Course Title: MANAGERIAL ECONOMICS

Module Title: UTILITY ANALYSIS OF CONSUMER DEMAND

Overview:

This module aims to discuss concepts on utility as an economic term. This economic concept
will help you understand more of consumers’ behaviour as to why others remain loyal to a
particular brand, while others shift from one brand to another. The Law of Diminishing Marginal
Utility will help us understand why people are able to consume more units of a commodity while
others consume less. The utility concept is the basic foundation for the understanding of
consumers’ demand

Learning Outcomes:

After successfully accomplishing this module, you will be able to:

1. Relate the importance of utility concept in the understanding of consumers behavior as a

major factor in business decisions
2. Relate the knowledge on DMU and Equi-Marginal Utility through a personal experience.
3. Clearly explain the importance of indifference curve to managerial decisions

Directions for Use:

The topics presented in this module maybe quite technical for you. That is why you need to
read diligently the topics on Utility, Law of Diminishing Marginal Utility, Equi-Marginal Principle,
and Indifference Curve. Should you have concerns in terms of difficulty of understanding some
discussion here, you can send a private message to me anytime through Messenger, or SMS; or, you
can search for it in Google if it suits you.

The last part of this module is the Knowledge Check and Review Questions that you need to
answer. You are going to write your answers on the Answer Sheet provided at the last page. Avoid
erasures and keep the Answer sheet neat and free from creases.

Content

What is Utility?

Utility is a term in economics that refers to the total satisfaction derived from consuimg a
good or service. Economic theories based on rational choice usually assume that consumers will
strive to maximize their utility. Utility of a good is its expected capacity to satisfy a human want. To
a consumer, the utility of a good is the satisfaction which he expects from its consumption. It is the
extent to which it is expected to satisfy his want(s). It is obvious that utility of a good to a consumer
can differ from the satisfaction which he actually derives from its consumption. The fact that utility
of a good is the satisfaction which the consumer expects from its consumption implies that it is a

Module No. 3. MANRECO Summer 2020 Chatty L. Suyom Page 1 of 8

subjective thing. It depends upon the mental assessment of the consumer and is determined by
several factors which influence the consumer’s judgment. These factors include the intensity of the
wants to be satisfied. Utility of a good is varies with the intensity to want to be satisfied by its
consumption.

Why is utility concept important in business?

The economic utility of a good or service is important to understand because it directly

influences the demand, and therefore price, of that good or service. In practice, a consumers’ utility
is impossible to measure and quantify. However, some economists believe that they can indirectly
estimate what is the utility for an economic good or service by employing various models.

Measurement of Utility

The need for measuring utility arises so that it can be used in the analysis of demand
behaviour of individual consumers, and, therefore, of the market as a whole. The basis of the
reasoning is that a consumer compares utility of a good with the price he has to pay for it. He keeps
buying additional units so long as the utility from them is at least equal to the price to be paid for
them.

In economic theory, utility is measured in two ways:

1. Cardinal Utility. In cardinal measurement, utility is expressed in absolute standard units,

such as there being 20 units of utility from the first loaf of bread and 15 units from the
second. The most convenient measure is money: the utility s measured by the monetary
units that the consumer is prepared to pay for another unit of the commodity

2. Ordinal Utility. In contrast, ordinal measurement of utility is the one in which it is not
expressed in absolute units. Utility from 2 or more sources is only “ranked” or “ordered” in
relation to each other. Utility from one source may be equal to, more than, or less than
utility from another source. But it is not possible to state the difference in absolute or
numerical units. For example, I may prefer hot ginger tea over a cup of coffee for breakfast. I
prefer hot ginger tea because it can give me greater health benefits than drinking a cup of
coffee. Thus, my utility derived in drinking hot ginger tea for breakfast is much higher
compared to having a cup of coffee. Satisfaction or utility cannot be measured in absolute
terms because it varies from one person to person making it subjective.

