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(3.1)
The term marginal utility, on the other hand, measures the change in utility resulting
from a one unit increase in the consumption of a good or service. It refers to the
contribution to utility resulting from consuming one extra unit of a product. The
contribution to utility from consuming the third cup of coffee would therefore be the
marginal utility of the third cup.
While we will assume, for simplicity that the higher quantity of a good or service
consumed, the higher the total utility, which determines the positive slope of the
utility function, we will also assume that extra units contribute less to total utility or
diminishing marginal utility. This assumption results from the contention that
consumers tend to grow tired of goods and services as their consumption increases,
and it is known in Economics as the Law of diminishing marginal utility. Figure 3.1
illustrates the representation of a positively sloped utility function, where utility
increases with quantity consumed, and where marginal utility diminishes with higher
output.
One of the main problems of the concept of utility resides in its difficulty to be
measured. Consumers cannot put a quantitative value to the utility they obtain from
consumption but only order. Thus, consumers are able to qualitatively put an order to
their preferences and state that they prefer one consumption bundle to another but not
by how much. Notwithstanding this limitation, the use of utility functions continues to
constitute the foundation of the theoretical study of consumer behaviour analyses. The
concept of utility is used in a number of applications in Managerial Economics. For
example, in decision making analysis utility functions are used to measure decision
makers attitude to risk.
q1
q0
q1
U
q1
The level of utility is held constant along the indifference curve. Thus, consumers are
indifferent between bundle A or B in Figure 3.2 as they are on the indifference curve
where utility is held unchanged. As consumers move from bundle A to bundle B, they
give up in the consumption of q2 in order to increase in the consumption of good q1
holding utility constant. Consequently, there is a trade off between the consumption of
the two goods.
While an indifference curve allows comparisons between bundles which yield
constant utility, one must illustrate an indifference map if it is wished to analyse
bundles with different utilities. There is an indifference curve for every level of
utility. But because there are infinite levels of utility, there will be infinite
indifference curves. An indifference map plots a whole set of indifference curves.
B
C
U2
U1
U0
q1
Higher levels of utility are depicted in Figure 3.3 as higher indifference curves. Thus,
consumers are indifferent between bundles A and B located on the same indifference
curve but prefer bundle C to bundles A and B as it is on indifference curve U1
connected to a higher level of utility. In turn, consumers prefer any bundle on U2 to
bundles on U1.
U1
q1
Negatively sloped
The negative slope of the indifference curve illustrates the fact that in order to
consume higher amounts of one good consumers must give up in the consumption of
the other if they are to hold utility constant. The slope of the indifference curve, thus,
determines a trade off.
While the previous subsection demonstrated that the Law of diminishing MRS
resulted in a convex indifference curve, we must demonstrate why this law operates.
The Law of diminishing marginal utility is the key to the demonstration of the Law
of diminishing MRS. As consumers consume more of a good or service, it was
contended they would obtain smaller marginal utility. This means consumers value a
product less as they consume additional units. Given decisions between two goods,
thus, consumers will value a good less the more they consume of it which means they
will be willing to give up less of the other good. The MRS thus must diminish.
AC
B
U1
U0
q1
Because A and B in Figure 3.5 are bundles on the same indifference curve U0, they
are equally preferred. Likewise, because A and C are in turn bundles on the same
indifferent curve U1, they are equally preferred. Because consumers are indifferent
between A and B and A and C, we can conclude they are indifferent between B and
C. However, a closer look to Figure 3.5 shows that, while including the same amount
of q1, bundle C includes a higher amount of q2 than bundle B, which means
consumers would prefer C to B. This contradicts the previous contention that
consumers were indifferent between bundles B and C. Therefore utility curves cannot
intersect.
M = p1 q1 + p 2 q 2
(3.2)
q1
Bundles of goods included in the region below the budget constraint illustrated in
Figure 3.6 can be afforded by consumers who do not spend all their income. The
bundles on the budget constraint can be afforded when consumers spend all their
income. Bundles included in the region above the budget constraint cannot be
afforded even when consumers spend all their income.
