Principle of Economics Chapter 5 PDF

PRINCIPLE OF ECONOMICS NOOR SA'ADAH SABUDIN SEFB CHAPTER 5 The Theory of Consumer Behaviour INTHISLECTURE The Concept of Utility Cardinal Utility Theory: Total Utility and Marginal Utility, The Law of Diminishing Marginal Utility and...

PRINCIPLE OF ECONOMICS NOOR SA'ADAH SABUDIN SEFB CHAPTER 5 The Theory of Consumer Behaviour INTHISLECTURE The Concept of Utility Cardinal Utility Theory: Total Utility and Marginal Utility, The Law of Diminishing Marginal Utility and Consumer Equilibrium (Mathematical Method) Ordinal Utility Theory: The Budget Line/Constraint (Definition, slope and changes), The Indifference Curve (Definition, slope, characteristic and changes) and Consumer Equilibrium (Graphical Method and changes) After studying this chapter, you will be able: To explain the concept of Total Utility and Marginal Utility. To explain the Law of diminishing marginal utility. To equate marginal utilities per price for each good. To explain consumer equilibrium conditions and determine the quantity of goods at consumer equilibrium. After studying this chapter, you will be able: To explain the definition, slope, s and changes of the the budget constraint/lines. To explain the definition, slope, characteristics and changes of the indifference curve. To explain consumer equilibrium conditions and determine the quantity of goods at consumer equilibrium. You want Adele’s album 21. Will you buy a CD for $9.99, or will you download it for $10.99? What determines our choices about how we buy recorded music? You know that diamonds are expensive, and water is cheap. Doesn’t that seem odd? Why do we place a higher value on useless diamonds than on essential-to-life water? THE THEORY OF CONSUMER BEHAVIOR Consumer behavior refers to the study of consumer while engaged in the process of consumption. ‘Utility’ means the satisfaction obtained from consuming goods or services. THE THEORY OF CONSUMER BEHAVIOR Ordinal Utility Theory The ordinal utility theory says that utility is not measurable, but it can be compared. Ordinal approach uses the ranking of alternatives as first, second, third and so on. Cardinal Utility Theory The cardinal utility theory says that utility is measurable and by placing a number of alternatives so that the utility can be added. The index used to measure utility is called utils. ORDINAL UTILITY THEORY The Budget Constraint: What The Consumer Can Afford The budget constraint depicts the limit on the consumption “bundles” that a consumer can afford. People consume less than they desire because their spending is constrained, or limited, by their income. The budget constraint shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods. ORDINAL UTILITY THEORY We’ll study the Consumption Choices of Lisa, who buys only two goods: movies and soda. A Consumer’s Budget Constraint Consumption Choices are limited by income, the price of a movie, and the price of soda. When Lisa spends all of her income, she reaches the limits of her Consumption Choices. Lisa’s budget constraint shows the limits of her Consumption Choices.  ORDINAL UTILITY THEORY Lisa has $40 to spend (Income =I), the price of a movie is $8 (price of good x = Px) and the price of soda is $4 a case (price of good y (Py).  Lisa can afford any of the combinations at ORDINAL UTILITY THEORY the points A to F. Some goods are indivisible and must be bought in whole units at the points marked (such as movies). Other goods are divisible goods and can be bought in any quantity (such as gasoline). The line through points A to F is Lisa’s budget constraint.  The budget ORDINAL UTILITY THEORY constraint is a constraint on Lisa’s consumption choices. Lisa can afford any point on her budget constraint or inside it. Lisa cannot afford any point outside her budget constraint. ORDINAL UTILITY THEORY The Equation of the Budget Constraint In general, the budget constraint can be written I = PXX + PYY where I = household income. PX = the price of X X = the quantity of X consumed PY = the price of Y Y = the quantity of Y consumed  Consumption Possibilities ORDINAL UTILITY THEORY The Budget Equation We can describe the budget constraint by using a budget equation. The budget equation states that: Expenditure = Income Lisa’s budget equation is: PSQS + PMQM = I or Y. Where, PS = price of soda QS = quantity of soda PM = price of a movie QM = quantity of movies I = Income. ORDINAL UTILITY THEORY Deriving Budget Constraint Step 1: Find intercept on axis X and Y. Formula: Intercept on axis X = I/PX Intercept on axis Y = I/PY Step 2: Draw the budget constraint.  Quantity of Soda ORDINAL UTILITY THEORY Deriving Budget Constraint A 10 Intercept on the axis X = 40/8 = 5 (point F) Intercept on the axis Y = 40/4 = 10 Consumer’s (point A) budget constraint F 0 5 Quantity of Movie  Deriving Budget Quantity of Soda Constraint ORDINAL UTILITY THEORY Any point on the budget constraint line A indicates the 10 consumer’s combination or trade- off between two goods. For example, if Lisa Consumer’s buys no movies, she budget constraint can afford 10 case of Soda (point A). If she buys no Soda, she can F 0 5 Quantity afford 5 movies (point of Movie F).  