The utility theory
The theory explains how an individual maximises utility gained from the consumption of
commodities. The theory assumes that the consumer seeks to maximise utility. The consumer is
assumed to have knowledge of all the information relevant for his utility maximising decisions
Economists use the term utility to describe the satisfaction or enjoyment derived from the
consumption of a good or service. If we assume that consumers act rationally, this means they will
choose between different goods and services so as to maximize total satisfaction or total utility.
Consumers take into consideration:
How much satisfaction they get from buying and then consuming an extra unit of a good or
service
The price that they have to pay to make this purchase
The satisfaction derived from consuming alternative products
The prices of alternatives goods and services
Total utility- total satisfaction or enjoyment derived from the consumption of a good or service.
Marginal utility-the extra satisfaction derived from consuming one more unit of the same product.
The table below shows the relationship between total and marginal utility
movies total marginal
watched per utility utility
week
0 0
1 30 30
2 55 25
3 75 20
4 87 12
5 97 10
6 104 7
7 108 4
8 110 2
9 110 0
10 108 -2
11 104 -4
Task plot the total utility and marginal utility figures on a graph
Total and marginal utility shown on the same diagram
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Diminishing marginal utility, refers to the reducing (decreasing) nature of the additional satisfaction
derived from the consumption of an extra unit of a commodity and the law is thus stated – “as
successive additional units of a commodity are consumed, the extra satisfaction derived continues to
decline.”
There are two basic theories on utility;
1. The Cardinalist theory
2. The Ordinalist theory
The Cardinalist theory (Marshallian approach)
Assumptions
The customer is assumed to be rational and aims to maximise utility derived from consuming
goods
Utility is assumed to be measurable using units called utils, alternatively utility can be measured
by measuring the amount of money a consumer is willing to sacrifice to gain an extra unit of a
given commodity
Constant marginal utility of money, the utility of money is assumed to be constant as
money/income increases
Diminishing marginal utility, satisfaction gained from consuming a product declines as more of
the product is consumed
Absence of differences in income, tastes, fashion etc.
Independent goods and independent utilities.
Demand for a commodity depends on its price alone; it excludes other determinants of demand.
Consumer equilibrium
Consumer equilibrium can be analysed at different levels:
1. Single good market
The consumer can either buy the good or retain his money. Equilibrium is achieved where
MUx = Px
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If the Mux >Px the consumer can improve his welfare by purchasing and consuming more units of X.
Similarly if Mux <Px the consumer can increase his satisfaction by cutting down on the quantity of X
consumed. Utility is therefore maximised where Mux = Px since at this state there is nothing the
consumer can do to further improve his satisfaction
2. Two or more products with the same price
Utility is maximised where the marginal utilities for all products are equal eg if a consumer consumes
products X,Y and Z and the products have the same price, utility is maximised by consuming
quantities of the 3 products such that MUx=MUy=MUz.
Where MUx>MUy the consumer can increase his satisfaction by consuming more units of product X
and reducing the quantity of Y
3. Two or more products with different prices
MUx MUy MUz
Utility is maximised where =
Px Py Pz
The utility maximising condition above is called the Equi-marginal utility principle. The Law of Equi-
Marginal Utility states that: “A household maximizes total utility from a given level of income by
equating the weighted marginal utilities of last units of all products it purchases, ceteris paribus.” Or
‘’The equimarginal principle states that consumers allocate their money such that
the marginal utility per dollar of each good is the same because this is how they maximize their total
utility’’. Weights imply prices of products and weighted marginal utility is the ratio of marginal utility
and price i.e. utility per dollar.
MUx MUy
Where > the consumer can increase his/her satisfaction by consuming more of good
Px Py
X and reducing the quantity of Y consumed
Critique of the cardinal approach
There are three basic weaknesses in the Cardinalist approach:
The assumption of cardinal utility is extremely doubtful. The satisfaction derived from various
commodities cannot be measured objectively.
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The assumption of constant utility of money is also unrealistic. As income increases the marginal
utility of money changes. Thus money cannot be used to measure utility since its own utility
changes.
