Behind The Demand Curve I

1
Behind The Demand Curve I

• 1.Marginal utility theory
• assumptions
• law of diminishing marginal utility
• optimal consumption
• critique
• 2. Uses of utility theory?

2
Uses

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

3
Assumptions

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

4
Measurement of utility

• Total utility
• 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.
• See Figure 1-3 - shape calculation

5
Utility from consuming cream cakes (daily)
No. of cream cakes
TU in utils
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
No. of cream cakes consumed (per day)
6
Utility from consuming cream cakes (daily)
TU
No. of cream cakes
TU in utils
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
No. of cream cakes consumed (per day)
7
Utility from consuming cream cakes (daily)
TU
No. of cream cakes
TU in utils
MU in utils
- 7 4 2 1 0 -1
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
No. of cream cakes consumed (per day)
8
Utility from consuming cream cakes (daily)
TU
DTU 2
DQ 1
Utility (utils)
MU DTU / DQ 2/1 2
MU
No. of cream cakes consumed (per day)
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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.
• Marginal analysis

10
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 you actually pay

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Optimal consumption - single good

• Buy one extra unit when
• MU gt Price
• MU (in monetary terms) marginal benefit
• Price marginal cost
• Stop when
• MU Price

12
Optimal consumption - consumer surplus(CS)

• Consumer surplus
• Price prepared to pay - price actually paid
• Marginal consumer surplus
• MCS MU - marginal expenditure
• MCS MU - P
• i.e. the excess of utility over price
• Buy more when MU gt P (MCS positive). Stop MU P

13
Derivation of the demand curve

• Equals the MU curve as long as consumers maximise
  CS
• If price falls buy more since MU gt P or MCS is
  positive
• movement along demand schedule

14
Marginal utility from petrol
MU
MU, P (pence per litre)
Q (litres per annum)
15
Optimal consumption - multi-good case

• Equi-marginal principle
• MUa \ Pa MUb \ Pb MUc \ Pc MUn \ Pn
• 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

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Uses

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