CPT Section C General Economics Unit 2 Ms. Anita Sharma

CPT Section C General Economics Unit 2 Ms. Anita Sharma

Demand for a commodity depends on the utility of that commodity to a consumer.

PROBLEM OF CHOICE RESOURCES (Limited) WANTS (Unlimited)

Problem Of Choice As we know resources are limited and wants are unlimited so there is a problem of choice for the consumer. It is also known as Problem of scarcity. That s why the consumer has to decide what to purchase from his existing income to gain maximum satisfaction.

Classification of wants

Classification of Wants. Necessities- Goods which are required for our survival. (Ex. Food, Medicines etc.) Comforts Goods which make our life easy. (Ex. Fan, Tables, Chairs etc.) Luxuries Goods which make our life lavish. (Ex. Car, AC etc.)

Utility is the want satisfying power of a commodity. OR Utility is satisfaction and it is subjective in nature. Utility Usefulness

By By, Alfred Alfred Marshal l Marshall Marginal Utility Analysis OR By Hicks & Allen Indifference Curve Analysis OR Cardinal Utility Analysis Ordinal Utility Analysis

Marginal Utility Analysis This theory will explain us how a consumer spends his income on different goods & services to attain maximum satisfaction. Utility can be of two types: TU Total Utility MU Marginal Utility

Total Utility It is the sum of utility derived from different units of a commodity consumed by a consumer. TU = sum of all MUs OR TU = MU

Marginal Utility It is the additional utility derived from the consumption of an additional unit of a commodity. MU = TU n Tu n-1 OR MU = Change in TU / Change in units

Hello Friends Lets Buy an Ice Cream

Unit 1 Unit 2 Unit 3 Unit 4 Unit 5 Unit 6 8 Utils 6 Utils 4 Utils 2 Utils 0 Utils -2 Utils

Schedule of TU & MU

Graphical presentation 25 20 15 10 TU MU 5 0-5 1 2 3 4 5 6

Relationship between TU & MU Ex. Suppose consumer wants to consume ice-cream. Units of Icecream TU MU 25 20 1 8 8 2 8+6 = 14 6 3 14+4 = 18 4 4 18+2 = 20 2 15 Utility 10 5 TU MU 5 20+0 = 20 0 6 20+(-2) = 18-2 0-5 1 2 3 4 5 6 1) Till MU remains +ve, TU increases. 2) When MU is zero, TU is maximum. 3) When MU is ve, TU decreases.

Assumptions The cardinal measurement of utility is possible MU of money remains constant The hypothesis of independent utility Consumer is rational

The Law Of Diminishing Marginal Utility The law is based on some important facts: Total wants of the person are unlimited but each single want is satiable. Since each want is satiable, as consumer consumes more & more units of a good, the intensity of his want for the good goes on increasing. The law describes fundamental tendency of human nature.

Law of DMU According to the Law of Diminishing Marginal Utility, as a consumer takes more and more units of a good, the extra(additional) satisfaction that he derives from an extra(additional) unit of a good goes on falling.

This is called Point Of Satiety. (maximum satisfaction)

Law of DMU (cont.) Quantity of ice-cream consumed Marginal Utility 1 30 2 20 3 10 MU 4 0 5-10

Limitations of Law of DMU Homogeneous Units Standard Units of consumption Continuous consumption The law fails in the case of prestigious goods Case of related goods

How to maximize total satisfaction? The consumer will maximize total utility when he allocates his income among various commodities in such a way that the MU of last rupee spent on each commodity is equal.

H.H.Gossen s Law H.H. Gossen s first law :- Law of Diminishing Marginal Utility Equi- Gossen s second law :- Law of marginal Utility

Consumer Surplus Marshall defined the concept as excess price which a consumer would be willing to pay rather than go without a thing over that which he actually does pay. Is called consumer s surplus.

Measurement of Consumer s Surplus No. of units of icecream M U Price Consumer s surplus 1 40 20 40-20 = 20 2 30 20 30-20 = 10 3 20 20 20-20 = 0 4 10 20 10-20 = -10

Measurement of Consumer s Surplus Purchase of 1 st unit MU = 40 Price = 20 Consumer s Surplus = 20 Purchase of 2 nd unit MU = 30 Price = 20 Consumer s Surplus = 10

Measurement of Consumer s Surplus Purchase of 3 rd unit MU = 20 Price = 20 Consumer s Surplus = 0 Here, Consumer is in Equilibrium. Given the price of Rs. 20 per unit of ice - cream. Total surplus = 20+10+0 = 30

Measurement At equilibrium(maximum satisfaction level) when consumer buys 3rd unit. - Marginal Utility = Market price (MUX = Px) - He is willing to pay a sum equal to the actual market price.

