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College of Education

School of Continuing and Distance Education 2014/2015 – 2016/2017

ECON 101

Introduction to Economics1

Session 8 – Consumer Choice Theory

Lecturer: Mrs. Hellen A. Seshie-Nasser, Department of Economics Contact Information: [email protected]

Session Overview

• In this session, we will take a close look at the determinants of consumer demand using the Marginal Utility Theory (MUT). We discuss why consumers behave the way they do; why the normal demand curve is downward sloping; why some goods consumers pay more for some goods than others; etc. using the marginal utility theory.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 2

Session Objectives

• At the end of the session, the student should be able to: – Understand the concept of Utility. – Explain the concepts of Total Utility and Marginal Utility and their

measurements. – Examine the effect of consumption quantity changes on total utility

and marginal utility. – Understand and explain the Law of Diminishing Marginal Utility. – Explain consumer Utility Maximization. – Demonstrate usage of the Utility Maximizing Rule. – Determine consumer equilibrium for one-good case and two-good

case. – Use consumer equilibrium to derive the normal demand curve and

explain the law of demand. – Understand some applications of Marginal Utility: the Paradox of

Value, consumer surplus, etc. – Understand the budget line


Slide 3

Session Outline

The key topics to be covered in the session are as follows:

• Marginal Utility theory

• Total Utility and marginal Utility

• Diminishing Marginal Utility

• Utility Maximization

• Consumers’ Demand curve

• Applications of the Marginal Utility Theory

– Paradox of Value

– Consumer Surplus

Slide 4 Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Reading List

• Lipsey R. G. and K. A. Chrystal. (2007). Economics. 11th Edition. Oxford University Press.

• Bade R. and M. Parkin. (2009). Foundations of Microeconomics. 4th Edition. Boston: Pearson Education Inc.,

• Begg. D. Fischer S. and R. Dornbusch. (2003). Economics. 7th Edition. McGraw-Hill


Consumer Choice

• The law of demand predicts an inverse relationship between price and quantity demanded of a good.

• The big question is “why this behaviour on the part of consumers?”

• Three theories set out to answer this question: • Marginal Utility Theory • Indifference Curve Theory • Revealed Preference Theory

• For this course, we focus only on Marginal Utility Theory


Slide 6

Marginal Utility Theory (MUT)

• It is assumed that the consumer derives satisfaction from the consumption of goods and services. This theory assumes that satisfaction is measured in units called Utils.

• 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.


Total Utility (TU)

• Total utility is the total satisfaction derived from consumption of all the units of goods and services.

• That is, the total benefit from consuming a good or service

• example

– total benefit from 3 biscuits/cookies


• TU increases as consumption increases, to a point

< TU 2 cookies TU 3 cookies

Total Utility (TU)

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 9

Marginal Utility (MU)

• Marginal Utility refers to the change in satisfaction as a result of consuming one more unit or one less unit of a product.

• MU is the change in TU from consuming one more or less of a good

• example

– how much MORE utility from an additional mobile phone?


Slide 10

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

Marginal Utility (MU)


Slide 11

Diminishing Marginal Utility

• The Law of Diminishing Marginal Utility (DMU) states that the marginal utility generated by additional units of any product diminishes as an individual consumes more of it, holding constant the consumption of all other products.

• MU falls as consumption rises

• The more ‘kenkey’ you consume the less of it you’ll want to eat.


MU of 1st cookie

> MU of 2nd cookie

0



TU

cookie

TU rises at slower and slower rate

as MU declines

MU

cookie



Example

Qty of biscuits/cookies

Total Utility Marginal Utility

0 0 _

1 30 30

2 50 20

3 65 15

4 75 10

5 80 5

6 80 0

7 78 -2

8 65 -7

9 60 -5


Utility Maximization

• Any rational consumer tries to obtain as much as possible the highest satisfaction he can derive from the consumption of a given commodity at any given time period.

• The point at which the individual obtains the maximum satisfaction from the commodity consumed is referred to as the equilibrium of the individual.

It occurs at a point when consumers: • Equalize MU to price of the good (single good case) OR • equalize MU/price across goods (Multiple goods case) “The real

case” • Using available budget


Slide 16

Equilibrium for one Product

• Assuming that utility is measured in utils or the money value of the utility can be identified and we are working with the money equivalents of utility.

• Assuming that consumption of all other products is held constant.

The consumer maximizes his total utility at a point when his marginal utility is equal to the price he pays for the product.

Marginal utility of commodity X = Price of X

MUx =Px Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 17

• If MUx > Px, the consumer will purchase more of the product. Based on the law of Diminishing Marginal Utility, his marginal utility will decline. He will continue buying until equilibrium is restored, Mux=Px.

• On the other hand, If MUx < Px, the consumer will reduce his consumption of the product. The less amount of the product he consumes the higher his marginal utility, based on the law of diminishing marginal utility. His marginal utility will increase. The consumer will buy less and less until until equilibrium is restored, Mux=Px.



Slide 18

• At quantity X1, MU is greater than the price of X. The consumer will continue buying more of the product until quantity X2 is reached.

