In This Lecture…
 Concepts of Utility:
Cardinal and Ordinal
 Law of Diminishing
Marginal Utility
 Indifference Curve (I...
In This Lecture…
 Consumer’s Equilibrium :
Budget Line and IC Curve
Analysis, Price Effect,
Income Effect, Substitution
E...
Utility Theory
 Utility is the want satisfying power of a good.
 There are two approach in this theory.
- Cardinal Utili...
No Interpersonal Utility
Comparison
Caution: The utility obtained by one
person cannot be scientifically or
objectively co...
Total Utility
 Total utility is the total satisfaction a
person receives from consuming a
particular quantity of a good.
...
Law of Diminishing
Marginal Utility
 As you consume more and more of a same
commodity at a point of time the marginal
uti...
TU and MU
TU and MU Schedule
Quantity of X

MUx

TUx

0

-

0

1

8

8

2

6

14

3

4

18

4

2

20

5

0

20

6

-2

18...
Contd..
•Graphical Presentation:TUx
TUx

O
MUx

Quantity

MUx=0
O
MUx

Quantity
TU and MU
 TU curve starts from the origin, reaches a
maximum point and starts declining.
 When TU is maximum, called sa...
Consumer’s Equilibrium
The consumer is in equilibrium when he
maximizes his level of satisfaction with
given income and ma...
Rationality
A rational consumer is the one who wants
to get maximum satisfaction out of his
given income.
Cardinal Utility
Utility can be cardinally measured, i.e. can
be expressed in exact units.
Utility is measurable in moneta...
Independent Utility
The utility that the consumer derives from
a commodity depends upon the quantity
of that very commodit...
MU of Money is Constant
It means that importance of money
remains unchanged.
MU of money is addition made to utility
of co...
Consumer’s Equilibrium – One
Commodity Case
 When a consumer buys a commodity he
pays a price for it. For each unit he ma...
Consumer’s Equilibrium – One
Commodity Case
 A rational consumer will be in equilibrium when
he consumes that quantity at...
Consumer’s Equilibrium – One
Commodity Case
Geometrically,
Price, Utility
CONSUMER’S EQULIBRIUM

10

E

MUx = Px (MUm)
MUx...
Consumer’s Equilibrium – One
Commodity Case
 If the consumer consumes more than
equilibrium point, then the utility value...
Consumer’s Equilibrium – Two
Commodity Case
 In reality consumer spends his income on
many goods.
 A rational consumer w...
Consumer’s Equilibrium – Two
Commodity Case - contd.
 Suppose a consumer spends on two goods
X and Y. Then he will be in ...
Consumer Equilibrium – Multiple
Commodity Case
 The analysis is based on the assumption that
individuals seek to maximize...
Ordinal Utility Theory
 Modern school does not believe that utility can
be measured using an absolute/ quantitative
scale...
Ordinal Utility Theory –
Indifference Curve Analysis
 It is consumer’s scale of preference that the
consumer determines h...
IC Curve – Schedule
Combinations

Apples

Oranges

A
B
C
D

1
2
3
4

10
7
5
4

 Satisfaction level at A = Satisfaction le...
IC Curve – Diagrammatic
Representation
Oranges
10
8
6
4
IC Curve
2

0

1

2

3

4

Apples
IC Curve Map
 A set of family of IC
curves is called IC Curve
Map.
 Higher the IC curve from
the origin the higher will
...
Indifference Curve AnalysisAssumptions
 Rationality : Consumers are assumed to be
rational and aims at maximizing his
ben...
Indifference Curve Analysis –
Assumptions Contd.
 Consistancy of Choice : If consumer prefers
good X over good Y in one t...
What is diminishing MRS?
 MRS shows how much of one commodity is substituted
for how much of another.


