Objective of the Session To know about utility To know about indifference curve To know about consumer s surplus
Choice and Utility Theory There is difference between preference and choice The consumers may have preference when they have a range of products to choose from Preferences depend on the consumers likes and dislikes but the final decision is dependent on budget constraints Utility in economics means the extent of satisfaction obtained from the consumption of products and services by consumers The concept of utility is purely subjective Utility is not measurable but can be compared
Measurement of Utility Cardinal utility approach: According to Marshall, utility can be measured. This approach based upon the assumption like: Utility can be measured Independent variables Ordinal utility approach: The utility cannot be measured, but can only be ranked in order of preferences. Consumer is consistent in ranking The preference of the customer is based on the choice of products available
Assumptions of Utility Theory Consumers are rational Consumers always prefer more quantity Consumer are ready to make tradeoffs Diminishing marginal rate of substitution
Total Utility In a given period of time, the amount of utility a person derives from the consumption of a particular product is called total utility In the initial stages of consumption, the total utility increases After consuming certain number of units the total utility becomes constant and beyond that it starts reducing
Marginal Utility The marginal utility of any quantity of a commodity is the increase in total utility which results from a unit increase in consumption Marginal utility starts diminishing as the consumer starts consuming more units of a product
Relation between Total Utility and Marginal Utility Units Total Utility Marginal Utility 0 0-1 5 5 2 8 3 3 10 2 4 10 0 5 9-1 6 7-2
Laws of Utility Law of Diminishing Marginal Utility Law of Equi-marginal Utility
Indifference Curve Analysis Y Product Y A B Indifference curve shows various combinations of two products which gives same level of satisfaction to consumer C D IC O Product X X
Assumptions of Indifference Curve (IC) It shows ordinal measurement of utility IC curve has negative slope IC curve is convex to the origin Diminishing Marginal Rate of Substitution Two IC curves cannot intersect each other
Marginal Rate of Substitution (MRS) Quantity of Product X Quantity of Product Y MRS XY Total Utility 1 12-100 2 8 1:4 100 3 5 1:3 100 4 3 1:2 100 5 2 1:1 100 Marginal rate of substitution is the rate at which a consumer is willing to substitute one product for the other product maintaining the same level of total utility
Marginal Rate of Substitution (MRS) Y Product Y Y A X B C D MRS XY = Y X IC O Product X X
Budget Constraints I P x Q x + P y Q y I = Income, P x = Price of X-Product, P y = Price of Y- Product, Q x = Quantity of X-Product, Q y = Quantity of Y-Product
Budget Constraints Y P Product Y A B C It also known as price line which show combination of two product that a consumer buy with his given income. Slope of Budget line = - P x /P y O L Product X X
Shift in Budget Constraints Change in Price Change in Income
Consumer s Equilibrium Price Line should be tangent to indifference curve that is Slope of Price Line = Slope of IC curve At the point of tangency IC curve should be convex to the origin
Consumer s Equilibrium Y Consumer s Equilibrium P A Product Y E IC 3 O Product X B IC 2 IC 1 L X
Consumer Surplus (CS) Consumer surplus is the difference between what consumer would like to pay for a product and what actually pays. Units MUx Px C.S. 1 50 20 30 2 40 20 20 3 30 20 10 4 20 20 0 5 10 20-10
Application of Consumer s Surplus Importance for the Govt. policies Importance to monopolist Importance in international trade Measurement of health of economy