Nature of Demand Curves, Relationship between Marginal Utility & Price, Rational Consumer Behaviour, Necessities
Total Utility, Marginal Utility & Marginal Analysis
Total Utility represents the total amount of satisfaction gained by consuming a good/service. The more you consume of something, the more satisfaction you get.
Utility has no units!
How do you calculate utility?
Marginal Utility is the change in total that one gets from consuming one more unit of a good. If eating 1 apple gives you 12 units of utility & 2 gives you 20, the marginal utility of 2nd apple is 8.
As total utility increases, marginal utility decreases. You get less utility out of something as you continue consuming it, similar to law of diminishing marginal returns.
Why Does Marginal Utility Diminish as We Consume More of a Good?
The concept of diminishing marginal utility is an empirical one. It states that as you consume more of a good in a specific time period, the additional satisfaction provided by the additional unit of good will diminish.
Yeah, but why does it diminish?
Economists assume consumers are rational & they’ll consume goods with large marginal utility.
In order for consumers to maximize well-being, given prices & income, then this must be true:
Understanding why this is true is a fundamental use of marginal analysis: a consumer will maximize total well-being if the last dollar spent on each good provides the same marginal utility as the last dollar spent on every other good. Maximum Satisfaction is when marginal utility/dollar of a good is equal to marginal utility/dollar of every other good!
Understanding marginal analysis is crucial to understanding why law of demand is true!
As you increase consumption of a good, its marginal utility diminishes. As you decrease consumption of a good, its marginal utility increases.
Income & Substitution Effects
As the price of what you purchase increases, your real income decreases. Real income represents the amount of goods/services that can be purchased, taking price changes (or purchasing power) into account.
A drop in real income means you have less to spend on all goods/services. This means that normal & inferior goods’ demands are still affected by real income!
The impact in real income by price changes depends on percent of income spent on the expenditure. The price change of a good that makes up a high percent of your income affects your real income greatly.
It is the substitution & income effects that together explain the downward-sloping demand curve for normal goods. For inferior goods, substitution & income effects don’t align.
Consumer Surplus is the difference between the price the consumer is willing to pay for a product (marginal benefit) and the market price (marginal cost). Consumer surpluses only exist when the difference is greater than 0.
Due to diminishing marginal utility, as people consume more, their consumer surplus shrinks until it is less than 0. Once it’s less than 0, consumer’s stop consuming a good.
In order to calculate consumer surplus, you find the area of the area of the triangle beneath a demand curve.
The Paradox Of Value
Water has great value & it’s a necessity for human survival, yet it’s relatively cheap. Diamonds are not necessary for survival, yet they’re extremely expensive.
This is because of supply! There is a greater supply for water than for diamonds.