Some simplifying assumptions Consumers objective to maximize hisher utility

Some simplifying assumptions  Consumer’s objective: to maximize his/her utility subject to income constraint  2 goods (X, Y)  Prices Px, Py are fixed  Consumer’s income (I) is given

Consumer Equilibrium  Marginal utility per price  additional utility derived from spending the next price on the good  MU per last dollar = MU P

Consumer Equilibrium  Optimizing condition:  If  spend more on good X and less of Y X Y X Y MU MU P P  X Y X Y MU MU P P 

Numerical Illustration Q x TU X MU X MUx Px Q Y TU Y MU Y MUy Py 1 30 30 15 1 50 50 5 2 39 9 4.5 2 105 55 5.5 3 45 6 3 3 148 43 4.3 4 50 5 2.5 4 178 30 3 5 54 4 2 5 198 20 2 6 56 2 1 6 213 15 1.5

Simple Illustration  Suppose: X = fishball Y = fishcake  Assume: P X = 2 P Y = 10

Cont.  2 potential optimum positions  Combination A:  X = 3 and Y = 4 – TU = TU X + TU Y = 45 + 178 = 223  Combination B:  X = 5 and Y = 5 – TU = TU X + TU Y = 54 + 198 = 252

Cont.  Presence of 2 potential equilibrium positions suggests that we need to consider income. To do so let us examine how much each consumer spends for each combination.  Expenditure per combination – Total expenditure = P X X + P Y Y – Combination A: 3(2) + 4(10) = 46 – Combination B: 5(2) + 5(10) = 60

Cont.  Scenarios: – If consumer’s income = 46, then the optimum is given by combination A. .… Combination B is not affordable – If the consumer’s income = 60, then the optimum is given by Combination B….Combination A is affordable but it yields a lower level of utility

The Ordinal Approach Economists following the lead of Hicks, believe that utility is measurable in an ordinal sense--the utility derived from consuming a good, such as X, is a function of the quantities of X and Y consumed by a consumer. U = f ( X, Y )

Cont.  Ordinal Utility Theory (TUO) – Can be measured in qualitative, not quantitative, but only lists the main options (indifference curves & budget line).