7
UTILITY AND
DEMAND
Outline
Water, Water, Everywhere
A. Why is water, which is so vital to life, far cheaper than
diamonds, which are not essential?
B. Why is the demand for heat and light inelastic while the demand
for PCs is elastic?
C. What determines the quantity demanded when the market price is
zero?
I.
Household Consumption Choices
A. Consumption Possibilities
1. A household’s consumption choices depend on its consumption
possibilities and its preferences.
2. A household’s consumption possibilities are constrained by
its budget and the prices of the goods and services it buys.
3. Figure 7.1, (page 150) shows a budget line, which separates
those combinations of goods that the household can afford
(points below and on the budget line) from those combinations
that it cannot afford (points above the budget line).
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B. Preferences
1. A household’s preferences determine the benefits or
satisfaction a person receives consuming a good or service.
2. The benefit or satisfaction from consuming a good or service
is called utility.
C. Total Utility
1. Total utility is the total benefit a person gets from the
consumption of goods. Generally, more consumption gives more
utility.
2. Table 7.1 (page 151) provides an example of total utility
schedules and Figure 7.2a (page 152) shows a total utility
curve. Total utility increases with the consumption of a
good.
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D. Marginal Utility
1. Marginal utility is the change in total utility that results from
a one-unit increase in the quantity of a good consumed.
2. As the quantity consumed of a good increases, the marginal
utility from consuming it decreases.
3. We call this decrease in marginal utility as the quantity of
the good consumed increases the principle of diminishing
marginal utility.
4. Figure 7.2b (page 152) illustrates diminishing marginal
utility.
5. Utility is similar to temperature. Both are abstract concepts
and both are measured in arbitrary units.
II. Maximizing Utility
A. The key assumption of marginal utility theory is that the
household chooses the consumption possibility that maximizes
total utility.
B. The Utility-Maximizing Choice
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1. We can find the utility-maximizing choice by looking at the
total utility that arises from each affordable combination.
2. Table 7.2 (page 153) shows an example of the utilitymaximizing combination, which is a consumer equilibrium.
C. Equalizing Marginal Utility per Dollar Spent
1. Using marginal analysis, a consumer’s total utility is
maximized by following the rule: Spend all available income
and equalize the marginal utility per dollar spent on all
goods.
2. The marginal utility per dollar spent is the marginal utility from a
good divided by its price.
a) That is: the marginal utility per dollar spent on movies
is MUM/PM and the marginal utility per dollar spent on soda
is MUS/PS.
3. Table 7.3 and Figure 7.3 (page 154) show why the utility
maximizing rule works.
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a) If MUM/PM > MUS/PS, then moving a dollar from soda to
movies increases the total utility from movies by more
than it decreases the total utility from soda, so total
utility increases.
b) Similarly, if MUS/PS > MUM/PM,then moving a dollar from
movies to soda increases the total utility from soda by
more than it decreases the total utility from movies, so
total utility increases.
c) Only when MUM/PM = MUS/PS, is it not possible to reallocate
the budget and increase total utility.
III. Predictions of Marginal Utility Theory
A. A Fall in the Price of a Movie
1. When the price of a good falls the quantity demanded of that
good increases—the demand curve slopes downward.
a) For example, if the price of a movie falls, we know that
MUM/PM rises, so before the consumer changes the quantities
consumed, MUM/PM > MUS/PS.
b) To restore consumer equilibrium (maximum total utility)
the consumer increases the quantity of movies consumed to
drive down the MUM and restore MUM/PM = MUS/PS.
2. Table 7.4 and Figure 7.4 (page 156) illustrate this
prediction.
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B. A Rise in the Price of Soda
1. When the price of a good rises the quantity demanded of that
good decreases—the demand curve slopes downward.
a) For example, if the price of soda rises, we know that
MUS/PS falls, so before the consumer changes the quantities
consumed, MUS/PS < MUM/PM.
b) To restore consumer equilibrium (maximum total utility)
the consumer decreases the quantity of soda consumed to
drive up the MUS and restore MUM/PM = MUS/PS.
2. Table 7.5 and Figure 7.5 (page 157) illustrate this
prediction.
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C. A Rise in Income
1. When income increases, the demand for a normal good
increases.
2. Table 7.6 (page 158) illustrate this prediction and Table 7.7
(page 158) summarizes the assumptions and predictions of
marginal utility theory.
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D. Individual Demand and Market Demand
1. The market demand for a good is the relationship between the
price of the good and total quantity demanded of that good.
2. The individual demand for a good is the relationship between
the price of the good and the quantity demanded by one
person.
3. Figure 7.6 (page 159) shows how we sum the individual demand
curves to obtain the market demand.
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E. Marginal Utility and Elasticity
1. We can predict the price elasticity of demand for a good by
knowing the characteristics of the marginal utility of the
good.
2. If as the quantity consumed, marginal utility diminishes
rapidly, then a given price change will bring a small
quantity change to restore consumer equilibrium, and demand
will be inelastic.
IV. Efficiency, Price, and Value
A. Consumer Efficiency and Consumer Surplus
1. When consumers maximize their utility, they are using
resources efficiently.
2. And the marginal benefit from a good or service is the
maximum price the consumer is willing to pay for an extra
unit of that good or service when his or her utility is
maximized.
B. The Paradox of Value
1. The paradox of value “Why is water, which is essential to
life, far cheaper than diamonds, which are not essential?” is
resolved by distinguishing between total utility and marginal
utility.
2. Figure 7.7 (page 161) illustrates the resolution of the
paradox.
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a) The total utility and consumer surplus from water is large
but the marginal utility and price of water is small.
b) In contrast, the total utility and consumer surplus from
diamonds is small but the marginal utility and price of a
diamond is large.