Finally, the axiom of diminishing marginal utility has been 'established' from introspection, it is a
psychological law which must be taken for granted.
The Ordinalist theory
Indifference curve – defined as the locus of possible combinations of two commodities their
consumption from which the consumer derives the same level of satisfaction. Such curves are
negatively sloped, do not intersect and are convex to the origin.
Budget line – refers to the locus of combinations of two goods whose purchase exhausts the
consumer’s budget constraint (money outlay).
X Y Combination
17 1 A
12 2 B
8 3 C
5 4 D
3 5 E
2 6 F
Assumptions
I. Rationality. The consumer is assumed to be rational- (s)he aims at the maximisation of his utility,
given his income and market prices. It is assumed he has full knowledge (certainty) of all relevant
information.
2. Utility is ordinal. The consumer can rank his preferences (order the various 'baskets of goods')
according to the satisfaction of each basket. He need not know precisely the amount of satisfaction.
3. Diminishing marginal rate of substitution. Preferences are ranked in terms of indifference curves,
which are assumed to be convex to the origin. The slope of the indifference curve is called the
marginal rate of substitution of the commodities. The indifference-curve theory is based, thus, on
the axiom of diminishing marginal rate of substitution (see below).
4. The total utility of the consumer depends on the quantities of the commodities consumed
5. Consistency and transitivity of choice. It is assumed that the consumer is consistent in his choice,
that is, if in one period he chooses bundle A over B, he will not choose B over A in another period if
both bundles are available to him. The consistency assumption may be symbolically written as
follows: If A > B, then B ≯ A.
Similarly, it is assumed that consumer's choices are characterised by transitivity: if bundle A is
preferred to B, and B is preferred to C, then bundle A, is preferred to C. Symbolically we may write
the transitivity assumption as follows: If A > B, and B > C, then A > C.
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The main characteristics of indifference curves
Indifference curves do not cross/ intersect, Indifference curves do not intersect because an
intersection would contradict the principles of consistency and transitivity. Intersection implies
that different levels of satisfaction can be derived on the same indifference curve (which is not in
accordance with the definition of indifference curves). The intersection point would also mean
that two indifference curves have the same level of utility which is also not true.
Indifference curves are always convex to the origin. The property of convexity to the origin of an
indifference curve has to do with diminishing marginal rate of substitution. MRS – is the amount
of one commodity that a consumer is just willing and able to give up for an extra/additional unit
of another related commodity, while remaining at the same level of satisfaction.
Given two or more indifference curves the one to the right shows a higher level of satisfaction
than the one to the left
Negatively sloped: Indifference curves slope downwards from left to right implying that more of
one commodity is consumed by reducing the consumption of the other commodity while
deriving the same level of satisfaction, that is, marginal rate of substitution (MRS).
Consumer equilibrium
Px/Py (slope of the budget line) = MRSxy (slope of the indifference curve)
IC is the indifference curve which shows bundles of goods to which the consumer is indifferent. The
consumer can consume any combination of good X and Y along the indifference curve and derive the
same level of satisfaction. AB is the budget line, it shows the amounts of X and Y the consumer can
purchase with his fixed income. Consumer equilibrium is achieved where the indifference curve is
tangent to the budget line. The slope of the indifference curve is the marginal rate of substitution, it
measures the amount of one commodity the consumer gains by giving up one unit of the other
commodity.
MUx Px
MRSxy = . The slope of the budget line is the ratio of prices of the two products X and Y ( ).
MUy Py
Px
The consumer equilibrium can therefore be expressed as where MRSxy = .
