1. Introduction and MU, economics, marginal utility

economics

1. What is Economics
SomeDefinitions:
#Itisascienceofscarcity.Economicsdealswithunlimitedwantsandalternative
usablelimitedresources.---L.Robbins
#Economicsisthestudyofmankindintheordinarybusinessoflife.---Marshall
@‘Iftherewerenoscarcity,therewouldbenoeconomicsystemandnoeconomics’.--
StainerandHague
##Economicsisthestudyoftheadministrationofthescarceresourcesandofthe##Economicsisthestudyoftheadministrationofthescarceresourcesandofthe
determinantsofincomeandemployment(i.e.,howthelevelofincomeand
employmentinasocietyaredetermined)----LordJohnMenardKeynes
###Economicsisthestudyofhowasocietychoosestouseitsalternative-usableand
limitedresourcestoproduce,exchangeandconsumegoodsandservicesforachieving
andmaintaininggrowthandstability.
BookoftheFatherofEconomics:
AdamSmith(1723-1790):AnEnquiryintotheNatureandCausesofWealthof
Nations.

2. WhyShouldyoustudyEconomics:
Youcannotbe,inanyrealsenseacitizenunlessyouarealsoinsomedegreeaneconomist.
Youneedtoknowhowthemoderneconomyfunctions.Withoutastudyofeconomics,you
cannotbefullyinformedaboutinternationaltrade,theeconomicimpactoftheInternet,or
thetrade-offbetweeninflationandunemployment.
Choosingyourlife’soccupationisthemostimportanteconomicdecisionyouwillmake.
Yourfuturedependsnotonlyonyourownabilitiesbutalsoonhoweconomicforcesbeyond
yourcontrolaffectyourwagesi.e.,economicconditionofyoursurroundings.
References
1.Economics
byJohnSloman,DeanGratt,JohnGust
2.MicroeconomicTheory
ByDominickSalvator(Schaum’sOutlineSeries)
3.ModernMicroeconomicTheory
byA.Koutsoyainnis

3. THE MAIN CHALLENGES
Scarcity,Efficiencyand Equity are the main challenges
Scarcityisauniversalproblem.WhereeveryouareyouwillfindscarcitythereExceptinthe
Paradise
Efficiencyreferstothemosteffectiveuseofasociety’sresourcesinsatisfyingpeople’swants
andneeds.Ineconomics,wesaythataneconomyisproducingefficientlywhenitcannotmake
anyoneeconomicallybetteroffwithoutmakingsomeoneelseworseoff.
Equityreferstofairdistributionofgoodsandservicesamongthemembersofasociety.
InordertoensureefficiencyandequitywemakeInordertoensureefficiencyandequitywemake
Choice:Whichoneofthealternativestobetakenup/implemented
AND
Allocation:Howmuchresourcestobeinvestedtodifferentprojects/sectors
Expressing the Challenges through problems
The Basic Problems are: What to produce; how to produce; and for whom to produce

4. Fundamental Economic Problems
AND
Alternative solutions under: Capitalism, Socialism and Mixed economy
Q1.(a)Whyis“whattoproduce”aproblemineveryeconomy?(b)Howdoestheprice
mechanismsolvethisprobleminafree-enterpriseeconomy?(c)Inamixedenterprise
economy?(d)Inacentralizedeconomy?
Ans:
(a)“Whattoproduce”referstothosegoodsandservicesandthequantityofeachthat
theeconomyshouldproduce.Sinceresourcesarescarceorlimited,noeconomycantheeconomyshouldproduce.Sinceresourcesarescarceorlimited,noeconomycan
produceasmuchofeverygoodorserviceasdesiredbyallmembersofsociety.Moreof
onegoodorserviceusuallymeanslessofothers.Therefore,everysocietymustchoose
exactlywhichgoodsandservicestoproduceandhowmuchofeachtoproduce.
(b)Inafree-enterpriseeconomy,the“whattoproduce”problemissolvedbytheprice
mechanism.Onlythosecommoditiesforwhichconsumersarewillingtopayapriceper
unitsufficientlyhightocoveratleastthefullcostofproducingthemwillbesuppliedby
producersinthelongrun.Bypayingahigherprice,consumerscannormallyinduce
producerstoincreasethequantityofacommoditythattheysupplyperunitoftime.On
theotherhand,areductioninpricewillnormallyresultinareductioninthequantity
supplied.

