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Faculty of Business and Management

September 2015 Semester

BBEK1103

Principle of Microeconomics

NAME : Angel Deborah John


MATRICULATION NO : 930113015622001
IDENTITY CARD NO : 930113-01-5622
TELEPHONE NO : 018-2699772
E-MAIL : angeldeborah93@yahoo.com
NAME OF LECTURER : Mr. Sulaiman Bin Hj Baputey
LEARNING CENTRE : Negeri Sembilan
BBEK1103 Principle Of Microeconomics

Table of Contents

No. Description Pages


1. Table of Contents 1
2. Concept of Utility 2
3. Cardinal Utility Theory 2-3
4. Total Utility and Marginal Utility 3-5
5. The Law of Diminishing of Marginal Utility 5-6
6. Ordinal Utility Theory 6
- Choice and Priority
7. Indifference Curve 7-9
8. Budget Line 9- 12
9. Difference between Cardinal and Ordinal Theory 13
10. Consumer Equilibrium
- Consumer equilibrium under Cardinal Utility 14-15
- Consumer equilibrium under Ordinal Utility 16-17
11. Summary 17
12. Bibiliography 18

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BBEK1103 Principle Of Microeconomics

The Concept of Utility


According to economists, the definition of Utility is the satisfaction gained by consumers from
the consumption of goods and services, or it can also be defined as the ability of a good to
provide satisfaction to its consumer. The concept of Utility was introduced to social thought by
a British philosopher named Jermy Bentham in 1789 through his book, titled Principles of
Morals and Legislation and to economics by William Stanley Jevons in the 19th century.
According to William Stanley Jevons, the term utility can also refer to pleasure,
satisfaction and a sense of fulfilment by desire. In other words, consumers makes decision to
buy or evaluate goods based on their satisfaction level. The product that I have selected for this
assignment is KFC Snack Plate. In abstract sense, the term utility refers to the power of a
commodity to satisfy a human need. For example, KFC Snack Plate can satisfy hunger. All the
goods that people consume has utility. Utility can also defined as the want-satisfying power of
a commodity. But it is relative to a persons need, it also depends on whether the person needs
that commodity. This is because not all people derive utility from what they consume. For
example, a vegetarian does not derive any utility from KFC Snack Plate. Therefore the utility is
derived from a person who desires for that commodity. In other words, the grater the need, the
greater the utility. Utility is free from all moral value as it is ethically neutral. For example,
eating KFC 6 piece Nugget maybe immoral for Hindus but if a Hindu takes it, it satisfy the
persons hunger. The measurement of utility has been and still remains has a debatable issue.
The early and modern economists has different answers to the measurement of utility. This is the
reason why the concept of Utility is measured in to ways, which is the cardinal and the ordinal
method.

Cardinal Utility Theory


The Cardinal Utility Theory is known as a neo-classical or the early theory. It was developed by
economists like Alfred Marshall, Pigou, Robertson, Leon Walrus, Carl Meneger and etc. It is
assumed that utility is measured in hypothetical units which is called util. The term util
introduced by Leon Walrus. The utility level is usually reflected by the willingness of a person to
pay based on the value of money. The assumptions in the cardinal utility theory can be analyze
as by assuming the consumer to be rational, which he tries to maximize his total utility under a

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constraint income. The higher the price willing to be paid, the high the level of satisfaction. For
example, eating a KFC Snack Plate will give 8 util, while KFC 6 piece Nugget will give 6 util.
The KFC Snack Plate gives 2 extra unit of utility compared to KFC 6 piece Nugget. Therefore,
the consumer will buy the KFC Snack Plate even if the price is higher. The most convenient way
to measure utility is by money. Thus utility can be measured quantitatively in monetary units or
cardinal units.

Total Utility and Marginal Utility


Total utility and marginal utility are two basic concepts of utility. The total satisfaction derived
from the consumption of given quantities of a commodity by a consumer within a given time
period is called total utility (TU). In other words, total utility (TU) is the addition of all marginal
utilities obtained from the consumption of different units of a commodity. For example, if a
consumer consumes first unit of KFC Snack Plate and gets 8 utils. As he consumes second unit
of KFC Snack Plate and gets 7 utils, his total utility (TU) increases to 15 utils. In the same way
total utility increases to 19 utils as he consumes third KFC Snack Plate and gets 4 utils from it.

