Marginal Utility Theory (Topic 9)
Consumption of goods and services is to derive ___________________
Economist use the term ____________ to describe the satisfaction or enjoyment derived
from the consumption of a good or service. If we assume consumers act rationally, this
means they will choose between different goods and services so as to maximise total
satisfaction or ______________________.
Consumers will take into consideration
How much satisfaction they get from buying and then consuming an extra unit of a good
The price that they have to pay to make the purchase
The satisfaction derived from consuming alternative products
The prices of alternative goods and services
Pints of orange juice Total utility (utils) Marginal uti;ity (MU)
0 0 0
1 12 10
2 16 6
Total utility is the utility derived from ________________ a given quantity of goods and
services within a given time period.
Marginal utility is the utility gained from an extra unit of the good consumed. It is the change
in total utility or satisfaction resulting from the consumption of one more unit of a good.
Conclusion from the graph:
1) Up to a certain point, the more of a commodity is consumed, the _________
will be total utility.
2) As more goods is consumed, MU _____________. This is the hypothesis of diminishing
marginal utility - states that as the quantity of a good consumed increases, the marginal
utility derived from the good decreases.
e.g. a consumer enjoys successive pints of of his favourite orange juice. The total and
marginal utility gained from each extra pint is shown in the table above. Total utility is
__________ when MU = __________
Consumer Equilibrium (optimising choices)
Every consumer has a limited income. Choices must be made. When a consumer has made all his
choices about what to buy and in what quantities and the total level of satisfaction/utility from that
set of choices is as great as it can be, we say that the consumer has optimised his consumption
1) when there is only 1 good – consumer will optimises consumption choices when
MU = Price
Assume that $1 = 1MU. Therefore if a person is willing to pay $25 for a pair of jeans, then
that pair of jeans will yield him 25 $ worth of MU i.e MU = $25.
Therefore a rational consumer will always try to maximise his satisfaction given his limited
income so as to reach equilibrium and that will occur when he equate MU with the price of the
product i.e MU = Price
2) when there are multiple goods in the market – Law of equi-marginal returns
A rational consumer will spend his income in a way that maximises the total utility
derived from all goods and services consumed.
Consider an example where a consumer has a choice between 2 goods A and B
which have prices Pa and Pb respectively.
Total utility is maximised when
M arg inal utility of good A m arg inal utility of good B m arg inal utilityof .... good n
Pr ice of good A price of good B price of ..... good n
MU a MU b MU n
--- Law of equi-marginal returns ie that the utility derived from
Pa Pb Pn
per $ spent on the last unit bought must be equal to the
utility derived per $ spent on the last unit consumed.
This means that the extra satisfaction per $ on the last unit of good A equals the extra
satisfaction per $ on the last unit of good B and that of C and so on.
If this was not the case, consumers would reorganize their spending and increase their
satisfaction. E.g the consumer will have to buy more of X and less Y
Given and if MUx = 20 utils and Px = $2
Muy = 10 utils and Py = $4
What should the consumer do to optimise his consumption?
2 Given income = $13, Px = $1 and Py = $2
Qty (X) TU (X) MU (X) MUx Qty (Y) TU (Y) MU (Y) MUy
1 9 1 25
2 17 2 45
3 24 3 60
4 30 4 70
5 35 5 75
6 39 6 75
Consumer will be in equilibrium when he consumes ____X and _____Y
Deriving the demand curve from the MU theory
The demand curve states that as the price , qty demanded and vice versa.
MU theory can be used to explain (prove) this.
Assume that initial equilibrium -
Assume Px to $4 Assume Px $1
Criticism of the utility theory
1) Some economist claim that utility cannot be measured objectively. It cannot be measured in
the absolute sense. We cannot say in exact terms how much the MU of one good exceeds
another. E.g. a good gives 2x more satisfaction, this is only a relative term. Thus at
equilibrium, how can we be sure that that the last $1 spent on each gives us exactly the
2) There is also doubts about the assumption of rational behaviour among consumers –
particularly in a world where consumers cannot expect to have all the information available
on the products market. Advertising may well influence the belief that we will derive a certain
satisfaction. Thus the optimum level of consumption may not in practice give consumers
maximum satisfaction for their money.
3) Some people associate status with price – upward sloping DD curve. Theory cannot explain
the phenomena for such goods.
Paradox of value ( Diamond water Paradox)
Adam Smith asked ‘How is it that water which is so essential to human life and thus has a high
value in use has such a low market value. How is it that diamonds which are relatively so trivial
have such a high market value?
Source of the market value of a good is its MU and not its TU.
Water – low MU, thus market value is low = low price
Diamonds – high MU, thus high market value = high price