Quantity of Soda ORDINAL UTILITY THEORY Deriving Budget Constraint A 10 Alternately, Lisa can buy 6 case of Soda and 2 movies per month. C 6 Consumer’s budget constraint F 0 2 5 Quantity of Movie  PSQS + PMQM = Y ORDINAL UTILITY THEORY Divide both sides of this equation by PS, to give: QS + (PM/PS)QM = Y/PS Then subtract (PM/PS)QM from both sides of the equation to give: QS = Y/PS – (PM/PS)QM Y/PS is Lisa’s real income in terms of soda. PM/PS is the relative price of a movie in terms of soda. ORDINAL UTILITY THEORY A household’s real income is the income expressed as a quantity of goods the household can afford to buy. Lisa’s real income in terms of soda is the point on her budget line where it meets the y-axis. A relative price is the price of one good divided by the price of another good.  Relative price is the magnitude of the slope of ORDINAL UTILITY THEORY the budget line (Px/Py). The relative price shows how many cases of soda must be forgone to see an additional movie. In this case, the slope of the budget constraint = -(Px/Py) -(8/4) -2 ORDINAL UTILITY THEORY Changes in Budget Constraint Two factors that influence changes in budget constraint : 1) Changes in price 2) Changes in income ORDINAL UTILITY THEORY A Change in Prices A change in the price of the good on the x- axis changes the slope of the budget line. Figure 9.2(a) shows the rotation of a budget line after a change in the relative price of movies.  A Change in ORDINAL UTILITY THEORY Prices A change in the price of the good on the Y- axis changes the slope of the budget line. Figure 9.2(b) shows the rotation of a budget line after a change in the relative price of movies. ORDINAL UTILITY THEORY A Change in Income An change in money income brings a parallel shift of the budget line. The slope of the budget line doesn’t change because the relative price doesn’t change. Figure 9.2(b) shows the effect of a fall in income. ORDINAL UTILITY THEORY A Change in Income Figure 9.2(b) shows the effect of a rise in income. Budget constraint shift to the right. Lisa can buy more combination of movies and soda.  Indifference Curve ORDINAL UTILITY THEORY Preferences: What The Consumer Wants A consumer’s preference among consumption bundles may be illustrated with indifference curves. An indifference curve represents all the possible combinations of two goods which will give the same level of satisfaction.  Deriving Indifference Curve ORDINAL UTILITY THEORY An indifference schedule is a list of combination of two goods that give equal satisfaction to the consumer. Combinations Good Y Good X A 12 2 B 6 4 C 4 6 D 3 8 E 2 12 The table above shows all the five combinations, which will give the equal level of satisfaction.  Deriving Indifference Curve ORDINAL UTILITY THEORY An indifference curve represents all those combinations of two goods; X and Y which yield the same level of satisfaction to a consumer. The Consumer’s Preferences The consumer is indifferent, or equally happy, with the combinations shown at points A, B, C, D and E because they are all on the same curve.  Deriving Indifference Curve ORDINAL UTILITY THEORY An indifference map shows a set of indifference curve. The higher the indifference curve from the origin, higher will be the utility. IC3 has the higher satisfaction. ORDINAL UTILITY THEORY Indifference Curve An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. At point C, Lisa sees 2 movies and drinks 6 cases of soda a month. Figure 9.3(a) illustrates Lisa’s indifference curve. ORDINAL UTILITY THEORY Indifference Curve Lisa can sort all possible combinations of goods into three groups: preferred, not preferred, and just as good. An indifference curve joins all those points that Lisa says are just as good as C. G is such a point. Lisa is indifferent between C and G. ORDINAL UTILITY THEORY Indifference Curve Lisa prefers any point above the indifference curve to any point on the curve. Lisa prefers any point on the indifference curve to any point below the indifference curve. ORDINAL UTILITY THEORY Indifference Curve A preference map is a series of indifference curves. Call the indifference curve that we’ve just seen I1. I0 is an indifference curve below I1. Lisa prefers any point on I1 to any point on I0. ORDINAL UTILITY THEORY Indifference Curve I2 is an indifference curve above I1. Lisa prefers any point on I2 to any point on I1. For example, Lisa prefers point J to either point C or point G. ORDINAL UTILITY THEORY The Marginal Rate of Substitution The slope at any point on an indifference curve is the marginal rate of substitution. It is the rate at which a consumer is willing to trade one good for another, or the ratio at which a household is willing to substitute X for Y. It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.  