CHAPTER 10: THE RATIONAL CONSUMER
Before we proceed with our discussion of household choice, we need to make a few basic
assumptions.
•
Perfect competition- An industry structure in which there are many firms, each small relative
to the industry and producing virtually identical products, and in which no firm is large enough
to have any control over prices. Example- An industry in which there are so many wheat
producing firms. One single firm can not control price of wheat.
•
Homogeneous Products- Undifferentiated outputs or products that are identical to or
indistinguishable from one another.
•
Perfect knowledge – The assumption that the household possess a knowledge of the qualities
and prices of everything available in the market and that firms have all available information
concerning wage rates, capital costs and output prices.
THE BASIS OF CHOICE: UTILITY
Utility- The satisfaction or reward a product yields relative to its alternative. The basis of
choice.
There are two types of utility as follows:
i. Cardinal Utility- Cardinal utility gives a value of utility to different options. One way to try
and put values on goods utility is to see what price they are willing to pay for a good.
If we are willing to pay £5,000 for a second-hand Nissan Car, we can infer we must get 5,000
utils. In other words, the value of cardinal utility is related to the price we are willing to pay.
ii. Ordinal Utility- In ordinal utility, the consumer only ranks choices in terms of preference
but we do not give exact numerical figures for utility.
For example, we prefer a BMW car to a Nissan car, but we don’t say by how much.
Total
Utility
The total amount
of satisfaction
gained from the
consumption of
good or service.
Marginal
Utility
The additional
satisfaction gained
by the consumption
or use of one more
unit of something
Principle of Diminishing Marginal Utility- The more of any good consumed in a given
period, the less satisfaction (utility) generated by consuming each additional (marginal) unit
of the same good.
The Utility-Maximizing Rule- Equating the ratio of the marginal utility of a good to its
price for all goods.
𝐔𝐭𝐢𝐥𝐢𝐭𝐲 𝐌𝐚𝐱𝐢𝐦𝐢𝐳𝐢𝐧𝐠 𝐫𝐮𝐥𝐞:
𝐌𝐔𝐱 𝐌𝐔𝐲
=
= 𝐟𝐨𝐫 𝐚𝐥𝐥 𝐠𝐨𝐨𝐝𝐬
𝐏𝐱
𝐏𝐲
Where MUx is the marginal utility derived from the last unit of good X consumed, MUy is the
marginal utility derived from last unit of good Y consumed, Px is the price per unit of good X
and Py is the price per unit of good Y.
DIMINISHING MARGINAL UTILITY AND DOWNWARD SLOPING DEMAND
Consider a price of $25. At this price, Tom buys 5 Thai meals. The first, second, third, fourth
and fifth meals each generate enough utility to justify the price. Tom reveal this by buying
five meals. After the fifth meal, the utility gained from the next meal is not worth $25.
Ultimately, every demand curve hits the quantity (horizontal) axis as a result of diminishing
marginal utility- in other words, demand curves slope downward. How many times will Tom
go if meals are free? They are probably going to have 25 meals and after that they are not
going to have any more Thai meals even is Thai meals are free.
Price Per Meals
40
25
Downward Sloping Demand
Curve
15
0
5
10
25
Thai Meals Per Month
Figure: Diminishing Marginal Utility and Downward Sloping Demand
Income effect- The change in price such as a decline in price of say good X, will make a person
better off since he or she can now buy same amount of good X with less money than before. He or
she is now left with extra money he or she can spend for other goods or for more of good X. This
improvement in well being is called income effect of price change
Substitution Effect- When the price of a product falls, that product also becomes relatively
cheaper. That is, it becomes more attractive relative to potential substitutes. A fall in the price of
good X might cause the household to shift its purchasing pattern away from substitutes toward
good X. This shift is called the substitution effect of price change.
OPTIMAL CONSUMPTION:
𝐔𝐭𝐢𝐥𝐢𝐭𝐲 𝐌𝐚𝐱𝐢𝐦𝐢𝐳𝐢𝐧𝐠 𝐫𝐮𝐥𝐞:
𝐌𝐔𝐱 𝐌𝐔𝐲
=
= 𝐟𝐨𝐫 𝐚𝐥𝐥 𝐠𝐨𝐨𝐝𝐬
𝐏𝐱
𝐏𝐲
SUMMARY
Utility is a measure of a consumer’s satisfaction from consumption, expressed in units of
utils.
Consumers try to maximize their utility. A consumer’s utility function shows the
relationship between the consumption bundle and the total utility it generates.
To maximize utility, a consumer considers the marginal utility from consuming one more
unit of a good or service, illustrated by the marginal utility curve.
In the consumption of most goods and services, and for most people, the principle of
diminishing marginal utility holds: each successive unit consumed adds less to total
utility than the previous unit.