UTILITY
-Utility is a measure of the level of happiness or satisfaction that someone receives
from the consumption of a good.
-Utility decreases with increased consumption of a good- the law of diminishing
marginal utility.
-The law of diminishing marginal utility: as consumption increases, the satisfaction
from consumption decreases.
-As the consumption of a good increases, the marginal utility will get smaller
Total utility- the overall satisfaction that is derived from the consumption of all units
of a good over a period of time.
Marginal utility -the additional utility derived from the consumption of one more unit
of a particular good.
-For example, if someone gets 10 units of satisfaction from consuming one pizza and
15 units after consuming two pizza then the marginal utility is 5 units.
The equimarginal principle
-A consumer is said to be in equilibrium when it is not possible to switch any
expenditure from, for example product A to product B to increase total utility.
-The equimarginal principle: consumers maximise their utility where their marginal
valuation for each product consumed is the same.
MUA/PA =MUB/PB=MUC/PC=…. MUN/PN
-If the marginal utility from consuming product A is 10 units and the price is $5, the
consumer is in equilibrium when consuming 20 units of product B if its price is $10
and so on.
-Where the equimarginal principle applies, it is not possible to invest total utility by
reallocating expenditure between any of the products available.
-A consumer has therefore allocated income in a way that has maximised utility,
resulting in consumer equilibrium.
-The principle is based on the following assumptions:
Consumers have limited income
Consumers will always behave in a rational manner.
Consumers seek to maximise their utility
-The idea of consumer equilibrium is shown in the table below
Consumer equilibrium
Product y ($2
Product x each)
($1 each
MU MU/P Quantity MU MU/P
60 60 1 42 21
40 40 2 32 16
25 25 3 24 12
12 12 4 18 9
5 5 5 14 7
2 2 6 12 6
-Two products x and y are priced at $1 and at $2 respectively.
-It is assumed that a consumer has $10 to spend.
-Consumer equilibrium is where MU/P is the same for each product.
-This is where 4x and 3y are consumed with a total utility score of 235.
-No other combination of goods generates a higher total utility;
therefore any other combination would provide less satisfaction.
Derivation of an individual demand curve
-Marginal utility can be used to explain be used to explain how an individual demand
curve as derived.
-In the table above, assume the price of y is now reduced to $1, the price of x and
the income remain unchanged
-MU/P can now be calculated again for product y.
-This gives a new consumer equilibrium of 4x and 6y, a gain of 3y.
-Total utility has increased.
-Part of the demand curve is shown below.
Limitations of normal utility theory and assumptions of rational behaviour
-Marginal utility assumes that consumers are capable of putting their wants in rank
order and assigning a value to the satisfaction gained from their consumption to
make.
-The law assumes consumers act and behave in a rational way in their purchasing
decisions.
-This is another major assumption to make.
-Empirical or real-world evidence consistently shows that there are other factors
apart from utility that determine what we purchase.
-To understand the behavioural factors involved requires being aware of what people
are thinking to determine and then model these psychological influences.