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8/9/2019 Lect4102 2005 Student

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Behind The Demand Curve IBehind The Demand Curve I

►1.Marginal utility theory1.Marginal utility theory

assumptionsassumptions

law of diminishing marginal utilitylaw of diminishing marginal utility

optimal consumptionoptimal consumption

critiquecritique

►2. Uses of utility theory?2. Uses of utility theory?

8/9/2019 Lect4102 2005 Student


UsesUses

►(i) Elasticity - determined by preferences.(i) Elasticity - determined by preferences.

How quickly MU diminishesHow quickly MU diminishes

►(ii) Efficiency - consumer surplus. Resource(ii) Efficiency - consumer surplus. Resource

allocationallocation

►(iii) Paradox of value - diamonds & water(iii) Paradox of value - diamonds & water

8/9/2019 Lect4102 2005 Student


AssumptionsAssumptions

►Consumers are rationalConsumers are rational

►Ceteris paribusCeteris paribus

►Cardinalist approach - utilsCardinalist approach - utils

►Utility = satisfaction (preferences)Utility = satisfaction (preferences)

8/9/2019 Lect4102 2005 Student


Measurement of utilityMeasurement of utility

► Total utility Total utility “…“… the total satisfaction gained from thethe total satisfaction gained from the

consumption of ALL units of aconsumption of ALL units of a

commodity.”commodity.”►Marginal utilityMarginal utility

“…“…thethe extraextra utility derived from theutility derived from the

consumptionconsumptionof of one moreone more

unit of a good,unit of a good,the consumption of all other goodsthe consumption of all other goods

remaining unchanged.”remaining unchanged.”

►See Figure 1-3 - shape & calculationSee Figure 1-3 - shape & calculation

8/9/2019 Lect4102 2005 Student


fig

-2

0

2

4

6

8

1 0

1 2

1 4

1 6

0 1 2 3 4 5 6

No. of cream

cakes

TU

in utils

0

1

23

4

5

6

0

7

1113

14

14

13

MU

in utils

-

7

42

1

0

-1

Utility

(utils)

No. of cream cakes consumed (per day)

TU

Utility from consuming cream cakes (daily)Utility from consuming cream cakes (daily)

8/9/2019 Lect4102 2005 Student


The Law of Diminishing Marginal The Law of Diminishing Marginal

UtilityUtility

►Slope of the MU scheduleSlope of the MU schedule

►DefinitionDefinition “…“…as the quantity of a good consumedas the quantity of a good consumed

by an individual increases, the marginalby an individual increases, the marginal

utility of the good will eventuallyutility of the good will eventually

decrease.”decrease.”

►Marginal analysisMarginal analysis

8/9/2019 Lect4102 2005 Student


Optimal consumption -Optimal consumption -

backgroundbackground

►Consumers have limited income.Consumers have limited income.

Choices. No savingChoices. No saving

►

Rational consumer - maximise utilityRational consumer - maximise utility

►Measurement problem - utils?Measurement problem - utils?

►Solution: measure utility in moneySolution: measure utility in money

price prepared to payprice prepared to pay

price you actually payprice you actually pay

8/9/2019 Lect4102 2005 Student


Optimal consumption - singleOptimal consumption - single

goodgood

►Buy one extra unit whenBuy one extra unit when

MU > PriceMU > Price

►MU (in monetary terms) = marginal benefitMU (in monetary terms) = marginal benefit►Price = marginal costPrice = marginal cost

►Stop whenStop when MU = PriceMU = Price

8/9/2019 Lect4102 2005 Student


Optimal consumption - consumerOptimal consumption - consumer

surplus(CS)surplus(CS)

►Consumer surplusConsumer surplus

Price prepared to pay - price actually paidPrice prepared to pay - price actually paid

►

Marginal consumer surplusMarginal consumer surplus MCS = MU - marginal expenditureMCS = MU - marginal expenditure

MCS = MU - PMCS = MU - P

► i.e. the excess of utility over pricei.e. the excess of utility over price

►Buy more when MU > P (MCS positive).Buy more when MU > P (MCS positive).

Stop MU = PStop MU = P

8/9/2019 Lect4102 2005 Student


Derivation of the demand curveDerivation of the demand curve

►Equals the MU curve as long asEquals the MU curve as long as

consumers maximise CSconsumers maximise CS

► If price falls: buy more since MU > P orIf price falls: buy more since MU > P or

MCS is positiveMCS is positive

movement along demand schedulemovement along demand schedule

8/9/2019 Lect4102 2005 Student


fig

Consumer Consumer

surplussurplus

4 0

5 0

6 0

7 0

8 0

9 0

1 0 0

1 1 0

1 2 0

0 2 5 0 5 0 0 7 5 0 1 0 0 0

Marginal utility from petrolMarginal utility from petrol

a

b

c

MU,P(penc

e

perlitre)

Q (litres per annum)

MU MU

8/9/2019 Lect4102 2005 Student


Optimal consumption - multi-goodOptimal consumption - multi-good

casecase

►Equi-marginal principleEqui-marginal principle

MUMUaa \ P\ Paa = MU= MUbb \ P\ Pbb = MU= MUcc \ P\ Pcc = … MU= … MUnn \ P\ Pnn

If price of a good changes - reallocate incomeIf price of a good changes - reallocate income

► If income is fixedIf income is fixed

……utility is maximised when the utility from theutility is maximised when the utility from the

LAST pound spent on ALL goods is equalLAST pound spent on ALL goods is equal

8/9/2019 Lect4102 2005 Student


UsesUses

►(i) Elasticity - determined by preferences.(i) Elasticity - determined by preferences.

How quickly MU diminishesHow quickly MU diminishes

►(ii) Efficiency - consumer surplus. Resource(ii) Efficiency - consumer surplus. Resource

allocationallocation

►(iii) Paradox of value - diamonds & water(iii) Paradox of value - diamonds & water

lect4102 2005 student

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