a good consumed increases. – This is called the principle of diminishing marginal utility. – Price is the indirect measure of the marginal utility of the commodity to the consumer. It measures the values of the additional product consumed.

Maximizing Total Utility – consumer equilibrium • The consumer is faced has limited amount of income at her disposal. She spends all income. • There is a fixed market price of the goods to be purchased by the consumer. • The consumer achieves this goal by choosing the point on the budget line at which the sum of the utilities obtained from all goods is as large as possible. • Make the marginal utility per dollar (cedi) spent the same for all goods.

Consumer equilibrium • For a single commodity, the consumer is in equilibrium when the marginal utility of a good is equal to its market price. Symbolically, • MUx = Px or MUx = λPx • Where λ is the (constant) utility of money • If MUx < Px, less will be consumed • If MUx > Px, more will be consumed

Derivation of demand • When Px increases (such that Px> MUx), MUx must increase in order to restore equilibrium, and MUx only increases when less is consumed. • When X is consumed, total utility increases but at a decreasing rate, reaches maximum and declines. Accordingly, MUx decreases continuously and after a certain point it becomes negative.

• In multiple commodities, equality of the ratios of the marginal utilities of the individual commodities to their prices ensures equilibrium • Spending should be allocated across goods so that the marginal utility per dollar (cedi) is the same for each good. Chapter 5: Demand: The Benefit Side of the Market Slide 11

Row C maximizes utility. The marginal utility per dollar spent is equal for the two goods.

The demand curve. • The derivation of demand is based on the axiom of diminishing marginal utility • The demand curve is the positive segment of the MU curve.

Some deductions • Different goods yield different Utilities to the same individual. • Same commodity yield different Utilities to the same individual at different times. • Same commodity yield different Utilities to different persons.

Revealed preference: -The chosen bundle is revealed to be preferred among all other alternative bundles available under the budget constraint. Indifference Curve: The consumer is in equilibrium when the slope of the indifference curve is equal to the slope of the budget line.

The difference between what a consumer is willing to pay and what he actually pays is called consumers surplus