CONSUMER DEMAND THEORY

Cardinal utility analysis

Total and marginal utility
Law of diminishing marginal utility
Law of Equi marginal utility
1 Ordinal utility analysis
Application of demand theory
THEORY OF CONSUMER BEHAVIOR

 Useful for understanding the demand side of the market.

 Satisfaction or pleasure one gets from consuming a commodity.

 Utility is subjective—a specific product may vary widely from person to

person

 Utility refers to want satisfying power of a commodity.

 In objective terms, Utility may be defined as the “amount of satisfaction

derived from a commodity or service at a particular time”.

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UTILITY CONT.
 There are two views of utility:
 Cardinal Utility (Jevons, Walras, and Marshall)
 Cardinal utility is the belief that utility can be measured and compared
on a unit by unit basis.
 measurement units  utils

 E.g., A utility measure of 200 is twice as big as a utility measure of 100.

 E.g., derive 100 utils from eating a slice of pizza

 Ordinal Utility (Pareto, Hicks, Slutsky)

 Ordinal utility is where you rank bundles of goods, but cannot say how
much greater one bundle is to another.
 Ranking is the only thing that matters when dealing with ordinal utility.

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CARDINAL UTILITY

Assumptions:

 Utility can be measured.

 Marginal Utility of money remains constant
 No change in income of the consumer, his taste & fashion to
be constant
 No substitute
 Independent marginal utility of each unit of commodity

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TOTAL UTILITY AND MARGINAL
UTILITY

 Total utility (TU) - the overall level of satisfaction derived

from consuming a good or service
 TU = Sum of all MU

 Marginal utility (MU)- additional satisfaction that an

individual derives from consuming an additional unit of a
good or service.
 MU = TU /  Q

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UTILITY

The exponents of the utility analysis have developed two laws

which occupy a very important place in economics theory and
they are :-

I. Law of Diminishing Marginal Utility

II. Law of Equi-Marginal Utility

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LAW OF DIMINISHING MARGINAL UTILITY
Though wants of an individual are unlimited in number yet each
individual want is satiable. Because of this, the more we have a
commodity, the less we want to have more of it.

This law states that as the amount consumed of a commodity

increases, the utility derived by the consumer from the additional
units, i.e. marginal utility goes on decreasing.

According to Marshall, “The additional benefit a person derives from

a given increase of his stock of a thing diminishes with every
increase in the stock that he already has”

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LAW OF DIMINISHING MARGINAL
UTILITY

 Law of Diminishing Marginal Utility - eventually, a point

is reached where the marginal utility obtained by
consuming additional units of a good starts to decline,
ceteris paribus.

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LAW OF DIMINISHING MARGINAL
UTILITY

 Example

• If I’m really hungry, I get a lot of satisfaction

from first slice of pizza.
• If I keep eating pizza, the satisfaction from the
8th slice would be much less than that of the
first slice.

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LAW OF DIMINISHING MARGINAL
UTILITY
Explanation:
As more and more quantity of a commodity is consumed, the
intensity if desire decreases and also the utility derived from the
additional unit.

Assumptions:
 All the units of a commodity must be same in all respects
 The unit of the good must be standard
 There should be no change in taste during the process of
consumption
 There must be continuity in consumption
 There should be no change in the price of the substitute goods

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LAW OF DIMINISHING MARGINAL
UTILITY
Total Utility

30
(1) (2) (3)

Total Utility (Utils)

Tacos Total Marginal
Consumed Utility, Utility, TU
Per Meal Utils Utils 20

0 0
] 10 10
1 10
] 8
2 18
] 6 0 1 2 3 4 5 6 7
3 24 Units Consumed Per Meal
] 4

Marginal Utility (Utils)

Marginal Utility
4 28
5 30
] 2 10

6 30
] 0 8
6
7 28
] -2 4
2
0
-2 MU
11
1 2 3 4 5 6 7
Units Consumed Per Meal
UTILITY
-- ICE CREAM
CONSUMPTION

Number of Total Marginal

cones Utility Utility
0 0 -
1 30 30
2 50 20
3 60 10
4 65 5
5 68 3
12
6 68 0
FIGURE 3: TOTAL AND MARGINAL
UTILITY
Utils 70
60 Total Utility
50
40 1. The change in total utility from
30 one more ice cream cone . . .
20
10

1 2 3 4 5 6
Ice Cream Cones per Week
2. is called the marginal utility 3. Marginal utility falls
Utils of an additional cone. as more cones are
30
20 consumed.
10
Marginal Utility
1 2 3 4 5 6
Ice Cream Cones per Week

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LAW OF DIMINISHING MARGINAL
UTILITY

Exceptions:
# Money
# Hobbies and Rare Things
# Liquor and Music
# Things of Display

Importance:
Basis of Law of Demand
Basis of Consumption Expenditure
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The basis of Progressive Taxation
LAW OF EQUI-MARGINAL UTILITY

This law states that the consumer maximizing his total utility will
allocate his income among various commodities in such a way that his
marginal utility of the last rupee spent on each commodity is equal.
Or
The consumer will spend his money income on different goods in such
a way that marginal utility of each good is proportional to its price
Or
Under cardinal utility analysis a consumer maximizes his total utility
by equalizing his marginal utility in relation to price in all the
directions of his consumption or on each good and service purchased
by him.

