In economic parlance, preference and choice are two distinct but related terms.

I may have desire to buy a particular car, but cannot buy it unless I have economic resources to buy it.

Extent of satisfaction that a person gets after consuming any product/service is called as utility.
utility denotes satisfaction.

Utility is a subjective concept that cannot be measured, bt can just be compared. Given the limited resources, a consumer can compare the utility of 2 goods or services from which he makes a choice. Thus, helping a consumer to make better choices.

The want satisfying power of commodity is utility. Same commodity gives different utility to different consumers. Even for the same consumer, utility varies from unit to unit, from time to time and from place to place.

 Cardinal utility approach:

based on Marshallian school of thought. It says that utility can be measured. It has come out with a unit called util to measure the utility. Util reveals how much of money a consumer is willing to pay for a given unit of product.

Ordinal utility approach:

based on view that utility cannot be measured at all; it can just be ranked in order of preferences. This approach is based on the assumption that a customer is consistent in ranking and preference is based on the choice of products available.

Alfred Marshall (1890) introduced the Cardinal Utility Theory also known as Marshallian Utility Theory.

It assumes that customers make a rational choice. Customers choose goods and services that give them maximum satisfaction considering their tastes and preferences and the resource constraints. consumers always prefer more quantity. Example: If there are two options, option A (3 biscuits and 10 chocolates and option B (3 biscuits and 12 chocolates), then consumers will always prefer option B, since the quantity is more.

 Nature

defined as the amount of utility a person derives from the consumption of a particular product in a given period. The sum- total of satisfaction which a consumer derives by consuming various units of a commodity. More units of a good he consumes, greater will be his TU or satisfaction from it up to a certain point. As he keeps on increasing the consumption of the good, he eventually reaches the point of saturation represented by the maximum total utility. If further units of the commodity are consumed, his total utility starts declining

of Total Utility:

Defined as the change in total utility resulting from 1 unit change in the consumption of the good. MU x = TU x / Qx MU x -- Marginal utility TU x change in total utility Qx change in quantity of good X respectively

MU of nth Unit = TU n - TU n-1

Another way of finding marginal utility is by differentiating total utility function: MUx = dTU x / dQx

Quantity of iceTotal Marginal cream utility utility consumed 0 0 1 6 6 2 10 4 3 13 3 4 14 1 5 14 0 6 12 -2

In the given table, the behavior or total utility schedule of person consuming icecream can be observed. It can be observed that total utility increases initially, later it become constant after reaching a certain point. Subsequently it starts declining. It can be seen that when a person starts consuming ice-cream, his total utility is increasing initially. When the person had consumed 5th unit of ice-cream, total utility stopped increasing. On consumption of the 6th unit, total utility started decreasing. Marginal utility starts decreasing as the consumer starts consuming more units of a product. If you refer to the above table, the marginal utility became zero, when the person has consumed 5th unit. Subsequent consumption leads to negative marginal utility.

 As consumption increases, TU rises but MU falls. When TU is maximum, MU falls to zero. When TU starts falling, MU becomes negative.
MU declines as consumer starts consuming more units of a particular commodity. It can be noted in the earlier example that, when the TU reaches its maximum, MU becomes zero. The decline in the total utility takes place when marginal utility becomes negative.

for any individual consumer the value that he attaches to successive units of a particular commodity will diminish steadily as his total consumption of that commodity increases, the consumption of all other goods being held constant. (R. G. Lipsey)

As consumer consumes extra units of a given good at a given time, his desire for every successive unit becomes less intense, thus utility derived from successive unit diminishes. the extra or MU declines as a person consumes more and more of any particular good. The TU grows at a slower rate, when a person consumes more and more of a good. TU grows at a slower rate as the MU starts diminishing with each additional unit consumed. The diminishing MUis a result of the fact that persons enjoyment of a good decline as more and more of the good is consumed.

1) Various units of goods are homogeneous. 2) No time gap between consumption of different units 3) Tastes, preferences and fashions remain unchanged 4) Consumer is rational ( i.e has complete knowledge and maximizes utility) If the above conditions holds good, law holds good universally.

 Equilibrium

(consumption of all other product remains constant) The utility maximizing consumer will adjust her purchases until the MU of last unit purchased equal to the price of a unit of that product. MU = P Or, MU/P = 1 Equilibrium for many products: To maximize utility, consumers allocate expenditure among products so that equal utility is derived from the last unit of money

for one product:

Law of equimarginal utility states that the

consumer will spend his money on different products in such a way that the marginal utility of each product is proportional to its price.
Thus, level of satisfaction would be the same while consuming the two products. A consumer with limited income has to choose between ice-cream and a leather belt. If the leather belt costs six times more than icecream, consumer would buy the leather belt only when its marginal utility is at least six times more than the marginal utility of ice-cream.

