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Utility Approach
Utility Approach
Utility Approach
MICRO ECONOMICS
UNIT 2
UTILITY
CLAIRE HELSBY
TASK 2.1
Read the case study below and answer the questions to follow:
QUIRKONOMICS
Wednesday, May 23, 2007
Diminishing Marginal Utility, Beer and the Internet.
Every self respecting student of economics knows at least a little smidgen about
marginal utility...
When we 'consume' a good or service we 'gain' something by doing so. This is
expressed as our 'utility' gained from that very act of consumption. Now diminishing
marginal utility is an interesting concept related to this. An individual's utility from
consumption alters with the amount of a good that he or she consumes.
Being a student, I'll relate it in a particularly topical manner - Beers.
I drink one beer, and in doing so gain a certain satisfaction from it, the utility of
consuming one beer is relatively high. Personally I'd probably quite enjoy another one
and so I grab the attention of the barkeep and get myself another frosty one.
This one seems to go down particularly well and I experience a bigger utility from the
second beer than that of the first. This cycle of a growing utility (- in this case
quantified by how much I enjoyed the last beer and therefore how likely I am to order
another) probably lasts up until around my fifth beer.
When Shakespeare penned the quote "one can have too much of a good thing" in As
you like it; he probably had a whopping 16th century hangover.
Shakespeare can not begin to conceive how right he was. By this point the utility
gained by consuming additional beers begins to reduce. Judgment becomes impaired
and although I probably feel great I'm already well on the downward path to a
hangover 5 centuries since Shakespeare first warned me. Any additional beers after 7
or 8 will give me very little utility at all. I'm sure whilst being completely trolleyed
and being sick is generally quite funny in the right company, it's not pleasant upon
reflection with a clear (non ale-bathed) mind. This is essentially the theory of
diminishing marginal utility in all its glory. The more I drink the less I gain from
doing so.
It appears thus, due to the vast scale and information within the net, the resource ( - or
good if you like.) is simply too valuable to consumers that quantity consumed has no
reduction in utility. This means our old pal Shakespeare has a flaw, there's an
exception to his insightful judgment and I call for a footnote in every English
literature students copy of "As you like it."
- "One can have too much of a good thing" - where 'good thing' does not = the
internet. Self proclaimed internet geeks can now relax, it's not their fault they sit at
computers for endless hours on end. The marginal utility of doing so simply never
declines enough to warrant stopping, it appears the only limiting factors are the 24
hour day and the fact we need to sleep at some point......
2.1.1 Utility
Utility is a term for consumer satisfaction. More specifically utility is: the degree of
satisfaction that a household or consumer derives or expects to derive from the
consumption of a good or service.1
The purpose of consumer behaviour can thus be restated as the maximisation of utility,
given the available means and alternative consumption possibilities.
Characteristics of Utility:
For example, the satisfaction derived from a night lamp is higher at night when
it is dark and you are trying to read a book, than in the day.
For example, the satisfaction derived from a surfboard would be greater when at
the coast than in Gauteng.
The Utility Approach is however based on the assumption that values (units of value)
can be assigned to the amount of satisfaction (utility) that is obtained from each extra
unit of a good/service consumed. To distinguish these units from other units of
measurement (such as metres, litres and rands) we call them utils. Therefore, a unit of
utility is known as a util.Error: Reference source not found
TOTAL UTILITY
Lets assume Ntombizanele eats 4 tubs of yoghurt in a row. The marginal utility of the
4th tub is 24 utils. However, the total utility is 178 (70+50+34+24). The total utility is
the sum of all the marginal utilities.
DISUTILITY
Table 2.1 illustrates that as Ntombizanele eats more and more tubs of yoghurt,
marginal utility decreases with each additional tub of yoghurt. Marginal utility will
decline until it reaches zero. In table 2.1 marginal utility is zero after the 8th tub of
yoghurt. A zero marginal utility illustrates that the consumer is satiated (satisfied).
Thereafter, marginal utility becomes negative. This is also known as disutility. Note
also that total utility increases when marginal utility is positive and decreases when
marginal utility is negative.
