Home > Micro > A2 Revision – Marginal Utility Theory

A2 Revision – Marginal Utility Theory

With the A2 exam not far away I thought it appropriate to post something on Marginal Utility. This is usually a multiple-choice question and part of an essay.

Consumers buy goods to derive satisfaction, or utility. Each unit purchased gives satisfaction (utility) and Marginal Utility is the satisfaction derived from the consumption of 1 more unit. Under normal circumstances the amount of satisfaction from each unit consumed will fall as more units are consumed e.g. when you finish a run your first drink will give you more satisfaction than your second and your second drink will give you more satisfaction than your third etc. – hence we get diminishing marginal utility see Table below. This is the basis of the normal demand curve, which slopes left to right – downwards.

The theory assumes that the RATIONAL CONSUMER aims to MAXIMISE SATISFACTION (or utility) by equating the MARGINAL UTILITIES yielded by the expenditure of a last money unit (cent or dollar) on each commodity purchased. The consumer is this is EQUILIBRIUM when the following formula is achieved:

  • MU of A   =     MU of B    =     MU of C       Etc.
  • Price of A       Price of B        Price of C

This means that the LAST unit of money spent provides the consumer with the same SATISFACTION (or UTILITY) irrespective of the good on which it is spent.

Examples

A consumer has $35 to spend. Price of X = $10 and Price Y = $5. What combination of X and Y maximize total satisfaction?

Quantity Bought Marginal Utility X Marginal Utility Y
1 30 15
2 20 12
3 15 10
4 9 8

 

  • MU of X   =     MU of Y
  • Price of X       Price of Y
  • 20   =   10
  • 10         5

Here the consumer buys 2X and 3Y

TOTAL UTILITY in this example = 30+20+15+12+10 = 87. (Note that TOTAL UTILITY is otherwise irrelevant to the calculation).

When the PRICE of a good falls, more will be bought (since the M.U. ÷ price formula is disturbed – and a LOWER M.U. {i.e. MORE BOUGHT} will restore equilibrium). Similarly, when the price of a good RISES less will be bought. This emerges from the LAW OF DIMINISHING MARGINAL UTILITY which states that as successful and equal quantities of a good are consumed, total utility increases but at a DIMINISHING RATE (i.e. MARGINAL UTILITY is FALLING – and can eventually become NEGATIVE.

Limitations of marginal utility theory 

  1. Unit of measurement – difficult to find an appropriate unit of measurement of utility.
  2. Habit and impulse – consumer spending on a particular product maybe habit forming or on impulse and therefore does not consider the marginal utility
  3. Enjoyment may increase as consumption increases – in some case utility may increase from further purchases of an item. A collector of memorabilia may obtain greater satisfaction from consuming an additional item – collecting a set of stamps etc
  4. Quality and consistency of successive units of a good – there is the assumption that all goods are homogenous but if successive can of soft drink are not the same then the marginal utility may change and be more or less than the previous one
  5. Other things remain constant – assumes that all factors affecting individuals’ satisfaction remain the same. However over time there maybe changes in income and the quality of other products as well as development of new products.
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