Consumer s Surplus What a consumer is ready to pay What he actually pays

It can not be measured precisely. In case of necessities the MU of earlier units are infinitely large. Affected by availability of substitutes. It can not be measured in terms of money.

MCQs for Cardinal Approach

MCQ.1:Utility refers to: a) usefulness b) importance c) satisfaction d) None Answer: (c)

MCQ.2: MU refers to the additional utility derived from consumption of of commodity. a) Substitute goods b) additional unit c) related goods d) all of the above Answer: (b)

MCQ.3: When TU increases, MU is a) negative b) zero c) positive d) infinitive Answer: (c)

MCQ.4:Consumer will be in equilibrium when: a) MU X > P X b) MU X = P X c) MU X < P X d) unlimited income Answer: (b)

MCQ.5: 5) Which is not the assumption of Law of DMU a) Consumer is rational b) goods are homogeneous c) standard units d) time gap required Answer: (d)

Consumer s Equilibrium for two commodity OR Law of Equi-Marginal Utility The consumer will spend his money income on two goods in such a way that Marginal Utility of each good is proportional to its price.

Condition of Equilibrium for two commodity MU x = MU Y = MU per unit of money P x P Y When MU X = MU of commodity X P X = price of commodity X MU Y = MU of commodity Y P Y = price of commodity Y

The consumer maximizing his TU will allocate his income among various commodities in such a way that the MU of the last rupee spent on each commodity is equal.

Law of equi-marginal utility The marginal utility of a rupee we spend on a good equals the marginal utility of the good divided by the price we pay for it. MU of a rupee = MU of the good = MU x Price of that good P x

Law of equi-marginal utility Suppose, a consumer spends his income on the purchase of only two commodities X and Y. The consumer will spend his money income on different goods in such a way that marginal utility of each good is proportional to its price. MU x = MU y = MU per unit of money P x P y

Law of equi-marginal utility Suppose a consumer wants to spend Rs. 40 on the purchase of two commodities X and Y.. The price of X good Rs. 5. The price of Y good Rs. 10.

Law of equi-marginal utility Income= Rs.40, Px = Rs.5, Py = Rs.10 Units MUx MUy MUx Px MUy Py (1) (2) (3) (4) (5) 1 50 80 10 8 2 45 70 9 7 3 40 60 8 6 4 35 50 7 5 5 30 40 6 4 6 25 30 5 3

Law of equi-marginal utility (i) (ii) (iii) Combinations 3 units of X + 1 unit of Y 4 units of X + 2 units of Y 5 units of X + 3 units of Y Total expenditure Rs. 25 ( 3*5+1*10 = 15+10 = 25 ) Rs. 40 ( 4*5+2*10 = 20+20 = 40 ) Rs. 55 ( 5*5+3*10 = 25+30 = 55 ) (iv) 6 units of X + 4 units of Y Rs. 70 (6*5+4*10 = 30+40 = 70 )

Law of equi-marginal utility Limitations: It is difficult to know MUs from different goods. Consumer in many cases, governed by habits and customs. Many consumers are ignorant. In case of expensive and indivisible goods it is not possible to equate MU of money spent on them.

1st Preference of consumer 2 nd Preference of consumer 3rd Preference of consumer

Both commodities give equal satisfaction to the consumer ARHAR DAL MOONG DAL

Ordinal Utility:- It implies that the consumer is capable of simply comparing the utility derived from different goods. Which good give him same utility Which good give him more utility Which good give him less utility So, according to Ordinal Utility approach Consumer behavior is based on consumer preferences OR Ordering of preferences.

Assumptions Rationality Ordinal utility Diminishing marginal utility Transitivity of choice

Transitivity of choice It means if consumer prefers A to B and B to C, he must prefer A to C. OR We can say tastes of the consumer are consistent.

Indifference Curve Analysis Indifference curve Analysis is based on the idea of a given scale of preference which can be explained with the help of an indifference curve.

Indifference Schedule Combinations Food (Units) Clothing (units) MRS A 1 10 - B 2 7 1:3 C 3 5 1:2 D 4 4 1:1 It refers to a schedule that shows various combinations of two goods which give equal amount of satisfaction to the consumer.

Indifference Curve An Indifference curve shows various combinations of two commodities which give equivalent satisfaction to the consumer.

Different points A, B,C & D on indifference curve show those combinations of food & clothing which give equal satisfaction to the consumer. NOTE:- An Indifference curve is also known as Iso- Utility Curve.

