Behind The Demand Curve I 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?

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.” “… 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.” “…the extra utility derived from the consumption of one more unit of a good, the consumption of all other goods remaining unchanged.” See Figure shape & calculation

fig Utility from consuming cream cakes (daily) No. of cream cakes TU in utils Utility (utils) No. of cream cakes consumed (per day)

fig Utility from consuming cream cakes (daily) No. of cream cakes TU in utils Utility (utils) No. of cream cakes consumed (per day) TU

fig No. of cream cakes TU in utils MU in utils Utility (utils) No. of cream cakes consumed (per day) TU Utility from consuming cream cakes (daily)

fig MU MU =  TU /  Q = 2/1 = 2 Utility (utils) No. of cream cakes consumed (per day) TU Utility from consuming cream cakes (daily)  TU = 2  Q = 1

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.” “…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 prepared to pay price you actually pay price you actually pay

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

Optimal consumption - consumer surplus(CS) Consumer surplus Price prepared to pay - price actually paid Price prepared to pay - price actually paid 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 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 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 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 …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 (ii) Efficiency - consumer surplus. Resource allocation (iii) Paradox of value - diamonds & water