A2-Unit-2 - The-Price-System 1 of 6

The Price System and the Micro
economy
A2 Unit 2
a) Law of diminishing marginal
utility
Very, Very important for exam!
Law of Diminishing Marginal Utility
Utility is the satisfaction one gets from consuming a good or

service
• Not the same as usefulness – items that are essentially

useless can provide a lot of utility (e.g. diamonds)
• Subjective – a single good may provide a different utility

depending on the person
• Difficult to quantify, economists call units of utility “utils”

but measuring them is difficult
5
• A “util” is one unit of satisfaction or pleasure
• Total utility is the total amount of satisfaction
• Marginal utility is the extra satisfaction from consumption of

an additional unit of the good
MU = ΔTU/ΔQ
6
What matters more to you: your first

million dollars, or your second million
dollars?
7
• Although consumers’ wants, in general, are insatiable, the

wants for specific commodities can be fulfilled.
• As consumption of a specific good or service increases, the

marginal utility obtained from each additional unit of the
good or service decreases.
• Explains downward sloping demand; in order for us to want to

by more, the price must fall.
8
Total Utility and Marginal Utility
Total Utility
30
(1) (2) (3)
Total Utility (Utils)

Tacos Total Marginal
TU
Consumed Utility, Utility,
Per Meal Utils Utils 20
0 0] 10 10
1 10 ]
8
2 18 ] 0
6 1 2 3 4 5 6 7
3 24
] 4
Marginal Utility (Utils)
4 28
] 2 10
5 30
] 0 8
6 30 6
] -2 4
7 28 2
0
-2
1 2 3 4 5 6 7 MU
9
Theory of Consumer Behavior
Rational behavior – consumers use their money or income to
maximize their own utility, deriving the greatest possible satisfaction
available in the market
Preferences – each consumer has logically consistent and ordered

preferences
– If I prefer Apples > Bananas and Bananas > Cantaloupes, I must
also prefer Apples > Cantaloupes
– If I prefer Apples = Oranges, I am indifferent over which one I
get, I’d flip a coin
10
Theory of Consumer Behavior
Budget constraint – at a static point in time the consumer has a
limited and fixed (think scarcity) amount of money to spend
• Prices – individuals are price takers, that is, a lone individual’s

consumption of a good has no effect on the market price
• Marginal Analysis – Consumers think at the margin
11
Utility Maximization and
Equi-Marginal Principle
Utility Maximizing Rule
A consumer is in equilibrium when utility is “balanced
Consumer allocates his or her income so that the last
dollar spent on each product yields the same amount of
extra (marginal) utility.
Algebraically:
We express the marginal utility of the good as marginal

utility per ($) spent since the two goods have different
prices.
13
Numerical Example
The Utility Maximizing Combination of Apples and Oranges Obtainable with an
Income of $10
(2) (3)
Apple (Product A): Oranges (Product B):
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility per Marginal Utility per
Unit of Utility, dollar Utility, dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
14
Decision-Making Process
Sequence of Purchases to Achieve Consumer Equilibrium, Given the data in
Table 6.1
Marginal
Choice Utility Income
Number Potential Choices per Dollar Purchase Decision Remaining
1 First Apple 10 First orange for $2 $8 = $10 - $2
First Orange 12
2 First Apple 10 First apple for $1 $5 = $8 -$3

Second Orange 10 and Second orange for $2
3 Second Apple 8 Third orange for $2 $3 = $5 - $2

Third Orange 9
4 Second Apple 8 Second apple for $1 $0 = $3 - $3

Fourth Orange 8 and Fourth orange for $2
15
Numerical Example
The Utility Maximizing Combination of Apples and Oranges Obtainable with an
Income of $10
(2) (3)
(b) (b)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
16
Numerical Example
Try it on your own.
(2) (3)
(b) (b)
First 10 10 24 24
Second 8 8 20 20
Third 7 7 18 18
Fourth 6 6 16 16
Fifth 5 5 12 12
Sixth 4 4 6 6
Seventh 3 3 4 4
17
Deriving the Demand Curve
$2
Price Per Quantity
Price of Orange
Orange Demanded
$2 4
$1 6
$1
DO
0
4 6
Quantity Demanded of Oranges
18
The equi-marginal principle is an extension of the law of
diminishing marginal utility.
It says that each consumer should consume such that the marginal
utility per dollar spent is constant across all consumed goods.
Hence the consuming until the ratio of MUₓ/Pₓ for each good x is
constant across all x yields the consumer’s utility maximizing
consumption choices.
19
For goods (1, 2, …, n) the following condition should hold in
equilibrium:
20
Equi-Marginal Principle Activity
• Given the following table…
• 1. what combination of goods satisfies the equi-marginal
principle for the following incomes? $15/$30?
• 2. What is the total utility for $15/$30?
• 3.How many utils/$ for $15/$30?
Units Good A Good B Good C
MU P MU/P MU P MU/P MU P MU/P
1 20 1 36 3 40 5
2 15 1 24 3 35 5
3 11 1 18 3 30 5
4 8 1 9 3 25 5
5 6 1 6 3 20 5
21
Equi-Marginal Principle Activity
Answer 1. $15 4A, 2B, 1C $30 5A, 3B, 3C
2. 154 utils 243 utils

