Utility Theory in Economics

Chapter 3: Theory of Consumer Behaviour

• The chapter covers consumer behaviour in three steps: examining preferences, understanding budget constraints, and determining consumer choice.
• Consumer behaviour is best understood by examining consumer preferences, which describes how people prefer one good to another.
• Budget constraints impact consumer choices—limited incomes restrict the quantities of goods that can be purchased.
• Consumer preferences and budget constraints are combined to determine consumer choices.

3.1 Consumer Preferences

• Consumers make choices by comparing bundles of goods.
• If one bundle is strictly better than another, the consumer strictly prefers one to the other (symbolized as >).
• If consumers are indifferent between bundles, the symbol ~ is used (e.g., X ~ Y).
• If consumers weakly prefer one bundle to another, then X ≥ Y.

3.2 The Concept of Utility

• Economists use "utility" to describe satisfaction or pleasure derived from consuming goods or services.
• Utility represents the power of a product to satisfy human wants.
• Given two bundles (X and Y), if a consumer prefers X to Y, then the utility of X is considered better than the utility of Y.

3.3 Approaches of Measuring Utility

• There are two main approaches: cardinal and ordinal.
• The cardinal approach suggests utility can be measured objectively; using units like utils (e.g., orange = 10 utils, banana = 8 utils).

3.3.1 The Cardinal Utility Theory

• Utility is measurable by arbitrary units, like utils.
• This suggests that consumer satisfaction from goods can be quantified.
• Consumption of an orange gives more satisfaction than a banana, for example.

3.3.2 The Ordinal Utility Theory

• Utility isn't measured in numerical values; instead, goods and services are ranked from preferred to less preferred.
• Consumers rank goods in order of their standard preferences (e.g., 1st, 2nd, 3rd choices).
• Consumers' rational choices are based on their preferences, not on quantified utility.

Learning Outcomes

• After completing this chapter, students will be able to:
  • Explain consumer preferences and utility
  • Differentiate cardinal and ordinal utility approaches
  • Define and discuss properties of indifference curves
  • Derive and explain budget lines
  • Describe consumer equilibrium conditions

Law of Diminishing Marginal Utility (LDMU)

• As consumption of a good increases, the utility derived from each additional unit decreases (all other things being equal).
• Consumers are rational.
• The goods consumed are homogenous (same quality, colour, etc.).
• No time gap is present in consumption
• Preferences remain unchanged

Consumer Equilibrium (One Commodity Case)

• Equilibrium occurs when the marginal utility of a good equals its market price (MUx = Px).

Consumer Equilibrium (Multiple Commodities)

• Equilibrium occurs when the marginal utility per unit of money spent is equal for all goods (e.g. MUx/Px = MUy/Py = ... = MUz/Pz).
• Consumer income will be spent completely.

Limitations of Cardinal Approach

• Utility is difficult to quantify objectively.
• The assumption of a constant marginal utility of money is unrealistic. As income increases, the marginal utility of money changes.

Assumptions of Ordinal Utility Theory

• Consumers are rational, maximizing utility given their income and prices.
• Utility is ordinal, not measurable in absolute numbers. Consumers rank preferences or order.

Diminishing Marginal Rate of Substitution (MRS)

• MRS is the rate at which a consumer is willing to substitute one good for another while staying on the same indifference curve.
• As a consumer consumes more of one good, they are willing to give up less of another to maintain the same level of satisfaction.
• Consumers' preferences for goods are consistent.
• Goods are interchangeable.

The Budget Line or the Price Line

• A budget line displays the combinations of goods that a consumer can afford, given prices and income.
• Changes in income or prices shift the budget line.
• An increase in income shifts the line outwards; increases in prices move it inwards.

Consumer Equilibrium under Indifference Curve Approach

• Equilibrium occurs where the indifference curve is tangent to the budget line, with the slopes being the same.
• Point 'E' represents where the consumer attains highest attainability of utility, consuming various combinations of goods 'X' and 'Y'.

Equilibrium of the Consumer

• Mathematically, consumer optimum(equilibrium) is attained at the point where the slope of the indifference curve equals the slope of the budget line.
• MUx/Px = MUy/Py = ... = MUz/Pz

Indifference Curve

• Shows various combinations of goods that provide equal levels of satisfaction for consumers.
• Downward sloping and convex to the origin.
• Higher indifference curves represent higher levels of satisfaction.
• Curves never cross.