Utility
We make countless decisions every day about how to allocate our scarce
money and time. Should we buy a plate of momo or samosa ? Buy a new
bike or fix our old one? Spend our income today or save for future
consumption? As we balance competing demands and desires, we make the
choices that define our lives. The results of these individual choices are what
underlie the demand curves and price elasticities that we met in earlier
chapters. This chapter explores the basic principles of consumer choice and
behavior. We shall see how patterns of market demand can be explained by
the process of individuals’ pursuing their most preferred bundle of
consumption goods. We also will learn how to measure the benefits that each
of us receives from participating in a market economy.
CHOICE AND UTILITY THEORY
In explaining consumer behavior, economics relies on the fundamental
premise that people choose those goods and services they value most highly.
To describe the way consumers choose among different consumption
possibilities, economists a century ago developed the notion of utility. From
the notion of utility, they were able to derive the demand curve and explain
its properties. What do we mean by “utility”? In a word, utility denotes
satisfaction. More precisely, it refers to how consumers rank different goods
and services. If basket A has higher utility than basket B for Mahesh, this
ranking indicates that Mahesh prefers A over B. Often, it is convenient to
think of utility as the subjective pleasure or usefulness that a person derives
from consuming a good or service. But you should definitely resist the idea
that utility is a psychological function or feeling that can be observed or
measured. Rather, utility is a scientific construct that economists use to
understand how rational consumers make decisions. We derive consumer
demand functions from the assumption that people make decisions that give
them the greatest satisfaction or utility.
In the theory of demand, we assume that people maximize their utility,
which means that they choose the bundle of consumption goods that they
most prefer.
Marginal Utility and the Law of Diminishing Marginal
Utility
How does utility apply to the theory of demand? Say that consuming the first
unit of ice cream gives us a certain level of satisfaction or utility. Now
imagine consuming a second unit. Our total utility goes up because the
second unit of the good gives us some additional utility. What about adding a
third and fourth unit of the same good? Eventually, if we eat enough ice
cream, instead of adding to our satisfaction or utility, it makes us sick! This
leads us to the fundamental economic concept of marginal utility. When we
eat an additional unit of ice cream, we will get some additional satisfaction or
utility. The increment to your utility is called marginal utility.
The expression “marginal” is a key term in economics and always means
“additional” or “extra.” Marginal utility denotes the additional utility we get
from the consumption of an additional unit of a commodity.
One of the fundamental ideas behind demand theory is the law of
diminishing marginal utility. This law states that the amount of extra or
marginal utility declines as a person consumes more and more of a good. To
understand this law, first remember that utility tends to increase as we
consume more of a good. However, as we consume more and more, our total
utility will grow at a slower and slower rate. This is the same thing as saying
that our marginal utility (the extra utility added by the last unit consumed of
a good) diminishes as more of a good is consumed.
The law of diminishing marginal utility states that, as the amount of
a good consumed increases, the marginal utility of that good tends
to decline.
We can illustrate utility numerically as in Table above. The table shows in
column (2) that total utility ( U ) enjoyed increases as consumption ( Q )
grows, but it increases at a decreasing rate. Column (3) measures marginal
utility as the extra utility gained when 1 extra unit of the good is consumed.
Thus when the individual consumes 2 units, the marginal utility is 7- 4 =3
units of utility (call these units “utils”). Focus next on column (3). The fact
that marginal utility declines with higher consumption illustrates the law of
diminishing marginal utility.
Relationship of Total and Marginal Utility.
Using Figure 5-1, we can easily see that the total utility of consuming a
certain amount is equal to the sum of the marginal utilities up to that point.
For example, assume that 3 units are consumed. Column (2) of Table 5-1
shows that the total utility is 9 units. In column (3) we see that the sum of
the marginal utilities of the first 3 units is also 4+ 3 +2 =9 units.
Total utility in (a) rises with consumption, but it rises at a decreasing rate,
showing diminishing marginal utility. This observation led early economists to
formulate the law of downward sloping demand.