2Aims & ObjectivesAfter studying this lesson, you will be able to understand:Concept of Utility & utility theoryLaw of diminishing marginal utility & Law of equi-marginal utilityConsumer’s equilibriumDownward slope of demand curveIncome effect & substitution effectMarket demand curveThe paradox of valueConsumer SurplusIndifference Curve, budget constraint & consumer’s equilibriumPrice Consumption CurveIncome Consumption CurveApplications & Extension
3Slope of demand curve: explained with utility analysis Recall: A demand curve, each point on which shows the quantity purchased of a good at a given prices, is downward sloping as quantity demanded of a good is inversely related to its priceNow Qs. is: Why does quantity demanded move in the opposite direction to that of price?Answer to this lies in utility analysis.
4UtilityUtility is the satisfaction one gets from consuming a good or serviceNot the same as usefulnessSubjectiveDifficult to quantify
5Utility analysis Util is one unit of satisfaction or pleasure Two important concepts of utility are: Total Utility (TU) and Marginal Utility (MU)TU – sum total of utility derived from all units of a good consumedMU – additional utility derived from each additional unit of a good consumed. Thus,MU = d(TU)/dq = TUn+1 – TunWhere ‘q’ denotes units consumed and ‘n’ and ‘(n+1)’ denotes two successive units consumed
6Relation between Total Utility and Marginal Utility 1020308642-21357Total Utility (Utils)Marginal Utility (Utils)(1)TacosConsumedPer Meal(2)TotalUtility,Utils(3)MarginalUtility,UtilsTU12345671018242830]108642-2Curves TU and MU are graphed from the data in the table. As more of a product is consumed, total utility increases at a diminishing rate, reaches a maximum, and then declines. Marginal utility, by definition, reflects the changes in total utility. Thus, marginal utility diminishes with increased consumption, becomes zero when total utility is at a maximum, and is negative when total utility declines. As shown by the shaded rectangles, marginal utility is the change in total utility associated with each additional taco. Or, alternatively, each new level of total utility is found by adding marginal utility to the preceding level of total utility.MU6-6LO1
7Law of diminishing marginal utility Marginal utility usually diminishes throughout or may rise briefly at first and then diminish throughout. This tendency leads to a very important law – the Law of Diminishing Marginal Utility (LDMU)The Law states - As a consumer consumes more and more units of a particular good, the Marginal utility derived from each additional unit diminishes
8Consumer’s Equilibrium Equilibrium for any economic agent refers to a state of balance in terms of his receipts & what he has to foregoFor a consumer the balance is ensured when the utility he receives from consumption of a good is equal to what he foregoes by the way of price he pays for the good
9Slope of demand curve explained by LDMU Let a consumer buying/consuming good X be initially in equilibrium i.e. MUx = Px i.e. what he is receiving as utility is exactly balanced by what he is foregoing as price. He is making the best use of his resources to reach the maximum satisfaction/valueNow let Px ↓ ⇒ MUx > Px ⇒ equilibrium disturbed. The consumer is now getting more value than he is foregoing. So he would want to get more and increase his consumption ⇒ Qx ↑. As Qx↑, MUx ↓ (LDMU works) and the system starts moving back to MUx = Px . The consumer reaches equilibrium once again. In the process Qx ↑. Thus as Px ↓ Qx ↑ which explains the inverse prices quantity relationship for a product.
