Unit 7

A Level Economics
The price system and the micro economy
Background to Demand

Marginal Utility Theory

• A good has unitary price elasticity of demand and at price 25 it
sells 100000 units, what would be the price to sell 125000
units
 Utility
• When a consumer consumes a commodity, he derives some
benefits in the form of satisfaction. This benefit or satisfaction
derived by a consumer is known as utility.
• It is the power or capacity of a commodity to satisfy human
wants.
• Utility is a subjective concept because it varies form person-to-
person, place-to-place, and time-to-time.
• For example, alcohol has no utility for non- alcoholic person,
meat as a commodity has no utility for a vegetarian.
 There are two major approaches to analyze
consumer behavior.
• 1. Cardinal Utility Approach
• The cardinal utility analysis was developed by
Classical and Neo-classical economists like H.H.
Gossen, Alfred Marshall.
• This theory assumes that utility obtained from goods
and services is measurable in terms of numbers such
as 1, 2, 3, 4…and so on.
• It also assumes that utility can be measured by an
imaginary unit i.e. utils.
 2. Ordinal Utility Approach
• The economists like W.E Johnson, A. L. Bowley, J.R Hicks, and
R.G.D. Allen developed the concept of ordinal utility analysis.
• This theory assumes that utility obtained from goods and
services is immeasurable. It can only be ranked in the order of
1st, 2nd, 3rd, and 4th and so on.
• Under this concept, consumers are supposed to be rational to
rank utility obtained from different units of a commodity.
 Total Utility (TU)
• Total utility is defined as the aggregate of all utilities, which is derived from
various units of a commodity over a specified period of time.
• When a consumer consumes some units of a commodity, he gets utility from each
unit. Therefore, total utility is the total addition of MU that a consumer derives
from the continuous consumption of units of a commodity.
• It can be expressed as
• TU = Σ(MU from 1st to nth units of a commodity)
• = Σ(MU1 +MU2 + ……………. MUn)

• Where, TU = Total Utility, MU1 = Marginal Utility derived from 1 st unit, MUn =
Marginal Utility derived from n th unit
 Marginal Utility (MU)

• The utility derived from an additional unit of commodity in the process of

continuous consumptions is known as marginal utility.
• It is also defined as the addition made to the total utility by consuming
one more unit of a commodity.
• Symbolically, it can be expressed as:
• MU =change in TU/ change in Q
• Where,
• MU = Marginal Utility
• TU = Total Utility
• Q = unit of commodity consumed
 Average Utility (AU)

• Average utility is per unit utility, which is obtained by dividing

total utility by the number of commodity consumed.
• For example, if the total utility is 100 utils from the
consumption of 5 units of a commodity, average utility is equal
to 20 utils. Mathematically, it is expressed as:
• AU = TU/Q= 100/5 = 20 utils.
 MARGINAL UTILITY THEORY

Assumptions:
We assume that marginal utility of money is constant.
We assume that our consumer is a rational human being and the main
aim is to maximize satisfaction.
 Cont.
• Utility is additive, that is, utility received from the consumption
of a good depends on that good only.
• Each consumer has perfect information about the quality,
quantity, price of the good and other aspects about the
market. The information is perfectly vailable to all consumers.
It is an IDEAL WORLD.
 DIMINISHING MARGINAL UTILITY

• In the following slide we notice that:

• Zero consumption yields zero utility [TU starts at the
origin].
• Then as consumption increases TU Increases but at a
diminishing rate (MU is decreasing but>0).
• Total Utility reaches the maximum level at a certain level
of consumption (MU=0).
• TU begins to decrease later as more units of the good is
consumed (MU<0).
 16 Mr. A’s utility from consuming banana chips (daily)
14
TU

12

10 Packets TU
8 of chips in utils
Utility (utils)

6 0 0
4
1 7
2 11
2
3 13
0 4 14
0 1 2 3 4 5 6
-2 5 14
6 13

Packets of banana chips consumed (per day)

 Mr. A’s utility from consuming chips (daily)
16 TU
14

12
Packets TU MU
of chips in utils in utils
10
Utility (utils)

0 0 -
8 7
1 7
6 2 11 4
3 13 2
4
4 14 1
2 5 14 0
6 13 -1
0
0 1 2 3 4 5 6
-2

Packets of chips (per day)

