2. Two major approaches to utility
KARDINAL ORDINAL
- immeasurability of utility
- direct measuribility of
utility Tools used:
- Indifference analysis
Tools used: - Basic assumption: consumer
- Total utility curve can rank market baskets
- Marginal utility curve (the most desired basket is
ranked first)
3. CARDINAL APPROACH TO UTILITY
Utility = satisfaction consumers receive from items
they require, activities they engage in, or services
they use
Total utility = total satisfaction enjoyed from
consuming any given quantity čit´s a subjective
concept
Marginal utility = the extra satisfaction a person
receives over a given period by consuming one extra
unit of a good
4. Relationship of Total and Marginal Utility
Quantity of good consumed Total utility Marginal utility
0 0
1 4 4
2 7 3
3 9 2
4 10 1
5 10 0
∆TU
MU =
∆Q
The relationship between total and marginal utility can be
expressed also graphically. The figure of total utility shows how
the total utility depends on the amount of consumed good the
ratio ∆TU represents than the slope of total utility curve.
∆Q
6. 1. Gossen´s law
The law of diminishing marginal utility – the amount of
extra or marginal utility declines as a person
consumes more and more of a good
čUtility tends to increase as you consume more of a
good, however, according to the law of diminishing
marginal utility, your total utility will grow at a slower
and slower rate
7. Consumer Equilibrium
As a rational consumer, you presumably seek to obtain
the greatest possible utility from your limited monthly
income.
On condition we don´t have to pay anything for a good,
the equlibrium level of consumption of that good would
be the amount that brings us the highest total utility.
Equilibrium amount of a good will be bought than, as
long as the marginal utility equals the price of that
product:
MU = P
8. 2. Gossen´s law
The law of equal marginal utilities per
dollar/euro.. = equimarginal principle
- to maximize utility, consumer must equalize
the marginal utility per euro spent on each
good
MUx MUy (MU of income)
=
Px Py
9. Deriving of demand curve
The demand curve represents a relationship between
the marginal utility of a good and the quantity
consumed, other things beings equal
A higher price for a good reduces the consumer´s
optimal consumption of that commodity, therefore for
each price exists the quantity demanded
corresponding the consumer optimum downward-
sloping demand curve!
10. ORDINAL APPROACH TO UTILITY
INDIFFERENCE CURVES THE BUDGET CONSTRAINT
A graph of various market baskets Budget line = represents all
that provide a consumer with equal
utility
alternative combinations of
Different individual will naturally rank two goods that consumer
market baskets differently can afford considering his
Main characteristics: fixed income (assuming fixed
∀ • convex to origin – represents the prices).
„law of substitution“ The equation of budget line
∀ • downward-sloping
is:
∀ • there is always an infinite number
of curves
I = Px ∗ X + Py ∗ Y
∀ • they never intersects mutually
• ∆Y Px
∆Y MUx The slope: =
MRSXY = = ∆X Py
∆X MUy
11. Consumer equilibrium
Represents that combination of goods purchases that
maximizes utility subject to the budget constraint
Geometrically, the equilibrium can be described as
that combination of goods corresponding to the point
at which the budget line is just tangent to the highest
attainable indifference curve in the consumer´s
indifference map
Px MUx
= substitution ratio =
Py MUy
13. DERIVING THE DEMAND CURVE
Kept other things constant, when the price of X has increased, it will mean that
the less of that product you can afford with your income
čgraphically it means the change of the budget line slope – it becomes steeper
and therefore will touch different indifference curve (representing lower level of
utility) each price corresponds other optimal point and therefore different
quantity of good demanded, in that way we can construct the demand curve
(individual)
14. CONSUMER SURPLUS
= the gap between the total utility of a good and its total
market value
The surplus arises because we „receive more than
we pay for“, it is rooted in the law of diminishing
marginal utility
we pay for each unit what the last unit is worth – but
by the law of diminishing marginal utility the earlier
units are worth more to us than the last thus, we
enjoy a surplus of utility on each of these earlier units
16. Tasks:
1. Can be TU positive and MU negative at the same time? Draw graphs and explain.
2. Knowing following dates:
a) Draw the graphs of TU and MU curves.
b) Calculate, how high consumer surplus you´ll get, when the market price of good is 8
Eur and decide, how many units you will consume.
Q 1 2 3 4 5 6 7
TU 20 36 48 56 60 60 58
3. Px = 120 Eur and Py = 80 Eur. Graphically show, what will happen when Px has
increased by 18 Eur and at the same time Py by 12 Eur. Use the tools of
indifference analysis.
4. Your function of TU is: TU = 10X – X2 . (where X is quantity of good consumed per
week).
a) Write the equation of MU and decide, at what level of consumption start TU decrease?
b) Derive and draw TU and MU curves.
c) Assume Px = 6 Eur. By what level of consumption of good X will household maximize
its utility, knowing, that the ratio MU/P for all other goods = 1)?