Marginal Utility (MU) can be defined as the increased in the total utility when consumption
increases by 1 unit. Marginal utility (MU) is the addition to the total utility derived from the
consumption of one additional unit. For example, when a consumer consumes one KFC Snack
Plate, he gets total utility equal to 8 utils. By consuming second KFC Snack Plate, total utility
becomes 15 utils. Therefore the marginal utility of the second KFC Snack Plate is 7 utils i.e 15-8.
The marginal utility can be calculated by using the formula below:

Marginal Utility, (MU) = Change in Total Utility, (TU)


Change in Quantity, (Q)

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The Table 1.0 below shows the relationship between Total Utility and Marginal Utility based on
the consumption of KFC Snack Plate when the consumer is hungry.

Quantity, (Q) Total Utility, (TU) Marginal Utility, (MU)


1 8 8
2 15 7
3 19 4
4 22 3
5 24 2
6 25 1
7 25 0
Table 1.0
According to the table above, the marginal utility of first unit of KFC Snack Plate is equivalent
to the total utility of the same KFC Snack Plate. The total utilities is calculated by adding the
given marginal utility of the quantity. For example, the marginal utility of the second unit of
KFC Snack Plate is 7, therefore the total utility will be 15 (8 + 7) utils and in the same manner
for all the other quantities. Marginal utility can be calculated by finding the changes of Total
Utility. For example, the marginal utility of the second unit of KFC Snack Plate that is 7 can be
calculated by subtracting 15-8 utils from the given total utility.

26 24 25 25
24 22
22
19
20
18
Total Utility, (TU)

15
16
14
12
10 8
8
6
4
2
0
0 1 2 3 4 5 6 7
Quantity, (Q)

Figure 1.0.1

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Figure 1.0.1 is the illustration of the total utility derived from Table 1.0. In this figure, we can
observed that as the quantity increases, the total utility also increases until the total utility reaches
constant. This is because when marginal utility is zero, total utility is the maximum. Total utility
generally remains positive and marginal utility can be positive, zero or even negative. The Figure
1.0.2 below is the illustration of the marginal utility derived from Table 1.0. In this figure below,
we can observe that the marginal utility decreases as the quantity increases. When marginal
utility is positive, total utility rises. When marginal utility is negative, total utility falls.

9
8
8
7
7
Marginal Utility, (MU)

5
4
4
3
3
2
2
1
1
0
0
0 1 2 3 4 5 6 7 8
Quantity, (Q)

Figure 1.0.2

The Law of Diminishing of Marginal Utility


The Law of Diminishing of Marginal Utility was first developed by a German economist named
Herman Heinrich Gossen, which is why it is commonly known as the first law of Gosse. The law
can be defined as the marginal utility obtained from the consumption of additional units will start
to decrease after a certain level of consumption when the amount consumed increases. The Law
of Diminishing of Marginal Utility is based on two important points which is;
1. Though humans desires are unlimited, each single desire is able to be satisfied.
2. Different commodities are not a perfect substitute for each other.
The law means that when a consumer consumes more and more unit of KFC Snack Plate, the
intensity of his/her desire of the KFC Snack Plate will decrease and reaches a point where the

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consumer do not want any more KFC Snack Plate. This is because when the saturation point is
reached, the marginal utility of a commodity becomes zero. Thus, as the quantity of the
consumption of KFC Snack Plate increases, the marginal utility decreases. The second point
states that the different commodities are not a perfect substitutes for each other. This means that
when a consumer eat more and more units of KFC Snack Plate, the intensity of his particular
desire for the KFC Snack Plate diminishes.

Ordinal Utility Theory


The Ordinal Utility Theory is known as the modern theory. It was introduced by economists like
Sir John Richard Hicks and Sir Roy George Douglas Allen. The definition of the Ordinal Utility
Theory can be defined as the benefit or satisfaction gained by consumers cannot be measured in
cardinal or numeric form, but in terms of comparison to the consumption of the other goods. The
Ordinal Utility Theory can be analyze by focusing on maximizing the utility, subjecting to price
and consumption expenditure. This theory means that there is no measurement unit for this
theory because it is compared to each product, which means you have to have at least two
product or more to compare or rank its utility. This also depends on the consumers choice and
priority.

