COECA1-B11

Chapter 8: Utility and Demand

 Lesson Outcomes
• After studying this chapter, you will be able to:

• Explain the limits to consumption and describe preferences using the concept
of utility.
• Explain the marginal utility theory of consumer choice.
• Use marginal utility theory to predict the effects of changes in prices and
incomes and to explain the paradox of value.
• Describe some new ways of explaining consumer choices.
 Mini Discussion Exercise
Question
• Distinguish between consumer surplus and producer surplus, and
explain how each is determined. (10 Marks)
 Answer
Answer
Note to Marker
Award 1 mark per tick as indicated to a maximum of 10 marks.
• When people buy something for less than it is worth to them, they receive a consumer surplus. 
• Consumer surplus is the excess of the benefit received from a good over the amount paid for
it.
• We can calculate consumer surplus as the marginal benefit (or value) of a good minus its price,
summed over the quantity bought. 
• When price exceeds marginal cost, the firm receives a producer surplus. 
• Producer surplus is the excess of the amount received from the sale of a good or service over the
cost of producing it. 
• It is calculated as the price received minus the marginal cost (or minimum supply-price),
summed over the quantity sold. 
 Consumption Choices
• The choices that you make as a buyer of goods and services (your
consumption choices) are influenced by many factors. We can
summarise them under two broad headings:

Consumption Possibilities
Preferences
 Consumption Choices
• Consumption Possibilities

• Your consumption possibilities are all the things that you can afford to buy.
• You can afford many different combinations of goods and services, but they are all
limited by your income and by the prices that you must pay.
• You will therefore spend less on the other goods as you spend more on the other
goods or services.
 Consumer’s Budget Line
• Consumer’s Budget Line
• Consumption possibilities are limited by income.
• When Lerato spends all her income, she reaches the limits to her consumption
possibilities.
• We describe this limit with a budget line, which marks the boundary between
those combinations of goods and services that a household can afford to buy and
those that it cannot afford.
Consumer’s Budget Line
Consumer’s Budget Line

• Points A to F in the graph illustrate the

possibilities presented in the table, and the
line passing through these points is Lerato’s
budget line.

• The budget line constrains choices: It marks

the boundary between what is affordable
and unaffordable.
• Lerato can afford all the points on the
budget line and inside it. Points outside the
line are unaffordable.
 Consumption Choices
Changes in Consumption Possibilities
• Consumption possibilities change when income or prices change.
• A rise in income shifts the budget line outward but leaves its slope unchanged. A
change in a price changes the slope of the line.
• Our goal is to predict the effects of such changes on consumption choices.

• To do so, we must determine the choice a consumer makes.

 Preferences
• Lerato’s income and the prices that she faces limit her consumption choices, but
she still has lots of choice.
• The choice that she makes depends on her preferences, a description of her likes
and dislikes which translate into the demand curve or what we refer to in the
previous chapter as Marginal Benefit curve.
 Preferences
• Marginal benefit curve is also a demand curve.
• The goal of a theory of consumer choice is to derive the demand curve from a
deeper account of how consumers make their buying plans.
• That is, we want to explain what determines demand and marginal benefit.
• We need to further describe preferences in a deeper way by explaining utility and
marginal utility
 Preferences
Preferences
• We approach preferences i.e. utility, and define utility as the benefit or satisfaction that a
person gets from the consumption of goods and services.
Total Utility
• The total benefit that a person gets from the consumption of all the different goods and
services is called total utility. More consumption generally gives more total utility

