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Ch 2 – The Theory of Demand

Typical exam question

 What do you understand by the law of diminishing

marginal utility? In which way is this law associated
with demand for a product?

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Total and Marginal Utility

 People buy goods and services because they get

satisfaction from them. Economists call this
satisfaction ‘utility’.

 Total utility (TU) is the total satisfaction a person

gains from all those units of a commodity consumed
within a given time period. Thus if Lucy drank ten
cups of tea day, her daily total utility from tea would
be the satisfaction derived from those ten cups.

Total and Marginal Utility

 Marginal utility (MU) is the additional

satisfaction gained from consuming one extra unit
within a given period of time. Thus we might refer to
the marginal utility that Lucy gains from her third
cup of tea of the day or her eleventh cup.

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How to measure utility ?

 Utility is subjective. There is no way of knowing what

another person’s experiences are really like. Just how
satisfying does Nick find his first cup of tea in the
morning? How does his utility compare with Lucy’s?
We do not have utility meters that can answer these
questions!

Diminishing marginal utility

 Up to a point, the more of a commodity you

consume, the greater will be your total utility.
However, as you become more satisfied, each extra
unit that you consume will probably give you less
additional utility than previous units. In other words,
your marginal utility falls, the more you consume.
This is known as the principle of diminishing
marginal utility.

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Total and marginal utility curves

Total and marginal utility curves

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Total and marginal utility curves

 Notice the following points about the two curves:

- The MU curve slopes downwards. This is simply
illustrating the principle of diminishing marginal
utility.
- The TU curve starts at the origin. Zero consumption
yields zero utility.
- It reaches a peak when marginal utility is zero. When
marginal utility is zero (at five packets of crisps), there
is no addition to total utility. Total utility must be at
the maximum – the peak of the curve.

The ceteris paribus assumption

 The table and graph we have drawn are based on the

assumption that other things do not change.

 In practice, other things do change – and frequently.

The utility that Ollie gets from crisps depends on what
else he eats.

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The optimum level of consumption: the

simplest case – one commodity

 Just how much of a good should people consume if they

are to make the best use of their limited income?
 One solution to the problem is to measure utility with
money. In this case, utility becomes the value that people
place on their consumption. Marginal utility thus
becomes the amount of money a person would be
prepared to pay to obtain one more unit: in other words,
what that extra unit is worth to that person. If Ollie is
prepared to pay 45p to obtain an extra packet of crisps,
then we can say that packet yields him 45p worth of
utility: MU = 45p.

Marginal consumer surplus

 Marginal consumer surplus (MCS) is the difference

between what you are willing to pay for one more
unit of a good and what you are actually charged. If
Ollie were willing to pay 45p for another packet of
crisps which in fact only cost him 40p, he would be
getting a marginal consumer surplus of 5p.

 MCS = MU − P

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Total consumer surplus

 Total consumer surplus (TCS) is the sum of all the

marginal consumer surpluses that you have obtained
from all the units of a good you have consumed. It is
the difference between the total utility from all the
units and your expenditure on them.

 TCS = TU − TE

Total consumer surplus

 People will go on purchasing additional units as long

as they gain additional consumer surplus: in other
words, as long as the price they are prepared to pay
exceeds the price they are charged (MU > P). But as
more units are purchased, so they will experience
diminishing marginal utility. They will be prepared
to pay less and less for each additional unit. Their
marginal utility will go on falling until MU = P: i.e.
until no further consumer surplus can be gained.

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Total consumer surplus

Total consumer surplus

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Marginal utility and the demand curve for a good

- An individual’s demand curve

 Individual people’s demand curve for any good will

be the same as their marginal utility curve for that
good, where utility is measured in money.

Marginal utility and the demand curve for a good

- An individual’s demand curve

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Marginal utility and the demand curve for a good

- The market demand curve
 The market demand curve will simply be the (horizontal)
sum of all individuals’ demand curves and hence MU
curves.

 The shape of the demand curve. The price elasticity of

demand will reflect the rate at which MU diminishes. If
there are close substitutes for a good, it is likely to have
an elastic demand, and its MU will diminish slowly as
consumption increases. The reason is that increased
consumption of this product will be accompanied by
decreased consumption of the alternative product(s).
Since total consumption of this product plus the
alternatives has increased only slightly (if at all), the
marginal utility will fall only slowly.

The optimum combination of goods

consumed

 We can use marginal utility analysis to show how a

rational person decides what combination of goods
to buy. Given that we have limited incomes, we have
to make choices. It is not just a question of choosing
between two obvious substitutes (like carrots and
peas or a holiday in Greece and one in Spain), but
about allocating our incomes between all the goods
and services we might like to consume.