Combinations

Ap...
What is diminishing MRS? Contd.
 As more and more of good Y is substituted for X MRS
starts to diminishes because X and Y...
IC Curve - Characteristics
 Downward Sloping to the right : It is
because when the consumer decides to
have more of one g...
IC Curve - Characteristics
 IC curves never intersect each other.
A

B
C

Here, level of satisfaction at A = B and A = C ...
Budget Line
 A rational consumer would always like to be on
the highest IC curve signifying highest level of
satisfaction...
Budget Line – Diagrammatic
Representation with example
 Suppose the income of a consumer is $60,
price of apples is $2 pe...
Budget Line – Diagrammatic
Representation with example Contd.
Good Y

60
50

Budget Line or Price Line

40
30
20
10
0
10

...
Shifting of Budget Line
Good Y
A’

Good Y
A

A

O

B

B’

Good X

Budget line when money income increases
prices remaining...
Consumer’s Equilibrium
 All bundles of goods are available to the
consumer in the sense that he can buy them if he
can. T...
Consumer’s Equilibrium
Good Y

60

Equilibrium Point

50
40

Q

IC4

30

IC3

20

IC2

10

0

IC1
10

20

30

Good X

Give...
Income Effect on Equilibrium
Good Y
S
P

ICC (Income Consumption Curve)

B
A

IC2
IC1

O

Q

R

Good X

With a rise in the...
Price Effect on Equilibrium
 The consumer will either be better off or
worse off depending on the change in
price of a go...
Price Effect on Equilibrium
Good Y

PCC (Price Consumption Curve)

P
C

IC3

B
IC2
A
O

IC1
Q

R

S Good X

With a fall in...
Price Effect on Equilibrium
Good Y

PCC (Price Consumption Curve)

P
C
B

IC3
IC2

A
O

IC1
Q

R

S Good X

If PPC curve i...
Price Effect on Equilibrium
Good Y

IC1

PCC (Price Consumption Curve)
IC2

P
IC3

B

C

A
O

Q

R

S Good X

If PPC curve...
Price Effect on Equilibrium
Good Y

IC1

PCC (Price Consumption Curve)
IC2

P
IC3
C
B
A
O

Q

R

If PPC curve is horizonta...
Price Effect and Substitution
Effect and Income Effect
A change in the price of a commodity leads to
a change in the relat...
Substitution Effect
It is a change in quantity demanded
resulting from a change in relative
price while retaining the same...
Substitution Effect on
Equilibrium
R
Good Y
A
P
C

O

B
T

IC1
S

IC2
Q Good X

With a fall in the price of X consumer can...
Substitution Effect on
Equilibrium
R
Good Y

Income Consumption Curve (ICC)
A

Price Consumption Curve (PCC)

