ECON 101 Introduction to Economics1

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1 ECON 101 Introduction to Economics1 Session 8 Consumer Choice Theory Lecturer: Mrs. Hellen A. Seshie-Nasser, Department of Economics Contact Information: haseshie@ug.edu.gh College of Education School of Continuing and Distance Education 2014/ /2017

2 Session Overview In this session, we will take a close look at the determinants of consumer demand using the Marginal Utility Theory (MUT). We discuss why consumers behave the way they do; why the normal demand curve is downward sloping; why some goods consumers pay more for some goods than others; etc. using the marginal utility theory. Slide 2

3 Session Objectives At the end of the session, the student should be able to: Understand the concept of Utility. Explain the concepts of Total Utility and Marginal Utility and their measurements. Examine the effect of consumption quantity changes on total utility and marginal utility. Understand and explain the Law of Diminishing Marginal Utility. Explain consumer Utility Maximization. Demonstrate usage of the Utility Maximizing Rule. Determine consumer equilibrium for one-good case and two-good case. Use consumer equilibrium to derive the normal demand curve and explain the law of demand. Understand some applications of Marginal Utility: the Paradox of Value, consumer surplus, etc. Understand the budget line Slide 3

4 Session Outline The key topics to be covered in the session are as follows: Marginal Utility theory Total Utility and marginal Utility Diminishing Marginal Utility Utility Maximization Consumers Demand curve Applications of the Marginal Utility Theory Paradox of Value Consumer Surplus Slide 4

5 Reading List Lipsey R. G. and K. A. Chrystal. (2007). Economics. 11 th Edition. Oxford University Press. Bade R. and M. Parkin. (2009). Foundations of Microeconomics. 4 th Edition. Boston: Pearson Education Inc., Begg. D. Fischer S. and R. Dornbusch. (2003). Economics. 7 th Edition. McGraw-Hill Slide 5

6 Consumer Choice The law of demand predicts an inverse relationship between price and quantity demanded of a good. The big question is why this behaviour on the part of consumers? Three theories set out to answer this question: Marginal Utility Theory Indifference Curve Theory Revealed Preference Theory For this course, we focus only on Marginal Utility Theory Slide 6

7 Marginal Utility Theory (MUT) It is assumed that the consumer derives satisfaction from the consumption of goods and services. This theory assumes that satisfaction is measured in units called Utils. What is UTILITY? benefit you get from consuming a good determined by your tastes/preferences (assuming these are stable) The value a consumer places on a unit of a good or service depends on the pleasure or satisfaction he or she expects to derive from having or consuming it at the point of making a consumption (consumer) choice. Slide 7

8 Total Utility (TU) Total utility is the total satisfaction derived from consumption of all the units of goods and services. That is, the total benefit from consuming a good or service example total benefit from 3 biscuits/cookies Slide 8

9 Total Utility (TU) TU increases as consumption increases, to a point TU 2 cookies < TU 3 cookies Slide 9

10 Marginal Utility (MU) Marginal Utility refers to the change in satisfaction as a result of consuming one more unit or one less unit of a product. MU is the change in TU from consuming one more or less of a good example how much MORE utility from an additional mobile phone? Slide 10

11 Marginal Utility (MU) change in TU from 0 to 1 biscuit/cookie 0 change in TU from 1 cookie to 2 cookies = = MU of 1 st Biscuit/ cookie MU of 2 nd cookie Slide 11

12 Diminishing Marginal Utility The Law of Diminishing Marginal Utility (DMU) states that the marginal utility generated by additional units of any product diminishes as an individual consumes more of it, holding constant the consumption of all other products. MU falls as consumption rises The more kenkey you consume the less of it you ll want to eat. Slide 12

13 Diminishing Marginal Utility MU of 1 st cookie 0 > MU of 2 nd cookie Slide 13

14 Diminishing Marginal Utility TU TU rises at slower and slower rate MU cookie as MU declines cookie Slide 14

15 Qty of biscuits/cookies Example Total Utility 0 0 _ Marginal Utility Slide 15

16 Utility Maximization Any rational consumer tries to obtain as much as possible the highest satisfaction he can derive from the consumption of a given commodity at any given time period. The point at which the individual obtains the maximum satisfaction from the commodity consumed is referred to as the equilibrium of the individual. It occurs at a point when consumers: Equalize MU to price of the good (single good case) OR equalize MU/price across goods (Multiple goods case) The real case Using available budget Slide 16