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UTILITY MAXIMIZATION WITH
SCARCITY
 Now suppose we focus on how a consumer chooses when
goods are not free  the issue becomes one of
maximizing utility subject to the constraint that your
income is limited and prices are greater than zero
 Suppose we now extend our analysis to the consumption
of two goods: pizza and video rentals
 Suppose we have the following information:
 The price of pizza is $8
 The rental price of a movie video is $4
 After tax income equals $40 per week

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CONSUMER
EQUILIBRIUM
 Consumer equilibrium is achieved when the
budget is completely spent and the last dollar
spent on each good yields the same additional
utility

MUp MUv

Pp Pv
 Where MUp is the marginal utility of pizza, pp is
the price of pizza, MUv is the marginal utility of
videos, and pv is the price of videos
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Example 2
Given the budget constraint, Individuals will attempt to
gain the maximum utility for each additional dollar spent,
“the marginal dollar.”
For PX = $3, the
MUX
Utility X MUX per dollar MUY Utility Y
PX PY
Qx TUx MUx spent on good Qy TUy MUy
X is;
1 30 30 10. 12 1 60 60
2 55 25 8.33 6 2 90 30
For PY = $5, the
3 75 20 6.67 MU per dollar 4 3 110 20
Y
4 90 15 5.00 spent on good 2 4 120 10
5 100 10 3.33 Y is; 1.6 5 128 8
6 105 5 1.67 0 6 128 0
7 105 0 0 7 120 -8
8 100 -5 8 100 - Slide
20
-- 18
Now the preferences of the individuals and the relative prices
of the two goods are displayed in the tables.

Utility X MUX MUY Utility Y

PX PY
Qx TUx MUx Qy TUy MUy
If the objective is
1 30 30 10. 12 1 60 60
to maximize utility
2 55 25 8.33 given prices, 6 2 90 30
3 75 20 6.67 preferences, and 4 3 110 20
4 budget, spend each 4
90 15 5.00 2 120 10
additional $ on the
5 100 10 3.33 good that yields 1.6 5 128 8
6 105 5 1.67 the greater utility 0 6 128 0
7 105 0 0 for that 7 120 -8
expenditure.
8 100 -5 8 100 - Slide
20
-- 19
Given the preferences of the individual and the relative
prices of the goods [PX = $3, PY = $5], the MU’s for
each dollar spent are:
To maximize TU given a budget of $ 43, the first
MUX expenditure would logically be for good Y since MUY
PX the MUY for each dollar is 12. PY

$3 The second expenditure is for good X, $5

10.  [MUX $ is greater than MUY $]
 12
8.33 $3   $5 6
The third & fourth expenditures are for
6.67 $3  good X since the MU per dollar spent is  $5 4
$3 greater for X than Y.
5.00  2
The fifth expenditure is for good X.
3.33 $3  1.6
Continue to maximize the MU per $ spent.
1.67 0
0
MUX
PX
> MUY
PY
, BUY X ! MUX
PX
< MUY
PY
, BUY Y !
Slide
-- 20
MUX
PX
> MU
P
Y says that the marginal utility of an additional
Y
dollar spent on good X is greater than that of
a dollar spent on good Y.

MUX
PX
< MU
PY
Y indicates that the MU per dollar spent on good
Y exceeds that of a dollar spent on good X.

If the amount spent on the two goods is equal to the budget

then
PX
>
MUX MUY suggests that the individual should buy
PY less of Y in order to buy more of X.

MUX
PX
< MU
P
Y says to purchase less X to pay for additional
Y
amounts of Y.

MUX MUY
PX = PY
is an equilibrium condition!
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MUX MUY
PX = PY
subject to the constraint:
PX X + PY Y = B

insures the individual has maximized their total utility and

has not spent more on the two goods than their budget.

This model can be expanded to include as many goods as

necessary:

MUX MUY MUZ

PX = PY
= PZ =...= MUN
PN
subject to;
PX X + PY Y + Pz Z + . . . + PN N = B

From this information a demand for the goods can be

constructed.
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LIMITATIONS OF LAW OF EQUI-MARGINAL
UTILITY

# It is difficult for the consumer to know the marginal utilities from

different commodities because utility cannot be measured.

# Consumer are ignorant and therefore are not in a position to arrive at

an equilibrium.

# It does not apply to indivisible and inexpensive commodity.

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ORDINAL VS CARDINAL RANKINGS
 Ordinal Ranking: gives us information on how a
consumer ranks different baskets of goods. But it does not
say by how much (i.e. 2 times as much)
 This is how we view preferences.
 Cardinal Rankings: Give us information on the intensity
of the consumer preferences (i.e. they like basket A 10
times more than basket B).
 Would be hard to say I like eating pizza out 10.5 times more than
eating bad Chinese. Putting an exact number to our preferences is
hard! – this is why we use ordinal rankings for consumer
preferences

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ORDINAL VS CARDINAL EXAMPLE
Students take an exam. After the exam, the students are ranked
according to their performance. An ordinal ranking lists the
students in order of their performance (i.e., Harry did best, Joe
did second best, Betty did third best, and so on).
A cardinal ranking gives the grade of the exam, based on an
absolute grading standard (i.e., Harry got 50, Joe got 100, so
Joe did 2 times better than Harry).

