Chapter 5 CONSUMER THEORY MUV Approach

Value of a good 1. Use value 2. Exchange value

The value of a good The maximum amount of another good which a person is willing to forgo to obtain it.

Exchange value of a good The market value of the good.

Different person have different values of a good, depending on: his wealth and income prices of other good how informed the person is, e.g.: his education and experience

Basic assumption of the approach 1. Each individual choose many goods 2. For each individual, some good are scare  each has to choose. 3. Economic goods are substitutes. 4. People have difference tastes and preference.  not all individuals choose the same goods 5. Individuals are consistent. 6. Postulate of diminishing MUV

1. Total Use Value (TUV) TUV of good x is measured by the maximum amount of other good that a person is willingly to sacrifice in order to obtain the total unit of good x. 2. Marginal Use Value (MUV) MUV of good x is measured by the maximum amount of another good that a person is willingly to pay for an extra unit of good x. 3. Average use value (AUV) Average use value is the total use value divided by the number of units of a good. Key Terms

8 The MUV schedule for Sam towards Hamburger 1st2nd3rd4th MUV$6$4$2$0 TUV$6 AUV$6 Diminishing MUV $10 $ 12 $5 $3$4

9 Findings 1. The greater the amount of a good one has, the greater its TUV to the person is. 2. The slope of the TUV schedule diminishes, reflecting the postulate of diminishing marginal value. 3. TUV is the sum of MUV 4. The value of TUV is maximized when MUV equal to zero. Q TUV 0 a) An TUV schedule  TUV  Q = MUV

10 Findings - continue 1. Area under the MUV curve is the TUV of the good. 2. The larger the amount of a good one has, the smaller of other goods one willingly to pay to an additional unit is. 3. The AUV of an unit of good is greater than its MUV 4. The slope of MUV is twice the slope of AUV Q TUV 0 MUVAUV b) An AUV schedule TUV

11 The slope of MUV is twice the slope of AUV For a straight line MUV curve, TUV is equal to:  MUV = Area DOC MUV AUV P Q O A B C D E  Area DOC = Area ABCD Hence,  ADE =  EBC  AE = EB Slope of MUV= AD AE Slope of AUV = AD = AD = 1 MUV AB 2AE 2  As TUV=AUV X Q TUV = Area ABCO

Demand Curve = MUV? An individual Demand shows the relationship between P and Qd, assuming other things being constant. One can look at an individual demand curve as “the max. price that would be paid for an extra unit of a goods at different amounts.” Based on this view, we can derive a demand curve of an individual for his or her MUV schedules. The Demand curve is just the same as MUV P Q

Law of Diminishing Use Value As more of a good a person owns, the amount of its total use value to him but the marginal use value to him. More X  TUV  MUV An individual’s MUV of any goods depends on the amount he has already had.

Consumer equilibrium is at P = D = MUV Q P 0 D = MUV * Consumer equilibrium If P > MUV  Qd until P = MUV If P < MUV  Qd until P = MUV If p = MUV  consumer equilibrium is attained. 5 10

15 Paradox of Value The things which have the greatest value in use frequently have little or no value in exchange and those which have the greatest value in exchange frequently are have little value in use. Example Water Vs Diamond. Why? Form a group and try to explain it by using the concept of TUV & MUV

Consumer Surplus The concept of consumer surplus was first introduced by Alfred Marshall in It is defined as the excess of Total Value (or Total Use Value) over the market expenditure (or Total Exchange Value). Consumer Surplus = TUV – TEV where TUV = the amount willingly paid. Where TEV = the amount actually paid.

Since TUV = ΣMUV and TEV = P X Q, the above formula can be rewritten as: Consumer Surplus = ΣMUV – P X Q Consumer surplus is the extra amount the consumer is willing to pay over and above what he actually pays, given the quantity demanded.

Total Consumer surplus PriceQuantityTotal Exchange Value Total Use Value Total consumer Surplus $101 $

Demand & Consumer Surplus At a price of $8, the amount purchased is 3 units.Total Exchange Value is $24(area ODBC). Total Use Value is OABC. Hence the consumer gains a surplus of ADB which is equal to $3. Q P 0 D = MUV 8 3 A B C D

20 Paradox of value P P MUV=D QQ Even the exchange value or P for water is lower than Diamond,the consumer gains a much larger surplus from water rather than it is from diamond.

21 How to extra the consumer surplus? Selling in package You can only choose to buy the entire units or none of them $30 for the entire 6 units

All-or-nothing Demand It shows the maximum amount a consumer is willing to pay for an extra unit of a good. Given that the consumer has to take all of the units at that price or have none of them.

All-or-nothing D is the same as AUV curve Q P 0 D = MUV All-or-nothing demand AUV1 = P1 P2P2 Q1Q1 Q2Q2 From the diagram: If price is at P1 Normally  the consumer will buy Q1 of the good. Under all-or-nothing arrangement:  the consumer has to buy Q2, Hence, the TUV of the good to the consumer = AUV1 x Q2 = total exchange value P1 x Q2  no consumer surplus  Hence, the 2 shaded triangles are exactly the same.

24 What’s the other way to extra consumer surplus? Charges an entrance fee which is equal to Consumer surplus