Lesson 4

CAPE Unit I Economics Module 1: Demand and Supply

From the syllabus - Topic 2: Theory of Consumer Demand

1. Explain the concept of utility: total, marginal, cardinal (marginalist approach), ordinal (indifference
curve approach).
2. a) Explanation of diminishing marginal utility.
b) The main assumptions and limitations of Marginal Utility Theory.
3. Indifference curves and the budget constraint, (budget lines).
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In the real world, consumers seek to maximise their welfare, subject to the constraints imposed by their income
and the market prices of goods and services. Economists have long been interested in the way that consumers
behave. A good starting point is the notion of utility. This term is used to record the level of happiness or
satisfaction that an individual derives from the consumption of a good. It can therefore be said that a consumer
will only purchase a good or service if it offers him utility, (satisfaction). It is assumed that this satisfaction can
be measured or quantified.
Economists are concerned with
o total utility the overall satisfaction that is derived from the consumption of all units of a good over a
given period of time.
o marginal utility the additional utility derived from the consumption of one more unit of a particular
good.

If the consumer realises a total utility of from consuming units of a commodity, and from
consuming units of the same commodity then the marginal utility derived from consuming the nth
unit is given by the formula below.

The marginal utility gained from the consumption of a product tends to fall as consumption increases. For
example, on a hot day, after a double period of PE, you would probably get a high level of satisfaction from
eating a sno-cone. If you consume a second sno-cone, you will still get some satisfaction, but this is likely to be
less than from the first one. A third sno-cone will yield even less satisfaction. This aspect of consumer
behaviour is referred to as the law of diminishing marginal utility. There may actually come a point, (maybe
by the tenth sno-cone), where you are feeling uncomfortable and bloated, and you no longer experience any

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satisfaction from consuming sno-cones. At this point, marginal utility is negative and indicates dissatisfaction or
disutility.

Total utility generally increases rapidly in the early

stages of consuming a commodity. As more and
more of the commodity is consumed, however, the
total utility curve increases at a decreasing rate,
indicating that the marginal utility from each
successive unit of the commodity falls.

When marginal utility is zero, total utility is at a

maximum.

When marginal utility is negative, total utility

declines.

Economics assumes that consumers have limited incomes, behave in a rational manner and seek to maximise
their total utility.
In a single commodity framework, a rational consumer will continue to demand a commodity up to the point
where the marginal utility derived from the last unit consumed is exactly equal to the price that the consumer
has to pay. If the marginal utility is greater than the price, the consumer can maximise total utility by purchasing
more of the good. A rational consumer would not pay more for a good than its marginal utility, so if the
marginal utility is less than the price, the consumer would purchase less of the good.

In a multi-good framework, the same principle can be applied. A consumer is said to be in equilibrium,
assuming a given level of income, when it is not possible to switch any expenditure from one product to another
in order to increase total utility. This is referred to as the equi-marginal principle, (or condition), and can be
represented by the equation

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 Lesson 4
Where = marginal utility
P= the price
A, B, C and N= individual products
This means that the extra satisfaction per $ on the last unit on good A equals the extra satisfaction per $ on the
last unit of good B etc. If this was not the case, consumers would reorganise their spending and increase their
satisfaction. For example, if the last unit of A per $ spent was more satisfying than the last unit of B consumed,
the consumer would buy more of A and less of B. (They are constrained by income so could not have purchased
more of both.) The marginal utilities would adjust until the condition of equi-marginal utility or consumer
equilibrium is re-attained.

Assumptions of Utility Theory

Rationality - This implies that the consumer aims to maximise their utility within the decision constraints faced.
Cardinal utility It is assumed that utility is measurable and countable. The convention is that utility is equated
with the monetary units that the consumer pays for a commodity.
Constant marginal utility of money If utility is to be measured in monetary terms then this assumption is
critical. The underlying feature of this assumption is the constancy of the unit of measurement.
Diminishing Marginal utility The utility derived from each successive unit of a commodity consumed
falls continually.
The total utility derived from a given basket of goods is equal to the sum of the utilities derived from each
commodity.