Table 2.1 illustrates that as Ntombizanele eats more and more tubs of yoghurt,
marginal utility decreases with each additional tub of yoghurt. This trend is called the
law of diminishing marginal utility. The law of diminishing marginal utility states that
the marginal utility of a good or service declines as more of it is consumed during
any given period. This law is also known as Gossen’s first law, after the German
economist, Hermann Heinrich Gossen, who formulated it in 1854.Error: Reference source not found
The law of diminishing marginal utility can also be expressed in terms of total utility.
As a consumer consumes more units of a particular good/service, the consumer’s total
utility in respect of that good will increase but at a decreasing rate, ceteris paribus.Error:
Reference source not found
It is assumed that consumers are able to arrange their needs and wants in order of
importance. This is known as scale of preferences.Error: Reference source not found
Lets assume that Ntombizanele has R16 a week to spend on her top three most
important foods, namely; yoghurt, fish and bread. In order to assist Ntombizanele to
decide how to get the best value for money and gain the highest possible level of
utility, Ntombizanele first has to calculate the weighted marginal utility:
Weighted marginal utility takes into consideration the price of the good, therefore
trying to reach the highest possible level of utility with a set price.
Once the weighted marginal utility is calculated for each of the three products,
Ntombizanele should first purchase the good with the highest weighted marginal
utility. This good is the first unit of yoghurt which has a weighted marginal utility of
70 utils. The next highest good is also yoghurt with 50 utils. The next highest good is
the first fish with 45 utils. The next is the first bread with 44 utils. The next is the
second fish with 40 utils. Then another unit of yoghurt, fish and bread all with the
same weighted marginal utility of 33 utils.
This is the best combination of products as it is the choice that will yield the highest
total utility and the highest weighted marginal utility. And it is affordable.
In table 2.2 the combination of 3 yoghurts, 3 fish and 2 loaves of bread is indeed
affordable and the weighted marginal utility of each product is equal to 33 utils. This
is the best possible selection as Ntombizanele cannot gain by switching her available
income from one good to another. If she switches, the weighted marginal utility she
sacrifices will be greater than the weighted marginal utility she gains. When the
weighted marginal utilities are equal and she has just spent her available income,
Ntombizanele is in equilibrium. At equilibrium she derives the same utility from the
last rand spent on each product.Error: Reference source not found Note that there may
be instances where other combinations of products have an equal weighted marginal
utility but are not affordable.
Note that simply comparing marginal utility is not adequate. Price needs to be brought
into the equation as utility is dependent on price. For example your house will yield a
larger utility than say bread, but the price is substantially different. Therefore utility is
greatly influenced by price, hence the reason for comparing the weighted marginal
utility and not just marginal utility.
This law states that the consumer’s subjective valuation of a good must be equal to the
objective valuation of the market otherwise the consumer will not be in equilibrium.
Consider that Ntombizanele wants to buy plums and apples. We already know that
there can only be consumer equilibrium if: MUP = MUA
PP PA
MUP = PP
MUA PA
This equation indicates that the ratio of the marginal utilities must be the same as the
ratio between the market prices of the goods.Error: Reference source not found
PLUMS APPLES
UNITS (PP = R4) (PA = R3)
MUP TUP MUP MUA TUA MUA
PP PA
1 40 40 10 35 35 11.7
2 32 70 8 24 60 8
3 24 92 6 16 76 5.3
4 12 104 3 6 82 2
5 2 106 0.5 1 83 0.3
Table 2.3 Ntombizanele’s scale of preference for the weekly consumption of plums, where the price is R4 (PP = R4), and apples,
where the price is R3 (PA = R3).
The weighted marginal utility of plums is equal to the weighted marginal utility of
apples when two units of each product are consumed. Also, this combination is
affordable as: 2 x plums = R8
2 x apples = R6
R14
Ntombizanele’s total utility is (70+60) = 130 utils. This is the best that can be
achieved by spending R14.