3. 154/$15= 10.26 utils/$ 243/$30= 8.1utils/$
Units Good A Good B Good C

MU P MU/P MU P MU/P MU P MU/P
1 20 1 20 36 3 12 40 5 8
2 15 1 15 24 3 8 35 5 7
3 11 1 11 18 3 6 30 5 6
4 8 1 8 9 3 3 25 5 5
5 6 1 6 6 3 2 20 5 4
22
Marginal Utility Applications 1
New products
iPods were a new product perceived by consumers as having a
greater marginal utility to price ratio than the older portable CD
players and other similar products, and thus resulted in a major
shift in demand for the new product as consumers attempted to
restore their consumer equilibrium.
23
Diamond-water paradox
Why do some goods that are essential to life have low prices and
goods that are not essential to life have high prices?
The marginal utility of the last unit of water consumed is small

because we consume a lot of water.
The marginal utility of the last diamond is large because we

consume few diamonds.
24
Opportunity cost and time
Time also has a value. When time is considered, consumer
behavior appears to be much more rational.
Highly skilled people, like doctors, earn high wages and therefore
incur a higher opportunity cost.
Unskilled workers or retirees have low opportunity costs for their

time.
Train and buses v’s taxi’s and airplanes
25
Cash and noncash gifts
Noncash gifts result in a loss of utility and we then take action to

maximize our utility, such as taking it back and exchanging it, etc.
26
Limitations of Marginal Utility
Utility is measurable
– How many utils did lunch give you?
Ignores complements and substitutes
– Utility of a good may depend upon other goods
– Unable to explain Giffen Paradox
Assumes consumer is rational
– Advertising
– Ignorance (i.e. imperfect information)
– Frequent change or reordering of preferences
– Advances in Behavioral Economics (Prospect Theory, etc.)
27
Sample “Consumer” Essays
(all from w2013)
28
Sample “Consumer” Essays
3 (a) A number of consumers are deciding whether to buy a product. How far
does economic theory explain the determination of the market demand curve
for that product? [12]
(b) Discuss whether that theory is still valid if the producer decides to advertise
the product, and consider the effects of the advertising on the demand curve for
the product. [13]
9708/42/O/N/16
29
Activity 1 print out for students
Using the information contained in the table below, derive and

draw a demand curve for product Y. Assume the consumer’s
budget is $12.
Activity 2
Using the information contained in the table below, derive and

draw a demand curve for apples. Assume the consumer’s budget
is $18.

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The Price System and the Micro

Utility is the satisfaction one gets from consuming a good or

• Not the same as usefulness – items that are essentially

• Subjective – a single good may provide a different utility

• Difficult to quantify, economists call units of utility “utils”

• Total utility is the total amount of satisfaction

• Marginal utility is the extra satisfaction from consumption of

What matters more to you: your first

• Although consumers’ wants, in general, are insatiable, the

• As consumption of a specific good or service increases, the

• Explains downward sloping demand; in order for us to want to

Total Utility (Utils)

Preferences – each consumer has logically consistent and ordered

• Prices – individuals are price takers, that is, a lone individual’s

• Marginal Analysis – Consumers think at the margin

We express the marginal utility of the good as marginal

2 First Apple 10 First apple for $1 $5 = $8 -$3

3 Second Apple 8 Third orange for $2 $3 = $5 - $2

4 Second Apple 8 Second apple for $1 $0 = $3 - $3

Price Per Quantity

Answer 1. $15 4A, 2B, 1C $30 5A, 3B, 3C

2. 154 utils 243 utils

Units Good A Good B Good C

The marginal utility of the last unit of water consumed is small

The marginal utility of the last diamond is large because we

Unskilled workers or retirees have low opportunity costs for their

Train and buses v’s taxi’s and airplanes

Noncash gifts result in a loss of utility and we then take action to

(all from w2013)

Using the information contained in the table below, derive and

Using the information contained in the table below, derive and

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