The Marginal Rate of Substitution ORDINAL UTILITY THEORY  If the indifference curve is relatively steep, the MRS is high. In this case, the person is willing to give up a large quantity of y to get a bit more x.  If the indifference curve is relatively flat, the MRS is low. In this case, the person is willing to give up a small quantity of y to get more x.  The Marginal Rate of Substitution ORDINAL UTILITY THEORY A diminishing marginal rate of substitution is the key assumption of consumer theory. A diminishing marginal rate of substitution is a general tendency for a person to be willing to give up less of good y to get one more unit of good x, while at the same time remaining indifferent as the quantity of good x increases. ORDINAL UTILITY THEORY The Marginal Rate of Substitution Figure 9.4 shows the diminishing MRS of movies for soda. At point C, Lisa is willing to give up 2 cases of soda to see one more movie— her MRS is 2. At point G, Lisa is willing to give up 1/2 a case of soda to see one more movie— her MRS is 1/2.  The Marginal Rate of Substitution ORDINAL UTILITY THEORY Diminishing MRS  The Marginal Rate of Substitution ORDINAL UTILITY THEORY Quantity of Pepsi Diminishing MRS 14 A MRS = 6 B 8 1 MRS = 4 C 4 D 3 MRS = 1 3 1 Indifference curve 0 2 3 6 7 Quantity of Pizza ORDINAL UTILITY THEORY Four Properties of Indifference Curves Higher indifference curves are preferred to lower ones. Indifference curves are downward sloping. Indifference curves do not cross. Indifference curves are bowed inward.  Four Properties of Indifference Curves ORDINAL UTILITY THEORY Higher indifference curves are preferred to lower ones Consumers usually prefer more of something to less of it. Higher indifference curves represent larger quantities of goods than lower indifference curves. Consumers’ preferences are transitivity.  Four Properties of Indifference Curves ORDINAL UTILITY THEORY Higher indifference curves are preferred to lower ones Higher indifference Quantity curves represent larger of Pepsi quantities of goods than lower indifference curves. I3 is more prefer Consumers’ than I2 and I1 preferences are C transitivity. Point E E is more prefer than point D and D I3 A B I2 A I1 0 Quantity of Pizza  Four Properties of Indifference Curves ORDINAL UTILITY THEORY Indifference curves do not cross We see from the graph that C lies above A, so C must be preferred to A because C contains more of Good Y and the same amount of Good X as does A, and more is preferred to less. But this violates transitivity, so indifference curves must not intersect.  ORDINAL UTILITY THEORY Four Properties of Indifference Curves Indifference curves do not cross. Points A and B The Impossibility of Intersecting Indifference Curves should make the consumer equally Quantity happy. of Pepsi Points B and C should make the C consumer equally happy. This implies that A and C would make A the consumer equally happy. B But C has more of both goods compared to A. Quantity of Pizza  Four Properties of Indifference Curves ORDINAL UTILITY THEORY Indifference curves are bowed inward People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little. These differences in a consumer’s MRS cause his or her indifference curve to bow inward to the origin.  Four Properties of Indifference Curves Indifference curves are bowed inward. ORDINAL UTILITY THEORY Quantity of Pepsi 14 MRS = 6 A 8 1 4 B MRS = 1 3 1 Indifference curve 0 2 3 6 7 Quantity of Pizza  The Consumer Equilibrium ORDINAL UTILITY THEORY Consumers want to get the combination of goods on the highest possible indifference curve. However, the consumer must also end up on or below his budget constraint. Combining the indifference curve and the budget constraint determines the consumer’s optimal choice. Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent. ORDINAL UTILITY THEORY Predicting Consumer Choices Here, the best affordable point is C. Lisa can afford to consume more soda and see fewer movies at point F. And she can afford to see more movies and consume less soda at point H. But she is indifferent between F, I, and H and she prefers C to I. ORDINAL UTILITY THEORY Predicting Consumer Choices At point F, Lisa’s MRS is greater than the relative price. At point H, Lisa’s MRS is less than the relative price. At point C, Lisa’s MRS is equal to the relative price.  ORDINAL UTILITY THEORY The Consumer Equilibrium Quantity The consumer would prefer to be on indifference curve I3, but does not have enough income to reach of Pepsi that indifference curve. Optimum (point e): Indifference curve tangent with budget constraint Slope of Indifference curve = slope of budget constraint e MRS = -PX / PY B A I3 The consumer can afford most of the bundles on I1, but why I2 stay there when you can move I1 out to a higher indifference curve, I2? Budget constraint 0 Quantity of Pizza  Preferences CARDINAL UTILITY THEORY The choice that Lisa makes depends on her preferences—her likes and dislikes. Her benefit or satisfaction from consuming a good or service is called utility. Total Utility Total utility is the total benefit a person gets from the consumption of goods. Generally, more consumption gives more total utility.  