• At quantity X3, his

marginal utility is less than the price of the commodity. He will therefore reduce the amount of the commodity he is consuming to X2 to restore equilibrium.

e Px

MUx

X1 X2 X3 Qtyx



Slide 19

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


The Demand Curve

• Supposing we start from consumer equilibrium when MUx = Px, let us analyze the effect of changes in price on the quantity of the product the consumer purchases (i.e. the Law of Demand)

Assume there is an increase in price. • This sends the consumer out of equilibrium, i.e. MUx < Px • In order to restore equilibrium, the consumer needs to increase his

marginal utility. To achieve that he buys less of the commodity.

Assuming a price fall. • MUx > Px. The consumer buys more of the product which then lowers

his marginal utility until equilibrium restored. • Resulting in an inverse relationship between price and quantity, thus

downward sloping demand curve. Slide 21 Mrs. Hellen Seshie-Nasser, Dept .of Economics,

University of Ghana

Equilibrium for Multiple Products

• Dropping the assumption of “consumption of all other products are held constant”, how does the consumer maximize utility?

• Two Products case, X and Y

• Let the Marginal Utility of the last unit of X be given as MUx and the price Px, and for good Y, MUy and Py.


In equilibrium, the consumer chooses combination of ‘kenkey’ and phone units such that:

price of kenkey price of credits

MU kenkey =

MU phone credits

Equilibrium for Multiple Products


WHY?

• Chose 6 balls of kenkey, one 1-cedit worth of phone credit

• Suppose MU/Gh¢1 of kenkey = 4,

MU/Gh¢1 of Phone units = 15

• By consuming fewer balls of kenkey and more phone credits…

You would add more to TU


Utility Maximizing Rule

The consumer’s money should be spent so that the marginal utility per dollar of each goods are equal.

MUx = MUy Px Py

Thus, the Utility Maximizing rule assumes that the individual always consume where MU/P for each product is equal


Assume apples cost $1 each and oranges cost $2 each. (If the consumer has $7), identify the combination that maximizes utility.

Example


• Rearranging the fundamental equation;

MUx = Px MUy Py

Utility Maximizing Rule

The relative price of the two goods which is determined by the market, and it is beyond the control of the consumer. He can only react to changes in the prices.

The relative ability of the two goods to add to the consumer’s satisfaction if he consumes a little more or less of either of them. This is within the control of the consumer.


Slide 27

• Assume that the price of the a unit of X is twice the price of a unit of Y, that is Px/Py =2, while the marginal utility of X is three times that of a unit of Y, i.e. MUx/MUy =3 . Thus;

To restore equilibrium, the consumer needs to reduce the left hand side. He

can achieve that by either consuming more of X or less of Y or both. When he buys more of X, the marginal utility of X will decline thereby

restoring him to equilibrium. Similarly, when he consumes less of Y, the marginal utility of Y will increase resulting into a decline in the relative marginal utility and restoring equilibrium.

MUx > Px

MUy Py

The Consumer’s Demand Curve



• If there is a fall in the price of X, the condition becomes;

• To restore equilibrium, the consumer will need the marginal utility of X to decline. He will therefore consume more of X.

• Thus giving us a downward sloping demand curve.

MUx > Px

MUy Py

Slide 29


• The Demand Curve

DD

X2 X1

P1

P2

a

b



Applications of Marginal Utility Theory

• Early thinkers struggled about the problem of what determines the relative prices of commodities.

• Generally, the value a consumer places on a unit of a good or service depends on the satisfaction he or she expects to derive from it.

• However, many essential products, without which the consumer could not live, have relatively low prices whilst some luxury products, such as diamond, have relatively high prices, even though consumes could easily survive without them.


Slide 31

TU vs. MU: The Paradox of Value

• For example:

• Diamond-Water paradox

• Gh¢10,000 for example can be used to purchase either – one carat diamond

OR

– 5 million gallons of tap water

• In other words, why should one carat diamond cost Gh¢10,000 while a big bottle of water will cost only Gh¢2?


WHY?

• Even though the Total Utility of water is greater than Total Utility of diamonds – Because water is essential for life

• BUT water is abundant, diamonds are rarer – Marginal Utility of last diamond is higher

• However, MU determines the price of the product.

• 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.


– 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 than that of a diamond ring.


Slide 34

MU and Demand

• From the earlier discussion, we can say that MU measures the willingness to pay.

• Price = MU

• Since MU declines as consumption rises, 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.


Example : Balls of Kenkey

P

Q

D

Gh¢1.0

4 balls

for 4th ball of kenkey

willing to pay Gh¢1.0

for 2nd ball of kenkey Gh¢1.5

2 balls

willing to pay Gh¢1.5


Slide 36

Consumer Surplus

• It is the difference between what the consumer actually pays for a good and what he is 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¢1.2

• Your consumer surplus then is = Gh¢2


Slide 37

P

Q

D

$10

The Demand Curve

$12

3

your consumer surplus


Slide 38

P

Q

D

Gh¢1.0

10,000

total consumer surplus area between D and price of kenkey

The Demand Curve


Slide 39

Consumer’s Budget

• 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

• consumption possibilities


Slide 40

Example

• 2 goods: bread & kenkey

• A loaf of bread = Gh¢1.0

• A ball of kenkey = Gh¢0.5

• daily budget = Gh¢4.0


Possible Combinations

kenkey bread

0 2 4 6 8

4 3 2 1 0


Budget line

Bread

Kenkey

8

4

2

6

0 4 2 1 3


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 X+ PyY = M


Slide 44

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


Slide 45

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