Marginal Utility
• Marginal utility is the change in total utility that results from a one-unit increase in the
quantity of a good consumed:
• Note the Calculation in Table 8.1
Preferences
 Marginal Utility
• Marginal utility is positive, but it diminishes as the quantity of a good consumed
increases.
• Positive marginal utility. All the things that people enjoy and want more have a
positive marginal utility.
• Some objects and activities can generate negative marginal utility – and lower
total utility. Two examples are hard labour and polluted air.
• But all the goods and services that people value and that we are thinking about
here have positive marginal utility.
• Total utility increases as the quantity consumed increases.
 Diminishing marginal utility
• Diminishing marginal utility As Lerato eats more chocolate, her total utility from
chocolate increases but her marginal utility from chocolate decreases.
• Similarly, as she consumes more cool drink, her total utility from cool drink
increases but her marginal utility from cool drink decreases
• The tendency for marginal utility to decrease as the consumption of a good
increases is so general and universal that we give it the status of a principle – the
principle of diminishing marginal utility
Marginal Utility
 Marginal Utility
• The figure below graphs Lerato’s total utility and marginal utility from cool drink
based on the numbers for the first 5 cans of cool drink a month in Table 8.1.
• Part (a) shows her total utility – increasing total utility.
• The columns along the total utility curve show the extra total utility from each
additional can of cool drink – marginal utility. Part (b) shows Lerato’s diminishing
marginal utility from cool drink.
Total utility and marginal utility
 Utility-Maximizing Choice
• Consumers want to get the most utility possible from their limited resources.
They make the choice that maximizes utility.

• To discover this choice, we combine the constraint imposed by the budget and the
consumer’s preferences and find the point on the budget line that gives the
consumer the maximum attainable utility.
Utility-Maximizing Choice
 Utility-Maximizing Choice
• Find the just-affordable combinations
• For example, in row A, Lerato buys only cooldrink at R4 per can and she buys 10
cans. In row B, Lerato eats 1 chocolate bar and buys 8 cans of cooldrink.
• She spends R8 on the chocolate bar. At R4 per can, she spends R32 on cooldrink
and is able to buy 8 cans. The combination in row B just exhausts her R40.
 Utility-Maximizing Choice
• Find the total utility for each just-affordable combination
• In row A of the table, Lerato eats no chocolate bars and buys 10 cans of cooldrink.
She gets no utility from chocolate and 260 units of utility from cooldrink.
• Her total utility from chocolate and cooldrink (the center column) is 260 units.
 Utility-Maximizing Choice
• In row C of the table, Lerato eats 2 chocolate bars and buys 6 cans of cool drink.
• She gets 90 units of utility from chocolate and 225 units of utility from cool drink.
• Her total utility from chocolate and cool drink is 315 units.
• This combination of chocolate and cool drink maximizes Lerato’s total utility.
 Consumer Equilibrium
Consumer Equilibrium
• Consumer equilibrium is a situation in which a consumer has allocated all of his
or her available income in the way that maximizes his or her total utility, given the
prices of goods and services.
• You have to measure total utility from all the affordable combinations of
chocolate and cool drink and then, by inspection of the numbers, select the
combination that gives the highest total utility.
• Lerato’s consumer equilibrium is 2 Chocolates and 6 Cans of cool drink (This
provides highest total utility).
 Choosing at the Margin
Marginal Utility per Rand
• Marginal utility is the increase in total utility that results from consuming one
more unit of a good.
• Marginal utility per rand is the marginal utility from a good that results from
spending one more rand on it.
• So to calculate the marginal utility per rand for chocolate (or cooldrink), we must
divide marginal utility from the good by its price.
• Call the marginal utility from chocolate MUCh and the price of a chocolate bar
PCh.
 Marginal Utility per Rand
• Then the marginal utility per rand from chocolate bars is:
• MUCh/PCh
• Call the marginal utility from cool drink MUCd and the price of a can of cooldrink
PCd.
• Then the marginal utility per rand from cool drink is:
• MUCd/PCd
• By comparing the marginal utility per rand from all the goods that a person buys,
we can determine whether the budget has been allocated in the way that
maximizes total utility.
 Utility-Maximising Rule
Utility-Maximising Rule
• A consumer’s total utility is maximized by two rules:
1. Spend all the available income
• More consumption brings more utility, therefore only those choices that exhaust income can
maximize utility.

2. Equalise the Marginal Utility per Rand

• The basic idea behind this rule is to move rand from good A to good B if doing so increases the utility
from good A by more than it decreases the utility from good B
• Such a utility-increasing move is possible if the marginal utility per rand from good A exceeds that from
good B.
 The Power of Marginal Analysis
The Power of Marginal Analysis
• If the marginal gain from an action exceeds the marginal loss, take the action.
• The rule that Lerato follows is simple: If the marginal utility per rand from
chocolate exceeds the marginal utility per rand from cool drink, eat more
chocolate and buy less cool drink;
• If the marginal utility per rand from cool drink exceeds the marginal utility per
rand from chocolate, buy more cool drink and eat fewer chocolate bars.
 Predictions of Marginal Utility Theory
Equalise the Marginal Utility per Rand
• You will see that marginal utility theory predicts the law of demand, to derive these
predictions, we will study the effects of three events:
• A fall in the price of a chocolate bar.
• A rise in the price of cool drink.
• A rise in income.
 A Fall in the Price of a Chocolate Bar
Finding the New Quantities of Chocolate Bars and Cool drink.

