The UK’s European university

Economics for Accounting

ECON3007
Autumn Term
5. Consumer Demand I: Theory
Aims and reading

• Aims
• To understand total and marginal utility

• To understand indifference curves

• To introduce budget constraint

• Reading
• Mulhearn & Vane Chapter 2; Sloman et.al. Chapters 5.5 & 6

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 Utility

Indifference curves

Budget constraint

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Utility

• Economists are interested in the level of satisfaction

that consumers obtain from their purchases

• Utility is a hypothetical measure of satisfaction that

people get from consuming goods and services

• Historically, utility as a measure of satisfaction is

grounded in utilitarianism

• Jeremy Bentham (1748-1832) believed that society

should strive to maximise utility

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Utility

• Utility is measured in utils, which are hypothetical units

of satisfaction

• The utility function assigns a value to the level of

satisfaction associated with the consumption of a
basket of goods
• Examples: Take aways, mobile phone, train tickets, etc.

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Marginal utility versus Total Utility

• Marginal utility is the additional utility gained from

consuming an additional unit

Marginal utility (mU) =

Extra satisfaction of the additional unit

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Marginal utility versus Total Utility

• Marginal utility is assumed to decrease because if it did

not consumers would spend all income on the good with
the highest mU

• Consumers get ‘bored’ of always consuming the

same good: the law of diminishing marginal utility

• They have a preference for variety (convex

preferences)

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Marginal utility versus Total Utility

• Total utility (TU) is the overall amount of satisfaction

a consumer obtains from consuming a given total of
a particular good

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The Law of Diminishing Marginal Utility

• The law of diminishing marginal utility states that

increasing consumption of a good decreases
marginal utility over a period of time

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The Law of Diminishing Marginal Utility
Total Utility
20

18 mU (4)

16 mU (3)

14

12 mU (2)
Marginal Utility

10

6
mU (1)
4

0
0 1 2 3 4

Quantity
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The Law of Diminishing Marginal Utility
 The marginal utility of the good
Marginal Utility (beers, cake, etc.) gets smaller
as the quantity consumed
12 increases
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Marginal Utility (utils)

 This is called the law of

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diminishing marginal utility

0
0 1 2 3 4

Quantity
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 Total and marginal utility

Indifference curves

Budget constraint

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Indifference curves

• Assumptions regarding the tastes of a consumer:

• Completeness

• Transitivity

• Consumer prefer more to less

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Indifference curves

• Marginal Rate of Substitution (MRS) is the slope of

the indifference curve

• MRS is the rate at which consumers are willing to

exchange one good for another while maintaining the
same level of utility

• Consumer tastes exhibit a diminishing marginal rate

of substitution when, to hold utility constant,
diminishing quantities of one good must be sacrificed to
obtain successive equal increases in the quantity of the
other good

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Indifference curves

• Indifference curves represent preferences in a

“consumption space”

Good 1

Good 2

• They are built from the consumer’s utility function over

bundles of goods

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Indifference curves

Good 1
IC shows all the consumption
bundles yielding a particular level
of utility

Indifference curve (IC)

0 Good 2

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Indifference curves

Good 1

IC4

IC3
IC2
IC1

0 Good 2
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Indifference curves

Good 1

D
B
E
C IC3
IC2
IC1

0 Good 2
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Indifference curves

• Key characteristics:
• IC have a negative slope

• IC are said to be convex to the origin

• IC never intersect each other

• Higher IC provide more satisfaction than lower IC

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Indifference curves

Good 1

ICs cannot intersect

Y
Z IC2
X
IC1

0 Good 2
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Total and marginal utility

Indifference curves

Budget constraint

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Budget constraint

• The budget constraint:

• The consumer has a limited income (I) to purchase
goods
• Each type of good has a defined price (p) per unit
• We assume that the consumer spends all his/her
income
–Savings are treated as another type of good

• A consumer’s income and the market prices of goods

define her budget constraint
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Budget constraint

• The budget constraint is:

I  p1 x1  p 2 x 2

• Example: imagine the following “student budget”

• Total income is £50
• The price of a meal is £10
• The price of a cinema ticket is £5

50 = £5 x tickets + £10 x meals

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Budget constraint

• The budget line shows how many

Meals tickets must be sacrificed to get another
meal
5 
• The slope of the budget line depends
only on the ratio of the prices of the two
goods (-PH/PV)

Budget line

10 Cinema tickets
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Budget constraint

Meals

5 A
E
B

D
K
E

F
10 Cinema tickets
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What have we learnt?

• Utility can be used as a measure of consumer

satisfaction

• Marginal utility diminishes as consumption increases

• mU versus Total Utility

• Law of diminishing marginal utility

• Budget constraint sets a limit to the consumer’s

consumption

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