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Unit 2.1: Demand Theory
- Institution
- CIE
Unit 2.1 - Marginal Utility Analysis - Indifference Curve Analysis
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Unit 2.1: Demand TheoryIntroduction
The demand theory explain why do people people buy more when the price falls.
They developed 2 demand theories:
o Law of Diminishing Marginal Utility
o Indifference Curve Analysis
The Law of Diminishing Marginal Utility
Utility: the satisfaction received from consumption
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 additionally utility derived from the consumption of one more unit of
the good or service
Law of diminishing marginal utility: MU gained from consumption of a product ↓ as
consumption ↑.
Utility maximisation: MU form the last unit is zero.
Marginal unity is the cardinal approach
o Suggest that satisfaction derived from consuming good can be quantified;
supported by numerical value
Why demand curve is downward sloping:
o As an extra unit of good/ service is consumed, MU ↓
o So less value derived
o Hence, a rational consumer is prepared to pay lesser for the extra unit as MU ↓
The assumptions in Law of Diminishing Marginal Utility
1. Consumers behave in rational manner
2. Consumers seek to maximise their total utility
3. Consumer have limited income
4. Satisfaction can express quantitatively, using utils. A ‘score’ is given to each additional unit
consumed.
5. The consumption of goods must be continuous.
6. Each unit of goods are identical in size, taste and shape.
Consumer Equilibrium
In the real world, a consumer may purchase more then one commodity.
The law of equi-marginal utility tells us the way how a consumer maximises his total utility.
Given that consumer is rational & wants to maximise satisfaction, they will consumer a
combination of good where the principle of equi-marginal returns is satisfied:
,
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