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Lifetime Learning… Building Success… Towards Globalization

Economics -Chapter 4Consumer Theory

Lifetime Learning… Building Success… Towards Globalization

The Consumer Theory

• Consumer behavior is explained using two main approaches:

1. Marginal utility theory

2. Indifference curve analysis.

EIBFS/Economics

• What is Utility?

• Utility is the satisfaction received when individualsconsume a good or service.

EIBFS/Economics

Marginal Utility Theory

• This theory is based on the concept that;– the amount of satisfaction or utility obtained from the

consumption of a particular product can be measured.

• The theory is developed by Alfred Marshall.• This approach is termed cardinal.• The unit of measurement is known as util.

EIBFS/Economics

Total and Marginal Utility

• Total utility is the total satisfaction obtained from allthe units of a particular product consumed over aperiod of time.

• Marginal utility is the addition to total utility derivedfrom the consumption of one more unit of theproduct.

• Note:

• The marginal utility falls with each extra unit consumed.

• Total Utility increases at a decreasing rate as additional units of agood are consumed up to a certain point then it began to fall.

EIBFS/Economics

The ‘law’ of diminishing marginal utility

• Principle of Diminishing Marginal Utility states that;

– The more an individual has of a product, the lessadditional utility will be gained from each extra unitconsumed.

• If the marginal utility from a product is negative it is said to represent disutility.

• NOTE: It is possible to use marginal utility as a means of deriving a demand curve

EIBFS/Economics

Total and Marginal Utility

Diminishing Marginal Utility

EIBFS/Economics

Total and marginal utility Explained

EIBFS/Economics

(a) Total Utility: As the

consumption of product x

rises, then the total

satisfaction (utility) obtained

by the individual rises up to

a certain point.

(b) Marginal utility: Extra

satisfaction obtained from

consuming one extra unit of

the product over a given

period of time. The figure

illustrates diminishing marginal utility

Consumer Equilibrium

• Consumer equilibrium is the consumption bundle where totalutility is maximum.

• where the marginal utility (MU) of all the products theconsumer consumes is equal.

• At equilibrium level Ratio of marginal utility to price (MU/P) isequal for all the products consumed.

• Assumptions :

• Individual ;

– has a limited income.

– acts in rational manner

– aims to maximize his/her utility

EIBFS/Economics

Consumer Equilibrium

• MU from the last penny spent on product x exactly equals the marginal utility from the last penny spent on product yequals the utility from the last penny spent on product n.

• MU = marginal utility

• P = price

• x, y and n = the individual products concerned

EIBFS/Economics

MUx = MUy = MUn PX Py Pn

Consumer Equilibrium

Product XPrice £ 2.00 each)

Quantity Demanded ofProduct X and Y

Product YPrice £ 4.00 each)

Total Utility

Marginal Utility

MU/P Total Utility

Marginal Utility

MU/P

80 80 40 1 68 68 17

132 52 26 2 100 32 8

152 20 10 3 128 28 7

168 16 8 4 152 24 6

176 8 4 5 172 20 5

Price of Product X £ 2.00 ; Price of Product Y £ 4.00 ; Consumer Income £16.00Consumer Equilibrium = 4 of Product X and 2 of Product Y (MU/P is same 8 for both Products)Total Utility at Equilibrium = 268 (168 of X and 100 of Y)

EIBFS/Economics

11

12

Calculate Marginal Utility using the schedule given below:

Quantity of Water Total Utility

(in utils)

Marginal Utility

(in utils)

0 0

1 60 60

2 110 50

3 150 40

4 180 30

5 200 20

6 210 10