The Theory of Consumer Behavior – the Theory of Utility

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Topic 6 - The Theory of Consumer Behavior – the theory of utility •The theory of consumer behaviour may be analysed by either utility theory and / or indifference curve analysis. •Note: this course only requires students to be aware of utility theory. Indifference curve analysis is undertaken in year 2 and is not a requirement of this course Basic Principles of the theory of Consumer Behaviour

Consumers are rational optimisers
Consumers seek to maximise total utility
Utility is achieved by the consumption of goods and services •Utility / consumption is dependent on and constrained by •budget or income
prices of goods and services
Utility Theory
Utility is defined as the satisfaction or pleasure which a consumer obtains from obtaining and consuming a good or service. •Consumers are assumed to be rational optimisers seeking to maximise total utility. Ordinal Utility

Satisfaction levels which may be ranked but not precisely measured Cardinal Utility
Utility which may be measured.
Much of the theory of consumer behaviour is based on ordinal utility Total Utility
is defined as the total satisfaction which consumers gain from the consumption of a particular good or service or combination of goods and services. •The unit of measurement of utility is utils

Marginal utility
is defined as the additional utility or satisfaction gained from obtaining and consuming an extra unit of a particular good or service. •Marginal utility is also measured in utils.
Marginal utility is measured by the following formula:
MUX = ΔTU
ΔX
X represents the quantity consumed of a particular product •An example of total and marginal utility
Qty of Product X ConsumedTotal Utility (utils)Marginal Utility (Utils) 00-
188
2146
3184
4202
5200

Total Utility

Characteristics of total and marginal utility
TU tends to increase as consumption increases
TU tends to increase at a decreasing rate as consumption increases •MU tends to decrease as consumption increases
Diminishing MU explains the decreased rate of growth of TU The Law of Diminishing Marginal Utility
Consumers will derive lower levels of utility from the consumption of additional units of a particular good or service. Marginal Utility per Dollar Spent
In attempting to maximise TU consumers make choices as to which combination of products will yield the highest level of utility within income and price constraints. •To make the MU of differently priced products comparable it is necessary to calculate the marginal utility per dollar spent. •MU per dollar spent is calculated by:

MUX
PX

An example: MU per dollar spent. 1 product. 2 Prices

Utility Maximisation (optimization) – household equilibrium •Utility is maximised when the MU per last dollar spent on one product is equal to the MU per last dollar spent on all other goods. •Utility is therefore maximised when the:

MU per dollar of Product A = MU per dollar of product B •An example of utility maximization

Utility Maximisation (optimization)
Occurs at the point where:
MU per dollar of Product X = MU per dollar of Product Y •The equilibrium MU per dollar is 8
The consumer would purchase 2 units of product X and 3 units of product Y to maximise total utility •At the equilibrium the consumer would realise 2920 utils •An income of $170 is required to realise utility maximisation

Example 2: Prices of Product Y increases ($40 to $100)

When the price of Product Y increases consumers realise less MU per dollar from the consumption of this product. •Consumers will switch from Product Y to Product X in order to maximise TU. •To restore equilibrium consumers will now purchase less of product Y and more of product X •The new equilibrium occurs at the MU per dollar of 4

Consumers will maximise TU by...
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