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
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 cakes figconsumed (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

► Buymore when MU > P (MCS positive).

Stop MU = P
 Derivation of the demand curve

► Equalsthe 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