Managerial Economics Is a Tool for Improving Management Decision Making

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Utility
Utility refers to want satisfying power of a commodity.

In objective terms, utility may be defined as the amount of satisfaction derived from a commodity or service at a particular time. Assumptions: Utility can be measured. Marginal Utility of money remains constant No change in income of the consumer, his taste & fashion to be constant No substitute Independent marginal utility of each unit of commodity

Characteristics: Utility is subjective/not measurable Utility is variable Utility is different from usefulness No legal or moral connotations Marginal Utility (MU)

Utility

The word Marginal means Border or Edge. It is the addition made to the total utility by consuming one more unit of a commodity.

Total Utility (TU)

Total Utility refers to the total satisfaction derived by the consumer from the consumption of a given quantity of a good. TU = Sum of all MU The exponents of the utility analysis have developed two laws which occupy a very important place in economics theory and they are :Law of Diminishing Marginal Utility Law of Equi-Marginal Utility

Law of Diminishing Marginal Utility

Though wants of an individual are unlimited in number yet each individual want is satiable. Because of this, the more we have a commodity, the less we want to have more of it. This law state that as the amount consumed of a commodity increases, the utility derived by the consumer from the additional units, i.e marginal utility goes on decreasing. According to Marshall, The additional benefit a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has

Law of Diminishing Marginal Utility

Explanation: As more and more quantity of a commodity is consumed, the intensity if desire decreases and also the utility derived from the additional unit. Assumptions: All the units of a commodity must be same in all respects The unit of the good must be standard There should be no change in taste during the process of consumption There must be continuity in consumption There should be no change in the price of the substitute goods

Law of Diminishing Marginal Utility

Exceptions: # Money # Hobbies and Rare Things # Liquor and Music # Things of Display
Importance:
Basis of Law of Demand
Basis of Consumption Expenditure The basis of Progressive Taxation

Consumers Equilibrium
Consumer will attain its equilibrium (maximum satisfaction) at the point, where marginal utility of a product divided by the marginal utility of a rupee, is equal to the price. Consumers equilibrium = Marginal utility of a product Marginal utility of a rupee = its price Steps: Generation of alternatives Evaluation of alternatives Choice of the best alternative Assumptions: Consumer behaviour is rational. Consumer behaviour is consistent. There are two commodities in consideration.

Law of Equi-Marginal Utility

This law states that the consumer maximizing his total utility will allocate his income among various commodities in such a way that his marginal utility of the last rupee spent on each commodity is equal. Or The consumer will spend his money income on different goods in such a way that marginal utility of each good is proportional to its price

Limitations of Law of Equi-Marginal Utility

It is difficult for the consumer to know the marginal utilities from different commodities because utility cannot be measured.
#

# Consumer are ignorant and therefore are not in a position to arrive at an equilibrium. # It does not apply to indivisible and inexpensive commodity.

Total and Marginal Utility

Total Utility (TU) - relates consumption of a good to the utility derived from consuming a good. (This could be many units of a good)

Marginal Utility (MU) - the change in total utility when consumption of a good changes by one unit.
MU = DTU / D Q consumed of a good

Law of Diminishing Marginal Utility

Law of Diminishing Marginal Utility eventually, a point is reached where the marginal utility obtained by consuming additional units of a good starts to decline, ceteris paribus.

Law of Diminishing Marginal Utility

Example
If Im really hungry, I get a lot of satisfaction from first slice of pizza. If I keep eating pizza, the satisfaction from the 8th slice would be much less than that of the first slice.

Marginal Utility
MU

MU

Consumer Equilibrium

Now that we understand the concepts of utility theory - we will use them to explain how consumers make decisions about what to buy

Consumer Equilibrium
For instance, I would much rather have a Jaguar instead of my Honda If I want to maximize my utility, why dont I buy a Jaguar?
Because it costs a lot more than the Honda

So if I want to maximize my utility, I dont just pick the thing that gives me the most pleasure. I have to weigh the price of the good in my decision as well

Consumer Equilibrium
So how can I compare a Jaguar and a Honda? Its like comparing apples and oranges. Instead, I need to somehow make them both comparable.

