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# CONSUMER THEORY

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### CONSUMER THEORY

1. 1. Lecture 2 September 10, 2013 1Hellen A. Seshie-Nasser
2. 2. Consumer Choice Marginal Utility Theory Consumer surplus Budget Constraints Indifference Curve Theory Revealed Preference Theory September 10, 2013 2Hellen A. Seshie-Nasser
3. 3. Consumer Choice Today’s lecture will cover  Marginal Utility Theory  Consumer surplus  Budget Constraints September 10, 2013 3Hellen A. Seshie-Nasser
4. 4. I. Marginal Utility Theory  what is UTILITY?  benefit you get from consuming a good  determined by your tastes/preferences (assuming these are stable) The value a consumer places on a unit of a good or service depends on the pleasure or satisfaction he or she expects to derive from having or consuming it at the point of making a consumption (consumer) choice. September 10, 2013 4Hellen A. Seshie-Nasser
5. 5. Total utility (TU)  total benefit from consuming good  example  total benefit from 3 biscuits/cookies September 10, 2013 5Hellen A. Seshie-Nasser
6. 6. TU increases as consumption increases, to a point < TU 2 cookies TU 3 cookies September 10, 2013 6Hellen A. Seshie-Nasser
7. 7. Marginal utility (MU)  MU is the change in TU from consuming one more of a good  example  how much MORE utility from an additional mobile phone? September 10, 2013 7Hellen A. Seshie-Nasser
8. 8. change in TU from 0 to 1 biscuit/cookie change in TU from 1 cookie to 2 cookies MU of 1st Biscuit/ cookie MU of 2nd cookie = = 0 September 10, 2013 8Hellen A. Seshie-Nasser
9. 9. Diminishing marginal utility  MU falls as consumption rises  You get sick of biscuits as you each more of it.  The more kenkey you consume the less you’ll want to each eat it. September 10, 2013 9Hellen A. Seshie-Nasser
10. 10. MU of 1st cookie > MU of 2nd cookie 0 September 10, 2013 10Hellen A. Seshie-Nasser
11. 11. TU cookie TU rises at slower and slower rate as MU declines MU cookie September 10, 2013 11Hellen A. Seshie-Nasser
12. 12. Consumer Equilibrium: How to maximize TU?  Equalize MU to price of the good (single good case)  equalize MU/price across goods (Multiple goods case) “The real case”  use available budget September 10, 2013 12Hellen A. Seshie-Nasser
13. 13. Consumer equilibrium Balls of kenkey Total Utility (in utils) Marginal Utility/Benefit 0 0 0 1 8 8 2 14 6 3 19 5 4 23 4 5 25 2 6 26 1 7 26 0 8 24 -2 How many balls of kenkey would you buy if the price per ball was Gh¢1? Marginal Cost Gh¢1 Gh¢1 Gh¢1 Gh¢1 Gh¢1 Gh¢1 Gh¢1 Gh¢1 Gh¢1 13September 10, 2013 Hellen A. Seshie-Nasser
14. 14. Marginal utility = Price MUx =Px Chose combination of kenkey and phone units where price of kenkey price of phone units MU kenkey = MU phone units September 10, 2013 14Hellen A. Seshie-Nasser
15. 15. why?  Chose 6 balls of kenkey, one 1-cedit worth of phone credit  suppose MU/Gh¢1 of cookies = 4, MU/Gh¢1 of Phone units = 15  by consuming fewer balls of kenkey and more phone credits… You would add more to my TU September 10, 2013 15Hellen A. Seshie-Nasser
16. 16. Utility Maximizing Rule The consumer’s money should be spent so that the marginal utility per dollar of each goods equal each other. MUx = MUy 16 Px Py September 10, 2013 Hellen A. Seshie-Nasser Thus, the utility maximizing rule assumes that you always consume where MU/P for each product is equal
17. 17. September 10, 2013 Hellen A. Seshie-Nasser 17 Assume apples cost \$1 each and oranges cost \$2 each. (If the consumer has \$7), identify the combination that maximizes utility. Example
18. 18. TU vs. MU: The Paradox of Value  Diamond-Water paradox  Gh¢10,000 for example can be used to purchase either  one carat diamond Or  5 million gallons of tap water September 10, 2013 18Hellen A. Seshie-Nasser
19. 19. why?  TU of water is greater than TU of diamonds  water is essential for life  BUT water is abundant, diamonds are rarer  MU of last diamond is higher  MU determines value  When diamonds are scarce and drinking water is abundant, marginal utility of a diamond ring is much higher than the marginal utility of water. Although the total utility of water may be greater than that of diamond rings. September 10, 2013 19Hellen A. Seshie-Nasser