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Equi-marginal principle

 This states that a consumer will get the highest

utility from a given level of income when the ratio of
the marginal utilities is equal to the ratio of the
prices. Algebraically, this is when, for any pair of
goods, A and B, that are consumed:

Equi-marginal principle

 To see the sense of this, say that the last unit of good A
you consumed gave three times as much utility as the last
unit of B. Yet good A only cost twice as much as good B.
You would obviously gain by increasing your
consumption of A and cutting your purchases of B. But as
you switched from B to A, the marginal utility of A would
fall due to diminishing marginal utility, and conversely
the marginal utility of B would rise. To maximise utility
you would continue this substitution of A for B until the
ratios of the marginal utilities (MUA/MUB) equaled the
ratio of the prices of the two goods (PA/PB). At this
point, no further gain can be made by switching from one
good to another. This is the optimum combination of
goods to consume.

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The multi-commodity version of marginal

utility and the demand curve

 For any given income, and given prices for good A

and all other goods, the quantity a person will
demand of good A will be that which satisfies
equation. One point on the individual’s demand
curve for good A has been determined. If the price of
good A now falls, we will have:

The multi-commodity version of marginal

utility and the demand curve

 Therefore the person would buy more of good A and

less of all other goods (B, C, D, E, etc.), until
equation (1) is once more satisfied. A second point
on the individual’s demand curve for good A has
been determined.

 Further changes in the price of good A would bring

further changes in the quantity demanded, in order
to satisfy equation (1). Further points on the
individual’s demand curve would thereby be derived.

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Typical exam question

 What are the characteristics of an indifference curve?

What is an indifference map?

Indifference Curve

 An indifference curve shows all the various

combinations of two goods that give an equal
amount of satisfaction or utility to a consumer.

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Indifference Curves

 This table is known as an indifference set. It shows

alternative combinations of two goods that yield the
same level of satisfaction. From this we can plot an
indifference curve. We measure units of one good on
one axis and units of the other good on the other
axis.

Indifference map

 More than one indifference curve can be drawn. For

example, referring back to Table 4.2, Ali could give
another set of combinations of pears and oranges that all
give him a higher (but equal) level of utility than the set
shown in the table. This could then be plotted in
Figure 4.5 as another indifference curve.

 Although the actual amount of utility corresponding to

each curve is not specified, indifference curves further
out to the right would show combinations of the two
goods that yield a higher utility, and curves further in to
the left would show combinations yielding a lower utility.

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Indifference map

Characteristics of Indifference Curves

 Indifference Curves are negatively sloped

 Higher Indifference Curve represents higher level of
Utility
 Indifference Curves are Convex to the Origin
 Indifference Curve Cannot Intersect Each Other
 Indifference Curves do not Touch the Horizontal or
Vertical Axis

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Indifference Curve and the law of diminishing

marginal utility

 Indifference Curves reflect the law of diminishing

marginal utility

 The slope of the curve is the ratio of marginal

utilities of the two goods, indicating that as quantity
of product A increases and the quantity of product B
decreases, the marginal utility derived from product
A decreases, while that derived from product B
increases

Budget line

Whereas indifference maps illustrate people’s

preferences, the actual choices they make will depend
on their incomes. The budget line shows what
combinations of two goods you are able to buy, given
(a) your income available to spend on them and (b)
their prices.

Definition: A graph showing all the possible

combinations of two goods that can be purchased at
given prices and for a given budget.

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Budget line

Budget line

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Budget line

 Therefore Income and Prices effect the slope and

position of the budget line.

Properties of the Budget Line

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Superimposition of Budget Line and Indifference

Curve

Superimposition of Budget Line and Indifference

Curve

 The consumer would like to consume along the highest

possible indifference curve. This is curve I3 at point t.
Higher indifference curves, such as I4 and I5, although
representing higher utility than curve I3, are in the
infeasible region: they represent combinations of X and Y
that cannot be afforded with the current budget. The
consumer could consume along curves I1 and I2,
between points r and v, and s and u respectively, but they
give a lower level of utility than consuming at point t.

 The optimum consumption point for the consumer, then,

is where the budget line touches (is ‘tangential to’) the
highest possible indifference curve.

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Superimposition of Budget Line and Indifference

Curve

How does a change in price of a good affect

consumption choices?

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How does a change in price of a good affect

consumption choices?

 Therefore as Price of a good decreases we will have a

pivot of the budget line (since now we are affording
more of this good) and therefore we could maximise
utility at a higher indifference curve tangent to the
new budget line.

How does a change in household income affect

consumption choices?

As income rises we will be affording more from the two

goods.

Therefore now we will have a shift of the budget line.

This new budget line will therefore be tangent to

higher indifference curve.

This means that now we can afford a higher

combination of goods which gives us a higher utility.

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Income / Substitution effect of a change in price

 As price rises consumers will purchase less because

of two reasons:

- They cannot afford to buy so much. This is the

income effect.

- The good is now more expensive relative to other

goods. Therefore consumers substitute alternatives
for it. This is the substitution effect.

Giffen Goods

 A Giffen good is a low income, non-luxury product

that defies standard economic and consumer
demand theory.

 Demand for Giffen goods rises when the price rises

and falls when the price falls.

 Example basic food such as rice and bread

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Normal goods and Inferior goods

 Normal goods can be defined as those goods for

which demand increases when the income of
the consumer increases and falls when income of
the consumer decreases, price of the goods
remaining constant.

 Inferior goods as a good which demand increases

when the income decreases. (cheap products)

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