ECON107 Principles of Microeconomics Week 9 NOVEMBER 2013 Chapter-8 1 9w/11/2013 Dr. Mazharul Islam 8 8w/11/2013 Utility and Demand Dr. Mazharul Islam 3 Lesson Objectives Examine how individual consumers allocate their incomes among the various goods and services that available to them to get maximum utility? Given a particular budget, how does a consumer decide what goods and services to buy? 9w/11/2013 Dr. Mazharul Islam 4 Issues of Discussion Utility Defined Total Utility Marginal Utility Subjective Nature Difficult to Quantify Law of Diminishing Marginal Utility 9w/11/2013 Dr. Mazharul Islam 5 Definitions Utility: It reflects the benefit or satisfaction or pleasure of consumers that gets from goods and services. Total utility is the total satisfaction a person derives from consumption. Generally, more consumption gives more utility. Marginal utility is the change in total utility resulting from one-unit change in consumption of a good. As the quantity consumed of a good increases, the marginal utility from consuming it decreases. 9w/11/2013 Dr. Mazharul Islam TOTAL AND MARGINAL UTILITY 6 TU 0 1 2 3 4 5 6 7 0 10 18 24 28 30 30 28 9w/11/2013 10 8 6 4 2 0 -2 20 10 0 Marginal Utility (utils) Number Total Marginal Of glass Utility, Utility, Utils Utils Total Utility (utils) 30 10 8 6 4 2 0 -2 1 2 3 4 5 6 7 Units consumed per beef burger (BB) 1 2 3 4 5 6 7 MU Units consumed per BB Dr. Mazharul Islam TOTAL AND MARGINAL UTILITY 7 TU 0 1 2 3 4 5 6 7 0 10 18 24 28 30 30 28 9w/11/2013 10 8 6 4 2 0 -2 20 10 Observe Diminishing Marginal Utility 0 Marginal Utility (utils) Number Total Marginal Of glass Utility, Utility, Utils Utils Total Utility (utils) 30 10 8 6 4 2 0 -2 1 2 3 4 5 6 7 Units consumed per beef burger (BB) 1 2 3 4 5 6 7 MU Units consumed per BB Dr. Mazharul Islam 8 Maximizing Utility The key assumption of marginal utility theory is that the household chooses the consumption possibility that maximizes total utility. The Utility-Maximizing Choice We can find the utility-maximizing choice by looking at the total utility that arises from each affordable combination. The utility-maximizing combination is called a consumer equilibrium. 9w/11/2013 Dr. Mazharul Islam 9 Maximizing Utility Utility-Maximizing Condition Consumer equilibrium is achieved when the budget is completely spent and Equalize the marginal utility per dollar for all goods. The marginal utility per dollar is the marginal utility from a good divided by its price. MUp MU v Pv Pp Where MUp is the marginal utility of pizza, pp is the price of pizza, MUv is the marginal utility of videos, and pv the price of videos 9w/11/2013 Dr. Mazharul Islam 10 Maximizing Utility If MUp/Pp > MUv/Pv, then spend more on pizza and less on videos. MUp will decrease and MUv will increase. If MUp/Pp < MUv/Pv, then spend more on videos and less on pizza. MUp will increase and MUv will decrease. Only when, MUp/Pp= MUv/Pv, is it not possible to reallocate the budget and increase total utility. 9w/11/2013 Dr. Mazharul Islam 11 Utility Maximization To see your income is allocated between two goods so as to maximize utility, suppose we start with some combination of pizzas and videos If we can increase utility by reallocating our expenditures we will do so, and we will continue to make adjustments as long as utility can be increased when no further utilityincreasing moves are possible, we have arrived at the equilibrium combination 9w/11/2013 Dr. Mazharul Islam 12 Example Suppose that we have the following bits of information The price of pizza per unit is $8 The rental price of a movie video is $4 After tax income equals $40 per week 9w/11/2013 Dr. Mazharul Islam 13 Consumed Per Week (1) Total Utility of Pizza (2) Marginal utility of Pizza (3) per Dollar Marginal utility (price=$8) (4) Video Total Rentals Utility of per Week Videos (5) (6) Marginal utility of Videos (7) per Dollar marginal Utility of (price=$4) (8) 0 0 - - 0 0 - - 1 56 56 7 1 40 40 10 2 88 32 4 2 68 28 7 3 112 24 3 3 88 20 5 4 130 18 2¼ 4 100 12 3 5 142 12 1½ 5 108 8 2 6 150 8 1 6 114 6 1½ To get the process going, suppose you start off spending your entire budget of $40 on pizza 5 pizzas per week at a total utility of 142. If you give up one pizza, you free up enough money to rent 2 videos. Would total utility increase from this reallocation? You give up 12 units of utility – the marginal utility of the 5th unit of pizza, to get 68 units of utility from the first 2 videos total utility increases from 142 to 198. 9w/11/2013 Dr. Mazharul Islam 14 Now it’s over for today. Do you have any question? 5w/9/2013 Dr. Mazharul Islam