Demand and Marginal Utility (With Diagram) | Indifference Curve
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These three assumptions form the basis of consumer theory. We add another one to these three assumptions, that, indifference curve is convex to the origin. Demand and Marginal Utility 6. In order to explain indifference curves, we will make simplifying assumption that the consumer only buys two goods or two baskets of goods — X and Y. Any combinations on indifference curve 3, such as E, is preferred to any market basket on curve 2, D, which, in turn, is preferred to any basket on 1, such as B or C.
An indifference curve joins together all the different combinations of two baskets of goods which yield the same utility to the consumer. Thus, every point on the graph represents some combinations of X and Y. A point very close to the origin, like A, represents very small quantities of X and Y; points further away from the origin represent bigger quantities.
Since points B and C are on the same indifference curve, the consumer is said to be indifferent between them, both combinations yield the same utility to him. Combination D is on a higher indifference curve than B or C. Thus, D is preferred to B and C. We assume that the consumer can rank his preference over the entire field of choice. This means that the consumer must be able to consider any two possible combinations of X and Y and say either that he prefers one to the other, or he is indifferent between them.
We assume further that our consumer is rational and must satisfy the following conditions: We must consider several important features of indifference curves. Demand and Marginal Utility 7.
If both X and Y are goods and if the consumer is rational, then we must conclude that if consumers give up some of X, they will want more of Y to remain at the same level of utility. In moving from A to B, as units of Y are given up, more units of X are obtained and the utility derived is unchanged.
For this to be true, the indifference curves must slope downwards from left to right. Demand and Marginal Utility 8. Indifference Curves are Convex to the Origin: As more and more units of one good, say Y, are given up, it is reasonable to suppose that successively bigger quantities of X must be obtained to compensate the consumer for his loss and leave him at the same level of utility. Since the slope of an indifference curve is called the marginal rate of substitution MRSthe proposition is sometimes summed up as the diminishing marginal rate of substitution.
When the MRS diminishes along an indifference curve, preferences are convex. The MRS at any point is equal, in absolute value, to the slope of the indifference curve at the point. Demand and Marginal Utility 9. Indifference Curves can never Intersect: This is shown in Fig. Since A and C are on the same indifference curve, the consumer must be indifferent between them. Combination B and C are also on the same indifference curve, so the consumer must be indifferent between them as well.
If a consumers is indifferent between A and C, and between B and C, he must by the rule of transitivity be indifferent between A and B. This is absurd and illogical because A contains more Y and the same amount of X as B and so must be preferred to it. This kind of absurd result occurs whenever indifference curves intersect. We conclude, thus, that indifference curves can never intersect each other. Demand and Marginal Utility Ordinal lersus Cardinal Rankings: We have shown only 3 indifference curves in Fig.
The three curves provide an ordinal ranking of baskets of goods. An ordinal ranking places baskets in the order of most preferred to least preferred, but it does not indicate by how much one market basket is preferred to another.
For example, we know that consumption of any basket on IC3, such as E, is preferred to consumption of any basket on IC2, such as D. However, the amount by which E is preferred to D is not revealed by the indifference map.
Relationship between “Marginal Utility”, “Total Utility” and “Average Utility”
By contrast, when economists first studied utility, they assumed that individual preference could easily be measured in terms of basic units and could, therefore, provide a cardinal measurement.
However, we now know that the particular unit of measurement is not important, and an ordinal ranking is sufficient to help us explain how most individual decisions are made. They cannot tell us which combinations will be chosen. Given these information, and assuming that he will choose the combinations of two goods which will yield him greatest utility, we can find out the combination of X and Y that the consumer will choose.
Now we can draw the budget line which shows all the combinations of two goods which can be purchased with a given level of income and the relative prices of the two goods. This is illustrated in Fig. Given preferences and budget constraints, we can choose how much of each good to buy.
We assume that consumers make this choice to maximise the satisfaction, given budget constraint. Now we draw indifference map on the graph 4. Assuming that the consumer spends all his income on X and Y, he will choose the combination represented by C. This is the point where the budget line is tangential with an indifference curve — the indifference curve I2 is the highest one that can be reached.
Point C is called the consumer equilibrium point where he maximises his utility subject to his budget constraint. At point C, the slope of the indifference curve MRS is equal to the slope of the budget line at that point.
