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The Utility Theory

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13 views5 pages

The Utility Theory

Uploaded by

reginaldmthabisi
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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The utility theoryThe theory assumes that the consumer seeks to maximise utility

The consumer is assumed to have knowledge of all the information relevant for his utility maximising
decisions

The theory explains how an individual maximises utility gained from the consumption of
commodities

Utility the satisfaction a consumer derives from consuming a commodity

Marginal utility the extra satisfaction derived from consuming one more unit of the same product.
The table below shows the relationship between total and marginal utility

movies total marginal


watched per utility utility
week
0 0
1 30 30
2 55 25
3 75 20
4 87 12
5 97 10
6 104 7
7 108 4
8 110 2
Task plot the total utility and marginal utility figures on separate graphs

There are two basic theories on utility;

1. The Cardinalist theory


2. The Ordinalist theory

The Cardinalist theory

Assumptions

 The customer is assumed to be rational and aims to maximise utility derived from consuming
goods
 Utility is assumed to be measurable using units called utils, alternatively utility can be
measured by measuring the amount of money a consumer is willing to sacrifice to gain an
extra unit of a given commodity
 Constant marginal utility of money, the utility of money is assumed to be constant as
money/income increases
 Diminishing marginal utility, satisfaction gained from consuming a product declines as more
of the product is consumed

Consumer equilibrium

1. Single good market


The consumer can either buy the good or retain his money. Equilibrium is achieved where
MUx = Px

utility/price

price

marginal utility

O quantity

If the Mux > Px the consumer can improve his welfare by purchasing and consuming more
units of X. Similarly if Mux < Px the consumer can increase his satisfaction by cutting down
on the quantity of X consumed. Utility is therefore maximised where Mux = Px since at this
state there is nothing the consumer can do to further improve his satisfaction

2. Two or more products with the same price


Utility is maximised where the marginal utilities for all products are equal eg if a consumer
consumes products X,Y and Z and the products have the same price, utility is maximised by
consuming quantities of the 3 products such that MUx=MUy=MUz.
Where MUx>MUy the consumer can increase his satisfaction by consuming more units of
product X and reducing the quantity of Y

3. Two or more products with different prices


Utility is maximised where Mux/Px=MUy/Py. Where Mux/Px>MUy/Py the consumer can
increase his satisfaction by consuming more of good X and reducing the quantity of Y
consumed

The Ordinalist theory


Assumptions
 Rationality of the consumer, the customer seeks to maximise utility. Maximisation of
utility given a fixed income is referred to as constrained optimisation.
 Utility is not measurable but consumers are able to rank baskets of goods according
the satisfaction derived from the goods
 Diminishing marginal rate of substitution, this makes the indifference curve convex
to the origin

Task Look at more rules for drawing indifference curves

 Indifference curves do not cross


 Indifference curves are always convex to the origin
 Given two or more indifference curves the one to the right shows a higher level
of satisfaction than the one to the left
Consumer equilibrium

IC is the indifference curve which shows bundles of goods to which the consumer is
indifferent. The consumer can consume any combination of good X and Y along the
indifference curve and derive the same level of satisfaction. AB is the budget line, it shows
the amounts of X and Y the consumer can purchase with his fixed income. Consumer
equilibrium is achieved where the indifference curve is tangent to the budget line. The slope
of the indifference curve is the marginal rate of substitution, it measures the amount of one
commodity the consumer gains by giving up one unit of the other commodity. The MRSxy =
Mux/MUy The slope of the budget line is the ratio of prices of the two products X and Y
(Px/Py). The consumer equilibrium can therefore be expressed as where MRSxy = Px/Py

Effect of changes in prices on the budget line


Assume the price of good Y on the diagram above decreases, the budget line shifts outwards
on the horizontal axis from AB to AB2 but remains pivoted at A as shown on the diagram
below

The equilibrium changes from E to E2 and at the new equilibrium more units of Y can be
consumed
Effect of changes in income on the budget line
A change in income results in a parallel shift of the budget line. Assume the income of the
consumer increases, this result in an outward shift of the budget line. This implies that the
consumer is now able to buy more of both goods
The original budget line is A1B1 and equilibrium is attained where IC intersects A1B1 which
is point E. An increase in income shifts the budget line to A2B2 resulting in a new equilibrium
point E2
Substitution and income effect
When the price of a good decreases the quantity consumed increases because of two factors
1. substitution effect, when the price of a good decreases the consumer substitutes
relatively expensive substitutes for the good whose price has decreased
2. income effect, when a good’s price decreases the real income(income in terms of
purchasing power) of the consumer increases hence the consumer can buy more the
product
On the diagram below YY1 is the substitution effect and Y1Y3 is the income effect

Normal good

For a normal good the substitution effect and the income effect are both positive thus
the two complement each other and the total price effect is positive (more normal
goods are purchased at low prices)

Inferior goods
For an inferior good the substitution effect is YY2 and the income effect isY2Y1. The
substitution effect is positive while the income effect is negative. The positive
substitution effect is greater than the negative income effect hence the overall effect is
positive (more inferior goods are purchased at low prices)
Giffen goods

The substitution effect is Y1Y2 and the income effect is Y2Y. The negative income effect
is greater than the positive substitution effect hence the total price effect is negative
(less giffen goods are purchased at low prices)

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