Grade 11 Economics Unit 1 PDF

11/3/2024 Grade 11 Economics Unit One Theory of Consumer Behavior and Demand By: Muhdin Z Secret Training Institute 1...

11/3/2024 Grade 11 Economics Unit One Theory of Consumer Behavior and Demand By: Muhdin Z Secret Training Institute 1 Contents Section I: Review of the Cardinal Utility Approach  Concepts of Utility and Marginal Utility  The Law of Diminishing Marginal Utility  Assumptions of Cardinal Utility  Consumer’s Optimum  Derivation of the Demand Curve Section II: The Ordinal Utility Theory and Preferences  Indifference Curve, Set and Map  Properties of Indifference Curves  The Marginal Rate of Substitution (MRS)  Special Types of Indifference Curves Section III: The Budget Line or the Price line  Concepts of Budget line  Slope of the Budget Line  Factors Affecting the Budget Line Section IV: Optimum of the Consumer  Consumer’s optimum  Effects of Changes in Income and Prices on Consumer’s Equilibrium 2 1  11/3/2024 Review of the Cardinal Utility Approach By: Muhdin Z Secret Training Institute 3 Concepts of Utility and Marginal Utility Cardinal utility theory is based on measurement of utility or satisfaction in absolute numbers.  Utility refers to “the level of satisfaction or happiness that consumers get from the consumption of goods and services.”  It is “the power of a commodity or a service to satisfy a human want or a want satisfying power of a commodity or service. “  Marginal utility “is the additional satisfaction that a consumer gets because of changing consumption by one unit.”  It is “an extra utility due to a change in consumption.” By: Muhdin Z secret Training Institute 4 2  11/3/2024 Law of Diminishing Marginal Utility The law of diminishing marginal utility explains an ordinary experience of a consumer. The law of diminishing marginal utility says that “as the amount of a good consumed increases, the marginal utility of the good decreases.” Thus, according to this law, the marginal utility decreases with the increase in the consumption of a commodity. By: Muhdin Z secret Training Institute 5 Assumptions of Cardinal Utility Analysis  Rationality of Consumers: The main objective of the consumer is to maximize his/her satisfaction given his/her limited budget or income.  Utility is cardinally Measurable: the utility or satisfaction of each commodity is measurable. – The unit of measurement is called “utils”.  Constant Marginal Utility of Money: Money is the most convenient measurement of utility.  Limited Income: The consumer has limited money income to spend on the goods and services he/she chooses to consume.  Diminishing Marginal Utility (DMU): The utility derived from each successive units of a commodity diminishes.  The total utility of a basket of goods depends on the quantities of the individual commodities: TU=f (Q) By: Muhdin Z secret Training Institute 6 3  11/3/2024 Consumer’s Optimum  A consumer reaches his/her optimum position “when he/ she maximizes his total utility, given his income and prices of commodities he/she consumes.” In a single commodity case: optimum occurs when the MU of commodity X is equal to its market price. MUx = Px In multiple commodities case: optimum occurs when marginal utility of one commodity divided by its market price is equal to the marginal utility of the other commodity divided by its market price i.e. MUx MUy  Px Py By: Muhdin Z secret Training Institute 7 Derivation of the Demand Curve  The demand curve is derived from  Consumer optimum.  The concept of DMU.  As the price changes, the consumer's optimum will also change.  By connecting these points, we create a downward-sloping curve.  This curve represents the “relationship between the price and the quantity demanded” and  It is known as the “demand curve”.  The demand curve for a commodity is the same as the positive segment of the marginal utility curve. 8 4  11/3/2024 The Ordinal Utility Theory and Preferences By: Muhdin Z Secret Training Institute 9  The ordinal utility approach argues that utility cannot be measured in cardinal numbers as suggested by the cardinalist approach.  The consumers are expected to rank different consumption bundles according to his/her preferences.  Consumers rank commodities in the order of their preference as 1st, 2nd, 3rd and so on.  Preference is simply “the ability of the consumer to state or express choices given alternatives.”  Preference relations shows order in which bundles are preferred. By: Muhdin Z secret Training Institute10 5  11/3/2024  If a consumer faces two consumption bundles, say, X and Y, preference relations are illustrated via o Strict preference  so x > y means that bundle x is preferred strictly to bundle y. o Indifferent preference  x ~ y means x and y are equally preferred. o Weak preference  x > y means x is preferred at least as much as is y.  