Theory of consumer behavior  cardinal approach
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Theory of consumer behavior cardinal approach

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Micro Economics

Micro Economics

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Theory of consumer behavior  cardinal approach Theory of consumer behavior cardinal approach Presentation Transcript

  • Theory of Consumer behavior How Consumers Make Choices under Income Constraints
  • Some Questions • What is behind a consumer’s demand curve? • How do consumers choose from among various consumer “goods”? • What determines the value of a consumer good?
  • Utility • The value a consumer places on a unit of a good or service depends on the pleasure or satisfaction he or she expects to derive form having or consuming it at the point of making a consumption (consumer) choice. • In economics the satisfaction or pleasure consumers derive from the consumption of consumer goods is called “utility”. • Consumers, however, cannot have every thing they wish to have. Consumers’ choices are constrained by their incomes. • Within the limits of their incomes, consumers make their consumption choices by evaluating and comparing consumer goods with regard to their “utilities.”
  • Our basic assumptions about a “rational” consumer: • Consumers are utility maximizers • Consumers prefer more of a good (thing) to less of it. • Facing choices X and Y, a consumer would either prefer X to Y or Y to X, or would be indifferent between them. • Transitivity: If a consumer prefers X to Y and Y to Z, we conclude he/she prefers X to Z • Diminishing marginal utility: As more and more of good is consumed by a consumer, ceteris paribus, beyond a certain point the utility of each additional unit starts to fall.
  • How to Measure Utility Measuring utility in “utils” (Cardinal): • Jack derives 10 utils from having one slice of pizza but only 5 utils from having a burger. Measuring utility by comparison (Ordinal): • Jill prefers a burger to a slice of pizza and a slice of pizza to a hotdog. Often consumers are able to be more precise in expressing their preferences. For example, we could say: • Jill is willing to trade a burger for four hotdogs but she will give up only two hotdogs for a slice of pizza. • We can infer that to Jill, a burger has twice as much utility as a slice of pizza, and a slice of pizza has twice as much utility as a hotdog.
  • Utility and Money • Because we use money (rather than hotdogs!) in just about all of our trade transactions, we might as well use it as our comparative measure of utility. (Note: This way of measuring utility is not much different from measuring utility in utils) • Jill could say: I am willing to pay $4 for a burger, $2 for a slice of pizza and $1 for a hotdog. Note: Even though Jill obviously values a burger more (four times as much) than a hot dog, she may still choose to buy a hotdog, even if she has enough money to buy a burger, or a slice of pizza, for that matter. (We will see why and how shortly.)
  • Cardinal Utility analysis and Ordinal Utility Analysis Utility Analysis Cardinal Utility analysis • Alfred Marshal • can be measured(Utils) • Law of Diminishing Ordinal Utility Analysis • J. R. Hicks & R.G.D. Allen Marginal Utility •Cannot be measured but •Quantitative compared •Law of Equi-marginal • Indifference Curve Utility •Marshellian Analysis analysis as rank
  • Total Utility versus Marginal Utility • Marginal utility is the utility a consumer derives from the last unit of a consumer good she or he consumes (during a given consumption period), ceteris paribus. MUn = TUn – TUn-1 MU =∆TU/∆Q • Total utility is the total utility a consumer derives from the consumption of all of the units of a good or a combination of goods over a given consumption period, ceteris paribus. Total utility = Sum of marginal utilities
  • Example of Total and Marginal Utility Unit of Mango Total Utility Marginal Utility 1 10 10 2 20 10 3 29 9 4 37 8 5 43 6 6 48 5 7 51 3 8 52 1 9 52 0 10 50 -2
  • Cardinal Utility Analysis a) Assumptions of Cardinal Utility analysis b) Law of Diminishing Marginal Utility c) Law of Equal-Marginal Utility
  • Assumptions of Cardinal Utility analysis 1. Rationality of consumer-seeks maximisation of total utility from what he buys. 2. Cardinal measurability of utility 3. Marginal Utility of Money is constant at all levels of income of the consumer. 4. Diminishing Marginal Utility 5. Utility is Additive – TU= Ux+ Uy+ Uz+…….+ Un 6. The hypothesis of Independent Utility- Utility of each commodity is experienced independently in a group of commodities. 7. Introspective method – basis his own experience, economists drew inferences about the behavior of other consumers.
  • Law of Diminishing Marginal Utility According to Alfred Marshall ‘the additional utility which a person derives from the consumption of a commodity diminishes, that is Total Utility increases at an diminishing rate ‘
  • The Law of Diminishing Marginal Utility • Over a given consumption period, the more of a good a consumer has, or has consumed, the less marginal utility an additional unit contributes to his or her overall satisfaction (total utility). • Alternatively, we could say: over a given consumption period, as more and more of a good is consumed by a consumer, beyond a certain point, the marginal utility of additional units begins to fall.