P
C

O

B
T
...
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  1. 1. In This Lecture…  Concepts of Utility: Cardinal and Ordinal  Law of Diminishing Marginal Utility  Indifference Curve (IC) Analysis : Concept, Properties, MRS
  2. 2. In This Lecture…  Consumer’s Equilibrium : Budget Line and IC Curve Analysis, Price Effect, Income Effect, Substitution Effect, Effects of changes in Income and Prices.
  3. 3. Utility Theory  Utility is the want satisfying power of a good.  There are two approach in this theory. - Cardinal Utility Theory - Ordinal Utility Theory  Cardinal Utility Theory : Classical school believes that utility can be measured using an absolute/ quantitative scale like the other physical characteristics – height and weight – and are comparable.  A util is an artificial construct used to measure utility.
  4. 4. No Interpersonal Utility Comparison Caution: The utility obtained by one person cannot be scientifically or objectively compared with the utility obtained from the same thing by another person because utility is subjective.
  5. 5. Total Utility  Total utility is the total satisfaction a person receives from consuming a particular quantity of a good. TUn = MU1 + MU2 + …….. + Mun  Marginal utility is the additional utility a person receives from consuming one extra unit of a particular good. MUn = TUn – TUn-1 or, MUx = Δ TUx ΔX
  6. 6. Law of Diminishing Marginal Utility  As you consume more and more of a same commodity at a point of time the marginal utility derived from each successive unit goes on declining assuming that the utility each unit of money paid as price of commodity is constant.  Law of DMU can be explained by the relationship between TU and MU.
  7. 7. TU and MU TU and MU Schedule Quantity of X MUx TUx 0 - 0 1 8 8 2 6 14 3 4 18 4 2 20 5 0 20 6 -2 18 7 -4 14 8 -6 8
  8. 8. Contd.. •Graphical Presentation:TUx TUx O MUx Quantity MUx=0 O MUx Quantity
  9. 9. TU and MU  TU curve starts from the origin, reaches a maximum point and starts declining.  When TU is maximum, called saturation point, MU is zero. Units of goods are consumed till saturation point.  When TU is rising, MU curve falls.  When TU is falling, MU curve becomes negative.  The falling MU curve exhibits the law of diminishing marginal utility.
  10. 10. Consumer’s Equilibrium The consumer is in equilibrium when he maximizes his level of satisfaction with given income and market price. Assumption : Rational Consumer  Cardinal Utility  Independent Utility  MU of money is constant
  11. 11. Rationality A rational consumer is the one who wants to get maximum satisfaction out of his given income.
  12. 12. Cardinal Utility Utility can be cardinally measured, i.e. can be expressed in exact units. Utility is measurable in monetary terms.
  13. 13. Independent Utility The utility that the consumer derives from a commodity depends upon the quantity of that very commodity alone and is not affected by the consumption of other goods.
  14. 14. MU of Money is Constant It means that importance of money remains unchanged. MU of money is addition made to utility of consumer as he spends one more unit of money income. This is assumed to be constant.
  15. 15. Consumer’s Equilibrium – One Commodity Case  When a consumer buys a commodity he pays a price for it. For each unit he makes a sacrifice in terms of price. In turn he gets utility from each unit. We know that the utility of each successive unit goes on diminishing as we consume more and more of it according to law of DMU with the assumption that that the utility each unit of money paid as price of commodity is constant.
  16. 16. Consumer’s Equilibrium – One Commodity Case  A rational consumer will be in equilibrium when he consumes that quantity at which utility value of money price is equal to marginal utility of the commodity.  Marginal Utility = Utility of Price of good Paid MUX = MUM X PX MUX = MUM PX
  17. 17. Consumer’s Equilibrium – One Commodity Case Geometrically, Price, Utility CONSUMER’S EQULIBRIUM 10 E MUx = Px (MUm) MUx O Here, MUm is constant and is equal to 10 utils. 9 Quantity
  18. 18. Consumer’s Equilibrium – One Commodity Case  If the consumer consumes more than equilibrium point, then the utility value of money price is higher than the marginal utility of the commodity and hence, consumer will be in disequilibrium.  If the consumer consumes less than equilibrium point, then the utility value of money price is lower than the marginal utility of the commodity and that there is the further scope of maximization of satisfaction/utility. Hence, consumer will be in disequilibrium.
  19. 19. Consumer’s Equilibrium – Two Commodity Case  In reality consumer spends his income on many goods.  A rational consumer will be in equilibrium when he consumes that quantity of Good X and Y at which utility value of money price is equal to marginal utility of the commodities.
