BOLD PUT IN POWERPOINT DONDI

Law of Diminishing Marginal Utility

Learning Objectives
LO7.1 Define and explain the relationship
between total utility, marginal
utility, and the law of diminishing
marginal utility.
LO7.2 Describe how rational consumers
maximize utility by comparing the
marginal utility-to-price ratios of all
the products they could possibly
purchase.
LO7.3 Explain how a demand curve can be
derived by observing the outcomes

of price changes in the utility-

maximization model.

LO7.4 Discuss how the utility-maximization

model helps highlight the income
and substitution effects of a price
change.
LO7.5 Give examples of several real-world
phenomena that can be explained
by applying the theory of consumer
behavior.

(Appendix) Relate how the

indifference curve model of
consumer behavior derives demand
curves from budget lines,
indifference curves, and utility
maximization.

So first we will talk about the..

Law
of diminishing marginal utility, the simplest theory of consumer behavior wherein in the context
of economics states that As more of a good or service is used by a person, its marginal
utility decreases. Economic actors receive less and less satisfaction from consuming
incremental amounts of a good.

An example would be that three bites of an apple are better than two bites, but the tenth
bite does not add much to the experience beyond the ninth bite and could even make it
worse

So this is subjective which varies which we will know later

Let us move on to the Terminology that is essential to know and center on this given law

So this is based on the book

- Utility and usefulness are NOT synonymous. Utility does not have the same meaning
as usefulness because utility means satisfaction from consumer goods, while
usefulness describes the importance of a good to an individual. A good cannot be
useful, but it will have utility.
- Example: alcohol provides utility but it is not useful as it is harmful.

- Utility is subjective. This means that it is relative and differs from

person-to-person, place-to-place and time-to-time. It is not standard and every
individual will obtain a different level of satisfaction (utility) from the consumption of the
same good.
- Example: the utility derived upon consumption of the same orange juice by two
different consumers can be different depending upon their likes and dislikes
therefore the utility is subjective.

- Utility is difficult to quantify. There are no individuals capable of adding various

categories of satisfaction they receive from multiple goods and services. But for
purposes of illustration and explanation, we assume that people can measure
satisfaction with utils( units of utility).

- Example: an individual judges that a piece of pizza will yield 10 utils and that a
bowl of pasta will yield 12 utils, that individual will know that eating the pasta will
be more satisfying.

These imaginary units of satisfaction are convenient for quantifying consumer

behavior for explanatory purposes.
So let us move on to the…

Total Utility and Marginal Utility

Total utility and marginal utility are related, but different ideas.

- Total utility - the total amount of satisfaction or pleasure a person

derives from consuming some specific quantity for example: 10 units
of a good or service. In other words, the aggregate amount of
satisfaction or fulfillment that a consumer receives through the
consumption of a specific good or service.

Marginal Utility on the other hand is.

the extra satisfaction a consumer realizes from an additional unit of

that product for example, from the eleventh unit. Alternatively,
marginal utility is the change in total utility that results from the
consumption of 1 more unit of a product. In Layman’s term,the
satisfaction a consumer receives from consuming one additional unit of a
good or service.

we can learn from the data in the table and the diagram below, we can
establish the following relationship between total utility and marginal utility
in the context of chocolates.
1. As total utility increases at a decreasing rate, then marginal utility decreases.
2. When total utility is at a maximum point, then marginal utility is zero.
3. When total utility starts to decline, then marginal utility becomes negative.

Now for the…

marginal utility and demand
- The law of diminishing marginal utility helps us understand the law of
demand. Because consumers will derive less happiness or benefit from
additional units of a good, they will only be willing to buy a larger quantity
if the price decreases. This explains why the demand curve for a given product
slopes downward. In simplest terms, it is the change in demand for a product or
service in response to a specific change in its price.

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Let us move on to the…

Theory of Consumer Behavior

The concept of diminishing marginal utility also explains how customers distribute their incomes
among the various goods and services offered for purchase, in addition to explaining the law of
demand.

Consumer Choice and the Budget Constraint

We shall assume for the sake of simplicity that the scenario for the The dimensions of the typical
consumer are as follows.

• Rational behavior - The consumer is a rational being who wants to maximize the utility
or satisfaction of his or her financial resources. Consumers aim to maximize their total
utility, or, more formally, to receive "the most for their money." They act in a logical manner.