Law of Diminishing Marginal Utility

The law of Diminishing Marginal Utility (LDMU) states that all else equal, as consumption
of a good increases, the marginal utility derived from each additional unit declines. Marginal utility is
derived as the change in utility as an additional unit is consumed. Since utility in economics is used
to represent satisfaction or happiness, marginal utility then is the incremental increase in utility
that results from consumption of one additional unit. This law (LDMU) directly relates to the
concept of diminishing prices. As the utility of a product decreases as its consumption increases,

Module No. 3. MANRECO Summer 2020 Chatty L. Suyom Page 2 of 8

consumers are willing to pay a smaller amount of money for more of the product. For example,
assume you pay P2,000 for a portable speaker. Since you have little value for another portable
speaker, you would be willing to pay only P200 or less for a second speaker. The law of diminishing
marginal utility impacts a company’s pricing because the price charged for an item must
correspond to the consumer’s marginal utility and willingness to consume or utilize the good.

Example of Diminishing Utility

A pizza store sells pizza at P20.00 per slice. You are quite hungry and decides to buy five
slices of pizza. After doing so, you consume the first slice of pizza and gains a certain positive utility
from eating the food. Because you are still hungry, and this is the first food you consumed, the first
slice of pizza has a high utility or brought you have utility or satisfaction. Upon consuming the
second slice of pizza, your appetite becomes satisfied. You were not as hungry as before, so the
second slice of pizza had a smaller benefit and enjoyment as the first. The third slice, as before,
holds even less utility as you are not hungry anymore. In fact the fourth slice of pizza you
experienced a diminished marginal utility as well, as it is difficult to be consumed because the
individual experiences discomfort upon being full from food. Finally, the fifth slice of pizza cannot
even be consumed. You are so full from the first four slices that consuming the last slice of pizza
results in negative utility. The five slices of pizza demonstrate the decreasing utility that is
experienced upon the consumption of any good.

In a business application, a company may benefit from having three accountants on its staff.
However, if there is no need for another accountant, hiring a fourth accountant results in a
diminished utility, as little benefit is gained from the new hire.

Below is a diagram showing the Law of Diminishing Marginal Utility.

Total Utility (TU) is the summation of utilities derived from consuming/using all units or
serving

Module No. 3. MANRECO Summer 2020 Chatty L. Suyom Page 3 of 8

 Average Utility (AU) is the average utility derived by a person from consuming a particular
product or service (Average Utility (AU) = TU/No.of units)

Marginal Utility (MU) is the additional utility or satisfaction/benefit one derives from
consuming an additional unit or serving

Using the cardinal utility approach, we can measure utility. Utils is the term used in
economics to measure utility. Below is a Utility schedule depicting the Total Utility, Average Utility,
and Marginal Utility of Slices of Bread

Slices of Bread (units) Total Utility Average Utility Marginal Utility

1 40 40 40
2 78 39 38
3 113 37.7 35
4 144 36 31
5 170 34 26
6 190 31.7 20
7 203 29 13
8 208 26 5
9 204 22.7 4

To better understand the Law of Diminishing Marginal Utility depicted in the above schedule, we
need to plot it this in a graph.

The Law of Equi-Marginal Utility

The law of Equi-Marginal Utility was propounded by Hermann Heinrich Gossen (1810-
1858). It states that the consumer will distribute his money income between the goods in such a
way that the utility derived from the last centavo spend on each good is equal. In other words, the
consumer is in equilibrium position when marginal utility of money expenditure on each goods is

Module No. 3. MANRECO Summer 2020 Chatty L. Suyom Page 4 of 8

the same. Further, this law points out how a consumer can get maximum satisfaction out of given
expenditure on different goods. Thus, we substitute some units of the commodity of greater utility
or some units of the commodity of less utility. The result of this substitution will be that the
marginal utility of the former will fall and that of the latter will rise, till the two marginal utilities
are equal. That is why this law is also called the Law of Substitution or Law of Maximum
Satisfaction. Suppose apples and oranges are the two commodities to be purchased. Suppose
further that you have seven hundred pesos to spend. You spend 300 pesos on oranges, and four
hundred pesos on apples. What is the result? The utility of the 3 rd unit of orange is 6 and that of the
4th unit of apple is 2. Since the marginal utility of oranges is higher, you should buy more oranges
and less of apples. You substitute one orange for one apple do that you can buy four oranges and
three apples. Now the marginal utility of both oranges and apples is the same, i.e. 4. This
arrangement yields maximum satisfaction. The total utility of 4 oranges would be 10+8+6+4=28
and of three apples 8+6+4=18 which gives us a total utility of 46. The satisfaction given by 4
oranges and 3 apples at one hundred each is greater than what could be obtained by any other
combination of apples and oranges. In no other case does this utility amount to 46. We may take
some other combinations and see.