In general, utility maximizing consumer spread out their expenditure until the following condition holds: (MU x / Px ) = (MU y/ Py) Another View: (MU x / MU y) = (Px / Py)

Review Questions

Marginal utilities of good A and B are 600 and 900, and the price of good B is Rs.120. if the consumer is in equilibrium what is the price of good A?

Review Question

A consumer has income of Rs. 24 to spend on 3 commodities X,Y and Z. The prices of X,Y and Z are Rs.2, Rs.3 and Rs.5 respectively. What is the optimal mix of X,Y and Z that the consumer should purchase? The MU schedules are given as follows:

Units MUx MUy MUz 1 2 3 30 20 16 24 15 9 15 10 8

4
5 6

8
6 4

6
3 1

5
1 0

Review Questions
Arun has monthly budget of Rs. 340 to be spent on fruit juices. The market price of Apple, Mango and Orange juices are Rs.20, Rs. 40 and Rs. 50 per bottle, respectively. The total utility schedule for Arun is given:

Bottles Consume d 1 2 3 4 5 6 7

Total Utility Apple Juice 70 130 170 205 230 250 260 Mango Orange Juice Juice 80 160 160 210 250 285 315 335 290 410 510 590 650 680

 Pioneered by Marshall.

The excess of the price which a consumer would be willing to pay rather than go without a thing over which he actually does pay, is the economic measure of his surplus satisfaction.
can be defined as the difference between what consumers would like to pay for a product and what they actually pay.

Consumers Surplus for an Individual (Explanation see in the next slide)

3.00

2.00

1.00

Market price

0.30

10

Glasses of milk consumed per week

Consumers Surplus for an Individual Consumers surplus is the sum of the extra valuations placed on each unit above the market price paid for each. For the 1st unit consumption of glass of milk, the price the consumer is willing to pay is 3 but the actual price which he pays is 0.30. Ms. Green pays the red area for the 8 glasses of milk she consumes per week when the market price is 0.30 a glass. The total value she places on these 8 glasses of milk is the entire shaded area (red and green). Hence her consumers surplus is the green area.

Limitations of Cardinal Utility Approach OUT deals with consumers behavior under the assumption that utility from different units of a good or between different goods need only be rankable and not measurable. If a consumer gets more utility from bundle A than from bundle B, it means that the consumer will rank bundle A above bundle B. He need not know by how much quantity A is preferred to B. This approach was originally due to Vilfredo Pareto and was further elaborated by John Hicks and R.G.D. Allen.

Rationality:

Utility is Ordinal :

A consumer aims to maximize his utility (subject to income and prices) The consumer can rank his preferences (order the various baskets of goods) according to the satisfaction of each basket. He need not know precisely the amount of satisfaction. this condition requires that if a consumer prefers bundle A to bundle B, he does not, at the same time prefers bundle B to bundle A.

Consistency:

Transitivity:

Non- satiety:

If the consumer prefers bundle A to B and B to C, he prefers bundle A to bundle C. A bigger bundle is preferred to a smaller bundle.

A curve showing different combinations of two goods yielding the same level of utility (satisfaction) to the consumer is known as an Indifference Curve/ Equal Utility Curve. Since all points on the curve yield equal satisfaction, the consumer likes equally all the combinations, and is thus indifferent between these combinations.

 A set of indifference curves is called an indifference map. The further the curve from the origin, the higher the level of satisfaction it represents.

 Indifference

curve is downward sloping:

By defn, different points on an indifference curve represents the same level of utility. If we decrease the consumption of one good, obviously we need to increase the consumption of the other good to attain the same level of satisfaction as before the change. This gives rise to a downward sloping indifference curve.

Indifference curve is convex to the origin:

Convexity of IC curve implies that the two goods can substitute on another, but not perfectly. As consumer gets additional units of good X at the cost of good Y, marginal utility of good X(MUx) decrease. On the other hand, due to reduced availability of good Y the marginal utility of Y(MUy) increases. So, consumer would be ready to sacrifice lesser and lesser amount of Y for each additional unit of X.This gives rise to diminishing MRS. In case the phenomenon of diminishing MRS holds good, the indifference curve would be convex to the origin

Indifference curve is convex to the origin (contd.):

Convexity assumption implies imperfect substitution among the two goods. However, there are cases where the shape and slope of indifference curve will not be convex to the origin. a) Perfect substitutes: Two goods are perfect

What about perfect complements?

substitutes if each is substituted for the other at a constant rate, e.g. ball pen and fountain pen. In other words, marginal rate of substitution of these goods is constant. This results in a straight line downward- sloping IC or IC becomes a straight line with negative slope.

Indifference Curves - Properties

Clothing 16 (units per week) 14

12 10

-6

Observation: The amount of clothing given up for a unit of food decreases from 6 to 1

A
1 -4 1 -2 1 -1 1

8
6

Question: Does this relation hold for giving up food to get clothing?

