Business Economics

Lecture - 5

Dr. Muhammad Mehboob

1
Department of Business Administration
IQRA, Karachi

MBA,
Outline

The Basis of Choice: Utility

Cardinal and Ordinal Approach
Total Utility and Marginal Utility
Law of Diminishing Marginal Utility
Utility Maximizing Rules
Preferences and Indifference Curves
Predicting Consumer Behavior
 The Basis of Choice: Utility

In economics, the satisfaction or pleasure consumers can derive from the

consumption of all units of a specific goods is called “utility”.

A set of numerical values that reflect the relative rankings of various bundles
of goods

The property of a good that enables it to satisfy human wants is called utility or
ability of a good to satisfy a want

Consumers, however, cannot have every thing they wish to have. Consumers’
choices are constrained by their incomes.

Within the limits of their incomes, consumers make their consumption choices
by evaluating and comparing consumer goods with regard to their “utilities.”

Basic Assumption: Consumers are utility maximizers

 How to Measure Utility
Cardinal Approach: Measuring utility in “utils”
Cardinal utility means that an individual can attach specific values or numbers of
utils from consuming each quantity of a good or basket of goods

e.g. Jack derives 10 utils from having one slice of pizza but only 5 utils from
having a burger.

Ordinal Approach: Measuring utility by comparison

Ordinal utility only ranks the utility received from consuming various amounts of a
good or baskets of goods.

Ordinal utility specifies that consuming two burgers gives the individual more
utility than when consuming one burger, but it does not specify exactly how much
additional utility the second burger provides.

Ali prefers a burger to a slice of pizza and a slice of pizza to a hotdog.

Ordinal utility only ranks various consumption bundles, whereas cardinal utility
provides an actual index or measure of satisfaction.
 Total Utility versus Marginal Utility
Marginal utility is the additional satisfaction gained by the
consumption or use of one more unit of something.

Marginal utility is the utility a consumer derives from the last unit of a
good she or he consumes (during a given consumption period),
ceteris paribus.

Total utility is the total utility a consumer derives from the consumption
of all of the units of a good or a combination of goods over a given
consumption period, ceteris paribus.

Total utility = Sum of marginal utilities

 The Law of Diminishing Marginal Utility
Over a given consumption period, the more of one good a consumer
has consumed, the less satisfaction (utility) generated by consuming
each additional (marginal) unit of the same good.

Alternatively, we could say: over a given consumption period, as more

and more of a good is consumed by a consumer, beyond a certain
point, the marginal utility of additional units begins to fall.

Example:
 Total and Marginal Utility for Ice Cream
Q ($) TU ($) MU
0 0
1 40 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10
145

Total utility increases at a decreasing rate, while marginal utility

decreases.
 Total and Marginal Utility for Ice Cream
Total Utility Q ($) TU ($) MU
200 0 0
150
1 40 40
100
2 85 45
50

0
3 120 35
1 2 3 4 5 6 7 8 9 10 11
4 140 20
($) M U 5 150 10
50
6 157 7
40
7 160 3
30

20
8 160 0
10 9 155 -5
0

-10
1 2 3 4 5 6 7 8 9 1 11 10 145 -10
-20
145
Consumer Equilibrium (Single Commodity)

Condition for the equilibrium

MUx = Px

If MUx > Px, the consumer can increase welfare by purchasing more of
x commodities

If MUx < Px, the consumer can increase his total satisfaction by cutting
down his purchase of x commodities

If MUx = Px, the consumer will be in equilibrium

 Utility Maximizing Rules (Two Commodities)
The consumer’s money income should be allocated so that the last dollar spent
on each product purchased yields the same amount of extra (marginal) utility

A consumer maximizes the total utility or satisfaction obtained from spending his
income and is in equilibrium when the marginal utility of the last dollar spent
on each commodity is the same. This equilibrium condition for utility
maximization can be restated as follows:

MUIce MUBurger
--------- = ----------
$PIce $PBurger
First, put the marginal utilities into a per-dollar-spent basis

Decision-making process: at each step, spend where the marginal utility per
dollar is highest
Optimal Purchase Mix: Ice Cream and Burger

Ice: p=$1 B p=$2

Q marginal
utility MU/p MU MU/p
1st 10 10 24 12
2nd 8 8 20 10
3rd 7 7 18 9
4th 6 6 16 8
5th 5 5 12 6
6th 4 4 6 3
7th 3 3 4 2

Income: 10$
 An Alternative Approach to the Consumer Theory

Indifference curve
An indifference curve is a line that shows different combinations of
two goods among which a consumer is indifferent and from which the
consumer draws the same amount of utility.