  • Example - Law of Diminishing Marginal Utility Unit of Mango Marginal Utility 1 10 10 2 MUn = TUn – TUn-1 MU =∆TU/∆Q Total Utility 20 10 3 29 9 4 37 8 5 43 6 6 48 5 7 51 3 8 52 1 9 52 0
  • Marginal Utility MU MU Q
  • Shape of MU • Eventually downward sloping • Law of diminishing marginal utility • Positive always • Rational behavior • Consumer only purchases a good if they get some positive utility from it.
  • Total Utility TU TU ∆Q ∆TU ∆TU ∆Q Q
  • Shape of TU • Positive slope • Consumer only purchases a good if gets some positive amount of utility (rational behavior) • Slope gets flatter as Q increases • Law of diminishing marginal utility
  • Law of Diminishing Marginal Utility the additional utility which a person derives from the consumption a commodity diminishes, that is Total Utility Unit of Mango Total Utility Margin increases at a diminishing rate ‘ al Utility 1 10 10 2 20 10 3 29 9 4 37 8 5 43 6 6 48 5 7 51 3 8 52 1 9 52 0 10 50 TU -2 T U No of mango MU No of mango M
  • Law of Diminishing Marginal Utility Saturation Point MU =0 or TU is maximum T U TU No of mango MU No of mango M
  • Law of Diminishing Marginal utility • According to the law, the consumer tries to equalize MU of a commodity with its price so that his satisfaction is maximized and he will reach equilibrium point. MUx=Px • When P falls, MU > than P-----No equilibrium , no max of TU. • Hence he’ll decrease MU till = reduced Price. • Increase in stock MU decreases. Consumer buys more when P falls.
  • Law of Equal-Marginal Utility • The total utility gained from a given budget will be maximized where the budget is all spent and marginal utility per dollar spent is equalized across all goods • Rule for a utility maximum: MUx/Px = MUy/Py or MUx/MUy = Px/Py
  • Utility Maximization under An Income constraint • Consumers’ spending on consumer goods is constrained by their incomes: Income = Px Qx + Py Qy + Pw Ow + ….+Pz Qz • While the consumer tries to equalize MUx/Px , MUy/ Py, MUw/Pw,………. and MUz/Pz , to maximize her utility her total spending cannot exceed her income.
  • Optimal Purchase Mix: Ice Cream and Hamburger Q 1 2 3 4 5 6 7 8 MUI 40 45 35 20 10 7 3 0 PI 10 10 10 10 10 10 10 10 MUI/PI MUH PH MUH/PH 4 45 6 7.5 4.5 30 6 5 3.5 20 6 3.3 2 15 6 2.5 1 10 6 1.7 0.7 6 6 1 0.3 3 6 0.5 0 0 6 0
  • Consumer’s Equilibrium under Marshellian analysis Explains how consumer maximizes his satisfaction by allocating his income to different commodities at different prices. • Condition for consumer equilibrium- two commodities MUx /Px = MUy /Py = MU m • Condition for consumer equilibrium –more than two commodities MUx /Px = MUy /Py = ……………………. MUn/P n = MU m
  • Consumer Equilibrium • For instance, I would much rather have a Jaguar instead of my Honda • If I want to maximize my utility, why don’t I buy a Jaguar? – Because it costs a lot more than the Honda • So if I want to maximize my utility, I don’t just pick the thing that gives me the most pleasure. I have to weigh the price of the good in my decision as well
  • Consumer Equilibrium So how can I compare a Jaguar and a Honda? It’s like comparing apples and oranges. Instead, I need to somehow make them both comparable.
  • Consumer Equilbrium In order to do that I will need to convert utility to utility per dollar. This way, I can see that even though the Jag gives me more utility, I get more utility per dollar from the Honda. So if I want to spend my money wisely, I buy the thing that gives me more utility per dollar.
  • Consumer Equilibrium • Let’s say I walk down to the cafeteria for lunch and they have Pizza and Ice Cream. • The pizza is $1 a slice and the Ice Cream is $2 a scoop. I have $7 in my pocket What do I buy?