• Preferences - Every customer has distinct preferences. just some of the products and
services that are offered in the store. Additionally, buyers are well-aware of the
How much incremental value they will receive from subsequent units of the different goods
people might buy.

• Budget constraint - At any point in time the consumer has a fixed, limited amount of
money income. Since each consumer supplies a finite amount of human and property
resources to society, he or she earns only limited income. every consumer faces a budget
constraint, even consumers who earn millions of dollars a year. Of course, this budget limitation
is more severe for a consumer with an average income than for a consumer with an
extraordinarily high income.

• Prices - Goods are scarce relative to the demand for them, so every good carries a price
tag. We assume that the price of each good is unaffected by the amount of it that is
bought by any particular person. After all, Every individual's purchase only makes up a little
portion of the overall demand. Additionally, the consumer cannot buy everything desired due to
the restricted amount of money available. Each consumer is made acutely aware of the realities
of scarcity by this time.

Therefore, consumers must make a compromise and select the combination of goods and
services that best suits their personal needs. Different people will select various combinations.

We then move on to the…

Utility-Maximizing Rule
- Of all the different combinations of goods and services a consumer can
obtain within his or her budget, which specific combination will yield the
maximum utility or satisfaction?
- To maximize satisfaction, the consumer should allocate his or her money
income so that the last dollar spent on each product yields the same
amount of extra (marginal) utility.

. Consumer Equilibrium
- This when consumer has “balanced his margins” using the rule of
Utility- Maximizing and has no incentive to alter the given pattern of the
expenditure. In fact, anyone who has achieved this would be worse off
when total utility would decline if by any chance there was/were any
alteration in the given goods being purchased provided that everything
stays the same.

So let us see an example or a given illustration in the numerical sense which will help
explain the utility-maximizing rule.

(change slide)
An illustration will help explain the utility-maximizing rule. For simplicity we limit our example to
two products, but the analysis also applies if there are more. Suppose consumer Holly is
analyzing which combination of two products she should purchase with her fixed daily income of
$10. Let’s suppose these products are apples and oranges. Holly’s preferences for apples and
oranges and their prices are the basic data determining the combination that will maximize her
satisfaction. The given table summarizes those data, with column 2a showing the amounts of
marginal utility she will derive from each successive unit of A (apples) and with column 3a
showing the same thing for product B (oranges). Both columns reflect the law of diminishing
marginal utility, which, in this example, is assumed to begin with the second unit of each product
purchased.

This is when we talk about the…

Marginal Utility per Dollar (MU/P)

- the amount of additional utility One receives given the price of a product.
- the amount of additional utility One receives given the price of a product.
To see how the utility maximizing rule works, we must put the marginal-utility information in
columns 2a and 3a on a per-dollar-spent basis. A consumer’s choices are influenced not only by
the extra utility that successive apples will yield but also by how many dollars (and therefore
how many oranges) she must give up to obtain additional apples.

The rational consumer must compare the extra utility from each product with its added cost (that
is, its price).

So let us switch examples for a moment. Let us say that one prefer a pizza whose marginal
Utility is 36 to a movie whose marginal Utility is 24 utils. But if the pizza’s price is $12 and the
movie costs only $6, you would choose the movie rather than the pizza!

MU for Pizza = 36 utils

MU for Movie = 24 utils

BUT…
Price of Pizza = $ 12
Price of Movie = $ 6

WHY?

Because the marginal utility per dollar spent would be 4 utils for the movie ( = 24 utils/$6)
compared to only 3 utils for the pizza (= 36 utils/$12). You could see two movies for $12 and,
assuming that the marginal utility of the second movie is, say, 16 utils, your total utility would be
40 utils. Clearly, 40 units of satisfaction (= 24 utils + 16 utils) from two movies is superior to 36
utils from the same $12 expenditure on one pizza.

MU/P for Movie = 4 utils( 24 utils/ $6)

MU/P for Pizza = 3 utils(36 utils/$12)

We go back to the example of the apples and oranges. To make the amounts of extra utility
derived from differently priced goods comparable, marginal utilities must be put on a
per-dollar-spent basis. We do this in columns 2b and 3b by dividing the marginal-utility data of
columns 2a and 3a by the prices of apples and oranges—$1 and $2, respectively, which we get
the Marginal Utility per dollar for both.

