Consumer Theory

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Economics for Management Studies
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Consumer Theory Knowledge Summary: 1. Total utility is the amount of joy we obtain from consuming a product Total utility (TU) is a function of the units we consume (Q), i.e., TU = F(Q) 2. Marginal Utility (MU) - Defined to be the utility we obtain from consuming a little bit more - It is the first derivative of TU regarding Q MU = dTU / dQ - Marginal utility is diminishing, i.e., the joy we obtain from consuming the first unit is greater than the joy we get from the second unit, etc 3. To obtain demand function: - We want to maximize the net benefit obtained from consuming product, i.e. we want to maximize the consumer surplus (CS) - CS = TU – Total expenditure = TU – TE - TU is a function of Q - TE = P x Q - CS = TU – TE - To maximize CS, we can set the first derivative of CS regarding Q to be zero. In this way, we can calculate the Q to consume in order to maximize the CS for a particular P - Mathematically, dCS/ dQ = 0 dTU/dQ – dTE/dQ = 0 We know that dTU/dQ = MU and dTE/dQ = d (P x Q) / dQ = P Thus, to maximize the net benefits, MU = P - P = MU is the demand function 4. Utility: the satisfaction or well-being that a consumer receives from consuming a good or service Total Utility: the full satisfaction resulting from the consumption of that product by a consumer Marginal Utility: the additional satisfaction resulting from consuming one more unit of that product Equation for marginal utility: dTU/dQ=P Law of Diminishing Marginal Utility: The utility that any consumer derives from successive units of a particular product consumed over some period of time diminishes as total consumption of the product increases (if the consumption of all other products is unchanged) Optimal purchase rule: the consumer should purchase units of the commodity until MU = price Consumer Surplus: the value of the goods to the consumer above and beyond the market price (Area below demand curve and above price) Producer Surplus: the difference in the amount that a producer actually receives for a product and what they are willing to receive for it (area above supply curve and below price) Summary of Questions to be asked: 1. Given utility function, derive the demand curve - Calculate MU = dTU / dQ - Set MU = P 2. Calculate the quantity to be consumed for a given price - Substitute the value of P to MU - Solve for the Q 3. Calculate the consumer surplus obtained from consuming a given amount of quantity - Calculate the Q to be consumed for a given P - Calculate TU = F(Q) - Calculate TE = P x Q - CS = TU - TE 4. Find the Consumer Surplus o Find the area of the triangle formed between the demand curve, equilibrium point and price o Note: When Price Elasticity of Demand (PED) is infinite, CS=0. When PED = 0, CS is infini
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