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Introduction to Economics Eco 101 Lecture# 4 Consumer behavior Cardinal Approach.

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1 Introduction to Economics Eco 101 Lecture# 4 Consumer behavior Cardinal Approach

2 The Theory of Consumer Behavior The principle assumption upon which the theory of consumer behavior is built is: a consumer attempts to allocate his/her limited money income among available goods and services so as to maximize his/her utility (satisfaction).

3 Theories of Consumer Choice The Marginal utility Analysis or Cardinal Approach –Utility is measurable in a cardinal sense The Indifference Curve Analysis or Ordinal Approach –Utility is measurable in an ordinal sense

4 Utility Utility is want satisfying power The utility of a good and service is the satisfaction or pleasure one gets from consuming it It is a subjective satisfaction derived from consumption, it means it can vary from person to person. e.g. eyeglasses can have greater utility for a person having poor eyesight,while no utility for a person having clear vision.

5 Total and Marginal Utility Total Utility (TU) is the satisfaction that a consumer receives from all units of a product consumed within a given time period Marginal Utility (MU) - the change in total utility when consumption of a good changes by one unit. MU = DTU / D Q consumed of a good

6 Law of Diminishing MU The law of diminishing marginal utility states that the more of a product the consumer has, the less will be its marginal utility. If a person started using some product eventually, a point is reached where the marginal utility obtained by consuming additional units of a good starts to decline. Example If you are really hungry, you get a lot of satisfaction from first slice of pizza. If you keep eating pizza, the satisfaction from the 8th slice would be much less than that of the first slice.

7 Relationship between Total Utility and Marginal Utility 0 10 20 30 10 8 6 4 2 0 -2 1234567 1234567 Total Utility Marginal Utility (1) Quantity consumed (2) Total Utility, (3) Marginal Utility, 12345671234567 10 18 24 28 30 28 ] ] ] ] ] ] ] 10 8 6 4 2 0 -2 TR MU Total Utility Marginal Utility Units Consumed

8 The Marginal Utility Curves As people have different tastes and preferences so the marginal utility curves are also different. First, Marginal utility may fall sharply as the consumption rises. this means the consumer want is fully satisfied for a few units of a product.As the previous example of pizza is showing the instant satisfaction MU Q

9 The Marginal Utility Curves Second, marginal utility may fall gently as consumption rises. The consumer want is slowly filled up as consumption rises For example you are buying 6 shirts in a year. But if you are offered another 6 shirts you will not possibly refuse. thus MU will fall slowly MU Q

10 The Marginal Utility Curves Third, the marginal utility can be always negative. If you dislike chicken or never touch it, the MU will remain in negative zone for any quantity of consumption. MU Q

11 Equilibrium conditions in cardinal approach In case of a single commodity  (x) MUx = Px will be the consumer equilibrium If MUx > Px – Consumer can increase his welfare by purchasing more units of x If MUx < Px---- Consumer can increase his total satisfaction by cutting down the quantity of x and keeping more of his income unspent.

12 Law of equi-marginal utility/ Utility maximizing Rule The marginal utility analysis explains how a rational consumer will allocate a given amount of income among different good to achieve the maximum level of satisfaction The law of marginal utility requires that a consumer Allocate Money Income in such way that Last Dollar Spent on Each Product Yields the Same Marginal Utility In case of more commodities the equilibrium condition of consumer is equality of ratios of the Marginal utilities of the individual commodities to their prices MUx/Px= MUy/Py=…..=MUn/Pn

13 Consumer Equilibrium In Multiple Good Case In case of more commodities the equilibrium condition of consumer is equality of ratios of the Marginal utilities of the individual commodities to their prices MUx/Px= MUy/Py=…..=MUn/Pn

14 Numerical Example MU Product X Units of Product X MU Product Y Units of Product Y 1234512345 16 12 10 8 6 14 10 6 4 2 1234512345 Utility-Maximizing Combination of Products X and Y Obtainable with an Income of $5 is the 3 units of x and 2 units of y. As the marginal utilities of last item of both products are equal and total utility is also maximum 62 units. If consumer chooses any other combination the utility will not be maximized according to law of equi marginal utility as if he purchase 4 units of X and 1 Unit of Y.the utility is 14+46 is 60 which is less than maximum combination and the utility of last units is also not same.

15 Graphical Representation Units of Products MU 543211 14 12 10 8 6 4 2 16 MUX X Y MUY 2345 Maximum satisfaction combination Disequilibrium condition

16 Consumer Equilibrium with Income Constraint Analysis If a consumer has to purchase various goods in given money income, he will spend his income in such a way that the marginal utility of last unit of each product should be same. This equilibrium condition is defined as MUx/Px= MUy/Py=…..=MUn/Pn in law of equi marginal utility But we can write this equilibrium condition in another way including the income constraint as XPX+YPY=I X = quantity of X, Y=quantity of Y I= income PX=price of X PY= price of Y

17 If we suppose Px = 2, PY=1, I=8 If consumer purchases 2 units of X and 4 units of Y income constraint function will be XPx+Ypy = I 2(2)+4(1) =8 8 =8 In consumer equilibrium condition MUx/Px =MUy/Py 16/2 =4/1 8 = 4 QxMU x QyMUy 12017 21626 31235 4844 5453

18 This analysis shows the selected combination can not satisfy consumer equilibrium condition as it was failed to satisfy both equations Suppose consumer choose another combination such as 3 units of X and 2 units of y The income constraint function will be XPx+YPy = I 3(2)+2(1) =8 8 =8 Consumer equilibrium condition will be MUx/Px =MUy/Py 12/2 =6/1 6 =6 This analysis shows this is the equilibrium combination having maximum level of satisfaction within the income constraint.

19 Derivation of an Individual Demand curve from Utility Approach Based on the law of DMU MU curve  a line with –ve slope Geometrically The MUx= slope of the total utility as Mu= DU/DQ Demand curve of good x is identical to the positive segment of the MU curve.

20 Graphical Representation Qx MUX Px QxQ1 MU1 MU2 Q2 P1 P2 Q1Q2

21 Critique of the Cardinal Approach The satisfaction derived from various commodities can not be measured objectively as utility is a state of mind Consumer purchases are mostly based on fashion, habits or customs instead of utility analysis No careful calculation exists in real life about the cost and benefit analysis

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