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# 1.01 utility

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### 1.01 utility

1. 1. Topic 1<br />UTILITY<br />
2. 2. UTILITY<br />Defined as the level of happiness and satisfaction that a person receives from consuming a good or service.<br />Assumptions<br />Utility can be measured<br />Individuals are rational (utility-maximizing consumers) <br />Trying to maximize their total utility<br />
3. 3. UTILITY<br />Total utility is defined as the overall satisfaction that a person derives from consuming all units of a good or service over a given time period<br />Marginal utility is defined as the additional utility (change in total utility) derived from consuming one more unit of a good or service<br />
4. 4. UTILITY<br />MUt = TUt – TUt-1<br />TU = ∑MU<br />Principle of Diminishing Marginal Utility<br />Marginal utility derived from consuming a product diminishes with an increase in its consumption<br />For example, the table showing utility derived from consuming successive ice-creams<br />Disutility<br />Point will come when an additional ice-cream actually dissatisfies the consumer<br />Marginal utility of this additional glass is negative<br />TU2 = MU1 + MU2<br />MU6 = TU6 – TU5<br />
5. 5. Utility<br />
6. 6. Consumer’s Equilibrium<br />Assumptions<br />Consumers have limited income<br />Face the problem of scarcity <br />Cannot purchase all the goods and services that they want<br />Consumers behave rationally – i.e. they try to maximize their total utility<br />They consider the marginal utility of a product with its opportunity cost<br />Consumers make their decisions at the margin<br />They do not look at their overall spending <br />They only consider the alternatives and select the one that maximizes their utility<br />Utility can be measured<br />Prices of products are fixed<br />Consumer tastes are constant<br />
7. 7. Consumer’s Equilibrium<br />Takes place when it is not possible for a consumer to increase his total utility by switching his expenditure from one product to another product<br />Principle of Equi-Marginal Utility<br />Consumer equilibrium takes place when the marginal utility per dollar of expenditure on all goods becomes equal<br />
8. 8. Consumer’s Equilibrium<br />Makes Product A more attractive<br />MUA/PA > MUB/PB<br />Switch expenditure from product B to A<br />Consumes more of product A<br />Marginal utility of product A falls<br /><ul><li>Consumes fewer units of product B</li></ul>Marginal utility of product B rises<br /><ul><li>Keep switching to product A till the marginal utility per dollar of A and B are equal</li></ul>No more opportunity to increase total utility by switching expenditure = Equilibrium MUA/PA = MUB/PB<br />
9. 9. Consumer Equilibrium & Money<br />Keep consuming a product till <br />MU/\$ spent on the product = opportunity cost of money<br />Opportunity cost of money = MU derived if one dollar of money is spent on consuming another product<br />For example <br />Price of product A is \$6 <br />Opportunity cost of \$1=2 units of utility<br />Using the table below consumer will consume 3 units of the product<br />
10. 10. Consumer’s Equilibrium<br />Criticism<br />Argued that economics portrays consumers as purely selfish<br />Not always true<br />Spend money on charity, on their children, and on other people<br />Shows that the utility gained from giving money away or spending it on others can be higher than from spending it on oneself<br />More likely to spend money on those in their immediate family than others<br />spending on family gives them a higher utility<br />
11. 11. Paradox of Value<br />Proposition that the value (price) of a good is determined by its relative scarcity rather than by its usefulness<br />Consumers are at times willing to pay a higher price for a non-essential item (e.g. diamonds) and a lower price for an essential item (e.g. water)<br />If goods are in limited supply, as with diamonds, then consumers are prepared to pay a high price for them<br />relatively few of them <br />marginal utility of another one is high<br />total utility for them is quite low because of low consumption<br />If goods are plentiful, as with water, then consumers are only prepared to pay a low price<br />because the extra utility of another unit is low<br />The total utility, however, is high<br /><ul><li>Consumers enjoy large amounts of consumer surplus on water because the price is low and large amounts are bought
12. 12. Far less consumer surplus is enjoyed by consumers on diamonds because far fewer diamonds are bought</li></li></ul><li>x e.g. diamonds<br />x e.g. water<br />Paradox of Value<br />water<br />diamonds<br />
13. 13. Deriving Demand Curve<br />At equilibrium<br />Increase in the price of product A<br />ratio of will fall making product A less attractive<br />Switch expenditure from product A to B to increase total utility<br />Fall in the demand of product A<br />An increase in the price of product A will lead to a fall in its quantity demanded<br />Proving that demand curve is downward sloping<br />
14. 14. Demand Curve<br />Shows the value that consumers place on the last unit bought of a product<br />If total demand for a product is 10 units at a price of \$5<br />value placed by consumers on the tenth unit must have been \$5<br />value placed on each of the other 9 units bought is likely to be above \$5<br />Marginal value of a good to the consumers (i.e. the marginal utility) is given by the price shown on the demand curve at that level of output<br />
15. 15. Utility of Money<br />Opinion 1 = Money experiences diminishing MU<br />Initial supply of money gives a person more utility <br />More dollars only changes MU at a diminishing rate<br />Opinion 2 = Does not experience diminishing MU<br />An increase in money keeps increasing the marginal utility for a consumer <br />He can afford to buy different types of goods and services that he was not able to buy before<br />
16. 16. Utility and Redistribution of Income<br />Law of Diminishing Marginal Utility would suggest that taking resources away from an affluent individual to give to a poor person will lead to an increase in the combined utility of the two individuals<br />Higher the spending of individuals, the less utility they get by spending an extra dollar<br />Utility derived from an extra \$10 a week to a poor family > Utility derived from an extra \$10 a week to a richer family<br />Implies that \$1 spent on tea by a high income earner gives less utility than \$1 spent on food by a poor individual<br />The implication is redistributing income from the rich to the poor increases total utility<br />Loss of utility by the rich person < the gain in utility by the poor person<br />Problems<br />Law of marginal utility refers specifically to spending changes by a single individual<br />Law in its strictest sense cannot be used to compare income change between individuals because it is not possible to make direct utility comparisons between individuals<br />
17. 17. Limitations of Utility Theory<br />Difficult to measure utility <br />Also difficult to measure the MU<br />Comparing utilities of two products is difficult<br />They will be giving different types of satisfaction and it is not possible to compare the two<br />Comparing utilities of two persons is difficult<br />Individuals have different characteristics and personality styles <br />They also consume different types of goods and services<br />Adding utilities of different products is difficult<br />Satisfaction derived is of different nature and cannot be compared nor added<br />