Let us look upon on the..

Decision-Making Process
- the process of identifying alternative courses of action and selecting
an appropriate alternative in a given decision situation.
Let us go back to the slide where the given table of apple and oranges is. It
shows Holly’s preferences on a unit basis and a per-dollar basis as well as
the price tags of apples and oranges. With $10 to spend, in what order should
Holly allocate her dollars on units of apples and oranges to achieve the
highest amount of utility within the $10 limit imposed by her income? And
what specific combination of the two products will she have obtained at the
time she uses up her $10?

Focus on columns 2b and 3b in the table, , we find that Holly should first spend
$2 on the first orange because its marginal utility per dollar of 12 utils is higher
than the first apple’s 10 utils. But now Holly finds herself
indifferent about whether to buy a second orange or the first apple because the
marginal utility per dollar of both is 10 utils per dollar. So she buys both of them.
Holly now has 1 apple and 2 oranges. Also, the last dollar she spent on each
good yielded the same marginal utility per dollar (10). But this combination of
apples and oranges does not represent the maximum amount of utility that Holly
can obtain. It cost her only $5 [5 (1 3 $1) 1 (2 3 $2)], so she has $5 remaining,
which she can spend to achieve a still higher level of total utility.

Examining the table again, columns 2b and 3b again, we find that Holly should
spend the next $2 on a third orange because marginal utility per dollar for the
third orange is 9 compared with 8 for the second apple. But now, with 1 apple
and 3 oranges, she is again indifferent between a second apple and
a fourth orange because both provide 8 utils per dollar. So Holly purchases 1
more of each. Now the last dollar spent on each product provides the same
marginal utility per dollar (8), and Holly’s money income of $10 is
exhausted.

The utility-maximizing combination of goods attainable by Holly is 2 apples and 4

oranges. By summing marginal utility information from columns 2a and 3a, we
find that Holly is obtaining 18 (5 10 1 8) utils of satisfaction from the 2 apples and
78 (5 24 1 20 1 18 1 16) utils of satisfaction from the 4 oranges. Her $10,
optimally spent, yields 96 (5 18 1 78) utils of satisfaction.

This table summarizes the step-by-step process for maximizing Holly’s utility. Note that we have
implicitly assumed that Holly spends her entire income. She neither borrows nor saves.

So let us have an example for the Inferior Options

Inferior Options
As an example, she can obtain 4 apples and 3 oranges for $10. But this
combination yields only 93 utils, clearly inferior to the 96 utils provided by
2 apples and 4 oranges.

= 31(10+8+7+6) utils of satisfaction from the 4 apples and 62(24+20+18)

utils of satisfaction from the 3 oranges.

Yes, there are other options for Holly of apples and oranges such as 4 apples and 5 oranges or
1 apple and 2 oranges in which the marginal utility of the last dollar spent is the same for both
goods oranges) in which the marginal utility of the last dollar spent is the same for both goods.
But all such combinations either are unobtainable with Holly’s limited money income (as 4
apples and 5 oranges(4 apples is $ 4 dollars in total and 5 oranges are $10 dollars in total which
is 14 dollars for inclusion of both so that is over the budget of $10) or do not exhaust her money
income (as 1 apple and 2 oranges is only $5) and therefore do not yield the maximum utility
attainable.

Let us then talk about the…

Algebraic Generalization

Economists generalize the utility-maximizing rule by saying that a consumer will maximize her
satisfaction when she allocates her money income so that the last dollar spent on product A, the
last on product B, and so forth, yield equal amounts of additional, or marginal, utility. The
marginal utility per dollar spent on A is indicated by the MU of product A divided by the price of
A (column 2b in Table 7.1), and the marginal utility per dollar spent on B by the MU of product B
divided by the price of B (column 3b in Table 7.1). Our utility-maximizing rule merely requires
that these ratios be equal for the last dollar spent on A and the last dollar spent on B. So in the
algebraic form the equation is

And, of course, the consumer must exhaust her avail-

able income. Table 7.1 shows us that the combination of

2 units of A (apples) and 4 of B (oranges) fulfills these

conditions in that

Wherein the consumer’s $10 income is all spent

But if the equation is not fulfilled, them some reallocation of the consumer’s expenditures
between A and B( from the low to the high MU/P product) will increase the consumer’s total
utility.