17 Equilibrium for one Product Assuming that utility is measured in utils or the money value of the utility can be identified and we are working with the money equivalents of utility. Assuming that consumption of all other products is held constant. The consumer maximizes his total utility at a point when his marginal utility is equal to the price he pays for the product. Marginal utility of commodity X = Price of X MUx =Px Slide 17

18 Equilibrium for one Product If MUx > Px, the consumer will purchase more of the product. Based on the law of Diminishing Marginal Utility, his marginal utility will decline. He will continue buying until equilibrium is restored, Mux=Px. On the other hand, If MUx < Px, the consumer will reduce his consumption of the product. The less amount of the product he consumes the higher his marginal utility, based on the law of diminishing marginal utility. His marginal utility will increase. The consumer will buy less and less until until equilibrium is restored, Mux=Px. Slide 18

19 Equilibrium for one Product Px e At quantity X1, MU is greater than the price of X. The consumer will continue buying more of the product until quantity X2 is reached. MUx X1 X2 X3 Qtyx At quantity X3, his marginal utility is less than the price of the commodity. He will therefore reduce the amount of the commodity he is consuming to X2 to restore equilibrium. Slide 19

20 Consumer Equilibrium Balls of Kenkey Total Utility (in utils) Marginal Utility/Benefit Marginal Cost Gh 1 Gh 1 Gh 1 Gh 1 Gh 1 Gh 1 Gh 1 Gh 1 Gh 1 How many balls of Kenkey would you buy if the price per ball was Gh 1? Mrs. Hellen Seshie-Nasser, Dept.of Economics, Slide 20

21 The Demand Curve Supposing we start from consumer equilibrium when MUx = Px, let us analyze the effect of changes in price on the quantity of the product the consumer purchases (i.e. the Law of Demand) Assume there is an increase in price. This sends the consumer out of equilibrium, i.e. MUx < Px In order to restore equilibrium, the consumer needs to increase his marginal utility. To achieve that he buys less of the commodity. Assuming a price fall. MUx > Px. The consumer buys more of the product which then lowers his marginal utility until equilibrium restored. Resulting in an inverse relationship between price and quantity, thus downward sloping demand curve. Slide 21

22 Equilibrium for Multiple Products Dropping the assumption of consumption of all other products are held constant, how does the consumer maximize utility? Two Products case, X and Y Let the Marginal Utility of the last unit of X be given as MUx and the price Px, and for good Y, MUy and Py. Slide 22

23 Equilibrium for Multiple Products In equilibrium, the consumer chooses combination of kenkey and phone units such that: MU kenkey price of kenkey = MU phone credits price of credits Slide 23

24 WHY? Chose 6 balls of kenkey, one 1-cedit worth of phone credit Suppose MU/Gh 1 of kenkey = 4, MU/Gh 1 of Phone units = 15 By consuming fewer balls of kenkey and more phone credits You would add more to TU Slide 24

25 Utility Maximizing Rule The consumer s money should be spent so that the marginal utility per dollar of each goods are equal. MUx = MUy P x P y Thus, the Utility Maximizing rule assumes that the individual always consume where MU/P for each product is equal Slide 25

26 Example Assume apples cost $1 each and oranges cost $2 each. (If the consumer has $7), identify the combination that maximizes utility. Slide 26

27 Utility Maximizing Rule Rearranging the fundamental equation; The relative ability of the two goods to add to the consumer s satisfaction if he consumes a little more or less of either of them. This is within the control of the consumer. MUx = Px MU y P y The relative price of the two goods which is determined by the market, and it is beyond the control of the consumer. He can only react to changes in the prices. Slide 27

28 The Consumer s Demand Curve Assume that the price of the a unit of X is twice the price of a unit of Y, that is Px/Py =2, while the marginal utility of X is three times that of a unit of Y, i.e. MUx/MUy =3. Thus; MUx > Px MU y P y To restore equilibrium, the consumer needs to reduce the left hand side. He can achieve that by either consuming more of X or less of Y or both. When he buys more of X, the marginal utility of X will decline thereby restoring him to equilibrium. Similarly, when he consumes less of Y, the marginal utility of Y will increase resulting into a decline in the relative marginal utility and restoring equilibrium. Slide 28

