# Behind The Demand Curve I 1.Marginal utility theory 1.Marginal utility theory assumptions assumptions law of diminishing marginal utility law of diminishing.

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Behind The Demand Curve I 1.Marginal utility theory 1.Marginal utility theory assumptions assumptions law of diminishing marginal utility law of diminishing marginal utility optimal consumption optimal consumption critique critique 2. Uses of utility theory? 2. Uses of utility theory?

Uses (i) Elasticity - determined by preferences. How quickly MU diminishes (i) Elasticity - determined by preferences. How quickly MU diminishes (ii) Efficiency - consumer surplus. Resource allocation (ii) Efficiency - consumer surplus. Resource allocation (iii) Paradox of value - diamonds & water (iii) Paradox of value - diamonds & water

Assumptions Consumers are rational Consumers are rational Ceteris paribus Ceteris paribus Cardinalist approach - utils Cardinalist approach - utils Utility = satisfaction (preferences) Utility = satisfaction (preferences)

Measurement of utility Total utility Total utility … the total satisfaction gained from the consumption of ALL units of a commodity. … the total satisfaction gained from the consumption of ALL units of a commodity. Marginal utility Marginal utility …the extra utility derived from the consumption of one more unit of a good, the consumption of all other goods remaining unchanged. …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 See Figure 1-3 - shape & calculation

fig No. of cream cakes TU in utils 01234560123456 0 7 11 13 14 13 MU in utils - 7 4 2 1 0 Utility (utils) No. of cream cakes consumed (per day) TU Utility from consuming cream cakes (daily)

The Law of Diminishing Marginal Utility Slope of the MU schedule Slope of the MU schedule Definition Definition …as the quantity of a good consumed by an individual increases, the marginal utility of the good will eventually decrease. …as the quantity of a good consumed by an individual increases, the marginal utility of the good will eventually decrease. Marginal analysis Marginal analysis

Optimal consumption - background Consumers have limited income. Choices. No saving Consumers have limited income. Choices. No saving Rational consumer - maximise utility Rational consumer - maximise utility Measurement problem - utils? Measurement problem - utils? Solution: measure utility in money Solution: measure utility in money price prepared to pay price prepared to pay price you actually pay price you actually pay

Optimal consumption - single good Buy one extra unit when Buy one extra unit when MU > Price MU > Price MU (in monetary terms) = marginal benefit MU (in monetary terms) = marginal benefit Price = marginal cost Price = marginal cost Stop when Stop when MU = Price MU = Price

Optimal consumption - consumer surplus(CS) Consumer surplus Consumer surplus Price prepared to pay - price actually paid Price prepared to pay - price actually paid Marginal consumer surplus Marginal consumer surplus MCS = MU - marginal expenditure MCS = MU - marginal expenditure MCS = MU - P MCS = MU - P i.e. the excess of utility over price i.e. the excess of utility over price Buy more when MU > P (MCS positive). Stop MU = P 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 Equals the MU curve as long as consumers maximise CS If price falls: buy more since MU > P or MCS is positive If price falls: buy more since MU > P or MCS is positive movement along demand schedule movement along demand schedule

fig Consumersurplus Marginal utility from petrol a b c MU, P (pence per litre) Q (litres per annum) MU

Optimal consumption - multi-good case Equi-marginal principle Equi-marginal principle MU a \ P a = MU b \ P b = MU c \ P c = … MU n \ P n MU a \ P a = MU b \ P b = MU c \ P c = … MU n \ P n If price of a good changes - reallocate income If price of a good changes - reallocate income If income is fixed If income is fixed …utility is maximised when the utility from the LAST pound spent on ALL goods is equal …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 (i) Elasticity - determined by preferences. How quickly MU diminishes (ii) Efficiency - consumer surplus. Resource allocation (ii) Efficiency - consumer surplus. Resource allocation (iii) Paradox of value - diamonds & water (iii) Paradox of value - diamonds & water

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