5. (c)Inamixed-enterpriseeconomysuchasours,thegovernment(throughtaxes,
subsidies,etc.)modifiesand,insomeinstances(throughdirectcontrols),replacesthe
operationofthepricemechanisminitsfunctionofdeterminingwhattoproduce.
(d)Inacompletelycentralizedeconomy,thedictator,ormorelikelyaplanning
committeeappointedbythedictatorortheparty,determineswhattoproduce.Wein
theWestbelievethatthisisinefficient.EventheSovietUnion(neveracompletely
centralizedeconomy)hasbeenmovingrecentlytowardmoredecentralizedcontrolof
theeconomyandtowardgreaterrelianceonthepricemechanismtodecidewhatto
produce.produce.

6. 2.(a)Whyis“howtoproduce”aproblemineveryeconomy?(b)Howdoestheprice
mechanismsolvethisprobleminafree-enterpriseeconomy?(c)Inamixed-enterprise
economy?(d)Inacentralizedeconomy?
(a)“Howtoproduce”referstothechoiceofthecombinationoffactorsandtheparticular
techniquetouseinproducingagoodorservice.Sinceagoodorservicecannormallybe
producedwithdifferentfactorcombinationsanddifferenttechniques,theproblemarisesasto
whichofthesetouse.Sinceresourcesarelimitedineveryeconomy,whenmoreofthem
areusedtoproducesomegoodsandservices,lessareavailabletoproduceothers.
Therefore,societyfacestheproblemofchoosingthetechniquewhichresultsintheleast
possiblecost(intermsofresourcesused)toproduceeachunitofthegoodorserviceitwants.possiblecost(intermsofresourcesused)toproduceeachunitofthegoodorserviceitwants.
(b)Inafree-enterpriseeconomy,the“howtoproduce”problemissolvedbythepricemechanism.
Becausethepriceofafactornormallyrepresentsitsrelativescarcity,thebesttechniquetousein
producingagoodorserviceistheonethatresultsintheleastdollarcostofproduction.Iftheprice
ofafactorrisesinrelationtothepriceofothersusedintheproductionofthegoodorservice,
producerswillswitchtoatechniquewhichuseslessofthemoreexpensivefactorinorderto
minimizetheircostsofproduction.Theoppositeoccurswhenthepriceofafactorfallsinrelation
tothepriceofothers.

7. (c)Inamixed-enterpriseeconomy,theoperationofthepricemechanisminsolvingthe
“howtoproduce”problemismodifiedandsometimesreplacedbyagovernmentaction.
(d)Inacentralizedeconomy,thisproblemissolvedbyaplanningcommittee.
3.(a)Whyis“forwhomtoproduce”aproblemineveryeconomy?(b)Howdoesthe
pricemechanismsolvethisproblem?(c)Whydoesthegovernmentinamixed-pricemechanismsolvethisproblem?(c)Whydoesthegovernmentinamixed-
enterpriseeconomymodifytheoperationofthepricemechanisminitsfunctionof
determiningforwhomtoproduce?
(a)“Forwhomtoproduce”referstohowthetotaloutputistobedividedamongdifferent
consumers.Sinceresourcesandthusgoodsandservicesarescarceineveryeconomy,no
societycansatisfyallthewantsofallitspeople.Thus,aproblemofchoicearises.

8. (b)Intheabsenceofgovernmentregulationorcontroloftheeconomy,theproblemof“forwhom
toproduce”isalsosolvedbythepricemechanism.Theeconomywillproducethosecommodities
thatsatisfythewantsofthosepeoplewhohavethemoneytopayforthem.Thehigherthe
incomeofanindividual,themoretheeconomywillbegearedtoproducethecommoditiesthe
consumerswant(iftheyarealsowillingtopayforthem).
(c)Inthenameofequityandfairness,governmentsusuallymodifytheworkingsoftheprice
mechanismbytakingfromtherich(throughtaxation)andredistributingtothepoor(through
subsidiesandwelfarepayments).Theyalsoraisetaxesinordertoprovideforcertain“public”
goods,suchaseducation,lawandother,anddefence.

