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# Lecture iv

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### Lecture iv

1. 1. CONSUMER BEHAVIOUR <ul><li>Consumer is a king -- buying power, preferences & price signals </li></ul><ul><li>Preference & choice </li></ul><ul><li>Objectives </li></ul><ul><li>To derive maximum utility </li></ul><ul><li>To pay lowest possible price </li></ul>
2. 2. UTILITY ANALYSIS <ul><li>Utility – capacity of commodity to satisfy human want </li></ul><ul><li>Cardinal approach -- measurability of utility </li></ul><ul><li>Ordinal approach – Ranking of utility </li></ul>
3. 3. UTILITY ANALYSIS 4 15 A4 3 18 A3 1 22 A2 2 20 A1 Ordinal Cardinal Good
4. 4. RELATION BETWEEN TOTAL & MARGINAL UTILITY <ul><li>Marginal utility is addition to total utility </li></ul><ul><li>Total utility increases with every addition at diminishing rate </li></ul><ul><li>Marginal utility diminishes with every additional unit consumed </li></ul><ul><li>When total utility is maximum Marginal utility is zero </li></ul><ul><li>Total utility diminishes when Marginal utility is less than zero </li></ul>
5. 5. THE LAW OF DIMINISHING MARGINAL UTILITY <ul><li>Dr. Marshall states “ the additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has” </li></ul>
6. 6. <ul><li>“ceteris paribus marginal utility from every successive unit consumed goes on declining” </li></ul><ul><li>Homogeneous units </li></ul><ul><li>Time period of consumption </li></ul><ul><li>Consumption up to the point where MU=PRICE </li></ul>
7. 7. ASSUMPTIONS OF THE LAW OF DMU <ul><li>Cardinal measurement of utility </li></ul><ul><li>Consumer is rational </li></ul><ul><li>Limited income </li></ul><ul><li>Constant prices </li></ul><ul><li>MUM is constant </li></ul>
8. 8. THE LAW OF EQUI-MARGINAL UTILITY <ul><li>The consumer will distribute his given amount of money on different goods in such a way that the marginal utility of last rupee spent on each good is made equal </li></ul><ul><li>Ratios of MU to P for all goods are equal </li></ul>
9. 9. CONSUMER’S EQUILIBRIUM <ul><li>Maximum satisfaction by allocating income over different goods in such a way that MU of all goods will be in proportion to their respective prices </li></ul><ul><li>MU of exp. or MU last rupee spent on each good will be made equal </li></ul><ul><li>MUa/Pa= MUb/Pb=MUc/Pc = ----MUn/Pn </li></ul>
10. 10. DIMINISHING MU & THE LAW OF DEMAND <ul><li>Demand curve slopes downward as MU declines with every additional unit consumed </li></ul><ul><li>Consumer demands the good till </li></ul><ul><li>MU = price </li></ul><ul><li>So lower quantity is demanded at high price & vice versa </li></ul>
11. 11. D MU Q Q1 Q2 Q Q1 Q2 A B C P2 P1 P P P1 P2 QD MU&P 0 0 P Utility MU & DD CURVE
12. 12. LIMITATIONS OF CARDINAL ANALYSIS <ul><li>Measurability of utility questioned </li></ul><ul><li>Utility is not independent </li></ul><ul><li>Mum is not constant </li></ul><ul><li>No distinction between income & substitution effects </li></ul><ul><li>Unable to explain Giffen paradox </li></ul><ul><li>Neglects cross effects of related goods </li></ul><ul><li>Unrealistic </li></ul>
13. 13. INDIFFERENCE CURVE (IC) ANALYSIS <ul><li>Scale of preference the base of IC technique </li></ul><ul><li>Based of Ordinal measurement of utility </li></ul><ul><li>Ranking of goods as per satisfaction derived </li></ul><ul><li>Two goods consumed </li></ul><ul><li>Independent of Prices & income </li></ul>
14. 14. ASSUMPTIONS OF IC ANALYSIS <ul><li>Rational consumer </li></ul><ul><li>two goods </li></ul><ul><li>Income, taste, habits, & prices of goods remain same </li></ul><ul><li>Comparison and ranking of alternative commodities in order of preference </li></ul><ul><li>Transitivity </li></ul><ul><li>Continuity </li></ul>
15. 15. IC SCHEDULE <ul><li>List of combinations of two goods X&Y giving same utility </li></ul>4 5 E 5 4 D 7 3 C 10 2 B 14 1 A Com. Y Com. X Combinations
16. 16. Techniques of (IC) ANALYSIS <ul><li>Indifference curve </li></ul><ul><li>A graphical representation of I schedule </li></ul><ul><li>It is a locus of various combinations of goods giving EQUAL satisfaction </li></ul><ul><li>Indifference map </li></ul><ul><li>It is a family/set of ICs </li></ul>
17. 17. INDIFFERENCE CURVE 0 Com. X Com. Y IC
18. 18. INDIFFERENCE MAP 1 2 3 0 X Y
