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