4
2 1 2

Food (units per week)

 ICs

do not intersect each other:

If they did, the point of their intersection would imply two different levels of satisfaction, which is impossible.
The

further away from the origin an IC lies, the higher the level of satisfaction it denotes;
bundles of goods on a higher indifference curve are preferred by the rational consumer.

Indifference Curves - Properties

Clothing (units per week)

U2

U1

Indifference Curves Cannot Cross

The consumer should be indifferent between A, B and D. However, B contains more of both goods than D.

A B D

Food (units per week)

Indifference Curves - Properties

Clothing (units per week)

D B A

Market basket A is preferred to B. Market basket B is preferred to D.

U3

U2 U1
Food (units per week)

Marginal Rate of Substitution

The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good.
It is measured by the slope of the indifference curve. Along an indifference curve there is a diminishing marginal rate of substitution.
Note: the MRS for AB was 6, while that for DE was 2.

Marginal Rate of Substitution

Clothing 16 (units per week) 14

A MRS = 6
-6

MRS C

12 10

B
-4

8
6

MRS = 2

4
2 1 2

1 -2 1 -1

E
1

G
Food (units per week)

The marginal rate of substitution of X for Y (MRSx,y) is defined as the number of units of good Y that must be given up in exchange for an extra unit of good X so that the consumer maintains the same level of satisfaction.
The rate at which one good is substituted for another good, while remaining on the same indifference curve. Thus,

(slope of indifference curve) = -dY / dX =

A good is demanded by the consumer if he has

(i) A preference for that good, and (ii) purchasing power to buy the good.

His preference pattern is represented by a set of ICs, His purchasing power depends upon his money income and market prices of the goods.

Assume that the consumer has allocated some money to be spent on goods X and Y, whose prices are Px and Py , then his purchasing power can be represented in terms of a budget equation: Y= Px Qx + Py Qy Where Y = Income or expenditure on goods X and Y Qx and Qy = Quantity of good X and Y respectively Px and Py = Prices of good X and Y respectively. The budget equation gives us a budget line.

The Budget Line

Market Basket Food (F) Clothing (C) Total Spending Pf = ($1) Pc = ($2) PfF + PcC = I

A
B

0
20

40
30

$80
$80

D
E

40
60

20
10

$80
$80

80

$80

The Budget Line

Clothing (units per week) Pc = $2 Pf = $1 I = $80

(I/PC) = 40 30

A B 10

Budget Line F + 2C = $80

1 Slope C/F - - PF/PC 2

D
Not affordable

20 20 E 10
Affordable

G
0 20 40 60 80 = (I/PF)

Food
(units per week)

Shifts in the Budget Line

Changes in the prices of the goods or income shift the budget line A change in income causes a parallel shift the budget line

A change in the price of one good swivels the budget line (i.e. the slope changes)

12

Effects of Changes in Income and Prices

Effects of Income Changes An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant).

A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant).

The Effect of Income Changes

Clothing (units per week)

80

A increase in income shifts the budget line outward

60
A decrease in income shifts the budget line inward
L3 (I = $40) L1 (I = $80) L2 (I = $160)

40

20
0

Food
(units per week)

40

80

120

160

Effects of Changes in Income and Prices

Effects of Price Changes If the price of one good increases, the budget line shifts inward, pivoting from the other goods intercept.

If the price of one good decreases, the budget line shifts outward, pivoting from the other goods intercept.

The Effect of Price Changes

Clothing (units per week) An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward. A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward.

40

L3
(PF = 2)
40

L1
(PF = 1)
80

L2
120 160

(PF = 1/2)
Food
(units per week)

Effects of Changes in Prices

If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change. The budget line will shift inward to a point parallel to the original budget line.

If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change. The budget line will shift outward to a point parallel to the original budget line.

Consumer Choice (Equilibrium)

Clothing (units per week)

Pc = $2

Pf = $1

I = $80
At market basket A the budget line and the indifference curve are tangent and no higher level of satisfaction can be attained.

40

30 A 20

At A: MRS =Pf/Pc = .5

U2
Budget Line 0 20 40 80

Food (units per week)

Equilibrium Conditions

The slope of the indifference curve equals the slope of the budget line

MRS = the relative price ratio Px/Py= MUx / MUy

16

Review Questions

A consumer has a monthly budget of rs.4000 he spends all his income on two goods A and B. the prices of goods A and B are Rs.2 and rs.4 respectively. His marginal utility functions are given by MUA = 3/A and MUB = 9/B. what is the optimum amount that should be spent on good A?

Review Questions

Utility function of a consumer is U = X1.5Y. Prices of good X and Y are Rs.3 and Rs.4 respectively. His weekly budget is Rs.100. what is the optimum allocation of expenditure on good X and good Y for the consumer?