Chapter 4.1Marginal Utility Theory

P91-101

Chapter 4.1Marginal Utility Theory

P91-101

Demand – AGAIN!Demand – AGAIN!

• We saw earlier that we observed some data We saw earlier that we observed some data on quantities purchased at different prices on quantities purchased at different prices and used these to calculate our demand and used these to calculate our demand curve.curve. P

Q

• Now we want to explore in more detail what Now we want to explore in more detail what drives the demands that people make.drives the demands that people make.

Happiness HappinessHappiness Happiness

• Basically we demand goods because they Basically we demand goods because they make us ‘happy’make us ‘happy’

• Or at least we would be unhappy if we Or at least we would be unhappy if we didn’t have them.didn’t have them.

• Either way we get Either way we get ‘JOLLIES’ ‘JOLLIES’ from themfrom them

• Economists, being boring old farts, have a Economists, being boring old farts, have a special term for Jollies – we call it special term for Jollies – we call it

UTILITYUTILITY

Utility TheoryUtility Theory

• Even Better – we have a theory to explain Even Better – we have a theory to explain behaviour called:behaviour called:

• Utility TheoryUtility Theory

• This theory relies on an important This theory relies on an important foundation. foundation.

• RationalityRationality

• We assume people choose their desired We assume people choose their desired consumption rationally or consistentlyconsumption rationally or consistently

RationalityRationality

• What do we mean by RationalityWhat do we mean by Rationality

• We do We do notnot mean that people are mean that people are fully fully informed or fully consciousinformed or fully conscious about every about every consumption decision they makeconsumption decision they make

• Rather we mean they act (consciously or Rather we mean they act (consciously or otherwise) in a consistent manner.otherwise) in a consistent manner.

TUin utils

Total UtilityTotal Utility

Packetsof crisps

0123456

07

1113141413

Total Utility in

Utils

We imagine that consumers act as if they are trying to

make themselves as happy as possible (broadly defined)

given their circumstances.

In the adjacent table the consumer gets ‘jollies’,

called UTILS from consuming crisps. The

table records his/her total utility.

-2

0

2

4

6

8

10

12

14

16

0 1 2 3 4 5 6

Darren’s utility from consuming crisps (daily)Darren’s utility from consuming crisps (daily)

Packetsof crisps

TUin utils

0123456

07

1113141413

Util

ity (

util

s)

Packets of crisps consumed (per day)

TU

MARGINAL UTILITY THEORYMARGINAL UTILITY THEORY

• Total and marginal utilityTotal and marginal utility

• Marginal Utility:Marginal Utility:

• The The change in Total Utility change in Total Utility as a result of as a result of consuming consuming one more unitone more unit of the good. of the good.

-2

0

2

4

6

8

10

12

14

16

0 1 2 3 4 5 6

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Util

ity (

util

s)

Packets of crisps consumed (per day)

TU

Darren’s utility from consuming crisps (daily)Darren’s utility from consuming crisps (daily)

Q1-Q0 =3-2=1

-2

0

2

4

6

8

10

12

14

16

0 1 2 3 4 5 6

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Util

ity (

util

s)

Packets of crisps consumed (per day)

TU

MU

Graphing Darren’s Marginal utility we get:Graphing Darren’s Marginal utility we get:

-2

0

2

4

6

8

10

12

14

16

0 1 2 3 4 5 6MU

TU = 2

Q = 1

MU = TU / Q = 2/1 = 2

Util

ity (

util

s)

Packets of crisps consumed (per day)

TU

Alternative representation of Darren’s Marginal Alternative representation of Darren’s Marginal utility)utility)

-2

0

2

4

6

8

10

12

14

16

0 1 2 3 4 5 6MU

TU = 2

Q = 1

MU = TU / Q = 2/1 = 2

Util

ity (

util

s)

Packets of crisps consumed (per day)

TU

Alternative representation of Darren’s Marginal Alternative representation of Darren’s Marginal utility)utility)Note this is

effectively measuring the

slope of the curve

-2

0

2

4

6

8

10

12

14

16

0 1 2 3 4 5 6MU

TU = 2

Q = 1

MU = TU / Q = 2/1 = 2

Util

ity (

util

s)

Packets of crisps consumed (per day)

TU

Alternative representation of Darren’s Marginal Alternative representation of Darren’s Marginal utility)utility)

MARGINAL UTILITY THEORYMARGINAL UTILITY THEORY

• Total and marginal utilityTotal and marginal utility

• Marginal Utility:Marginal Utility:

• The The change in Total Utility change in Total Utility as a result of as a result of consuming consuming one more unitone more unit of the good. of the good.