Preference relations are related themselves: they are not independent. o x > y and y > x imply x ~ y. o x > y and (not y > x) imply x > y. 11 Assumptions of Ordinal Utility Theory  The consumers are rational: the goal of the consumers is maximization of their satisfaction or utility given their limited income and market prices.  Ordinal measurement of utility: utility is not absolutely (cardinally) measurable.  This is because consumers are required only to order or rank their preference for various bundles of commodities.  Diminishing marginal rate of substitution (MRS): the marginal rate of substitution is the rate at which a consumer is willing to substitute one commodity (x) for another commodity (y) without affecting the total satisfaction of the consumer.  MRS is the slope of the indifference curve.  Complete ordering: all possible combinations of goods can be ordered into preferred, indifferent or inferior combinations when compared to a given combination of the goods. 12 6  11/3/2024  The total utility (U) of the consumer depends on the quantities of the commodities consumed, i.e. 1 2 3 ( , , , , ): U=f(Xn).  Preferences are transitive or consistent:  Transitive preference: if the consumer prefers market basket X to market basket Y, and prefers Y to Z, and then he/she must also prefer X to Z.  Consistency of preference: if market basket X is preferred to market basket Y (X>Y) then, Y cannot be preferred to X at another time (Y not >X) for the same consumer.  Limited money income: the consumer is confronted with limited money income so that optimization is mandatory.  This assumption is used to show the scarcity concept in economics.  Non – satiation assumption: consumers always prefer more of a good to less and they are never satisfied or satiated.  For example, if they are confronted with any two consumption bundles A and B, A is preferred to B if A contains at least more of one commodity. By: Muhdin Z secret Training Institute13 Indifference Curve, Set and Map  The ordinal utility approach is based on two important tools or instruments. o Indifference curve o Budget line  An indifference curve (IC) is a concept used to represent an ordinal measure of the tastes and preferences of the consumer.  The ordinal utility theory is also known as “indifference curve analysis”, since it uses ICs to study the consumer’s behavior.  There are three interrelated terminologies which are linked with concept of indifference: the indifference schedule (set), curve and map. 7  11/3/2024  Indifference set (schedule): It is a tabular presentation of the various combinations of goods from which the consumer derives the same level of utility. The consumer is indifferent to choose among the bundles.  Indifference Curve:  It is a line that shows various combinations of two goods.  The combinations provide the consumer with the same level of utility or satisfaction.  The consumer is indifferent between the combinations.  As a result, an indifference curve is an iso-utility curve.  Indifference Map:  It is a set or a collection of indifference curves.  Different curves represent different levels of satisfactions.  It shows the tastes and preferences of the consumer. By: Muhdin Z secret Training Institute 8  11/3/2024 Properties of Indifference Curves  Indifference curves have a negative slope.  The consumption level of one commodity can be increased only by reducing the consumption level of another commodity for a movement along an ICs.  Indifference curves do not intersect each other:  When ICs intersect, the transitivity rule is violated.  Intersection leads to contradiction.  A higher indifference curve are preferred by the rational consumer to lower one.  It contains more of the commodities than the lower ones.  Indifference curves are convex to the origin. o It implies that the commodities are not perfect substitutes. o It also reflects the concept of diminishing MRS. By: Muhdin Z secret Training Institute 9  11/3/2024 Marginal Rate of Substitution  Marginal rate of substitution of X for Y is defined as “the number of units of commodity Y that must be given up in exchange for an extra unit of commodity of X so that the consumer maintains the same level of satisfaction.”  It is the rate at which one commodity can be substituted for another while keeping the level of satisfaction the same.  MRS reflects a movement along the same indifference curve.  The MRS decreases as we move downwards to the right.  