CONSUMER THEORY

Lecture 2
September 10, 2013 1Hellen A. Seshie-Nasser

Consumer Choice
Marginal Utility Theory
Consumer surplus
Budget Constraints
Indifference Curve Theory
Revealed Preference Theory

Consumer Choice
Today’s lecture will cover
 Marginal Utility Theory
 Consumer surplus
 Budget Constraints

I. Marginal Utility Theory
 what is UTILITY?
 benefit you get from consuming a good
 determined by your tastes/preferences
(assuming these are stable)
The value a consumer places on a unit of a good or service
depends on the pleasure or satisfaction he or she expects
to derive from having or consuming it at the point of
making a consumption (consumer) choice.

Total utility (TU)
 total benefit from consuming good
 example
 total benefit from 3 biscuits/cookies

TU increases as consumption
increases, to a point
<
TU 2 cookies TU 3 cookies

Marginal utility (MU)
 MU is the change in TU from consuming one more of a
good
 example
 how much MORE utility from
an additional mobile phone?

change in TU from
0 to 1 biscuit/cookie
change in TU from
1 cookie to 2 cookies
MU of 1st Biscuit/
cookie
MU of 2nd cookie
=
=
0

Diminishing marginal utility
 MU falls as consumption rises
 You get sick of biscuits as you each more of it.
 The more kenkey you consume the less you’ll want to
each eat it.

MU of 1st cookie
> MU of 2nd cookie
0

TU
cookie
TU rises at
slower and
slower rate
as MU
declines
MU
cookie

Consumer Equilibrium: How to
maximize TU?
 Equalize MU to price of the good (single good case)
 equalize MU/price across goods (Multiple goods case)
“The real case”
 use available budget

Consumer equilibrium
Balls of
kenkey
Total Utility
(in utils)
Marginal
Utility/Benefit
0 0 0
1 8 8
2 14 6
3 19 5
4 23 4
5 25 2
6 26 1
7 26 0
8 24 -2
How many balls of kenkey would you buy
if the price per ball was Gh¢1?
Marginal Cost
Gh¢1
Gh¢1
Gh¢1
Gh¢1
Gh¢1
Gh¢1
Gh¢1
Gh¢1
Gh¢1
13September 10, 2013 Hellen A. Seshie-Nasser

Marginal utility = Price
MUx =Px
Chose combination of kenkey and
phone units where
price of kenkey price of phone units
MU kenkey
=
MU phone units

why?
 Chose 6 balls of kenkey, one 1-cedit worth
of phone credit
 suppose MU/Gh¢1 of cookies = 4,
MU/Gh¢1 of Phone units = 15
 by consuming fewer balls of kenkey and
more phone credits…
You would add more to my TU

Utility Maximizing Rule
The consumer’s money should be spent so that
the marginal utility per dollar of each goods
equal each other.
MUx = MUy
16
Px Py
September 10, 2013 Hellen A. Seshie-Nasser
Thus, the utility maximizing rule assumes that you
always consume where MU/P for each product is equal

September 10, 2013 Hellen A. Seshie-Nasser 17
Assume apples cost $1 each and oranges cost $2 each.
(If the consumer has $7), identify the combination that
maximizes utility.
Example

TU vs. MU: The Paradox of Value
 Diamond-Water paradox
 Gh¢10,000 for example can be used to purchase either
 one carat diamond
Or
 5 million gallons of tap water

why?
 TU of water is greater than TU of diamonds
 water is essential for life
 BUT water is abundant, diamonds are rarer
 MU of last diamond is higher
 MU determines value
 When diamonds are scarce and drinking water is
abundant, marginal utility of a diamond ring is much
higher than the marginal utility of water. Although the
total utility of water may be greater than that of
diamond rings.

 Stranded on a desert island with no water, one may be
happy, though, to trade his diamond ring for a bottle of
drinking water.
Under such conditions, the marginal utility of water must
be greater that that of a diamond ring.

MU and demand
 MU declines as consumption rises
 Price = MU
 willingness to pay is less for each additional unit
Hence
 downward sloping demand
 The more consumed the less willingness to pay, hence
the lesser price offered for the product.

example : balls of kenkey
P
Q
D
Gh¢1.0
4 balls
for 4th ball of
kenkey
willing to pay Gh¢1.
for 2nd ball of kenkeyGh¢1.5
2 balls
willing to pay Gh¢1.5

II. Consumer Surplus
 It is the difference between what you pay for a good
and what you are WILLING to pay for the good
Example:
 market price of a ball of kenkey = Gh¢1.0
 your marginal value of the 3rd ball is = Gh¢12
 Your consumer surplus then is = Gh¢2

P
Q
D
$10
The demand curve
$12
3
your consumer surplus

P
Q
D
Gh¢1.0
10,000
total consumer surplus
area between D
and price of kenkey

III. The Budget Line
 A budget constraint is a constraint on how much
money (income, wealth) an economic agent can spend
on goods. We denote the amount of available income
by M
 given:
 consumer’s budget
 prices
 draw a line representing choices
 consumption possibilities

example
 2 goods: bread & kenkey
 A loaf of bread = Gh¢1.0
 A ball of kenkey = Gh¢0.5
 daily budget = Gh¢4.0

Possible Combinations
kenkey bread
0
2
4
6
8
4
3
2
1
0

budget line
Bread
Kenkey
8
4
2
6
0
421 3

budget line
Bread
kenkey
8
4
2
6
0
421 3
Affordable
Unaffordable

Mathematically
Let Px= price of good X
Py = price of good Y
M = Income of the consumer
Assuming the consumer spends all his/her income on
only two goods, X and Y
Then the budget equation is given by;
Px + Py = M

Changes in Money Income
 Changes in the consumer’s income
 budget line shifts
 Increases in income shift the budget line outward away
from the origin, and vice versa
 suppose a consumer income changes from Gh¢5 to
Gh¢4

bread
kenkey
budget = Gh¢4
budget = Gh¢5
8
4
2
6
0
10
421 3 5

Changes in Relative prices
Changes in one price, holding other prices and income
constant;
 changes slope of budget line
 Suppose price of kenkey rises from Gh¢.5 to Gh¢1.0

bread
kenkey
8
4
2
6
0
421 3
kenkey = $.50
kenkey = $1

 Changes in the prices of goods lead to changes in the
real income of the consumer. He therefore buys less of
one or both goods.
 He can choose to buy less amount of the relatively
expensive good and more or the same quantity of the
relatively cheap good
 Or the same quantity of the relatively expensive good
and less of the relatively expensive good.

Exercise
Assume apples cost $1 each and oranges cost $2 each. If
the consumer has $7, identify the combination that
maximizes utility.
Find the quantities of apple and oranges the consumer
will purchase if
a. Price of oranges falls to $1
b. Income of the consumer increases to $10
c. Price of apples rises to $1.5

sum it up
 consumer decisions are based on
 preferences
 budget constraint
 consumer decisions are made at the margin
 marginal benefit of one more
 compared to price of one more

CONSUMER THEORY

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