ECON107Principles of

MicroeconomicsWeek 9

NOVEMBER 2013

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Chapter-8

8 Utility and Demand

Lesson ObjectivesExamine how individual consumers

allocate their incomes among the various goods and services that available to them to get maximum utility?

Given a particular budget, how does a consumer decide what goods and services to buy?

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Issues of Discussion

Utility DefinedTotal Utility Marginal Utility Subjective NatureDifficult to QuantifyLaw of Diminishing Marginal Utility

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Definitions Utility: It reflects the benefit or

satisfaction or pleasure of consumers that gets from goods and services.

Total utility is the total satisfaction a person derives from consumption. Generally, more consumption gives more utility.

Marginal utility is the change in total utility resulting from one-unit change in consumption of a good. As the quantity consumed of a good increases, the marginal utility from consuming it decreases.

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TOTAL AND MARGINAL

UTILITY

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TotalUtility,Utils

MarginalUtility,Utils

01234567

010182428303028

10 8 6 4 2 0 -2

Units consumed per beef burger (BB)

Units consumed per BB

30

20

10

To

tal

Uti

lity

(u

tils

)M

arg

ina

l U

tili

ty (

uti

ls)

10 8 6 4 2 0 -2

TU

MU

0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

Number Of glass

TOTAL AND MARGINAL

UTILITY

7

TotalUtility,Utils

MarginalUtility,Utils

01234567

010182428303028

10 8 6 4 2 0 -2

Units consumed per beef burger (BB)

Units consumed per BB

30

20

10

To

tal

Uti

lity

(u

tils

)M

arg

ina

l U

tili

ty (

uti

ls)

10 8 6 4 2 0 -2

TU

MU

0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

Number Of glass Observe

DiminishingMarginal

Utility

Maximizing Utility The key assumption of marginal utility

theory is that the household chooses the consumption possibility that maximizes total utility.

The Utility-Maximizing ChoiceWe can find the utility-maximizing choice

by looking at the total utility that arises from each affordable combination.

The utility-maximizing combination is called a consumer equilibrium.

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Maximizing UtilityUtility-Maximizing ConditionConsumer equilibrium is achieved when the budget is completely spent and Equalize the marginal utility per dollar for all goods. The marginal utility per dollar is the marginal utility from a good divided by its price.

Where MUp is the marginal utility of pizza, pp is the price of pizza, MUv is the marginal utility of videos, and pv the price of videos

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v

v

p

p

PMU

PMU

Maximizing Utility If MUp/Pp > MUv/Pv, then spend more on pizza and less on

videos. MUp will decrease and MUv will increase.

If MUp/Pp < MUv/Pv, then spend more on videos and less on

pizza. MUp will increase and MUv will decrease.

Only when, MUp/Pp= MUv/Pv, is it not possible to reallocate the budget and increase total utility.

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Utility MaximizationTo see your income is allocated

between two goods so as to maximize utility, suppose we start with some combination of pizzas and videos

If we can increase utility by reallocating our expenditures we will do so, and we will continue to make adjustments as long as utility can be increased when no further utility-increasing moves are possible, we have arrived at the equilibrium combination

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ExampleSuppose that we have the following bits of information

The price of pizza per unit is $8The rental price of a movie

video is $4After tax income equals $40 per

week

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Total Marginal per Dollar Video Total Marginal per DollarConsumed Utility utility Marginal utility Rentals Utility of utility of marginal Utility of Per Week of Pizza of Pizza (price=$8) per Week Videos Videos (price=$4) (1) (2) (3) (4) (5) (6) (7) (8)

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 2¼ 4 100 12 3 5 142 12 1½ 5 108 8 2 6 150 8 1 6 114 6 1½

To get the process going, suppose you start off spending your entire budget of $40 on pizza 5 pizzas per week at a total utility of 142.

If you give up one pizza, you free up enough money to rent 2 videos. Would total utility increase from this reallocation? You give up 12 units of utility – the marginal utility of the 5th unit of pizza, to get 68 units of utility from the first 2 videos total utility increases from 142 to 198.

Now it’s over for today. Do Now it’s over for today. Do you have any question? you have any question?

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