Utility and Demand

Chapter 8

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Main ideas
After studying this chapter, you will be able to:

• Explain the limits to consumption and describe preferences using the concept
of utility
• Explain the marginal utility theory of consumer choice
• Use marginal utility theory to predict the effects of changes in prices and
incomes and to explain the paradox of value
• Describe some new ways of explaining consumer choices

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Consumption Choices
Consumption Possibilities
• Your consumption possibilities are all the things that you can afford to buy
A Consumer’s Budget Line
• Consumption possibilities are limited by income
Changes in Consumption Possibilities
• Consumption possibilities change when income or prices change
Preferences
• We approach preferences i.t.o utility, and define utility as the benefit or satisfaction
that a person gets from the consumption of goods and services
Total Utility
• The total benefit that a person gets from the consumption of all the different goods
and services is called total utility
• More consumption generally gives more total utility
Marginal Utility
• Marginal utility is the change in total utility that results from a one-unit increase in the
quantity of a good consumed

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Utility-Maximising Choice
• Consumers want to get the most utility possible from their limited resources
• They make the choice that maximises utility
Consumer Equilibrium
• Consumer equilibrium is a situation in which a consumer has allocated all of his or
her available income in the way that maximises his or her total utility, given the prices
of goods and services
Choosing at the Margin
Marginal Utility per Rand
• Marginal utility is the increase in total utility that results from consuming one more
unit of a good
• Marginal utility per rand is the marginal utility from a good that results from spending
one more rand on it
Utility-Maximising Rule
• A consumer’s total utility is maximised by two rules
• Spend all the available income
o More consumption brings more utility, therefore only those choices that exhaust
income can maximise utility

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Utility-Maximising Choice
Equalise the Marginal Utility per Rand
o The basic idea behind this rule is to move rand from good A to good B if doing so
increases the utility from good A by more than it decreases the utility from good
B
o Such a utility-increasing move is possible if the marginal utility per rand from
good A exceeds that from good B
The Power of Marginal Analysis
• If the marginal gain from an action exceeds the marginal loss, take the action

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Predictions of Marginal Utility Theory
Equalise the Marginal Utility per Rand
• You will see that marginal utility theory predicts the law of demand
• To derive these predictions, we will study the effects of three events:
o A fall in the price of a chocolate bar
o A rise in the price of cooldrink
o A rise in income

A Fall in the Price of a Chocolate Bar

Finding the New Quantities of Chocolate Bars and Cooldrink
1. Determine the just-affordable combinations of chocolate bars and cooldrink at the
new prices
2. Calculate the new marginal utilities per rand from the good whose price has changed
3. Determine the quantities of chocolate bars and cooldrink that make their marginal
utilities per rand equal

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Predictions of Marginal Utility Theory
A Change in the Quantity Demanded
• We illustrate a change in the quantity demanded by a movement along a demand
curve
A Change in Demand
• We illustrate a change in demand by a shift of a demand curve

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Predictions of Marginal Utility Theory
A Rise in the Price of Cooldrink
• When the price of cooldrink rises
and the price of a chocolate bar
and Lerato’s income remain the
same, the quantity of cooldrink
demanded by Lerato decreases
• Figure 8.5 shows points on
Lerato’s demand curve for
cooldrink
• It also shows the change in the
quantity of cooldrink demanded
when the price of cooldrink rises
and all other influences on
Lerato’s buying plans remain the
same

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Predictions of Marginal Utility Theory
A Rise in Income

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Predictions of Marginal Utility Theory
The Paradox of Value
• The price of water is low and the price of a diamond is high, but water is essential to
life while diamonds are used mostly for decoration
• How can valuable water be so cheap while a relatively useless diamond is so
expensive?
• This so-called paradox of value has puzzled philosophers for centuries
The Paradox Resolved
• The paradox is resolved by distinguishing between total utility and marginal utility
• The total utility that we get from water is enormous, but remember, the more we
consume of something, the smaller is its marginal utility
• We use so much water that its marginal utility – the benefit we get from one more
glass of water or another 30 seconds in the shower – diminishes to a small value
• Diamonds, on the other hand, have a small total utility relative to water, but because
we buy few diamonds, they have a high marginal utility

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New Ways of Explaining Consumer Choices
Behavioural Economics
• Behavioural economics studies the ways in which limits on the human brain’s ability
to compute and implement rational decisions influences economic behaviour – both
the decisions that people make and the consequences of those decisions for the
way markets work
• People are assumed to have three impediments that prevent rational choice:
bounded rationality, bounded willpower, and bounded self-interest
Bounded Rationality
• Bounded rationality is rationality that is limited by the computing power of the human
brain
• We cannot always work out the rational choice
Bounded Willpower
• Bounded willpower is the less-than-perfect willpower that prevents us from making a
decision that we know, at the time of implementing the decision, we will later regret

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New Ways of Explaining Consumer Choices
Bounded Self-Interest
• Bounded self-interest is the limited self-interest that results in sometimes
suppressing our own interests to help others
The Endowment Effect
• The endowment effect is the tendency for people to value something more highly
simply because they own it
Neuroeconomics
• Neuroeconomics is the study of the activity of the human brain when a person
makes an economic decision
• The discipline uses the observational tools and ideas of neuroscience to obtain a
better understanding of economic decisions

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