Unit 7 The price system and the microeconomy
Utility and marginal utility
Utility is used to record the level of happiness or satisfaction that someone receives
from the consumption of a good.
Utility: The satisfaction received from consumption.
Total utility: The total satisfaction received from consumption.
Marginal utility: The utility derived from the consumption of one more unit of the
good or service.
The marginal utility gained from consumption of a product tends to fall as
consumption increases. For example, when you consume one ice cream you enjoy it
a lot, and when you get another you are still likely to like it but not as much.
Diminishing marginal utility: The fall in marginal utility as consumption increases.
In considering the consumer’s equilibrium, it is necessary to remember that it is
assumed that consumers have limited incomes, act in a rational way and always
seek the maximum total utility from their consumption.
Equimarginal principle: Consumers maximise their utility where their marginal
valuation for each product consumed is the same.
This can be represented as MUa/Pa = MUb/Pb where MU = marginal utility, P is the
price and A and B are different products.
It is possible to use marginal utility to derive an individual demand curve as MUa/Pa
would decrease because price increases. Therefore the marginal utility of A per
dollar will be less compared to other products making consumers spend that money
on other products and in turn reduces the marginal utility of A. In conclusion, the
demand curve for good is downward sloping.
Are consumers rational?
The law of diminishing marginal utility assumes that consumers act and behave in a
rational way in their purchasing decisions. However, consumers do not always act
rationally, for a number of reasons:
, ● Special offers: Such as ‘buy one get one free’. Consumers may have no
intention of buying the product until they enter the shop. Seeing the offer
produces an impulsive cognitive response to buy.
● Availability of deferred payment: This allows people to pay outright at the
time of sale - they may use a credit card.
● Brand loyalty/prejudice: This could be because of personal taste or
connection to the seller, and it influences consumption.
If consumers were rational there would be little need for marketing. It is useful to
bear these points in mind when evaluating the effectiveness of conventional
economic models like that of utility.
Budget lines
Budget line: The combinations of two products obtainable with given incomes and
prices.
Quantity of A ($20 each) Quantity of B ($10)
10 0
9 2
8 4
7 6
6 8
5 10
4 12
3 14
2 16
1 18
0 20
, 10
BL1 is the first budget line.
BL2 is the new budget line
Product when the price of B
A decreases. As the price of
B has fallen relative to that
of A, which is unchanged,
5 consumers will substitute
BL1 BL2 B for A. This is known as
the substitution effect of
a price change.
0
10 20 30
Product B
With the fall in the price of B, the consumer has more money to spend on other
products, B included. Real income has therefore increased, which may mean that a
consumer may now purchase more of product B. This is called the income effect of
a price change.
Substitution effect: Where following a price change, a consumer will substitute the
cheaper product for the one that is now relatively more expensive.
Income effect: Where following a price change, a consumer will purchase more of
this product.
Indifference curves - representing what consumers want
Indifference curves: This shows the different combinations of two goods that give a
consumer equal satisfaction.
Marginal rate of substitution: The rate at which a consumer is willing to substitute
one good for another.
, Quantity of good A
l2
l1
0
Quantity of good B
● Higher indifference curves represent higher levels of consumption.
Consumers therefore prefer to be on a higher rather than lower indifference
curve.
● All indifference curves are downward sloping to indicate a fall in the quantity
consumed of one good is accompanied by an increase in consumption of the
other good.
● Indifference curves cannot cross.
● Indifference curves are concave or bowed inward to the origin.
Effect of a change in income on consumer choice
A consumer’s choice is optimal at the point where the budget line touches or is at a
tangent to the highest indifference curve.
If income increases then this will allow the consumer to choose a better combination
of goods A and B which will usually be more of both goods.
Utility and marginal utility
Utility is used to record the level of happiness or satisfaction that someone receives
from the consumption of a good.
Utility: The satisfaction received from consumption.
Total utility: The total satisfaction received from consumption.
Marginal utility: The utility derived from the consumption of one more unit of the
good or service.
The marginal utility gained from consumption of a product tends to fall as
consumption increases. For example, when you consume one ice cream you enjoy it
a lot, and when you get another you are still likely to like it but not as much.
Diminishing marginal utility: The fall in marginal utility as consumption increases.
In considering the consumer’s equilibrium, it is necessary to remember that it is
assumed that consumers have limited incomes, act in a rational way and always
seek the maximum total utility from their consumption.
Equimarginal principle: Consumers maximise their utility where their marginal
valuation for each product consumed is the same.
This can be represented as MUa/Pa = MUb/Pb where MU = marginal utility, P is the
price and A and B are different products.
It is possible to use marginal utility to derive an individual demand curve as MUa/Pa
would decrease because price increases. Therefore the marginal utility of A per
dollar will be less compared to other products making consumers spend that money
on other products and in turn reduces the marginal utility of A. In conclusion, the
demand curve for good is downward sloping.
Are consumers rational?
The law of diminishing marginal utility assumes that consumers act and behave in a
rational way in their purchasing decisions. However, consumers do not always act
rationally, for a number of reasons:
, ● Special offers: Such as ‘buy one get one free’. Consumers may have no
intention of buying the product until they enter the shop. Seeing the offer
produces an impulsive cognitive response to buy.
● Availability of deferred payment: This allows people to pay outright at the
time of sale - they may use a credit card.
● Brand loyalty/prejudice: This could be because of personal taste or
connection to the seller, and it influences consumption.
If consumers were rational there would be little need for marketing. It is useful to
bear these points in mind when evaluating the effectiveness of conventional
economic models like that of utility.
Budget lines
Budget line: The combinations of two products obtainable with given incomes and
prices.
Quantity of A ($20 each) Quantity of B ($10)
10 0
9 2
8 4
7 6
6 8
5 10
4 12
3 14
2 16
1 18
0 20
, 10
BL1 is the first budget line.
BL2 is the new budget line
Product when the price of B
A decreases. As the price of
B has fallen relative to that
of A, which is unchanged,
5 consumers will substitute
BL1 BL2 B for A. This is known as
the substitution effect of
a price change.
0
10 20 30
Product B
With the fall in the price of B, the consumer has more money to spend on other
products, B included. Real income has therefore increased, which may mean that a
consumer may now purchase more of product B. This is called the income effect of
a price change.
Substitution effect: Where following a price change, a consumer will substitute the
cheaper product for the one that is now relatively more expensive.
Income effect: Where following a price change, a consumer will purchase more of
this product.
Indifference curves - representing what consumers want
Indifference curves: This shows the different combinations of two goods that give a
consumer equal satisfaction.
Marginal rate of substitution: The rate at which a consumer is willing to substitute
one good for another.
, Quantity of good A
l2
l1
0
Quantity of good B
● Higher indifference curves represent higher levels of consumption.
Consumers therefore prefer to be on a higher rather than lower indifference
curve.
● All indifference curves are downward sloping to indicate a fall in the quantity
consumed of one good is accompanied by an increase in consumption of the
other good.
● Indifference curves cannot cross.
● Indifference curves are concave or bowed inward to the origin.
Effect of a change in income on consumer choice
A consumer’s choice is optimal at the point where the budget line touches or is at a
tangent to the highest indifference curve.
If income increases then this will allow the consumer to choose a better combination
of goods A and B which will usually be more of both goods.