Also, note the ratio between marginal utility at equilibrium is the same as the ratio
between the prices of the two products:
MUP = 32 = 1.33
MUA 24
PP = 4 = 1.33
PA 3
Suppose the price of apples drops to R2 per unit, ceteris paribus. Ntombizanele’s new
scale of preference is shown below.
PLUMS APPLES
UNITS (PP = R4) (PA = R2)
MUP TUP MUP MUA TUA MUA
PP PA
1 40 40 10 35 35 17.5
2 32 70 8 24 60 12
3 24 92 6 16 76 8
4 12 104 3 6 82 3
5 2 106 0.5 1 83 0.5
Table 2.3 Ntombizanele’s scale of preference for the weekly consumption of plums, where the price is R4 (PP = R4), and apples,
where the price is R3 (PA = R3).
The only things that have changed in the table are the price of apples and the weighted
marginal utilities of apples. For the same price of R14, Ntombizanele can now
purchase 2 plums and 3 apples. Total utility has increased and the ratio between the
marginal utilities of the two products at equilibrium is the same as the ratio between
the prices of the products.
PP = 4 = 2
PA 2
This means that Ntombizanele will increase her utility by consuming a greater
quantity of apples when the price of apples decreases, ceteris paribus. This is what the
law of demand is all about.
A utility-maximising consumer will demand more of a product when the price of the
product falls, while all other things remain unchanged (ceteris paribus).
To plot the graph we can say that at the price of R3 Ntombizanele demanded 2 apples,
and at a price of R2 Ntombizanele demanded 3 apples.
A
3
PRICE (R)
B
2
0
0 1 2 3 4
QTY OF APPLES
Consider the graph above. Ntombizanele has moved from point A to point B as the
price of apples dropped. At point B Ntombizanele can now purchase more apples and
get a greater total utility.
2.2.5 What is the difference (in your own words) between marginal utility and total
utility? (2)
Read the case study below and answer the questions to follow:
Lets assume that Zena has R41 a week to spend on her top three luxury foods,
namely; chocolate, popcorn and soda. A slab of chocolate costs R7, a packet of
popcorn costs R4 and a tin of soda costs R5. Refer to the table below and help Zena
decide which combination of these products will give her the highest possible level of
utility.
2.3.1 Lets assume Zena has R41 allocated to buy her top three luxury products.
Given this allocated amount, what quantity of each product should Zena buy to
give her the highest possible level of utiliy? Motivate your choice. (3)
3 x Soda
3 x Popcorn
2 x Chocolate
The consumer is in equilibrium at this point (the WMUs is equal) and it adds
up to R41 (therefore it is affordable).
2.3.2 Lets assume Zena has R41 allocated to buy her top three luxury products.
Given this allocated amount, which order should Zena purchase her products
in? Motivate your choice. (8)
Zena should purchase those products that give her the highest utility first.
579 utils
2.3.5 Identify the other product combination that also reflects equal weighted
marginal utilities. Motivate why this combination does/does not reflect
consumer equilibrium. (2)
2 x soda
2 x popcorn
1 x chocolate
The consumer is not in equilibrium at this point even though the WMUs are
all equal at 14 utils. The consumer is not in equilibrium at this point because
the full R41 has not been utilised.
2.3.6.1 What effect will this have on consumer equilibrium? Motivate. (2)
It would appear that the consumer will now be able to purchase an extra tin of
soda, but this is inaccurate as an extra tin of soda will amount to R42. This is
not affordable as Zena only has R41 despite the fact that the WMUs are
equal.
2.3.6.2 What effect will this have on total utility? Motivate. (2)
Total utility will stay the same because Zena will not be able to consume
more sodas as it is not affordable.
2.3.6.3 What effect will this have on the demand for soda? Motivate. (2)
The demand for sodas will increase because the price has dropped. This is
known as the law of Demand.
This however will not apply to Zena as she still cannot afford an extra tin of
soda despite a drop in the price.
6
5 A
4 B
PRICE
3
2
1
0
0 1 2 3 4
TINS OF SODA
2.3.8 What does the above demand curve tell you about the relationship between
price, demand and utility? (2)
Although the price has dropped, Zena’s demand has not increased because
she cannot affort to purchase more tins of soda. This will result in her total
utility and her weighted marginal utility not changing as she was unable to
purchase extra tins of soda.