Marginal rate of substitution (MRS) It is the rate at which the consumer is prepared to exchange goods X and Y. Combinations Food (Units) Clothing (units) MRS A 1 10 - B 2 7 1:3 C 3 5 1:2 D 4 4 1:1

Marginal rate of substitution (MRS) It is the rate at which the consumer is prepared to exchange goods X and Y. Shape Of IC IC is convex to the origin. IC would be a straight line. MRS If MRS is falling If MRS is constant

Indifference Map: A set of Indifference curves is called Indifference Map Higher IC shows higher level of satisfaction. IC 3 > IC 2 > IC 1

MRS is the rate at which the consumer is willing to substitute one good for another without changing the level of satisfaction. NOTE:- 1) The want for particular good is satiable so that when a consumer has more of it, his intensity of want for it decreases. Therefore, MRS falls. 2) Goods are imperfect substitutes.

Properties of Indifference Curves 1) An indifference curve slopes downward from left to right, i.e. It has a negative slope.

2) Indifference curves are always convex to the origin. It is based on the assumptions of diminishing MRS. As more and more of One commodity(food) is substituted for another(clothing). The consumer is willing to part with less & less of the commodity being substituted(clothing).

3) Higher IC yield higher satisfaction. An IC which lies above and to the right of another IC gives a higher level of satisfaction than the lower one.

4) Two indifference curves never intersect each other Because each IC represent different level of satisfaction so they do not intersect each other.

5) Indifference curve will not touch either axes Based on the assumption that consumer wants both commodities.

Budget Line (Price line) A budget line shows all those combinations of two goods which the consumer can buy spending his given money income on the two goods at their given price.

Two Constraints He has to pay prices for the goods & He has a limited income.

Suppose consumer s income = Rs.20 price of good 1 = Rs.4 per unit price of good 2 = Rs. 2 per unit (Here, Total expenditure is P 1.Q 1 + P 2.Q 2 = Income) Budget Schedule combi nation Good 1 Good 2 A 0 10 20 B 1 8 20 C 2 6 20 D 3 4 20 E 4 2 20 F 5 0 20 Total expenditu re Good 2 12 10 8 6 4 2 0 0 1 2 3 4 5 Good 1 Budge t Line

All those combinations which are within the reach of the consumer (assuming that he spends all his money income) will lie on the budget line.

Any point outside the given price line, will be beyond the reach of the consumer. Any combination lying within the line, shows under utilization by the consumer of his income.

Properties of Budget Line It is negatively sloped line. The slope of budget line is equal to the price ratio of two commodities. It is a straight line.

Consumer s Equilibrium A consumer is in equilibrium when he is deriving maximum possible satisfaction from the goods and therefore is in no position to rearrange his purchases of goods.

Consumer is in equilibrium position when price line is tangent to the indifference curve OR Marginal rate of substitution of good X & Y is equal to Slope of budget line.

Assumptions The consumer has a given indifference map which shows his scale of preferences for various combinations of two goods X and Y. He has a fixed money income which he has to spend wholly on goods X and Y. Prices of goods X & Y are given and are fixed. All goods are homogeneous and divisible. The consumer acts rationally and maximizes his satisfaction.

At equilibrium- MRS XY = MU x = P x MU Y P Y Slope of IC = Slope of Budget Line

Slope of Budget Line = Price ratio Y = P x X P Y

Indifference Curve: Budget Line: It shows the taste and preferences of the consumer. It tells us what the household can do(purchase). Consumer s equilibrium: It means getting maximum satisfaction.

MCQs for Ordinal Approach

MCQ.1:Indifference analysis is based on the idea of a) Law of DMU b) Ordinal Utility c) Cardinal Utility d) None Answer: (b)

MCQ.2; MRS is the rate at which the consumer is willing to substitute one good for another without changing the level of. a) income b) price c) satisfaction d) none Answer: (c)

MCQ.3:Two ICs never intersect each other because a) they can t be close to each other b) they represent different levels of satisfaction c) both d) None Answer: (b)

MCQ.4: The budget line is also known as: a) income line b) price line c) preference line d) none Answer: (b)

MCQ.5: Condition of consumer s equilibrium: a) Slope of IC = slope of budget line b) MRS XY = PX/PY c) MRS = price ratio of two goods d) all of the above Answer: (d)

Similarity between Two approaches (Cardinal & Ordinal) Consumer is rational Law of diminishing marginal utility. Identical equilibrium condition.

Superiority of Indifference Curve Analysis CARDINAL 1) Utility can be measured cardinally. 2) MU of money constant. 3) It does not segregates price effect into income effect and substitution effect. ORDINAL 1) Ordinal (ranking) measurement of utility is possible. 2) It does not assume constancy of money. (It is unrealistic) 3) It segregates income effect and substitution effect.

