1. Principals of Economics Law_class
By Edward Gatwaza
12/03/2018
Lesson four

2. The theory of Consumer Behaviour
4.1. Utility
Utility is usefulness of a commodity.
The theory of utility analysis and the desire to satisfy wants has been a challenge to philosophers and economists. Jeremy Bentham in the nineteen century talked of the happiness for the greatest number.
In the abstract sense “ Utility refers to the power or property of a commodity to satisfy human needs.

3. Utility cont’d..
Utility depends on place. A glass of water may have more utility than a glass full of pieces of gold. To a rooster or chicken a grain of maize is worth more than a piece of diamond.
Utility depends on time. During the rainy season a raincoat has more utility than in the dry season. Wine gets more value when it stays in a cellar for a long time.
It also depends on culture. Beef is a good food in Rwanda but it is not eaten among Hindus, Dogs are pets in many places but in some restaurants in Asia dog meat is a delicacy.

4. Law of diminishing Marginal Utility
The law of diminishing marginal utility follows the diagram below. The more one consumes the higher is the level of satisfaction. Two glasses of milk have a higher capacity of satisfying wants than one glass. The glasses can satisfy wants more than two. Total utility increase progressives with successive consumption of goods. But according to the law of diminishing marginal utility the incremental rise is not uniform. It declines at every marginal unit consumed.
Therefore the marginal utility curve always slopes down wards. It means the marginal utility of consuming an additional unit will always be less than the previous one consumed.

5. 4.2. Total Utility and Marginal Utility

6. 4.4. Indifference curve
In microeconomics, an indifference curve is a graph showing combination of two goods to which an economic agent (such as a consumer or firm) is indifferent, that is, it has no preference for one combination over the other. They are used to analyze the choices of economic agents.
For example, if a consumer was equally satisfied with 1 apple and 4 bananas, 2 apples and 2 bananas, or 5 apples and 1 banana, these combinations could all be on the indifference curve.

7. Indifference curve

8. Features of indifference curves
An Indifference curve slopes downward from left to right (negative slope). The negative slope is a consequence of the fact the demand for one commodity (X) increases while the demand for another commodity (Y) decreases (because of diminishing marginal utility of Y), which is necessary to maintain the total satisfaction.
Indifference curves do not intersect. This is a consequence of the assumption that consumers will always prefer to have more of either good than to have less.

9. Features of indifference curves
The curves are convex which is a consequence of the assumption that as consumers have less and less of one good, they require more of the other good to compensate corresponding to the law of diminishing marginal utility.
The Indifference Curves are ubiquitous throughout an indifference map. In other words, there exists an indifference curve through any given point on an indifference map.

10. Features of indifference curves
The slope of an indifference curve, known by economists as the marginal rate of substitution which shows the rate at which consumers are willing to give up one good in exchange for more of the other good.
For most goods the marginal rate of substitution is not constant so their indifference curves are curved.
The curves are convex to the origin indicating a diminishing marginal rate of substitution.

11. 4.5. Indifference Map
For a given pair of goods, many indifference curves can be drawn and placed next to each other. This representation is called an Indifference Map. The rational consumer is expected to prefer the higher or right most Indifference curve, since they represent combinations of goods providing higher levels of consumption

12. Indifference Map

13. 4.6. Budget constraint and line
A consumer would have wanted to locate his or her consumption at the highest possible indifferent curve. However there is always a budget constraint. There is always limited amount of money to satisfy every need. The consumer has to choose that combination which maximizes his or her utility and at the same time be within his or her means.

14. Budget line for Commodity A and B

15. Budget line for Commodity A and B
A budget line represents such a constrained maximization problems. A consumer can choose either to spend all the money on good A or all the money on good B. Joining the two extremes gives a budget line. This means he or she can spend some money on commodity A and some money on commodity B. At 1 a consumer is having more of commodity A relative to B. At 2 a consumer is using his budget to purchase more of commodity B relative to commodity A.

16. Budget line for Commodity A and B when there is an increase in income

17. Budget line for Commodity A and B when there is an increase in income
A parallel shift to the right of the budget line represents an increase in income. This is the case with budget line AaBb in the diagram above.

18. Budget line when price of B changes

19. Budget line when price of B changes
A change in the price of one good if that of the other remains constant is represented by a change in the slope of the budget line. The change is represented by a tilt of the budget line hinging on the commodity whose price does not change. For line ABb the price of commodity B has fallen.

20. 4.7. Consumer equilibrium

21. Consumer equilibrium

22. Consumer equilibrium cont’d
From the first diagram above the point of equilibrium is tenable where the budget line is tangent to the highest possible indifference curve. This is point R it is a point where some amount of Y i.e, Y0 and some amount of commodity X i.e. X0 satisfy the wants of the consumer.
In the second diagram the price of A has changed instead of B as in the previous case. A new equilibrium point that maximizes utility is arrived at c. in both cases, the consumer attempts to maximize utility, and the level of satisfaction from two commodities constrained by the budget or income available. Of course the problem is more difficult in reality since there are not only two goods that have to satisfy human wants under conditions of scarce monetary resources.

23. 4.8. Derivation of demand

24. Derivation of demand

25. Derivation of demand
As price of one commodity changes, the slope of the budget line also changes. The equilibrium amount of the particular commodity, say X also changes. So if the equilibrium amount of X was X0 the quantity must be corresponding to a certain price. A consumer optimum changes as price change.

26. Derivation of demand
As price falls the slope of the budget line also changes and becomes less sleep. More of commodity X, which is x1 is demanded as price falls. When the consumer equilibrium resulted in quantity x0 being consumed, the corresponding price was P0. When price fell to P1 more of commodities X, in fact x1 was demanded. Joining the points and others corresponding to equilibria at different prices derives the law of demand.