The Objectives Of Utility Theory

1355 words (5 pages) essay in Economics

5/12/16 Economics Reference this

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Q;1-utility is a psychological phenomenon. Utility from a customer point of view may be defined as the sum of utility derived by a consumer from various units of a commodity or services consumed at a point of time. For example, a customer consumes five units of a commodity at a time and derives utility from successive units of consumptions as u1, u2, u3, u4 and u5. The total utility of the consumer can be measured as follows-

Ux= u1+u2+u3+u4+u5

Utility theory supplies the methodological model for the evaluation of alternative choices to be made by the customers and organisations. Utility relates to the satisfaction that each choice renders to the decision maker. Thus, utility theory from the customer point of view assumes that any decision which is made on the basis of utility maximization principle, the best choice made is the one that provides the highest level of satisfaction (utility)to the decision maker.

Utility theory is used to explain the behaviour of individual customers’. Marginal utility is the change in total utility with additional consumptions of a commodity. Demand arises due to utility. The utility is measured as cardinal utility and ordinal utility. In cardinal utility, utility is measurable objectively. And in ordinal utility, utility is ranked according to the preferences by the individual customers. The utility theory from customer’s point of view explains that in law of diminishing marginal utility which states that as the quantity consumed by an individual for a commodity increases, the utility gained from additional units goes on diminishing. As the choice is constrained by price and the income of the customer, a rational customer will not spend on an additional unit of a commodity or services unless its marginal utility is equal or greater than that of a unit of another commodity or services. The price of a commodity or services is related to its marginal utility and the ranking will be given by the customer as according to the preferences.

Q:2- Optimal market basket is the best possible combinations of goods and services in particular conditions. From all the goods and services available to a customer, they tend to choose a combination of items which gives the highest satisfaction and meeting all the conditions of the buyer. Buyers choose between different combinations of goods and different market basket which bring the expected satisfaction. However, the resulting optimum market basket of goods and services must meeting up with two important conditions-

The optimal market basket rests above the budget line. The budget line is the representation of all the combinations of goods and services that can be purchased for a fixed amount. The market basket combinations which lie to the right and above the budget line are expensive to purchase within the limited fixed amount. The market basket combinations in the budget line which lies below and left to the budget line would leave the funds unused and would let to the reduction of consumptions of goods and services. The best possible market combinations lay on the budget line which is also the optimal market basket on the part the customers. This graphical model can be shown algebraically if it is recognized that all income must go to only two commodities in a two-dimensional two-goods model. All of income (M) will be spent on good X and good Y. The amount spent on each will be the price of the good times the quantity of the good purchased. Therefore M = PxX + PyY where Px and Py are the prices of goods X and Y, which then are multiplied times the quantities of X and Y that are purchased. Simple algebraic manipulation of the equation shown above leads to the equation that represents the budget line: Y = M/Py- (Px/Py) X.

The optimal market basket contemplates the considerations of marginal cost and marginal benefits. The customers before purchasing any combinations of goods and services must weigh the relative marginal cost and marginal benefits from the consumptions. At the margin, if the customers receive twice as much satisfaction from the consumption of goods as from the use of the services, then the customer would be willing to pay twice the marginal cost for the goods as compared to the services.

The model of customers as buyers are based on following two conditions-

The given two market baskets, A and B, the customer will know which one to be preferred A to B, B to A or is indifferent to them.

With the given market basket A and B , the customer will always opt for the that has more of at least one item and no less of the other items.

Suppose, Riga and Alex has identical incomes of $1000 , with their individual taste and preferences, Px=$5 and Py= $5 and their utility functions are as follows- Riga: U(X,Y) = 9X + 3Y

Alex: U(X,Y) = 3X + 9Y .

So their optimal consumptions bundles will be as follows-

Therefore, the customers will receive the optimal market basket which will be resting on the budget line. In this line the combinations of goods and services laying on the budget will enable the customer to purchase the goods and services at the optimal combinations and without wasting any recourse. The combinations in the budget will consist of all the feasible combinations of goods and services for an limited amount of funds and this feasible combination will provide the highest satisfaction level within the limited funds.

Q:3- The indifference curves shows the various different combinations of two goods which generate equal level of satisfaction to the customers. It shows the combinations of two goods a person is indifferent to. For example, Mr Cook spends two days witting article and three days in singing in concerts, he will gain same level of utility from the combinations these two activities. A customer faces an exchange that occurs as compromises in the purchasing decisions due the limited income and indefinite number of choices and demand. In order to make the best possible choices, the customers must merge budget constrains like what they are capable to purchase and what they prefer to consume. A budget constraints refer to the fact that what a customer can purchase is tightened-up by the income or the funds he has to consume. The slope of budget constraints refers the measurement of rate at which the customer can compromise one good for another and also the relative price of the two goods. Thus, budget constraints are based on the income of the customers and price of the two goods. The indifference curves are the inward curves and the slopes of indifference curves showing marginal rate of substitutions. The marginal rate of substitutions is the rate at which the customer is willing substitutes one good for another.

Car buyers are sometimes confronted by sales representatives who argue that they can offer a vehicle that is “just as good as a BMW, but at one-half the price.” According to the concept of indifference curve, this claim of sales representative is credible. The indifference curve shows the different combinations of two goods which are equally preferred by the customers. In this case, the sales representative know that the customers are willing to buy a car meeting their all the essential necessities and also will prefer for a car as good as BMW but due insufficiency of funds they are not capable to spend on buying a BMW. By considering reason of budget constraints, the choice between what a customer can afford and what a customer prefers make the claims of sales representative credible; and taking into the account the concept of indifference curves where a customer’s derives same utility from the combinations of two different goods. The customer will receive equal amount of utility by purchasing the car half a price of BMW as compared to buying a BMW within the limited funds available to him.

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