2. Utility Analysis
Utility
Satisfaction derived from consumption
Subjective
Assumption
Tastes are given
Tastes are relatively stable
2
3. Total Utility & Marginal
Utility
Total utility
Total satisfaction
Marginal utility
Change in total utility from one-unit change in
consumption
3
5. The Law of Diminishing
Marginal Utility
The more of a good consumed
The smaller the increase in total utility
Marginal utility from each additional unit
Declines as more is consumed
Disutility
Negative marginal utility
5
6. Measuring Utility
Units of utility
Each person has a unique subjective utility scale
Two Approaches:
Cardinal
Ordinal
6
8. Total Utility and Marginal Utility You Derive from
Drinking Water after Jogging Four Miles
Total utility increases with each of the
first 4 glasses of water consumed but
by smaller and smaller amounts
The 5th glass causes TU to fall
Marginal utility declines
MU of the 5th glass is negative
5
Glasses (8-ounce)
4
3
2
1
0
20
40
60
80
Total
utility
(a) Total utility (b) Marginal utility
5
Glasses (8-ounce)
4
3
2
1
0
20
40
Marginal
utility
8
10. Utility Maximization
Without Scarcity
Free good
Increase consumption as marginal utility is positive
Two free goods
Until the marginal utility of each is 0
Tastes, preferences
10
11. Total and Marginal Utilities from
Tea and Rice
Tea Rice
Consumed
per Week
Total
Utility
Marginal
Utility
Marginal
Utility per
Rupee if
P=Rs. 8
Consumed
per Week
Total
Utility
Marginal
Utility
Marginal
Utility per
Rupee if
P=Rs. 4
0 0 __ __ 0 0 __ __
1 56 56 7 1 40 40 10
2 88 32 4 2 68 28 7
3 112 24 3 3 88 20 5
4 130 18 2.25 4 100 12 3
5 142 12 1.5 5 108 8 2
6 150 8 1 6 114 6 1.5
11
12. Utility Maximization With
Scarcity
Goods – not free
Tastes, preferences
Limited income
Maximize utility
Equilibrium
Any affordable change will reduce utility 12
13. Utility-Maximizing Conditions
Equilibrium
There is no way to increase utility by reallocating the
budget
Last Rupee spent on each good yields the same marginal
utility
R
R
T
T
p
MU
p
MU
13
15. Total and Marginal Utilities from Tea and Rice After
the Price of Tea Decreases from Rs.8 to Rs.6
Tea Rice
Consumed
per Week
Total
Utility
Marginal
Utility
Marginal
Utility per
Rupee if
P=Rs. 6
Consumed
per Week
Total
Utility
Marginal
Utility
Marginal
Utility per
Rupee if
P=Rs. 4
0 0 __ __ 0 0 __ __
1 56 56 9.33 1 40 40 10
2 88 32 5.33 2 68 28 7
3 112 24 4 3 88 20 5
4 130 18 3 4 100 12 3
5 142 12 2 5 108 8 2
6 150 8 1.33 6 114 6 1.5
15
16. Marginal Utility and
the Law of Demand
Max U; budget = Rs.40
QT = 3; PT =Rs.8; one point on D curve
(QR = 4 ; PR = Rs.4)
Price of Tea drops to Rs.6, other things constant
Max U; budget = Rs.40
QT = 4; PT = Rs.6; second point on D curve
(QR = 4 ; PR = Rs.4)
16
17. Demand for Tea Generated from
Marginal Utility
2
4
6
Rs.8
Price
per
Tea
Tea per week
3
2
1
0 4
D
a
b
P=Rs.8, consumer equilibrium at
Q=3
MU per Rupee is the same for all
goods consumed
P=Rs.6, consumer equilibrium at
Q=4
17
19. 19
Festive Offer Only FOR
TODAY!!!!!!!