Other key points in the analysis of the budget constraint concern its slope and
position. The slope of the budget constraint is determined by the relative prices of the
two goods with a negative sign to indicate the negative slope: p1 p 2 . An increase
in p1 relative to p2 results in a steeper budget constraint. On the other hand, a
reduction in p1 relative to p2 results in a flatter budget constraint. The budget constrain
will shift upwards to the right when consumers income increases and will shift
downwards to the left when income decreases.
q2 *
q1 *
U2
U1
U0
q1
Figure 3.7 illustrates that the highest indifference curve consumers can reach is U1 as
it shares a tangency point with the budget constraint. Consumers optimise their utility
when they consume q1* and q2*. At this equilibrium point, the slope of the budget
constraint is equal to the MRS.
pm
s
U
Qpm
Qs
sales
Figure 3.8, in this context illustrates Baumols contention that due to the separation of
ownership from control in modern corporations, management who have discretion
over the resources of the firm, may be able to increase revenue above the level
consistent with profit maximisation as long as their revenue contributes to their utility.
The tangency point between the profit constraint and managements indifferent curves
occurs to the right of the profit maximising level of revenue.
Study Guide 1 contends that the use of indifference curves to ascribe management
behaviour can also be used to illustrate other theories built in the context of the
agency relationships resulting from the separation of ownership from control such as
Marris theory of growth and Williamson theory on management discretion. These
issues will be explored in detail in Unit 1 and in the workshops in the Managerial
Economics course.
3.2 Elasticity
One of economists and businessmen most useful tools for the purpose of sensitivity
analysis is the use of elasticity. It is not difficult to underline the contribution of the
concept of elasticity to managerial decision-making as it measures the responsiveness
of a number of variables to the implementation of potential strategies. The ex ante
application of the concept of the price elasticity of demand, for example, resides in its
contribution to the understanding of the likely response of customers to price changes.
The ex post application of the price elasticity of demand, in contrast, permits the
evaluation of the effectiveness of price changes concerning customer response which,
coupled with the study of competitors reactions, constitutes the foundation for the
analysis of future price changes. While there are a large number of elasticity
measures, our focus is on demand measures of elasticity. This is the reason for the
inclusion of the concept of elasticity in a chapter dedicated to consumer theory.
p =
% q d
% p
(3.3)
results in an equally proportional quantity change, the absolute value of the price
elasticity of demand p is one.
Because we only consider negatively sloped demand curves, the relationship between
the price and the quantity demanded is negative. This results in a negative price
elasticity value. For simplicity, nevertheless, a large number of economists consider
the absolute value of the price elasticity of demand ( p ). Thus, the formula can take
the values summarised by Table 3.1.
p <1 inelastic
p =1 unit elastic
p >1 elastic
In the extreme when any change in the price does not effect the quantity demanded,
the p =0 and the demand curve is illustrated as a vertical line. In contrast, when the
price change results in an infinite change in the quantity demanded, p = , the
demand function is plotted as a horizontal line. The demand functions are perfectly
inelastic and perfectly elastic respectively.
p =
%q d q d p 0
=
% p
p q d0
(3.4)
where q d is the change in the quantity demanded from the original to the new point
on the demand curve, p is the change in price, p 0 is the original price, and q d0 is the
original quantity demanded.
Note that while we have based our percentages from the original point with values p0
and q0, one could base the percentage on the middle point or any point as long as the
calculations used were consistent through the analysis.
Figure 3.9 illustrates graphically the calculation of the arc price elasticity of
demand.
E0
E1
p1
q0
q1
D
qd
q
Suppose, for example, two points on a demand function are given: p0=9, q0=98, and
p1=39, q1=10. The absolute value of the arc price elasticity of demand would be:
p =
10 98 9
= 0.269
39 9 98
Because the absolute value is smaller than 1, the demand curve between the two
points is considered to be inelastic.
In contrast to the arc measure, the point price elasticity of demand measures the
value of the price elasticity of demand at one point on the demand function. This
measure results from reducing the arc existing between two points on a demand
function so much that the difference becomes infinitesimally small. The intuition
explaining this reduction is that the price elasticity of demand is computed at one
point. Mathematically, this can be expressed with the use of the derivative of the
demand function at that particular point:
p =
where
% q d dq d p 0
=
%p
dp q d0
dq d
is the derivative of the demand function with respect to the price.
dp
(3.5)
p =8
3
= 1. 6
15
Because the absolute value of the point price elasticity of demand is greater than 1,
the demand curve at this point is elastic.
p >1
=1
p
p <1
q*
MR
q*
D=AR
TR
q
p
p
Inelastic demand
p <1
Elastic demand
p >1
TR
TR
TR
TR
The usefulness of the total revenue test resides in the prescriptions it offers to revenue
optimising managers. Nonetheless, the test can be criticised since it does not consider
the competitive response of rivals in oligopolistic industries. While consumers
increase the demand for a good when a firm decreases its price on the elastic range of
the demand curve in order to increase revenue, competitors may match a price
decrease so as not to lose market share. Other problems connected to the test are
discussed in much detail in Study Guide 3 in the Managerial Economics course.
