## Thursday, 4 October 2012

### Principles of Economics: Marginal Utility Theory (Microeconomics)

In this blog I'll be looking at one of the theories as to how exactly we derive the demand. This is called the marginal utility theory. All the way through this we make the assumption that consumers act and behave in a rational manner - they choose their consumption rationally and consistently. A rational consumer therefore would be one that aims to get the best value for their money. Bear that in mind and remember it as we run through this principle.

Lets start at the very basics by defining a few things. A phrase that will crop up a lot now is 'utility'. Basically, this is the term economists give to the satisfaction a consumer receives when consuming a good. Obviously, it's a totally theoretical thing as it's near on impossible to actually measure how happy or satisfied a consumer gets when consuming a good. But, for the benefit of the theory and the examples it is used. Total utility will then refer to the total satisfaction or happiness gained from all the units of the good that have been consumed. Another term here is marginal utility. This is the additional satisfaction from consuming one extra unit of a good. If i gained 10 utility from eating 6 bananas and 12 utility from eating 7 bananas then the marginal utility here would be 2 (12-10). Utility, like i said, is a very subjective thing, we have to make an assumption that it can be measured. The measurement of utility is a util. One util is one unit of satisfaction.

Marginal utility follows a diminishing pattern, the more of a good the consumer consumes the lower the marginal utility gets. This is because for every extra unit of a good consumed you won't be getting as happy until you finally reach a point at which total utility is at maximum and will only fall if any more of the good is consumed. Lets look at an example, here we have a table for the consumption of a good and the utility it gives the consumer:

This data can then be plotted onto a graph, displaying the total and marginal utility curves like this:

Before I continue, I apologise for the graphs.. I try my hardest, I'm just not a dab hand at using Paint! Anyway, here we have the total utility and the marginal utility for the table above drawn out. As you can see, marginal utility slopes downwards and total utility always starts at the origin. Total utility will peak when marginal utility is at 0. We can take any point on the total utility curve and it'll equate to the equivalent point on the marginal utility curve. For example, between 2 and 3 consumption the change in the total utility is 2 and the change in quantity consumed is 1. 2/1 = 1 of course, which if we look at the marginal curve is where MU is at 3 consumption. The general rule for that is (change in total utility) / (change in consumption) = MU.

We can also work out what the optimum level of consumption for one good is with utility, to do this we need to measure utility with money. So utility now becomes the value people place on their consumption and marginal utility is the amount a person would pay to achieve one more unit of a good. We open up a new principle here, the marginal consumer surplus or MCS for short. This is the difference between what someone is willing to pay for one more good and what they actually pay. An equation for this would be: MCS = Marginal Utility (MU) - Price (P). Total consumer surplus (TCS) can come into play now too, this being the sum of all marginal consumer surpluses that are gained from all the good consumed. This is effectively the difference between the total utility from all units in monetary terms and the actual expenditure on them. In equation form: TCS = Total utility (TU) - Total expenditure (TE). As with most things economical, we can graph out this concept.

The rational consumer is aiming to maximise their consumer surplus. So, on the diagram, area 1 represents the consumers total expenditure. It'd value out at P x Q. The total utility of the consumer is area 1 + area 2. As we stated above, the total consumer surplus is TU - TE so therefore area 2 on its own is the total consumer surplus. The quantity Q here maximises consumer surplus, so that is the point to consume at. Any lower quantity and consumer surplus wouldn't be maximised, any higher and consumer surplus wouldn't increase but spending would.

The market demand curve for a good can be derived from the individuals demand curves. The individuals demand curve is the MU curve for the good. So the market demand curve for a good is the sum of all individual MU curves. It's shape depends entirely on the rate that MU falls in general for the individuals. A shift could occur if, for example, the price of a substitute good rises the MU will rise because people will desire the original good more instead of the higher priced substitute.

This theory for working out the optimal consumption of one good does have it's limitations:
• A change in consumption will affect the MU of both substitute and complimentary goods and also effect income left over to spend.
• Money itself doesn't have a constant MU.
• Income rising means extra money meaning each pound will bring less satisfaction.
• We cannot literally use money in an absolute sense to measure utility. ]

It's more appropriate to measure the optimal consumption of goods in combination, two goods in the example. This involves finding the equi-marginal price. This is where the consumer gets the highest utility from a level of income, which is where the ratio of the MUs of the two goods is equal to the ratio of the price. In equation form this would be (MU of good A) / (MU of good B) = (Price of good A) / (Price of good B).

...And exhale. That's me done, the basics of marginal utility and how it can be used to derive demand. A lot in one go I know, but you'll get the hang of it. My next post on the principles of economics will be focused on indifference curves. Thanks for reading guys, have a good night!

Sam.