19. 19. MARGINAL RATE Of SUBSTITUTION <ul><li>MRS is the amount of commodity Y given up to obtain additional unit of commodity X </li></ul>1/1 1:1 4 5 E 2/1 2:1 5 4 D 3/1 3:1 7 3 C 4/1 4:1 10 2 B -- -- 14 1 A ∂ y/∂x MRSxy Com. Y Com. X Combn
20. 20. MARGINAL RATE OF SUBSTITUTION <ul><li>MRS diminishes for normal goods </li></ul><ul><li>To obtain one more unit of X less & less of Y would be given up </li></ul><ul><li>So IC takes negative shape </li></ul>
21. 21. IC FOR NORMAL GOODS <ul><li>DMRS so IC takes convex shape </li></ul>0 X Y 1
22. 22. IC FOR SUBSTITUTES <ul><li>Constant MRS so IC is straight line </li></ul>Y X 0 a b
23. 23. IC FOR COMPLEMETS IC1 IC2 IC3 IC4 0 X Y Consumption in fixed proportion
24. 24. PROPERTIES OF IC <ul><li>All ICs slope downwards from left to right </li></ul><ul><li>No two ICs intersect </li></ul><ul><li>IC is convex to origin (reasons) </li></ul><ul><li>Higher IC represents higher level of satisfaction </li></ul><ul><li>IC can not touch either axis </li></ul><ul><li>ICs need not be parallel to each other </li></ul>
25. 25. BUDGET OR PRICE LINE <ul><li>PL shows various quantities of goods can be purchased with given income </li></ul>0 Com. X Com. y A B X Y M= Pxqx + Pyqy
26. 26. CONSUMER’S EQUILIBRIUM <ul><li>Transformation of scale of preferences into reality by buying certain units of x & y to maximize satisfaction </li></ul><ul><li>No tendency to rearrange his purchases </li></ul><ul><li>Constraints faced by Consumer </li></ul><ul><li>prices of goods </li></ul><ul><li>Consumer’s income </li></ul>
27. 27. ASSUMPTIONS <ul><li>IC map for X&Y is given </li></ul><ul><li>Constant prices of X&Y </li></ul><ul><li>Price ratio remains constant </li></ul><ul><li>Entire income is spent </li></ul><ul><li>X & Y are divisible </li></ul><ul><li>Rational consumer </li></ul>
28. 28. EQUILIBRIUM CONDITIONS <ul><li>The tangency of price line (PL) & IC is necessary condition for equilibrium i.e. slope of PL = slope of IC </li></ul><ul><li>IC has to be convex at the point of tangency </li></ul><ul><li>MRSxy=PX/PY = MUx/Px = MUy/Py </li></ul>
29. 29. CONSUMER’S EQUILIBRIUM <ul><li>COM.Y </li></ul>1 2 3 4 E A B 0 C D Y COM.X
30. 30. INCOME EFFECT--IE <ul><li>Change in real income changes the position of consumer equilibrium </li></ul><ul><li>Consumer is better/worse off </li></ul><ul><li>Real income increases or declines </li></ul><ul><li>Incase of normal goods IE is positive </li></ul><ul><li>Income consumption curve rises upward </li></ul>
31. 31. INCOME EFFECT--IE <ul><li>COM.Y </li></ul>ICC 1 2 3 A B B1 B2 0 COM.X E E1 E2
32. 32. INCOME EFFECT--IE <ul><li>In case of normal goods IE is Positive </li></ul><ul><li>If commodity x is inferior IE is negative ICC rises up and bends backward </li></ul><ul><li>If commodity y is inferior IE is negative </li></ul><ul><li>ICC rises up and turns downward </li></ul>
33. 33. SUBSTITUTION EFFECT--SE <ul><li>Change in price influences the position of consumer equilibrium </li></ul><ul><li>Adjustment in money income to maintain real income constant </li></ul><ul><li>Price effect= Income effect+ substitution effect </li></ul>
34. 34. SUBSTITUTION EFFECT-- SE E E1 1 A COM.X COM.Y 0 B B2 B1 A1
35. 35. PRICE EFFECT--PE <ul><li>Change in price influences the position of consumer equilibrium </li></ul><ul><li>Consumer is better/worse off </li></ul><ul><li>Real income increases or declines </li></ul><ul><li>Incase of normal goods PE is positive </li></ul><ul><li>PE is negative for inferior/Giffen goods </li></ul><ul><li>Price effect= income effect+ substitution effect </li></ul>
36. 36. PRICE EFFECT--PE PCC 1 2 3 A B B1 B2 0 COM.Y COM.X
37. 37. DERIVATION OF DEMAND CURVE FROM PRICE CONSUMPTION CURVE
38. 38. SUPERIORITY OF IC ANALYSIS <ul><li>Ordinal utility </li></ul><ul><li>Consideration of Diminishing MUM </li></ul><ul><li>Separating price effect into income & substitution effects </li></ul><ul><li>Explains Giffen's paradox </li></ul><ul><li>Better way of classifying substitutes & complementary goods </li></ul><ul><li>Wider application </li></ul>
39. 39. Consumer’s surplus <ul><li>Dr. Marshall defines consumer’s surplus as “excess of the price which a consumer would be willing to pay, rather than go without a thing over that which he actually does pay, is the economic measure of this surplus satisfaction– it may be called consumer’s surplus” </li></ul><ul><li>Consumer’s surplus= Σ MU - Σ P </li></ul>