9. Branches of ECONOMICS
Everyfieldofstudyhasitsownlanguageanditsownwayofthinking.Economicsisno
different.
Manysubjectsarestudiedonvariouslevels.Economicsisalsostudiedonvarious
levels.Wecanstudythedecisionsofindividualhouseholdsandfirms.Orwecanstudythe
interactionofhouseholdsandfirmsinmarketsforspecificgoodsandservices.Orwecan
studytheoperationoftheeconomyasawhole,whichisjustthesumoftheactivitiesofall
thesedecisionmakersinallthesemarkets.
Thefieldofeconomicsistraditionallydividedintotwobroadsubfields.
MicroeconomicsisthestudyofhowhouseholdsandfirmsmakedecisionsandhowtheyMicroeconomicsisthestudyofhowhouseholdsandfirmsmakedecisionsandhowthey
interactinspecificmarkets.
Macroeconomicsisthestudyofeconomywidephenomena
Thefieldofeconomicsisdividedintotwosubfields:microeconomicsandmacroeconomics.
Microeconomistsstudydecisionmakingbyhouseholdsandfirmsandtheinteraction
amonghouseholdsandfirmsinthemarketplace.Macroeconomistsstudytheforcesand
trendsthataffecttheeconomyasawhole.

10. Distinguishbetween(a)ahypothesis,(b)atheory,and(c)alaw.
(a)Ahypothesisisan“if-then”propositionusuallyconstructedfromacasualobservationof
areal-worldeventwhichrepresentsatentativeandyetuntestedexplanationoftheevent.
(b)Atheoryimpliesthatsomesuccessfultestsofthecorrespondinghypothesishavealready
beenundertaken.Thus,atheoryimpliesagreaterlikelihoodoftruththanahypothesis.
Thegreaterthenumberofsuccessfultests(andlackofunsuccessfulones),thegreaterthe
degreeofconfidencewehaveinthetheory.
(c)Alawisatheorywhichisalwaystrueunderthesamesetofcircumstances,as,for(c)Alawisatheorywhichisalwaystrueunderthesamesetofcircumstances,as,for
example,thelawofgravity.

11. There are TWO approaches to Measure Utility: CARDINAL and ORDINAL
The CARDINAL Approach to Consumer Equilibrium
Utilityisthepropertyofacommoditythatsatisfieswantorneedofaconsumer.
Utilisanimaginaryunitofsatisfactionfromtheconsumptionofagood.
Totalutility(TU)isthetotalsatisfactionapersongainsfromallthoseunitsofacommodity
consumedwithinagiventimeperiod.
Theory of Demand: Utility Analysis
consumedwithinagiventimeperiod.
Marginalutility(MU)istheadditionalsatisfactiongainedfromconsumingoneextraunit
withinagivenperiodoftime.Inotherwords,Marginalutility(MU)isthechangeinthe
totalutilityperunitchangeinthequantityofacommodityconsumedperunitoftime.
Principleofdiminishingmarginalutility:Aconceptstatingthatasanindividualconsumes
moreunitsofacommodityperunitoftime,thetotalutilityreceivedincreases,buttheextraor
marginalutilitydecreases.Asmoreunitsofagoodareconsumed,additionalunitswillprovide
lessadditionalsatisfactionthanpreviousunits.

12. ConsumersurplusTheexcessofwhatapersonwouldhavebeenpreparedtopayforagood(i.e.
theutility)overwhatthatpersonactuallypays.
Rationalconsumerbehaviour:Theattempttomaximisetotalconsumersurplus.
SaturationpointThepointwherethetotalutilityreceivedbyanindividualfromconsuminga
commodityismaximumandthemarginalutilityiszero.
Theoptimumlevelofconsumption:thesimplestcase–onecommodityJusthowmuchofagood
shouldpeopleconsumeiftheyaretomakethebestuseoftheirlimitedincome/money?Toanswer
thisquestionwemusttackletheproblemofhowtomeasureutility,giventhatinpracticewecannot
measure‘utils’.Onesolutiontotheproblemistomeasureutility.
Assumptions of cardinal utility Analysis
1.Rationality :
2.Cardinal Utility
3.Diminishing MU
4.Constant Marginal Utility (MU) of Money
5.Total utility depends on quantities of commodities
6.Utilities are additive

