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Summary Varsity College BCOM Year 1 Economics Ch 7
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Economics Ch7Ch 7 – The theory of demand: The utility approach
7.1 Utility
The purpose of consumption is to satisfy wants.
Utility = simple term for consumer satisfaction! It expresses the degree of satisfaction that a
household or consumer derives or expects to derive from the consumption of a good or service.
The purpose of consumer behaviour can thus be restated as the maximisation of utility, given the available
means and alternative composition possibilities.
The utility of a particular good or service is the degree to which it satisfies human wants. However, we cannot
compare one consumer’s level of utility with that of another because they are all different.
CARDINAL AND ORDINAL UTILITY
Cardinal utility = involves the idea that utility can be measured in some way.
Ordinal utility = involves the ranking of different bundles of consumer goods or services in order of preference.
(ordering)
The utility approach to the analysis of consumer behaviour is based on the assumption that a consumer can
assign values to the amount of satisfaction (utility) that they gain from the consumption of each successive unit
of a consumer g/s.
the utility approach = based on the notion of cardinal utility.
The indifference approach = employs the notion of ordinal utility, which requires consumers to rank only
different bundles of goods or services in order of preference
FURTHER KEY ASSUMPTIONS
The notion of an individual who consistently act rationally in their own interest = economic man (Homo
economicus).
7.2 Marginal utility and total utility
The utility approach to the analysis of consumer behaviour is based on the assumption that an individual
consumer can and does subjectively assign units of value to the utility derived from the consumption of
successive units of a product. To distinguish these units from other units of measurement (such as metres,
litres and rand) we call them utils.
Example – I buy apples, the first apple I consume gives No. of apples Marginal utility Total utility
consumed (utils) (utils)
me a utility of 50 utils. After I eat the apple, my want for
1 50 50
the apple decreases and the second apple I buy has a
utility of 35 utils. 2 35 85
3 29 114
The extra/additional utility that a consumer derives from
4 18 132
the consumption of one additional unit of a good is called
marginal utility. 5 12 144
Total utility is the sum all of the marginal utilities. You calculate total utility by adding 35 to 50 to get 85.
The example shows that if identical / homogeneous units of a good are consumed one after the other, the
marginal utility will decrease until it becomes 0. After it reaches 0 it will become a negative, negativity is
usually called disutility. Total utility increases as long as marginal utility is positive. It reaches
maximum when marginal utility is zero and then decreases when marginal utility becomes negative.
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, Economics Ch7
Law of diminishing marginal utility / Gossen’s first law = the marginal utility if a good / service
eventually declines as more of it is consumed during any given period.
TOTAL, AVERAGE AND MARGINAL MAGNITUDES
Example 1: Sam Sibanda, has to submit ten assignments during the year that count 100 marks. For the 1 st
assignment he got 70 marks. For the 2nd, he got 50. This addition to his total marks now becomes his marginal
mark, which is now 50. His total marks at this stage are 70 plus 50, that is, 120. His average mark is now 120
divided by 2, that is, 60. His average mark has fallen bc his marginal mark (50) is lower than his previous
average (70). When the marginal value is lower than the previous average value, the average value falls.
For the third assignment he receives 60 marks. This extra or additional mark now becomes his marginal mark.
His total marks at this stage are 180 (ie 70 + 50 + 60). His average mark is 180 divided by 3, that is, 60. His
average mark remains unchanged. When the marginal value is equal to the previous average value, the
average value remains unchanged.
For the fourth assignment he is awarded 80 marks. His marginal mark is thus 80 and his total marks increase to
260 (ie 70 + 50 + 60 + 80). His average mark is 260 divided by 4, that is, 65. His average mark has increased.
Why? Because his marginal mark is higher than his previous average mark. When the marginal value is greater
than the previous average value, the average value increases.
Sam's performance in the remaining six assignments and the corresponding total, marginal and average values
are summarised in the following table. Work through the table and note how the three rules referred to above
always hold.
TOTAL AND MARGINAL VALUES
When a total magnitude is rising, the corresponding When a marginal magnitude is positive, the
margining magnitude is positive. corresponding total magnitude is rising.
When a total magnitude is falling, the When a total magnitude is negative, the
corresponding marginal magnitude is negative. corresponding marginal magnitude is falling.
When a total magnitude reaches maximum or a When marginal magnitude is zero, the
minimum, the corresponding marginal corresponding total magnitude remains
magnitude is zero unchanged.
MARGINAL AND AVERAGE VALUES
When the marginal magnitude is lower than the When the average magnitude is falling, the marginal
average magnitude, the average magnitude falls. magnitude must lie below it.
When the marginal magnitude is higher than the When the average magnitude is rising, the marginal
average magnitude, the average magnitude magnitude must lie above it.
increases.
When the marginal value is equal to the average When the average magnitude is neither rising nor
value, the average value remains unchanged. falling the marginal magnitude must be equal to it.
A MATHEMATICAL INTERPRETATION
A marginal function is the 1st derivative of the corresponding total function.
A marginal function is given by the slop of the corresponding total function.
An average function is given by the slope of a line from the origin to the total function.
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