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Consumer choice theory


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Consumer choice theory

  1. 1. Consumer Choice Theory 1
  2. 2. Consumer choice theory• Utility is the satisfaction orpleasure derived from consumptionof a good or service.• Actual measurement of utility isimpossible, but economists assumeit can be measured by a fictitiousunit called the util. 2
  3. 3. • Cardinal Utility Theory – Utility can bequantified.• Ordinal Utility Theory – Utility cannot bequantified. Consumers can only rank theirpreferences.• Total utility (TU) is the total level ofsatisfaction derived from all units of a good orservice consumed.• Marginal utility (MU) is the change in totalutility from a one unit change in the quantity ofa good or service consumed. 3
  4. 4. Diminishing Marginal Utility8 Marginal Utility642 MU Q 1 2 3 4 4
  5. 5. Total Utility16 Utils TU128 4 Q 1 2 3 4 5
  6. 6. Even though water provides a greater utility than diamonds, why are diamonds more expensive? DIAMOND-WATER PARADOX- Water is plentiful in most of the world, so its marginal utility is low, hence its price is also low- Diamonds are scarce, so its marginal utility is high, hence its price is high 6
  7. 7. Marginal Utility of Diamonds 8 SMarginal Utility 6 4 2 MU Q 1 2 3 4 7
  8. 8. Marginal Utility of Water 8 SMarginal Utility 6 4 2 MU Q 1 2 3 4 8
  9. 9. • The law of diminishing marginalutility states that marginal utility of agood or service eventually declines asconsumption increases.• Consumer equilibrium is thecondition of reaching the maximumlevel of satisfaction, given a budget,when the marginal utility per dollarspent on each good purchased is equal. 9
  10. 10. • Consumer equilibrium and the lawof diminishing marginal utility canbe used to derive a downward-sloping demand curve.• When the price of a good falls,consumer equilibrium no longerholds because the marginal utilitythe marginal utility per dollar for thegood rises. 10
  11. 11. • To restore equilibrium, theconsumer must increaseconsumption.• As the quantity demandedincreases, the marginal utility fallsuntil equilibrium is again achieved.• Thus, the price falls and thequantity demanded rises, aspredicted by the law of demand 11
  12. 12. Consumer Equilibrium MU A MU B MU Z1. price A = price B = price Z1. Total expenditure = Budget If the marginal utility per last dollar spend on each good is equal and the entire budget is spent, total utility is maximized. 12
  13. 13. If the marginal utility per lastdollar spend on each good is equaland the entire budget is spent, totalutility is maximized. When the price of a normalgood falls, the income effect andthe substitution effect combine tocause the quantity demanded toincrease. 13
  14. 14. • The income effect and thesubstitution effect arecomplementary explanations for thelaw of demand.• When the price changes, theseeffects work in combination tochange in the quantity demanded inthe opposite directions. 14
  15. 15. Income effect and substitution effect • As the price falls, the consumer substitutes the cheaper the cheaper good for other goods that are now relatively more expensive. This is the substitution effect. • Also, as the price falls, real purchasing power increases, causing an increase in the consumer’s willingness and ability to purchase a good or service. This is the income effect. 15
  16. 16. ORDINAL UTILITY THEORY• Utility cannot be quantified• Consumers can only rank their preferences• E.g. Hani gets a higher utility from consuming an orange than an apple• Uses indifference curve analysis 16
  17. 17. INDIFFERENCE CURVE ANALYSIS• Uses two types of curves:2. Indifference Curve (IC) is a curve that shows various combinations of two goods that give a consumer the same level of satisfaction3. Budget Line (BL) is a line that shows various combinations of two goods that can be bought by a consumer, given a certain level of income and prices of the two goods 17
  18. 18. INDIFFERECE CURVEY8 A Point Units of Y Units of X A 8 46 B B 6 6 C 4 9 C D 2 154 7 D2 IC 46 8 15 X 18
  19. 19. INDIFFERENCE MAP and CHARACTERISTICS OF IC • Indifference Map is a diagram that contains a number of indifference curves. • Characteristics of IC: 3. Downward sloping from left to right 4. Convex to origin 5. The farther away an IC from the origin, the higher the level of satisfaction 6. Indifference curves cannot intersect each other 19
  20. 20. The Law of Diminishing Marginal Rate of Substitution (MRS)• MRS is the amount of one good a consumer is willing to sacrifice in order to obtain one more unit of another good.• The Law of DMRS states that the rate at which a consumer is willing to trade one good for another falls as he has fewer and fewer of the first good.• The Law of DMRS is the reason why an IC is normally convex to origin. 20
  21. 21. BUDGET LINE (BL)• BL shows various combinations of two goods that can be bought by a consumer, given his income and prices of the two goods.• Example: next slide  21
  22. 22. Budget LineAssume: Income = RM30.00 Price of Banana = RM2.00 Price of Orange = RM3.00 Combinations Banana Orange A 15 0 B 12 2 C 9 4 D 6 6 E 3 8 F 0 10 22
  23. 23. CONSUMER EQUILIBRIUM• Consumer equilibrium is achieved when the consumer purchases the combination that gives him the highest level of satisfaction, given his income and the prices of the two goods.• CE is achieved at the point where IC is tangent to BL where price ratio = MRS 23