Understanding Utility in Economics

• Chapter three discusses the theory of consumer behavior

Concepts of Utility

• Explores what utility is and how it relates to consumer demand
• Discusses the assumptions of cardinal and ordinal utility approaches
• Marginal and total utility are important to understand consumer choices
• How indifference curves and their properties affect decision-making
• Maximizing one's utility is a key concept

Introduction to Consumer Behavior

• A need or desire from consumer causes the demand for a commodity
• Economists use "utility" to describe satisfaction from consuming a commodity
• An individual receives satisfaction utility from consuming a good or service
• Utility is an "ex-ante" concept, meaning that the individual feels a certain way before buying or consuming a commodity
• Utility is about what an individual expects to get, not necessarily what they actually get
• If given two consumption bundles (X and Y), the consumer wants the one with better utility
• Consumers are typically rational, seeking to maximize their satisfaction by consuming goods given their money income.

Utility vs Usefulness

• "Utility" and "Usefulness" are not synonyms
• Utility is consumer centric
• Usefulness is product centric
• Utility is subjective, varying from person to person, for example non-smokers
• Utility may be different based on place and time, as exemplified by coffee consumption

Ways to Measure Utility

• There are two approaches to measuring/comparing consumer utility: cardinal and ordinal
• The cardinalist approach says utility can be measured objectively
• The ordinalist approach says utility cannot be measured in numbers, instead consumers rank their derived utility from goods/services

Cardinal Utility Theory

• Utility can be measured in arbitrary units called "utils" (e.g., 1, 2, 3)
• For example, an orange may give a person 10 utils while a banana gives 8 utils

Assumptions of Cardnial Utility Theory

• Consumers are rationale, aiming to maximize satisfaction given budget/income
• Utility is cardinally measurable
• There is a constant marginal utility of money, the value of which remains the same regardless of time/place
• Diminishing marginal utility (DMU) exists
• Total utility from goods depends on the amount of individual commodities

Total Utility (TU) vs Marginal Utility (MU)

• Total Utility (TU) is the total satisfaction from consuming commodities at a particular time
• As consumption of a good increases, total utility increases over a period of time
• Marginal Utility (MU) is the extra satisfaction from an additional unit of a product
• Marginal utility refers to change in total utility from consuming one more unit of a product
• In a graph, marginal utility is the slope of total utility
• Mathematically, marginal utility is the change in total utility divided by the change in quantity
• Total utility increases, maximizes when 6 units are consumed, then declines as quantity consumed increases
• As the quantity increases, marginal utility continuously declines

Diminishing Marginal Utility (LDMU)

• States that as the quantity of a commodity increases per unit of time, the utility from each successive unit decreases with other commodities remaining constant
• The extra satisfaction a consumer derives declines as consumption of the same product increases over a given period

Assumptions of LDMU

• The consumer is rational
• A consumer consumes identical or homogenous products
• Products consumed should have similar quality, color, design, ect
• There can be no time gap between consumption of the product
• The consumers taste/preferences remain unchanged

Equilibrium for Consumers

• The objective of a rational consumer is to maximize total utility
• A consumer will desire to consume more of a product if the additional unit gives positive marginal utility because the total utility will increase
• Consumers must decide what combination of goods and services will give them the maximum total utility given limited income and the price level of goods/services

The Case of One Commodity

• The equilibrium for consumers who consumes one single good occurs when the marginal utility of X is qual to Px (The price of X)

The Case of Two or More Commodities

• Consumer equilibrium is achieved with two or move goods when the marginal utility per money spent is equal for each good purchased and available money is exhausted for the goods
• MUX/PX = MUY/PY = MUN/PN and PxQx+PyQy +...+ PNQN = M, where M is the income of the consumer

Limitations of the Cardinal Approach

• The cardinal approach assumes cardinal utility, but this is doubtful because utility may not always be able to be quatified
• Utility also cannot always be measured objectively
• The approach assumes constant MU but this is unrealistic since as income increases, the marginal utility of money changes

The Ordinal Utility Theory

• Ordinal utility theory dictates that consumers can "order" commodities in their preferences from 1st, 2nd, 3rd, ect
• Consumers do not need to know specific units to make choices on commodities
• It is enough that the consumer can rank the basket of goods based on satisfaction

Assumptions of the Ordinal Utility Theory

• Consumers are rational
• Utility is ordinal
• There is a diminishing marginal rate of substitution
• Total utility is measured by the amount of items in a consumption basket.
• Consumer preferences are consistent (if X is preferred to Y, and Y to Z, X must be preferred to Z, aka, transitivity)

Indifference Set vs Indifference Curve

• An indifference set/schedule is a combination of goods for which the consumer is indifferent
• It demonstrates the combinations of goods from which the consumer derives the same level of satisfaction
• An indifference curve is expressed graphically
• Indifference curves show different combinations of two goods which generates the same utility (level of satisfaction) for the consumer
• A set of indifference curves is called an indifference map.

Properties of The Indifference Curve

• Curves have a negative slope (sloping downward from left to right)
• Curves are convex to the origin.
• Curves are always preferred from the consumers point of view
• Curves intersect with each other

Marginal Rate of Substitution (MRS)

• Means the rate that consumers substitute one commodity for another while remaining the same indifference curve.
• Willingness indicates a customer's willingness to substitute a good while remaining indifferent between bundles
• Marginal rate of substitution of X for Y is defined as the amount of units of Y that must be given up for an extra unit of X to maintain same level of satisfaction

The concept of a Budget Line

• Indifference curves do not tell us what a customer is willing to buy/ can show
• The customer is constrained by income and prices of commodities
• Budget lines refer to the commodity bundles that ca be purchased if all income if spent
• A graph shows the customer can buy two products with the constraints of limited income and prices

Drawing a Budget line

• Must be considered that only two goods are bought in quantities, nameley X and Y
• Each consumer is with market determined prices, PX and PY
• Customers only have a fixed monetary income
• M=P_xX+P_yY

Budget Line Equation

• Y = M/Py - Px/Py X

What Occurs with Income Change

• Budget line will also shift along with prices commodities (Unchanged)
• Causing more income: Upward on buying goods & services in budget line that consumer can use
• Causing less income: Inward shifts due to being less quantity and also leads to decline of the two goods

Change In Prices

• Equal increase with prices result in an inward direction, showing that customer has an lesser amount of two goods
• Equal decrease with prices shift for outward showing that both goods are cheaper
• Increasing and decreasing the price on on good shows that budget line will affect how much the money is

Equilibrium of the Consumer

• The consumers preferences are indicated based on the indifference curve
• The budget line and its limitations determines the limit of commodity customer can puchase
• A rationale ensures that consumer tries to attain with he budget line
• This happens when the consumer indifference curve is tangent to the budget line The equation of the indifference curve equals the line MSRxy + Px/pY

Explore the concept of utility in economics, differentiating it from usefulness. Understand why economists assume consumers maximize satisfaction and the differences between ordinalist and cardinalist schools of utility. Learn how rational consumers make purchasing decisions to maximize their satisfaction given their income.