20. 20.  Stranded on a desert island with no water, one may be happy, though, to trade his diamond ring for a bottle of drinking water. Under such conditions, the marginal utility of water must be greater that that of a diamond ring. September 10, 2013 Hellen A. Seshie-Nasser 20
21. 21. MU and demand  MU declines as consumption rises  Price = MU  willingness to pay is less for each additional unit Hence  downward sloping demand  The more consumed the less willingness to pay, hence the lesser price offered for the product. September 10, 2013 21Hellen A. Seshie-Nasser
22. 22. example : balls of kenkey P Q D Gh¢1.0 4 balls for 4th ball of kenkey willing to pay Gh¢1. for 2nd ball of kenkeyGh¢1.5 2 balls willing to pay Gh¢1.5 September 10, 2013 22Hellen A. Seshie-Nasser
23. 23. II. Consumer Surplus  It is the difference between what you pay for a good and what you are WILLING to pay for the good Example:  market price of a ball of kenkey = Gh¢1.0  your marginal value of the 3rd ball is = Gh¢12  Your consumer surplus then is = Gh¢2 September 10, 2013 23Hellen A. Seshie-Nasser
24. 24. P Q D \$10 The demand curve \$12 3 your consumer surplus September 10, 2013 24Hellen A. Seshie-Nasser
25. 25. P Q D Gh¢1.0 10,000 total consumer surplus area between D and price of kenkey September 10, 2013 25Hellen A. Seshie-Nasser
26. 26. III. The Budget Line  A budget constraint is a constraint on how much money (income, wealth) an economic agent can spend on goods. We denote the amount of available income by M  given:  consumer’s budget  prices  draw a line representing choices  consumption possibilities September 10, 2013 26Hellen A. Seshie-Nasser
27. 27. example  2 goods: bread & kenkey  A loaf of bread = Gh¢1.0  A ball of kenkey = Gh¢0.5  daily budget = Gh¢4.0 September 10, 2013 27Hellen A. Seshie-Nasser
28. 28. Possible Combinations kenkey bread 0 2 4 6 8 4 3 2 1 0 September 10, 2013 28Hellen A. Seshie-Nasser
29. 29. budget line Bread Kenkey 8 4 2 6 0 421 3 September 10, 2013 29Hellen A. Seshie-Nasser
30. 30. budget line Bread kenkey 8 4 2 6 0 421 3 Affordable Unaffordable September 10, 2013 30Hellen A. Seshie-Nasser
31. 31. Mathematically Let Px= price of good X Py = price of good Y M = Income of the consumer Assuming the consumer spends all his/her income on only two goods, X and Y Then the budget equation is given by; Px + Py = M September 10, 2013 Hellen A. Seshie-Nasser 31
32. 32. Changes in Money Income  Changes in the consumer’s income  budget line shifts  Increases in income shift the budget line outward away from the origin, and vice versa  suppose a consumer income changes from Gh¢5 to Gh¢4 September 10, 2013 32Hellen A. Seshie-Nasser
33. 33. bread kenkey budget = Gh¢4 budget = Gh¢5 8 4 2 6 0 10 421 3 5 September 10, 2013 33Hellen A. Seshie-Nasser
34. 34. Changes in Relative prices Changes in one price, holding other prices and income constant;  changes slope of budget line  Suppose price of kenkey rises from Gh¢.5 to Gh¢1.0 September 10, 2013 34Hellen A. Seshie-Nasser
35. 35. Changes in Relative prices bread kenkey 8 4 2 6 0 421 3 kenkey = \$.50 kenkey = \$1 September 10, 2013 35Hellen A. Seshie-Nasser
36. 36. Changes in Relative prices  Changes in the prices of goods lead to changes in the real income of the consumer. He therefore buys less of one or both goods.  He can choose to buy less amount of the relatively expensive good and more or the same quantity of the relatively cheap good  Or the same quantity of the relatively expensive good and less of the relatively expensive good. September 10, 2013 36Hellen A. Seshie-Nasser
37. 37. Exercise Assume apples cost \$1 each and oranges cost \$2 each. If the consumer has \$7, identify the combination that maximizes utility. Find the quantities of apple and oranges the consumer will purchase if a. Price of oranges falls to \$1 b. Income of the consumer increases to \$10 c. Price of apples rises to \$1.5 September 10, 2013 37Hellen A. Seshie-Nasser
38. 38. sum it up  consumer decisions are based on  preferences  budget constraint  consumer decisions are made at the margin  marginal benefit of one more  compared to price of one more September 10, 2013 38Hellen A. Seshie-Nasser