Lecture 4
Demand and supply have become an integral part of microeconomics since their introduction by
Alfred Marshall in 1890. Demand and supply curves are essentially used for determination of
price and output in a competitive market. However, they are also employed in different
applications of the price system, resource allocations and welfare analysis. It is the bread and
butter tool for the applied microeconomists.
Utility and the Law of Demand
Utility
Is the satisfaction derived from the consumption of goods and services.
Utility function
The utility function is a concept that economists use to help them think about consumer
behavior; utility functions do not exist in any fundamental sense.
Ordinal Utility
A consumer can rank his preferences according to the satisfaction of each basket of goods. E.g.
food was very tasty, tasty, average etc. or exam grade A, B, C etc.
Cardinal Utility:
The utility of each commodity is measurable. Utility is a cardinal concept. The most convenient
measure is money: the utility is measured by the monetary units that the consumer is prepared to
pay for another unit of the commodity.
Total Utility
The total utility of a ‘basket of goods’ depends on the quantities of the individual commodities.
If there are n commodities in the bundle with quantities x1, x2, . . . . , xn, the total utility is
U = f (x1, x2, …, xn)
In very early versions of the theory of consumer behaviour it was assumed that the total utility is
additive,
U= U1(x1)+ U2(x2) + . . . + Un(xn)
The additivity assumption was dropped in later versions of the cardinal utility theory. Additivity
implies independent utilities of the various commodities in the bundle, an assumption clearly
unrealistic, and unnecessary for the cardinal theory.
2. Diminishing Marginal Utility:
The utility gained from successive units of a commodity diminishes. In other words, the marginal
utility of a commodity diminishes as the consumer acquires larger quantities of it. This is the
axiom of diminishing marginal utility.
MUx = ∆TUx/∆Qx
Marginal Utility
the extra utility that a consumer gets from consuming the last unit of a good
Equilibrium of the Consumer:
We begin with the simple model of a single commodity x. The consumer can either buy x or
retain his money income Y. Under these conditions the consumer is in equilibrium when the
marginal utility of x is equated to its market price (Px). Symbolically we have
MUX = Px
If the marginal utility of x is greater than its price, the consumer can increase his welfare by
purchasing more units of x. Similarly if the marginal utility of x is less than its price the
consumer can increase his total satisfaction by cutting down the quantity of x and keeping more
of his income unspent. Therefore, he attains the maximization of his utility when MUX = Px.
Deriving demand curve
the supply-and demand model cannot be used to answer questions concerning individuals, such
as
whether a relocated employee will benefit by moving from Karachi to Hyderabad.
Individual tastes or preferences determine the amount of pleasure people derive from the goods
and services they consume.
Consumers maximize their well-being or pleasure from consumption, subject to the constraints
they face.
Consumers spend their money on the bundle of products that give them the most pleasure…ice
cream vs. burger
But keeping in mind the constraints…
Constraints may be by budget or by govt. e.g. drink and smoking is prohibited for a specific level
of age
Preferences
Consumer must allocate the money to buy a bundle (market basket or combination) of goods.
Consumer chooses the goods blindly or has some preferences
Economists make three critical assumptions about the properties of consumers’ preferences.
Such as completeness, transitivity, and more is better.
Completeness
Only one of the following relationships is true: a _ b, b _ a, or both relationships hold so that a
b.
Transitivity
The transitivity property eliminates the possibility of certain types of illogical behavior.
According to this property, a consumer’s preferences over bundles is consistent in the sense that,
if the consumer weakly prefers a to b, a _ b, and weakly prefers b to c, b _ c then the consumer
also weakly prefers a to c, a _ c.
More Is Better
Bad vs. Good
Indifference Curves
set of all bundles of goods that a consumer views as being equally desirable.
Indifference map or preference map,
1. Bundles on indifference curves farther from the origin are preferred to those on indifference
curves closer to the origin.
2. There is an indifference curve through every possible bundle.
3. Indifference curves cannot cross.
4. Indifference curves slope downward.
Willingness to trade one good for another is measured by her marginal rate of substitution
(MRS): the maximum amount of one good a consumer will sacrifice to obtain one more unit of
another good.
Rationality:
The consumer is rational. He aims at the maximization of his utility subject to the constraint
imposed by his given income.
Budget Constraint
If we cannot save and borrow, our budget is the income we receive in a given period.
pBB + pZZ = Y,
The opportunity set
is all the bundles a consumer can buy, including all the bundles inside the budget constraint and
on the budget constraint (all those bundles of positive Z and B such that ( ).
Slope of the Budget Constraint
The slope of the budget line is determined by the relative prices of the two goods. Slope of the
line is PB/Pz
The slope of the budget line is called the marginal rate of transformation (MRT): the trade-off
the market imposes on the consumer in terms of the amount of one good the consumer must give
up to purchase more of the other good:
The Consumer’s Optimal Bundle
Given information about consumer’s preferences (as summarized by her indifference curves) and
how much she can spend (as summarized by her budget constraint), we can determine the
optimal bundle. Her optimal bundle is the bundle out of all the bundles that she can afford that
gives her the most pleasure.
Budget line shifting … Budget line rotating
Corner Solution
If a consumer buys positive quantities of two goods, the indifference curve is convex and tangent
to the budget line at that optimal bundle.