1st Burger at Rs. 55
2nd Burger at Rs. 50
3rd Burger at Rs. 45
4th Burger at Rs. 40
5th Burger at Rs. 35
20. Consumer Surplus
– Value of a good purchased must at least
equal the P
D curve
– Marginal valuation
Consumer surplus
– Consumer bonus
– Value of total utility minus total spending
– Area under D, above P 20
21. Consumer Surplus from Sub Sandwiches
D
2
4
6
Rs.8
Price
per
subs
7
5
3
1
Subs per
month
3
2
1
0 4 5 6 7 8
At P=Rs.4:
•1st sub valued at Rs.7
•2nd sub valued at Rs.6
•3rd sub valued at Rs.5
•4th sub valued at Rs.4
•Willing to pay Rs.22 for 4 subs
•Pays only Rs.16 for 4 subs
•Consumer surplus
Rs.22-Rs.16 = Rs.6
When P drops to Rs.3, consumer surplus increases by Rs.4 21
22. Market D and
Consumer Surplus
Market D curve
– Horizontal sum of individual D curves
– Total quantity demanded, per period, by all consumers, at
various prices
Consumer surplus for the market
– Amount consumers are willing to pay minus amount they pay
– Net benefit for consumers
– Economic welfare
22
23. Summing Individual Demand Curves to Derive
Market Demand for Sub Sandwiches
0 2 4 6
Price
2
4
$6
dY
(a) You
0 2 4
2
4
$6
dS
(b) Sandy
Subs per month
0 2
2
4
$6
dC
(c) Crains
0 2 6 12
2
4
$6
dY+dS+dC=D
(d) Market demand
for subs
Market demand curve is the horizontal sum of individual demand curves 23
24. Market Demand and Consumers Surplus
0 Quantity per period
D
1
Rs.2
Price
per
unit
Consumer surplus at a price of
Rs.2 is shown by the blue area.
If the price falls to Rs.1, consumer
surplus increases to include the
green area.
At a zero price, consumer surplus
increases to the entire area under
the D curve.
24
25. Ordinal Approach-Indifference
Curves and Utility Maximization
Indifference curve
– Combinations of goods
– Same total utility
– Slope downward to right
– Convex to origin
25
26. An Indifference Curve
I
2
3
4
5
10
8
Rice
per
week a
b
c
d
1 2 3 4 5 10
Tea per week
0
An indifference curve (I) shows all
combinations of two goods that
provide a particular consumer with
the same total utility.
Indifference curve:
• negative slope
• convex to origin
26
27. Indifference Curves and
Utility Maximization
Marginal rate of substitution MRS
– Willingness to trade
– Slope of indifference curve
Law of diminishing MRS
– Diminishing slope of I curve
27
28. Indifference Curves and
Utility Maximization
Indifference map
– Graphical representation of consumer’s tastes
– Each I: different utility levels
– The further indifference curve from origin
• The higher the utility
• More of both goods
28
29. An Indifference Map
I1
5
10
Rice
per
week
5 10
Tea per week
0
I2
I3
I4
Indifference curves I1 through
I4 are examples from a
consumer’s particular
indifference map.
Indifference curves farther
from origin depict higher
levels of utility.
A line intersects each higher
indifference curve, reflecting
more of both goods.
29
30. Indifference Curves Do Not Intersect
Rice
per
week
Tea per week
0
I’
I
i
k
j
If indifference curves crossed (i)
every point on I and every point on
I’ would have to reflect the same
level of utility as i.
Indifference curves cannot intersect
k: more Tea and Rice than
j; higher utility than j
30
32. A Budget Line
The budget line
– Combinations of goods
– Able to buy
– Consumption possibilities
frontier
Slope of budget line:
33. A Budget Line
5
10
Rice
per
week
5 10
Tea per week
0
Slope = -pT / pR = -Rs.8/Rs.4 = -2
Slope = -2: the price of 1 Tea is 2 Rice.
Budget line: all combinations of Tea and Rice that
can be purchased at fixed prices with a given income.
33
34. Indifference Curves and Utility
Maximization
R
R
T
T
R
T
R
T
p
MU
p
MU
MU
MU
MRS
p
p
MRS
Consumer equilibrium at the tangency
– Maximize utility
– Indifference curve tangent to budget line
34
38. Indifference Curves and Utility
Maximization
Effects of a change in price
– Derive the D curve
1. Income effect
2. Substitution effect
38
39. Effect of a Drop in the Price of Tea
D
I”
I
e
5
10
Rice
per
week
4
e”
5
Tea per week
0 3 4 6.67
e
Rs.8
Price
per
Tea
6
e”
Tea per week
0 3 4
(a) (b)
A reduction in the price of Tea rotates
the budget line rightward.
The consumer is back in equilibrium
at point e” along the new budget line.
A drop in price of Tea increases
quantity demanded.
39
40. Substitution and Income Effects of a Drop in the
Price of Tea from Rs.8 to Rs.4
I
I*
e
e*
5
10
Rice
per
week
4
C
e’
5 10
Tea per week
0 3 F
4
Income
effect
Substitution
effect
A reduction in the price of Tea moves the
consumer from e to e*.
Substitution effect: e to e’; consumer’s reaction
to a change in relative prices along the
original indifference curve.
Income effect: e’ to e*; moves the
consumer to a higher indifference
curve at the new relative price ratio.
40
