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Economics 1- Lecture Note 3. Each day involves decisions about how to allocate scarce money and resources. As we balance competing demands and desires, we make the choices that define our lives. The result of these individual choices are what underlie the demand curves and price elasticities.
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Each day involves decisions about how to allocate scarce money and resources. • As we balance competing demands and desires, we make the choices that define our lives.
The result of these individual choices are what underlie the demand curves and price elasticities.
Now, we will observe patterns of market demand can be explained by process of individuals’ pursuing their most preferred bundles of consumption goods.
Choice and Utility • In explaining consumer behavior, economics relies on the fundamental premise that people choose those goods and services they value most highly.
To describe the way consumers choose among different consumption possibilities, economists a century ago developed the notion of utility. • From the notion of utility, they are able to derive demand curve and its properties.
What do we mean by utility? • In a word utility, it denotes satisfaction. • More precisely, it refers to how consumers rank different goods and services .
Example: • If basket A has a higher utility than basket B for Naruto, this ranking indicates that Naruto prefers A over B.
Often, it is convenient to think of utility as the subjective pleasure or usefulness that a person derives from consuming a good or service.
In the theory of demand, we say that people maximize utility , which means that they choose the bundle of consumption goods that they most prefer.
Cardinal vs. Ordinal Utility • Cardinal Utility- the magnitude of utility differences is treated as an ethically or behaviorally significant quantity.
Since utility is not observable, however, there is an extremely difficult measurement problem in constructing an index reflecting personal preferences.
Economists today generally reject the notion of a cardinal (measurable utility) because we cannot make interpersonal comparisons of utility.
Ordinal Utility- Under this approach, consumers need to determine only their preference ranking bundles of commodities. “ Is bundle A preferred to bundle B?”
Marginal Utility and Law of Diminishing Marginal Utility • When you eat an additional unit of ice cream, you will get some additional satisfaction or utility. This increment will add to your utility called marginal utility.
The expression “marginal” is a key term in economics and always means “additional” or “extra.” • Marginal utility denotes the additional utility you get from the consumption of an additional unit of a commodity.
A century ago, when economists thought about utility, they enunciated the law of diminishing marginal utility. • This law states that the amount of extra or marginal utility declines as a person consumes more and more of a good.
What is the reason for this law? • Utility tends to increase as you consume more of a good. However, according to the law of diminishing marginal utility, as you consume more and more, your utility will grow at a slower and slower rate.
Growth in total utility slows because your marginal utility diminishes as more of the good is consumed. • The diminishing marginal utility states that, as the amount of a good increases, the marginal utility of a good tends to diminish.
Relationship between Total and Marginal Utility • Using the figure, we can easily see the total utility of consuming a certain amount is equal to the sum of the marginal utilities up to that point. • Or TU= sum of MU
Axioms of Consumer Preference • Axiom 1: Preferences are complete. For any two consumption goods bundles A and B, a consumer can make three comparisons. • 1. A is preferred to B • 2. B is preferred to A • 3. A is indifferent to B
This axiom implies that a consumer can make such a comparison for every possible pair of consumption bundles. We refer to a ranking of consumption bundles for one consumer as that preference ordering.
Axiom 2- Preferences are transitive. If a consumer prefers A to B and B to C, then the consumer also prefers A to C. • This axiom simply says that the consumer preferences are internally consistent.
Indifference curve • an indifference curve is a graphshowing different bundles of goods each measured as to quantity, between which a consumer is indifferent.
Locus of different combinations of commodities X and Y consumed yet yielding the same level of utility.
Characteristics of Indifference Curve • 1. It slopes downward to the right.
3. Higher Indifference curves implies higher level of utility.
‘ • 4. It can never intercross or intersect
Why Demand curves Slope Downward? • Using the fundamental rule for consumer behavior, we can easily see why the demand curves slopes downward.
Budget line- depicts different combination of commodity x and y purchased with a fixed budget. • Define algebraically • B = PxQx + PyQy
