Consumer demand is the largest component of the total demand for products. Economists
believe, as previously discussed, that consumer demand behaves according to the LAW OF
DEMAND, i.e. the higher the price of a product, the lower the quantity demanded of the product,
other things equal (ceteris paribus) and vice versa. This means that consumer demand is a
negative relationship between price and quantity and will graph as a curve that slopes downward
to the right. But why do consumers demand more the lower the price and less the higher the
price? What are the underlying reasons that support the law of demand? Why does the
consumer demand curve slope downward and to the right? According to economist the answers
to these questions are because of the income effect, the substitution effect and diminishing
Income Effect, Substitution Effect and Diminishing Marginal Utility
These three factors are the primary reasons why consumers demand products the way they
do and are important to understand.
- As the price of a product changes, consumers effectively have more or less to
spend on a product. Note that although their actual income has not changed as we
assume it is constant, their “real income” has changed meaning they can by more
or less with the same income as before.
- As the price of a product falls, real income rises and consumers will buy more.
When the price increases, real income falls and consumers will buy less.
- As the price of a product changes, consumers will evaluate purchasing more or
less of a substitute produce.
- When the price of a product falls, consumers will buy more of it and less of a
substitute product. When the price of a product increases, consumers will buy less
of it and more of a substitute product which is now relatively less expensive.
Diminishing Marginal Utility
- Diminishing marginal utility is an important concept in economics. The law of
diminishing marginal utility states that as additional units of a product are
consumed, the utility derived from each additional unit declines, ceteris paribus.
Economist measure utility or satisfaction in “utils”. Utils are an abstract measure
and can not actually be calculated. Diminishing marginal utility works like this.
If you have just been rescued after spending 4 days lost in the desert, the first
glass of water you drink is very high in utils, the second glass is also very high in
utils, but not as high as the first glass, the third glass is high in utils, but not as high
as the second glass. So as additional glasses of water are consumed, the level of
satisfaction derived from each successive glass of water is less than that derived
from the previous glasses.
- Since marginal utility declines as more units of a product are consumed,
consumers will not pay the same price for additional units because they are
worth less in terms of utils.
Because of the above three factors, the consumer demand curve is always downward sloping
to the right.
Total Utility vs. Marginal Utility
TOTAL UTILITY (TU) is the total satisfaction derived from the total number of units of a
Product consumed. Total utility = the sum of the satisfaction derived from each unit.
MARGINAL UTILITY (MU) is the satisfaction derived from each unit of a product consumed.
Marginal utility = the change in TU divided by the change in the number of units (Q)
consumed. As discussed above, economists believe marginal utility continuously declines;
as more of a product is consumed, the satisfaction from each “additional” unit declines.
Therefore total utility will continue to rise (as each unit of a product is consumed) as long as
the marginal utility (which is declining) stays positive. When marginal utility becomes
negative (no more of a good is wanted even if it is free), total utility will then start to decline.
For example: MARGINAL TOTAL
CONSUMPTION UTILITY UTILITY
1ST glass of water 100 utils 100 utils
2nd glass 90 190
3rd glass 80 270
4th 50 320
5th 20 340
6th -10 320
Notice in the above example that while marginal utility always declines as consumption increases,
total utility increases as consumption increases until marginal utility = 0. When
marginal utility is negative, total utility is declining.
Important note: If marginal utility of a product declines as more units of it are consumed,
then marginal utility will rise if less units of it are consumed!
How do consumers go about maximizing their total utility when purchasing two or more
different products? The simple answer is that they spend their money so that they receive the
highest marginal utility (MU) per $1.00 spent. As a simple example, assume that you could
buy good A and that it would provide you with a marginal utility of 10 units of satisfaction “per
dollar”. Or you could buy good B and get a marginal utility of 15 units of satisfaction “per
dollar”. Which one would you select? A rational consumer would choose Good B of course!
Since consumers strive to maximize satisfaction, they will purchase in theory a combination of
products where the “per dollar” marginal utilities are equal. At this point where the per dollar
marginal utilities are equal, a consumer can not increase total utility by purchasing more of
one and less of another, i.e. they have maximized their total utility.
Calculation of Marginal Utility Per Dollar
Per dollar marginal utility is found by dividing the marginal utility (MU) gained from the
purchase of a unit of a product by the price of the product. For example, if the MU from
purchasing a unit of a product is 240 utils and the product costs $4.00/unit, the MU per
$1.00 spent = 60 utils.
To maximize utility then, the MU per dollar of each unit of a product purchased must be equal.
This can otherwise be stated as follow: the MU of product A divided by PRICE of product A =
MU of product B divided by the PRICE of product B. This formula is also called the Utility
Let’s look at an example how a consumer goes about maximizing utility according to the utility
Assume: consumer has $160 to spend on three products a, b & c. The prices
and marginal utility (MU) of each are shown below. Note that when a
unit of a product is purchased the MU of its next unit is lower.
a b c Product Chosen Income Spent
Price: $10 $50 $100
Utils: 40 MU 150 MU 250 MU 1st A at 4 MU/$1 $10
20 MU 2nd B at 3 MU/$1 60
100 MU 3rd C at 2.5 MU/$1 160
The above consumer has maximized total utility with the three purchases shown. Why?
Note in the above table that as a unit of product a, b or c is purchased, the utils of the next unit (marginal util) go down, e.g. 40 to 20 for a, 150 to 100 for b and 250 to 200 for c (law of diminishing marginal utility).
Applications of Utility Maximization Rule
1). Selection of product to purchase next.
If: MUa > MUb
Pa Pb consumer should buy more of product a. Why?
If: MUa < MUb
Pa Pb consumer should buy more of product b. Why?
2). Diamond/Water Paradox
The price of diamonds a non-essential product is high. The price of water an
essential product is low. Why?
MU OF WATER ? = MU OF DIAMONDS ?
P WATER LOW P DIAMONDS HIGH
The reason for the paradox is that the MU of water is low and the price of diamonds
is high. Note that the “total utility” of water is very high, but the total utility of
diamonds is low.
3). Non-Cash Vs. Cash Gifts
Which type of gift would you prefer?
Most people would choose a cash gift because non-cash gifts often don’t match
a persons taste or preferences and the MU of a cash gift is higher because the
person can choose to buy the product that gives the greatest MU/$1.
4). Value of Time
We have not factored in the “cost” of time in our analysis of consumer demand.
Time does have value and can make a difference in demand. The cost (price) of a
product that requires a lot of time to use is higher when the value of time is added.
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