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Summary of the price system and the theory of the firm
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Unit 7 The price system and the microeconomyUtility and marginal utility
Utility is used to record the level of happiness or satisfaction that someone receives
from the consumption of a good.
Utility: The satisfaction received from consumption.
Total utility: The total satisfaction received from consumption.
Marginal utility: The utility derived from the consumption of one more unit of the
good or service.
The marginal utility gained from consumption of a product tends to fall as
consumption increases. For example, when you consume one ice cream you enjoy it
a lot, and when you get another you are still likely to like it but not as much.
Diminishing marginal utility: The fall in marginal utility as consumption increases.
In considering the consumer’s equilibrium, it is necessary to remember that it is
assumed that consumers have limited incomes, act in a rational way and always
seek the maximum total utility from their consumption.
Equimarginal principle: Consumers maximise their utility where their marginal
valuation for each product consumed is the same.
This can be represented as MUa/Pa = MUb/Pb where MU = marginal utility, P is the
price and A and B are different products.
It is possible to use marginal utility to derive an individual demand curve as MUa/Pa
would decrease because price increases. Therefore the marginal utility of A per
dollar will be less compared to other products making consumers spend that money
on other products and in turn reduces the marginal utility of A. In conclusion, the
demand curve for good is downward sloping.
Are consumers rational?
The law of diminishing marginal utility assumes that consumers act and behave in a
rational way in their purchasing decisions. However, consumers do not always act
rationally, for a number of reasons:
, ● Special offers: Such as ‘buy one get one free’. Consumers may have no
intention of buying the product until they enter the shop. Seeing the offer
produces an impulsive cognitive response to buy.
● Availability of deferred payment: This allows people to pay outright at the
time of sale - they may use a credit card.
● Brand loyalty/prejudice: This could be because of personal taste or
connection to the seller, and it influences consumption.
If consumers were rational there would be little need for marketing. It is useful to
bear these points in mind when evaluating the effectiveness of conventional
economic models like that of utility.
Budget lines
Budget line: The combinations of two products obtainable with given incomes and
prices.
Quantity of A ($20 each) Quantity of B ($10)
10 0
9 2
8 4
7 6
6 8
5 10
4 12
3 14
2 16
1 18
0 20
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