 DIMINISHING MARGINAL UTILITY

• In the following slide we notice that:

When TU is increasing at a diminishing rate, MU is diminishing

but it is positive.
When TU is its maximum MU = zero.
When TU begins to diminish MU is negative.
 Mr. A’s utility from consuming crisps (daily)
TU
16

14 Packets TU MU
of crisps in utils in utils
12
0 0 -
Utility
(utils)

10
1 7 7
8
2 11 4
6 3 13 2
4 14 1
4
5 14 0
2 6 13 -1
0
0 1 2 3 4 5 6
-2
MU

Packets of crisps consumed (per day)

 Exceptions/Limitations of the law

• 1. Dissimilar units: small and large units of a commodity

• 2. Very small unit: drink water from spoon
• 3. Time interval: morning and afternoon
• 4. Rare collection: stamp collection, coin
• 5. Durable goods: TV, refrigerator, motorbike etc.
• 6. Abnormal person: like drunkards, gamblers, addicts
• 7. Fashion and income:
 Importance of the law
• 1. Basis of some other laws of economics: like law of
demand, law of Equi-marginal utility
• 2. Guideline to the finance minister: tax policy
determination
• 3. Determining market price: considering demand
• 4. To regulate the household expenditures: on the basis of
utility
• 5. Useful to reduce unequal distribution of income and
wealth: using progressive tax system
 The law of equi marginal utility
• This law was propounded by the economist H. H. Gossen. This
is also known as the second law of Gossen , the law of
substitution, law of maximum satisfaction , law of
proportionality rule.
• As we know, our resources are limited to satisfy unlimited
wants, so a consumer always try to get maximum satisfaction
out of his expenditure.
• So the law which explains how to provide equal MU from the
consumption of different goods to get maximum satisfaction is
known as the law of Equi marginal utility.
• This law is based on the substitution of the units of goods
having lesser MU for the goods having higher MU. So the law
is also known as the law of substitution.
• Assumptions
• 1 The budget of the consumer should be fixed during
experiment
• 2 Utility can be measured in numbers by an unit utils.
• 3. MU of different commodities are supposed to be different.
• 4. Consumers should be rational
• 5. Goods are divisible and all units of the commodity should be
homogeneous.
• Consumers can receive maximum satisfaction by applying
proportional rule which indicates that a consumer reaches
equilibrium when weighted MU of selected commodities are
equal with the units of money.
• The following formula helps to get equal marginal utilities from the selected units of commodities.

• MUx/Px = MUy/Py=……..MUn/Pn
• Where ,
• MUx= marginal utility of good X, Px= Price of good X
• MUy= marginal utility of good Y, Py= price of good Y
• MUn= marginal utility of good N, Pn= price of good N,
• MU of money is constant.
• The following example shows the clear knowledge about the law.
• Let us assume that a consumer has $ 19 to spend on two different commodities.
• Say good X and good Y
• Price of these goods are $2 per unit of X and $ 3 per unit of Y
 Marginal utility schedule

units MUx MUy

1 24 18
2 20 15
3 16 12
4 12 9
5 8 6
6 4 3
• The consumer is rational and seeks maximum satisfaction.
• Now the question is how she would spend $19 so that she
derives the maximum satisfaction from certain units of the
selected goods.
• The following table shows the consumption ratios of both
commodities.
 Px= 2 and Py=3

