Introduction to Economics ECO401
UNIT - 4
BACKGROUND TO DEMAND/CONSUMPTION
Scarcity and Rational Choice:
Although scarcity, as defined in Lectures 1-2 was of a different nature, the most common form
of scarcity is the scarcity of income, i.e., the money resources are limited and consumers are
faced with the decision on how to spend those scarce resources on different goods and
Rational choice consists in evaluating the costs and benefits of different decisions and then
choosing the decision that gives the highest benefit relative to cost.
While taking decisions, economics stress the importance of weighing the marginal costs
against marginal benefits rather than total costs and benefits.
Ignorance and Irrationality:
There is a difference between "ignorance" and "irrationality." A person operating under
uncertainty and thus at least partial ignorance can still make rational decisions by taking into
account all the information she has at her disposal. Rationality is an ex-ante concept.
Economists do not judge rational behavior on the basis of actual outcomes, rather on the basis
of choices made.
There are two approaches to analyzing consumer behavior;
· Marginal utility analysis
· Indifference curve approach.
Marginal Utility Approach:
Marginal utility approach involves cardinal measurement of utility, i.e., you assign exact values
or you measure utility in exact units, while the indifference curve approach is an ordinal
approach, i.e., you rank possibilities or outcomes in an order of preferences, without assigning
them exact utility values.
Utility is the usefulness, benefit or satisfaction derived from the consumption of goods and
Total utility is the entire satisfaction one derives from consuming a good or service.
Marginal utility is the additional utility derived from the consumption of one or more unit of the
The Law of Diminishing Marginal Utility:
The law of diminishing marginal utility states that as you consume more and more of a
particular good, the satisfaction or utility that you derive from each additional unit falls.
The marginal utility curve slopes downwards in a MU-Q graph showing the principle of
diminishing marginal utility. The MU curve is exactly equal to the demand curve.
The total utility curve starts at the origin and reaches the peak when marginal utility is zero.
Marginal utility can be derived from total utility. It is the slope of the lines joining two adjacent
points on the TU curve.
Marginal utility functions can also be derived using calculus.
Consumer Surplus and Optimal Point of Consumption:
Consumer surplus is the difference between willingness to pay and what the consumer
actually has to pay: i.e. CS= MU-P. Total consumer surplus is the area between the MU curve
and the horizontal market price line. Thus as price increases, consumer surplus shrinks, and
Introduction to Economics ECO401
The optimal point of consumption is that point where consumer surplus becomes zero. If
marginal utility is greater than price, consumption will increase causing MU to fall until it equals
price, and vice versa.
The Equi-marginal Principle:
In the case of more than two goods, optimum consumption point can be arrived at by using the
equi-marginal principle. This states that a person will derive a maximum level of TU from
consuming a particular bundle of goods when the utility derived from the last dollar spent on
each good is the same:
MUa = MUb = MUc ................
Supply Side and Demand Side Views on the Value of Good:
According to the supply side view on the value of a good, the value of a good was determined
by the labor content that had gone into producing good, either directly or indirectly.
According to the demand side view on the value of a good, the value of a good was
determined by its marginal utility. This helped solve the diamond-water paradox, i.e. why
diamonds have such a high price while water (much more essential for life) sell so cheaply.
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