13. 1.Rationality:Theconsumerisrational.Heaimsatthemaximisationofhisutility
subjecttotheconstraintimposedbyhisgivenincome.
2.Cardinalutility:Theutilityofeachcommodityismeasurable.Utilityisacardinal
concept.Themostconvenientmeasureismoney:theutilityismeasuredbythe
monetaryunitsthattheconsumerispreparedtopayforanotherunitofthe
commodity.
3.Diminishingmarginalutility:Theutilitygainedfromsuccessiveunitsofa
commoditydiminishes.Inotherwords,themarginalutilityofacommodity
diminishesastheconsumeracquireslargerquantitiesofit.Thisistheaxiomof
diminishingmarginalutility.diminishingmarginalutility.
4.Constantmarginalutilityofmoney:Thisassumptionisnecessaryifthe
monetaryunitisusedasthemeasureofutility.Theessentialfeatureofastandard
unitofmeasurementisthatitbeconstant.Ifthemarginalutilityofmoneychanges
asincomeincreases(ordecreases)themeasuring-rodforutilitybecomeslikean
elasticruler,inappropriateformeasurement.

14. 5.The total utility of a 'basket of goods' depends on the quantities of the individual
commodities. If there are n commodities in the bundle with quantities x
1
, x
2,
x
3
. . . . x
n
, the
total utility is
6. Utilities from different commodities can be summed up

15. Three Baskets of commodities
A= 5000 util
B = 3500
util
C = 2100 util
ii) Utility is cardinal

16. Rifat’sutility from consuming crisps (daily)

17. Graphical Presentation of TU and MU
Saturation point

18. The Total and Marginal Utility Functions

19. UtilitytableshowingconditionforConsumerEquilibrium
Quantit
y of Ice
cream
Q
x
1
Margina
l Utility
(MU
x)
2
Total
Utility
(TU)
3
Price of
the good
P
x
/Disutility
4
Total
cost/
disutility
5
Marginal
Consumer
Surplus
(MCS)
(2-4)= 6
Total
Consumer
Surplus
(TCS)
(3-5)=7
1st 100
(util)
100 50 (util)50 50 50
2nd 80 180 50 100 30 80:
MUx>PxMUx>Px
3
rd
50 230 50 150 0 80
MUx=Price
,Px
4th 5 235 50 200 -45 35:
MUx<Px
5
th
0 235 50 250 -50 15
6th -20 215 50 300 -70
Let say, Tk.1 = I util, So, tk. 50 = 50 util

20. CONSUMER EQUILIBRIUM/Optimal Consumption Point
Rationalconsumerbehaviourastheattempttomaximiseconsumersurplus.
Marginalconsumersurplus
Marginalconsumersurplus(MCS)isthedifferencebetweenwhatyouarewilling
topayforonemoreunitofagoodandwhatyouareactuallycharged.IfDarrenwere
willingtopay25pforanotherpacketofcrispswhichinfactonlycosthim20p,he
wouldbegettingamarginalconsumersurplusof5p.
MCS=MU–P
Totalconsumersurplus
Totalconsumersurplus(TCS)isthesumofallthemarginalconsumersurplusesthatTotalconsumersurplus(TCS)isthesumofallthemarginalconsumersurplusesthat
youhaveobtainedfromalltheunitsofagoodyouhaveconsumed.Itisthedifference
betweenthetotalutilityfromalltheunitsandyourexpenditureonthem.IfDarren
consumesfourpacketsofcrisps,andifhewouldhavebeenpreparedtospend£1.20
onthemandonlyhadtospend80p,thenhistotalconsumersurplusis40p.
TCS=TU–TE
whereTEisthetotalexpenditureonagood:i.e.P×Q.