29 The Consumer s Demand Curve If there is a fall in the price of X, the condition becomes; MUx > Px MU y P y To restore equilibrium, the consumer will need the marginal utility of X to decline. He will therefore consume more of X. Thus giving us a downward sloping demand curve. Slide 29

30 The Consumer s Demand Curve The Demand Curve P 1 P 2 a b DD X 1 X 2 Slide 30

31 Applications of Marginal Utility Theory Early thinkers struggled about the problem of what determines the relative prices of commodities. Generally, the value a consumer places on a unit of a good or service depends on the satisfaction he or she expects to derive from it. However, many essential products, without which the consumer could not live, have relatively low prices whilst some luxury products, such as diamond, have relatively high prices, even though consumes could easily survive without them. Slide 31

32 TU vs. MU: The Paradox of Value For example: Diamond-Water paradox Gh 10,000 for example can be used to purchase either one carat diamond OR 5 million gallons of tap water In other words, why should one carat diamond cost Gh 10,000 while a big bottle of water will cost only Gh 2? Slide 32

33 WHY? Even though the Total Utility of water is greater than Total Utility of diamonds Because water is essential for life BUT water is abundant, diamonds are rarer Marginal Utility of last diamond is higher However, MU determines the price of the product. When diamonds are scarce and drinking water is abundant, marginal utility of a diamond ring is much higher than the marginal utility of water. Although the total utility of water may be greater than that of diamond rings. Slide 33

34 Stranded on a desert island with no water, one may be happy, though, to trade his diamond ring for a bottle of drinking water. Under such conditions, the marginal utility of water must be greater than that of a diamond ring. Slide 34

35 MU and Demand From the earlier discussion, we can say that MU measures the willingness to pay. Price = MU Since MU declines as consumption rises, willingness to pay is less for each additional unit Hence downward sloping demand The more consumed the less willingness to pay, hence the lesser price offered for the product. Slide 35

36 Example : Balls of Kenkey P Gh 1.5 Gh 1.0 willing to pay Gh 1.5 for 2nd ball of kenkey willing to pay Gh 1.0 for 4th ball of kenkey D 2 balls 4 balls Q Slide 36

37 Consumer Surplus It is the difference between what the consumer actually pays for a good and what he is WILLING to pay for the good Example: market price of a ball of kenkey = Gh 1.0 your marginal value of the 3rd ball is = Gh 1.2 Your consumer surplus then is = Gh 2 Slide 37

38 The Demand Curve P $12 $10 your consumer surplus D 3 Q Slide 38

39 The Demand Curve P Gh 1.0 total consumer surplus area between D and price of kenkey D 10,000 Q Slide 39

40 Consumer s Budget A budget constraint is a constraint on how much money (income, wealth) an economic agent can spend on goods. We denote the amount of available income by M given: consumer s budget Prices consumption possibilities Slide 40

41 Example 2 goods: bread & kenkey A loaf of bread = Gh 1.0 A ball of kenkey = Gh 0.5 daily budget = Gh 4.0 Slide 41

42 Possible Combinations kenkey bread Slide 42

43 Budget line Kenkey Bread Slide 43

44 Mathematically Let Px= price of good X Py = price of good Y M = Income of the consumer Assuming the consumer spends all his/her income on only two goods, X and Y Then the budget equation is given by; Px X+ PyY = M Slide 44

45 Exercise Assume apples cost $1 each and oranges cost $2 each. If the consumer has $7, identify the combination that maximizes utility. Find the quantities of apple and oranges the consumer will purchase if a. Price of oranges falls to $1 b. Income of the consumer increases to $10 c. Price of apples rises to $1.5 Slide 45

ECON 101 Introduction to Economics1

ECON 101 Introduction to Economics1 Session 12 Market Structures(Monopoly) Lecturer: Mrs. Hellen A. Seshie-Nasser, Department of Economics Contact Information: haseshie@ug.edu.gh College of Education School