ECON107 Principles of Microeconomics Week 9 NOVEMBER w/11/2013 Dr. Mazharul Islam Chapter-8

8 Utility and Demand Dr. Mazharul Islam 8w/11/2013

Lesson Objectives  Examine 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 ? 3 Dr. Mazharul Islam 9w/11/2013

Issues of Discussion  Utility Defined  Total Utility  Marginal Utility  Subjective Nature  Difficult to Quantify  Law of Diminishing Marginal Utility 4 Dr. Mazharul Islam 9w/11/2013

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. 5 Dr. Mazharul Islam 9w/11/2013

TOTAL AND MARGINAL UTILITY 6 Dr. Mazharul Islam 9w/11/2013 Total Utility, Utils Marginal Utility, Utils Units consumed per beef burger (BB) Units consumed per BB Total Utility (utils) Marginal Utility (utils) TU MU Number Of glass

TOTAL AND MARGINAL UTILITY 7 Dr. Mazharul Islam 9w/11/2013 Total Utility, Utils Marginal Utility, Utils Units consumed per beef burger (BB) Units consumed per BB Total Utility (utils) Marginal Utility (utils) TU MU Number Of glass Observe Diminishing Marginal 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 Choice We 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. 8 Dr. Mazharul Islam 9w/11/2013

Maximizing Utility Utility-Maximizing Condition  Consumer 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 MU p is the marginal utility of pizza, p p is the price of pizza, MU v is the marginal utility of videos, and p v the price of videos 9 Dr. Mazharul Islam 9w/11/2013

Maximizing Utility  If MU p / P p > MU v / P v, then spend more on pizza and less on videos. MU p will decrease and MU v will increase.  If MU p / P p < MU v / P v, then spend more on videos and less on pizza. MU p will increase and MU v will decrease. Only when, MU p / P p = MU v / P v, is it not possible to reallocate the budget and increase total utility. 10 Dr. Mazharul Islam 9w/11/2013

Utility Maximization  To 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 11 Dr. Mazharul Islam 9w/11/2013

Example Suppose that we have the following bits of information  The price of pizza per unit is $8  The rental price of a movie video is $4  After tax income equals $40 per week 12 Dr. Mazharul Islam 9w/11/2013

13 Dr. Mazharul Islam 9w/11/2013 Total Marginal per Dollar Video Total Marginal per Dollar Consumed Utility utility Marginal utility Rentals Utility of utility of marginal Utility of Per Weekof Pizza of Pizza (price=$8) per Week Videos Videos (price=$4) (1) (2) (3) (4) (5) (6) (7) (8) ¼ ½ ½ 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 you have any question? 14 Dr. Mazharul Islam 5w/9/2013