How do consumers make their spending decisions?

Answering this question will strengthen our understanding of the law of demand.

total utility total satisfaction resulting from the consumption of a given commodity by a consumer Marginal utility additional satisfaction obtained by a consumer from consuming one additional unit of a commodity

Central hypothesis of utility theory often called the law of diminishing marginal utility: The utility that any consumer derives from successive units of a particular product consumed over a period of time diminishes as total consumption of the product increases

Two approaches to the measurement of utility

1.

The cardinalist approach tries to assign some values to utility and it uses utils as a unit of measurement. The ordinary approach uses indifference curve to order utility

2.

Suppose you are asked to assign some values to utility derived from consuming successive units of glasses of water. The following is the summary of your total utility, marginal and units consumed

 Two

simplifying assumptions:

Utility can be measured

Different amounts of utility

received from consuming different products can be compared.

Units (glasses of water) Total utility

Marginal Utility

0 1 2 3 4 5 6

0 14 26 36 44 51 57

0 14 12 10 8 7 6

60

50

40

30

Series1

20

10

0 1 2 3 4 5 6 7

16

14

12

10

Series1

Marginal utility declines as consumption increases Each successive drink yields less and less extra utility than the previous one

0 1 2 3 4 5 6

Help to explain the law of demand Also explain how consumers should allocate their money income among products available for purchase

Consumers seek to maximize their total utility subject to the constraints they face Constraints:- income and markets prices of various goods

Utility is maximised when:

Marginal Utility = Zero

How should consumers decide to allocate their consumption of good x and good y in such a way to maximize their utility? To maximize utility the consumer must satisfy the equimarginal principle : A utility maximizing consumer must allocates expenditures so that the utility obtained from the last dollar spent on each product is equal. Consumers money income should be allocated so that the last dollar spent on each and every product purchased yields the same amount of extra satisfaction.

MUy/P = MUx/P

A well behaved indifference curve is convex to the origin Along the indifference curve utility is constant all consumption bundles on the same indifference curve yield the same level of satisfaction

The consumer is indifferent between consuming at A or B

The slope of the indifference curve shows the marginal rate of substitution (MRS) the amount of one commodity the consumer must give up to get more of another commodity while keeping the level of satisfaction constant For the consumer to have more of one good he or she have to give up the other good. The rate at which the consumer substitute good X for good Y is called the marginal rate of substitution of good X for good Y

Perfect substitutes: MRS is constant goods can be exchanged one on one IC is a straight line.

Goods needed in fixed proportions eg left socks and right sock No additional level of only one of them raises consumers satisfaction, only more of both raises consumer satisfaction

L2 L1

Curves cant cross because we said utility is constant on an indifference curve so two different curves can not yield the same satisfaction

7.Higher indifference curves shows higher level of utility This is called the indifference curve map

 Identify

an explain other special cases where the indifference curve above fails to hold

Shows the maximum combination of goods a consumer can afford given income and prices The budget line is also called the consumers possibility line.

 Assume a monthly income (M) of $1000 and that only two commodities are consumed food (f) and transport (r). Food costs $20/kg and transport costs $10 per ride. The budget for the constraint for the consumer if we assume full utilization of income is given as;

If we assume the consumer will spend all income on food then expenditure on transport is zero.
We now have

Pf Qf + PrQr = M

Substituting our values $20Qf Qf

PfQf = M
= $ 1000 = $ 1000/$20/kg = 50 kg

 Similarly for transport we have 100 rides. If we represent this data on a graph we have Any point along the budget line like A and B is efficient and leaves the consumer with no income these points are represented by the equation Any point inside the budget like C is inefficient and leaves the consumer with some income they are represented by the inequality. This is referred to as the budget set. All combination of goods in the budget set are attainable Any point outside the budget line like D is unattainable this represent the concept of resource scarcity. They are represented by the following inequality

Pf Qf + PrQr = M

Pf Qf + PrQr < M

Pf Qf + PrQr > M

The slope of the budget line is the ratio of prices of the two goods
Slope of the BL = Pf/Pr The budget line shows the tradeoffs the consumer can make between transport and food.

 An increase in income increases the purchasing power on the consumer and the consumer is now able to by more of both goods. The budget line have parallel shift outwards whereas a decrease in income have the reverse effect.

Change in relative prices induces a pivotal shift on the budget line

For example Suppose the price for transport increases from $10 to $20 per ride while that for food remain constant

The consumer can now have less rides than before. There is therefore a pivotal shift on the budget line

The consumer is in equilibrium when the budget line is tangent to the indifference curve Point E is more preferred to A and B because it lies on a higher indifference curve At point E the slope of the indifference curve is equal to the slope of the budget line thus MUx/MUy = Px/Py

 Thus the consumer maximise utility where the ratio of marginal utility is equal to the ratio of prices Thus the fomular:

MUx/MUy = Px/Py

When the price of a good changes the consumer is affected in two ways

Firstly the consumers real income changes this is called the income effect
o Real income increases when prices fall o Real income decreases when prices increases

Secondly the consumer is likely to substitute a relatively cheaper commodity for the relatively expensive commodity the substitution effect.

Has positive income and substitution effect The total effect is positive
When price of X fall more of X is

demanded. There is a pivotal shift of the budget line The consumer moves from the original indifference curve IC1 on the old budget line B1 L1to a higher indifference curve IC2 on budget line B1 L3 To decompose the income effect from the substitution effect of a price change we draw a compensatory budget line B2L2 which is tangent to the old indifference curve and parallel to the new budget line

 The movement from;

o E1 to E2 is the substitution effect shows the effect of price change on demand holding real income constant
o E2 to E3 is the income effect it shows the extent to which the change in real income affect the quantity purchased holding prices constant o E1 to E3 is the total effect of a price change For a normal good both the income and substitution effects are positive

The income effect is negative but the substitution effect is positive the total effect is positive

We have a strong income effect that outweighs the substitution effect

Movement from
E1 to E2 is the positive substitution effect E2 to E3 is the negative income effect E1 to E3 positive total effect

The total effect is positive due to a strong negative income effect that outweighs the positive substitution effect.

Movement from;
E1 to E2 is the positive substitution effect

E2 to E3 the negative income effect E1 to E3 the negative total effect

When price for commodity X fall the consumer is able to by of X so the movement from B1L1 to B1L2 The consumer now attains new equilibrium at E2 on the diagram below the corresponding initial price is P1 when the price fall then the new price is P2 and the consumer is able to buy more of commodity X. We can have two points that equates our old price and quantity point a and new price and quantity point b joining these point gives us the demand curve for commodity X