Dr. Rama PalHSS, IITB

Demand and Consumer Behaviour

Choice and Utility Theory

Utility means satisfaction

Utility is a scientific construct that economists use to understand how rational consumers make decisions

In the theory of demand, we assume that people maximize their utility, which means that they choose the bundle of consumption goods that they most prefer

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Marginal Utility

Marginal means additional or extra.

Marginal utility denotes the additional utility you get from the consumption of an additional unit of a commodity

Law of Diminishing Marginal Utility It states that, as the amount of a good consumed

increases, the marginal utility of that good tends to decline

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Example: Consumption of Ice-cream

Q TU MU

0 0

1 4 4

2 7 3

3 9 2

4 10 1

5 10 0

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Total Utility: Consumption of Ice-cream

0123456789

10

0 1 2 3 4 5

Total Utility

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Marginal Utility: Consumption of Ice-cream

0

1

2

3

4

5

1 2 3 4 5

Marginal Utility

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Relation between TU and MU

Total utility of consuming a particular amount is equal to the sum of the marginal utilities up to that point

TU is maximum when MU is zero.

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Equimarginal Principle

Assumption: consumer maximizes utility

Equimarginal principle: It states that a consumer will achieve maximum satisfaction or utility when the marginal utility of the last rupee spent on a good is exactly the same as the marginal utility of the last rupee spent on any other good

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Equimarginal Principle

The common marginal utility per rupee of all commodities in consumer equilibrium is called the marginal utility of income. It measures the additional utility that would be gained if the consumer could enjoy an extra rupees worth of consumption

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Equimarginal Principle

Why demand curves slope downward

A higher price for a good reduces the consumers desired consumption of that commodity

)(...2

2

1

1 incomeofrupeeperMUP

MUP

MUP

MUn

n

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Examples

Allocation of money

Allocation of time

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Behavioural Economics

Calculation of marginal utility

Consumers are reasonably consistent in their tastes and actions

Irrational or inconsistent behaviour

Asymmetric information

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The Indifference Curve The points on the indifference curve represent consumption

bundles among which the consumer is indifferent; all are equally desirable

X

Y

A=(X1,Y1)

B=(X2,Y2)

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The Indifference Curve

Marginal rate of substitution slope of indifference curve = Y/ X = -MUX/MUY

Diminishing MRS (convexity): the more you have of one of the goods the more you can give it up in exchange for other good

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Diminishing Marginal MRS

Quantityof Pizza

Quantityof Pepsi

0

Indifferencecurve

8

3

A

3

7

B

1

MRS = 6

1MRS = 14

6

14

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Indifference Map

Quantityof Pizza

Quantityof Pepsi

0

Indifferencecurve, I1

I2

C

B

A

D

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Indifference Map

Consumption bundles on IC which are farther from the origin are preferredMore is betterPreferences over Bads

There is an IC through each bundle

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Properties of Indifference Curves Indifference curves cannot cross

Indifference curves slope downwards and is convex to the origin

Indifference curves cannot be thick

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The Impossibility of Intersecting ICs

Quantityof Pizza

Quantityof Pepsi

0

C

A

B

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IC: Perfect Substitutes

Example: Red pencil and blue pencil

Red Pencil

Blue Pencil

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IC1

IC2

IC: Complements

Example: Tea and sugar

Tea

Sugar

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IC2

IC1

Problem # 1 Plot the indifference curves showing preferences

over consumption good, x and work, l. Here, your satisfaction goes up in x and down in work (i.e., you enjoy leisure).

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