Choice and Priority


The difference between choice and priority is that, choice does not depend on the price of goods
and income. Choice can change but it does not based on the ability to pay. For example, even if
consumer cannot afford both KFC 6 piece Nugget and a KFC Snack Plate, does not mean that he
does not like both. Priority is opposite of choice. Consumers may have so many choices but they
will have to choose only one which becomes their priority. For example, the consumer that could
not afford both KFC 6 piece Nugget and a KFC Snack Plate, therefore he chooses a choice which
will provide him more satisfaction to his hunger which is the KFC Snack Plate. Hence, the KFC
Snack Plate becomes his priority. Consumers will often use the concept of priority when facing
various choices and the ability to pay for it. For example, the KFC Snack Plate is same price as
the KFC 6 piece Nugget. Based on his hunger and choice, the consumer have to choose a food
choice that is affordable and also satisfy his hunger.

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Indifference Curve
The Indifference Curve was invented by Francis Ysidro Edgeworth. The indifference curve can
be defined as the locus point of all the combination of two products that produces the same level
of satisfaction or utility to the consumer. When choice involves only two products, which is KFC
Snack Plate and KFC 6 piece Nugget, an indifference curve will show various combination of
KFCs Snack Plate and 6 piece Nugget that can give the equal satisfaction or utility to the
consumer.

Various Combinations
Utility
Combinations Unit of KFCs Snack Plate Unit of KFCs 6 piece Nugget
A. 7 1 40u
B. 3 2 40u
C. 2 4 40u
Table 2.0

8
Combo A (1,7)
7

6
KFC's Snack Plate

4
Combo B (2,3)
3
Combo C (4,2)
2

0
0 1 2 3 4 5
KFC's 6 piece Nugget

Figure 2.1
The Table 2.0 above shows various combination of the products that will yield the same amount
of utility. The point mark on Figure 2.1 graph shows the equivalent amount of utility.

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When you have various group of combinations that will yield to various amount of utility, if you
connect them and build a set of indifference curve on the same graph, you have already formed
an indifference map. It consist of a series or group of curves showing various level of satisfaction
or utility of the consumers. The higher the indifference curve is from the original position, then
the higher the utility is. For example, the curve KFC3 in Figure 2.2 gives a higher level of
satisfaction compared to curve KFC1 and KFC2. The same as curve KFC2, the lower the curve
from the original position, the lower the utility.
KFCs Snack Plate

KFC3
KFC1
KFC2

KFCs 6 piece Nugget

Figure 2.0
(a) Assumptions
There are a few assumptions that will be used to ensure an accurate consumer analysis:

(i) Every combination of product KFCs Snack Plate and KFCs 6 piece Nugget must
be on the same in indifference curve.
(ii) An indifference curve has a negative gradient because you must obtain more of
product KFCs 6 piece Nugget if you give up a part of KFCs Snack Plate to
ensure satisfaction remains unchanged.
(iii) A higher indifference curve is preferred as it represents more consumption.
(iv) The indifference curve can never intersect as each curve on the indifference map
represents different combinations with different level of satisfaction.

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(b) Diminishing Marginal Rate of Substitution


The Marginal Rate of Substitution is the concept of imperfect substitution that changes
according to the consumption level in an indifference analysis. The gradient of the
indifference curve in Figure 2.1 is obtained by -( /
6 ) .

Example:
Gradient at Combo B


= 6
73
= 21

=-4

Thus, the gradient of the indifference curve has a -4 gradient which is referred to as
marginal rate of substitution of KFCs Snack Plate and KFCs 6 piece Nugget [MRSXY =
-( /) ]. This gradient indicates the rate where the consumer is willing to give up
KFCs Snack Plate to obtain an additional unit of KFCs 6 piece Nugget with the utility
remaining unchanged.

Budget Line
The Budget Line can be defined by a curve that shows the combinations of two products that can
be purchased by consumer using a certain amount of income and based on the market price of
the product.
For example, lets assume the income of consumer is Income (I) = 80,
The Price of KFCs Snack Plate (Y) = RM 10
The Price of KFCs 6 piece Nugget(X) = RM 5

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Various Combinations
Income, (I)
Combinations Unit of KFCs Snack Plate, (Y) Unit of KFCs 6 piece Nugget, (X)
A 8 0 80
B 6 4 80
C 4 8 80
D 2 12 80
E 0 16 80
Table 3.0

Budget Line Y = Px x X + Py x Y

9
Combo A
8

7
Combo B
6
KFC'S Snack Plate

5
Combo C
4

3
Combo D
2

1
Combo E
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
KFC's 12 piece Nugget

Figure 3.1
The slope of the budget line indicates how many unit of KFCs Snack Plate the consumer
must give up to buy one more unit of KFCs 6 piece Nugget. For example, the slope at Combo B
on the budget line is /.

