Micro Economics

1. Theory of Consumer
behavior
How Consumers Make Choices
under Income Constraints

2. 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?

3. 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.”

4. 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.

5. 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.

6. 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.)

7. 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

8. 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

9. 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

10. Cardinal Utility Analysis
a) Assumptions of Cardinal Utility analysis
b) Law of Diminishing Marginal Utility
c) Law of Equal-Marginal Utility

11. 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.

12. 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 ‘

13. 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.

14. 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

15. Marginal Utility
MU
MU
Q

16. 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.

17. Total Utility
TU
TU
∆Q
∆TU
∆TU
∆Q
Q

18. 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

19. 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

20. Law of Diminishing Marginal Utility
Saturation Point MU =0 or TU
is maximum
T
U
TU
No of mango
MU
No of mango
M

21. 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.

22. 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

23. 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.

24. 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

25. 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

26. 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

27. 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.

28. 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.

29. 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?

30. 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

31. 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
--

32. 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

33. 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.

34. 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

35. 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.

36. 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.

37. 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.

38. 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=

39. 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

40. Consumer Surplus
This is the Consumer
Surplus for the
second case of soda
P
$9
S
$7
$5
0
D
1
2
3
Q

41. Consumer Surplus
Here is the generally
accepted method of finding the
total Consumer Surplus in
a market

42. Consumer Surplus
P
The area of this
triangle is the total
Consumer Surplus
S
P*
0
D
Q*
Q

43. 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?

44. (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.

45. How a Price Change Affects
Consumer Optimum
• The Substitution Effect
– The tendency of people to substitute cheaper
commodities for more expensive commodities
45

46. 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

47. How a Price Change Affects
Consumer Optimum
• Purchasing Power
– The value of money for buying goods
and services
47

48. 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

49. 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