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CONSUMER PREFERENCES

 Indifference Curves
● indifference curve Curve representing all combinations of market
baskets that provide a consumer with the same level of satisfaction.

An Indifference Curve

The indifference curve U1 that

passes through market basket
A shows all baskets that give
the consumer the same level of
satisfaction as does market
basket A; these include
baskets B and D.

Our consumer prefers basket

E, which lies above U1, to A,
but prefers A to H or G, which
lie below U1.

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CONSUMER PREFERENCES

 Indifference Maps
● indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.

An Indifference Map

An indifference map is a set of

indifference curves that
describes a person's
preferences.
Any market basket on
indifference curve U3, such as
basket A, is preferred to any
basket on curve U2 (e.g.,
basket B), which in turn is
preferred to any basket on U1,
such as D.

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CONSUMER PREFERENCES

 Indifference Maps

Indifference Curves Cannot Intersect

If indifference curves U1 and U2

intersect, one of the
assumptions of consumer
theory is violated.
According to this diagram, the
consumer should be indifferent
among market baskets A, B,
and D. Yet B should be
preferred to D because B has
more of both goods.

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CONSUMER PREFERENCES

The Marginal Rate of Substitution

● marginal rate of substitution (MRS) Maximum amount of a good
that a consumer is willing to give up in order to obtain one additional
unit of another good.

The Marginal Rate of Substitution

The magnitude of the slope of an

indifference curve measures the
consumer’s marginal rate of
substitution (MRS) between two
goods.
In this figure, the MRS between clothing
(C) and food (F) falls from 6 (between A
and B) to 4 (between B and D) to 2
(between D and E) to 1 (between E and
G).
Convexity The decline in the MRS
reflects a diminishing marginal rate of
substitution. When the MRS
diminishes along an indifference curve,
the curve is convex. 29
CONSUMER CHOICE
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination
of goods and services.

Maximizing Consumer Satisfaction

A consumer maximizes satisfaction

by choosing market basket A. At
this point, the budget line and
indifference curve U2 are tangent.
No higher level of satisfaction (e.g.,
market basket D) can be attained.
At A, the point of maximization, the
MRS between the two goods equals
the price ratio. At B, however,
because the MRS [− (−10/10) = 1]
is greater than the price ratio (1/2),
satisfaction is not maximized.
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CONSUMER PREFERENCES

 Perfect Substitutes and Perfect Complements

● perfect substitutes Two goods for which the marginal rate

of substitution of one for the other is a constant.

● perfect complements Two goods for which the MRS is

zero or infinite; the indifference curves are shaped as right
angles.
Bads
● bad Good for which less is preferred rather than more.

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CONSUMER PREFERENCES

 Perfect Substitutes and Perfect Complements

Figure 3.6
Perfect Substitutes and Perfect Complements

In (a), Bob views orange juice and In (b), Jane views left shoes and
apple juice as perfect substitutes: right shoes as perfect complements:
He is always indifferent between a An additional left shoe gives her no
glass of one and a glass of the extra satisfaction unless she also 32
other. obtains the matching right shoe.
INDIFFERENCE CURVE ANALYSIS
 BudgetLine (Constraint)
Income Changes
Price Changes
12

10

Quantity of A
8 (Unattainable)
6

2 (Attainable)

0
2 4 6 8 10 12
Quantity of B 33
INDIFFERENCE CURVE ANALYSIS
 What is Preferred
Down sloping
Convex to Origin
Marginal Rate of Substitution (MRS)
12
j
Combination Units of A Units of B 10

Quantity of A
8
j 12 2
6 k
k 6 4
l
4 m
l 4 6
2 I
m 3 8
0
2 4 6 8 10 12
Quantity of B 34
INDIFFERENCE CURVE ANALYSIS
 The Indifference Map
 Equilibrium Position at Tangency

12

10
PB
MRS =
PA
8
Quantity of A

Preferred –
6 W But Requires
More Income
4 X

I4
2 I3
I2
I1
0
2 4 6 8 10 12 35
Quantity of B
DERIVATION OF THE DEMAND CURVE
 Measurement of Utility
12
Marginal Utility Marginal Utility
10 of A of B
Quantity of A
8 Price of A = Price of B
6
X
At $1 Price for B,
4
6 Units are Purchased
2
I3 Record the Results
I2
0 As Price of B Increases to
2 4 6 8 10 12
Quantity of B $1.50,
Only 3 Units of B are
Bought Record the Results
Price of B

$1.50 Connect the Points to

1.00 Create the Demand Curve
.50
DB 36
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of B