The principle of diminishing marginal utilityThe principle of diminishing marginal utility

Note that the Marginal Utility curve is downward Note that the Marginal Utility curve is downward

– This give us:This give us:

– The principle of diminishing marginal utilityThe principle of diminishing marginal utility

– As more units of a good are consumed, As more units of a good are consumed, additional units will provide us with less additional units will provide us with less additional satisfaction than previous unitsadditional satisfaction than previous units

Now lets look at two goodsNow lets look at two goods

Packetsof crisps

TUin utils

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07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

Looking at the utility from beer compared with crisps do you think Darren should spend all his money on

beer?

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

Suppose that Crisps cost 25p

And Beer cost 1.50 per pint,

How should Darren allocate his income between beer and crisps

Bang per buckBang per buck

Packetsof crisps

TUin utils

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07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

The crucial issue is not how many utils you get from consuming another beers or packet of crisps

But rather the ‘bang per buck’ or utils per pound

Bang per buckBang per buck

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

The crucial issue is not how many utils you get from consuming another beers or packet of crisps

But rather the ‘bang per buck’ or utils per pound

P

MU

Bang per buckBang per buckof Crispsof Crisps

Packetsof crisps

TUin utils

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07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

The crucial issue is not how many utils you get from consuming another beers or packet of crisps

But rather the ‘bang per buck’ or utils per pound

-28

MU/P MU/P

2825.

7

P

MU

Bang per buckBang per buckof Beerof Beer

Packetsof crisps

TUin utils

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07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

The crucial issue is not how many utils you get from consuming another beers or packet of crisps

But rather the ‘bang per buck’ or utils per pound

-28

MU/P MU/P

-46.6

6.465.1

70

P

MU

46.6 v 28 Buy Beer46.6 v 28 Buy Beer

Packetsof crisps

TUin utils

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07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-28

MU/P MU/P

-46.6

Bang per buckBang per buckof 2of 2ndnd Beer Beer

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-28

MU/P MU/P

-46.6

40

405.1

60

P

MU

40 v 28 Buy 240 v 28 Buy 2ndnd Beer Beer

Packetsof crisps

TUin utils

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07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-28

MU/P MU/P

-46.6

40

Bang per buckBang per buckof 3of 3rdrd Beer Beer

Packetsof crisps

TUin utils

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07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-28

MU/P MU/P

-46.6

4033.3

3.335.1

50

P

MU

33.3 v 28 Buy 333.3 v 28 Buy 3rdrd Beer Beer

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-28

MU/P MU/P

-46.6

4033.3

Bang per buckBang per buckof 4of 4thth Beer Beer

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-28

MU/P MU/P

-46.6

4033.324.6

6.245.1

37

P

MU

24.6 v 28 Buy 124.6 v 28 Buy 1stst Crisps Crisps

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-28

MU/P MU/P

-46.6

4033.324.6

Bang per buckBang per buckof 2of 2ndnd Crisps Crisps

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-2816

MU/P MU/P

-46.6

4033.324.6

1625.

4

P

MU

24.6 v 16 Buy 424.6 v 16 Buy 4thth Beer Beer

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-2816

MU/P MU/P

-46.6

4033.324.6

Bang per buckBang per buckof 5of 5thth Beer Beer

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-2816

MU/P MU/P

-46.6

4033.324.6

8

850.1

12

P

MU

8 v 16 Buy 28 v 16 Buy 2ndnd Crisps Crisps

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-2816

MU/P MU/P

-46.6

4033.324.6

2

Bang per buckBang per buckof 3of 3rdrd Crisps Crisps

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-2816

8

MU/P MU/P

-46.6

4033.324.6

2

825.

2

P

MU

8 v 8 8 v 8 So Buy either 3So Buy either 3rd rd Crisps or 5Crisps or 5thth Beer Beer

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217220220

0

MUin utils

-7060503712

0-220

-2816

8

MU/P MU/P

-46.6

4033.324.6

8

Packetsof crisps

TUin utils

0123456

07

1113141413

MUin utils

-74210

-1

Pints of Beer

TUin utils

01234567

070

130180217229220

0

MUin utils

-7060503712

0-220

-2816

840

-4

MU/P MU/P

-46.6

4033.324.6

80

-146.6

Allocation is that we should allocate our spending such that

B

B

c

c

P

MU

P

MU

50.1

128

25.

2

Allocation is that we should allocate our spending such that

E

E

D

D

c

c

B

B

A

A

P

MU

P

MU

P

MU

P

MU

P

MU

Etc,etc

Alternatively we can write the condition for equilibrium as:

B

A

B

A

P

P

MU

MU