Schedule of Classes
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September, 3
September, 10
September, 17 – in-class#1
September, 19 – in-class#2
September, 24 – in-class#3 (open books)
• September, 25, 4-30 p.m. – test
• September, 26, 10-45 a.m. – results
Topic 2.
Demand and Supply
Topic 2.1.
Individual Consumer Demand
Utility
• The decision to buy is based upon two considerations:
– The utility that you derive from the commodity
– The ability to pay for it
• Def.: Utility – the pleasure or satisfaction associated with
having, using, or consuming goods or services
– The cardinal approach to consumer equilibrium
– The ordinal approach to consumer equilibrium
The Cardinal Approach
to Consumer Equilibrium
Utility Function
• Utility can be measured in units called utils
• A utility function is obtained by attaching a number to
each market basket, so that if market basket is preferred
to market basket B, the number will be higher for A than
for B
Marginal Utility
• Marginal utility is defined as the change in total utility
that results from a one-unit change in consumption
TU X
MU X 
QX
The Law of Diminishing Marginal Utility
• Marginal utility diminishes as quantity of the commodity
consumed increases
• The assumption of diminishing marginal utility is one of
the most important cornerstones of economic theory
• The saturation point at which TU is maximum is
determined as the point where MU=0
The Model of Consumer Behavior
(Assumptions)
• Consumers are free to spend their incomes as they
please
• Consumers have perfect knowledge of all factors that
may affect their decision
• The sales units of commodities are divisible
• The consumer’s tastes and preferences are well
established
• The marginal utility of each commodity diminishes for the
consumer as the quantity consumed increases
• More is better than less
• Consumers always attempt to maximize utility
Consumer Equilibrium at Maximum
Utility
• ?: How does a consumer decide what to buy?
– Consumers always try to get the most for their money
• Maximum utility is a position of equilibrium
• The cost of consumption (the utility of money) is
balanced against the utility to be gained from the
purchase (see next slide)
Consumer’s Equilibrium
• Each commodity purchased provides marginal utility that
diminishes as consumption increases
– and each can be purchased at a particular price
MU X MU Y

 ...  MU M
PX
PY
• At this point the consumer can no longer increase total
utility by buying more or less
– The marginal utility per last dollar spent is equal for all
commodities
Effects of Advertising and Promotion
• Ex: suppose beef sales are rising at the expense of pork
sales
MU
MU
beef
Pbeef

pork
Ppork
• How can the producers of pork halt the decline in their
sales?
– Reduce the price of pork to equalize the ratios
– Change the marginal utility of pork
• The utility of commodity exists only in the consumer’s
mind
– Marginal utility may be changed by persuasive advertising and
promotion
Marginal Utility and Demand Curves
• A consumer’s demand curve can be derived from
marginal utility data
MU X
PX 
MU M
• E.g.:
• MUM=2; MUX= 200 – 4QX
• Calculating of price from information on marginal
utility of commodity X and marginal utility of money
The Ordinal Approach
to Consumer Equilibrium
The Characteristics of the Consumer’s
Preferences
• Given three bundles of goods (A, B, and C), if an
individual prefers A to B and B to C, he must prefer A to
C
– If an individual is indifferent between A and B and between B and
C, he must be indifferent between A and C
• If an individual can rank any pair of bundles chosen at
random from all conceivable bundles, he can rank all
conceivable bundles
• If bundle A contains at least as many units of each
commodity as bundle B, and more units of at least one
commodity, A must be preferred to B
Indifference Curves
• Def.: An indifference curve is the set of all
combinations of commodities X and Y that yield the
same level of total utility or satisfaction
– An indifference map is a graph that shows a set of indifference
curves
Characteristics of Indifference Curves
• They are infinite in number and every point in the
commodity space lies on an indifference curve
• They are continuous and downward sloping
• They are concave from above (convex to the origin)
• The farther away from the origin an indifference curve is,
the higher the level of utility it represents
• They cannot intersect, since each curve represents a
different and unique level of utility
Marginal Rate of Substitution (1)
• Def.: the marginal rate of substitution, X for Y, (written
MRSXY) indicates the number of units of Y that must be
given up to acquire one additional unit of X while
satisfying the condition of constant total utility
Y
MRS  
X
• MRSXY is defined as the slope of the indifference curve
at a certain point
• When the MRSXY diminishes along the indifference
curve, the indifference curve is convex
Perfect Substitutes and
Perfect Complements
• The two goods are perfect substitutes when the
marginal rate of substitution of one good for another is a
constant
– The indifference curves are straight lines
• The two goods are perfect complements when the
marginal rate of substitution of one good for another is
infinite
– The indifference curves are shaped as right angles
The Budget Line
• Def.: the budget line or line of attainable combinations is
the set of all combinations of commodities X and Y that
can be purchased when all available income is spent on X
and Y
Marginal Rate of Substitution (2)
• Relationship between MU and MRSXY
• MRSXY and the exchange of goods
Consumer Equilibrium
• Utility maximization is achieved when the budget is
allocated so that the marginal utility per dollar of
expenditure is the same for each good
MU X MU Y

PX
PY
Individual Demand
• Price-consumption curve for X
– Traces the utility-maximizing combinations of goods X and Y
associated with each and every price of good X
• The demand curve relates the quantity of good X that the
consumer will buy to the price of X
– The lower the price of the product, the higher the level of utility
– At every point at the demand curve, the consumer is maximizing
utility
• Ordinary vs. Giffen goods
Income Changes
• Income-consumption curve
– Traces the utility-maximizing combinations of goods X and Y
associated with different levels of income
• Engel curves
– Relate the quantity of a good consumed to income
• Normal vs. inferior goods