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Overview

If people make choices on the basis of what’s going to bring them the most happiness, they need a way of comparing how much happiness each option brings.

Utility

Economists suppose that you can compare all possible things that you may experience with a common measure of happiness or satisfaction, which they call utility.

Two important measures are:

Total utility

The overall satisfaction that is derived from the consumption of all units of a good over a given time period.

Marginal utility

The additional utility is derived from the consumption of one more unit of a particular good.

When you look at these numbers, you notice that the extra utility each additional slice brings is decreasing:

First slice:

Total utility increases by 8 utils, from 0 to 8 utils.

Second slice:

The increase is only 6 utils; total utility increases from 8 utils to 14 utils.

Third slice:

Total utility increases only 4 utils, from 14 to 18.

Sixth slice:

Total utility actually goes down, because slice number five can make even the most rabid pizza lover feel a little sick. This decrease in total utility implies that marginal utility must be negative for slice six.

The right column shows the diminishing marginal utility that comes with eating more and more slices of pizza because the marginal utility that comes with each additional slice is always less than that of the previous slice.

Specifically, although marginal utility is 8 utils for the first slice, it falls to 0 utils for slice five and then actually becomes negative for slices six because eating it makes just about anyone ill.

We can use marginal utility analysis to show how a rational person decides what combination of goods to buy. Given that we have limited incomes, we have to make choices.

The equi-marginal principle

The rule for rational consumer behaviour is known as the equi-marginal principle. This states that a consumer will get the highest utility from a given level of income when the ratio of the marginal utilities is equal to the ratio of the prices. This is when, for any pair of goods, A and B, that are consumed:

Say that the last apple🍎 you ate gave you three times as much utility as the last banana. Yet an apple🍎 only costs twice as much as a banana🍌!

You would obviously gain by increasing your consumption of apples🍎 and cutting your purchases of bananas🍌.

But as you switched from bananas to eating more apples🍎, the marginal utility of eating apples🍎 would fall due to diminishing marginal utility (i.e you get tired of eating apples).

Conversely, the marginal utility of bananas🍌 would rise.

To maximise utility you would continue this substitution of apples🍎 for bananas🍌 until:

The ratios of the marginal utilities (MUA🍎/MUB🍌)

The ratio of the prices of the two fruits (PA🍎/PB🍌).

At this point, no further gain can be made by switching from one fruit to another. This is the optimum combination of apples🍎 and bananas🍌 to consume.

The optimum combination of goods consumed

Perfect for A level, GCSEs and O levels!

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