A2 Economics Notes

7.1 Utility

Utility

- refers to the subjective satisfaction, pleasure, or value that an individual derives from consuming a good, service, or engaging in an activity.
- It represents the individual's preference or level of desirability associated with the consumption or use of a particular item.
- It is a concept used in economics to understand and analyze consumer behavior and choices.

Total Utility

- Is the overall satisfaction or pleasure that a consumer derives from consuming a certain quantity of a good, service, or activity.
- It represents the cumulative sum of the utility gained from each unit consumed.
- Total utility is determined by summing up the individual utilities derived from each unit consumed.

Marginal Utility

refers to the additional satisfaction or benefit gained by consuming one additional unit of a good, service, or activity.
It measures the change in total utility resulting from the consumption of an extra unit.
Marginal utility generally decreases as more units are consumed due to the principle of diminishing marginal utility.
Marginal utility is calculated by subtracting the total utility of the previous consumption level from the total utility of the current consumption level. (MUn = TUn - TUn-1)

Relationship between total utility and marginal utility

As we consume more
- - Total utility increases at diminishing rate
  - Marginal utility diminishes
When total utility reaches maximum, marginal utility (MU) is zero.
When total utility declines, marginal utility (MU) becomes negative.
Table and chart 7.11 provides an illustration of both total utility and marginal utility for a consumer of ice cream. It is evident from the table that total utility continues to increase; however, the rate of increase starts to diminish after the consumption of the second unit, indicating the onset of diminishing marginal utility.

The law of diminishing marginal utility states that the satisfaction or benefit derived from consuming additional units of a good or service tends to decrease after a certain point.
As individuals consume more of a good or service, their desire or need for each additional unit diminishes, leading to a decrease in marginal utility. It highlights the trade-offs individuals make when allocating their limited resources among different goods and services.
It helps explain consumer behavior, including choices, preferences, and demand patterns.
This law implies that all goods and services have downward-sloping marginal utility curves.
It is the basis for the negatively sloped marginal benefit curve in consumer choices.

Equi-Marginal Principle

Definition

It states that for a consumer to maximize their satisfaction or utility, they should allocate their resources so that the marginal utility per unit of resource spent is equal across all options.
In other words the consumer is in equilibrium position when marginal utility of money spent on each good is same.

Equilibrium of the Consumer - Single Commodity

Single commodity - the consumer is in equilibrium when the marginal utility of good x is equal to price of x.
MUx = Px
If MUx < Px : consumer increases total satisfaction by decreasing consumption of x.
If MUx > Px : consumer increases total satisfaction by increasing consumption of x.

Equilibrium of the Consumer - More than one commodity

the condition for equilibrium of the consumer is the equality of the ratios of the marginal utilities of the individual commodities to their prices.
MUx / Px = MUy / Py
The principle helps individuals make rational decisions by weighing the additional benefit (marginal utility) they gain from consuming or investing in one option compared to another.
If the marginal utility per unit of resource spent is greater for one option compared to others, the individual should allocate more resources towards that option to increase overall satisfaction.
Conversely, if the marginal utility per unit of resource spent is lower for a particular option, the individual should reduce their allocation of resources towards that option.

- Example
  - - A consumer buys just two goods, chips and soda. If at the current level of consumption MUchips/Pchips > MUsoda/Psoda, to maximise total utility the consumer should buy more chips relative to soda. This would cause MUchips to fall (and MUsoda to rise) until MUchips/Pchips = MUsoda/Psoda.

Derivation of an Individual Demand Curve (single commodity)

According to the law of diminishing marginal utility, as the quantity of a good increases for a consumer, the marginal utility (satisfaction) derived from each additional unit decreases.
The consumer will continue purchasing goods until the marginal utility of the goods equals the market price.
The equilibrium point for the consumer is reached when the marginal utility of the goods is equal to its price, maximizing satisfaction.
This condition of equilibrium is known as "marginal utility = price."
When the price of a good falls, the consumer will buy more of it to align the marginal utility with the new lower price.
The law of diminishing marginal utility leads to a downward-sloping demand curve, indicating that as the price of a good decreases, the quantity demanded increases.
The law of demand is directly derived from the law of diminishing marginal utility.
The downward-sloping marginal utility curve is transformed into the downward-sloping demand curve, representing the relationship between price and quantity demanded.
We assume the income is constant.
Example : Figure 7.12 shows as a consumer acquires larger quantities of good x, his marginal utility diminishes. Consequently, at lower price, the quantity demanded of the good x increases.

Limitations of Marginal Utility Theory

Subjectivity - The satisfaction derived from various commodities cannot be measured objectively
Constant marginal utility of money is also not constant. As income increases the marginal utility of money changes. Thus money cannot be used as measuring rod since its own utility changes.
Lack of Real-world Application - The assumptions of rational behavior and consistent decision-making may not hold in real-world situations where individuals may be influenced by emotions, habits, or cognitive biases.
Bandwagon effect - Marginal utility theory assumes that consumer choices are independent of others' actions, overlooking the influence of social interactions, network effects, and externalities on decision-making. For an example, demand for a good by a person who wants to be in style because possession of a good is in fashion and therefore many others have it. This bandwagon effect is the important objective of marketing and advertising strategies of several manufacturing companies.
Limited Scope - The theory focuses on analyzing consumer choices in isolation, neglecting factors such as income inequality, market power, and distributional concerns.

Assumptions of Rational Behavior:

Complete Information - The theory assumes that consumers possess complete information about available choices, prices, and their own preferences, which may not be realistic in many situations.
Consistency: Rational behavior assumes that consumers have consistent preferences and make choices that maximize their utility, disregarding inconsistencies or changing preferences over time.
Self-Interest: The theory assumes that individuals act solely in their own self-interest, neglecting altruistic motives or considerations of societal welfare.
Rationality in Decision-making: Given his income and the market prices of the various commodities, he plans the spending of his income so as to attain the highest possible satisfaction or utility. Rational behavior assumes that individuals carefully evaluate all available options and make optimal choices, while in reality, individuals often rely on heuristics or make decisions based on limited information.