INTERMEDIATE

MICROECONOMICS
Introduction

• PREREQUISITES: INTRODUCTION TO MICRO AND MACRO

ECONOMICS
• REVISE YOUR CALCULUS
• Module is available however it should not be used alone. (use
recommended text books as well)
CONSUMER CHOICE
THEORY
Unit 1a
• The theory of consumer behavior is the concern of how consumers
decide on the basket of goods and services they consume in order to
maximize their satisfaction (utility).
Utility
• 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 form having or consuming it at the point of making a
consumption (consumer) choice.

• In economics the satisfaction or pleasure consumers derive

from the consumption of consumer goods is called “utility”.
• Consumers, however, cannot have every thing they wish to
have. (unlimited wants)
• 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”.
In explaining Consumer Behaviour we
assume:
• The Consumer is rational.
• Given his/her income and the market price of the commodities,
he/she plans the spending of his/her income so as to attain the
highest possible satisfaction or utility.
• This is the axiom of utility maximization.
• [axiom-a statement that is taken to be true or principle accepted as
true because it is self evident or useful)

• The consumer has complete knowledge of all the information

relevant to his/her decision. [what is the relevant information?]
Our basic assumptions about a “rational”
consumer:
• Consumers are utility maximizers
• Consumers prefer more of a good (thing) to less of it.
• Facing choices X and Y, a consumer would either prefer X to Y or
Y to X, or would be indifferent between them.
• Transitivity: If a consumer prefers X to Y and Y to Z, we conclude
he/she prefers X to Z
• Diminishing marginal utility: As more and more of good is
consumed by a consumer, ceteris paribus, beyond a certain point
the utility of each additional unit starts to fall.
 How to Measure Utility

Measuring utility in “utils” (Cardinal):

Measuring utility by comparison (Ordinal):

 Cardinal Utility analysis and Ordinal Utility Analysis
Utility Analysis

Cardinal Utility analysis Ordinal Utility Analysis

• Alfred Marshal
• J. R. Hicks & R.G.D. Allen
• Can be measured(Utils)
•Cannot be measured but compared
• Law of Diminishing
as rank
Marginal Utility
• Indifference Curve analysis
•Quantitative
•Law of Equi-marginal
Utility
•Marshallian Analysis
Revision of important concepts; Total Utility versus
Marginal Utility
Cardinal Utility Analysis
• The cardinal school postulated that utility (i.e., satisfaction) gained
from a particular good or service can be measured in numbers.

• HOW POSSIBLE IS THAT?!

• In monetary units i.e., by the amount of money that the consumer is
willing to sacrifice for another unit of a commodity or by subjective unit
called “utils”.
• We focus on:

a)Assumptions of Cardinal Utility analysis

b)Law of Diminishing Marginal Utility

c)Law of Equal-Marginal Utility

 Assumptions of Cardinal Utility analysis

1. Rationality of consumer-seeks maximization of his/her utility

subject to the constraints imposed by his/her income
2. Cardinal measurability of utility using money
3. Marginal Utility of Money is constant at all levels of income of
the consumer.
4. Diminishing Marginal Utility- the MU of a commodity diminishes
as the consumer acquires more and more of it.
5. Utility is Additive i.e TU= Ux+ Uy+ Uz+…….+ Un

6. The hypothesis of Independent Utility- Utility of each

commodity is experienced independently in a group of
commodities.

7. The total utility of a basket of goods and services depends

on the quantities of the individual commodities. That is:
U=f(Y, X, Z).
The Law of Diminishing Marginal Utility

• Over a given consumption period, the more of a good a consumer

has, or has consumed, the less marginal utility an additional unit
contributes to his or her overall satisfaction (total utility).

• 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.
• At some level of consumption, the total utility received by an
individual from consuming the commodity will reach a
maximum and the marginal utility will be zero.

• This is the Saturation Point

• After this point additional units of the commodity cause

total utility to fall and marginal utility to become
negative.
 Example - Law of Diminishing Marginal Utility

Unit of Mango Total Utility Marginal Utility

1 10 10
2 20 10
MUn = TUn – 3 29 9
TUn-1 4 37 8
MU =∆TU/∆Q
5 43 6
6 48 5
7 51 3
8 52 1
9 52 0
SHAPE OF MARGINAL UTILITY CURVE

•Eventually downward sloping

• Law of diminishing marginal utility

•Positive always
• Rational behavior
• Consumer only purchases a good if they get some positive utility
from it.
SHAPE OF TOTAL UTILITY

•Positive slope
• Consumer only purchases a good if gets some
positive amount of utility (rational behavior)

•Slope gets flatter as quantity increases

• Law of diminishing marginal utility
Law of Diminishing Marginal utility

• According to the law, the consumer tries to equalize MU of a

commodity with its price so that his satisfaction is maximized
and he will reach equilibrium point. MUx=Px
• When P falls, MU > than P-----No equilibrium , no max of
TU.
• Hence he’ll decrease MU till = reduced Price.
• Increase in stock MU decreases. Consumer buys more when
P falls.
So what is Consumer Equilibrium?

• Occurs where the ratio of marginal utility between different goods is

equal to their respective price ratios.

• Consider a consumer who has to choose between two types of

commodity, X and Y, which have prices Px and Py respectively.

• Let us assume that the individual is rational and so wishes to maximize

utility subject to the size of his income.
• The consumer will be maximizing total utility when his income has
been allocated in such a way that the utility to be derived from the
consumption of one extra Kwacha's worth of X, is equal to the utility
to be derived from the consumption of one extra Kwacha's worth of
Y.

• In other words, the marginal utility per Kwacha of X is equal to the

marginal utility per Kwacha of Y.
Law of Equal-Marginal Utility

• The total utility gained from a given budget will be maximized where
the budget is all spent and marginal utility per Kwacha spent is
equalized across all goods
• Rule for a utility maximum:
MUx/Px = MUy/Py or
MUx/MUy = Px/Py
• Example 1.1
• Assume an individual wants to purchase bottles of fruit juice, beer and
wine to buy in order to maximize her utility.

• Assume for simplicity that a bottle of beer costs K2, a bottle of soda
cost K1 and a bottle of wine costs K4.
• In order to derive the individual's demand curve for commodity X,
consider what happens to the consumer's equilibrium condition when
the price of X falls.
• The consumer can now increase his or her total utility by consuming
more units of goods X. This will have the effect of decreasing
marginal utility of X because of the hypothesis of diminishing
marginal utility.
• As a result, consumer will continue increasing his or her expenditure
on X until the equality is restored.
• A fall in the price of goods will, ceteris peribus, give rise to an
increase in consumer’s demand for it.
 Critical evaluation of Cardinal Utility analysis

• Utility is not Cardinally measurable (cannot be measured

objectively)

• Marginal Utility of money is not constant

• Utilities are interdependent.

• Failure to explain Giffen Paradox

• Failure to distinguish income effect and substitution effect