units MUx/ Px MUy/Py

1 24/2=12 18/3=6

2 20/2=10 15/3=5

3 16/2=8 12/3=4

4 12/2=6 9/3=3

5 8/2=4 6/3=2

6 4/2=2 3/3=1
• According to the law , the consumer would get maximum satisfaction, when she
consumes 5 units of good X and 3 units of good Y.
• MUx/Px =MUy/Py
• i.e. 8/2=4=12/3=4
• Spent money: $ 10 on good X to purchase 5 units and $ 9 on good Y to purchase 3 units.
• The total utility she derives from the consumption of these units are given as:
• Tux(5) = 24+20+16+12+8= 80
• TUy(3) = 18+15+12=45
• TUx(5) + TUy (3) = 80+45= 125 utils
• 125 utils are the maximum aggregate satisfaction that the consumer derives from her
given money income.
• Any other combination of both goods will not give her that much
satisfaction.
• For example, if she consumes 6 units of good X and 2 Units of good Y
• She gets,
• Tux (6)= 24+20+16+12+8+4=84
• TUy(2)= 18+15= 33
• TU=84+33= 117
• Thus the first combination is the best combination through which the
consumer is able to maximize her satisfaction from her given money
income because she is able to equalize the ratios of MU.
Figure of Equi marginal concept
 OPTIMUM LEVEL OF CONSUMPTION

we ‘measure’ utility via money [the value that consumers place on

their consumption of the good].
MU becomes the amount of money a consumer is prepared to pay to
obtain one more unit. So for one good Price must be equal to
Marginal Utility ( P = MU ).
In order to establish how much the rational consumer should
consume we use the concept of CONSUMER SURPLUS.
The following table shows the concept of consumer’s
surplus.
Units of a Willing or Price per unit of Consumer's
commodity expected Price the commodity Surplus / MCS(MU–
/Marginal Utility P)

1 12 $ 4 8
2 10 $ 4 6
3 8 $ 4 4
4 6 $ 4 2
5 4 $ 4 0

TU = Total money spent Consumer's

40 = $ 20 Surplus = 20
Equilibrium of a consumer
 Optimum level of consumption [Max. TCS]

MARGINAL CONSUMER SURPLUS [MCS] is the difference between what

a person is willing to pay for one more unit and the price [MCS = MU –
P]. For optimization it must be zero.
TOTAL CONSUMER SURPLUS [TCS] is the sum of MCSs obtained from all
units of the good consumed and it is at the maximum when marginal
consumer surplus is zero.
We reasonably define RATIONAL CONSUMER BEHAVIOUR as behaviour
that maximises TCS. People will go on consuming additional units as
long as they gain additional consumer surplus – as long as MU exceeds
P.
MU, P
Consumer surplus

P1

Total
consumer MU
expenditure

O Q1 Q
MU, P
Consumer surplus

Total
consumer
surplus
P1

Total
consumer MU
expenditure

O Q1 Q
 MARGINAL UTILITY & THE DEMAND CURVE
A person’s demand curve [for a good] will be the same as their
MU curve for that good because the theory behind the law of
demand is diminishing marginal utility.

Since a consumer optimizes his level of satisfaction when P =

MU, the consumer will buy more units of the good only when
price decreases because when he consumes more units of the
good marginal utility decreases.

So a consumer buys more at lower price and vice versa.

 Marginal Utility's Influence on Demand
The level of MU
at various price
points
determines the
quantity of a
good a
consumer is
willing to
purchase.
As MU
decreases, the
consumer's
willingness to
pay for
additional units
decreases,
leading to a
lower quantity
demanded.
MU, P Deriving an individual’s demand curve

Consumption at Q1
a where P1 = MU
P1

MU = D

O Q1 Q
MU, P Deriving an individual person’s demand curve

Consumption at Q2
a where P2 = MU
P1
b
P2

MU = D

O Q1 Q2 Q
MU, P Deriving an individual person’s demand curve

Consumption at Q3
a where P3 = MU
P1
b
P2
c
P3

MU = D

O Q1 Q2 Q3 Q
 Significance of MU Analysis
• It is a basis of some other laws of economics such as law of
demand.
• It is used in marginal decision-making by economic agents.
They equate Marginal Benefit (MU/MB or MR) with marginal
cost (P or MC).
 Significance of MU Analysis
• Progressive taxation system is based on MU principle because
the rich have a lower marginal utility of money in comparison
to the poor.
• Marginal Utility Principle has been to resolve the Diamond-
Water Paradox( by Adam Smith and Carl Manger): The utility
theory assumes that consumers assign lower value to the goods
that yield lower satisfaction/utility. But the consumers assign
lower value to water than diamond, although water yields
higher satisfaction than diamond. This is the paradox of value.
• This paradox of value can be explained by differentiating the concept of total
utility and marginal utility.
• The total utility derived from water is higher than that derived from diamond
as water has multiple uses while diamond has a single use.
• However, the MU derived from water goes on decreasing as its consumption
increases while the MU derived from diamond increases as its stock with a
consumer increases.
• This is because water is abundantly available in nature while diamond is rare.
Due to this reason water is valued less than diamond. This shows that the
consumers assign value to the goods on the basis of the MU derived from
the goods.
 Limitations of MU Analysis
• Same as diminishing MU theory
 Numerical
• An individual reads Magazines and listens Music CD’s. The
following table shows utility he derives from consuming
different quantities of them over a period of time. The price of
Magazines is $1.50 and price of CD’s is $7.50. He has $30 to
spend on both the goods.
 Numerical