10Law of equi-marginal Utility (LEMU) In the real world a consumer takes his consumption decision not with respect to one product but with respect to a number of products he purchases/consumes. Thus, he does not quite reach his equilibrium when MUx = PxHe reaches his equilibrium when marginal utility of his expenditure in all directions of his purchases are equalized i.e. if he is buying two goods X & Y at prices Px & Py then he is in equilibrium whenMUx/Px = MUy/Py = MUmwhere Mum denotes marginal utility from total money he has.This is referred to as consumers’ equilibrium as per law of equi- marginal utility
11Slope of demand curve explained by LEMU Let a consumer buying/consuming two goods X & Y be initially in equilibrium i.e. MUx/Px = MUy/Py i.e. the marginal utility of expenditure on X is equal to the marginal utility of expenditure on Y. Hence he consumes both and maximizes his utility.Now let Px ↓ ⇒ MUx/Px > MUy/Py ⇒ equilibrium disturbed. The consumer’s MU of expenditure on X is greater than MU of expenditure on Y and hence he wants buy more of X with his scarce money ⇒ qx ↑. As qx↑, MUx ↓ (LDMU works) and the system starts moving back to MUx/Px = MUy/Py . The consumer reaches equilibrium once again. In the process qx ↑. Thus as Px ↓ qx ↑ which explains the inverse prices quantity relationship for a product
12Marginal Utility per dollar Numerical ExampleThe Utility Maximizing Combination of Apples and Oranges Obtainable with an Income of $10(2)Apple (Product A):Price = $1(3)Oranges (Product B):Price = $2(1)Unit of Product(a)Marginal Utility,Utils(b)Marginal Utility per dollar(MU/Price)First102412Second820Third7189Fourth616Fifth5Sixth43Seventh2It is assumed in this table that the amount of marginal utility received from additional units of each of the two products is independent of the quantity of the other product. For example, the marginal utility schedule for apples is independent of the number of oranges obtained by the consumer. When determining whether to buy the apples or oranges, we will compare the marginal utility per dollar.6-12LO2
13Decision making Process Sequence of Purchases to Achieve Consumer Equilibrium, Given the data in Table 1Choice NumberPotential ChoicesMarginal Utilityper DollarPurchase DecisionIncome Remaining1First AppleFirst Orange1012First orange for $2$8 = $10 - $22Second OrangeFirst apple for $1and Second orange for $2$5 = $8 -$33Second AppleThird Orange89Third orange for $2$3 = $5 - $24Fourth OrangeSecond apple for $1and Fourth orange for $2$0 = $3 - $3This illustration shows how consumers must choose among alternative goods with their limited money incomes. As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of marginal utility per dollar just equals that of the other product. This table summarizes the step-by-step decision making process the rational consumer will pursue to reach the utility maximizing combination. The algebraic statement of this utility-maximizing state is that the consumer will allocate income in such a way that: MU of apples/price of apples = MU of oranges/price oranges6-13LO2
14Deriving the Demand Curve Price of Orange$1$246Quantity Demanded of OrangesQuantityDemandedPrice PerOrange$2416At a price of $2 the consumer represented by the data in the table maximizes utility by purchasing 4 oranges. The decline in the price of oranges to $1 disrupts the consumer’s initial utility-maximizing equilibrium. The consumer restores equilibrium by purchasing 6 rather than 4 oranges. Thus, a simple price-quantity schedule emerges, which creates two points on a downsloping demand curve.DO6-14LO3
15Slope of a demand curve revisited The inverse price-quantity relationship and hence the downward slope of a demand curve may also be explained with the help of the following two concepts:Income effectSubstitution effect
16Income effect Px ↓ → Real income ↑→ Qx ↑ When the price of a commodity falls less has to be spent on the purchase of the same quantity of the commodity. This leads to an increase in purchasing power of the money with the buyer. This is referred to an increase in real income of the consumer.The increase in real income leads to an increase in purchase of the commodity whose price has fallen. This is referred to as income effect of a price change.Px ↓ → Real income ↑→ Qx ↑
17Income effect negative or positive? Px ↓ → Real income ↑→ Qx ↑ ⇒ income effect is positive ⇒ X is a normal goodPx ↓ → Real income ↑→ Qx ↓ ⇒income effect is negative ⇒ X is an inferior good
18Px ↓→ it is relatively cheaper and hence attractive→ Qx ↑ Substitution EffectWhen price of a commodity falls, its becomes cheaper relative to other commodities. This leads to substitution of other commodities( which are now relatively more expensive) by this commodity. Thus the demand for the cheaper good rises. This is called the substitution effect.Px ↓→ it is relatively cheaper and hence attractive→ Qx ↑
19Substitution effect negative or positive? Substitution effect is always positive.
