Unit 7

After studying this chapter, you will be able to:

Explain what limits a household’s consumption choices
Describe preferences using the concept of utility and
distinguish between total utility and marginal utility
Explain the marginal utility theory of consumer choice
Use marginal utility theory to predict the effects of
changing prices and incomes
Explain the paradox of value
Themes of this chapter:
1.The Household’s Budget
2.Preferences and Utility
3.Maximising Utility
4.Predictions of Marginal Utility Theory
5.Efficiency, Price and Value (Paradox of Value)
The Household’s Budget
Consumption Possibilities
A household tries to get the most out of a limited income for a given set
of prices. Its consumption choices are constrained by its income and by the
prices of the goods and services it buys. The household has a given amount of
income to spend and cannot influence the prices of the goods and services it
buys.
A household’s budget line describes the limits to its consumption choices. Let’s
consider Lerato’s household. Lerato has an income of R30, and she plans to buy
only two goods: cooldrink and chocolate. The price of a can of cooldrink is R6;
the price of a small bar of chocolate is R3. If Lerato spends all her income, she
will reach the limits to her consumption of cooldrink and chocolate.
Figure 6.1 illustrates Lerato’s possible consumption of cooldrink and chocolate.
Rows A to F in the table show six possible ways of allocating R30 to these two
goods. For example, Lerato can drink 2 cans of cooldrink for R12 and eat 6 bars
of chocolate for R18 (row C). Points A to F on the graph illustrate the
possibilities presented in the table. The line passing through these points is
Lerato’s budget line.
Lerato’s budget line is a constraint
on her choices. It marks the
boundary between what she can
afford and what she cannot afford.
She can afford all the points on the
line and those inside it. She cannot
afford the points outside the line.
Lerato’s consumption
possibilities depend on the price of a
can of cooldrink, the price of a bar
of chocolate, and her income. Her
consumption possibilities change
when the price of a can of cooldrink,
the price of a bar of chocolate, or her
income changes.
The budget line can be described by
the relative price of the two goods
and the consumer’s real income.
Relative Price
A relative price is the price of one good divided by the price of another
good. The price of a can of cooldrink is R6 and the price of a bar of
chocolate is R3, so the relative price of a can of cooldrink in terms of
chocolate is R6 per can of cooldrink divided by R3 per bar of chocolate,
which equals 2 bars of chocolates per can of cooldrink. That is, to buy one
more can of cooldrink, Lerato must give up 2 bars of chocolate. The the
opportunity cost of a can of cooldrink is 2 bars of chocolate.

A Price Change
The relative price of the good measured on the x-axis is the magnitude of the
slope of the budget line. And when a price changes, the relative price
changes, and the slope of the budget line changes. Figure 6.2(a) illustrates
two changes. If the price of a can of cooldrink falls from R6 to R3, Lerato’s
budget line rotates outward and she can afford to consume more of both
goods. If the price of a can of cooldrink rises from R6 to R12, Lerato’s
budget line rotates inward and she cannot afford as much of either good.
Real Income
A household’s real income is the household’s income expressed as the
quantity of goods that the household can afford to buy. Expressed in terms
of chocolate, Lerato’s real income is 10 bars of chocolate. This quantity is
the maximum number of bars that she can buy. It is equal to her money
income, R30, divided by the price of one bar of chocolate, R3.

A Change in Income
If incomes increases, ceteris paribus, the household will buy more.
If prices increase/decrease ceteris paribus the household will buy
less/more.
Real income in terms of chocolate is the point at which the budget line
intersects the y-axis. And when money income changes, real income changes
and the budget line shifts. But the slope of the budget line doesn’t change.
Figure 6.2(b) illustrates two changes in money income. When Lerato’s
money income rises from R30 to R42, her budget line shifts outward and she
can afford to consume more of both goods. When Lerato’s money income
falls to R18, her budget line shifts inward and she cannot afford as much of
either good.
Preferences and Utility
How does Lerato divide her available budget between cooldrink and
chocolate? The answer depends on her likes and dislikes – her
preferences. Economists use the concept of utility to describe
preferences. The benefit or satisfaction that a person gets from the
consumption of a good or service is called utility. Let’s now see how
we can use the concept of utility to describe preferences.
