Marginal Utility Theory The Concept of the Margin

Candidates should be able to: Explain what is meant by the concept of the margin Calculate the appropriate marginal value from a given set of data Evaluate the extent to which the marginal concept is useful to economic agents in decision making Evaluate the concept of rationality as a way of understanding the behaviour of economic agents

The Concept of the Margin Marginal Principle The idea that economic agents may take decisions by considering the effect of small changes from the existing situation Marginal utility theory examines the increase in satisfaction consumers gain from consuming an extra unit of a good. Utility is an idea that people get a certain level of satisfaction / happiness / utility from consuming goods and service. Marginal utility is the benefit from consuming an extra unit E.g. When buying say an extra portion of chips, one would consider whether their price warrants the extra benefit one would get from consuming them Links to OPPORTUNITY COST and the LAW OF DIMINISHING RETURNS

How much would you pay for an extra slice of chocolate cake?

Diminishing Utility Quantity Marginal Utility Total Utility 1 100 2 170 3 190 4 180 5 140 This utility is not constant. Often we get diminishing marginal utility. The first piece of chocolate cake gives more utility than the 5th piece. Utility is maximised after consuming 3 pieces of cake

Utility and Price One way to measure utility is to give the utility a monetary value. For example, if I would pay £0.70 for a piece of cake, then we can say the utility is at least £0.70

How much to consume? In the above example, if a piece of cake cost 70p, it would make sense to consume 2 pieces. The first piece gives 100p of utility – which is greater than the price of 70p. The second piece gives a utility equal to the price. The third piece would give marginal utility of only 20 – which is less than the price of 70p

Applicable in firm and societal level decisions A firm will only take on an extra worker, if the benefit of employing them is greater than or equal to the wage paid When externalities are present – say a factory produces goods, but in so doing creates atmospheric pollution It should produce where MSB = MSC i.e. where the extra cost to society of producing one more unit equals the extra benefit received by production Beyond this point, the MSC > MSB so the production of extra units would make society worse off (allocatively inefficient)

Assumption of Rationality We are assuming that economic agents make rational decisions Rational Decision Making A decision that allows an economic agent to maximise their objective, by setting the marginal benefit of an action equal to its marginal cost But do economic agents behave rationally? Do firms always aim to maximise profits? Do consumers always carefully consider their actions and never act on impulse?

The Demand Curve and Marginal Utility Our demand curve is derived from our marginal utility. If a good gives us more satisfaction, e.g. it becomes more fashionable, our MU and demand curve will shift to the right.

Link to Consumer Surplus A Person’s Consumer Surplus from Petrol                                                                                                                                                     Link to Consumer Surplus This is the excess of what a consumer would have been prepared to pay compared to what they actually pay. A Person’s Consumer Surplus from Petrol At 500 litres, the MU is 80p > than the price = 50p. Therefore, a rational consumer will increase consumption of petrol, until the MU of petrol equals the price at 50p and a quantity of 800. Marginal Consumer Surplus = The excess of a person’s total utility from the consumption of a good (MU) over the price paid: MCS = MU – P

The Equi-Marginal Principle In the real world, we are not just deciding how much of one good to buy. We are also deciding how to choose between different combinations of goods. Because the quantity chosen of one good affects the quantity chosen of the other, to maximise utility the equi-marginal principle is used The Equi Marginal principle in consumption states that consumers will maximise total utility from their incomes by consuming that combination of goods where: MUa = Pa MUb Pb

Example – Budget £10, Rational Consumer What is the best combination of lemonade and sandwiches to maximise utility? Lemonade £2 per pint Total Utility Marginal Utility Sandwiches £1 each 1 30 13 2 55 25 3 75 36 4 90 46 5 100

Assumptions of Marginal Utility Theory Consumers are rational Utility can be described in cardinal terms (e.g. monetary units) Constant prices and incomes. Goods can be split up into small units Marginal utility and diminishing marginal returns For most goods, we expect to see diminishing marginal returns. This means the marginal utility of the fifth good tends to be lower than the marginal utility of the first good. The more we buy, the less total utility increases.

Limitations of Marginal Utility Theory Difficulty of evaluating utility. When consumers purchase goods, they may have a rough idea of how much utility the good will give, but often they don’t – especially for new goods. In practical terms, consumers can’t give a cardinal (numerical) value to utility Consumers don’t have time to work out Marginal utility / price. Instead, they often purchase out of habit or gut feeling. Consumers are not always rational. For example, we often see over- consumption of demerit goods (goods which give very low marginal benefit). Or consumers may be influenced by advertising and purchase on impulse. Numerous goods. In the real world, consumers have fluctuating income, and innumerable goods to choose between. This makes even rough calculations difficult. Many goods are related – the utility of a video recorder, depends on the quality of video cassettes. Often goods can’t be split up into small portions, e.g. cars.