Utility and Demand Theory - Term Paper Example

Running Head: Utility and Demand Theory Utility and Demand Theory Utility is a measure of the level of satisfaction an individual gains from the consumption of a unit of a good, utility is measure in two ways and they include cardinal and ordinal utility. Marginal utility is an important law given that it explains why the demand curve is negatively sloped. This paper utilises the utility theory to show that assuming that there are only two good then an increase in the price of one good will reduces the demand of both goods, a reduction in the price of one good will result into an increase in the demand of the two goods. Outline: Utility and Demand Theory 1) Introduction: 2) Utility and demand theory i) Utility ii) Marginal utility 3) Optimal level of consumption i) Budget line ii) Indifference curve 4) Optimal consumption level i) Factors affecting the optimal level (a) Increase in price of good X: (b) Decline in price of good X: (c) Increase in income: (d) Decline in income 5) Conclusion 6) References Introduction: This paper discusses the utility theory in relation to the law and shape of the demand curve, the paper defines utility and also discusses cardinal utility and ordinal utility with reference to the consumption behaviour of consumers. The optimal consumption level of two goods is also discussed with reference to indifference curve and the budget line and also the changes in the equilibrium level due to change in prices of goods and also change in income. Utility: Utility is defined as the amount of satisfaction a consumer derives from consuming a unit of a good or service, in the study of utility is measured in two ways namely cardinal utility and ordinal utility, cardinal utility involves assigning utils which is a measure of the level of utility, for example the utility derived from consuming a unit of good X is 4 utils and utility derived from consuming good Y is 5 utils. Ordinal utility on the other hand involves comparing the utility gained from the consumption of two different goods, for example a consumer may be willing to trade 1 units of good X for 5 unit of good Y, this means that good Y has 5 times more utility than good X. (Hardwick, P, 2002) Marginal utility: Marginal utility is an important concept when analysing the demand theory, marginal utility refers to the additional utility derived from the consumption of one extra unit of a good. The theory states that as the number of units consumed of a good increases the total utility increases but the marginal utility declines, the following table shows a hypothetical example of the increase in total revenue and the decline in marginal revenue: good X quantity total utility marginal utility 1 5 2 25 20 3 43 18 4 59 16 5 73 14 6 85 12 7 95 10 8 103 8 9 109 6 10 113 4 From the above chart and table it is evident that total utility increases but at a decreasing rate, this is because there is a decline in the marginal utility or the additional utility gained from the consumption of one extra unit of a good. The utility theory is based on a number of assumptions and they include the following: I. Consumers aim at maximising their utility level II. Consumers will prefer more of a good than less III. When we have good Y and X the consumer will prefer X to Y or Y to X. IV. If the consumer prefers Y to X, and that he or she prefers X to K then the customer prefers Y to K. V. The consumers experiences diminishing marginal utility when the number of units of a good increases (Fishburn, P, 1998) Optimal number of units consumed: Budget line: The number of units of goods consumed will be determined by the level of income, the level of income will determine the maximum number of units that can be purchased and therefore this aids in the development of a budget line. The opportunity cost will also determine the number of units consumed of a good, and finally the number of units consumed will be determined by the level of utility derived. (Neumann, J, 2000) Given two goods Y and X and given that the price of X = 10 and price of Y = 15, also given that the level of income is 150 then the budget line will be determined as follows: Maximum units of unit is determined by the income divided by the price Maximum units of X = 150/10 = 15 units Maximum units of Y = 150/15 = 10 units The budget line is as follows assuming that there are only two goods to choose from: The diagram above shows the budget line, the maximum number of good X that can be consumed is 15 units while the maximum units of good Y that can be consumed is 10. A change in the price of either good X or Y will shift the budget line, example when the price of good X shifts from price 10 to price 15 then this means that the maximum number of units that can be consumed of good X will be 10 and therefore the budget line will shift. Indifference curve: Indifference curves arte curves that shows the different combination of two goods that derive the same amount of utility, the indifference curves are negatively sloped, the slope of the curve indicates the rate of substitution between the two goods, they run parallel to each other and never cross, they are convex to the origin and that the indifference curves that are further the origin represents higher utility levels, the following