Limitations of the Marginal Utility Theory

There are three basic weaknesses of the cardinalist utility theory.
o The concept of cardinal utility does not hold in reality, in that satisfaction cannot be objectively
measured and quantified.
o The assumption of the constant utility of money is also doubtful, especially because as income
increases, the marginal utility of money changes.
o The axiom of diminishing marginal utility has not been developed from hard core scientific evidence
and cannot therefore hold up as an irrefutable economic law.

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Indifference curve analysis is another tool used in economics to explain consumer behaviour in different
market situations. Indifference curve analysis utilises two major tools; the indifference curve and the budget
line.
An indifference curve is a graph showing different bundles of goods or services between which a consumer is
indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another. One
can equivalently refer to each point on the indifference curve as rendering the same level of satisfaction for the
consumer.

On the indifference curve U3,

the points C and D are C
equally desirable.

In the real world, economic agents make trade-offs between the goods they consume. Indifference curve
analysis can help to make these trade-offs clearer. The slope of the indifference curve illustrates that the
consumer will be willing to give up progressively fewer units of Good B for Good A if they wish to remain at
the same level of satisfaction, i.e. on the same indifference curve.
To quantify the amount of Good B that a consumer is willing to give up for Good A, economists calculate the
marginal rate of substitution, (MRS). The MRS of Good A for Good B can be described as the number of units
of Good A sacrificed for one unit of Good B. The MRS is therefore the slope of the indifference curve. It is
clear that the slope of the indifference curve falls continually.

Properties of indifference curves

Indifference curves do not intersect. This is a mathematical impossibility in that it would imply that one
point is characterised by two levels of satisfaction.
Indifference curves slope downwards from left to right. This shows that there is an opportunity cost
involved in increasing the consumption of one commodity as against the other.
The curve is convex to the origin. The convexity of the curve reflects the nature of the opportunity cost,
that is, it is decreasing over the length of the curve.

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The further away the indifference curve is from the origin, the higher the level of satisfaction. In the
diagram above the indifference curve U2 offers more satisfaction than U1 and U3 offers greater
satisfaction than either U2 or U1.
An indifference map is the collection of indifference curves possessed by an individual. See the diagram
below.

We can draw more than one indifference curve

on the same diagram. This family of curves is
called indifference map. We know that the right
side curve yields higher utility and it goes on
increasing as we move further to the right. While
the curve in the left yields lesser utility and it
goes on decreasing as we move towards left.

All consumers are constrained in what they are able to buy because of their income and the prices of the goods
and services that they wish to buy. These two underpinning principles of consumer behaviour are brought
together in the idea of the budget line. This illustrates all the possible combinations of two products that a
consumer can purchase with a given income and fixed prices.

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Summary Exercise

1. The table below shows the utility that Simone gets from the consumption of DVDs and Kindle books.
Simone has $100 per month to spend on DVDs and Kindle books. Both DVDs and Kindle books cost
$20 each.
Quantity Utility from DVDs Utility from Kindle books
0 0 0
1 30 30
2 40 38
3 48 44
4 54 46
5 58 47

a) Define the term marginal utility.

b) Calculate Simones marginal utility for DVDs and for Kindle books.
c) Calculate the marginal utility per dollar of Simones consumption choices.
d) State the optimal number of DVDs and Kindle books for Simones consumption in one month.

2. Use the table below to draw an indifference curve to illustrate the different bundles of clothing and food
that give a consumer equal satisfaction.
Bundle Clothing Food
A 30 1
B 18 2
C 13 3
D 10 4
E 8 5
F 7 6

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3. Rachel has $200 to spend on two products, A and B. The table below shows the possible combinations
that can be purchased. Construct a budget line to illustrate these combinations that can be purchased on
an income of $200.
Quantity of A Quantity of B
($20 each) ($10 each)
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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