Behind The Demand Curve IBehind The Demand Curve I

►1.Marginal utility theory1.Marginal utility theory assumptionsassumptions law of diminishing marginal utilitylaw of diminishing marginal utility optimal consumptionoptimal consumption critiquecritique

►2. Uses of utility theory?2. Uses of utility theory?

UsesUses

►(i) Elasticity - determined by (i) Elasticity - determined by preferences. How quickly MU diminishespreferences. How quickly MU diminishes

►(ii) Efficiency - consumer surplus. (ii) Efficiency - consumer surplus. Resource allocationResource allocation

►(iii) Paradox of value - diamonds & water(iii) Paradox of value - diamonds & water

AssumptionsAssumptions

►Consumers are rationalConsumers are rational

►Ceteris paribusCeteris paribus

►Cardinalist approach - utilsCardinalist approach - utils

►Utility = satisfaction (preferences)Utility = satisfaction (preferences)

Measurement of utilityMeasurement of utility

►Total utilityTotal utility “… “… the total satisfaction gained from the the total satisfaction gained from the

consumption of ALL units of a consumption of ALL units of a commodity.”commodity.”

►Marginal utilityMarginal utility “…“…the the extraextra utility derived from the utility derived from the

consumption consumption of of one moreone more unit of a good, unit of a good, the consumption of all other goods the consumption of all other goods remaining unchanged.”remaining unchanged.”

►See Figure 1-3 - shape & calculationSee Figure 1-3 - shape & calculation

fig

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No. of creamcakes

TUin utils

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MUin utils

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Util

ity (

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No. of cream cakes consumed (per day)

TU

Utility from consuming cream cakes (daily)Utility from consuming cream cakes (daily)

The Law of Diminishing Marginal The Law of Diminishing Marginal UtilityUtility

►Slope of the MU scheduleSlope of the MU schedule

►DefinitionDefinition “…“…as the quantity of a good consumed as the quantity of a good consumed

by an individual increases, the marginal by an individual increases, the marginal utility of the good will eventually utility of the good will eventually decrease.”decrease.”

►Marginal analysisMarginal analysis

Optimal consumption - Optimal consumption - backgroundbackground

►Consumers have limited income. Consumers have limited income. Choices. No savingChoices. No saving

►Rational consumer - maximise utility Rational consumer - maximise utility ►Measurement problem - utils?Measurement problem - utils?►Solution: measure utility in moneySolution: measure utility in money

price prepared to payprice prepared to pay

price you actually payprice you actually pay

Optimal consumption - single Optimal consumption - single goodgood

►Buy one extra unit whenBuy one extra unit when

MU > PriceMU > Price►MU (in monetary terms) = marginal benefitMU (in monetary terms) = marginal benefit►Price = marginal costPrice = marginal cost

►Stop when Stop when MU = PriceMU = Price

Optimal consumption - consumer Optimal consumption - consumer surplus(CS)surplus(CS)

►Consumer surplusConsumer surplus Price prepared to pay - price actually paidPrice prepared to pay - price actually paid

►Marginal consumer surplusMarginal consumer surplus MCS = MU - marginal expenditureMCS = MU - marginal expenditure MCS = MU - PMCS = MU - P

► i.e. the excess of utility over pricei.e. the excess of utility over price

►Buy more when MU > P (MCS positive). Buy more when MU > P (MCS positive). Stop MU = PStop MU = P

Derivation of the demand curveDerivation of the demand curve

►Equals the MU curve as long as Equals the MU curve as long as consumers maximise CSconsumers maximise CS

► If price falls: buy more since MU > P or If price falls: buy more since MU > P or MCS is positiveMCS is positive movement along demand schedulemovement along demand schedule

fig

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Marginal utility from petrolMarginal utility from petrol

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MU

, P (

pen

ce p

er li

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Q (litres per annum)

MUMU

Optimal consumption - multi-good Optimal consumption - multi-good casecase

►Equi-marginal principleEqui-marginal principle MUMUaa \ P \ Paa = MU = MUbb \ P \ Pbb = MU = MUcc \ P \ Pcc = … MU = … MUnn \ P \ Pnn If price of a good changes - reallocate If price of a good changes - reallocate

incomeincome

► If income is fixedIf income is fixed ……utility is maximised when the utility utility is maximised when the utility

from the LAST pound spent on ALL goods from the LAST pound spent on ALL goods is equalis equal

UsesUses

►(i) Elasticity - determined by (i) Elasticity - determined by preferences. How quickly MU diminishespreferences. How quickly MU diminishes

►(ii) Efficiency - consumer surplus. (ii) Efficiency - consumer surplus. Resource allocationResource allocation

►(iii) Paradox of value - diamonds & water(iii) Paradox of value - diamonds & water