Utility Theory in Economics

Utility Theory

• Limited Income: Individuals have limited money income, which means they must make choices about how to allocate their income.
• Opportunity Cost: Buying one good involves going without something else, and consumers weigh up the opportunity costs to obtain maximum satisfaction.

Utility and Marginal Utility

• Total Utility: The total satisfaction a person derives from consuming a certain number of units of a product within a given time period.
• Marginal Utility: The change in satisfaction resulting from a one-unit change in the consumption of a product within a given period of time.
• Marginal Utility Formula: Marginal Utility = Change in Total Utility / Change in Number of Units Consumed
• Utility is Subjective: Utility cannot be measured and varies from person to person, place to place, and over time.

Law of Diminishing Marginal Utility

• Definition: The law states that the more a consumer has of a given commodity, the smaller the satisfaction gained from consuming each extra unit.
• Graphical Representation: Figure 5.1 shows the relationship between Total Utility and Marginal Utility, with Marginal Utility decreasing as the quantity consumed increases.

Marginal Utility and Demand Curve

• Rational Consumer: A consumer will continue consuming a good as long as Marginal Utility is greater than or equal to the price.
• Individual's Demand Curve: The demand curve is the same as the Marginal Utility curve, and the consumer will buy more of a good if the price falls.
• Consumer's Surplus: The difference between the maximum amount a consumer is willing to pay and the market price, represented by the area below the demand curve and above the market price.

Utility-Maximizing Choice

• Rational Consumer: A consumer will allocate their expenditure to maximize total utility by comparing the marginal utility per euro spent on different goods.
• Equi-Marginal Principle: A consumer will buy goods up to the point where the Marginal Utility per euro spent is equal for all goods.

Substitution and Income Effects

• Substitution Effect: The change in consumption of a good associated with a change in its own price, leading to an increase in consumption of a cheaper good and a decrease in consumption of a more expensive good.
• Income Effect: The change in consumption of a good associated with a change in real income, leading to an increase in consumption of a normal good and a decrease in consumption of an inferior good.
• Price Elasticity of Demand: The bigger the income and substitution effects, the higher the price elasticity of demand.

Giffen Goods

• Definition: A Giffen good is a type of inferior good for which an increase in price leads to an increase in quantity demanded.
• Characteristics: Giffen goods have a high percentage of expenditure and few close substitutes, leading to a strong income effect that outweighs the substitution effect.

Relationship between Marginal Utility and Price Elasticity of Demand

• Inelastic Demand: A good with a rapidly decreasing Marginal Utility has an inelastic demand, meaning a small percentage change in price leads to a small percentage change in quantity demanded.
• Elastic Demand: A good with a slowly decreasing Marginal Utility has an elastic demand, meaning a small percentage change in price leads to a large percentage change in quantity demanded.

The Paradox of Value

• Total Utility vs. Marginal Utility: Total utility refers to the total satisfaction derived from a good, while marginal utility refers to the additional satisfaction derived from one more unit of the good.
• Diamonds and Water: Diamonds have a high marginal utility and a high price, while water has a low marginal utility and a low price. The marginal utility per pound spent is equal for both goods.
• Demand and Supply: The price of diamonds is high due to low supply, and the price of water is low due to high supply.