DEMAND AND CONSUMER

BEHAVIOUR Utility Theory

and Derivation of Demand
Curves

IN THIS LECTURE, WE SHALL

STUDY
The
Diamond-Water
Paradox
The Utility Theory
The Law of Diminishing
Marginal Utility
Equimarginal Principle
Why
Demand
Curves
Slope Downward?
Analytical Developments
in Utility Theory

DIAMOND-WATER PARADOX
The Paradox of Adam Smith:
Nothing is more useful than water;
but it will scarce purchase anything.
A diamond, on the other hand, has
scarce any value in use; but a very
great quantity of other goods may
frequently be had in exchange for
it. (Smith, 1776)
How can this be explained?
Utility theory provides a solution!

UTILITY THEORY
Utility is a measure of the satisfaction,
happiness, or benefit that results from the
consumption of a good.
A util is an artificial construct used to
measure utility.
Total utility is the total satisfaction a person
receives from consuming a particular
quantity of a good.
Marginal utility is the additional utility a
person receives from consuming an
additional unit of a particular good.
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LAW OF DIMINISHING MARGINAL

UTILITY
The marginal utility gained by consuming
equal successive units of a good will decline
as the amount consumed increases.
The total utility of something can be rising as
the marginal utility of that something is falling.

TOTAL UTILITY, MARGINAL UTILITY, AND THE

LAW OF DIMINISHING MARGINAL UTILITY

Both total utility and marginal utility are

expressed in utils.
Marginal utility is the change in total utility
divided by the change in the quantity
consumed of the good, MU = TU/Q.

TOTAL UTILITY, MARGINAL UTILITY, AND THE

LAW OF DIMINISHING MARGINAL UTILITY

LAW OF DIMINISHING MARGINAL

UTILITY APPLICATION
The law of diminishing marginal utility is
based on the idea that if a good has a variety
of uses but only 1 unit of the good is
available, then the consumer will use the first
unit to satisfy his or her most urgent want.
If 2 units are available, the consumer will use
the second unit to satisfy a less urgent want.

NO INTERPERSONAL UTILITY
COMPARISON
Caution: The utility obtained by one person
cannot be scientifically or objectively
compared with the utility obtained from the
same thing by another person because utility
is subjective.

DIAMOND-WATER PARADOX
RESOLVED
The total utility of water is high because
water is extremely useful.
The total utility of diamonds is low in
comparison because diamonds are not as
useful as water.
The marginal utility of water is low
because water is so plentiful that people
end up consuming it at low marginal utility.
The marginal utility of diamonds is high
because diamonds are so scarce that
people end up consuming them at high
marginal utility.
Do prices reflect total or marginal utility?
Marginal utility.

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THE EQUIMARGINAL PRINCIPLE

The fundamental condition of maximum satisfaction or
utility is the equimarginal principle.
It holds that a consumer gets maximum satisfaction or
utility, when the marginal utility of the last dollar spent on
a good is exactly the same as the marginal utility of the
last dollar spent on any other good.

Why must this condition hold?

Because, the consumer will increase the use of good giving
more MU, until the MUs of all goods are equal. Conversely, if
any good gives less MU, he/she will buy less of it until the MU
of the last Rs spent on it rises back to the common level. 11

THE EQUIMARGINAL PRINCIPLE

Lets take an example to understand this principle: Your family goes to four types of places for eating out in the
evening.
These places are Pizza Hut (PH), Chinese (CH), Pearl
Continental (PC) and Jalil Tikka (JT).
Initially MU/P of each eating place is different; but after
understanding the practical application of the Principle of
Equimarginal Principle, you change your routine as follows:-

Choi
ce

MUPH /PPH

MUCH/PCH

MUPC /PPC

MUJT /PJT

10

7.5

12

TAKE ANOTHER EXAMPLE

You want to make a study schedule after you come to
know your scores in initial quizzes.
You apply the Principle of Equimarginal Principle to
get maximum marginal utility of the time you spend
on your studies.
Study the choices given below; which one would you
prefer.
Choi MUECO /TECO
ce

MUENG/TENG

MUMGT /PMGT

MUMATH
/PMATH

50

60

90

40

60

70

80

50

67

67

67

67

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WHY DEMAND CURVES SLOPE

DOWNWARD?
Hold the common MU per Rs of income
constant; then increase price of good 1
MUgood1/P1 < MUgood2/P2

Consumer reduces the use of good1 as it has

decreased his/her income.
Reduced consumption of good1 will raise its
MU until it again equals MU per Rs spent on
other goods.
A higher price for a good reduces the
consumers desired consumption of that
commodity; this shows why demand curves
slope downward.
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FROM INDIVIDUAL TO MARKET

DEMAND
The demand curve for a good for the
entire market is obtained by summing
up the quantities demanded by all the
consumers.
Each consumer has a demand curve
along which the quantity demanded
can be plotted against the price
It generally slopes downward and to
the right.
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FROM INDIVIDUAL TO MARKET

DEMAND
People differ in their tastes
Some have high incomes, some low.
Some greatly desire coffee; others
prefer tea.
To obtain the total market demand
curve, we calculate the sum total of
what all the different consumers
consume at each price.
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CONSUMER SURPLUS
The gap between the total utility of a
good and its total market value is
called Consumer Surplus.
The surplus arises because, we receive
more than we pay for as a result of
Law of diminishing marginal utility.
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CONSUMER SURPLUS
We pay the same amount for each unit of
commodity that we buy, from the first to the
last.
Thus we pay for each unit what the last unit
is worth.
But, by law of diminishing marginal utility,
the earlier units are worth more to us than
the last; thus we enjoy a surplus of utility on
each of these earlier units.
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CONSUMER SURPLUS IN A
MARKET

We can also apply the concept of

consumer surplus to a market as a whole.

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CONSUMER SURPLUS IN A
MARKET
Because consumers pay the price of
the last unit for all units consumed,
they enjoy a surplus of utility over cost.
Consumer surplus measures the extra
value that consumers receive above
what they pay for a commodity.
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APPLICATION OF CONSUMER
SURPLUS
Economists use the concept of consumer
surplus, when they perform a cost-benefit
analysis.
This concept attempts to determine the costs
and benefits of a government program.
Generally an economist would recommend
that a free road should be built if its total
consumer surplus exceeds its costs.
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APPLICATION OF CONSUMER
SURPLUS
How can the government decide on the
value of building a new highway or of
preserving recreation site?
Suppose a new highway has been
proposed, being free to all, it will bring in
no revenue.
The value to users will be found in time
saved or in safer trips and can be
measured by individual consumer surplus.
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SELF-TEST
1. Allah Ditta purchases two goods, X and Y,
and the utility gained for the last unit
purchased of each is 16 utils and 23 utils,
respectively. The prices of X and Y are $1
and $1.75, respectively. Is Allah Ditta in
consumer
equilibrium?
Explain
your
answer.
Ans: Allah Ditta is not in consumer equilibrium

because the marginal utility per dollar of X

is 16 utils, and the marginal utility per dollar
of Y is 13.14 utils. To be in equilibrium, a
consumer has to receive the same marginal
utility per dollar for each good consumed. 27