An indifference curve is a line that shows different combination of

goods X and Y, all of which yields the same total utility.

Budget lines
A budget line is a line that shows various combinations of two goods
which the consumer can purchase at given market prices within a
certain level of income.
 Budget Line
Figure shows Ali’s budget line.
The budget line is a
constraint on Ali’s choices. Income $30

Soda (packs per month)

This is the budget constraint Movies $6 each
when income equals $30 a Soda $3/pack
dollars per month, the price of 10
Soda is $3/pack, and the price b
of a movies is $6 each.
8
Ali can afford any point on the c Unaffordable
budget line or inside it.
6
Ali cannot afford any point d
outside his budget line.
Point inside does not
4
Affordable e
exhaust the entire income
available 2
f
0 1 2 3 4 5 6 7 8
Movies (per month)
 Preferences and Indifference Curves (cont..)
At point C, Ali
consumes 2 movies and
six packs soda per
month.

Soda (Packs per month)

Ali can sort all possible 10
combinations of goods
into three groups:
8
preferred, not preferred,
and indifferent. C
6
An indifference curve
joins all those points
4
G
that Ali says are just as
good as C. 2

G is such a point. Ali is

indifferent between C and G. 0 2 4 6 8
Movies (per month)
 Preferences and Indifference Curves (cont..)

All the points above the

indifference curve are

Soda (Packs per month)

preferred to the points 10
on the curve.
And all the points on 8
the indifference curve
are preferred to the C
6
points below the Preferred
curve. 4
Indifferent between C G
2 Not
and G. preferred

0 2 4 6 8
Movies (per month)
 Preferences and Indifference Curves (cont..)

Indifference Map
10

Soda (Packs per month)

An indifference map is a
series of indifference
curves. 8
Call the indifference C
curve that we’ve just 6
seen I1.

I0 is an indifference curve 4
G
below I1.
2
Ali prefers any point on I1 I0 I1
to any point on I0 .

0 2 4 6 8
Movies (per month)
 Preferences and Indifference Curves (cont..)

Indifference Map
10

Soda (Packs per month)

I2 is an indifference curve
above I1. 8
C
Ali prefers any point on I2 6 J
to any point on I1 .

For example, Ali prefers 4

point J to either point C or G
I2
point G.
2
I0 I1

0 2 4 6 8
Movies (per month)
 Preferences and Indifference Curves (cont..)

Properties of Indifference curves

Indifference curves for two “goods” are generally negatively sloped

The slope of an indifference curve reflects the degree of

substitutability of two goods for one another

Indifference curves are generally convex, reflecting the principle of

diminishing returns

Indifference curves never cross

Indifference curves that are farther from the origin represent higher
levels of utility
 Preferences and Indifference Curves (cont..)

Marginal Rate of Substitution

The marginal rate of substitution, (MRS) measures the rate at which

a person is willing to give up good y, (the good measured on the y-axis)
to get an additional unit of good x (the good measured on the x-axis)
and at the same time remain indifferent (remain on the same
indifference curve).

The magnitude of the slope of the indifference curve measures the

marginal rate of substitution.
 Predicting Consumer Behavior

The consumer’s best affordable point is:

 On the budget line

 On the highest attainable indifference curve
 Has a marginal rate of substitution between the two goods equal to
the relative price of the two goods
 Predicting Consumer Behavior
Ali will choose the combination of Soda and Movies that maximizes
total utility. Graphically, the Ali will move along the budget constraint
until the highest possible indifference curve is reached.

10
Best
affordable
Soda (packs per month)

8 F point
C
6

4
I
2 I2
H I1 1
I0
0 2 4 6 8
Movies (per month)
 Predicting Consumer Behavior

The best affordable point is C.

Ali can afford to consume more soda and see fewer movies at point
F.
And He can afford to see more movies and consume less soda at
point H.
But he is indifferent between F, I, and H and she clearly prefers C to
I.
At point F, Ali’s MRS is greater than the relative price.
At point H, Ali’s MRS is less than the relative price.
At point C, Ali’s MRS is equal to the relative price.