  20. 20. Consumer’s Equilibrium – Two Commodity Case - contd.  Suppose a consumer spends on two goods X and Y. Then he will be in equilibrium when, MUX = MUM X PX ……………… (i) MUY = MUM X PY………………. (ii) Or, MUX / PX = MUM and MUY / PY = MUM Or, MUX / PX = MUY / PY = MUM This is subject to money income of the consumer being constant.
  21. 21. Consumer Equilibrium – Multiple Commodity Case  The analysis is based on the assumption that individuals seek to maximize utility.  Occurs when the consumer has spent all income and the marginal utilities per dollar spent on each good purchased are equal: where the letters A–Z represent all the goods a person buys.
  22. 22. Ordinal Utility Theory  Modern school does not believe that utility can be measured using an absolute/ quantitative scale like the other physical characteristics – height and weight – and are comparable.  All desires of a consumer are not of equal importance or urgency. Due to resources being scarce, the problem of choice arises and that a consumer cannot satisfy all his desires. So some desires take precedence over others. It is consumer’s scale of preference that determines his expenditure pattern.
  23. 23. Ordinal Utility Theory – Indifference Curve Analysis  It is consumer’s scale of preference that the consumer determines his expenditure pattern in such a way that maximizes his level of satisfaction. For this Indifference Curves or IC curves are drawn.  IC curve is the diagrammatic representation of a set of combinations of two commodities that offers a consumer same level of satisfaction and that he is indifferent between these combinations given his level of income and price of the commodities.  IC curve is also known as Iso-utility curve.
  24. 24. IC Curve – Schedule Combinations Apples Oranges A B C D 1 2 3 4 10 7 5 4  Satisfaction level at A = Satisfaction level at B = Satisfaction level at C = Satisfaction level at D
  25. 25. IC Curve – Diagrammatic Representation Oranges 10 8 6 4 IC Curve 2 0 1 2 3 4 Apples
  26. 26. IC Curve Map  A set of family of IC curves is called IC Curve Map.  Higher the IC curve from the origin the higher will be the level of satisfaction.  Level of satisfaction of F > Level of satisfaction of E > Level of satisfaction of A > Level of satisfaction of D > Level of satisfaction of C
  27. 27. Indifference Curve AnalysisAssumptions  Rationality : Consumers are assumed to be rational and aims at maximizing his benefits from consumption, given his income and price of good.  Ordinality : Utility is expected satisfaction that a consumer gets and is subjective in nature. He ranks utilities derived from the commodities and has a scale of preferance between different combination of two goods.
  28. 28. Indifference Curve Analysis – Assumptions Contd.  Consistancy of Choice : If consumer prefers good X over good Y in one time period, the consumer will not prefer Y over X in another in another time period.  Transitivity of Choice : If good X is preferred to good Y, and good Y is preferred to good Z, then good X is preferred to Z.  Convexity : IC curve is always convex to the origin due to diminishing marginal rate of substitution (MRS).
  29. 29. What is diminishing MRS?  MRS shows how much of one commodity is substituted for how much of another.  Combinations Apple A B C D Orange 1 2 3 4 10 7 5 4  For combination B 3 oranges are sacrificed for 1 apple and C, 2 for 1 and D, 1 for 1..  It can be observed that as the consumer consumes more and more of a same good he is prepared to forego less and less of other as his desire for the former becomes less and less intense with more and more of it.  Therefore, MRS of apple to orange fall as he has more of apple.
  30. 30. What is diminishing MRS? Contd.  As more and more of good Y is substituted for X MRS starts to diminishes because X and Y are imperfect substitutes to one another. Orange ΔY1/ ΔX1 > ΔY2 / ΔX2 > ………. > ΔYn/ ΔXn ΔY1 ΔX1 ΔY2 ΔX2 O Apple
  31. 31. IC Curve - Characteristics  Downward Sloping to the right : It is because when the consumer decides to have more of one good he will have to reduce the number of consumption of other good to remain on the same level of satisfaction / IC curve.  The further away the IC curve from the origin the higher the level of satisfaction and are preferred by the rational consumer.
  32. 32. IC Curve - Characteristics  IC curves never intersect each other. A B C Here, level of satisfaction at A = B and A = C . But B ≠ C  IC curves are always convex to the origin due to diminishing MRS.
