The Theory of Consumer Behavior †the Theory of Utility free essay sample

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 consuming 3 units of Product X and 2 units of Product Y. Example 3: The marginal utility per dollar and the level of income. We will write a custom essay sample on The Theory of Consumer Behavior – the Theory of Utility or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page Income = $120 †¢The point of utility maximisation is where the marginal utility per dollar for each product is 10 †¢The consumer would purchase 2 units of product X and 2 units of product Y. This would require expenditure of $120 †¢This combination of consumption would yield 2000 utils An increase in income to $160 †¢Assuming that savings are zero the consumer would allocate all income to purchase the combination of products that yields the highest total utility. †¢An increase in income of $40 allows the consumer to purchase one additional unit of Product Y or 2 additional units of Product X. †¢The consumer would allocate marginal income to the product which yields the next highest MU per dollar †¢In this example the consumer would purchase one dditional unit of Product Y as the MU per dollar of this product (8) is higher than the MU per dollar of consuming additional units of Product X ( 5, 2. 5 ) †¢When income increases from $120 to $160 the combination of products that yields the highest total utility is : †¢ 3 units of Product Y and 2 units of Product X †¢The consumer will attain 2320 utils of total utility. The Budget Constraint †¢The limited amount of income available to consumers to spend on goods and services. †¢The budget constraint and prices of products will determine the consumer’s level of utility. Remembering that MU per dollar of Product X = MU per dollar of Product Y to achieve consumer equilibrium or optimisation †¢Example: Two products are used in this example – pizza and coke The price of pizza is $2 per slice The price of coke is $1 In this example 3 consumption combinations satisfy optimisation: 1 pizza and 3 coke ( MU per $ = 10) 3 pizza and 4 coke ( MU per $ = 5) 4 pizza and 5 coke ( MU per $ = 3) Optimisation continued †¢A consumer with a budget constraint of $13 will maximise utility with 4 slices of pizza and 5 cups of coke. TU = 105 utils) †¢A consumer with a budget constraint of $5 will maximise utility with one slice of pizza and 3 cups of coke (TU = 65 utils) Deriving the demand curve from utility analysis †¢The demand curve may be derived from the principles of utility maximisation and consumer equilibrium. †¢Law of demand: As the price of a product decreases the quantity demanded increases. †¢Total utility, marginal utility and the budget constraint can all be linked and be used to explain the law of demand. †¢The following example demonstrates how the demand curve for Product B is derived. Product A = $4 Qty Tu MU MU per $ 0 0 1 600 600 150 2 800 200 50 3 960 160 40 4 1040 120 30 Product B P= $2 TU MU MU per $ 0 700 700 350 900 200 100 1000 100 50 1040 40 20 P = $5 MU per $ 140 40 20 8 †¢When PA = $4 and PB = $2 consumer equilibrium is achieved when the consumer consumes 2 units of A and 3 units of B. When PB increases to $5, consumer equilibrium is achieved when the consumer consumes 3 units of A and 2 units of B. The demand schedule for PB PB QDB $2 3 $52 Utility and consumer decision making In summary, the two conditions for maximising utility are: 1. 2. Spending on Product A + Spending on Product B = Amount available to be spent. The marginal rate of substitution †¢Marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of utility. The formula is: