Topic 2: Economics of markets 1: Consumption and utility

Topic 2
Economics of markets 1:
Consumption and utility

Objectives
At the end of Topic 2, students should

1. To develop an understanding of the concepts of:

 utility
 marginal utility
 income
 diminishing marginal utility
 marginal rate of substitution
2. have an understanding of the economic concept of utility and the economic theory of
preferences;
3. be able to define total utility (TU) and marginal utility (MU);
4. have a knowledge of indifference curves, their properties and underlying
assumptions;
5. have an understanding of the concept of marginal rate of substitution (MRS)
between two goods or services;
6. be able to construct an indifference map to illustrate ordinal utility.

Contents
1. Introduction
2. Consumer preferences
3. Basic assumptions underlying consumer preferences
a. Completeness assumption
b. Transitivity assumption
c. ‘More is better than less’ or non-satiation assumption
4. Utility
5. Budget constraint
6. Indifference curves
7. Marginal rate of substitution
8. Maximising consumer satisfaction
9. Summary
10. Keywords
11. References

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Topic 2: Economics of markets 1: Consumption and utility

_________________________________________________________________

1. Introduction
Topic 2 introduces consumer theory and the concept of utility with a discussion of consumer
preferences and underlying assumptions. The behaviour of individuals as economic agents
in the market for goods and services is discussed. Basic economic theory is described in
the context of consumer preferences and an individual consumer’s willingness to make
trade-offs between goods and services in order to increase their satisfaction or utility.

The theory of preferences underlying consumer behaviour in economics relies on certain

assumptions. These assumptions regarding preferences, combined with properties of
indifference curves, are necessary to enable both a graphical and an algebraic solution to
the consumer problem.

From data about individual preferences for different bundles of goods and services we are
able to construct a set of indifference curves. This information combined with a consumer’s
income (budget constraint) and the prices of goods and services provides us with a solution
to the consumer problem: How a consumer allocates their limited budget across the goods
and services that they desire (where the consumer faces a market price for each good or
service) to maximize their utility.

2. Consumer Preferences
Individual tastes or preferences are likely to dictate economic decisions, ie choices. For
some goods ‘preference ordering’ is relatively straightforward, for example if you had to
order your preferences for money you would choose the bundle that contained the most
money. Similarly choices of other economic goods such as DVDs, clothes, and books
would be relatively simple, we would generally make the decision on the basis of ‘more is
better’.

However, as economic agents we also have to make choices between goods and
services, for example between DVDs and books. We can think of these choices as being
between alternative bundles of goods or services over which we are likely to have certain
preferences. These choices however may require us to value different combinations of
books and DVDs, thus we may have to trade-off books for DVDs. Whilst trade-offs
between goods may not seem too difficult, other bundles of goods and services make
preference ordering less straightforward.

For example ‘how might our preferences be defined for the consumption of haircuts or
medical care?’ Do we have enough information to value services such as medical care in
order to then make a choice as to the type of care that we prefer? We also make chooses,
and therefore by definition have preferences, over less tangible economic goods such as
how we spend our time; our occupation or employment; and where we choose to live.

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Topic 2: Economics of markets 1: Consumption and utility

3. Basic Assumptions Underlying Consumer

Preferences
Firstly we need to construct a situation where an individual can make a preference
statement across two or more consumption bundles; that is they can make a statement
such as ‘I like this bundle the best’ or ‘I am indifferent between the bundles’. If a person is
able to make a preference statement and their preferences are consistent then we will be
able to order their preferences.

The assumptions that enable this are:

1. Completeness
2. Transitivity
3. ‘More is better than less’ or ‘non-satiation’

1 Completeness assumption
This assumption implies that consumers are able to compare and rank possible
consumption bundles or baskets of goods and services. That is, given any two baskets,
one of the following statements is true:

• ‘Basket A is preferred to Basket B’

• ‘Basket B is preferred to Basket A’
• ‘Basket A and B are equally preferred, ie the person is indifferent between
A and B’

2 Transitivity assumption
This is the consistency of preferences assumption; that is if a consumer is given a choice of
any three baskets of goods, then the following statement will hold:

• ‘if A is at least as good as B, and B is at least as good as C,

then A is at least as good as C’, ie A≥B, and B≥C, then A≥C
(where ‘≥’ means ‘as least as good as’ or ‘equally preferred’)

3 ‘More is better than less’ or non-satiation assumption

This is the assumption that goods are considered to be desirable, that is consumers always
prefer to have more of a good than less. Given any two baskets containing at least 2
goods:

• if basket A contains more of any one good than basket B

and if it does not contain any less of the other good/s,
then basket A is preferred to basket B.

