Utility is the satisfaction derived from consuming a good or service. For example, a person can satisfy his or her hunger by eating a hamburger or a bowl of noodles. In economic theory, the amount of satisfaction or utility derived is expressed in units called utils. This way, comparisons can be made more easily between different goods based on the amount of utility derived. This aids an individual in making consumption decisions including what to buy with the limited income he has and the relative amount much one is willing to pay for different goods. Thus the consumer will pay more for a hamburger worth 3 utils than a bowl of noodles worth 2 utils.
The theory or law of diminishing ...view middle of the document...
Two, consumers have limited incomes.
Based on this theory and its assumptions, consumers would buy a good until where price (P) equals MU. The price one is prepared to pay is the value he or she places on the good. When price charged (P) is below MU, the consumer is prepared to pay more than he is charged and thus can increase total utility by increasing consumption of the good. When P is above MU, the consumer is prepared to pay lesser than he is charged for the good and can increase total utility by decreasing consumption of the good. In other words, a rational consumer will only be prepared to buy a good as long as the marginal benefits (marginal utility) he gains are higher than the marginal costs (price charged) of the good. To sum it up, the equilibrium level of consumption is where consumer utility is maximized that is where P = MU.
This analysis thus demonstrates that an individual’s demand curve is the same as the individual’s marginal utility curve, where utility is measured in money. When the price charged is lower, the marginal cost of the good to the individual is lower and the rational will buy more of the good at the lower price than at a higher price.
The equi-marginal principle also demonstrates this to be true. It states that a combination of goods gives a consumer maximum utility when the ratio of the MU is equal to the ratio of the prices (□(MUa/MUb)=□(Pa/Pb)). This means that the MU per unit price is the same for, say, good A and good B (□(MUa/Pa)=□(MUb/Pb)).
To illustrate this concept suppose the last unit of good A consumed gave as much utility as the last unit of good B consumed (□(MUa/MUb)=1) but good A costs twice as much as good B (□(Pa/Pb)=2). The rational consumer will buy less of good A and more of good B. According to the LDMU, MUA will rise and MUB will fall. The ratio □(MUa/MUb) will rise. To maximse...