CH# 02 Consumer Theory & Utility Analysis.ppt - Consumer Theory Utility Analysis The Theory of Consumer Behavior The principle assumption upon which

Consumer Theory & Utility Analysis

The Theory of Consumer Behavior The principle assumption upon which the theory of consumer behavior is built is: a consumer attempts to allocate his/her limited money income among available goods and services so as to maximize his/her utility (satisfaction).

Theories of Consumer Choice  Utility Concepts: – The Cardinal Utility Theory • Utility is measurable in a cardinal sense • cardinal utility - assumes that we can assign values for utility, (Marshall). E.g., derive 100 utils from eating a slice of pizza – The Ordinal Utility Theory • Utility is measurable in an ordinal sense • ordinal utility approach - does not assign values, instead works with a ranking of preferences. ( Hicks, Slutsky)

The Cardinal ApproachNineteenth century economists, such as Jevons, and Marshall, assumed that utility was measurable in a numerical values e.g. 1,3,10 & 100 e.t.c.Utility is maximized when:MUX / MUY= PX/ P Y

Theory of Consumer Behavior  Utility – Utility is the satisfaction that a person gets from consumption of a good or service. ….measurement units  utils

The Cardinal Approach  Total utility (TU) - the overall level of satisfaction derived from consuming a good or service  Marginal utility (MU) additional satisfaction that an individual derives from consuming an additional unit of a good or service.  Formula : MU = Change in total utility Change in quantity = ∆ TU ∆ Q

EXAMPLE Number Purchased Total Utility Marginal Utility 0 0 0 1 4 4 2 7 3 3 8 1 4 8 0 5 7 -1

The Cardinal ApproachTU, in general, increases with QAt some point, TU can start falling with Q (see Q = 5)If TU is increasing, MU > 0From Q = 1 onwards, MU is declining principle of diminishing marginal utility As more and more of a good are consumed, the process of consumption will (at some point) yield smaller and smaller additions to utility 