Superiority of Indifference Curve Analysis (cont.) 4) It fails to explain the case of Giffen goods. 4) It explains the case of Giffen goods with the help of Income effect & Substitution effect. 5) It assumes too much and explains too little. 5) It assumes less and explain more.

FAQs 1) shows various combinations of two products that give same amount of satisfaction: a) ISO cost curve b) Indifference curve c) Marginal utility curve d) ISO quant Answer: (b)

FAQs 2) TU is maximum when: a) MU is maximum b) MU is zero c) Average utility is maximum d) Average utility is zero Answer: (b)

FAQs 3) An Indifference Curve is always: a) Concave to the origin b) Convex to the origin c) L-shaped d) A vertical straight line Answer: (b)

FAQs 4) Marginal utility curve of a consumer is also his: a) Indifference Curve b) Total utility curve c) Supply curve d) Demand curve Answer: (d)

FAQs 5) At equilibrium, the slope of the indifference curve is: a) Equal to the slope of budget line b) Greater than the slope of budget line c) Smaller than the slope of budget line d) None Answer: (a)

FAQs 6) The law of equi-marginal utility considers price of money as: a) zero b) less than one c) more than one d) one Answer: (d)

FAQs 7) Marginal utility approach was given by: a) J.R. Hicks b) Alfred Marshall c) Robbins d) A.C. Pigou Answer: (b)

FAQs 8) Indifference curves between income and leisure for an individual are generally: a) Concave to the origin b) Convex to the origin c) Negatively sloped straight lines d) Positively sloped straight lines Answer: (d)

FAQs 9) Incase of a right angled indifference curve the goods are: a) Perfect complements b) Perfect substitutes c) Inferior goods d) Giffen goods Answer: (a)

FAQs 10) Indifference curves never intersect each other due to: a) Different levels of satisfaction b) Same levels of satisfaction c) Convex to origin d) Concave to origin Answer: (a)

FAQs 11) A budget constraints line is a result of: a) Market price of commodity X b) Market price of commodity Y c) Income of the consumer d) All of these Answer: (d)

FAQs 12) The difference between what a consumer is ready to pay and what he actually pays is: a) Consumer surplus b) Consumer deficit c) Both d) None Answer: (a)

FAQs 13) If TU of a commodity is 5 and MU is 1, a person consumes 3 units. What is the consumer surplus? a) 4 b) 3 c) 6 d) 2 Answer: (d)

FAQs 14) The slope of IC curve is always: a) downward b) upward c) straight line d) can be all above Answer: (a)

FAQs 15) Marginal Utility is a Concept. a) Cardinal b) Ordinal c) Both d) None Answer: (a)

FAQs 16) Indifference curves are a) Convex to origin b) Concave c) Neither a nor b d) None Answer: (a)

FAQs 17) Consumer surplus is based on which concept? a) Diminishing Marginal Utility b) Law of Demand c) Indifference Curve Approach d) None Answer: (a)

FAQs 18) Cardinal measurement is related to a) Indifference curve b) Equi-marginal utility c) Law of Diminishing Marginal Utility d) None of the above Answer: (b)

FAQs 19) Fall in the value of commodity due to substitution effect shows: a) upward movement on a indifference curve b) downward movement on a indifference curve c) shifting from lower IC to higher IC d) None of the above Answer: (c)

FAQs 20) Suppose a consumer is getting satisfaction equal to Rs.320 due to consumption of a good. If the price of good is Rs.180. Calculate Consumer s surplus. a) Rs.180 b) Rs.200 c) Rs.140 d) Rs.500 Answer: (c)

FAQs 21) Law of equi marginal utility is one of the law under parameters of marginal utility analysis. The second law is : a) Diminishing Marginal utility b) Proportion of law c) Law of consumer surplus d) Law of increasing returns Answer: (a)

FAQs 22) If the IC is of L-shaped then two goods would be: a) complementary goods b) substitute goods c) perfect substitutes d) perfect complementary goods Answer: (a)

FAQs 23) Indifference curve analysis is based upon: a) Cardinal approach b) Ordinal approach c) Cardinal and ordinal both d) none Answer: (b)

FAQs 24) ICs are always convex to the origin because they are based upon: a) marginal rate of substitution increases b) marginal rate of substitution diminishes c) marginal rate of substitution is constant d) marginal rate of substitution is zero Answer: (b)

FAQs 25) Due to consumption of a commodity if MU becomes zero then: a) TU will be zero b) TU will be maximum c) TU increases d) TU diminishes Answer: (b)

Tips to Learn the Concept of Consumer Behavior Utility Law of Diminishing Marginal Utility Consumer Surplus Indifference Curve Marginal rate of substitution Consumer s Equilibrium

Presented by: ANITA SHARMA (ECONOMICS FACULTY) (circ, jaipur branch)