  • Consumer Equilibrium • Remember, I want to choose the combination of pizza and Ice Cream that gives me the greatest possible utility for my $7 • Consider the following table, which states the total utility I get from all possible quantities of Pizza and Ice Cream
  • Utility Table Ice Cream Pizza Quantity Total Util. Marginal Util. Total Util.Marginal Util. 0 0 -- 0 1 24 29 2 44 46 3 60 56 4 70 58 5 72 59 6 72 59 --
  • Utility Table Ice Cream Pizza Quantity Total Util. Marginal Util. Total Util.Marginal Util. 0 0 -- 0 -- 1 24 24 29 29 2 44 20 46 17 3 60 16 56 10 4 70 10 58 2 5 72 2 59 1 6 72 0 59 0
  • Consumer Equilibrium • We need to find the marginal utility per dollar for both goods. • Consider the first scoop of ice cream - MU 12 per dollar. MU of the first slice of pizza 29 per dollar. So I want to buy the pizza. Now I have $6. • Now I have to compare my second slice of pizza (MU is 17 /$) with the first scoop of ice cream (MU is 12 /$). I will want to buy the second slice of pizza. I have $5.
  • Consumer Equilibrium • Now I have to compare the third slice o pizza (MU 10/$) with the first scoop of ice cream (MU 12/$). I will want to buy the ice cream. I have $3. • Now I have to compare the third slice of pizza (MU 10 /$) with the second scoop of ice cream (MU 10 / $). It doesn’t matter which I pick, since they make me equally happy. I’ll take the pizza. Now I have $2
  • Consumer Equilbrium • Now I have to compare the fourth slice of pizza (MU is 2/$) to the second scoop of ice cream (MU is 10 /$). I will want to buy the ice cream. I have no more money. • I bought 3 slices of pizza which give a total utility of 56 and 2 scoops of ice cream which give a total utility of 44. My total utility from lunch is 56+44=100. There is no other combination of pizza and ice cream that give a greater utility for $7.
  • Consumer Equilbrium • What if the price of the ice cream dropped to $1 a scoop. • Assignment: Convince yourself that I will buy 4 scoops of ice cream and 4 slices of pizza. • Note that when the price went down, I bought more - THIS IS WHERE THE LAW OF DEMAND COMES FROM.
  • Consumer Equilibrium • In summary, you need to convert marginal utility to marginal utility per dollar • Then compare MU/P for the two goods and buy the one that gives the greatest MU/P • Subtract the price from your budget • Compare the next available units of both goods and repeat the process until you are out of money.
  • Law of Equal-Marginal Utility Consumer’s Equilibrium under Marshellian analysis Condition for consumer equilibrium MUx /Px = MUy /Py =MUm MUA Apple (A) 1 60 2 48 3 42 4 36 5 30 6 24 7 18 Price of A = 3 MU/PA 20 16 14 12 10 8 6 MUB MU/PB Banana (B) 1 60 12 2 55 11 3 50 10 4 45 9 5 40 8 6 35 7 7 20 4 Price of B =5 MU of Money = 10 Expenditure = 5x Price of A + 3 X Price B =5x3+ 3X5=
  • Consumer Surplus • Consumer Surplus - the difference between the price buyers pay for a good and the maximum amount they would have paid for the good. • Example: • I’m willing to pay $6 for a case of soda • Soda is on sale for $5 a case • Consumer surplus = $1
  • Consumer Surplus This is the Consumer Surplus for the second case of soda P $9 S $7 $5 0 D 1 2 3 Q
  • Consumer Surplus Here is the generally accepted method of finding the total Consumer Surplus in a market
  • Consumer Surplus P The area of this triangle is the total Consumer Surplus S P* 0 D Q* Q
  • An Optimal Change Recall that to maximize utility a consumer would set: (MUx/Px) = (MUy/Py) If Px increases this equality would be disturbed: (MUx/Px) < (MUy/Py) To return to equality the consumer must adjust his/her consumption. (Have in mind that the consumer cannot change prices, and he/she has an income constraint.) What are the consumer’s options?
  • (MUx/Px) < (MUy/Py) In order to make the two sides of the above inequality equal again, given that Px and Py could not be changed, we would have to increase MUx and decrease MUy. Recalling the law of diminishing marginal utility, we can increase MUx by reducing X and decrease MUy by increasing Y.
  • How a Price Change Affects Consumer Optimum • The Substitution Effect – The tendency of people to substitute cheaper commodities for more expensive commodities 45
  • How a Price Change Affects Consumer Optimum • The Principle of Substitution – Consumers and producers shift away from goods and resources that become priced relatively higher in favor of goods and resources that are now priced relatively lower. Chapter 21 - Consumer Choice 46
  • How a Price Change Affects Consumer Optimum • Purchasing Power – The value of money for buying goods and services 47
  • How a Price Change Affects Consumer Optimum • Real-Income Effect – The change in people’s purchasing power that occurs when, other things being constant, the price of one good that they purchase changes – When that price goes up (down), real income, or purchasing power, falls (increases). 48
  • Critical evaluation of Cardinal Utility analysis • Utility is not Cardinally measurable • Marginal Utility of money is not constant • Inadequacy of methods of introspection • Utilities are interdependent. • Failure to explain Giffen Paradox • Failure to distinguish income effect and substitution effect