Module 1: Unit 2.

The concept of Utility

Consumer preferences are defined by the consumption bundles that consumer face.
Consumers buy or demands goods and services because it provides satisfaction to them and
consumers should feel better off after the purchase. A consumer thinks about his/her demand
for a commodity on the basis of utility derived from the commodity. He feels that his/her given
need/want is satisfied by the use or consumption of the commodity purchased. Utility is the
basis of consumer demand.

Question: In your own perspective can you measure your satisfaction in

consuming/purchasing a good or a service? If yes what is/are your basis. If no, why not?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

Diamond- water paradox

In your own opinion,
Why is it that diamonds, shiny and nice as a fashion statement, are valued more highly than
water, a prerequisite for sustaining life? Why are things valued this way?
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
Getting enough water to sustain life typically has a low price, while a piece of diamond jewelry
has a high price. This is the diamond-water paradox, also known as paradox of value, and it
was first presented by the economist Adam Smith in the 1700s.
In this paradox Adam Smith points out that practical things that we use every day often have
little or no value in exchange. On the other hand, things that often have the greatest value in the
market have little or no practical use.
In explaining the diamond-water paradox, marginalists explain that it is not the total usefulness
of diamonds or water that determines price, but the usefulness of each unit of water or
diamonds. It is true that the total utility of water to people is tremendous, because we need it to
survive. However, since water is in such large supply in the world, the marginal utility of water is
low.
In a typical situation, we aren't willing to pay a lot of money for one more drink of water.
Diamonds, however, are scarce or even rare, and they are hard to find and attain, our marginal
utility (additional satisfaction), for adding a diamond to our collection is much higher than
someone offering us one more drink of water. Which means consumers are willing to pay more
to obtain them, making their marginal utility higher than water, which is less scarce.
But in another situation, if one is dying of thirst, then this paradox might not make sense, and
the marginal utility from another drink of water would be much higher than the additional
satisfaction of owning a diamond.
Understanding why the paradox exists can help us understand the economic terms known as
marginal utility and scarcity.
Scarcity was discussed earlier. It can be simply defined as how readily available a good, skill,
or service is. Is there a lot of it compared to what people are demanding?
Marginal utility is the additional satisfaction or gain someone gets from using or purchasing an
additional unit of a particular good or service. People are willing to pay a higher price for goods
with greater marginal utility.
Definition of Utility:
People buy goods because they get satisfaction from them. This satisfaction which the
consumer experiences when he consumes a good, when measured as number of utils is called
utility.
Utility is the economist's way of measuring pleasure or happiness and how it relates to the
decisions that people make. Utility measures the benefits (or drawbacks) from consuming a
good or service or from working. Although utility is not directly measurable, it can be inferred
from the decisions that people make.

The concept of “utility” in economics can be understood in two broad perspectives: from
the product’s perspective and the consumer’s perspective.
⮚ From the product’s perspective, it can be defined as the want-satisfying property of the
commodity.
⮚ From the consumer’s perspective, it means a psychological feeling of pleasure,
satisfaction, well-being, happiness which consumer expects to derive from the
possession, consumption and the use of the commodity.
Total utility would be the number of units of utility that a consumer gains from consuming a
given quantity of a good, service, or activity during a particular time period. The higher a
consumer’s total utility, the greater that consumer’s level of satisfaction.

Marginal utility (MU) is a way to measure how much value or satisfaction a consumer gets out of
consuming something.
⮚ Marginal utility is the concept that each unit of a good or service is a little less useful to
you than the first. At some point, you won’t want it anymore, and the marginal utility
drops to zero.
Example: Let’s assume you are thirsty. You go to your favorite milktea store. You order for a
medium cup milktea. When your order arrives, you drink so quickly that you barely taste it
because of thirst you consume it immediately. You order another cup and consume it slowly its
actually pleasurable to drink slowly as you consume. Think of the satisfaction you got from the
first cup of milktea. While consuming the second cup you want to drink milktea, but less thirsty
than you were consuming your first cup of milktea. And so, the satisfaction you got from first cup
of milktea was more than the second cup of milktea. Same as with the case of the 3rd cup. You
realize that 3rd cup was a definite mistake, because it actually decreased your total pleasure in
consuming milk tea this time.

Why is marginal utility important?

Overall satisfaction with a product or service gauges future consumer decisions.
For example, a snack manufacturer creates a new sandwich cookie featuring a flavor that has
never been used before. The sandwich cookies are only distributed to test markets. After some
time has passed, reviews of the product appear online showing that people love it. The
remainder of the product leaves shelves fast as consumers buy multiple units at a time. This
proves to the manufacturer that positive marginal utility has occurred, and they can expand their
market range.

