Microeconomics Analysis

LESSON # 16
Consumer Choice and Utility
Maximization (Part 03)
Microeconomics Analysis

Module # 62
Microeconomics Analysis

Consumer Behaviour:
Cardinal Utility
Consumer Behaviour

Consumer Choices
- Cardinal Utility
• Cardinal Utility approach was given
by neo-classical economists, mainly
by Prof. Alfred Marshall
• Satisfaction gained after using a
certain commodity can be termed as
Utility.
• That cardinal utility can be measured
in quantitative terms (or money),
• A theory that attach a significance to
the magnitude of utility
 Consumer Behaviour
Cardinal Utility
Why measurement is needed?
• Which has the larger utility. • To decide whether one
Knowing how much larger 2 1 bundle or another has
doesn’t add anything to our to be chosen
description of choice.

• To assess the welfare status • To compare the

of people or communities magnitude of utility
attached with various
4 3 consumption bundles
 Consumer Behaviour
Assumptions for Cardinal Utility

A single unit of a certain Transitivity

commodity will provide the same IF a good X>Z and (X>Y)
level (utils) of satisfaction to all
2 by a customer and good (Y>Z)
individuals. then he must prefer X over Z
1

Marginal utility of money: 3

Daniel Bernoulli said that 4
measurement of goods can be Completeness of commodity
done in terms of money only if Either A is preferred over B or
the marginal utility of the money vice versa or indifferent
remains constant,
Consumer Behaviour

Cardinal Utility
There are two basic concepts that explain
it all together which are as follows –
Total Utility:
 Refers to the total satisfaction derived
by the consumer after consuming a
certain(fixed) quantity.
 The higher the consumption, the higher
the level of satisfaction of the
consumer. However, the term TUn
represents the total satisfaction gained
from a number of quantities.
Consumer Behaviour

Cardinal Utility
Marginal Utility:
 Refers to the extra satisfaction obtained
from consuming one more unit of the
commodity.
 The change in total utility due to one
additional unit of a commodity.
 Consumer Behaviour

Law Of Diminishing Marginal Utility

Graphical Representation
 Consumer Behaviour
Law Of Diminishing Marginal Utility
Graphical Representation
When total Utility is
maximum m marginal is
minimum.
Microeconomics Analysis

Module # 63
Microeconomics Analysis

Consumer Behaviour:
Constructing a Utility Function
Consumer Behaviour

Consumer Choices
- Constructing a Utility Function
1 Not all kinds of preferences can
be represented by a utility
function.

2 Suppose that someone had

transitive preferences so that
A≻B≻C≻A

3 Then a utility function for these

preferences would have to
consist of numbers U(A), U(B),
and U(C)
Consumer Behaviour

Consumer Choices
- Constructing a Utility Function
4 Suppose that we are given an
indifference map as in Figure.

5 Utility function is a way to label the

indifference curves such that higher
indifference curves get larger numbers.

6 One way is to draw the diagonal line

illustrated and label each indifference
curve with its distance from the origin
measured along the line
Consumer Behaviour
 Consumer Behaviour

• Every bundle is getting a • If preferences are

label, and those bundles on 2 1 monotonic then the line
higher indifference curves through the origin must
are getting larger labels— intersect every indifference
and. curve exactly once.

• Not always a natural way • One way to find a labeling of

always but indifference curves, at least
• Any kind of “reasonable” as long as preferences are
preferences can be
3
monotonic.
4
represented by a utility
function
Microeconomics Analysis

Module # 65
Microeconomics Analysis

Consumer Behaviour:
Utility Maximization Subject
to Budget Constraint
Consumer Behaviour

Consumer Choices
- Utility maximization subject to budget
constraint
1 Consumer has various indifference
curves

2 A fixed budget constraint with

income m and prices of
commodities fixed
We want to find the bundle in the
3
budget set that is on the highest
indifference curve
Consumer Behaviour
Boundles preferred to (X∗1, The bundle of goods with the
X∗2) but not affordable highest indifference curve that just
touches the budget line is labeled
(X∗1, X∗2)

