Chapter II

Fundamental microeconomic concepts applicable in architecture

[Link] Behaviour Theory

Consumer Behaviour:Early approaches

There are three early approaches explaining how a consumer will
decide about her purchases while in the market under certain market
conditions and we assume that she has complete knowledge of the
market conditions. They are the utility approach based on the
psychology of the consumer which is the subjective or introspective
approach, the indifference curve approach which is objective
approach and the revealed preference approach. Here we discuss the
first two only.

Choice, Utility and Preferences

Consumer behaviour theory tries to explain the relationship between
price changes and consumer demand. Utility is a concept used to
denote the subjective satisfaction or usefulness attained from
consuming goods and services. This concept helps to explain how
consumers divide their limited income / resources among different
choices of goods and services that help attain them satisfaction
(utility). The issue however is how we are supposed to measure utility
and how the value of utility derived from various choices can be
quantified. Because of these issues, the consumer behaviour theory
has been reformulated and utility is viewed as a way to describe
preferences. It was recognised that all that mattered about utility is
whether one combination of choice had a higher utility than another;
by how much higher or lower didn't really matter
Preferences of consumers is the fundamental description
important for analyzing choice while utility is just a simple way of
describing preferences
Total utility
The total satisfaction or fulfilment received by a consumer through
the consumption of a good or service or a combination of both is
defined as Total utility. For instance if a person consumes five units
of a commodity and derives U1, U2, U3, U4, U5 utility from the
successive units of a good, his total utility will be,
TU = U1+ U2 +U3+ U4+ U5
Total utility increases with an increase in consumption, but as
consumption rises, total utility grows at a diminishing rate.
Every unit of a good or service has a marginal utility and the total
utility is a simple addition of all the marginal utilities of the units
of goods or services
All consumers want to achieve the maximum possible total utility for
their spending and thus they look to combine different bundles of
goods and services. With their limited resources, consumers make
various choices in order to increase their total utility with each
additional unit of consumption.

Marginal utility
As discussed above all consumers attempt to maximize their total
utility from the goods and services they consume. This process of
optimisation leads the consumers to consider the marginal utility of
acquiring additional units of the product or service and of acquiring
one product or service as opposed to another. Product characteristics
and individual tastes and preferences apart from available resources
(money) determine direct demand. Utility is maximised when
products are bought at levels such that relative prices equal the
relative marginal utility derived from consumption.

The marginal utility of a good is the increase in total utility gained

by consuming one additional unit of that good, for a given level of
consumption of other goods

Law of diminishing marginal utility

We have discussed earlier that with an increase in consumption total
utility increases but at a slower and slower rate. Law of diminishing
marginal utility explains this concept. The law of diminishing
marginal utility says that as consumption rises the marginal utility of
consuming the next unit is less than the previous one. Accordingly the
marginal utility of good decreases as more and more units of that
good are consumed as shown in the table and figure below:

Quantity of Good Total Utility (TU) Marginal Utility (MU

1 10 10

2 19 9

3 27 8
 4 34 7

5 40 6

Equimarginal Utility
The dollar value of a consumer's marginal utility from consuming
additional unit of a product is called the marginal benefit. It is the
maximum price that a consumer will pay for an additional unit and
will fall as consumption increases. When different products are
available a consumer will ensure that the last dollar spent on each
product gives an equal marginal utility (MU) per dollar spent.
For two products A and B this can be expressed as:
MUA/PA=MUB/PB,
Where, MUA and MUB are marginal utilities of A and B, and PA
and PB are prices of A and B
Indifference Curve Analysis
As we know that the consumer is able to rank bundles of goods and
services based on the utility he derives from them. This makes
possible joining together of all these bundles that give the consumer
equal utility / satisfaction. The curve drawn on these bundles or
combinations of goods and services is known as indifference curve.
At all points across the indifference curve the consumer derives same
level of utility. And thus the consumers are indifferent because they
do not care which of the bundles on the indifference curve they have.

Compare the consumption bundles shown on the figure above. The

indifference curve I1 tells us that Bundles A, B and C give the
consumer equal satisfaction. Bundle E contains fewer bananas and
fewer apples than Bundle B, and therefore Bundle B (and A and C)
must be preferred to Bundle E. Similarly Bundle D contains more
bananas and more apples than Bundle B, and therefore Bundle D must
be preferred to Bundle B (and A and C). While bundle D should be on
a higher indifference curves as it gives more utility to the consumer, E
should be on a lower curves as it gives lesser utility. The indifference
curves are convex to the origin as because to keep the consumers’
utility constant he must be compensated with increasingly larger
amounts of good X for each additional unit of good Y he is giving up.
This concept stems from the fact of diminishing marginal utility and
is explained below in Marginal rate of [Link] of an
Indifference curve is given by:

MRS = - ΔApples/ΔBananas, or, simply

MRS=-ΔA/ΔB
where ΔA and ΔB are changes in the consumption of A and B. In
order to consume more B and get same level of satisfaction, quantity
of A has to be reduced
All of the points along an indifference curve represent
combinations of goods / services that are equally satisfying to the
consumer

Marginal Rate of Substitution

The amount of one unit of good that a consumer is prepared to forego
for one extra unit of another good is known as the marginal rate of
substitution. The marginal rate of substitution of good A for good B is
the number of good A the consumer is willing to give up to gain
another unit of good B without affecting total satisfaction. A
diminishing marginal rate of substitution of good B for good A
implies that the consumer is willing to give up diminishing quantities
of good A to gain each additional good B. This means that if it takes,
say, n extra units of good A to convince a consumer to give up one
unit of good B, it will take more than another n extra good A to
persuade her to give up yet another unit of good B.