The diminishing slope of an indifference curve is the main reason why we have a convex IC in the standard case. Marginal Rate of Substitution and Marginal Utility  Marginal rate of substitution (MRS) is defined as the negative of the marginal utilities ratios. Hence, the MRSxy is related to the MUx and the MUy MU X MRS X ,Y  MU Y  MRS is negative, because of the law of substitution which implies that the consumption of commodity increase at the expense of another commodity. By: Muhdin Z secret Training Institute 10  11/3/2024 Special Types of Indifference Curves  So far, we have seen the shape of “standard indifference curve” which is downward sloping and convex to the origin.  In this situation, the two commodities such as X and Y can substitute one another to a certain extent but are not perfect substitutes.  There is imperfect substitutability between the two commodities.  However, the shape of the indifference curve depends on “how they value different goods relative to each other”: perfect substitutes, perfect complements, close substitution. By: Muhdin Z secret Training Institute Perfect Substitutes  The utility function is given  These “are goods which can be as substituted for one another at a U(X, Y) = aX + bY constant rate.” o The two goods are essentially the same. o The indifference curve becomes a straight line but has a negative slope o MRS (Slope) for perfect substitutes is constant.  A simple example a blue pen and a black pen  That the rate of exchange can be 1:1, 2:1 or 2:3 or another number. 11  11/3/2024 Perfect Complements  The utility function is  These are goods which are to be given as consumed always jointly at a U(X, Y) = Min (aX ,bY) constant rate.  Example: a consumer wears a left shoe with a right shoe.  The combination is 1:1.  In this case the indifference curve becomes L-shaped (shape of a right angle)  The vertex of the IC represents the right combination.  The preference is determined by the number of pairs.  If you have 5 left shoes and 3 right shoes, your utility will only be 3, as you can only form 3 pairs  The further indifference curve, the higher is the utility that it denotes. of shoes. The Budget Line or Price Line By: Muhdin Z Secret Training Institute 24 12  11/3/2024  The indifference curves show  This constraint is often the rate at which the consumer presented with the help of the is willing to substitute one good budget line. for another, utility remaining the same.  A budget line is “a line or a graph which indicates different  Unfortunately, Indifference combinations of two goods curves only tell us the that a consumer can buy with consumer’s preference for any a given income at a given two goods; they cannot tell us prices.” which combination of the two  In other words, the budget line goods will be chosen or bought. “shows that the basket of goods that consumers can  The consumer’s decision is purchase, given their income restricted by his/her income and and prevailing market prices.” price of the two commodities.  Together with an indifference  Therefore, in addition to curve, a budget line is required consumer preferences, we need to to derive consumer optimum. know the consumer’s income and price of the goods.  Assumptions to Draw a Budget Line 1. There are only two goods, X and Y, bought in quantities X and Y. 2. Each consumer is confronted with M/PY market determined prices, Px and Py, of good X and good Y B respectively. 3. The consumer has a known and A fixed money income (M). 4. A change in price, income leads to change in position of budget line. M/PX  If the consumer spends all his/her income on two goods (X and Y), we can express the budget constraint as: 13  11/3/2024 Rearrange the equation Budget constraint is PxX + PyY = M. M  P X X  PY Y Y M  XP X  YP Y Vertical Intercept (Y-intercept), when X=0. M P M /py Y   X X PY PY Not affordable: IE X  The slope of a budget line is given by as the negative of the ratio of the prices of the two goods.  It is defined as a ratio of the price of the good on the x-axis to the price of the good on the y-axis. 27 Factors Affecting the Budget Line  The budget line depends on the price of the two goods and the income of the consumer.  Any change in the price of the goods or the income of the consumer results in a shift or rotation in the budget line.  These are changes o in the slope, o the X-intercept, o and the Y-intercept By: Muhdin Z secret Training Institute 14  11/3/2024 Effects of Changes in Income  Increase in income causes an upward shift of the budget line allowing a consumer to buy more goods and services.  