97

UTILITY AND
DEMAND

Outline
Water, Water, Everywhere
A. Why is water, which is so vital to life, far cheaper than diamonds, which are
not essential?
B. Why is the demand for heat and light inelastic while the demand for PCs is
elastic?
C. What determines the quantity demanded when the market price is zero?
I.

Household Consumption Choices

A. Consumption Possibilities
1. A households consumption choices depend on its consumption
possibilities and its preferences.
2. A households consumption possibilities are constrained by its budget
and the prices of the goods and services it buys.
3. Figure 7.1, (page 150) shows a budget line, which separates those
combinations of goods that the household can afford (points below and
on the budget line) from those combinations that it cannot afford
(points above the budget line).

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B. Preferences
1. A households preferences determine the benefits or satisfaction a
person receives consuming a good or service.
2. The benefit or satisfaction from consuming a good or service is called
utility.
C. Total Utility
1. Total utility is the total benefit a person gets from the consumption of
goods. Generally, more consumption gives more utility.
2. Table 7.1 (page 151) provides an example of total utility schedules and
Figure 7.2a (page 152) shows a total utility curve. Total utility increases
with the consumption of a good.

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D. Marginal Utility
1. Marginal utility is the change in total utility that results from a oneunit increase in the quantity of a good consumed.
2. As the quantity consumed of a good increases, the marginal utility from
consuming it decreases.
3. We call this decrease in marginal utility as the quantity of the good
consumed increases the principle of diminishing marginal utility.
4. Figure 7.2b (page 152) illustrates diminishing marginal utility.
5. Utility is similar to temperature. Both are abstract concepts and both
are measured in arbitrary units.
II. Maximizing Utility
A. The key assumption of marginal utility theory is that the household
chooses the consumption possibility that maximizes total utility.
B. The Utility-Maximizing Choice
1. We can find the utility-maximizing choice by looking at the total utility
that arises from each affordable combination.
2. Table 7.2 (page 153) shows an example of the utility-maximizing
combination, which is a consumer equilibrium.

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C. Equalizing Marginal Utility per Dollar Spent

1. Using marginal analysis, a consumers total utility is maximized by
following the rule: Spend all available income and equalize the
marginal utility per dollar spent on all goods.
2. The marginal utility per dollar spent is the marginal utility from a
good divided by its price.
a) That is: the marginal utility per dollar spent on movies is MUM/PM and
the marginal utility per dollar spent on soda is MUS/PS.
3. Table 7.3 and Figure 7.3 (page 154) show why the utility maximizing
rule works.

a) If MUM/PM > MUS/PS, then moving a dollar from soda to movies

increases the total utility from movies by more than it decreases the
total utility from soda, so total utility increases.

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b) Similarly, if MUS/PS > MUM/PM,then moving a dollar from movies to

soda increases the total utility from soda by more than it decreases
the total utility from movies, so total utility increases.
c) Only when MUM/PM = MUS/PS, is it not possible to reallocate the
budget and increase total utility.
III. Predictions of Marginal Utility Theory
A. A Fall in the Price of a Movie
1. When the price of a good falls the quantity demanded of that good
increasesthe demand curve slopes downward.
a) For example, if the price of a movie falls, we know that MUM/PM rises,
so before the consumer changes the quantities consumed, MUM/PM
> MUS/PS.
b) To restore consumer equilibrium (maximum total utility) the
consumer increases the quantity of movies consumed to drive down
the MUM and restore MUM/PM = MUS/PS.
2. Table 7.4 and Figure 7.4 (page 156) illustrate this prediction.

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B. A Rise in the Price of Soda

1. When the price of a good rises the quantity demanded of that good
decreasesthe demand curve slopes downward.
a) For example, if the price of soda rises, we know that MUS/PS falls, so
before the consumer changes the quantities consumed, MUS/PS <
MUM/PM.
b) To restore consumer equilibrium (maximum total utility) the
consumer decreases the quantity of soda consumed to drive up the
MUS and restore MUM/PM = MUS/PS.
2. Table 7.5 and Figure 7.5 (page 157) illustrate this prediction.

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C. A Rise in Income
1. When income increases, the demand for a normal good increases.
2. Table 7.6 (page 158) illustrate this prediction and Table 7.7 (page 158)
summarizes the assumptions and predictions of marginal utility theory.

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D. Individual Demand and Market Demand

1. The market demand for a good is the relationship between the price
of the good and total quantity demanded of that good.
2. The individual demand for a good is the relationship between the price
of the good and the quantity demanded by one person.
3. Figure 7.6 (page 159) shows how we sum the individual demand curves
to obtain the market demand.

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E. Marginal Utility and Elasticity

1. We can predict the price elasticity of demand for a good by knowing the
characteristics of the marginal utility of the good.
2. If as the quantity consumed, marginal utility diminishes rapidly, then a
given price change will bring a small quantity change to restore
consumer equilibrium, and demand will be inelastic.
IV. Efficiency, Price, and Value
A. Consumer Efficiency and Consumer Surplus
1. When consumers maximize their utility, they are using resources
efficiently.
2. And the marginal benefit from a good or service is the maximum price
the consumer is willing to pay for an extra unit of that good or service
when his or her utility is maximized.
B. The Paradox of Value
1. The paradox of value Why is water, which is essential to life, far
cheaper than diamonds, which are not essential? is resolved by
distinguishing between total utility and marginal utility.
2. Figure 7.7 (page 161) illustrates the resolution of the paradox.

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a) The total utility and consumer surplus from water is large but the
marginal utility and price of water is small.
b) In contrast, the total utility and consumer surplus from diamonds is
small but the marginal utility and price of a diamond is large.