Behind The Demand Curve I

1.Marginal utility theory

 assumptions

law of diminishing marginal utility
 optimal consumption
 critique

2. Uses of utility theory?

 Uses

(i) Elasticity - determined by preferences.

How quickly MU diminishes

(ii) Efficiency - consumer surplus.

Resource allocation

(iii) Paradox of value - diamonds & water

 Assumptions

Consumers are rational

Ceteris paribus

Cardinalist approach - utils

Utility = satisfaction (preferences)

 Measurement of utility

Total utility
 “… the total satisfaction gained from the
consumption of ALL units of a commodity.”
Marginal utility
 “…the extra utility derived from the
consumption of one more unit of a good, the
consumption of all other goods remaining
unchanged.”
See Figure 1-3 - shape & calculation
 Utility from consuming cream cakes (daily)
16

14

12

10 No. of cream TU
cakes in utils
8
Utility (utils)

0 0
6 1 7
2 11
4 3 13
4 14
2 5 14
6 13
0
0 1 2 3 4 5 6
-2

No. of cream cakesfigconsumed (per day)

 Utility from consuming cream cakes (daily)
16

14
TU
12

10 No. of cream TU
cakes in utils
8
Utility (utils)

0 0
6 1 7
2 11
4 3 13
4 14
2 5 14
6 13
0
0 1 2 3 4 5 6
-2

No. of cream cakesfigconsumed (per day)

 Utility from consuming cream cakes (daily)
16

14
TU
12
No. of cream TU MU
10
cakes in utils in utils
8
Utility (utils)

0 0 -
1 7 7
6
2 11 4
4
3 13 2
4 14 1
2 5 14 0
6 13 -1
0
0 1 2 3 4 5 6
-2

No. of cream cakesfigconsumed (per day)

 Utility from consuming cream cakes (daily)
16

14
TU
12
∆ TU = 2
10
∆ Q=1
8
Utility (utils)

4
MU = ∆ TU / ∆ Q = 2/1 = 2

0
0 1 2 3 4 5 6
-2

MU
No. of cream cakesfigconsumed (per day)
The Law of Diminishing Marginal Utility

Slope of the MU schedule

Definition
 “…as the quantity of a good consumed by an
individual increases, the marginal utility of the
good will eventually decrease.”

Marginal analysis
 Optimal consumption - background

Consumers have limited income. Choices.

No saving
Rational consumer - maximise utility
Measurement problem - utils?
Solution: measure utility in money
 price prepared to pay

 price you actually pay

 Optimal consumption - single good

Buy one extra unit when


MU > Price
MU (in monetary terms) = marginal benefit
Price = marginal cost

Stop when
 MU = Price
 Optimal consumption - consumer
surplus(CS)

Consumer surplus
 Price prepared to pay - price actually paid
Marginal consumer surplus
 MCS = MU - marginal expenditure
 MCS = MU - P

i.e. the excess of utility over price

Buy more when MU > P (MCS positive).
Stop MU = P
 Derivation of the demand curve

Equals the MU curve as long as

consumers maximise CS

If price falls: buy more since MU > P or

MCS is positive
 movement along demand schedule
 120
Marginal utility from petrol
110

100 a
MU, P (pence per litre)

90 b
Consumer
80 surplus c
70 MU

60

50

40
0 250 500 750 1000

fig
Q (litres per annum)
Optimal consumption - multi-good case

Equi-marginal principle
 MUa \ Pa = MUb \ Pb = MUc \ Pc = … MUn \ Pn
 If price of a good changes - reallocate income

If income is fixed
 …utility is maximised when the utility from the
LAST pound spent on ALL goods is equal
 Uses

(i) Elasticity - determined by preferences.

How quickly MU diminishes

(ii) Efficiency - consumer surplus.

Resource allocation

(iii) Paradox of value - diamonds & water