CHAPTER 5 Consumer Choice Theory

INTRODUCTION Consumer Choice Theory is important in economic activities because producers are always competing with each other to get consumers to buy their products. Consumer Choice Theory further explains the existing behaviour of consumers.

THEORY OF UTILITY Utility means satisfaction gained by the customer from the consumption of goods and services. Utility is defined as affordability of the consumer to consume goods and services that will give satisfaction to the customer. Theory of Utility: Satisfaction received by the consumer or pleasure from consuming a good is a basis to make a choice of goods and to value goods. Economists term this satisfaction as utility.

TYPES OF UTILITY There are two approaches of utility, which are ordinal and cardinal utility. 1) Cardinal Approach Utility is measured using the unit called “utils”. For example, drinking one glass of lemonade will give 2 unit of utils and a cup of coffee will give 1unit of utils.

TYPES OF UTILITY (CON’T) 2) Ordinal Approach Satisfaction cannot be measured. An ordinal measure means that the exact number does not matter, but rather the relationship between those numbers matter.

CARDINAL UTILITY THEORY Cardinal Utility Theory is an approach that says that utility can be measured using the unit “utils”. For example, eating bread gives 8 utils, while eating biscuit gives 4 utils, which means bread gives twice as many utils compared to biscuit. When the level of utility is associated with the consumers willingness to pay. The higher the price, the higher the satisfaction will be.

TOTAL UTILITY(TU) Total utility (TU) is the total satisfaction that a person gains from the consumption of goods and services. Au: Which table are you referring to? Kindly provide table.

Change in Total Utility MARGINAL UTILITY (MU) Marginal utility (MU) is the change in total utility derived from consuming extra one unit of the same goods and services. The formula to calculate the marginal utility as follows: Au: Kindly add the required formula here. MU = Change in Total Utility Change in Quantity

TOTAL UTILITY AND MARGINAL UTILITY Based on the table above, MU of the 1st unit is equal to TU. When we add up the MU until the consumption of the 6th unit, we will get 72 utils, which is equals to the total utility of that unit. Au: Add the required information here.

LAW OF DIMINISHING MARGINAL UTILITY Law of Diminishing Marginal Utility is a point where marginal utility obtained by consuming additional units of a good starts to decline, ceteris paribus.

LAW OF DIMINISHING MARGINAL UTILITY (CON’T) This law states that the marginal utility curve is downward sloping and the total utility curve will become flatter. The TU curve is equal to the slope of the MU curve.

CONSUMER EQUILIBRIUM WITH ONE GOOD One of the way to maximize satisfaction from our limited income is to measure utils with the value of money. So, the unit utils become value of consumption. Marginal utility (MU) becomes the amount of money that a consumer is willing to pay in order to get an extra unit of good. If the consumer is willing to pay RM1 for a can of soft drink, the MU of the can of soft drink will be MU=RM1. Herewith, when consumption only involves one good, then consumer will maximize satisfaction when marginal utility of consumption of that good equal to price.

CONSUMER EQUILIBRIUM WITH TWO GOODS OR MORE In real life, consumers can choose a variety of goods and services. When the consumer needs to divide his income for two or more goods, equilibrium is obtained when Au: Add missing information in this slide. MUn Pn MUn = Marginal Utility of goods P = price of goods Where

ORDINAL UTILITY THEORY In this approach, the satisfaction received by the consumer can’t be quantitatively stated. This approach states that different goods that are consumed by consumers bring different levels of satisfaction. Au: Add missing information in this slide.

PREFERENCES OF A TYPICAL CONSUMER FIRST ASSUMPTION Preferences are complete and can be ranked. The ranking is done by the consumer in all market baskets. Au: Add missing information in this slide.

PREFERENCES OF A TYPICAL CONSUMER (CON’T) SECOND ASSUMPTION Preferences are transitive Transitivity means that if a consumer prefers market basket A to B and B to C, then the consumer prefers A to C. Au: Add missing information in this slide.

PREFERENCES OF A TYPICAL CONSUMER (CON’T) THIRD ASSUMPTION Consumer is presumed to prefer more of any good to less of any good. Au: Add missing information in this slide.

INDIFFERENCE CURVE ANALYSIS Consumer’s preferences allow an individual to choose among different goods and services. An indifference curve analysis shows the combination of consumption that makes the consumer satisfied when he chooses both goods. Au: Add missing information in this slide.

FOUR PROPERTIES OF INDIFFERENCE CURVES Higher indifference curves are preferred to lower ones. Indifference curves are downward sloping. Indifference curves do not cross each other. Indifference curves are bowed inwards. Au: Add missing information in this slide.

INDIFFERENCE CURVE EXAMPLES PERFECT SUBSITUTES Certain goods are perfect subsitutes in consumption. For example, you will be willing to trade ten cents and two five cents because it offers the same satisfaction. Au: Add missing information in this slide.

INDIFFERENCE CURVE EXAMPLE PERFECT SUBSITUTES (CON’T) These goods need one another before it can consumed. To consume a pair of shoes, we need a left and a right shoe together. Missing shoes would make the pair incomplete. Au: Add missing information in this slide.

THE BUDGET CONSTRAINT This is a set of basket that a consumer can purchase with a limited amount of income. Au: Add missing information in this slide.

COMBINING THE INDIFFERENCE CURVE AND THE BUDGET LINE By combining the indifference curve and the budget line, we can determine the market basket that the consumer will actually choose. Au: Add missing information in this slide. And also provide the full form of BL

CORNER SOLUTION This is a situation in which a particular good is not consumed at all by an individual because the value of the first unit is less than its cost. Au: Add missing information in this slide.

CHANGES IN INCOME AND CONSUMPTION CHOICES A change in income will affect consumption choices by changing the set of market baskets that the consumer can afford. This results in a shift in the budget line. Au: Add missing information in this slide.

NORMAL GOODS These are goods where the consumer purchases more when income rises. Au: Add missing information in this slide.

INFERIOR GOODS These are goods where consumption is inversely related to income. This means that as income rises, the consumption of inferior goods will drop. Au: Add missing information in this slide.

PRICES CHANGES AND CONSUMPTION CHOICES Changes in price would affect the market basket that the consumer chooses. Au: Add missing information in this slide.

INCOME EFFECT AND SUBSTITUTION EFFECT When the price of a good falls, the consumer’s real purchasing power would increase. Substitution Effect When the price of a good falls, the consumer has an incentive to increase consumption at the expense of another more expensive good. Au: Add missing information in this slide.

CONSUMER SURPLUS This is the net benefit or gain secured by an individual from consuming one basket instead of another. Au: Add missing information in this slide.

DEMAND CURVE TO MEASURE CONSUMER SURPLUS Au: Add missing information in this slide.