Quantity TUm MUm Mum/PM TUcd MUcd Mucd/pcd

1 60 60 360 360
2 111 51 630 270
3 156 45 810 180
4 196 40 945
5 232 1050
6 265 1140
7 295 1215
8 322 1275
9 347 1320
10 371 1350
 Numerical
• Calculate the marginal utility he derives from Magazines and
CD’s?
• What is his utility if he spends his money entirely on CD’s?
• Calculate the ratios of marginal utility to price for each of the
commodities?
• What combination of the two commodities maximize his utility
with given budget?
 Numerical
• A person consumes three goods; A , B and C and derives
utilities through the consumption of certain units of the goods
over a period of time.
• The person has $40 to spend on the goods and prices of the
goods are; Pa=$2, Pb=$4 and Pc=$8 respectively.
• The following table shows the utilities derived:
 Numerical

Quantity Tua Mua Mua/Pa Tub Mub Mub/Pb Tuc Muc Muc/ Muc/
Pc 1 Pc 2
1 9 9 18 18 27 27

2 17 35 17 51

3 24 49 75

4 30 61 99

5 34 69 109

6 36 73 113

7 36 72 110
 Numerical
1. What would be the consumer’s total utility from consumption of
these goods if he bought:
i) 4 units of A+ 2 units of B+ 3 units of C.
ii) 2 units of A+ 7 units of B+ 1 unit of C.
iii) 2 units of A+ 3 units of B+ 3 units of C.
2. Calculate marginal utilities for all goods.
3. Calculate the ratios between MU/P of the
respective goods.
4. Why the purchases in 1 does not optimize the level of satisfaction.
 Numerical
5. Which combinations of goods gives the
consumer the maximum satisfaction.
6. If the price of good C fell to $6 per unit what
would happen to his combination of
purchases?
7. As a result of the fall in price of good C what
has happened to the level of demand for
good C?
 Budget line
• A budget line shows all those combination of two goods that
can be purchased by spending the given money income.
• It explains the budgetary limitation of the consumer to
purchase commodities with the given prices of goods.
• In other words, a consumer’s attempt to maximize satisfaction
is governed by two factors, his money income and the prices of
goods
• For example:
• Income of a consumer= $200
• Price of good X= $10, price of good Y= $ 20
• Combination: A B C D E F
• Good X: 20 16 12 8 4 0
• Good Y: 0 2 4 6 8 10
• It is shown in the figure below:
 Change in budget line
• If a change in price of one good, with income remaining
unchanged, then the budget line will pivot.
• For example: if the price of good X i.e. chicken wings falls, then
more units of this product can be purchased at given level of
income.
• The budget line will shift outward from its initial point as
shown in the following figure.
Change in money income of consumer
Change in prices of both goods
Change in price of one good
• For example:
• Income of a consumer= $200
• Price of good X= $10, price of good Y= $ 20
• Combination: A B C D E F
• Good X: 20 16 12 8 4 0
• Good Y: 0 2 4 6 8 10
• It is shown in the figure below:
 Substitution effect
• As the price of good X has fallen in comparison to good Y
( whose price is unchanged), consumer will substitute good X
for good Y
• This is known as substitution effect of a change in price.
 Income effect
• It is always the case that a rational consumer will substitute
towards the product which has become relatively cheaper.
• With the fall in price of X, the consumer actually has more
money to spend on other products including good X.
• Therefore real income has increased. It means that a consumer
may now actually purchase more units of product X, this is
income effect.