Utility and Demand

Chapter 8
 Main ideas
After studying this chapter, you will be able to:
•Explain the limits to consumption and describe preferences using the concept
of utility
•Explain the marginal utility theory of consumer choice
•Use marginal utility theory to predict the effects of changes in prices and
incomes and to explain the paradox of value
•Describe some new ways of explaining consumer choices

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 Consumption Choices
Consumption Possibilities
•Your consumption possibilities are all the things that you can afford to buy
A Consumer’s Budget Line
•Consumption possibilities are limited by income
Changes in Consumption Possibilities
•Consumption possibilities change when income or prices change
Preferences
•We approach preferences i.t.o utility, and define utility as the benefit or satisfaction
that a person gets from the consumption of goods and services
Total Utility
•The total benefit that a person gets from the consumption of all the different goods and
services is called total utility
•More consumption generally gives more total utility
Marginal Utility
•Marginal utility is the change in total utility that results from a one-unit increase in the
quantity of a good consumed

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 Utility-Maximising Choice
• Consumers want to get the most utility possible from their limited resources
• They make the choice that maximises utility
Consumer Equilibrium
• Consumer equilibrium is a situation in which a consumer has allocated all of his or her
available income in the way that maximises his or her total utility, given the prices of
goods and services
Choosing at the Margin
Marginal Utility per Rand
• Marginal utility is the increase in total utility that results from consuming one more unit of
a good
• Marginal utility per rand is the marginal utility from a good that results from spending one
more rand on it
Utility-Maximising Rule
• A consumer’s total utility is maximised by two rules
• Spend all the available income
• More consumption brings more utility, therefore only those choices that exhaust income can
maximise utility

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 Utility-Maximising Choice
Equalise the Marginal Utility per Rand
• The basic idea behind this rule is to move rand from good A to good B if doing so
increases the utility from good A by more than it decreases the utility from good B
• Such a utility-increasing move is possible if the marginal utility per rand from
good A exceeds that from good B

The Power of Marginal Analysis

•If the marginal gain from an action exceeds the marginal loss, take the action

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 Predictions of Marginal Utility Theory
• You will see that marginal utility theory predicts the law of demand
• To derive these predictions, we will study the effects of three events:
• A fall in the price of a chocolate bar
• A rise in the price of cooldrink
• A rise in income

A Fall in the Price of a Chocolate Bar

Finding the New Quantities of Chocolate Bars and Cooldrink
• Determine the just-affordable combinations of chocolate bars and cooldrink
at the new prices
• Calculate the new marginal utilities per rand from the good whose price has
changed
• Determine the quantities of chocolate bars and cooldrink that make their
marginal utilities per rand equal

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 Predictions of Marginal Utility Theory
A Change in the Quantity Demanded
•We illustrate a change in the quantity demanded by a movement along a
demand curve
A Change in Demand
•We illustrate a change in demand by a shift of a demand curve

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 Predictions of Marginal Utility Theory
A Rise in the Price of Cooldrink
• When the price of cooldrink
rises and the price of a
chocolate bar and Lerato’s
income remain the same,
the quantity of cooldrink
demanded by Lerato
decreases
• Figure 8.5 shows points on
Lerato’s demand curve for
cooldrink
• It also shows the change in
the quantity of cooldrink
demanded when the price of
cooldrink rises and all other
influences on Lerato’s
buying plans remain the
same

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 Predictions of Marginal Utility Theory
A Rise in Income

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 Predictions of Marginal Utility Theory
The Paradox of Value
•The price of water is low and the price of a diamond is high, but water is essential
to life while diamonds are used mostly for decoration
•How can valuable water be so cheap while a relatively useless diamond is so
expensive?
•This so-called paradox of value has puzzled philosophers for centuries
The Paradox Resolved
•The paradox is resolved by distinguishing between total utility and marginal utility
•The total utility that we get from water is enormous, but remember, the more we
consume of something, the smaller is its marginal utility
•We use so much water that its marginal utility – the benefit we get from one
more glass of water or another 30 seconds in the shower – diminishes to a small
value
•Diamonds, on the other hand, have a small total utility relative to water, but
because we buy few diamonds, they have a high marginal utility

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 New Ways of Explaining Consumer Choices
Behavioural Economics
•Behavioural economics studies the ways in which limits on the human brain’s
ability to compute and implement rational decisions influences economic
behaviour – both the decisions that people make and the consequences of those
decisions for the way markets work
•People are assumed to have three impediments that prevent rational choice:
bounded rationality, bounded willpower, and bounded self-interest
Bounded Rationality
•Bounded rationality is rationality that is limited by the computing power of the
human brain
•We cannot always work out the rational choice
Bounded Willpower
•Bounded willpower is the less-than-perfect willpower that prevents us from
making a decision that we know, at the time of implementing the decision, we will
later regret

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 New Ways of Explaining Consumer Choices
Bounded Self-Interest
•Bounded self-interest is the limited self-interest that results in sometimes
suppressing our own interests to help others

The Endowment Effect

The endowment effect is the tendency for people to value something more
highly simply because they own it

Neuroeconomics
•Neuroeconomics is the study of the activity of the human brain when a person
makes an economic decision
•The discipline uses the observational tools and ideas of neuroscience to obtain
a better understanding of economic decisions

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