Consumer Behaviour: Marginal Utility, Demand, and Consumer Surplus

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Chapter 6: Consumer Behaviour

Overview

This chapter explores how consumers make choices to maximize their satisfaction, or utility, from consuming goods and services. It introduces the concepts of total and marginal utility, the law of diminishing marginal utility, and how these ideas underpin the demand curve and consumer surplus in microeconomics.

Marginal Utility and Consumer Choice

Utility: Definition and Types

Utility: The total satisfaction or pleasure derived from consuming goods and services.
Total utility: The overall satisfaction obtained from consuming a certain quantity of a product.
Marginal utility: The additional satisfaction gained from consuming one more unit of a product.

Example: If drinking a second bottle of juice increases your total satisfaction from 30 to 50, the marginal utility of the second bottle is 20.

Diminishing Marginal Utility

The law of diminishing marginal utility states that, ceteris paribus (all else equal), as a consumer consumes more units of a good, the additional satisfaction from each extra unit decreases.

Marginal utility falls as the level of consumption rises.
Example: The first liter of water per week is highly valued, but the value of each additional liter decreases.

Key Assumptions:

Individuals know the utility from different actions.
Individuals can compare the utility from different actions.

Utility Schedules & Graphs

Utility schedules and graphs illustrate how total and marginal utility change with consumption.

Bottles	Alison's Total Utility	Alison's Marginal Utility
0	0	0
1	30	30
2	50	20
3	65	15
4	75	10
5	83	8
6	89	6
7	93	4
8	96	3
9	98	2
10	99	1

Graphical Representation: Total utility increases at a decreasing rate, while marginal utility declines as quantity increases.

Total Utility, Marginal Utility, and the Demand Curve

The shape of the marginal utility curve mirrors the shape of the demand curve.
Marginal utility is the slope of the total utility function.
As marginal utility decreases, consumers are willing to pay less for additional units, resulting in a downward-sloping demand curve.

Market Demand Curves

The theory of consumer behaviour predicts a negatively sloped market demand curve, as well as for each individual.
Market demand is the horizontal sum of individual demand curves.

Maximizing Utility

The Utility-Maximizing Rule

Consumers allocate their income to maximize total utility, given their budget constraint. For two goods, x and y:

Objective:
Subject to:

The utility-maximizing condition is:

Consumers adjust their spending so that the marginal utility per dollar is equalized across all products.

Example: If burritos and juice both cost $1 and the consumer has $6, they should allocate their spending so that the last dollar spent on each yields the same marginal utility.

Income and Substitution Effects of Price Changes

Substitution Effect

When the price of a good falls, it becomes relatively cheaper, so consumers substitute it for other goods, increasing its quantity demanded.

Income Effect

A price decrease increases the consumer's real income (purchasing power).
For a normal good, the income effect increases quantity demanded.
For an inferior good, the income effect may decrease quantity demanded.

The overall effect of a price change is the sum of the substitution and income effects. For normal goods, both effects reinforce a downward-sloping demand curve.

Consumer Surplus

Definition and Measurement

Consumer surplus is the difference between what a consumer is willing to pay for a good and what they actually pay.
It represents the net benefit or 'bargain' consumers receive in the market.

Example: If a consumer is willing to pay $5 for a product but buys it for $3, the consumer surplus is $2.

Graphical Representation

Consumer surplus is the area between the demand curve and the market price, up to the quantity purchased.

The Paradox of Value

Explanation

The 'paradox of value' refers to the observation that essential goods (like water) often have low prices, while non-essentials (like diamonds) have high prices.
This is resolved by distinguishing between total value (overall importance) and marginal value (value of the last unit consumed).
Market price reflects marginal value, not total value.

Example: Water is vital (high total value) but abundant (low marginal value and price); diamonds are less useful but scarce (high marginal value and price).

Summary Table: Key Concepts

Concept	Definition	Example
Total Utility	Total satisfaction from consumption	100 utils from 10 bottles of juice
Marginal Utility	Extra satisfaction from one more unit	5 utils from the 11th bottle
Consumer Surplus	Willingness to pay minus actual price	Willing to pay $10, pays $7, surplus = $3
Substitution Effect	Change in consumption due to relative price change	Buy more juice when its price falls
Income Effect	Change in consumption due to real income change	Buy more normal goods when price falls