These three assumptions regarding preferences underlie the economic theory of the
consumer and rational decision-making. They support the notion of ‘consumer
sovereignty’ in the market; that is the individual consumer knows what is best for him or
herself. To translate this idea to yourself as the individual, consider the case when you go
shopping - you know your own tastes, needs, and affordability, so you take this information
into consideration (implicitly or explicitly) when you decide what to buy.
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Topic 2: Economics of markets 1: Consumption and utility

4. Utility
Utility is the economic concept used to describe the satisfaction that an individual gets from
engaging in an economic activity, such as consuming a good or service, participating in the
workplace, going on a holiday, etc. Utility is defined broadly so as to encompass all
aspects of personal satisfaction. Not only do we receive satisfaction from fish and chips,
silk ties and skiing trips, but also from being with our families, feeling comfortable and
seeing our friends made better off. The utility derived from being in hospital may reflect
more than the restoration of health, and may include the value the patient places on the
kindness of medical and nursing staff and visits from family members. On the other hand,
these positive utilities are usually offset by the negative utility associated with undergoing
medical treatment. The disutility of most treatment processes is a special feature of health
care consumption, which tends to limit demand for health services to circumstances in
which symptoms or illness generates a ‘need’ for them.

Different consumers may value goods differently because they give people different levels
of satisfaction or utility. In economic theory it is assumed that “rational” consumers, in
attempting to maximise their utility, will organise their purchases in such a way as to make
themselves as well off as possible. Economics refer to this as consumer sovereignty.

In general the greater the utility that we expect to derive from a particular commodity, the
more we shall be willing to pay for it. However, if the price of a commodity is greater than
the utility we expect to receive from it, then we would be better off spending our money on
something which gives us greater satisfaction. Thus, utility also lies behind the concept
of opportunity cost, it determines the value of the benefits that are foregone by
purchasing a particular commodity.

If we attach a hypothetical number to a level of utility that the consumer gets from
consuming one good, and another number to the consumption of a different good, it
enables us to both calculate total utility and rank different bundles of goods with respect to
utility. This information also enables us to graphically construct a utility function. Total
utility is the total amount of utility a consumer gets from consuming the good or service in a
given time period.

Figure 1 shows an individual’s total utility function for the consumption of food. Utility
increases as more is consumed (upward sloping function), however the rate of increase in
utility decreases (slope of the function becomes flatter). As you consume more of a good or
service, you are likely to get less satisfaction from each additional unit consumed. Although
total utility may continue to increase, it will do so at a decreasing or diminishing rate. This is
the concept of diminishing marginal utility. To use chocolate as an example – the first
piece of chocolate tastes great (especially if you haven’t eaten any for awhile), the second
piece tastes almost as good, however if we continue to consume chocolate each bit tastes
progressively less good. This example illustrates the concept of diminishing marginal utility.
Total utility continues to increase but at a diminishing rate (that is the slope of the utility
function gets flatter).

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Topic 2: Economics of markets 1: Consumption and utility

Units of
Utility/
Benefit

Total utility (TU)

13.2
13
12

10

Qty of food (units)

0 1 2 3 4

Figure 1: An individual’s total utility function for consumption of food

Marginal utility refers to the additional utility received from consuming one more unit of a
good or service. As a general rule the marginal utility received from a commodity will
diminish as more is consumed. This rule holds for all goods and services, including health
care. Note that the concept of ‘the margin’ is important in economics – you will come
across it many times.

Figure 2 shows the marginal utility function for the same consumer, note the shape of the
curve that shows diminishing marginal utility.

While the trend is always for marginal utility to fall as more is consumed, this does not
preclude the possibility of temporary increases in utility, or a delay before utility begins to
fall. For example, the utility of the first five minutes spent in a GP consultation may be small
if this time is spent exploring a patient’s medical history. But once a diagnosis has been
made and a treatment prescribed, the additional benefits of continuing the consultation
begin to diminish. Similarly, it may be necessary to complete a full course of treatment
before a patient begins to derive any benefit, so initially the marginal utility of treatment may
be zero. Nevertheless, the law of diminishing marginal utility still holds because as
treatment continues, at some point the extra benefits will diminish.

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Topic 2: Economics of markets 1: Consumption and utility

Marginal
Utility 10

1 2 3 4
Qty of food (units)
Figure 2: An individual’s marginal utility function for consumption of food

5. Budget Constraint
The notion of a consumer having unlimited wants and therefore being able to attain a higher
level of utility, however unrealistic, is not an unattractive proposition. However clearly we
cannot have all the goods and services we might desire – our choices are limited by the
income or budget at our disposal. Affordability is both a function of a consumer’s income
and the prices of goods and services. To illustrate affordability in economics we use a
budget constraint or budget line. A constraint denotes that our consumption choices are
limited. The budget constraint on choice force consumers to select those goods and
services which yield the greatest satisfaction.

The budget constraint shows all combinations of goods for which the total amount spent is
equal to a consumer’s income. Usually we choose two goods or services (A and B),
include the price of good A (PA) and the price of good B (PB) and represent the affordable
combinations graphically. The intercepts of each axis are determined as if the consumer’s
entire budget was spent on one or the other good.

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Topic 2: Economics of markets 1: Consumption and utility

Exercise: Utility function for chocolate

On Figure 3 below, show the impact on the total utility for chocolate if
the consumer were to consume the 4th piece of chocolate and
become unwell.