Total Utility
Total utility is the total benefit that a person gets from the consumption of goods
and services. It depends on the level of consumption – more consumption generally
gives more total utility. The units of utility are arbitrary and can be measured. For
example, we’re going to label the utility from no consumption, zero. Then we are
going to label the utility Lerato gets from 1 can of cooldrink a day, 50 units. We
then ask her to tell us, on the same scale, how much she would like 2, 3, and more
cans of cooldrink up to 14 a day. We also ask her to tell us, on the same scale, how
much she would like 1 bar of chocolate a day, 2 bars of chocolate, and more up to
14 bars of chocolate a day.
Table 6.1 shows Lerato’s answers.
Marginal Utility
Marginal utility is the change in utility gained from consuming another unit of a
good.
When the number of bars of chocolate Lerato buys increases from 4 to5 a day, her
total utility from chocolate increases from 181 units to 206 units. So for Lerato, the
marginal utility from consuming the fifth bar of chocolate is 25 units.
The table in Figure 6.3 shows Lerato’s marginal utility from chocolate. Notice that
marginal utility appears midway between the quantities of chocolate. It does so
because it is the change in consumption from 4 to 5 bars of chocolate that produces
the marginal utility of 25 units. The table displays calculations of marginal utility
for each number of bars of chocolate that Lerato buys from 1 to 5.
Figure 6.3(a) illustrates Lerato’s total utility from chocolate. The more chocolate
Lerato eats in a day, the more total utility she gets. Figure 6.3(b) illustrates her
marginal utility. This graph tells us that as Lerato eats more chocolate, her marginal
utility from chocolate decreases. For example, her marginal utility decreases from
75 units from the first bar of chocolate to 42 units from the second bar of chocolate
and to 36 units from the third.
Diminishing Marginal Utility
Increasing consumption of a good leads to diminishing marginal utility.
As the quantity of the good consumed increases, its marginal utility decreases. That is
the principle of diminishing marginal utility.
Marginal utility is positive but diminishes as consumption of a good increases. Why
does marginal utility have these two features? In Lerato’s case, she likes chocolate,
and the more she eats the better. That’s why marginal utility is positive. The benefit
that Lerato gets from the next bar of chocolate consumed is its marginal utility. To
see why marginal utility diminishes, think about the following two situations: In one,
you’ve just been studying all through the day and evening and you’ve been too busy
finishing an assignment to go shopping. A friend drops by with a bar of chocolate.
The utility you get from that chocolate is the marginal utility from one bar of
chocolate.
In the second situation, you’ve been on a chocolate binge (spree). You’ve been
working on an assignment all day but you’ve guzzled (consuming something
greedily) three bars of chocolate while doing so. You are up to your eyeballs in
chocolate. You are happy enough to have one more bar. But the thrill that you get
from it is very small. It is the marginal utility of the fourth bar in a day.
 Maximising Utility
A household’s income and the prices that it faces limit its consumption choices, and the
household’s preferences determine the utility that it can obtain from each consumption
possibility. The key assumption of marginal utility theory is that the household chooses the
consumption possibility that maximises its total utility. This assumption of utility
maximisation is a way of expressing the fundamental economic problem: scarcity. People’s
wants exceed the resources available to satisfy those wants, so they must make difficult
choices. In making choices, they try to get the maximum attainable benefit – that is, to
maximise total utility.
Let’s see how Lerato allocates R30 a day between cooldrink and chocolate to maximise her
total utility. We still assume that cans of cooldrink cost R6 each and chocolate costs R3 per
bar of chocolate.
The most direct way of calculating how Lerato spends her income to maximise her total
utility is by making a table like Table 6.2. The rows of this table show the affordable
combinations of cooldrink and chocolate that lie along Lerato’s budget line in Figure 6.1.
The table records three things: first, the number of cans of cooldrink seen and the total utility
derived from them (the left side of the table); second, the number of bars of chocolate
consumed and the total utility derived from them (the right side of the table); and third, the
total utility derived from both cooldrink and chocolate (the centre column). When Lerato
buys 2 cans of cooldrink and 6 bars of chocolate, she gets 313 units of total utility. This is the
best Lerato can do, given that she has only R30 to spend and given the prices of cans of
cooldrink and bars of chocolate.
From that, we’ve just described Lerato’s consumer equilibrium. A situation
in
which a consumer has allocated all his or her available income in the way that,
given the prices of goods and services, maximises his or her total utility.
