Introduction to Economics Egor Sidorov
Consumer and utility Cardinal utility theory Ordinal utility theory
Rational consumer model • Economics doesn’t analyze individual preferences and tastes. It analyzes the individual behavior aimed at satisfying needs. • Economics gives an answer to the question: How should one act in the most rational manner? • Model of rational consumer describes the general patterns of consumer behavior. • The aim of the rational consumer is to use limited resources on the purchase of goods and services to get maximum satisfaction, which, of course, is a subjective phenomenon.
Rationalism is not about the specific consumer aims, but the way he reaches these aims. • Rational consumer uses his recourses in a way that additional utility from enjoying each of existing alternatives is the same.
Utility • Utility –is a measure of the relative satisfaction from consumption of various goods and service • Cardinal utility theory – one can measure utility (e.g. In USD – willingness to pay) • Ordinal utility theory – one can’t measure utility precisely, however we can compare utilities together vs.
Utility contd. • The doctrine of utilitarianism saw the maximization of utility as a moral criterion for the organization of society. • society should aim to maximize the total utility of individuals, aiming for "the greatest happiness for the greatest number of people". • Subjective happiness – hard-to-formalize. • Objective happiness managed by the professionals, state, etc. Jeremy Bentham
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Cardinal utility theory Utility is the function of quantity of goods consumed. MU2 = TU2-TU1 TU (Total Utility) MU (Marginal Utility) 150 Law of Diminishing Marginal Utility A 100 100 75 50 50 Mathematically marginal utility is the first derivation of utility function 25 A Q 2 2 3 3 1 1 4 4 5 5 6 6 Q
Law of Diminishing Marginal Utility • „Marginal“ means „additional“. • Marginal utility is the change in utility obtained by increasing use of good by unit (e.g. extra movie). • The highest additional utility is connected with consumption of the firs unit. Every next unit brings less satisfaction. • The total utility is therefore growing with every next consumed unit of good at constantly declining growth rate.
Individual consumer surplus • Different consumers perceive utility differently. • Consumer surplus is the difference between the willingness to pay for the good and actual established market price. Price and WTP (USD) 60 Consumer surplus: the total consumer surplus USD 70 is the sum of individual consumer surpluses 40 20 Price E 2 3 1 4 5
Rational consumer and marginal utility equality principle • If pizza costs 5 times more than the cheeseburger, one would buy pizza given that its marginal utility is at least 5 times higher compared to cheeseburger. MU MU = 50 CZK 1O CZK
Utility maximization constraint • given limited budget, consumer facing the market prices maximizes his utility if the MU per dollar additionally spent on one good is equal to MU per dollar additionally spent on any other good. • In other words marginal utility generated by spending the dollar should be equal for every good in the consumer basket.
Rational consumer • Individuals tend to be irrational, they make decisions under pressure, in accordance with habits and actual moods. None of us neither measures marginal utility nor calculates optimal conditions. • Economists deal with the law of large numbers: when the significant number of agents acts consistently avoiding mistakes and consumer behavior fluctuations the above mentioned economic laws hold. vs.
Rational consumer and marginal utility equality principle • If cheeseburger had higher marginal utility than pizza, one could increase the total utility by switching from pizza to buying cheeseburgers. This would continue until marginal utility of cheeseburger per money unit is equal to marginal utility of pizza according to the law of diminishing marginal utility. MU MU < 50 CZK 1O CZK
Why does supply curve has down warding slope? • If price of cheeseburger goes up (ceteris paribus) the MU to price ratio would be lower than in pizza’s. In this respect one would reduce consumption of pizza and therefore reach the equilibrium state. In this respect increase in price involves decrease of quantity demanded. • If MU is measured in money, then the marginal utility curve is equal to demand curve. MU MU > 50 CZK 1O CZK
6 4 2 30 10 20 Consumer budget Budget equation: 300=50*Qp+10*Qh I = Px*Qx + Py*Qy Budget line – depicts the maximum affordable baskets of goods given the fixed consumer income.
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Ordinal utility: indifference analysis • The consumer is capable of defining which consumer basket of goods is more preferable. However he cannot determine its absolute utility as in case of cardinal theory. TU (total utility) TU Celkový užitek A is the indifference curve with the level of total utility equal to TU 1 TU1 TU1 A
Ordinal utility: indifference analysis • All goods’ combinations on A curve have the same utility: • The consumer chooses more goods over less. • The set of indifference curves is called an indifference map. = + + 6 C 4 B 2 A 10 30 20
Ordinal utility: substitution rate • The more scarce good has higher relative rate of substitution. Its marginal utility grows compared to marginal utility of the more abundant good:compare 4:5 vs ½:10. 6 4 C 4 B 5 2 0,5 A 10 10 30 20
Ordinal utility: rational consumer behaviour • The consumer achieves optimal state in the point where the budget line is actually a tangent line to the highest possible indifference curve, where the substitution rate is equal to its slope. • Indifference curve exists in each point of the map. • The consumer chooses the E set of goods on the B curve:3x a 15x 6 E C 4 B 2 A 10 30 20
Demand curve • If the cheeseburger price goes up (e.g. by 50 percent) ceteris paribus one would reduce its consumption and would move to the lower indifference curve with a lower utility level. • Again the price growth causes the decrease of quantity demanded. 6 E C 4 B 2 A 10 30 20
Thank you for attention! Sources: SAMUELSON, P. A., NORDHAUS, W. D. Ekonomie 18. vydání. Praha: Svoboda, 2005. KRAFT, J., RITSCHELOVÁ, I. Ekonomie pro environmentální management. Ústí n. L.: UJEP, 2003. MCDOUGAL LITTELL. Economics: Concept and Choices. Canada: McDougal Littell, 2008. HOŘEJŠÍ, B. et al. Mikroekonomie. 4. rozšířené vydání. Praha: Management press, 2006.