Py
Effect of changes in prices on the budget line
Assume the price of good Y on the diagram above decreases, the budget line shifts outwards on the
horizontal axis from AB to AB2 but remains pivoted at A as shown on the diagram below
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The equilibrium changes from E to E2 and at the new equilibrium more units of Y can be consumed
Effect of changes in income on the budget line
A change in income results in a parallel shift of the budget line. Assume the income of the consumer
increases, this result in an outward shift of the budget line. This implies that the consumer is now
able to buy more of both goods
The original budget line is A1B1 and equilibrium is attained where IC intersects A1B1 which is point
E. An increase in income shifts the budget line to A2B2 resulting in a new equilibrium point E2
Substitution and income effect
When the price of a good decreases the quantity consumed increases because of two factors
1. substitution effect, when the price of a good decreases the consumer substitutes relatively
expensive substitutes for the good whose price has decreased
2. income effect, when a good’s price decreases the real income(income in terms of purchasing
power) of the consumer increases hence the consumer can buy more the product. On the
diagram below YY1 is the substitution effect and Y1Y3 is the income effect
Normal good
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For a normal good the substitution effect and the income effect are both positive thus the two
complement each other and the total price effect is positive (more normal goods are purchased at
low prices)
Inferior goods
For an inferior good the substitution effect is YY2 and the income effect isY2Y1. The substitution
effect is positive while the income effect is negative. The positive substitution effect is greater than
the negative income effect hence the overall effect is positive (more inferior goods are purchased at
low prices)
Giffen goods
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The substitution effect is Y1Y2 and the income effect is Y2Y. The negative income effect is greater
than the positive substitution effect hence the total price effect is negative (less giffen goods are
purchased at low prices)
Indifference curves for selected products
Substitutes Complements
Perfect substitutes will have a linear indifference curve with a constant slope and therefore a
constant MRS. Perfect complements will have an L shaped indifference curve and the MRS does not
exist.
Limitations of the indifference Approach:
The indifference curves approach has the following limitations:
Indifference curve analysis is only possible for 2 or at best for 3 goods.
It is almost impossible to practically derive indifference curves.
The consumer may not always behave rationally.
The consumer may not always realize the level of utility (ex-post) from consumption, that she
originally expected (ex-ante).
Indifference curve analysis cannot help when one of the goods (X or Y) is a durable good.
Derivation of an individual demand schedule
1. Using the Cardinalist approach
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If the marginal utility is measured in monetary units the demand curve for x is identical to the
positive segment of the marginal utility curve. At x 1 the marginal utility is MU1 in the diagram
above. This is equal to P1, by definition. Hence at P1 the consumer demands x1 quantity. Similarly at
x2 the marginal utility is MU2, which is equal to P2. Hence at P2 the consumer will buy x2, and so on.
The negative section of the MU curve does not form part of the demand curve, since negative
quantities do not make sense in economics.
2. Using the Ordinalist approach
The price–consumption line in the diagram above (top) shows how demand for X increases as its
price falls relative to Y. The lower diagram plots the price of X against the demand for it. If we
correlate quantities of X demanded along the price–consumption line with the various prices on the
demand curve we derive a normal downward-sloping demand curve. Thus as price has fallen from
OA to OB to OC, so quantity demand has expanded from OL to OM to ON.
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Rational behaviour versus behavioural economic model
A major assumption that underpins marginal utility theory is that consumers can always be expected
to act rationally. Rational behaviour essentially means the following:
● Individuals will take decisions to maximise their own utility or satisfaction.
● Individuals have access to all the information that they need to make a decision at zero cost.
● Individuals take decisions that are based on a very careful comparison of the benefits and costs to
achieve the optimum outcome.
● Decisions will be taken by individuals based on changes at the margin.
● The preferences of individuals and their attitude to risk are assumed to be fixed.
Behavioural economics, on the other hand, stresses that the behaviour of individuals may differ
greatly from these assumptions — in other words, it is often irrational rather than rational.
Behavioural economics attempts to explain behaviour that may appear as ‘irrational’. It is not limited
to economics, but also brings in concepts and theories from sociology and psychology.
It is assumed that individuals take optimal decisions based on the information that is available to
them, but behavioural economists suggest that there may be so much information available that
individuals often take the same decision that they always have — that is, they often base decisions
on past experience. In this sense, individuals are ‘creatures of habit’ and are strongly influenced by
brands and the uses made of branding in marketing. The individual’s ability, and indeed willingness,
to act in a rational manner is therefore restricted in certain ways.
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