Lerato’s consumer equilibrium is 2 cans of cooldrink and 6 bars of chocolate.
In finding Lerato’s consumer equilibrium, we measured her total utility from
all the affordable combinations of cooldrink and chocolate. But there is a
better way of determining her consumer equilibrium.
Equalising Marginal Utility per Rand
A consumer’s total utility is maximised by following the rule:
Spend all the available income and equalise the marginal utility per rand for all
goods.
The marginal utility per rand is the marginal utility from a good divided by its
price. For example, Lerato’s marginal utility from drinking 1 can of cooldrink a
day, MUCo, is 50 units of utility. The price of a can of cooldrink, PCo, is R6, which
means that the marginal utility per rand from 1 can of cooldrink a day, MUCo/PCo, is
50 units divided by R6, or 8,33 units of utility per rand.
You can see why following this rule maximises total utility by thinking about a
situation in which Lerato has spent all her income but the marginal utilities per rand
are not equal.
Suppose that Lerato’s marginal utility per rand for chocolate, MUCh/PCh, exceeds that for
cans of cooldrink. By spending a rand more on chocolate and a rand less on cans of
cooldrink, her total utility from chocolate rises and her total utility from cans of
cooldrink falls. But her utility gain from chocolate exceeds her utility loss from cans of
cooldrink, so her total utility increases. Because she’s consuming more chocolate, her
marginal utility from chocolate has fallen. And because she drinks fewer cans of
cooldrink, her marginal utility from cans of cooldrink has risen. Lerato keeps increasing
her consumption of chocolate and decreasing her consumption of cans of cooldrink until
the two marginal utilities per rand are equal, or when:
Table 6.3 calculates Lerato’s marginal utility per rand for each good
which, like marginal utility, decreases as more of the good is consumed.
Predictions of Marginal Utility Theory
A Fall in the Price of a Can of Cooldrink
As prices fall/rise, the household buys more/less of a good.
A fall in the price of a can of cooldrink, other things remaining the same, changes the
quantity of cans of cooldrink demanded and brings a movement along the demand curve
for cans of cooldrink. We’ve already found one point on Lerato’s demand curve for cans of
cooldrink:
When the price of a can of cooldrink is R6, Lerato drinks 2 cans of cooldrink a month.
Figure 6.5 shows this point on Lerato’s demand curve for cans of cooldrink.
To find another point on her demand curve for cans of cooldrink, we need to work out
what Lerato buys when the price of a can of cooldrink changes. Suppose that the price of a
can of cooldrink falls from R6 to R3 and nothing else changes.
To work out the effect of this change in the price of a can of cooldrink on Lerato’s buying
plans, we must first determine the combinations of cooldrink and chocolate that she can
afford at the new prices. Then we calculate the new marginal utilities per rand. Finally, we
determine the combination that makes the marginal utilities per rand for cooldrink and
chocolate equal.
The rows of Table 6.4 show the combinations of cooldrink and chocolate that exhaust Lerato’s
R30 of income when the price of a can of cooldrink is R3 and the price of a bar of chocolate is
R3. Lerato’s preferences do not change when prices change, so her marginal utility schedule
remains the same as that in Table 6.3. Divide her marginal utility from cans of cooldrink by R3
to get the marginal utility per rand for cans of cooldrink.
A Rise in the Price of Chocolate
Demand curves slope downwards due to diminishing
marginal utility.
A Rise in Income
A rise/fall income will shift the demand curve to the right/left.
In Figure 6.5(b), we know only one point on Lerato’s demand curve for chocolate
when the price of a can of cooldrink is R3. To find Lerato’s demand curve for
chocolate, we must see how she responds to a change in the price of chocolate.
Suppose that the price of chocolate rises from R3 to R6 per bar. The rows of Table 6.5
show the combinations of cooldrink and chocolate that exhaust Lerato’s R30 of
income when the price of a can of cooldrink is R3 and the price of a bar of
chocolate is R6. Again, Lerato’s preferences don’t change when the price changes.
Divide Lerato’s marginal utility from chocolate by R6 to get her marginal utility per
rand for chocolate.