diagram shows indifference curve: The above diagram shows indifference curves, indifference curve 3 represents higher utility level than both indifference curve 2 and 1 and that indifference curve 2 represents higher utility than indifference curve 1. Optimal consumption level: The optimal consumption level will be determined by the point where the slope of the indifference curve is equal to the slope of the budget line, this point represents the most optimal level of consumption of the two goods in order to maximise utility, the following diagram shows the optimal level of consumption: From the above diagram the most optimal point is the point where indifference curve 2 touches the budget line, therefore a rational consumer will consume Y’ units of good Y and X’ units of good X. Factors affecting the optimal level: When the income level of the consumer increases this means that he or she will purchase more of good Y and X, this means that the budget line will shift upward and therefore the new equilibrium point will be at a higher indifference curve therefore level of utility will rise as the number of units consumed increase. If the price of one good is reduced then this also means that the consumer real income will increase and therefore the consumer will shift to a higher indifference curve. (Hardwick, P, 2002) Increase in price of good X: Given two goods Y and X and given that the price of X = 10 and price of Y = 15, also given that the level of income is 150, if the price of good X increases to 30 then the maximum number of units that the consumer can consume of good X is 5, following will be the effect on the optimal consumption level: The above diagram shows the impact of an increase in the price on the optimal consumption level, it is evident that the budget line shifts from budget line 1 to budget line 2 when the price of X increases, the customer faces a lower indifference curve and consumption shifts from indifference curve 2 to indifference curve 1, it is therefore evident that due to this increase in price the customer indifference curve shifts to a lower indifference curve and the amount of good Y consumed shifts from Y’ to Y” and for good X shifts from X’ to X”.(Hardwick, P, 2002) Decline in price of good X: Given two goods Y and X and given that the price of X = 10 and price of Y = 15, also given that the level of income is 150, if the price of good X reduces to 5 then the maximum number of units that the consumer can consume of good X is 30, following will be the effect on the optimal consumption level: From the above chart it is evident that the decline in the price of good X shifts the budget lien from budget line 1 to budget line 2, the consumer indifference curve shifts from indifference curve 2 to indifference curve 3, consumption of good X increases from X’ to X” and for good Y increases from Y’ to Y”. This shows that decline in the price of one good will increase the consumption of both goods and also the consumer will derive higher utility. (Hardwick, P, 2002) Increase in income: Given two goods Y and X and given that the price of X = 10 and price of Y = 15, also given that the level of income is 150, if the income of the consumer increases to 300 then the maximum number of good X that can be purchased is 30 units while for good Y is 20 units, the following diagram shows the change in consumption and utility: From the above diagram it is evident that an increase in the income of a consumer will result into an increase in the optimal level of consumption for both goods, for good Y in the chart the optimal level shifts from Y’ to Y” while for good X the level increases from X’ to X”, the customer also experiences a higher indifference curve meaning that he or she gains higher utility levels as a result of the increase in income. (Gregory, M, 2004) Decline in income: A decline in income will result into a decline in the maximum number of units the consumer can purchase, therefore the budget line shift downward and therefore the optimal level of both goods decline, the customer also experiences a lower indifference curve.(Gregory, M, 2004) Conclusion: The above analysis highlights the theory of utility and marginal utility, the marginal utility their states that as the consumption of good increases then the additional utility derived declines as the units increase, using this concept the marginal utility theory is linked to the shape of the demand curve. It is evident that the optimal consumption level is determined using the budget line and the indifference curve, finally a change in price or income will affect the optimal consumption for a rational consumer. The utility theory has contributed much to the understanding of consumer behaviour and therefore studies should be aimed at researching more on the utility theory. Some of the areas of further research would be an analysis of impact of utility on the economy and also its impact on market demand. Reference: Fishburn, P. Utility Theory for Decision Making. New York: McGraw Hill publishers, 1998. Gregory, M. Principles of microeconomics. New Jersey: Prentice Hall publishers, 2004. Hardwick, P. Introduction to modern economics, New York: McGraw Hill Publishers, 2002. Neumann, J. Theory of Games and Economic Behaviour. New Jersey: Princeton publishers, 2000. Read More