I = Px x X + Py x Y

Slope of Budget Line = = 6 =

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If the consumer spends all his money on KFCs Snack Plate, he will obtain 8 units of it;
and if the consumer spends all money on KFCs 6 piece Nugget, he will obtain 16 units of it. The
consumer can use any combination as long the combination satisfy the rule I = PxX + PyY, that is
income (I) is equivalent to the total expenditure (PxX + PyY).

(a) Effect of Change in Income


When there is a change in the income of the consumer, and the prices of the products
remains same, but the budget line will shift upward in a parallel position with the rise in
income.

16

8
KFCs Snack Plate

16 32
KFCs 6 piece Nugget

Figure 3.2

(b) Effect of Change in Price

Lets assume that the price of one product changes, but the income of the consumer and
price of other product is held constant. For instance, there is a fall in the price of KFCs
Snack Plate, the consumer will purchase more of that particular product than before. A
price change can cause the budget line to rotate. This is because the equation is changed.
From, I = PxX + PyY

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When Y is placed in the Y-axis, the equation can be written as:


Y=

Since Px/Py is the gradient of the budget line, if either one of the price changes, the
gradient of the curve will also change.

Y (a) Decrease in Price Y (b) Increase in Price Y


Y
16 A

A
8 8

A
A A
16 X 16 X

Figure 3.3

Lets assume that initially, the price of KFCs 6 piece Nugget is RM 5 and price of KFCs Snack
Plate is RM 10, and income is RM 80, the budget line AA line in Figure 3.3(a). When the price
of KFCs Snack Plate drops to RM 5, the slope becomes steeper (AA). This indicates that more
KFCs Snack Plate can be bought with the available income. In Figure 3.3(b) shows that when
the price is increased to RM 20, the slope becomes shallow (AA). This indicates that less
KFCs Snack Plate can be bought with the available income. There are no changes in the X-axis
of both as the price of KFCs 6 piece Nugget remained unchanged.

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Differences between Cardinal and Ordinal Utility Theory

Cardinal Utility Theory Ordinal Utility Theory


States that the utility that the consumer States that utility that the consumer
derives from consuming products and derives from consuming products and
services can be measured with numbers. services cannot be measured in
numbers but it can be compared with
other products.
Uses a measurement unit called Util Utility is used for ranking of the
which helps in understanding how much products depending on the choice and
utility is derived from the consumption priority of a consumer.
of a product.
A quantitative measure A qualitative measure
Assume that consumers derive utility Assume that a consumer may derive
through consumption of one products at utility through consumption of a
a time. combination of products, which will
be then ranked according to choice
and priority.
Consumer equilibrium is achieved when Consumer equilibrium is achieved
Marginal Utility of a product is equal to when the indifference curve is tangent
the price of the product (MUx = Px). with the budget line and both have the

equal gradient. = .

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Consumer Equilibrium
Consumer Equilibrium under Cardinal Utility
A consumer equilibrium is achieved when a consumer reaches his maximum satisfaction level
when the last unit of money spent on each product that yields the same utility. In Cardinal
Utility, there are consumption equilibrium for one good and consumer equilibrium for two goods
or more.
(a) Consumption Equilibrium for one good
One way to gain maximum satisfaction from a limited income is by measuring util in
monetary value. The marginal utility becomes the sum of money in which the consumer
is willing to pay to obtain extra one unit of a product. For example, if the consumer is
willing to pay RM 2 for an additional unit of KFC Snack Plate, then the KFC Snack Plate
has MU = RM 2. Since, it only involves consumption of one product, the consumer will
maximize satisfaction when marginal utility from the consumption of the good is
equivalent to the price (MU = P) because marginal utility indicates the willingness to pay.
Along the demand curve, marginal utility is equivalent to price (MU= P), where the
consumer are at an optimum condition.