57 utils
Read the case study below and answer the questions to follow:
Lets assume that Ashlyn has R144 a week to spend on her top three luxury foods,
namely; chips, pizza slices and soda. A bag of cooked chips costs R10, a slice of pizza
costs R16 and a tin of soda costs R6. Refer to the table below and help Ashlyn decide
which combination of these products will give her the highest possible level of utility.
CHIPS (PC = R10) PIZZA SLICES (PP = R16) SODA (PS = R6)
UNITS MUC MUP MUS
MUC TUC MUP TUP MUS TUS
PC PP PS
1 140 140 14 120 7.5 93 15.5 46.5
2 108 248 10.8 96 6 71 11.8 35.5
3 81 329 8.1 79 4.9375 52 8.6 26
4 60 389 6 64 359 4 36 6 18
5 40 429 4 50 3.125 24 276 4 12
6 29 458 2.9 38 2.375 15 2.5 7.5
7 19 477 1.9 28 1.75 8 1.3 4
8 10 487 1 19 1.1875 3 0.5
9 4 491 0.4 11 0.6875 0 0
10 (a) 491 0 4 0.25 -1 -0.16666667
11 (b) 488 -0.3 0 0 -4 -0.6666666
2.4.1 Lets assume Ashlyn has R144 allocated to buy her top three luxury products.
What combination of products should Ashlyn buy to be in equilibrium? (3)
5 x chips
4 x pizza slices
5 x soda
This is where the WMUs are = 4.
2.4.2 Lets assume Ashlyn has R144 allocated to buy her top three luxury products.
Given this allocated amount, which order should Ashlyn purchase her products
in? List the first 7 products she should buy. (7)
1. soda
2. chips
3. soda
4. chips
5. soda
6. chips
7. pizza
1064 utils
(a) 0
(b) -3
2.4.4.2 Identify and explain what (a) and (b) depicts. (4)
(a) Satiation/Saturation.
At this point the consumer gains and loses nothing. The consumer should not
consume more. At this point the consumer has had enough.
(b) Disutility.
At this point the consumer is receiving negative utility and is not benefiting
from the extra units consumed, but is suffering from consuming extra units.
2.4.5 Identify the other product combination that also reflects equal weighted
marginal utilities. Motivate why this combination does/does not reflect
consumer equilibrium. (5)
4 x chips
2 x pizza slices
4 x soda
It does not reflect consumer equilibrium because it is not using up the full
R144. Therefore with this combination money will be left over which could
have been spent on more goods which would have rendered a higher utility.
This combination does not give the consumer the highest possible utility.
2.4.6.1 What effect will this have on consumer equilibrium? Motivate. (2)
2.4.6.2 What effect will this have on total utility? Motivate. (2)
Total utility will increase because more sodas will be consumed. Therefore
the consumer will consume more causing total utility to increase.
2.4.6.3 What effect will this have on the demand for soda? Motivate. (2)
2.4.7 Explain the relationship between price, demand and utility? (2)
When the price decreases, demand is increases (the law of demand), when
demand is high (consumption is high) people receive more total utility and
more WMU. And vice versa. Ceteris paribus.
74.5 utils
2.4.9 Calculate the ratio, according to Gossen’s improved second law, between soda
and pizza slices. (1)
MUs = 24
MUp = 64 = 0.375
Ps = R6
Pp = R16 = 0.375
2.4.10 Calculate the ratio, according to Gossen’s improved second law, between
chips and pizza slices. (1)
MUc = 40
MUp = 64 = 0.625
Pc = R10
Pp = R16 = 0.625
2.4.11 Calculate the ratio, according to Gossen’s improved second law, between
chips and soda. (1)
MUc = 40
MUs = 24 = 1.66
Pc = R10
Ps = R6 = 1.66
The valuation that the consumer gives to marginal utility (MU) must be same
as the market valuation (P). Otherwise the ratio’s will not equal and the
consumer will not be in equilibrium.