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Lecture 5

Lecture 5. The Theory of Consumer Behavior Utility Maximization. Utility. Definition : Utility refers to the satisfaction derived from consuming a good or a service.

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Lecture 5

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  1. Lecture 5 The Theory of Consumer Behavior Utility Maximization

  2. Utility • Definition: Utility refers to the satisfaction derived from consuming a good or a service. • Utility is a way to describe to preference of a consumer. This implies that if I derive higher satisfaction or utility from a good then I will prefer to consume the good more. • For example: If I get more utility from good A than good B then I will prefer good A to good B.

  3. 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 form having or consuming it at the point of making a consumption (consumer) choice. • In economics the satisfaction or pleasure consumers derive from the consumption of consumer goods is called “utility”. • Consumers, however, cannot have every thing they wish to have. Consumers’ choices are constrained by their incomes. • Within the limits of their incomes, consumers make their consumption choices by evaluating and comparing consumer goods with regard to their “utilities.”

  4. Types of UtilityCardinal Utility vs. Ordinal Utility • Cardinal Utility: Assigning numerical values to the amount of satisfaction • Ordinal Utility: Not assigning numerical values to the amount of satisfaction but indicating the order of preferences, that is, what is preferred to what

  5. How to Measure Utility Measuring utility in “utils” (Cardinal): • Jack derives 10 utils from having one slice of pizza but only 5 utils from having a burger. Measuring utility by comparison (Ordinal): • Jill prefers a burger to a slice of pizza and a slice of pizza to a hotdog. Often consumers are able to be more precise in expressing their preferences. For example, we could say: • Jill is willing to trade a burger for four hotdogs but she will give up only two hotdogs for a slice of pizza. • We can infer that to Jill, a burger has twice as much utility as a slice of pizza, and a slice of pizza has twice as much utility as a hotdog.

  6. Total Utility versus Marginal Utility • Marginal utility is the utility a consumer derives from the last unit of a consumer good she or he consumes (during a given consumption period). • Total utility is the total utility a consumer derives from the consumption of all of the units of a good or a combination of goods over a given consumption period. Total utility = Sum of marginal utilities

  7. Marginal Utility: As we consume more and more of a good our utility usually increases. This implies we get additional satisfaction or utility from our additional consumption. This increment to our utility is known as marginal utility.

  8. As we consume more and more of a good our utility usually increases. But utility increases at a decreasing rate. This implies that the total utility will grow at a slower and slower rate. In the given example the utility increase from first unit of the good is 4. But utility increase from the second unit of good is 3. So the rate at which utility is increasing is falling. This happens because of the law of diminishing marginal utility.

  9. Law of Diminishing Marginal Utility Law of Diminishing Marginal Utility: This law states that the marginal utility declines as a person consumes more and more of a good. Question: Can the marginal utility be negative? Yes. • Think of a daily life example when marginal utility can become negative.

  10. Implication of the law: The demand curve slopes down because of the law of diminishing marginal utility. Explanation: From the law we know that when a person consumes more of a good, his marginal utility/satisfaction decreases. We also know that a person is willing to pay a price of a product that is equal to its marginal utility (which shows his satisfaction or benefit). So the price a person wants to pay for additional units of a good will also decrease when he consumes more of a good. This implies that price (maximum willingness to pay) and quantity are negatively related. So the demand curve slopes downward.

  11. Deriving a Demand Curve Using Law of Diminishing Marginal Utility

  12. Consumer Surplus • The difference between what a consumer is willing to pay for an addition unit of a good and the market price that he/she actually pays is referred to as “consumer surplus”. • The demand curve shows the marginal utility (MU) or maximum willingness to pay which is a downward sloping line. The market price is fixed for a certain period of time and so the price line is horizontal . So consumer surplus is the area between the demand curve ( MU curve) and the price.

  13. Consumer Surplus in Graph

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