TOPIC 3: DEMAND AND

CONSUMERS

The Concept of Utility

UTILITY

Utility:
The enjoyment or satisfaction people receive from consuming goods and
services

The assumptions of traditional consumer theory:

• People seek to maximise their utility
• People are rational: their choices are consistent with utility maximisation, in that they
have full information, and they are fully able to process this information and make the
decision consistent with their own self-interest.

Although we assign numbers to this satisfaction, it is important to remember these

are specific to the individual. As such we can’t compare the ‘numbers’ people
associate with the consumption of a good with anyone else’s.
• i.e. what’s the scale? 0 to 1? 0 to a gadzillion?

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 Let’s take an example:

Assume Professor Nerdstrom likes oranges. He receives a certain level of

satisfaction from the oranges he eats every week.

The Total Utility is simply the sum of the satisfaction he gains from eating
oranges.

The Marginal Utility is the extra satisfaction he gets from eating one more
orange.
Utility

Oranges 35 Total Utility

34
Quantity Total Utility Marginal Utility
32
0 .. .. 29
1 15 15 24
2 24 9
3 29 5 15
4 32 3
5 34 2
6 35 1
Marginal Utility

1 2 3 4 5 6 Oranges
per week

MARGINAL UTILIT Y

• What is happening?
• Utility ↑ when consumption ↑, but at a decreasing rate:
Known as diminishing marginal utility

• Eventually, there is a point where the change (MU) is equal to zero.

This is where total utility is maximised.

• Note that MU can in theory be negative. This implies that the consumption of this additional
unit actually reduced Total Utility. Although possible, we assume consumers are rational, and
so don’t (often) keep consuming a good or service to the point where it reduces their TU.

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 INTRODUCING CHOICE AND
CONSTRAINT S

• In most situations, economists are not so interested in how much people enjoy each
orange but rather how people choose between alternative consumption bundles with
constrained resources.

• In reality:
• People face budget (income) constraints
They can’t consume as much as they like!
• People face choice constraints
They have to allocate their scarce resources across many goods and services, and
each of these yield specific utilities which diminish at specific rates.
• When discussing the efficiency of markets we talk about allocative efficiency. When
examining consumer behaviour, we use the very same principle to explain how
people maximise their utility when faced with choice and budget constraints:
• Income should be allocated to where they yield the greatest MU per dollar
spent.

Therefore, a rational consumer will

consumer units of X and Y up to
the point where:

𝑀𝑈𝑋 𝑀𝑈𝑌
=
𝑃𝑋 𝑃𝑌

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• Example: Professor Nerdstrom consumes oranges and lemonade at a café:
• Budget: $20
• Price of oranges: $2 each
• Price of lemonade: $4 per glass.
• Current status:
• 6 oranges: MU of oranges: 1
 budget exhausted
• 2 glass of lemonade: MU of lemonade: 8
• Is Professor Nerdstrom maximising his utility? If not, what should he do to improve the
situation?
• Lemonade is currently providing more
• Using the MUx/Px = MUy/Py rule: satisfaction per dollar spent than
oranges.
8
• The MU per dollar spent on lemonade is currently
4
1 • What should the Prof do??
• The MU per dollar spent on oranges is currently
2 • start drinking more lemonade
8 1 (hence Mulemonade will fall) and
• > stop eating so many oranges
4 2
(MUoranges will rise).

CONSUMER SURPLUS

• When people engage in the exchange of goods and services, they do so

voluntarily (otherwise they wouldn’t do it!).

• We use the concept of consumer and producer surplus to gauge how much
benefit consumers and producers get from trade.

• Consumer surplus = the difference between the maximum price a consumer is

willing to pay for a good and the price they actually pay for that good.

• Producer surplus = the difference between the (marginal) cost of producing a

good and the price actually received for that good.

[Note: the text does not discuss the concept of producer surplus, and so is put in here so you can see
that similar principles apply on both the demand and supply side]

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 • In equilibrium, all consumers
CONSUMER SURPLUS FOR who were willing and able to
Price ORANGES purchase this good paid
(per kg) $10.00/kg.
Supply • can see that many were
$20
willing to pay more than
$10.00 if they had to.
$15 • E.g for the consumer of the
$5 C.S. 10,000th kg of oranges, they
were willing to pay $15, but
only had to pay $10.
$10
• Consumer surplus on that unit
= $15 - $10 = $5.
• The summation of all
$5 individual’s consumer surplus
gives us the market consumer
surplus.
Demand

10 20 40
Quantity (‘000s kgs)

PRODUCER SURPLUS FOR

Price ORANGES
(per kg) • In equilibrium, firms received
$10.00/kg .
Supply
$20
• However, some firms were
willing and able to produce
units of this good for less than
$10.00.
• E.g producer of the 10,000th
kg was willing to sell this unit
for $7.50, but received $10.
$10
$2.50 Producer surplus on that unit
P.S. = $10 - $7.50 = $2.50.
$7.50
• The summation of all
producers’ surplus gives us the
market producer surplus.

Demand

10 20 40
Quantity (‘000s kgs)

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 TOTAL ECONOMIC SURPLUS
Price FOR ORANGES
(per kg)

Supply
$20

The Total (Economic) Surplus from this market is

therefore just:
Total Consumer surplus + Total Producer Surplus.
$10
This gives us the value of the total gains from the
exchange of oranges in the Perth market.
NOTE: in terms of efficiency we do not care WHO is earning
the surplus (consumers or producers), just that the total
surplus is maximised.
Demand

20 40
Quantity (‘000s kgs)