20Inferior good vs Giffen good A good with negative income effect is referred to as inferior goodA good whose negative income effect dominates the positive substitution effect is a Giffen good.Thus, all Giffen goods are inferior goods but all inferior goods are not Giffen goods
21Market Demand CurveThe market demand curve is the sum of individual demands at each priceGraphically, a market demand curve is the horizontal summation of individual demand curves
22Consumer’s surplusThis refers to the difference between what a consumer is willing to pay and what he actually paysDConsumer surplusAPD’Q
23Further Behind the demand curve Consumers equilibrium can also be explained using the two concepts of:Indifference curveBudget Line
24Indifference CurvesAn indifference shows various combinations of two goods that fetches the same level of utility/satisfaction to the consumerBasic Characteristics of Indifference CurvesHigher indifference curves represent higher levels of utilityIndifference curves do not intersect.Indifference curves slope downward.Indifference curves are concave to origin.
26Slope of an indifference curve & MRSxy Slope of an Indifference Curve = - dY/dX = the Marginal rate of technical substitution between X & Y (MRSxy) = -MUX/MUYThe Marginal rate of technical substitution between X & Y (MRSxy) represents the rate at which X gets substituted for Y as a consumer moves down an indifference curveThe MRSxy diminishes as one moves down an indifference curve. This is the Law of Diminishing Marginal Rate of substitution. This explains the concave to the origin (or convex from the origin) property of an indifference curve
27Budget ConstraintsBudget constraint shows the various combinations of two goods that a consumer can have for a given money outlayIf a consumer is buying only two goods X and Y in quantities x & y respectively and at prices Px and Py respectively with his entire income M thenM = xPx + yPyThis represents the consumer’s budget constraint or budget lineBasic Characteristics of Budget ConstraintsShows affordable combinations of X and Y.Slope of –PX/PY reflects relative prices.Effect of increase in relative pricesSlope of Budget line changes. It shifts outward/inward with one of its points either on Y axis(when Px changes) or on X axis (when Py changes) remaining fixedEffects of Changing Income with prices constantIncome increase causes parallel outward shift.Income decrease causes parallel inward shift.
29Optimal Consumption/consumer’s equilibrium A consumer does his optimal consumption at the point where his utility is maximized subject to this budget constraint i.e. he reaches the highest possible indifference curve given the budget constraintMathematically, this Utility Maximization happens when the budget line becomes tangent to the highest possible indifference curve for the consumer. At this point slope of budget line becomes equal to slope of indifference curve (IC) i.e.-PX/PY = - MRSxy = - MUX/MUY. i.e.MUX/PX = MUY/PY.Condition for Consumer’s equilibrium. This is same as obtained from Law of equi-marginal utility
30Each of A, B, C represents consumer’s Equilibrium for different budget constraintfaced by the consumer.
31Price consumption curve, Income consumption curve, Engle curve Shows how consumption is affected by price changes (movement along demand curve).Income-consumption CurveShows how consumption is affected by income changes (shifts from one demand curve to another).Engle CurvesPlot between income and quantity consumed.Consumption of normal goods rises with income.Consumption of inferior goods falls with income (rare).
