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Utility and Diminishing Marginal Utility

Utility measures the satisfaction derived from consuming goods, with the law of diminishing marginal utility indicating that additional consumption leads to decreased satisfaction. The equi-marginal principle states that consumers achieve maximum utility when the marginal utility per dollar spent is equal across all products. Limitations of this theory include assumptions about consumer rationality and the ability to rank preferences, which may not hold true in real-world scenarios.

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Tejasvin Janikaramudu
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39 views4 pages

Utility and Diminishing Marginal Utility

Utility measures the satisfaction derived from consuming goods, with the law of diminishing marginal utility indicating that additional consumption leads to decreased satisfaction. The equi-marginal principle states that consumers achieve maximum utility when the marginal utility per dollar spent is equal across all products. Limitations of this theory include assumptions about consumer rationality and the ability to rank preferences, which may not hold true in real-world scenarios.

Uploaded by

Tejasvin Janikaramudu
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Utility and Diminishing marginal utility

• Utility is a measure of the level of happiness or satisfaction that someone receives from the
consumption of a good.
• Utility assumes that satisfaction can be measured in units, in the same way that the actual
goods consumed can be determined.
• Suppose you were hungry and wanted a slice of pizza. How much would you pay for it?
Let us say you paid $2 for one slice. If you were still hungry, how much would you pay for
a second slice of pizza? You might be willing to pay slightly less than you paid for the first
slice, perhaps $1.50.
• If you wanted a third slice, you might be prepared to pay less still, perhaps $1.25. This is
because the satisfaction or utility you derived from consuming a further piece of pizza has
decreased as your consumption increases. The reduced amount you have paid for each
successive piece of pizza is indicative of the reduced satisfaction you have received from
consumption. This is an example of the principle or law of diminishing marginal utility
where marginal utility is the additional utility that is derived from the consumption
of one more unit of a good. The law of diminishing marginal utility suggests that as
consumption of a good increases, the marginal utility will get smaller.
• According to the law of diminishing marginal utility, when someone consumes successive
unit od a good, his marginal utility will eventually fall.
Two important measures of satisfaction are:
• total utility - the overall satisfaction that is derived from the consumption of all units of a
good over a given time period.
• marginal utility - 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 piece
of pizza and 15 units after consuming two pieces of pizza, then the marginal utility is five
units.
• The law of diminishing marginal utility can also be applied to a situation where a consumer
sees an item on sale at a price less than expected. The consumer is likely to buy the item.
By contrast, if an item is priced at more than the expected price, a consumer will be unlikely
to buy the item at this time. Both consumers are linking the item's utility with the actual
price at the point of sale.
Let’s consider an example,
Units of a Total Marginal
commodity Utility(TU) Utility(MU)
consumed

1 3 -
2 4 1
3 6 2
4 9 3
5 11 2
6 12 1
7 12 0
8 11 -1
Total Utility

Marginal Utility

1) From 0 to Q units of a commodity consumed, the consumer’s TU increases at an


increasing rate and his MU rises.

2) From Q to Q1 units of the goods consumed, TU rises at a diminishing rate and MU falls
but it is still positive.

3) At point a, TU is maximum, and MU is zero.

4) Beyond Q units of the good consumed, TU falls and MU becomes negative.

5) cb: Diminishing Marginal Utility(DMU): Demand curve(It is downward sloping, and it


can be explained by the DMU)
The equi-marginal principle
• A consumer is said to be in equilibrium when it is not possible to switch any expenditure
from, for example, product A to product B to increase total utility. This is referred to as
the equi-marginal principle. If the marginal utility from consuming product A is ten
units and the price is $5, the consumer is in equilibrium when consuming 20 units of
product B if its price is $10 and so on.
• equi-marginal principle refers to a situation where consumers maximise their utility
where their marginal valuation for each product consumed is the same.
MUA = MUB = MUC ...... = MU N
PA PB PC PN
where MU = marginal utility
P = the price
A, B, C and N = different products
• Where the equi-marginal principle applies, it is not possible to increase total utility by
reallocating expenditure between any of the products that are available. A consumer has
therefore allocated income in a way that has maximised utility, resulting in consumer
equilibrium.
• Consumer equilibrium simply means the point of consumption when an individual
consumer enjoys the highest level of satisfaction.
• It should be recognised that the equi-marginal principle is based on the following
assumptions:
1. consumers have limited incomes
2. consumers will always behave in a rational manner
3. consumers seek to maximise their utility.
• The idea of consumer equilibrium is shown in Table 1 below.
• Two products, x and y, are priced at $1 and $2 respectively. It is assumed that a
consumer has $10 to spend. Consumer equilibrium is where the MU/P is the same for
each product. This is where 4x and 3y are consumed with a total utility score of 235.
No other combination of goods generates a higher total utility; therefore, any other
combination would provide less satisfaction.
Product x Product y
($1 each) ($2 each)

MU MU/P Quantity MU MU/P


60 60 1 42 21
40 40 2 32 16
25 25 3 24 12
12 12 4 18 9
5 5 5 14 7
2 2 6 12 6
Table 1:consumer equilibrium
Derivation of an individual demand curve
• Marginal utility can be used to explain how an individual's demand curve is derived.
• Look again at Table 1. Assume the price of y is now reduced to $1; the price of x and
the income remain unchanged.
• MU/P can now be calculated again for product y. This gives a new consumer
equilibrium of 4x and 6y, a gain of 3y. Total utility has increased.
• Part of the demand curve is shown in Figure 1 below.

Figure 1: Derived individual demand curve for product y

Limitations of marginal utility theory and assumptions of rational behaviour


• Marginal utility theory assumes that consumers are capable of putting their wants in
rank order and assigning a value to the satisfaction gained from their consumption. This
is a major assumption to make. The law of diminishing marginal utility further assumes
that consumers act and behave in a rational way in their purchasing decisions.
• This is another major assumption. Empirical or real world evidence consistently shows
that there are other factors apart from utility that determine what we purchase. To
understand the behavioural factors involved requires being aware of what people are
thinking to determine and then model these psychological influences.

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