Budget Constraint
The bundle of goods and services that the consumer can afford
depends on two factors namely;

 Price of the goods; and

 Income of the consumer

Further to ascertain the bundles affordable by the consumer we

assume that both the above factors are fixed which implies that the
two factors are independent of the choice of consumption bundle
The budget line thus is a line drawn on all points that is affordable to
the consumer, assuming that all income is spent
As shown in figure above, with a given income and prices of goods, if
a consumer spends all his income on apples, he or she can afford to
buy A apples. Alternatively, the consumer could buy B bananas, or an
intermediate bundle such as E. The equation for the budget line here
is:
Y= Pa(Qa)+Pb(Qb), where Pa,Pb,Qa and Qb are prices and quantities
of apples and bananas
or,
Y-PaQa= PbQb,
Y-PaQa/Qb =Pb,
Y/Qb-PaQa/Qb= Pb,
Therefore, Y(1/Qb)- Pa(Qa/Qb) =Pb

Consumer Equilibrium
Individuals (consumers in this case) make their choices about the
quantity of goods and services to be consumed with the objective to
maximize their total satisfaction. But in maximizing total satisfaction
they face several constraints, the foremost being the individual’s
income level and the prices of the goods and services that he desires
to consume. These constraints as discussed above forms the budget
line of the consumer. The consumer's effort to maximize total
satisfaction, subject to the budget line, includes decisions about how
much he would consume of the goods and services and the
combination of goods and services at which the consumer maximises
its total utility is called consumer equilibrium.
A consumer facing the budget line (fixed income and given market
prices of goods) can come to a point (or equilibrium) of maximum
only by acting in the following manner.
Each product is demanded up to the point where the marginal
satisfaction for every unit of money spent on it is exactly the same as
the marginal satisfaction of the spent on any other good. This
fundamental condition of consumer equilibrium can be written in the
following compact way:

MRS apples/MRS banana = - Price of apples/Price of bananas,

or the consumer will be in equilibrium when the ratios of MRS
between two commodities (here apples and bananas) is equal to the
price ratios of the two goods. This will happen at the point wherte the
highest attainable indifference curve is tangent to the budget line or
the price ratio line as shown in the following diagram:

Some applications of the utility concept

[Link]

Marginal willingness to pay (MWTP) for the environment = MU of

environmental quality ÷ marginal utility of a dollar higher income.
People will prefer greater investment in personal safety even if it
reduces environmental quality if the improvement in utility through
health are greater than the decrease in utility from the reduction in the
environmental quality. Marginal utility of a dollar should decrease as
per capita income goes up. As marginal utility of a dollar goes down,
the willingness to spend those same dollars on environmental goods
goes up.

[Link] estate

Additional utility an individual receives when purchasing an

additional unit of a commodity or service is marginal utility. There is
a trade off between units of cost and unit of utility. For example,
consider an individual who builds a luxury home with a swimming
pool. To build a tennis court as an additional facility in the house let
us assume that it would cost $50,000 and require yearly maintenance.
Suppose that adding an additional tennis court provides the owner a
marginal utility of building equal to $25,000. Now this is not enough
to offset the additional cost involved. However, if it cost only $5,000
to build the additional tennis court, then there may be sufficient
marginal utility to justify its construction.

[Link] utility & diminishing marginal utility in healthcare

The two primary uses of medical funds are physician services and
hospital services. The importance of utility analysis is to
understand why people demand health. Excellent medical care
creates satisfaction to consumers and generates utility through
improved quality life. A healthy person does not need to allocate
time for sickness, hence use more healthy days to pursue other
activities, to work and increase income. The law of diminishing
the marginal utility indicates that each incremental improvement
to health generates minute additions to the total efficiency.

The marginal utility of a service or product declines as the supply

increases. When a person receives a product with economic value,
the person values the use of that product. The first product
obtained is the most valued unit by the person. When the person
receives the product for the 2nd time, the person’s value for the
product may be less than the first time. This scenario shows that
when a person buys products over some time, the person does not
give equal importance to the product. Sometime, a person may
pay more for a product and less for some other product.
Each additional improvement in health generates a smaller
increase in utility because of the law of diminishing marginal
utility.
([Link]
healthcare)

[Link]
%20Architecture%20_%20by%20Vanessa%20Xinyi%20Mao%20_%[Link]

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