A decrease in income leads to a downward shift of the budget line that leads the consumer to buy less of the two goods.  There will be new X and Y intercepts with the new income.  In this regard, the slope of the budget line (the ratio of the two prices) does not change when income rises or falls.  When price of Y decrease, keeping price of X and Income Effects of Changes in of the consumer constant, the Price of the Commodities budget line rotates outward.  Changes in the prices of good X or good Y causes a rotation in the position of the budget lines.  When price of X increase, keeping price of Y and Income of the consumer constant, the Budget line rotates in ward. By: Muhdin Z secret Training Institute 15  11/3/2024 What would happen if price of What would happen if price of X falls, while the price of good X rises, while the price of good Y and income remain constant? Y and income remain constant? By: Muhdin Z secret Training Institute Optimum of the Consumer By: Muhdin Z Secret Training Institute 32 16  11/3/2024  Consumers seek to maximize utility or satisfaction by spending their income on goods and services.  The indifference curves reflect preferences of a consumer  The budget line specifies the different combinations of X and Y which the consumer can purchase with the limited income.  Therefore, the consumer tries to obtain the highest possible satisfaction within his/her limited budget or money income.  This occurs where an indifference curve is at a tangent to the budget line  which implies that the slope of the indifference curve (MRSX,Y) is equal to the slope of the budget line (PX /PY ). By: Muhdin Z secret Training Institute  Hence, Consumer’s Optimum  The Indifference curves above the region of the MRS XY  PX / PY budget line are beyond the reach of the consumer and But also: IC is convex are irrelevant for Y equilibrium consideration. A More preferred  Point A and B o Are attainable but bundles represent lower level of G utility. E  At point ‘G’ o beyond the reach of the consumer or are Affordable unattainable with the bundles B existing income and price of the goods. X  Point ‘E’ is the preferred position by the consumer 34 17  11/3/2024 Effects of Changes in Income and Prices on Consumer’s Equilibrium  Changes in income and prices of the two goods are the main factors that cause a change in the position of the budget line, and hence consumer’s optimum position. Change in Income  An increase in the consumer’s income (all other things held constant) results in an upward parallel shift of the budget line.  Following the shifts in the budget line outward, the consumer will be able to meet the higher ICs which was not previously achievable.  This creates a new equilibrium position.  A further increase in income shifts the budget line outward  Hence, another equilibrium position will be achieved and so on.  If we connect all the points representing equilibrium points, the resulting curve is called the income consumption Curve (ICC). By: Muhdin Z secret Training Institute 18  11/3/2024  ICC may take various shapes based on whether a commodity is a normal or inferior good.  ICC is  Upward sloping for normal goods (since QD and Income changes in the same direction)  Downward sloping for inferior goods (since QD and Income changes in opposite direction).  From the ICC we can derive the Engle Curve.  The Engle Curve shows the relationship between the equilibrium quantity purchased of a good and the level of income.  It shows the equilibrium (utility maximizing) quantities of a commodity, which a consumer will purchase at various levels of income (celeries paribus). A. Normal good Both ICC and Engel curve are upward sloping Y Income ICC Engel I3 curve I2 I1 X1 X2 X3 X X1 X2 X3 X 19  11/3/2024 B. Inferior good Both ICC and Engel curves are downward sloping Y I ICC Engel curve I1 I2 I3 X1 X2 X3 X X 3X 2X 1 X Change in Price  A change in price of one or both of the goods changes the position of the budget line and hence, affects consumer optimum.  This process leads to a new curve called the “price consumption curve”  The price-consumption curve is the “locus of the utility-maximizing combinations of products that result from variations in the price of one commodity” say X.  When looking PCC of X, things we assume remaining constant are:  Prices of other product  Income of consumers  Other factors 20  11/3/2024  We can derive the demand curve of an individual for a commodity from the price consumption curve.  Demand shows an inverse relationship between price of a good and quantity demanded at equilibrium.  The demand for an individual consumer is derived from the utility maximization points. End of Unit One 42 21