Consumer Equilbrium
In order to do that I will need to convert utility to utility per dollar. This way, I can see that even though the Jag gives me more utility, I get more utility per dollar from the Honda. So if I want to spend my money wisely, I buy the thing that gives me more utility per dollar.

Consumer Equilibrium
Lets say I walk down to the cafeteria for lunch and they have Pizza and Ice Cream. The pizza is $1 a slice and the Ice Cream is $2 a scoop. I have $7 in my pocket What do I buy?

Consumer Equilibrium
Remember, I want to choose the combination of pizza and Ice Cream that gives me the greatest possible utility for my $7 Consider the following table, which states the total utility I get from all possible quantities of Pizza and Ice Cream

Utility Table
Ice Cream Quantity Total Util. Marginal Util. Pizza Total Util. Marginal Util.

0 1 2 3 4 5 6

0 24 44 60 70 72 72

--

0 29 46 56 58 59 59

--

Utility Table
Ice Cream Quantity Total Util. Marginal Util. Pizza Total Util. Marginal Util.

0 1 2 3 4 5 6

0 24 44 60 70 72 72 24 20 16 10 2 0

--

0 29 46 56 58 59 59 29 17 10 2 1 0

--

Consumer Equilibrium
We need to find the marginal utility per dollar for both goods. Consider the first scoop of ice cream - MU 12 per dollar. MU of the first slice of pizza 29 per dollar. So I want to buy the pizza. Now I have $6. Now I have to compare my second slice of pizza (MU is 17 /$) with the first scoop of ice cream (MU is 12 /$). I will want to buy the second slice of pizza. I have $5.

Consumer Equilibrium
Now I have to compare the third slice o pizza (MU 10/$) with the first scoop of ice cream (MU 12/$). I will want to buy the ice cream. I have $3. Now I have to compare the third slice of pizza (MU 10 /$) with the second scoop of ice cream (MU 10 /$). It doesnt matter which I pick, since they make me equally happy. Ill take the pizza. Now I have $2

Consumer Equilbrium
Now I have to compare the fourth slice of pizza (MU is 2/$) to the second scoop of ice cream (MU is 10 /$). I will want to buy the ice cream. I have no more money. I bought 3 slices of pizza which give a total utility of 56 and 2 scoops of ice cream which give a total utility of 44. My total utility from lunch is 56+44=100. There is no other combination of pizza and ice cream that give a greater utility for $7.

Consumer Equilbrium
What if the price of the ice cream dropped to $1 a scoop. Assignment: Convince yourself that I will buy 4 scoops of ice cream and 4 slices of pizza. Note that when the price went down, I bought more - THIS IS WHERE THE LAW OF DEMAND COMES FROM.

Consumer Equilibrium
In summary, you need to convert marginal utility to marginal utility per dollar Then compare MU/P for the two goods and buy the one that gives the greatest MU/P Subtract the price from your budget Compare the next available units of both goods and repeat the process until you are out of money.

Consumers Equilibrium: Principle of Equi Marginal Utility

- Principle of Equi marginal utility occupies an important place in cardinal utility analysis. - The consumer equilibrium is explained by means of this principle.

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illustration: A consumer has a given income which he has to spend on various goods he wants. Now the question is how he would allocate his given money among various goods, that is to say what would be his equilibrium position in respect of the purchases of the various goods.

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Assumptions: Consumer is assumed to be rational. i.e., He carefully calculates utilities and substitutes one good for another so as to maximize his utility or satisfaction.

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Case 2
Suppose there are only two goods X and Y on which a consumer has to spend a given income. The Consumers behaviour will be governed by 2 factors: - Marginal utilities of the goods. - Prices of two goods

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Definition: Law of Equi-marginal utility

It states that the consumer will distribute his money income between the goods in such a way that the utility derived from the last rupee spent on each good is equal.

In other words, consumer is in equilibrium position when marginal utility of money expenditure on each good is the same. Now, the marginal utility of money expenditure on a good is equal to the marginal utility of a good divided by the price of the good.