  33. 33. Budget Line  A rational consumer would always like to be on the highest IC curve signifying highest level of satisfaction. But it is governed by the level of income of the consumer and prices of goods in the market.  Budget line is a line that shows the different possible combinations of two goods X and Y, which a consumer can buy given his budget and the prices of good X and Y.  Anywhere on the budget line a consumer is spending his entire income either on Good X or on Good Y or the combination of both X and Y.
  34. 34. Budget Line – Diagrammatic Representation with example  Suppose the income of a consumer is $60, price of apples is $2 per unit and oranges $1 per unit. Apples Oranges 0 10 20 30 60 40 20 0
  35. 35. Budget Line – Diagrammatic Representation with example Contd. Good Y 60 50 Budget Line or Price Line 40 30 20 10 0 10 20 30 Good X Consumer cannot go beyond Budget line as any point beyond it shows a non-attainable / nonfeasible combination.
  36. 36. Shifting of Budget Line Good Y A’ Good Y A A O B B’ Good X Budget line when money income increases prices remaining unchanged – that is why there is a parallel shift in budget line. O B’ B Good X Budget line when price of X increases price of Y and money income remaining unchanged
  37. 37. Consumer’s Equilibrium  All bundles of goods are available to the consumer in the sense that he can buy them if he can. The consumer’s IC map establishes a rank ordering of these bundles.  The consumer’s budget space is established by his fixed money income and relative commodity prices; it shows bundles he can purchase.  Rational consumer selects the most preferred bundle of goods in his budget space.
  38. 38. Consumer’s Equilibrium Good Y 60 Equilibrium Point 50 40 Q IC4 30 IC3 20 IC2 10 0 IC1 10 20 30 Good X Given the IC map consumer is in equilibrium when the budget line is tangent with the highest possible IC curve where he maximizes his level of satisfaction with his given income and the market prices.
  39. 39. Income Effect on Equilibrium Good Y S P ICC (Income Consumption Curve) B A IC2 IC1 O Q R Good X With a rise in the income of the consumer he attains a higher level of equilibrium from A to B. ICC traces the income effect. It shows how the changes in income of the consumer will affect the consumer’s purchases of good X and Y– price of X and Y, taste and income being constant
  40. 40. Price Effect on Equilibrium  The consumer will either be better off or worse off depending on the change in price of a good.  With a change in price of a good, the consumer will be at a higher level of satisfaction with a fall in price and will be at a lower level of satisfaction with a rise in price.
  41. 41. Price Effect on Equilibrium Good Y PCC (Price Consumption Curve) P C IC3 B IC2 A O IC1 Q R S Good X With a fall in the price of Good X the consumer attains a higher level of equilibrium from A to B and B to C. PCC traces the price effect. It shows how the changes in price of good X will affect the consumer’s purchases of good X and Y – price of Y, taste and income being constant
  42. 42. Price Effect on Equilibrium Good Y PCC (Price Consumption Curve) P C B IC3 IC2 A O IC1 Q R S Good X If PPC curve is backward sloping it indicates that good X is an inferior good because with a fall in price of X less of X is demanded. (PED<1)
  43. 43. Price Effect on Equilibrium Good Y IC1 PCC (Price Consumption Curve) IC2 P IC3 B C A O Q R S Good X If PPC curve is forward sloping it indicates that good X is a superior good because with a fall in price of X more of X is demanded (PED>1)
  44. 44. Price Effect on Equilibrium Good Y IC1 PCC (Price Consumption Curve) IC2 P IC3 C B A O Q R If PPC curve is horizontal it indicates PED = 1 S Good X
  45. 45. Price Effect and Substitution Effect and Income Effect A change in the price of a commodity leads to a change in the relative prices of the goods – a change in terms at which a consumer can exchange one good for another (substitution effect) and a change in the real income of the consumer. If the price of a good X falls then the real income of the consumer goes up leading to income effect and that the relative price of X to Y will be lower as well and consumers will substitute more of X to Y.
  46. 46. Substitution Effect It is a change in quantity demanded resulting from a change in relative price while retaining the same level of satisfaction or on same IC curve.
  47. 47. Substitution Effect on Equilibrium R Good Y A P C O B T IC1 S IC2 Q Good X With a fall in the price of X consumer can move from C to A – Income Effect or to B – Price Effect; and since the relative price of X is lower to Y, consumer can move from A to B by retaining the same level of satisfaction, nominal income being constant.
  48. 48. Substitution Effect on Equilibrium R Good Y Income Consumption Curve (ICC) A Price Consumption Curve (PCC) P C O B T IC1 S With ICC and PCC curves. Movement from C to A – Income Effect Movement from C to B – Price Effect Movement from A to B – Substitution Effect IC2 Q Good X
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