Marginal Utility Theory. K. Adjei-Mantey Department of Economics

Transcription

1 Marginal Utility Theory K. Adjei-Mantey Department of Economics

2 Utility and Marginal Utility Every economic agent attempts to make the best out of every decision Marginal utility theory explains how consumers get the best satisfaction possible given their preferences and their constraints. Consumers striving to maximize their utility Utility actual quantitative measure of well-being or satisfaction Measured in utils Anything that makes a consumer better off Increases utility Anything that makes a consumer worse off Decreases utility 2

3 Total Utility and Marginal Utility Assume a consumer, Ama, who likes cone ice cream 3

4 Total Utility and Marginal Utility Total Utility is the total satisfaction an individual gains from consuming all the quantities of a commodity. Marginal utility is the change in utility that an individual enjoys from consuming an additional unit of a good The Law of Diminishing marginal utility As consumption of a good or service increases, marginal utility decreases The marginal utility of a thing to anyone diminishes with every increase in the amount of it s/he already has 4

5 Total Utility and Marginal Utility- Number of cones Total Utility (Utils) 0 0 utils Marginal Utility (Utils) Ama s total utility increases with each cones consumed However additional utility from each successive cone decreases, as she consumes more cones

6 Utility and Marginal Utility- Graphical Illustration Number of cones Total Utility 0 0 utils Marginal Utility Utils Utils Total Utility 5 6 Ice cream cones per week 6 Given the preferences assumptions of the Marginal Utility theory, would Ama ever consume more than 5 ice cream cones? Marginal Utility 6 Ice cream cones per week

7 Combining the Budget constraint and Preferences Marginal Utility Tells us about a person s preferences Budget Constraint Which combinations of goods s/he can afford Combining both preferences and budget constraint can yield an individual s utility-maximising choice Recall meaning of demand Willingness + ability = demand 7

8 Illustration Go back to Kweku and his consumption of concerts and movies Same information about his budget constraint Entertainment budget, prices of movies and concerts Additional information about preferences 8

9 The Budget Constraint and Preferences 9 Kweku Consumption Possibilities with Income of Ghc150 per month Point on Budget line Concerts at Ghc30 No. of concerts / month MU from last concert (MU) MU per Ghc spent on last concert (MU/P) Movies at Ghc10 No. of Movies / month MU from last movie (MU) A B C D E F MU per Ghc spent on last movie (MU/P)

10 Budget Constraint and Preferences MU/P is marginal utility per Ghc spent by Kweku on concerts or movies Gain in utility for each Ghc Kweku spends on each good MU/P also decreases with increases in consumption Why? 10

11 Budget Constraint and Preferences Kweku s aim is to find affordable combination of movies and concerts that gives him highest possible utility This is where the marginal utility per Ghc is the same for both goods i.e. (MU/P) movies = (MU/P) concerts Why is this so? 11

12 The Budget Constraint and Preferences 12 Kweku Consumption Possibilities with Income of Ghc150 per month Point on Budget line Concerts at Ghc30 No. of concerts / month MU from last concert (MU) MU per Ghc spent on last concert (MU/P) Movies at Ghc10 No. of Movies / month MU from last movie (MU) A B C D E F MU per Ghc spent on last movie (MU/P)

13 Movies per month The Budget Constraint and Preferences Kweku will continue to shift consumption until he is at point D A B (MU/P)c= 40; (MU/P)m= 15 9 C (MU/P)c= 20; (MU/P)m 6 D (MU/P)c= 15; (M 3 E 13 F Concerts Per month

14 Budget Constraint and Preferences Generalization For any two goods x and y, with prices Px and Py, Whenever MUx/Px > MUy/Py, A consumer is made better off by shifting spending away from y and towards x...and vice-versa 14

15 Budget Constraint and Preferences Further Generalization A utility-maximising consumer will choose a point on the budget line where marginal utility per dollar is the same for both goods 15

16 Marginal Utility (MU) versus Marginal Utility per Price (MU/P) Shouldn t a consumer spend whenever marginal utility is greater? Suppose individual likes private jet rides and wrist watches. MU for private jet ride is 2000utils; MU for a watch is 1000utils. Should funds be diverted to private jets or wrist watches? What if private jet costs Ghc200 but wrist watches cost Ghc20? Is your answer the same? 16

17 Marginal Utility (MU) versus Marginal Utility per Price (MU/P) 17 Shouldn t a consumer spend whenever marginal utility is greater? No! Why? Private Jet MU P MU/P Wrist watch Private jet rides give twice as much additional satisfaction but cost 10 times more than wrist watches Give up 10 wrist watches for a single private jet ride Additional utility from spending Ghc1 on watches is 50; only 10 from private jets Spend on wrist watches

18 What happens when things change? Changes in Income Suppose Kweku s income increases to Ghc300? What do you think will happen to his budget line? 18

19 The Budget Constraint and Preferences Kweku Consumption Possibilities with Income of Ghc300 per month Concerts at Ghc30 Movies at Ghc10 No. of concerts / month MU from last concert (MU) MU per Ghc spent on last concert (MU/P) No. of Movies / month MU from last movie (MU) MU per Ghc spent on last movie (MU/P) 19

20 The Budget Constraint and Preferences Movies per month 27 K At H, what type of a good is concerts? Movies? At point J, what type of a good is concerts? Movies? At K, what type of a good is 12 H concerts? Movies? 6 D 3 J Concerts Per month 20

21 The Budget Constraint and Preferences Change in income A rise in income with no change in prices leads to a new quantity demanded for each good. Whether a particular good is normal (increase in quantity demanded) or inferior (quantity demanded decreases) depends on the individual s preferences 21

22 What happens when Things Change? Change in Price What happens to Kweku s consumption when the price of a concert decreases from Ghc30 to Ghc10 Assume income and price of movies remains constant 22

23 The Budget Constraint and Preferences Kweku Consumption Possibilities with Income of Ghc150 per month Concerts at Ghc10 Movies at Ghc10 23 No. of concerts / month MU from last concert (MU) MU per Ghc spent on last concert (MU/P) No. of Movies / month MU from last movie (MU) MU per Ghc spent on last movie (MU/P)

24 Deriving the Demand Curve What happens if price of concerts falls further to Ghc5? Show diagram Each time the price of concerts changes, so does quantity demanded of concerts 24

25 Deriving the demand Curve Movies per month Price per Concert Concerts Per month Concerts Per month

26 Take- home assignment Draw a downward sloping demand curve for movies when its price falls, using the marginal utility approach Try identifying points on Kweku s budget line that would VIOLATE the law of demand i.e. construct an upward-sloping demand curve when prices change for concerts or movies 26

27 Discuss: The Paradox of Value Sometimes referred to as the Diamond-water paradox Why do many essential products that we use have relatively low prices? On the other hand, luxury products like diamonds have very high prices. 27

28 The Paradox of Value Goods like water are readily available As consumers consume more and more of them, their marginal utility falls It is not total use of diamonds or water that matters Use of each additional unit, rather Since water so readily available, marginal utility from additional unit is low Diamonds are not as available and therefore, consumption is low and additional unit worth more People willing to pay higher price for it 28

29 Next Class Indifference Theory Diminishing marginal rate of substitution consumer equilibrium price consumption curve income consumption curve Derivation of the consumer s demand curve 29