Chapter 5
Consumer behaviour and Utility maximisation
Utility
Is a want-satisfying power
The utility of a good or service is the satisfaction or pleasure one gets from
consuming it
The three characteristics of this concept:
o Utility and usefulness are not synonymous
o Utility is subjective – utility of a specific product may vary from person
to person
o Two methodologies of measuring utility.
First option is where utility is measurable in numerical values
referred to as cardinal utility
The second form of utility measurement is captured in ordinal
utility theory of utility measurement. – consumers’ satisfaction is
not quantifiable but the level of satisfaction is expressed in
indifferent curves
Total utility and marginal utility (Related but different ideas)
Total utility - is the total amount of satisfaction or pleasure a person derives
from consuming some specific quantity
Marginal utility – is the extra satisfaction a consumer realises from an
additional unit of that product
o Example: from the eleventh unit.
o Alternatively, marginal utility is the change in total utility that results
from the consumption of 1 more unit of a product
Diminishing Marginal Utility (look at key graph page 101)
Law of Diminishing marginal utility
o The satisfaction declines as a consumer consumes additional units of a
given product. (more of a specific product a consumer obtains the less
they want it)
Marginal utility and demand
The law of diminishing marginal utility explains why the demand d=curve for a
given product slopes downward.
A consumer would rather spend additional rands on a product that provide
more (or equal) utility, not less utility.
Thus, additional product with less utility are not worth buying unless the price
drops. Therefore, diminishing marginal utility supports the idea that price must
decrease for quantity demanded to increase. In other words, consumers
behave in a way that make demand curves downward sloping
Theory of consumer behaviour
Consumer choice and budget constraint
we assume that the situation for the typical consumer has the following characteristics
Rational behaviour
o Consumer uses their money income to derive the greatest amount of
satisfaction or utility from it
Preferences
o Each consumer has their own preferences for certain foods and
services that are available
Budget constraint
o At any point in time the consumer has a fixed, limited of money income.
Prices
o Goods are scarce relative to the demand for them, so every good
carries a price tag
Utility maximising rule
To maximise satisfaction, the consumer should allocate his/her money income
so that the last rand spent on each product yields the same amount of extra
(marginal) utility. = utility-maximising rule
To make the amounts of extra utility derived from differently priced goods
comparable, marginal utilities must be put on a per-rand spent basis.
MU
price
Where MU= marginal utility
Algebraic re-statement
our allocation rule says that a consumer will maximise their satisfaction
when they allocate their money income so that the last rand spent on
product A, the last rand spent on product B, and so forth, yield equal
amounts of additional, or marginal utility.
The marginal utility per rand spent on A is indicated by the MU of product
A divided by the price of A same for B and so forth.
The utility-maximising rule merely requires that these ratios be equal
MU of product A MU of product B
=
Price of A Price of B
Look at example on page 105/106
Utility maximisation and the demand curve (read over and copy) page 107
recall that the basic determinates of an individuals demand for a specific product are
1) preferences or taste, 2) money income, and 3) the prices of other goods.
(read page 106)
Income and substitute goods
Income effect – the impact that a change in the price of a product has on a
consumers’ real income and consequently, on the quantity demanded of that
good
In contrast Substitution Effect – the impact that a change in a product’s price
has on its relative expensiveness and consequently on the quantity
demanded
Read over applications and extensions on page 108
Indifference curve analysis
A consumer must simply rank their various combinations of two goods in
terms of preference. This model has two main elements, the budget line and
indifference curves.
The budget line – or a budget constraint is a schedule curve (straight line usually)
showing various combinations of two products a consumer can purchase with a
specific money income. (insert figure 5.3 here page 109)
A budget line has two other specific characteristics
Income changes
o An increase in money income shifts the budget line to the right
o A decrease in money income shifts the budget line to the left
Price changes
o A decline in the price of both products – equivalent of increase in real
income – shifts the curve to the right
o An increase in price of both products – shifts curve to the left
Note what happens if PB changes while PA and money income remain
constant. If PB drops the lower end of the budget line fans outward to the right
If PB increases, the lower end of the line fans inward.
Indifference curves: what is preferred?
Budget line reflects ‘objective’ market data while indifference curves reflect
‘subjective’ market data.
Indifference curves show all the combinations of two products A and B that
will yield the same total satisfaction or total utility to a consumer
o they are downward sloping because more of one product means less
of the other product if total utility is to remain unchanged
marginal rate of substitution (MRS) – the measure of the slope of an
indifference curve of the combination of two goods represented by that point.
o The slope is measure by drawing a tangent line at that particular point
then measuring the rise over run of the straight line
The indifference map
Many indifference curves. Where each curve represents a different level of
total utility and therefore never crosses another indifference curve.
Each curve to the right of the original curve reflects combinations of A and B
that yield more total utility, conversely each curve to the left of the original
reflects combinations of A and B that yield less total utility
Equilibrium tangency
The budget line indicates all the combinations of A and B that the consumer
can attain within their money income, given the prices of A and B. of these
combinations the consumer will prefer the combination that yields the greatest
satisfaction or utility.
Specifically, the utility-maximising combination will be the combination lying
on the highest attainable indifference curve.
o It is called the consumers’ equilibrium position
The consumers’ optimal or equilibrium position is the point where
PB
MRS=
PA