Quantity of KFC
Total Utility Marginal Utility Price (RM)
Snack Plate
1 5 5 10
2 11 6 10
3 16 5 10
4 20 4 10
5 23 3 10
6 20 -3 10
Table 4.0
The table above shows total utility, marginal utility and the price for KFC Snack Plate.
From the table above, the consumer has achieved equilibrium at the third unit. This is
because the marginal utility is equivalent to the price.

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When the consumer obtain particular product free-of-charge, there are no budget
constraint and the consumer will not be restricted by the willingness to pay. Therefore,
the consumer will use the product until maximum total utility is reached which is in the
fifth unit according to the table. If the consumer purchase the sixth unit, he/she will feel
uncomfortable due to excessive consumption.

(b) Consumer Equilibrium for Two Goods or More


In the case of two products KFC Snack Plate and KFC 6 piece Nugget whose price are Px
and Py respectively.

Consumer equilibrium is given as:


MUx = Px and MUy = Py

The consumers equilibrium is expressed as =1=
() ()

Therefore, it can be rewritten as:



=

The above equation indicates that a consumer reaches equilibrium when MU derived
from each Ringgit spent on two products is equal.

The above equation indicates that a consumer is in equilibrium when MU ratio of any
two products equals to the price ratio.

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BBEK1103 Principle Of Microeconomics

Consumer Equilibrium under Ordinal Utility

KFCs Snack Plate

C
B
KFC3
KFC1
KFC2

KFCs 6 piece Nugget

Figure 4.1
Figure 4.1 illustrates the 3 levels of satisfaction represented by 3 indifference curve. According
to the figure, the line that intersect the indifference map is called the budget line. Therefore,
consumers may not choose curve like KFC3 due to budget constraints.

The consumer can choose combination A and C but that point is not optimal as it is a downward
movement along the budget line that may still increase the satisfaction. When point B is
achieved, the consumer has reach equilibrium because after that point the total utility will
decrease. Point B is the equilibrium point where the indifference curve is tangent with the budget
line. Hence, both will have the equal gradient.

=

This rule is same as obtained the cardinal utility.



Another way to state the maximization rule is = . Meaning, the marginal rate of

substitution of KFC Snack Plate and KFC 6 piece Nugget is the amount of ringgit that we are
willing to exchange for one additional unit of KFC 6 piece Nugget. Therefore, in order to

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maximize the utility, the consumer has to choose the combination of products where the
marginal rate of substitution is equivalent to the relative price.

Summary
In conclusion, we can see how the Cardinal and Ordinal utility theory has influence the
consumer to behave according to the Law of Demand. There are many difference between
Cardinal and Ordinal. The consumer rational thinking, choice and priority is important in
the economy world as there are many business owners compete to win the consumers heart
to buy their products. In the analysis of both theories, we can conclude and see how the
consumer achieve maximum satisfaction from a constrained income. In the ordinal theory,
we could see how the budget line changes when there is a change in the price of goods and
how the consumer chooses and prioritize their needs. As a rational consumer, the consumer
will choose the products which will let the consumer gain more satisfaction from the
consumption of products within their budget because the consumer wants satisfaction from
every single Ringgit and wants the money that he/she spent to be valuable.

(3500 words)

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Bibiliography
Ahmad Samidi, M., Abdullah, N., Ali, J., & Mohd Mohaideen, Z. (2013). Utility
Analysis. In BBEK1103 Principles of Microeconomics/Microeconomics I (2nd ed.). Seri
Kembangan, Selangor: Meteor Doc. Sdn. Bhd.
Chand, S. (2013, September 19). The Concept of Utility: Its Meaning, Total Utility and
Marginal Utility | Economics. Retrieved November 10, 2015, from
http://www.yourarticlelibrary.com/economics/the-concept-of-utility-its-meaning-total-
utility-and-marginal-utility-economics/8866/
Dwivedi, D. (1985). Theory of Consumer Demand. In Principles of economics (2 ed.).
New Delhi, Delhi: Vani Educational Books.
Dwivedi, D. (2011). Cardinal Utility approach to demand analysis. In Microeconomics I
For University of Delhi. Delhi: Pearson.
Rittenberg, L., & Tregarthen, T. (n.d.). Principles of Microeconomics, v. 1.0. Retrieved
November 12, 2015, from
http://catalog.flatworldknowledge.com/bookhub/21?e=rittenberg-ch07_s02

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