The choice (X∗1, X∗2) is an

optimal choice for the
consumer.
Consumer Behaviour

Consumer Choices
Since preferences are well-behaved, so
that more is preferred to less.
 Restrict attention to bundles of
goods that lie on the budget line
and not those beneath the budget
line.
 Moving along the budget line we
note that we are moving to higher
and higher indifference curves.
 We stop when we get to the
highest indifference curve that just
touches the budget line.
 Consumer Behaviour
Utility maximization subject to budget constraint
A mathematical analysis
Max U = f(X1 X2) = X 12 X 2
[X1* X2*]

Subject to
g(X1 X2) = P1X1 + P2X2 = M

Two ways to do this:

 By Substitution
 Lagrange Multiplier
 Consumer Behaviour
Method 1: By Substitution
Step 1: Use the constraint to express X2
in terms of X1 (or vice-versa)
M P1
X2   X1
P2 P2

Step 2: Substitute expression for X2

into the objective function
2 2M P1 
U  X1 X 2  X1   X1 
P
 2 P2 

2 2 M P
Max U  X 1 X 2  X 1  X 13 1
*
X 1 P2 P2
 Consumer Behaviour
Step 3:
2 2 M P
Max U  X 1 X 2  X 1  X 13 1
*
X 1 P2 P2
F.O. Condition
dU  f1.dX 1  0
M 2 P
f1  2 X 1  3X1 1
 0
P2 P2
M P
2  3X1 1
P2 P2
2 M
X *
1 
3 P1
( P1X1 = 2/3M, expenditure on good 1 is 2/3 of
income)
 Consumer Behaviour

S. O. Condition
For a Max,
d 2U  f11 .dX 2
1 0
M P
f11  2  6 X1 1
P2 P2

X1 needs to be large enough to sign N.D.

How Large? First find the X1 that sets,
M P1
f11  2  6 X1  0
P2 P2
1 M
Answer: X1 
3 P1

2 M
The optimal   f11 < 0
*
X 1
3 P1
 Consumer Behaviour

Step 4: Substitute this value into constraint

to find corresponding value of X2 that
maximises objective function
Since P1X1 + P2X2= M
M P1 M P1  2 M  1 M
X 2
*
 X1    
P2 P2 P2 P2  3 P1  3 P2
(note, rearranging, P2X2 = 1/3 M . expenditure on
good 2 is 1/3 of M)
 Consumer Behaviour
Method 2: By The Lagrange Multiplier
Max the Objective function:
Max U = f (X1 X2) = X 12 X 2
[ X1* X2* ]
Subject to the constraint:
g (X1 X2) = P1X1 + P2X2 – M = 0
Step 1: Define the Lagrangean Function L

(L= objective function +  constraint)

Max L = f(X1 X2 ) + g(X1 X2)
[X1* X2* *]

Max L = X12X2 + (M – P1X1– P2X2 )

[X1* X2* *]

OR L = X21X2 – (P1X1 + P2X2 –M)

 Consumer Behaviour

Step 2: Find all first order partial

derivatives, set dL = 0

1. LX1 = 2X1X2 –  P1 =0 eq1

2. LX2 = X12 –  P2 =0 eq2
3. L = M – P1X1 – P2X2 = 0 eq3

Step 3: Solve the system of equations

Solving equations 1 & 2:

 = 2X1X2 / P1 = X12/P2
so 2X1P2X2 = P1X12
so 2P2X2 = P1X1
expenditure on good 2 is twice that of good 1
 Consumer Behaviour

And substituting into eq 3

P1X1 + P2X2 – M = 0
2P2X2+ P2X2 – M = 0
X2* = 1/3 M/p2

and from eq 3:
X1 = M/P1 - P2X2/P1
X1* = 2
Substituting in for X2: /3 M/P1

1 M  2 M 
X *2    & X *
1   
3
 2P 3
 1P

(again, note that rearranging reveals that P1X! = 2/3

M and P2X2 = 1/3 M .
2/3 of income spent on good 1, and 1/3 on good2)
Consumer Behaviour