21. Equilibriumoftheconsumer/OptimalConsumptionpoint
Webeginwiththesimplemodelofasinglecommodityx.The
consumercaneitherbuyxorretainhismoneyincomeY.Underthese
conditionstheconsumerisinequilibriumwhenthemarginal
utilityofxisequatedtoitsmarketprice.Symbolicallywe
haveMU
x
=P
x
,
Ifthemarginalutilityofxisgreaterthanitsprice,theconsumercanIfthemarginalutilityofxisgreaterthanitsprice,theconsumercan
increasehiswelfarebypurchasingmoreunitsofx.Similarlyifthe
marginalutilityofxislessthanitspricetheconsumercanincreasehis
totalsatisfactionbycuttingdownthequantityofxandkeepingmoreof
hisincomeunspent.Therefore,heattainsthemaximisationofhisutility
whenMU
x
=P
x.
Iftherearemorecommodities,theconditionfortheequilibriumoftheconsumeris
theequalityoftheratiosofthemarginalutilitiesoftheindividualcommoditiestotheir
prices.

23. Derivationofthedemandoftheconsumer
Thederivationofdemandisbasedontheaxiomof
diminishingmarginalutility.Themarginalutilityof
commodityxmaybedepictedbyalinewithanegative
slope(figure2).Geometricallythemarginalutilityofxis
theslopeofthetotalutilityfunctionU=f(q
x
).Thetotal
utilityincreases,butatadecreasingrate,uptoquantityx,utilityincreases,butatadecreasingrate,uptoquantityx,
andthenstartsdeclining(figure2).Accordinglythe
marginalutilityofxdeclinescontinuously,andbecomes
negativebeyondquantityx.Ifthemarginalutilityis
measuredinmonetaryunitsthedemandcurveforxis
identicaltothepositivesegmentofthemarginalutility
curve.

24. Atx
1
themarginalutilityisMU
1
(figure2).Thisisequalto
P
1
,bydefinition.HenceatP
1
theconsumerdemandsx
1
quantity(figure2).Similarlyatx
2
,themarginalutilityis
MU
2
,whichisequaltoP
2
.HenceatP
2
theconsumerwillbuy
x
2
,andsoon.ThenegativesectionoftheMUcurvedoesnotx
2
,andsoon.ThenegativesectionoftheMUcurvedoesnot
formpartofthedemandcurve,sincenegativequantitiesdo
notmakesenseineconomics.

27. Consumer surplus An Individual’s demand curve

30. Whyiswater,whichisessentialtolife,socheapwhilediamonds,
whicharenotessentialtolife,soexpensive?
Sincewaterisessentialtolife,theTUreceivedfromwaterexceedstheTUreceivedfrom
diamonds.However,thepricewearewillingtopayforeachunitofacommoditydependsnot
ontheTUbutontheMU.Thatis,sinceweconsumesomuchwater,theMUofthelastunit
ofwaterconsumedisverylow.Therefore,wearewillingtopayonlyaverylowpriceforthis
lastunitofwaterconsumed.Sincealltheunitsofwaterconsumedareidentical,wepaythe
samelowpriceonalltheotherunitsofwaterconsumed.Ontheotherhand,sincewe
purchasesofewdiamonds,theMUofthelastdiamondpurchasedisveryhigh.Therefore,wepurchasesofewdiamonds,theMUofthelastdiamondpurchasedisveryhigh.Therefore,we
arewillingtopayahighpriceforthislastdiamondandforalltheotherdiamondspurchased.
ClassicaleconomistsdidnotdistinguishTUfromMUandthustheywereunabletoresolve
thisso-called“water-diamondparadox.”

32. Equi-marginalPrincipleinconsumption
Theruleforrationalconsumerbehaviourisknownastheequi-marginalprinciple.Thisstatesthat
aconsumerwillgetthehighestutilityfromagivenlevelofincomewhentheratioofthemarginal
utilitiesisequaltotheratiooftheprices.Algebraically,thisiswhen,foranypairofgoods,Aand
B,thatareconsumed:
MU
A/MU
B=P
A/P
B
Toseethesenseofthis,saythatthelastunitofgoodAyouconsumedgavethreetimesasmuch
utilityasthelastunitofB.YetgoodAonlycosttwiceasmuchasgoodB.YouwouldobviouslyutilityasthelastunitofB.YetgoodAonlycosttwiceasmuchasgoodB.Youwouldobviously
gainbyincreasingyourconsumptionofAandcuttingyourpurchasesofB.Butasyouswitched
fromBtoA,themarginalutilityofAwouldfallduetodiminishingmarginalutility,and
conversely