Download Economics: Demand and Consumer Behavior Utility Utility: The

Economics: Demand and Consumer Behavior
Utility
Utility: The extent to which goods and services satisfy or are preferred by consumers.
Marginal Utility: The amount of increase in utility per additional unit of a good.
 For example, you have a tub of ice cream.
o For the first scoop, you are really satisfied, giving it high (marginal) utility.
o For the second scoop, you are just satisfied, giving it lower marginal utility.
o For the succeeding scoops, marginal utility continuously decreases until it
reaches zero – or in real-life meaning you’re now sick of eating ice cream.
 From the above example, we can define the Law of Diminishing Marginal
Utility (LDMU), which states that the amount of extra (or marginal) utility
decreases as a person consumes more of a good.
NOTE: While marginal utility decreases as you consume more of a good, total utility, or the total
satisfaction derived from the consumption of a good, increases. However, due to the LDMU, the amount
of increase in total utility decreases for every additional unit of the good consumed.
Illustration:
Quantity Consumed (Q)
0
1
2
3
4
5
Total Utility (U)
0
4
7
9
10
10
Marginal Utility (MU)
-4
3
2
1
0
Utility
NOTE: The total utility at a given
quantity is actually the sum of the
marginal utilities up to that point.
Additionally, the area under the
marginal utility graph’s slope at any
point is equal to the corresponding
height in the total utility graph’s
slope.
Quantity
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Ordinal Utility: A type of utility where the amount of satisfaction derived is irrelevant or
unneeded. Just like in ordinal comparisons, ordinal utility ranks the utility between two
or more goods without specifying how much satisfaction is derived from each good.
Equilibrium and Utility (Maximizing Utility):
 To get the equilibrium between two utilities, we must first assume that people
tend to maximize utility by choosing the most preferable bundle or combination of
available goods.
 To achieve equilibrium, the ratio of the marginal utility and the price of one good
must be equal to that of another good.
MU1 MU 2 MU 3
MU n MU


 ... 

P1
P2
P4
Pn
Y
NOTE: For Income, equilibrium is achieved when the ratio of the marginal utility and the price of a good
is equal to the marginal utility per unit of income.
APPLICATION:
 Let’s say you have two goods A and B.

o
o
If good A gave more marginal utility per Peso, I would naturally consume more of good A
than good B until the LDMU lowers the marginal utility (per Peso) of good A such that it is
equal with that of good B.
Inversely, since good B gives less marginal utility per Peso, I would most probably
consume less of good B until the marginal utility (per Peso) of good B rises until it is the
same as that of good A.
Marginal Utility of Income:
 The common marginal utility per of unit income for all commodities in consumer
equilibrium.
 Simply put, the additional utility gained from consumption for every additional unit
of income. *(Illustrated above as MU/Y)
Relations with the Law of Downward Sloping Demand (LDSD):
 First of all, assume that the marginal utility of income is held constant.
 If we increase the price of a good A, we expect the following to happen:
o
o

If quantity consumed does not change then A will have a lower marginal utility per Peso
as compared to other goods (since MUA is constant while PA increases).
Thus, the consumer will lower consumption of good A to raise its marginal utility until its
marginal utility per Peso is equal to that of other goods.
Therefore, as price increases, consumers tend to reduce consumption of a good
to maintain maximal utility. Thus the downward slope of demand.
o However, exceptions to this rule exist. (i.e. Necessities)
Fun Fact:
The concept of utilities does not apply only to economics but to life as well, one example being
time management. People tend to spend their time in such a way that they maximize the satisfaction
gained per unit of time among the activities they plan to do. Sounds familiar! :>
RECALL…
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For info on the income effect, the substitution effect, substitutes, and
complements, please refer to the handout on Elasticity.
Market Demand: The sum of individual demands at each price.
The Paradox of Demand (the Water-Diamond Paradox):
 Why is water – which is essential to life – so much cheaper than diamonds –
which are virtually useless to human survival?
o
o

Since the supply and demand curves of water have a very low equilibrium price, while
those of diamonds have a very high one.
This is because diamonds are scarce while water is very abundant.
SO WHAT?! (Let’s now apply utility to this example.)
o The marginal utility of water (if we take, for example, the LAST glass of
water) is extremely low, since there is just SO MUCH of it. The first few
glasses may have a high marginal utility, but this quickly decreases with
each succeeding glass.
o On the other hand, since there are so few diamonds in the world, the
marginal utility of the LAST diamond relative to that of the last glass of
water is extremely high, since the amount of diamonds relative to water is
extremely small; thus the water-diamond paradox. <start applause here>
Consumer Surplus:
 The additional utility enjoyed by a consumer over what they pay for a good.
o
o

Example:
o
o

Since price is held constant, we essentially pay the price for the last unit of a particular
good for each unit purchased.
However, due to the LDMU, each preceding quantity of a good has a higher marginal
utility; thus, we derive more satisfaction from a good than what we actually pay for.
Let’s say a person buys a hippo figurine.
While the figurine may cost one Peso, the consumer may be willing to actually pay nine
Pesos for the first figurine. Due to this, the consumer has a surplus of eight Pesos (for
the first purchase), since he spent eight Pesos less than what he was willing to spend for
the (first) hippo figurine.
Graphically, consumer surplus is the area below the demand curve and above
the price line.
APPLICATION:
 For example, the MMDA plans to build another of their brilliant elevated U-turns.
o
o
o
We can say that since it will cost consumers nothing, they each have a surplus of ten
Pesos.
We can also assume that 1,000 people will use it everyday and derive the same amount
of satisfaction from it (and thus have the same consumer surplus).
Therefore, through cost-benefit analysis – which recommends going through with
projects where total consumer surplus exceeds costs – the project should be
implemented if it costs (1,000 x 10 Pesos) 10,000 Pesos or less.
Indifference Curve:
 The graphical representation of all equally desirable combinations of two goods.
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



Represents the combinations of two goods to which the consumer is indifferent.
Its slope represents the measure of the two goods’ relative marginal utilities.
Moving along the indifference curve produces no change in utility derived.
The table of values represented by the indifference curve is the indifference
map.
Law of Substitution:
 The scarcer the good, the greater its relative substitution value.
 The scarcer the good, the higher its marginal utility compared to a good that is
more plentiful.
Budget Line (or Budget Constraint):
 The graphical representation of the possible combinations of two goods one can
consume given a fixed income.
 One can consume any combination of goods below or on the budget line, but
never above it.
Equilibrium Position of Tangency:
 Where the budget line is tangent to the highest indifference curve.
 At this point, the substitution ratio (or the slope of the indifference curve) is equal
to the budget line’s slope.
PA MUA

PB MUB
Changes in Income and Price:
 A lower income shifts the budget line towards the origin (diagonally downwards).
 A higher income shifts the
 budget line away from the origin (diagonally upwards).
 A higher price for good A creates a steeper budget line.
o

The x-intercept moves towards the origin.
A lower price for good A creates a flatter budget line.
o The x-intercept moves away from the origin.
NOTE: The y-intercept remains unchanged in both cases.
CAVEAT: Assume good A
is on the x-axis
Reference:
Economics: 15th Edition by Samuelson and Nordhaus
1. Chapter 5: Demand and Consumer Behavior, pp. 73 – 79 & 82 – 85
2. Appendix 5: Geometrical Analysis of Consumer Equilibrium, pp. 87 – 91
Additional Reading:
Don’t forget to consult Sir Job’s powerpoint! It’s more complete. :-j
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