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MUx MUm = --------Px Mum = Marginal Utility of money expenditure. MUx = Marginal Utility of X Px = Price of X

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Consumer is in equilibrium in respect of the purchases of two goods X and Y when

MUx MUY --------- (a) = -------- (b) Px PY

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Case 1: If (a) not equal to (b) and (a) > (b) The consumer will substitute good X for good Y. Result: Due to substitution Marginal utility of good X will fall and marginal utility of good y will rise. The consumer will continue substituting good X for good Y until both are equal. Case 2: The equality can be achieved not only at one level but at different levels of expenditure.

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Case 3:If there are more than 2 goods

If there are more than 2 goods on which the consumer is spending his income the equation below must hold good for all of them.
MUx --------- = Px MUY MUn -------- = . = -------- = MUm PY Pn

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Limitations of the Law of Equi Marginal Utility Like other laws of economics, law of Equi - marginal utility is also subject to various limitations. 1. For applying this law of Equi marginal utility in the real life, consumers must weigh his mind the marginal utilities of different commodities

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2. For applying this law in actual life and equate the marginal utility of the last rupee spent on different commodities, the consumers must be able to measure the marginal utilities of different commodities in cardinal terms. 3. Another limitation of the law of Equi marginal utility is found in the case of indivisibility of certain goods.

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Graphing the Indifference Curve

A Group of Indifference Curves

Sophie will have a whole group of indifference curves, each representing a different level of happiness.

A Group of Indifference Curves

If she prefers more to less, she is better off with the indifference curve that is farthest to the right.

A Group of Indifference Curves

Why Indifference Curves Cannot Cross

If indifference curves crossed, it would violate the prefer-more-to-less principle.

Why Indifference Curves Cannot Cross

Indifference Curves and Budget Constraints

Sophie will maximize her utility by consuming on the highest indifference curve as possible, given her budget constraint.

Indifference Curves and Budget Constraints

The best combination is the point where the indifference curve and the budget line are tangent.

Indifference Curves and Budget Constraints

The best combination is the point where the slope of the budget line equals the slope of the indifference curve.
PS MUS MUC MUS so that PC MUC PC PS

Indifference Curves and Budget Constraints

Consumer Preferences
Completeness (DO NOT KNOW does not exist)
The consumer is capable of expressing a preference for all bundles of goods.

Transitivity
Given 3 bundles of goods: A, B & C. If A B and B C, then A C. If A B and B C, then A C.

More is Better

Indifference Curve Analysis

Clothing (units per week)

50 40

B H A G D E

The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A.

30
20 10 10

20

30

40

Food (units per week)

Indifference Map
Good Y III. II.
An indifference map is a set of indifference curves that describes a persons preferences for all combinations of two commodities.

I.

Indifference Curve A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction.

Good X

Marginal Rate of Substitution

Clothing 16 (units per week) 14

A
Marginal Rate of Substitution The rate at which a consumer is willing to substitute one good for another and stay at the same satisfaction level.

12
10 B D

8
6

4
2 1 2 3 4

G
Food (units per week)

Clothing 16 (units per week) 14

A MRS = 6

MRS DC

DF

12 -6 10
1 -4

B
D
1 -2

8
6

Along an indifference curve there is a diminishing marginal rate of substitution. MRS = 2

4
2 1 2

E
1 -1 1

G
Food (units per week)

The Budget Constraint

Preferences do not explain all of consumer behavior. Budget constraints also limit an individuals ability to consume in light of the prices they must pay for various goods and services.

The budget line indicates all combinations of two commodities for which total money spent equals total income.

Comparative Statics
Changes in prices
Substitute Goods
An increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y.

Complementary Goods
An increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y.

Complementary Goods
When the price of good X falls, the consumption of complementary good Y rises. Crude (Y)

B Y2 A Y1 I 0 II

X1

X2

Fuel (X)

Changes in income
Normal Goods
Good X is a normal good if an increase (decrease) in income leads to an increase (decrease) in its consumption.

Inferior Goods
Good X is a inferior good if an increase (decrease) in income leads to an decrease (increase) in its consumption.

Normal Goods
Y An increase in income increases the consumption of normal goods.
B A I 0 II