The law of diminishing marginal utility describes a familiar and fundamental tendency of
human behavior. The law of diminishing marginal utility states that, “other things being held
constant, as more and more units of a commodity are consumed, the additional satisfaction or
utility derived from the consumption of each successive unit will decrease. This is only true if all
other factors such as income, time, etc. remain unchanged”.

What Are Some Real-Life Examples of Diminishing Marginal Utility?

A common real-life example of diminishing marginal utility is the all-you-can-eat-buffet,

according to Investopedia. As a person begins to fill up on food, the enjoyment declines with
each serving until the satisfaction falls low enough to stop eating.
The theory of marginal utility was applied not only to consumption but also to production. The
value of productive resources is based on their contribution to the final product recognizing that
changes in the amount used of one productive factor would alter the productivity of other
factors. The concept of opportunity cost in which the cost of a factor production can be
determined by its utility in some alternative use (the opportunity forgone) which was introduced
by Friedrich von Wieser.

Maximizing Utility
In economics we assume that consumers behave in a manner consistent with the maximization
of utility. It must be taken into consideration the fact that the ability of consumers to purchase
goods and services is limited by their budgets. Remember the concept of scarcity mentioned
earlier.

The Budget Constraint

In reality, there are many goods and services consumers to choose from, but economists limit
the discussion to two goods at a time for graphical simplicity.
The budget constraint represents all of the points where the consumer is spending all of their
income. It describes all combinations of goods and services that the consumer can afford.
Consumers consumption choices are constrained by the income available and the prices of
goods and service. And yet the goal of each customer is to maximize the total utility.

Individuals of course have choices either choose to save or to borrow. A consumer may in some
time save for future consumption and in other time borrow on future income for present
consumption. Whatever the time period, a consumer’s spending will be constrained by his or her
budget. Take note the word scarcity.

Applying the Marginal Decision Rule

If a consumer decides to spend more on one good, he or she must spend less on another in
order to satisfy the budget constraint (don’t forget the trade-off and opportunity cost).
The marginal decision rule states that an activity should be expanded if its marginal benefit
exceeds its marginal cost. In other word expand production if and only if the price is greater than
the marginal cost. Utility is maximized if the total cost/ expenses is equal to the budget
available.
Marginal analysis is important in decision-making for it helps the company maximize their
potential profits.
For example: Let’s say ABM Company wants to hire additional workers, using the marginal
decision rule they would analyze labor cost versus the potential revenue from sales they could
generate from hiring additional worker. The question, is the cost/expense the company will incur
worth it?

Utility, marginal utility, law of diminishing marginal utility explained in a simpler way.
How to calculate marginal utility?
Example:
No of units (Q) Total utility Marginal utility
1 150
100
2 250
50
3 300
25
4 325
0
5 325

Marginal =
Utility
Change in Total Utility = 250-1 =100
(ΔTU) 50

Change in No. of Units

Consumed (ΔQ)

2-1

⮚ Observe that at Q1-The consumer’s willingness to pay is an indicator of the perceived

value and hence can be used as a proxy for total utility.
⮚ This theory states that perceived satisfaction gained by a consumer increases with the
consumption of each additional unit until a certain level and then it starts to decrease
which indicates that the consumer is losing interest in the good or service. Now, this
concept is used by sellers to understand consumer behavior and determine the price
point and different levels of consumption.
 ⮚ One of the best examples of the seller using marginal utility theory to lure consumers is
at shopping malls.

The graph of total utility and marginal utility.

Another example:

Utility is Subjective:
No commodity possesses utility in itself independently of the consumer. It is the consumer’s
mind which gives it utility. A cigarette has no utility for a non-smoker. Utility varies from individual
to individual. Even for the same individual, a commodity may possess different utilities at
different times or in different places. A warm suit has greater utility in winter than in summer. A
raincoat has greater utility in the hills during the rainy season. It all depends on a man’s
circumstances. That is why we say that utility is subjective. It depends on a man’s mind rather
than on the things itself.

Utility Varies in Different Situations:

Moreover, the same thing may possess different utilities for different purposes. For example,
water has different utilities when used for drinking, bathing or washing. Further, utility changes
with the advancement of knowledge. We may discover new uses for a commodity. That is why
utility varies in different situation remember that man has varied needs and wants and man is
never satisfied.

The budget constraint graphical explanation.