Faculty: Sunil Kumar

Objective of the Session

† To know about utility
† To know about indifference curve
† To know about consumer’s surplus

Faculty: Sunil Kumar

Choice and Utility Theory
† There is difference between preference and choice
† The consumers may have preference when they
have a range of products to choose from
† Preferences depend on the consumers’ likes and
dislikes but the final decision is dependent on
budget constraints
† Utility in economics means the extent of
satisfaction obtained from the consumption of
products and services by consumers
† The concept of utility is purely subjective
† Utility is not measurable but can be compared
Faculty: Sunil Kumar
Measurement of Utility
† Cardinal utility approach:
„ According to Marshall, utility can be measured. This
approach based upon the assumption like:
† Utility can be measured
† Independent variables
† Ordinal utility approach:
„ The utility cannot be measured, but can only be ranked in
order of preferences.
† Consumer is consistent in ranking
† The preference of the customer is based on the choice of products
available
Faculty: Sunil Kumar
Assumptions of Utility Theory
† Consumers are rational
† Consumers always prefer more quantity
† Consumer are ready to make tradeoffs
† Diminishing marginal rate of substitution

Faculty: Sunil Kumar

Total Utility
† In a given period of time, the amount of utility a
person derives from the consumption of a
particular product is called total utility
† In the initial stages of consumption, the total
utility increases
† After consuming certain number of units the
total utility becomes constant and beyond that it
starts reducing
Faculty: Sunil Kumar
Marginal Utility
† The marginal utility of any quantity of a
commodity is the increase in total utility which
results from a unit increase in consumption
† Marginal utility starts diminishing as the
consumer starts consuming more units of a
product

Faculty: Sunil Kumar

Relation between Total Utility and
Marginal Utility
Units Total Utility Marginal Utility
0 0 -
1 5 5
2 8 3
3 10 2
4 10 0
5 9 -1
6 7 -2

Faculty: Sunil Kumar

Laws of Utility
† Law of Diminishing Marginal Utility
† Law of Equi-marginal Utility

Faculty: Sunil Kumar

 Indifference Curve Analysis
Y
† Indifference curve
shows various
combinations of two
A products which gives
same level of
Product Y satisfaction to
B consumer

C
D
IC

O X
Product X
Faculty: Sunil Kumar
Assumptions of Indifference Curve
(IC)
† It shows ordinal measurement of utility
† IC curve has negative slope
† IC curve is convex to the origin
† Diminishing Marginal Rate of Substitution
† Two IC curves cannot intersect each other

Faculty: Sunil Kumar

 Marginal Rate of Substitution (MRS)
Quantity Quantity MRSXY Total † Marginal rate of
of Product of Product Utility
X Y substitution is the rate
at which a consumer is
1 12 - 100
willing to substitute
2 8 1:4 100 one product for the
other product
3 5 1:3 100 maintaining the same
4 3 1:2 100 level of total utility

5 2 1:1 100

Faculty: Sunil Kumar

Marginal Rate of Substitution (MRS)
Y

A
Y
MRSXY =
Product Y

Y X
B
X C
D

IC

O X
Product X
Faculty: Sunil Kumar
Budget Constraints

I ≥ PxQx + PyQy
I = Income,
Px= Price of X-Product,
Py= Price of Y- Product,
Qx= Quantity of X-Product,
Qy= Quantity of Y-Product
Faculty: Sunil Kumar
 Budget Constraints
Y † It also known as
price line which
P show combination of
A two product that a
Product Y consumer buy with
B his given income.
† Slope of Budget line
C
= - Px /Py

O L X
Product XFaculty: Sunil Kumar
Shift in Budget Constraints
† Change in Price
† Change in Income

Faculty: Sunil Kumar

Consumer’s Equilibrium

† Price Line should be tangent to indifference

curve that is
Slope of Price Line = Slope of IC curve
† At the point of tangency IC curve should be
convex to the origin

Faculty: Sunil Kumar

Consumer’s Equilibrium
Y
Consumer’s
Equilibrium
P A
Product Y
E
IC3
IC2
B
IC1
O Product X L X
Faculty: Sunil Kumar
 Consumer Surplus (CS)
‰ Consumer surplus is Units MUx Px C.S.
the difference 1 50 20 30
between what
2 40 20 20
consumer would like
to pay for a product 3 30 20 10
and what actually 4 20 20 0
pays.
5 10 20 -10

Faculty: Sunil Kumar

Application of Consumer’s Surplus
† Importance for the Govt. policies
† Importance to monopolist
† Importance in international trade
† Measurement of health of economy

Faculty: Sunil Kumar