An example is when if the consumer spent $10 on 4 of A(apples) and 3 of B(oranges) which we
can find that
Here the last dollar spent on A provides only 6 utils of satisfaction, while the last dollar spent on
B provides 9 (which is 18/$2). So the consumer can increase total satisfaction by purchasing
more of B and less of A.

As dollars are reallocated from A to B, the marginal utility per dollar of A will increase
while the marginal utility per dollar of B will decrease. At some new combination of A and
B the two wil lbe equal and consumer equilibrium will be achieved. Here that combination
is 2 of A (apples) and 4 of B (oranges). At some new option of A and B the two will
be equal and consumer equilibrium will be seen which is the option of 2 apples and 4 oranges.

Now we then move on to a very important subject on the …

Utility Maximization and the Demand Curve

Once you understand the utility-maximizing rule, you can easily see why product price
and quantity demanded are inversely related. Recall that the basic determinants of
an individual’s demand for a specific product are (1) preferences or tastes, (2)
money income, and (3) the prices of other goods. The utility data in the previous
table with the apple and oranges reflect the consumer’s preferences. Continue to
suppose that her money income is $10. And, concentrating on the construction of an
individual demand curve for oranges, we assume that the price of apples, now
representing all “other goods,” is still $1.

We then go further by knowing and moving on to the..

Deriving of the Demand Schedule and Curve

We can derive a single consumer’s demand schedule for oranges by considering

alternative prices at which oranges might be sold and then determining the quantity the
consumer will purchase. We already know one such price quantity option of a combination in
the utility maximizing example: Given tastes, income, and the prices of other goods, Holly
will purchase 4 oranges at $2.

Now let’s assume the price of oranges falls to $1.

The MU/P column in the table will double because the price of the oranges has been halved
which will then have the same data with the apple. The doubling of the MU per dollar for each
successive orange means that the purchase of 2 apples and 4 oranges is no longer an
equilibrium combination. By applying the same reasoning we used previously, we now find that
Holly’s utility-maximizing combination is 4 apples and 6 oranges.

As what is being shown in the table and graph, Holly will purchase 6 oranges when the
price of oranges is $1. Using the data in this table, we can sketch the downward-sloping
demand curve for oranges, D shown in the graph. This clearly connects the dots and
sums up the utility maximizing behavior of a consumer and that person’s downsloping
demand curve for a particular product.

Income and Substitution Effects

Discuss how the utility-maximization model helps highlight the

income and substitution effects of a price change.
Income effect - the impact that a change in the price of a product has
on a consumer’s real income and consequently on the quantity
demanded of that good.

In contrast

Substitution effect - the impact that a change in a product’s price has

on its relative expensiveness and consequently on the quantity
demanded. This helps explain the effects in the demand curve.

Let’s first look at the substitution effect. Recall that before the price of
oranges declined, Holly was in equilibrium when purchasing 2 apples and 4
oranges because

Holly was in equilibrium when purchasing 2 apples and 4 oranges

But after the price of oranges declines from $2 to $1,

It clearly shows that the last dollar spent on oranges now produces greater
utility which is 16 utils compared to the last dollar spent on apples which is
8 utils. This will lead Holly to switch, or substitute, pur chases away from
apples and toward oranges so as to restore consumer equilibrium.

This substitution effect contributes to the inverse relationship

between price and quantity that is found along her demand curve for
oranges: When the price of oranges declines, the substitution effect
causes Holly to buy more oranges.

What about the income effect? The decline in the price of oranges from
$2 to 1 increases Holly’s real income. Before the price decline, she
maximized her utility and achieved consumer equilibrium by selecting 2
apples and 4 oranges. But at the lower $1 price for oranges, Holly
would have to spend only $6 rather than $10 to buy that particular
combination of goods. That means that the lower price of oranges has
freed up $4 that can be spent on buying more apples, more oranges, or
more of both. How many more of each fruit she ends up buying will be
determined by applying the utility-maximizing rule to the new situation. But
it is quite likely that the increase in real Income caused by the reduction in
the price of oranges will cause Holly to end up buying more oranges than
before the price reduction. Any such increase in orange purchases is
referred to as the income effect of the reduction in the price of oranges and
it, too, helps to explain why demand curves are downward sloping: When
the price of oranges falls, the income effect causes Holly to buy more
oranges.