34Applications and Extensions New productsiPodDiamond-water paradoxOpportunity cost and timeiPods were a new product perceived by consumers as having a greater marginal utility to price ratio than the older portable CD players and other similar products, and thus resulted in a major shift in demand for the new product as consumers attempted to restore their consumer equilibrium.Why do some goods that are essential to life have low prices and goods that are not essential to life have high prices? The marginal utility of the last unit of water consumed is small because we consume a lot of water. The marginal utility of the last diamond is large because we consume few diamonds.Time also has a value, so this must be considered in decision making and utility maximization. When time is considered, consumer behavior appears to be much more rational. Highly skilled people, like doctors, earn high wages and therefore incur a higher opportunity cost whenever they use their time in some other way. They are more likely to buy goods over the internet and pay higher prices for things that will save them time. Unskilled workers or retirees have low opportunity costs for their time and therefore will use time to search out ways to save money. They are more likely to search for bargains and take longer trips if it saves them money. Foreigners observe that Americans waste material goods but conserve time. This could be because our high productivity makes our time more valuable than many of the goods we waste.With medical care purchases we pay an upfront fixed charge each month and this charge is not affected by the amount we consume. The additional marginal benefit is higher than the marginal cost of additional use. This explains why we use so much more than if we had to pay full price.Noncash gifts result in a loss of utility and we then take action to maximize our utility, such as taking it back and exchanging it, etc. Noncash gifts may yield less utility to the receiver than a cash gift of equal monetary value because the noncash gift may not match the receiver’s preferences. Individuals know their own preferences better than the gift giver.6-34LO5
35The iPodThe iPod came on the market in November Less than six years later, Apple sold its 100 millionth unit. Furthermore, those units enabled Apple to sell more than 2.5 billion songs through its online iTunes store.a. The swift ascendancy of the iPod resulted mainly from a leapfrog in technology Not only is the iPod much more compact than the portable digital CD player that it replaced, it can hold a lot more songs.b. This example demonstrates a simple but important point: New products succeed by enhancing consumers’ total utility.
36Diamond-water paradox Why does water so essential and hence valuable for life command either a small or no price? While diamond which is only an item of conspicuous consumption command such a high price?The answer lies in the fact that while diamond is scarce, water is abundant. Besides, as price for water is fixed based on additional units of consumption, the additional units of utility derived from consumption of additional units of water gradually diminishes.
37Opportunity cost and time Time also has a value, so this must be considered in decision making and utility maximization. The total price of an item must include the opportunity cost of the time spent in consuming the product, i.e., the wage value of an hour of time. When the opportunity cost of time is considered, consumer behavior appears to be much more rational.1. Highly paid doctors may not spend hours hunting for bargains because their time is more valuable than the money to be saved from finding the best buy.
38Prospect TheoryTraditional theory asserts that people are always rational and are not impacted by emotion. →this is what we have done in utility theoryBehavioral economics focuses on consumers’ decisions in light of emotion and negative possible outcomes.Status quo – gains and losses are essentially measured against the change in the status quo.We know about diminishing marginal utility with goods but there’s also diminishing marginal disutility with losses where there’s a much greater decrease in marginal utility with the first loss.People are loss averse and will feel losses to a greater magnitude than gains of an equal amount.
39Prospect theory: examples and applications Losses and Shrinking Packages.When making purchases, consumers tend to focus only on price when determining their gains and losses.Therefore to makeup for increased costs, Hershey’s decreased the size of their chocolate bar in order to avoid an increase in price.The important point is that consumers don’t view this as a loss because they focus on price and price didn’t change (no observable change in status quo).Framing Effects and AdvertisingEvaluation of gains and losses largely depends on a person’s mental frame and when new information is introduced to change a person’s frame their gains/losses are called framing effects.For example, making Rs 100,000 may be appealing to someone until they find out they had been earning Rs. 140,000.Another example of framing is in advertising. Often burger producers label burger as “80% lean” not “20% fat” because 80% lean is framed as a gain.
40Prospect theory: examples and applications Mental accounting and over priced warrantiesSometimes consumers don’t view all of their consumption options simultaneously as predicted by the utility-maximization rule. Richard Thaler called it mental accounting when consumers looked at some purchases as isolated transactions.When making big-item purchases like a Rs.80,000 TV, the buyer is offered a warranty. The buyer often looks at this transaction in isolation, viewing this as a potential Rs.80,000 loss if the TV breaks. The buyer is usually enticed to buy the warranty even though there’s a small possibility of it breaking because the consumer doesn’t consider their future income.
41NudgingBehavioral economics examines how consumers arrive at decisions that may appear on the surface to be irrational. Behavioral economists explain these nuisances through the lens of “nudges” which are very subtle ways to “encourage” individuals to behave in a specific way.Example, a power company in California sent bills to their customers with their usage and neighbors’ usage along with and as an indication of whether or not they used too much energy, or were doing a great job conserving. The smilies proved to be an effective “nudge.”A key point is that nudges are a form of manipulation to get an individual to do what someone wants him to do.