<7.1 UTILITY>

--7.1.1 TOTAL & MARGINAL UTILITY--

--INTRODUCTION--

Economists have long been interested in the way that consumers behave. Aspects of demand theory were introduced earlier in Chapter 2. For the demand curve, it was assumed that it could be derived from data collected for the demand schedule. Here we shall look behind the demand curve and explore why it really is the case that consumers buy more of a good when its price falls. A relevant starting point is the notion of utility. This idea dates back to the nineteenth century and is a term used to record the level of happiness or satisfaction that someone receives from the consumption of a good. The concept assumes that this satisfaction can be measured in the same way that the actual units consumed can be calculated. Two important measures are:

--TOTAL UTILITY--

TOTAL UTILITY (TU) refers to the overall satisfaction that is derived from the consumption of all units of a good over a given time period.

--MARGINAL UTILITY--

MARGINAL UTILITY (MU) refers to the additional utility derived from the consumption of one more unit of a particular good. So, if someone gets ten units of satisfaction from consuming one bar of chocolate and 15 units aft er consuming two bars, then the marginal utility is five units.

--7.1.2 DIMINISHING MARGINAL UTILITY--

THINK AHEAD

"If your favourite food was completely free, would eating twice as much always make you twice as happy? Why?"

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"Nah, the second time it wouldn't give you as much satisfaction, as you eat more, your level of utility clearly starts to 'diminish', if not you would eat til you exploded."

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"In other words, the marginal utility gained from the consumption of a product tends to fall as consumption increases. This aspect of consumer behaviour is referred to as 'THE LAW OF DIMINISHING MARGINAL UTILITY'. As consumption increases, there may actually come a point where marginal utility is negative, indicating dissatisfaction or disutility.

--TASK--

"Look at the image below showing an individual's TU for the consumption of doughnuts. Derive and plot the MU with 'doughnuts' on the x-axis and 'utils' on the y-axis."

"If he is 'rational' how many will he eat, and why?"

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"That's right! A rational consumer seeks 'utility maximisation', which occurs when no more utils can be attained. You will notice that the 6th unit gives no utility (MU = 0). As such, this consumer will stop at the 5th."

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"REALITY CHECK!!!"

"This example is basically a 'free doughnut-only buffet', so working out how to maximise utility is pretty easy...

"...however, in reality, prices, budgets, and different-priced alternatives exist, making the decision-making process much more complicated."

--7.1.3 EQUI-MARGINAL PRINCIPLE--

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"Now if we imagine you have two goods to choose from, pizza and arcade games, and the MU from the first slice of pizza is 54 utils and only 20 utils for the first arcade game, you should naturally choose the slice of pizza, right?"

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"Wrong! We have not considered the relative prices of both goods, which a rational consumer would do. So if a slice of pizza costs £3 and an arcade game costs only £1, would you still choose it first?" "It is rational to compare goods and make your allocation decisions on a 'MU per £' basis."

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In other words, a consumer should always spend their next £1 on whichever good provides the greatest additional satisfaction per £. Without budgetary restrictions, they will continue reallocating spending until the marginal utility per £ is equal across all goods...

"...and at this point, total utility is maximised, and there is no way to rearrange spending to become better off.

This process is called the EQUI-MARGINAL PRINCIPLE.

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"Let's look at an example!"

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"I should allocate my spending based on the marginal utility per £1. Here is my marginal utility schedule for both goods"

--7.1.4 INDIVIDUAL DEMAND CURVE--

--7.1.4 DERIVATION OF AN INDIVIDUAL DEMAND CURVE--

It is possible to use marginal utility to derive an individual demand curve. Th e fundamental principle of demand is that an increase in the price of a good leads to a reduction in its demand. Using the above principle, this can now be proved. Th e value of the expression
As the price of A RISES, the marginal utility of A per dollar spent will now be LESS than on any other goods. The consumer will therefore increase total utility by spending less on good A and more on all other goods. Tis will in turn reduce the value of their marginal utility.
In other words, the consumer only maximises total utility by buying less of good A. Th e conclusion is that the demand curve for a good is downward sloping.

--7.1.5 LIMITS OF UTILITY THEORY--

--7.1.5 LIMITATIONS OF MARGINAL UTILITY THEORY AND ITS ASSUMPTIONS OF RATIONAL BEHAVIOUR--

Are consumers rational?

Th e law of diminishing marginal utility assumes that

consumers act and behave in a rational way in their

purchasing decisions. Th is is a big assumption to make.

Empirical evidence consistently shows that there are other

factors apart from just utility that determine what we

purchase. To understand the behavioural factors involved

requires ‘getting inside people’s heads’ to determine and

then model such psychological infl uences.

A few examples will show why consumers oft en act in

an irrational way.

■ In the case of special off ers such as ‘buy one get one free’.

Consumers may have no intention of buying the product

until they enter the shop. Seeing the off er produces an

impulsive cognitive response to buy.

■ Where payment can be deferred. This allows consumers to

purchase beyond their ability to pay outright at the time of

sale – they may use a credit card to obtain what they want.

■ Where a consumer is emotionally attached to a brand or

where there is a prejudice against a brand, so influencing

consumption.

Th is type of behaviour cannot be represented in a rational

economic model. Interestingly, if consumers were rational,

fi rms would have little need for marketing. Advertising that

is designed to infl uence consumer choice would appear to

be irrelevant. Behavioural economic models explore why

consumers make irrational decisions, against what might

have been predicted by conventional economic theory.

It is therefore useful to bear these points in mind when

evaluating the eff ectiveness of conventional economic

models like that of utility.

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