Units of
Utility/Benefit

Total utility (TU)

13.2
13
12

10

Qty of chocolate
0 1 2 3 4
(pieces)

Figure 3: An individual’s utility function for consumption of

chocolate

6. Indifference curves
The economic tool used to describe preferences graphically is referred to as a ‘set of
indifference curves’ or an ‘indifference map’. An indifference map shows all combinations
of goods or services that provide the same level of satisfaction or utility to a consumer, ie
they are equally preferred. This may mean that a bundle with more of good A is equally
preferred to a second bundle, taking the preference assumptions this can only occur if the
second bundle contains more of another good (good B).

Underlying this thinking about indifference curves is the idea of trade-offs, that is a
consumer will sacrifice some of one good if they are compensated with an increase in the
amount of the other good.

Properties of indifference curves

1. The Indifference Map
Completeness of preference ordering means that there is an indifference curve for every
possible basket of goods. This means that a set of indifference curves or an indifference
map can fill a plane represented by two goods (for example clothes and food; medical care
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Topic 2: Economics of markets 1: Consumption and utility

and haircuts; movies and tennis; work and leisure; etc). There can be an indefinite number
of indifference curves in an indifference map. Normally many indifference curves are
represented, for example you could assume additional curves lying between U1, U2 and U3,
as shown by the dotted lines in Figure 3 below. The curves represented by the dotted lines
have the same properties as the indifference curves U1, U2 and U3, though there are
different levels of utility associated with each.

Figure 4: The Indifference Map

Clothing (units
per week)

U3

U2

U1

Food (units per week)

As we move outwards from the origin in Figure 4 we have more of at least one good,
therefore baskets of goods moving out from the origin are preferred, compared to those
closer to the origin. Therefore as you move out to the right, each indifference curve
represents a higher level of utility or satisfaction; that is the utility associated with U2 is
higher than U1, and U3 has a higher level of utility than U2. See Figure 5.

2. Shape of Indifference Curves

Indifference curves between two baskets of goods are negatively sloped or downward
sloping, this follows from the preference assumption that more of a good is better than less
and also represents the trade-offs that can be made between two or more goods. The
shape of an indifference curve shows how much of one good a consumer is willing to trade-
off for another.

Indifference curves cannot intersect under the assumption of transitivity above, intersecting
indifference curves would mean that consumer preferences were not consistent. Figure 5.

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Topic 2: Economics of markets 1: Consumption and utility

Figure 5: Indifference Map showing Increasing Utility

Clothing (units
per week)

U4

U3 Preferred baskets of
U2 clothes and food
(increased utility)
U1

Food (units per week)

7. Marginal rate of substitution

This willingness to trade-off one good for another is referred to as the marginal rate of
substitution (MRS). The MRS of good A for good B is calculated as the maximum of A
that a consumer is willing to give up for one additional unit of B; this means that one unit of
good B is valued in terms of good A,

Where MRS = - ∆A
∆B
An additional unit of B means that the ∆B = 1
Because we have to give up A, assume the change in A (∆A) = -ve X

=> MRS = – (-X) = X

(1)
Convexity
Indifference curves are convex to the origin, this means that the slope of the indifference
curve increases as we move along the curve, thus the marginal rate of substitution (MRS)
decreases as we move along the curve.

This demonstrates diminishing marginal rate of substitution (MRS), which can be simply
explained. If a consumer has less of one good then they are more likely to trade more of
the good they have in abundance for a smaller amount of the good that is scarce. This is
because as we have more of one good it becomes less valuable to us, therefore we are
more likely to be willing to give some up in exchange for a good that we have less of. Thus
either end of the indifference curve will represent an increased willingness to trade one
good for another. This is the thinking behind diminishing marginal rate of substitution.

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Topic 2: Economics of markets 1: Consumption and utility

8. Maximizing consumer satisfaction

By combining the budget constraint and indifference curves we can now determine the
point at which the consumer will choose to consume. We can think of this as the point at
which the consumer is best off, or at which they maximize their satisfaction or utility. To
maximize their utility, the consumer must be on their budget constraint and on the highest
attainable indifference curve. The point of tangency between the budget constraint and an
indifference curve meets these conditions.

9. Summary
This topic introduces some important economic concepts in the area of consumer theory. It
forms a basis to demand theory in Topic 3, particularly the shape of the demand curve, and
the influence of income and prices on an individual’s consumption decisions.

The key features of consumption theory in economics are:

• the measure of a consumer’s satisfaction is expressed as utility
• generally as more of a good or service is consumed utility increases but at a
diminishing rate
• the extra utility from each additional unit of consumption is called marginal utility
• a consumer’s income or budget represents a constrain on choice

10. Keywords
 utility  diminishing marginal utility
 marginal utility  Indifference curves
 consumer sovereignty  Consumer preferences
 Marginal rate of  Budget constraint
substitution

11. References
Eaton BC, Eaton, DF & Allen, DW (2005). Microeconomics: Theory with Applications,
6th ed., pp.36-42.

Pindyck RS & Rubinfield DL (2005). Microeconomics: Theory and applications, 6th ed.
‘Chapter 3: Consumer Behaviour’, pp.63-87, 92-97, 102-103.

Hamilton, JH & Suslow, VY (2005). Study Guide to Microeconomics 6th ed, Chapter 3,
pp.35-64.

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