Lerato now eats 2 bars of chocolate a day and drinks 6 cans of cooldrink a day. Lerato
substitutes cans of cooldrink for bars of chocolate. Figure 6.6 shows both of these
effects. In part (a), we’ve found another point on Lerato’s demand curve for
chocolate. And we’ve confirmed that this demand curve obeys the law of demand. In
part (b), we see that a rise in the price of chocolate increases the demand for cans of
cooldrink. The demand curve for cans of cooldrink shifts rightward. This change
again tells us that for Lerato, bars of chocolate and cans of cooldrink are substitutes.
Marginal utility theory predicts these two results:
1. When the price of a good rises, the quantity demanded of that good decreases.
2. If the price of one good rises, the demand for another good that can serve as a
substitute increases.
These predictions of marginal utility theory sound familiar because they
correspond to the assumptions that we made about demand in Chapter 3. There,
we assumed that the demand curve for a good slopes downward and that a rise in
the price of a substitute increases demand.
We have now seen that marginal utility theory predicts how the quantities of
goods and services that people demand respond to price changes.
The theory enables us to derive the consumer’s demand curve and predict how
the demand curve for one good shifts when the price of another good changes.
Let’s suppose that Lerato’s income increases to R42 a day and that the price of a can
of cooldrink is R3 and the price of a bar of chocolate is R3. We saw in Table 6.4 that
with these prices and with an income of R30 a day, Lerato drinks 5 cans of cooldrink
and eats 5 bars of chocolate a day.
We want to compare this choice of cooldrink and chocolate with Lerato’s choice
when her income is R42. Table 6.6 from the textbook shows the calculations needed
to make the comparison. With R42, Lerato can drink 14 cans of cooldrink a day and
buy no chocolate or buy 14 bars of chocolate a day and drink no cooldrink or choose
any combination of the two goods in the rows of the table.
We calculate the marginal utility per rand in exactly the same way as we did before
and find the quantities at which the marginal utility per rand for cans of cooldrink and
the marginal utility per rand for bars of chocolate are equal. When Lerato’s income is
R42, the marginal utility per rand for each good is equal when she drinks 7 cans of
cooldrink and eats 7 bars of chocolate a day.
By comparing this situation with that in Table 6.4, we see that with an additional R12
a day, Lerato buys 2 more bars of chocolate and drinks 2 more cans of cooldrink a
day. Lerato’s response arises from her preferences, as described by her marginal
utilities. Different preferences would produce different quantitative responses. With a
larger income, the consumer always buys more of a normal good and less of an
inferior good. For Lerato, chocolate and cooldrink are normal goods. When her
income increases, Lerato buys more of both goods.
Table 6.7 summarises the key assumptions, implications, and predictions of the
Efficiency, Price and Value (Paradox of Value)
Consumer Efficiency
When Lerato allocates her limited budget to maximise utility, she is using her resources
efficiently. Any other allocation of her budget wastes some resources.
But when Lerato has allocated her limited budget to maximise utility, she is on her
demand curve for each good. A demand curve is a description of the quantity
demanded at each price when utility is maximised. When we studied efficiency in
Chapter 5, we learned that value equals marginal benefit and that a demand curve is
also a willingness-to-pay curve. It tells us a consumer’s marginal benefit – the benefit
from consuming an additional unit of a good. You can now give the idea of marginal
benefit a deeper meaning:
Marginal benefit is the maximum price a consumer is willing to pay for an extra unit of
a good or service when utility is maximised.
Therefore, the demand curve is also a marginal benefit or marginal willingness
to pay curve.
The Paradox of Value
Water is low in price but high in value.
For centuries, philosophers have been puzzled by the above paradox: Water, which is
essential to life itself, costs little, but diamonds, which are useless in comparison to
water, are expensive. Why? Adam Smith tried to solve this paradox. But not until the
theory of marginal utility had been developed could anyone give a satisfactory answer.
You can solve this puzzle 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 – 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. When a
household has maximised its total utility, it has allocated its budget in the way that
makes the marginal utility per rand equal for all goods. That is, the marginal utility
from a good divided by the price of the good is equal for all goods.
This equality of marginal utilities per rand holds true for diamonds and water:
Diamonds have a high price and a high marginal utility. Water has a low price and a
low marginal utility. When the high marginal utility of diamonds is divided by the high
price of a diamond, the result is a number that equals the low marginal utility of water
divided by the low price of water. The marginal utility per rand is the same for
The Paradox of Value
Value and Consumer Surplus
Diamonds are high in price but low in value.
The water-diamond paradox of value is resolved by
understanding the difference between total utility and
marginal utility.