• Determine the just-affordable combinations of chocolate bars and cool drink at the
new prices.
• Calculate the new marginal utilities per rand from the good whose price has
changed.
• Determine the quantities of chocolate bars and cool drink that make their marginal
utilities per rand equal.
 Predictions of Marginal Utility Theory
• When the price of a chocolate bar falls and the price of cool drink remains the
same, the quantity of chocolate bars demanded by Lerato increases, in part (a)
Figure 8.4.
• Lerato moves along her demand curve for chocolate. Also, when the price of a
chocolate bar falls, Lerato’s demand for cool drink decreases, and in part (b)
Figure 8.4 her demand curve for cool drink shifts leftward.
• For Lerato, cool drink and chocolate are substitutes.
 Predictions of Marginal Utility Theory
A Change in the Quantity Demanded
• We illustrate a change in the quantity demanded by a movement along a demand curve.
A Change in Demand
• We illustrate a change in demand by a shift of a demand curve.
Predictions of Marginal Utility Theory
A Rise in the Price of Cool drink
• When the price of cool drink rises and the price of a
chocolate bar remain the same and Lerato’s income
remain the same, the quantity of cool drink demanded
by Lerato decreases.

• Figure 8.5 shows points on Lerato’s demand curve for

cool drink.
• It also shows the change in the quantity of cool drink
demanded when the price of cool drink rises and all
other influences on Lerato’s buying plans remain the
same.
 Predictions of Marginal Utility Theory
A Rise in Income

• When Lerato’s income increases, her demand for chocolate and her demand for cool drink
increase. Lerato’s demand curves for chocolate, in part (a) Fig 8.6 and for cool drink, in part (b)
Fig 8.6 shift rightward. For Lerato, chocolate and cooldrink are normal goods.
 Predictions of Marginal Utility Theory
The Paradox of Value
• The price of water is low and the price of a diamond is high, but water is essential to life
while diamonds are used mostly for decoration.
• How can valuable water be so cheap while a relatively useless diamond is so expensive?
• This so-called paradox of value has puzzled philosophers for centuries
The Paradox Resolved
• The paradox is resolved by distinguishing between total utility and marginal utility.
• The total utility that we get from water is enormous, but remember, the more we consume
of something, the smaller is its marginal utility.
• We use so much water that its marginal utility – the benefit we get from one more glass
of water or another 30 seconds in the shower – diminishes to a small value.
• Diamonds, on the other hand, have a small total utility relative to water, but because we
buy few diamonds, they have a high marginal utility.
 New Ways of Explaining Consumer
Choices
Behavioral Economics
• Behavioral economics studies the ways in which limits on the human brain’s
ability to compute and implement rational decisions influences economic
behavior – both the decisions that people make and the consequences of those
decisions for the way markets work.

• People are assumed to have three impediments that prevent rational choice:
bounded rationality, bounded willpower, and bounded self-interest.
 New Ways of Explaining Consumer
Choices
Bounded Rationality
• Bounded rationality is rationality that is limited by the computing power of the
human brain. We cannot always work out the rational choice.
Bounded Willpower
• Bounded willpower is the less-than-perfect willpower that prevents us from
making a decision that we know, at the time of implementing the decision, we will
later regret.
Bounded Self-Interest
• Bounded self-interest is the limited self-interest that results in sometimes
suppressing our own interests to help others.
 New Ways of Explaining Consumer
Choices
The Endowment Effect
• The endowment effect is the tendency for people to value something more highly
simply because they own it.
Neuroeconomics
• Neuroeconomics is the study of the activity of the human brain when a person
makes an economic decision.
• The discipline uses the observational tools and ideas of neuroscience to obtain a
better understanding of economic decisions.