# A2 Revision – Marginal Utility Theory

With the A2 exam not far away I thought it appropriate to post something on Marginal Utility. This is usually a multiple-choice question and part of an essay.

Consumers buy goods to derive satisfaction, or utility. Each unit purchased gives satisfaction (utility) and Marginal Utility is the satisfaction derived from the consumption of 1 more unit. Under normal circumstances the amount of satisfaction from each unit consumed will fall as more units are consumed e.g. when you finish a run your first drink will give you more satisfaction than your second and your second drink will give you more satisfaction than your third etc. – hence we get diminishing marginal utility see Table below. This is the basis of the normal demand curve, which slopes left to right – downwards.

The theory assumes that the RATIONAL CONSUMER aims to MAXIMISE SATISFACTION (or utility) by equating the MARGINAL UTILITIES yielded by the expenditure of a last money unit (cent or dollar) on each commodity purchased. The consumer is this is EQUILIBRIUM when the following formula is achieved:

• MU of A   =     MU of B    =     MU of C       Etc.
• Price of A       Price of B        Price of C

This means that the LAST unit of money spent provides the consumer with the same SATISFACTION (or UTILITY) irrespective of the good on which it is spent.

Examples

A consumer has \$35 to spend. Price of X = \$10 and Price Y = \$5. What combination of X and Y maximize total satisfaction?

 Quantity Bought Marginal Utility X Marginal Utility Y 1 30 15 2 20 12 3 15 10 4 9 8

• MU of X   =     MU of Y
• Price of X       Price of Y
• 20   =   10
• 10         5

Here the consumer buys 2X and 3Y

TOTAL UTILITY in this example = 30+20+15+12+10 = 87. (Note that TOTAL UTILITY is otherwise irrelevant to the calculation).

When the PRICE of a good falls, more will be bought (since the M.U. ÷ price formula is disturbed – and a LOWER M.U. {i.e. MORE BOUGHT} will restore equilibrium). Similarly, when the price of a good RISES less will be bought. This emerges from the LAW OF DIMINISHING MARGINAL UTILITY which states that as successful and equal quantities of a good are consumed, total utility increases but at a DIMINISHING RATE (i.e. MARGINAL UTILITY is FALLING – and can eventually become NEGATIVE.

Limitations of marginal utility theory

1. Unit of measurement – difficult to find an appropriate unit of measurement of utility.
2. Habit and impulse – consumer spending on a particular product maybe habit forming or on impulse and therefore does not consider the marginal utility
3. Enjoyment may increase as consumption increases – in some case utility may increase from further purchases of an item. A collector of memorabilia may obtain greater satisfaction from consuming an additional item – collecting a set of stamps etc
4. Quality and consistency of successive units of a good – there is the assumption that all goods are homogenous but if successive can of soft drink are not the same then the marginal utility may change and be more or less than the previous one
5. Other things remain constant – assumes that all factors affecting individuals’ satisfaction remain the same. However over time there maybe changes in income and the quality of other products as well as development of new products.

# A2 Revision – Marginal Utility Theory

With the A2 exam not far away I thought it appropriate to post something on Marginal Utility. This is usually a multiple-choice question and part of an essay.

Consumers buy goods to derive satisfaction, or utility. Each unit purchased gives satisfaction (utility) and Marginal Utility is the satisfaction derived from the consumption of 1 more unit. Under normal circumstances the amount of satisfaction from each unit consumed will fall as more units are consumed e.g. when you finish a run your first drink will give you more satisfaction than your second and your second drink will give you more satisfaction than your third etc. – hence we get diminishing marginal utility see Table below. This is the basis of the normal demand curve, which slopes left to right – downwards.

The theory assumes that the RATIONAL CONSUMER aims to MAXIMISE SATISFACTION (or utility) by equating the MARGINAL UTILITIES yielded by the expenditure of a last money unit (cent or dollar) on each commodity purchased. The consumer is this is EQUILIBRIUM when the following formula is achieved:

• MU of A   =     MU of B    =     MU of C       Etc.
• Price of A       Price of B        Price of C

This means that the LAST unit of money spent provides the consumer with the same SATISFACTION (or UTILITY) irrespective of the good on which it is spent.

Examples

A consumer has \$35 to spend. Price of X = \$10 and Price Y = \$5. What combination of X and Y maximize total satisfaction?

 Quantity Bought Marginal Utility X Marginal Utility Y 1 30 15 2 20 12 3 15 10 4 9 8

• MU of X   =     MU of Y
• Price of X       Price of Y
• 20   =   10
• 10         5

Here the consumer buys 2X and 3Y

TOTAL UTILITY in this example = 30+20+15+12+10 = 87. (Note that TOTAL UTILITY is otherwise irrelevant to the calculation).

When the PRICE of a good falls, more will be bought (since the M.U. ÷ price formula is disturbed – and a LOWER M.U. {i.e. MORE BOUGHT} will restore equilibrium). Similarly, when the price of a good RISES less will be bought. This emerges from the LAW OF DIMINISHING MARGINAL UTILITY which states that as successful and equal quantities of a good are consumed, total utility increases but at a DIMINISHING RATE (i.e. MARGINAL UTILITY is FALLING – and can eventually become NEGATIVE.