Maximizing Utility CARDINAL UTILITY THEORY Table 8.1 shows Lisa’s total utility schedule. Total utility from a good increases as the quantity of the good increases. For example, as Lisa sees more movies in a month, her total utility from movies increases.  Marginal Utility CARDINAL UTILITY THEORY Marginal utility from a good is the change in total utility that results from a unit-increase in the quantity of the good consumed (∆TU/ ∆Q). As the quantity consumed of a good increases, the marginal utility from it decreases. We call this decrease in marginal utility as the quantity of the good consumed increases the principle of diminishing marginal utility. Law of Diminishing Marginal Utility states that as consumption increases more and more, marginal utility will be less and less.  Law of Diminishing Marginal Utility CARDINAL UTILITY THEORY The law of diminishing marginal utility is based on the idea that if a good has a variety of uses but only 1 unit of the good is available, then the consumer will use the first unit to satisfy his or her most urgent want. If 2 units are available, the consumer will use the second unit to satisfy a less urgent want. CARDINAL UTILITY THEORY Maximizing Utility Table 8.1 shows how to calculate Lisa’s marginal utility from her total utility. Marginal utility from a good decreases as the quantity of the good increases. For example, as the number of movies seen in a month increases, marginal utility from movies decreases.  Maximizing Utility CARDINAL UTILITY THEORY Figure 8.2(a) shows Lisa’s total utility and marginal utility from soda. Total utility from soda increases as more soda is consumed. The bars along the total utility curve show the extra total utility (marginal utility) from each additional case of soda. CARDINAL UTILITY THEORY Maximizing Utility Figure 8.2(b) illustrates diminishing marginal utility. As Lisa increases the quantity of soda she drinks, her marginal utility from soda diminishes.  CARDINAL UTILITY THEORY Maximizing Utility TU increases from consumption of 1st unit of apple until the 5th unit of apples. After the 5th unit of apples, TU will decrease. Units of Total Utility Marginal Utility Apples 1 20 20 2 35 15 MU will decrease 3 45 10 and become zero at the 5th unit of apples 4 50 5 and further 5 50 0 consumption of 6 45 -5 apples will not satisfy the consumer 7 35 -10 as the MU shows 8 20 -15 negative signs.  Maximizing Utility CARDINAL UTILITY THEORY When TU is increasing, MU will be positive. When TU is at its maximum, MU will be zero. When TU is decreasing, MU will be negative.  Consumer Equilibrium- Utility Maximizing Choice CARDINAL UTILITY THEORY Find Just-Affordable Combinations Lisa has $40 a month to spend on movies and soda. The price of a movie is $8 and the price of soda is $4 a case. Each row of Table 8.2 shows a combination of movies and soda that exhausts Lisa’s $40. CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice Find the Total Utility for Each Just- Affordable Combination When Lisa sees 1 movie and drinks 8 cases of soda a month, she gets 50 units of utility from the 1 movie and 248 units of utility from the 8 cases of soda. Her total utility is 298 units. CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice Consumer Equilibrium Lisa chooses the combination that gives her the highest total utility. Lisa maximizes her total utility when she sees 2 movies and drinks 6 cases of soda a month. Lisa gets 90 units of utility from the 2 movies and 225 units of utility from the 6 cases of soda. CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice Consumer equilibrium is the situation in which Lisa has allocated all of her available income in the way that maximizes her total utility, given the prices of movies and soda. Lisa’s consumer equilibrium is 2 movies and 6 cases of soda a month. CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice A more natural way of finding the consumer equilibrium is to use the idea of choices made at the margin. Choosing at the Margin Having made a choice, would spending a dollar more or a dollar less on a good bring more total utility? Marginal utility is the increase in total utility that results from consuming one more unit of the good. The marginal utility per dollar (MU/P) is the marginal utility from a good that results from spending one more dollar on it. CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice The marginal utility per dollar equals the marginal utility from a good divided by its price. Calling the marginal utility from movies MUM and the price of a movie PM, then the marginal utility per dollar from movies is MUM/PM. Calling the marginal utility of soda MUS and the price of soda PS , then the marginal utility per dollar from soda is MUS/PS. By comparing MUM/PM and MUS/PS , we can determine whether Lisa has allocated her budget in the way that maximizes her total utility. CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice Lisa’s Marginal Calculation Figure 8.3 shows why the utility-maximizing rule works. Each row of the table (on the next slide) shows a just-affordable combination. Start by choosing a row—a point on the budget constraint.  CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice In row B, MUS/PS < MUM/PM. Lisa spends too much on soda and too little on movies.  CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice If Lisa spends less on soda and more on movies, … MUS increases and MUM decreases.  CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice In row D, MUS/PS > MUM/PM. Lisa spends too little on soda and too much on movies.  CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice If Lisa spends more on soda and less on movies, MUS decreases and MUM increases.  CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice In row C, MUS/PS = MUM/PM. Lisa is maximizing utility.  Predictions of Marginal Utility Theory CARDINAL UTILITY THEORY A Fall in the Price of a Movie When the price of a good falls the quantity demanded of that good increases—the demand curve slopes downward. For example, if the price of a movie falls, we know that MUM/PM rises, so before the consumer changes the quantities bought, MUM/PM > MUS/PS. To restore consumer equilibrium (maximum total utility), the consumer increases the movies seen to drive down the MUM and restore MUM/PM = MUS/PS.  Predictions of Marginal Utility Theory CARDINAL UTILITY THEORY A change in the price of one good changes the demand for another good. You’ve seen that if the price of a movie falls, MUM/PM rises, so before the consumer changes the quantities consumed, MUM/PM > MUS/PS. To restore consumer equilibrium (maximum total utility), the consumer decreases the quantity of soda consumed to drive up the MUS and restore MUM/PM = MUS/PS.  Predictions of Marginal Utility Theory CARDINAL UTILITY THEORY Table 8.3 shows Lisa’s just-affordable combinations when the price of a movie is $4. Before Lisa changes what she buys MUM/PM > MUS/PS. To maximize total utility, Lisa sees more movies and drinks less soda.  Predictions of Marginal Utility Theory CARDINAL UTILITY THEORY A Rise in the Price of Soda Now suppose the price of soda rises. We know that MUS/PS falls, so before the consumer changes the quantities bought, MUS/PS < MUM/PM. To restore consumer equilibrium (maximum total utility), the consumer decreases the quantity of soda consumed to drive up the MUS and increases the quantity of movies seen to drive down MUM. These changes restore MUM/PM = MUS/PS. CARDINAL UTILITY THEORY Predictions of Marginal Utility Theory Table 8.4 shows Lisa’s just-affordable combinations when the price of soda is $8 and the price of a movie is $4. Before Lisa changes what she buys, row A tells us that MUM/PM > MUS/PS. To maximize her total utility, Lisa drinks less soda.  CARDINAL UTILITY THEORY Consumer Equilibrium- Utility Maximizing Choice EXAMPLE: Arwin has an income of RM37 and the prices of goods P, Q and R are RM5, RM1 and RM4 respectively. Condition 1 : Every ringgit spent on every commodity must Fulfilling condition 1, two combination of goods are obtained: yield the same marginal utility. Combination 1 : 2P, 4Q and 1R Combination 2 : 4P, 5Q and 3R Quantity Product P Product Q Product R Total MUP/PP Total Utility MUQ/PQ Total Utility MUR/PR Utility 1 21 4.2 7 7 16 4 2 41 4 13 6 30 3.5 3 59 3.6 18 5 42 3 4 74 3 22 4 50 2 5 85 2.2 25 3 55 1.25 6 91 1.2 27 2 58 0.75 7 91 0 28 1 60 0.5 Condition 2 : Total Combination 1 : 2P, 4Q and 1R expenditure of all goods must 2(5) + 4(1) + 1(4) = 18 be equal to the total budget Combination 2 : 4P, 5Q and 3R allocated to maximize utility. 4(5) + 5(1) + 3(4) = 37 So, 4 units of Product P, 5 units of Product Q and 3 units of Product R will be purchased by Arwin.  Predictions of Marginal Utility Theory CARDINAL UTILITY THEORY The Paradox of Value Water, which is essential to life, is far cheaper than diamonds, which are not essential. The paradox of value of why water is far cheaper than diamonds is resolved by distinguishing between total utility and marginal utility. We use so much water that the marginal utility from water consumed is small, but the total utility is large. We buy few diamonds, so the marginal utility from diamonds is large, but the total utility is small.  Predictions of Marginal Utility Theory CARDINAL UTILITY THEORY Paradox Resolved The paradox is resolved by distinguishing between total utility and marginal utility. For water, the price is low, total utility is large, and marginal utility is small. For diamonds, the price is high, total utility is small, and marginal utility is high. But marginal utility per dollar is the same for water and diamonds. Think for a moment.