Units Marginal Utility of Oranges Marginal Utility of Apples

1 10 8
2 8 6
3 6 4
4 4 2
5 2 0
6 0 -2
7 -2 -4
8 -4 -6

We thus come to the conclusion that we obtain maximum satisfaction when we equalize
marginal utilities by substituting some units of the more useful for the less useful commodity.

This is very important in the field of consumption because every consumer wants to get
maximum satisfaction from his limited income or budget. Along with those goods which consumers
are consuming presently, they also keep goods for future consumption, so that they can get equal
utility at both the times.

Indifference Curve

An indifference curve is a graph that shows a combination of two goods that give a
consumer equal satisfaction and utility, thereby making the consumer indifferent. Standard
indifference curve analysis operates on a simple two-dimensional graph. Each axis represents one
type of economic good. Each point on an indifference curve indicates that a consumer is indifferent
between the two and all points give him the same utility. Along the curve, the consumer has no
preference for either combination of goods because both goods provide the same level of utility to
the consumer. It explains the effect of the fall in the price of an inferior good on consumer's

Module No. 3. MANRECO Summer 2020 Chatty L. Suyom Page 5 of 8

demand. For example, a young boy might be indifferent between possessing two comic books and
one toy truck, or four toy trucks and one comic book.

A consumer can create many indifference curves - A higher indifference curve represents a
higher level of satisfaction than a lower indifference curve. In real life , indifference curve analysis
helps to give an account for the explanation of government policies of food stamps , indirect taxes,
subsidies etc. Although indifference curves are based on various assumptions but still they help to
explain them easily. It also aids in understanding human behavior. Indifference curves explain
negotiations, which are complex movements on the indifference curves of at least two individuals.

An indifference map is the graphical representation of two or more indifference curves

showing the several combinations of different quantities of commodities, which consumer
consumes, given his income and the market price of goods and services.

Implications of the LDMU, EMU, and IC in business.

Managers are faced with many alternatives before they make the final decision. The
principles behind the Law of Diminishing Marginal Utility, the Law of Equi-marginal utility, and the
indifference curve dictate managers to weigh identified alternatives out of a given problem. He
needs to choose the best alternative that will result to higher return and benefits to the business.

Module No. 3. MANRECO Summer 2020 Chatty L. Suyom Page 6 of 8

 Module No. 3 ANSWER SHEET

Knowledge Check
1. Compute for the Average Utility and Marginal Utility. Indicate your answer in the Utility
schedule below.
Utility Schedule for Sliced Pineapple

Slices of Pineapple Total Utility Average Utility Marginal Utility

(units)
1 35
2 50
3 85
4 120
5 180
6 230
7 220
8 200
9 190

Review Questions

1. What do you understand by utility analysis of consumer demand? (3 points)

__________________________________________________________________________________________________________
__________________________________________________________________________________________________________
_______________________________________________________________________________________________________
2. Why would it be a need for a manager to understand the concept of indifference curve? (4
points)
__________________________________________________________________________________________________________
__________________________________________________________________________________________________________
__________________________________________________________________________________________________________
______________________________________________________________________________________________________
3. Narrate your understanding on the Law of Diminishing Returns and relate it to your
experience in consuming your favorite food. (8 points)
__________________________________________________________________________________________________________
__________________________________________________________________________________________________________
__________________________________________________________________________________________________________
__________________________________________________________________________________________________________
__________________________________________________________________________________________________________
____________________________________________________________________________________________________

Module No. 3. MANRECO Summer 2020 Chatty L. Suyom Page 7 of 8

Module No. 3. MANRECO Summer 2020 Chatty L. Suyom Page 8 of 8