Limitations of marginal utility theory

1. Unit of measurement – difficult to find an appropriate unit of measurement of utility.
2. Habit and impulse – consumer spending on a particular product maybe habit forming or on impulse and therefore does not consider the marginal utility
3. Enjoyment may increase as consumption increases – in some case utility may increase from further purchases of an item. A collector of memorabilia may obtain greater satisfaction from consuming an additional item – collecting a set of stamps etc
4. Quality and consistency of successive units of a good – there is the assumption that all goods are homogenous but if successive can of soft drink are not the same then the marginal utility may change and be more or less than the previous one
5. Other things remain constant – assumes that all factors affecting individuals’ satisfaction remain the same. However over time there maybe changes in income and the quality of other products as well as development of new products.

# Introduction to Behavioural Economics – Mind over Money

Here is a great documentary on behavioural economics from PBS – features Richard Thaler – University of Chicago and co-author of Nudge, Gary Becker Univerisity of Chicago, Jennifer Lerner – Harvard – social psychologist. The main model of consumer behaviour assumes that we never buy anything until we’ve calculated the impact on, for example, our retirement fund, and we’re so good at maths we use interest rates to compute our pleasure, over time, after buying something.

At the centre of all the rational models lies an unflinching belief in free markets. The idea is to keep regulation and government interference to a minimum, in both the every day consumer market and in the giant money markets of Wall Street. Rational economists believe that the increase in wealth, worldwide, over the last 30 years, is a triumph for free markets.

With the GFC, the rift in economics widens between the rationalists and the behaviouralists. So which side is right? Are we rational about money, or do our emotions and psychology play a much bigger role than previously realized?

The programme features loads of experiments:
\$20 auction. People bid for the \$20 but the second highest bidder receives nothing and pays the amount of the losing bid. See what happens.

a) Would you prefer \$100 in a year’s time or \$102 in a year one day?
b) Would you prefer \$100 right now or \$102 tomorrow?

# Neuroeconomics – consumption experiences

An article in the recent Eco@Otago publication, from the University of Otago in New Zealand, showed how the changing properties of a product which are unrelated to its natural characteristics can affect people’s satisfaction.

Beer with vinegar in it

Dan Ariely (of “Predictably Irrational” fame) and others carried out research in 2006 where they offered patrons at a bar two types of beer:

1. A common brew
2. A common brew with a few drops of balsamic vinegar.

They divided the testers into 3 groups:

1. They had no information about the beers’ ingredients – “blind”
2. They were told which beer had vinegar in it before tasting both – “before”
3. They were told which beer had vinegar in it after tasting both – “after”

If knowing about the vinegar has no impact on preference then the outcome of tastes tests should be the same across all groups. If knowledge about vinegar influences tastes then the results from the blind group should differ between the “before” and “after” groups. The study showed that revealing the vinegar in the brew did affect the satisfaction only if the tasters were told “before” they tried the beer. Therefore, expectations changed the satisfaction that tasters received from their drinks.

Coke or Pepsi?

A similar experiment explored the cultural influences on satisfaction. It involved a taste test with Coke and Pepsi, two similar products but each have their own cult following. This study conducted ‘functional magnetic resonance imaging’ (fMRI) while participants were tasting to identify the effect consumption of each drink had on brain function.

Participants revealed which drink they perferred and were then subject to either blind taste tests OR taste tests with information about which cola they consumed. Consumers who preferred Coke experienced greater brain activity in the prefrontal cortex, hippocampus and midbrain when they were drinking it – versus when tehy did not know it was the brand they tasted. Therefore knowledge of brand can actually produce a physical response during consumption.

Does a higher price = more satisfaction?

A similar experiment showed how economic decision-making is affected by price and satisfaction. In this study participants performed blind taste tests with fMRI scanning for 5 different types of wine. They also conducted taste tests after revealing the prices of the wines to the participants to see if their preferences depended on cost. There were two innovative elements of this study:

1. There were actually only 3 wines – two of the wines were re-administered to the participants but were assigned different prices before doing so.
2. The fMRI focused on the area of the brain believed responsible for satisfaction – the medial orbitofrontal cortex (mOFC).

Taste tests revealed that subjects exhibited more activity in the mOFC when they tasted highly-priced wine versus the same wine with a lower price tag. Therefore more expensive wines regardless of their composition led to the following:

Expected higher quality wine = higher price = physically generated enhanced experience.

Purchasing decisions are more complex than traditional textbooks describe and what goods are perceived to be has a significant influence.

# Diminishing Marginal Utility – not the case with chocolates!

Many thanks to colleague Warren Baas for this article in the New Zealand Herald. After having just taught diminishing marginal utility to my A2 class, researchers have found that when you are down to your last chocolate you’ll find that it tastes better than those previously consumed. The textbooks state that as you consume an additional unit of output your utility (satisfaction) from each unit consumed will fall as more units are consumed – see the graph below.

The US researchers fed men and women five small chocolates of different flavours and asked them to rate their enjoyment of each as they ate it.

The flavours were given in different orders and some were told when they were on their last chocolate, while others were not given any warning.

Those that were pre-warned found the last sweet much more tasty than the others, the journal Psychological Science reports. Asked which chocolate was their favourite, those who knew when they were on their last chocolate plumped for that one 66 per cent of the time. University of Michigan researcher Ed O’Brien said: “Endings affect us in lots of ways and one is this ‘positivity effect’. It is something motivational. You think, ‘I might as well reap the benefits of this experience even though it is going to end’ or, ‘I want to get something good out of this while I still can’.”

Also knowing something is ending might make us more content. For example when an examiner finishes the 200th paper (and last of his quota) does he/she still mark the paper with the same focus as the first. Also is there an advantage in going last at a job intereview? These are further areas discussed in the article.