The number and closeness of substitute products. This is one of the most
important determinants of the price elasticity of demand. The possibility of
buying substitute products implies customers response to price changes is
huge compared to situations where there are no substitutes. In this sense, the
smaller the number and the more differentiated products are, the more inelastic
the demand function. In contrast, the higher the number and the closer
substitute products are, the more elastic the demand. Thus, customers decrease
the demand for green beans more than proportionately when their price is
increased since there are many other vegetables they can buy but keep buying
petrol even when its price increases as they cannot use other substitutes. The
demand for vegetables is therefore quite elastic while the demand for petrol is
quite inelastic. Producers could try to differentiate their products from those
produced by their competitors in order to gain sustainable competitive
advantage which can, in turn, result in more inelastic demands and the
possibility, through the total revenue test, to increase prices and profits.
The time period. The longer the time period under consideration the more
elastic the demand is likely to be. This is due to the fact that consumers are
able to adapt to price changes over time. Thus, for example, while the demand
for petrol is very inelastic in the short run, it tends to be more elastic over time
as consumers find other substitutes. A consumer who uses the car to get to
work every day will still have to buy petrol even if its price doubles in the
short run, however, in the long run, she may decide to use public transport,
buy a smaller car or even change the job. Europe became more efficient over
time in the use of petrol after the 1970s petrol crises by using less energy,
promoting smaller engines than their American counterparts and by
encouraging the use of other energy sources like gas.
Proportion of income spent on the good. The lower the proportion of
income spent on the good, the more inelastic the demand is likely to be. In
contrast, the higher the percentage of income spent on the good, the more
elastic the demand is likely to be. If a consumer with a yearly income of
39,000, for instance, buys 5p worth of chewing gum every morning, she is
not likely to stop buying chewing gum when its price goes up by 100 per cent
to 10p because 10p represents a minute percentage of total income. In contrast,
a miniscule percentage change in the price of a car, which constitutes a high
percentage of her yearly income, would have a large effect on the consumers
decision to buy it.
Habit creating and addictive goods. When consumers are addicted to some
products, they are not likely to reduce their consumption much when their
price increases. Thus, goods such as cigarettes, alcohol or drugs are consumed
even when their prices increase. Their demand is inelastic. Governments who
need a quick source of income tend to increase indirect taxes in these goods
because due to their inelastic demand, consumers will buy them even when
their prices increase.
Luxuries and necessities. The demand for luxuries tends to be more elastic
than the demand for necessities. Consumers could stop buying luxuries should
their price increase but must buy necessities even when their price is
increased.
y =
%q d
%Y
(3.6)
relationship
Type of good
negative
Inferior good
0 < y <1
positive
Subsistence good
y >1
positive
luxuries
AB =
%q B
%p A
(3.8)
relationship
AB
AB < 0
AB = 0
AB > 0
complements
unrelated
substitutes
The cross elasticity of demand is useful in determining which are the products
competing in the same industry. It is crucial for example to know any firms substitute
products in the analysis of the likely response of competitors to the implementation of
any strategy.
The cross price elasticity is also used in the study of a relevant market as a first step in
antitrust investigations. Thus, for example, should a firm report a competitor for
anticompetitive practices such as predatory pricing or abuse of dominant position to
the competition authorities, it will firstly need to prove that they compete in the same
market. The cross price elasticity of demand is used to determine whether or not the
goods produced by the two firms are substitutes.
3.3 Conclusion
This unit has presented some crucial concepts in Economics related to the consumer.
On the one hand, the contribution of indifference curve analysis to decision making
was highlighted. Indifference curves will be used in Unit 1 in the Managerial
Economics course to describe the behaviour of the firm in a world where management
and ownership are divorced. On the other hand, the concept of the price elasticity of
demand and its application to revenue optimising pricing were outlined. The unit also
included the study of the income elasticity of demand and the cross price elasticity of
demand. These concepts will be used in Unit 3 in the Managerial Economics course
to study the response of customers and competitors to the implementation of
strategies.