Posted: April 8th, 2015

Utility maximization

THEORY OF CONSUMER BEHAVIOR

Consumer is assumed to be rational. Given his income and the market prices of the various commodities, he plans the spending of his income so as to attain the highest possible satisfaction or utility. This is the axiom of utility maximization. In the traditional theory it is assumed that the consumer has full knowledge of all the information relevant to his decision, that is he has complete knowledge of all the available commodities, their prices and his income, to attain this objective the consumer must be able to compare the utility (satisfaction) of the various baskets of goods which he can buy with his income . To study the consumer’s comparison of utilities there are two approaches: 1- Cardinal Utility theory. 2- Ordinal Utility theory, which includes: Indifference Curve Theory and Revealed Preference Hypothesis. THE CARDINAL UTILITY THEORY Assumptions: 1- Rationality: the consumer is rational. He aims at the maximization of his utility subject to the constraints imposed by his given income. 2- Cardinal utility: The utility of each commodity is measurable. Money is the most convenient measure. 3- Constant Marginal Utility of money. If the marginal utility of money changes as income changes the measuring rod of utility becomes inappropriate for measurement. 4- Diminishing marginal utility. The utility gained from successive units of a commodity diminishes. 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: X1, X2,..Xn, the total utility (U) is: U= ƒ (X1, X2,……,Xn)………………

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