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CHAPTER 5 THE THEORY OF

CONSUMER BEHAVIOUR

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Table of Content
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3.
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5.
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7.
8.

Cardinal Utility Theory


Total and Marginal Utility
The Law of Diminishing Marginal Utility
Consumer Equilibrium Mathematical Method
Ordinal Utility Theory
The Budget Line
The Indifference Curve
Consumer Equilibrium Graphical Method

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DIAMOND-WATER PARADOX

- The paradox: Water is cheap and diamonds are


expensive!
- The observation that things that have the greatest value
in use sometimes have little value in exchange and things
that have little value in use sometimes have the greatest
value in exchange.
- How can this be explained???
- Utility theory provides a solution!

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5.1 CARDINAL UTILITY THEORY

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Utility Theory
Utility is a measure of the satisfaction,
happiness, or benefit that results from the
consumption of a good.
A util is an artificial construct used to measure
utility.
Total utility is the total satisfaction a person
receives from consuming a particular quantity of
a good.
Marginal utility is the additional utility a person
receives from consuming an additional unit of a
particular good.
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Law of Diminishing
Marginal Utility
The marginal utility gained by consuming equal
successive units of a good will decline as the
amount consumed increases.
The total utility of something can be rising as the
marginal utility of that something is falling.

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Total Utility, Marginal Utility, and the Law of


Diminishing Marginal Utility

Both total utility and marginal utility are


expressed in utils.
Marginal utility is the change in total
utility divided by the change in the
quantity consumed of the good, MU =
TU/Q.
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Total Utility, Marginal Utility, and the Law of


Diminishing Marginal Utility

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Law of Diminishing Marginal Utility


Application
The law of diminishing marginal utility is based
on the idea that if a good has a variety of uses
but only 1 unit of the good is available, then the
consumer will use the first unit to satisfy his or
her most urgent want.
If 2 units are available, the consumer will use the
second unit to satisfy a less urgent want.

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Interpersonal Utility Comparison


Comparing the utility one person receives from a good,
service, or activity with the utility another person receives
from the same good, service, or activity.

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No Interpersonal Utility Comparison


Caution: The utility obtained by one person cannot be
scientifically or objectively compared with the utility
obtained from the same thing by another person because
utility is subjective.

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Diamond-Water Paradox Resolved


The total utility of water is high because water is extremely
useful.
The total utility of diamonds is low in comparison because
diamonds are not as useful as water.
The marginal utility of water is low because water is so
plentiful that people end up consuming it at low marginal
utility.
The marginal utility of diamonds is high because diamonds
are so scarce that people end up consuming them at high
marginal utility.
Do prices reflect total or marginal utility? ___________
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Consumer Equilibrium Mathematical


Method
The analysis is based on the assumption that
individuals seek to maximize utility.
Occurs when the consumer has spent all income
and the marginal utilities per dollar spent on
each good purchased are equal:

where the letters AZ represent all the goods a


person buys.
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Marginal Utility Analysis and the Law of


Demand
Marginal utility analysis can be used to illustrate the law
of demand, which states that price and quantity
demanded are inversely related, ceteris paribus.
Starting from consumer equilibrium in a world containing
only two goods, A and B, a fall in the price of A will cause
MUA /PA to be greater than MUB /PB.
As a result, the consumer will purchase more of good A
to restore herself to equilibrium.

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ORDINAL UTILITY THEORY


Budget line/constraint (BC):
all the combinations or
bundles
of two goods a person can
purchase given a certain
money
income and prices for the
two goods.
Slope of BC: represent the
relative prices of two goods
(Px/Py)
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Indifference Curve (IC)


Indifference set: group of bundles of two goods that give an
individual equal total utility.
Indifference Curve: represent an indifference set. A curve
that shows all the bundles of two goods that give an
individual equal total utility.
Characteristics of IC that are consistent with reasonable
assumption about consumer behaviour.
(a) downward sloping
(b)convex to the origin
(c)farther from the origin are preferable
(d) do not cross (intersect)
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Consumer Equilibrium (CE)- Graphical


Method
CE exists at the point where the slope of the BC = the
slope of an IC

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