- Relationship between Total Utility and Marginal Utility
- Demand and Marginal Utility (With Diagram) | Indifference Curve
- Difference Between Total and Marginal Utility
Perfect Substitute and Perfect Complement: The ICS with perfect substitute have a constant slope. An additional left shoe gives consumer no extra satisfaction unless consumer also obtains the matching right shoe.
Effect of Income Change: Similarly, if his income falls, his budget line will shift downwards remaining parallel. The important result to remember is that when income changes, the budget line shifts but remains parallel. DCB is called the income-consumption curve.
Effect of Price Change: We now examine the effect of a price change. Suppose the price of X falls, ceteris paribus. When the price of one of the goods falls, the budget line does not shift, but this pivots and so does not remain parallel to the original one. It becomes less steep reflecting the fall in the relative price of X. The effect of the price fall on the consumer equilibrium point is shown in Fig. The line CB is called the price- consumption curve.
There are two possible reasons for this: The consumer is, thus, induced to substitute X for Y. This is called the substitution-effect of the price change.
This may allow him to buy more of X and more of Y. This is called the income effect of the price change. It is possible to identify these two effects graphically and this is done in Fig. The first step is to eliminate the income effect: The substitution effect always acts in such a way that when the relative price of a good falls real income remaining constantmore of it is purchased.
If he buys more, it is a normal good: If he buys less, the good is an inferior good this is shown in Fig. If he buys less, and the income effect is actually bigger than the substitution effect so that the overall effect of the price fall is decreased in consumption, then the good is a Giffen good: Derivation off the Demand Curve for a Normal Good: The price- consumption curve in Fig.
The resulting demand curve is downward-sloping from left to right. We have completed a full circle.
Under certain exceptional circumstances, a demand curve which slopes upwards from left to right is drawn in Fig. Derivation of the Demand Curve for a Giffen Good: We now consider individual demand curve for good X as shown in Fig. It is clear from Fig. This theory is based on the assumption that a consumer will actually choose to consume the collection of goods that he prefers.
All that was required was that the consumer behaved consistently. Suppose that the line AB in Fig. The movement from C to D is the substitution effect of the price fall and thus, consumer purchases more of X following the price fall.
It is important to notice that, to arrive at this conclusion, no mention of the abstract concept of utility was made. Thus, the revealed preference theory can be described as a more objective approach to the theory of consumer behaviour. However, some subjective element is still implicit when consumers reveal their preferences for goods.
A possible reason for this is that consumers are often swayed by differences within a product. For example, the minor differences in brands of washing powder which may seem trivial to the logical economists may be important to the consumer, who is willing to pay for them.
Those who work on advertising are well aware that it is often the emotional content of a product which is more important than the rational. This does not necessarily contradict our analysis — as Lancaster argues it is the characteristics or attributes of goods which yield satisfaction to the consumer, rather than the goods themselves.
We have examined the various approaches to the analysis of consumer behaviour, and looked more closely into the proposition that a fall in the price of a normal good will cause an increase in the quantity of that good demanded by an individual consumer. Income-consumption curves can be used to construct Engel curves, which relate the quantity of a good consumed to income. In both figures, as income increase, the consumption of X also increases. The upward-sloping Engel curve applies to all normal goods.
We see that rice consumption increases initially as income increases. As income increases further, consumption falls. The portion of the Engel curve that is downward-sloping is the income range in which rice is an inferior good. So far we have discussed the demand curve for an individual consumer. In this article we will discuss about the relationship between Total Utility and Marginal Utility.
Every commodity possesses utility for the consumer. When the consumer buys apples he receives them in units, 1, 2, 3, 4 etc. To begin with, 2 apples have more utility than 1; 3 more utility than 2, and 4 more than 3.
Relationship between “Marginal Utility”, “Total Utility” and “Average Utility”
The units of apples which the consumer chooses are in a descending order of their utilities. In his estimation, the first apple is the best out of the lot available to him and thus gives him the highest satisfaction, measured as 20 utils.Micro 2.12- Maximizing Utility Practice and the Law of Diminishing Marginal Utility
The second apple will naturally be the second best with lesser amount of utility than the first, and has 15 utils. The third apple has 10 utils and the fourth 5 utils. Total utility is the sum total of utilities obtained by the consumer from different units of a commodity. Marginal utility is the addition made to total utility by having an additional unit of the commodity. The total utility of the two apples is 35 utils. When the consumer consumes the third apple, the total utility becomes 45 utils.
Thus, marginal utility of the third apple is 10 utils 45—