Marginal Utility and the Law of Diminishing Marginal Utility:

How does utility apply to the theory of demand?

 The increment to your utility is called Marginal Utility.

 A century ago economists formulated an important relationship quite analogous to the law of
diminishing returns.

 This law states that the amount of extra or marginal utility declines as a person consumes more and
more of a good.

 Utility tends to increase as you consume more of a good.

 As you consume more and more, your total utility will grow at a slower and slower rate. Growth in
total utility slows because your marginal utility (the extra utility added by the last unit consumed of a
good) diminishes as more of the good is consumed.

 The law of diminishing marginal utility states that, as the amount of a good consumed increases, the
marginal utility of that good tends to diminish.
A Numerical Example:
 Figure shows in column (2) that the total utility (U) enjoyed increases as consumption (Q) grows, but
grows at a decreasing rate. Column (3) measures marginal utility as the extra utility gained when one
extra unit of the good is consumed.

 The fact that marginal utility declines with higher consumption illustrates the law of diminishing
marginal utility.

 Part (a), the gray blocks add up to the total utility at each level of consumption. In addition, the smooth
black curve shows the smoothed utility level for fractional units of consumption. It shows utility
increasing, but at a decreasing rate.

 Part (b) depicts marginal utilities. Each of the gray blocks of marginal utility is the same size as the
corresponding block of total utility in (a). The straight blue line in (b) is the smoothed curve of marginal
utility.

Substitution & Income Effect’s:

Substitution Effect:

The substitution effect says that, when the price of a good rises, consumers will
tend to substitute other goods for the more expensive good in order to achieve desired satisfaction most
cheaply.

Income Effect:

 Income effect signifies the impact of a price change on consumer’s real incomes. When a price rises
and incomes are fixed consumers real incomes fall and they are likely to buy less of almost all goods
(whose prices price has risen).

 To obtain a quantitative measure of the income effect, we examine a good’s income elasticity. This
term denotes the percentage change in quantity demanded divided by the percentage change in
income, holding other things, such as prices, equal high income elasticities, such as are found for air-
line travel or VCRs, indicate that the demand in these goods rises rapidly as income increases. Low
income elasticities, such as for food or cigarettes denote a weak response of demand as income rises.

 Income and substitution effects combine to determine the major characteristics of different
commodities.

 If a commodity, such as salt, requires only a small fraction of the consumer’s budget, is not easily
replacement by other items, and is needed in small amount complement more important items, then
both income and substitution effects are small and demand will tend will tend to be price inelastic.
Demand Shifts:
• Factors other than changes in the price of coffee can change the quantity of item demanded.

• An increase in income tends to increase the amount we are willing to buy of any good. Necessities tend
to be less responsive than most goods to income changes, while luxuries tend to be more responsive to
income. And there are a few abnormal goods, known as inferior goods, for which purchases may shrink
as income increases because people can afford to replace them.

What does all this mean in terms of the demand curve?

• The demand is also affected by the prices of other goods, by consumer income, and by special
influences. The demand curve was drawn on the assumption that these other things were held
constant. But what if they change? Then the whole demand curve will shift to the right or to the left.

• Given people’s incomes and the prices for other goods, we can draw the demand curve for Coffee as
DD. Assume that price and quantity are at point A. Suppose that incomes rise while the price of coffee
is unchanged. Because coffee is a normal good with a positive income elasticity, people will increase
the purchase of coffee. Hence the demand curve of coffee will shift to tight say to D’D’ with A’
indicating the new quantity demand of coffee. If income should fall then we would expect a reduction
in demand and in quantity bought. This download shift will illustrate by D’’D’’ and by A’’.

• Still other factors operate all the time to shift demand.

Consumer Surplus:
• The paradox of value emphasizes that the recorded money value of a good (measured by price x
quantity) may be very misleading as an indicator of the total economic value of that good.

• 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”.

• The previous illustrates the concept of consumer surplus for an individual who consumes water. The
price of water is $1 per gallon. This is shown by the horizontal line at $1 in the diagram. The consumer
considers how many gallon jugs to buy at that price. The first gallon is highly valuable, slaking extreme
thirst, and the consumer is willing to pay $9 for it.—so the consumer has gained a surplus of $8.

• The Consumer equilibrium comes at point E, where 8 gallons of water are bought at a price of $1 each.

• Even though the consumer has paid only $8 the total value of the water is $44. This is obtained by
adding up each of the marginal utility columns (=$9+$8+…..$2) Thus the consumer has gained surplus
of $36 over the amount paid.

• The logic of the individual consumer surplus carries over to the market as a whole. The area of the
market demand curve above the price line, shown as NEB below, represents the total consumer
surplus.
Factors Affecting Demand:

 changes in the prices of substitutes. If the price of a substitute falls, then demand for the good or
service will also fall (or contract, to use the correct terminology).
 changes in the prices of complements. If the price of a complement rises, then the demand for the
good or service will fall (or ''contract'').
 changes in the size and age distribution of the general population. As Australia's population is rapidly
aging (as a result of smaller numbers of children per family), demand for many goods and services
demanded by older people has risen. For example, in the building industry, there has been an increase
in demand for retirement homes, and ''medium density'' housing.
 changes in interest rates and the general availability of credit. Many households finance consumption
through borrowing. If interest rates rise, demand contracts for many goods and services; particularly
housing.
 advertising and changes in fashion can have a market effect on demand. Indeed, producers of goods
that are close substitutes generally spend large amounts on advertising, reminding consumers that
their product is ''better'' than the opposition's product. (Whether or not this is reality true, of course is
another matter).
 seasonal changes. For example, demand for icecreams rises in warmer weather, and falls in the colder
months of the year.
 changes in technology. Firms are constantly attempting to gain greater sales through improvements in
the quality and features of their product. This is seen clearly in the computer market. The introduction
of a new personal computer with a bigger memory chip or a faster operating speed soon results in
prices of older model computers rapidly falling.
 consumer expectations also effect demand. People tend to maintain high levels of consumption when
they feel confident about their continuing employment in the future. If people, for whatever reason,
feel less confident about the future, they tend to decrease consumption and increase saving.
If households believe that inflation will rise in the future, or that government taxes will rise, they will
increase their demand for many goods and services, to ''beat'' the price rise