Utility in the Context of Microeconomics - Case Study Example

OUTLINE I. INTRODUCTION II. BODY A. Utility A Cardinal and Ordinal Utility A.2. Total and Marginal Utility A.3. Law of Diminishing Marginal Utility B. Consumer Behavior B.1. Indifference Curve Analysis B.2. Budget Constraints and Budget Line C. Maximizing Utility III. CONCLUSION IV. WORKS CITED Utility in the Context of Microeconomics Introduction Economics is probably one of the most interesting fields in social science. It is somewhat being in the middle of the exact sciences and social sciences because of its quantifiable factors. These factors make economics a more interesting field to study. Although it is considered as a social science, many people and scholars cannot help but label the field of economics as “trying hard” to belong to the exact sciences because it tries to quantify factors and variables that may not seem to be quantifiable at all. However, not everyone has that notion that economics is trying hard to belong to the exact sciences. Some scholars even say that economics is one of the most successful social sciences because of its ability to express different factors in different manners. Economics focuses on satisfying unlimited human wants by allocating scarce resources (“Economics Basics: Utility”). So basically, what economics aims to do is to achieve efficient allocation of resources. The concept of utility in Microeconomics can explain how humans can attain satisfaction given limited or scarce resources. What makes utility interesting is that, as said earlier, it tries to quantify the satisfaction that consumers get from a certain combination of goods or services. Utility, in the context of economics, is assumed to be measurable. This is probably the “magic” of economics. People, without having the knowledge on utility, would just measure their satisfaction by being satisfied or not satisfied. But in Microeconomics, measuring utility does not have to be this binary. It gives us options on how to measure one’s satisfaction. This paper will try to discuss the underlying concepts and theories behind utility. The paper will include how consumers can maximize their utility given a budget constraint. In order to discuss all of these, topics like consumer choice, indifference curves, and income and substitution effects will be introduced. A. Utility People consume goods in order to get pleasure or satisfaction. Utility represents the level of satisfaction that the consumer derives from a particular market basket. The term utility was coined by an English philosopher named Jeremy Bentham. Since then, the term was used to pertain to satisfaction, preference, pleasure, happiness, and their other equivalents (Dolan and Lindsey 544). Utility can be measured in different manners. It can either be cardinal or ordinal. A.1. Cardinal and Ordinal Utility The measures of utility can be cardinal or ordinal. Cardinal utility is said to be a measurable quantity. This means that cardinal utility can be represented by measurable concrete quantities. One way of measuring cardinal utility is the use of “utils” as a form of measurement (“Utility-Cardinal and Ordinal Utility”). For example, if a glass of wine gives a consumer a utility of 100 utils while a cup of coffee gives him utility of 50 utils, we can say that the glass of wine is twice as desirable as a cup of coffee. Ordinal utility, on the other hand, measures utility in terms of preference. With this approach, the consumer is expected to prefer one choice over the other. To measure the consumer’s preference, the ordinal utility approach uses tools like indifference curves. From the word itself, ordinal utility is measured by ordering the consumers’ preferences from most preferred to least preferred (“Utility-Cardinal and Ordinal Utility”). Given the example above, we cannot say that the glass of wine is twice as desirable as a cup of coffee. All we can derive is that the glass of wine is preferred over a cup of coffee. A.2. Total and Marginal Utility It is said earlier that utility can be measured by means of utils or the preference of the consumer. For example, the utility attached to the market basket containing 2 cartons of milk and 5 pieces of eggs is 50 utils. The total utility derived from the market basket is represented by the number of utils. In general, total utility is the overall satisfaction that you derive from the consumption of a good. It is said that as more of a good is consumed, total utility increases (“Economics Basics: Utility”). Marginal utility, however, is described as the additional satisfaction obtained from consuming an additional amount of the good or the basket of goods holding other things constant (Dolan and Lindsey 546). Unlike total utility, marginal utility tends to decrease at a certain level of consumption. This is what the law of diminishing marginal utility states. A.3. Law of Diminishing Marginal Utility The law of diminishing marginal utility was developed by an English economist named William Stanley Jevons. He was the first one to set forth the idea that through some range of consumption levels, marginal utility may increase as consumption increases, beyond that range, marginal utility decreases (Dolan and Lindsey 545). If you think about it, it actually makes sense. Imagine having a box of chocolates. After consuming a piece, the consumer tends to want more of an additional piece. After consuming another piece, the consumer will increase its additional satisfaction. However, there will come a point that the consumer will be less satisfied compared to his first chocolate piece. This is the reason why people do not spend all their money to just one commodity. B. Consumer Behavior The consumer always tends to consume the goods that will give them maximum satisfaction. However, consumers only have limited income. Because of this, consumers are face with budget constraint. In order to achieve maximum satisfaction, consumers have to make choices and consume the maximum amount of goods that meet their budget constraints (“Theory of Consumer Choice”). B.1. Indifference Curve Analysis An Indifference curve is a locus of points which contains combination of goods wherein the consumer is indifferent or derives the same satisfaction for the different combination of goods (“Indifference Curve Analysis”). Market baskets on higher indifference curves have higher utilities than those on lower indifference curves. Market baskets with higher utilities are preferred over market baskets with lower utilities. Figure 1 shows that an individual can get the same level of utility for different combinations of work and leisure as long as it lies on the same indifference curve. Figure 1. Indifference curve for work and leisure SOURCE: Biz/ed B.2. Budget Constraints and the Budget Line The budget constraint limits the consumer’s choices because of limited income. Budget constraints are determined by the consumer’s income and the relative prices of a good (“Theory of Consumer Choice”). The maximum combination of commodities that the consumer can afford can be shown by the budget line (“Indifference Curve Analysis”) C. Maximizing Utility The consumer will maximize utility by consuming on the highest possible indifference curve given a budget constraint. The point of tangency of the highest possible indifference curve to the budget line maximizes utility. Figure 1 shows that the consumer could consume at G, but would maximize utility at H, which lies on a higher indifference curve. This means that consuming Q1 of product A and Q2 of product B will give maximum utility (“Indifference Curve Analysis”). Fig. 1. The Optimum Consumption Point Source: Oxford University Press If the price of product B will decrease, the budget line will rotate upward. The consumer will now maximize utility on the point where the indifference curve is tangent to the new budget line. The consumer has to consume Q3 of product A and Q4 of product B to maximize utility. The fall in the price of product B resulted to an increase in quantity demanded from Q2 to Q4. Fig. 2. A Decrease in the Price of Product B Source: Oxford University Press Conclusion Microeconomics is successful in trying to explain different phenomena concerning individual consumers and producers. This paper chose to dwell only on the side of the consumers because the concept of utility focuses on consumer satisfaction. The concept of utility is not as simple and easy as most people think. It is not just about the preference for one good over the other. It is not just about consuming more to gain higher utility. Microeconomics has provided theories and principles that will explain the underlying concepts behind consumer satisfaction. Also, concepts on utility can be used in our everyday lives. The law of marginal utility, for instance, holds true for our everyday consumption. It is also a relief to know that individuals can still get maximum satisfaction even though they have limited income. These everyday phenomena that we do not usually notice are given attention by the field of economics. Its goal of efficiently allocating scarce resources to satisfy unlimited human wants is manifested in the concept of utility. Although resources are scarce, economics can provide solutions and theoretical evidence that these “unlimited human wants” can still be satisfied. Once again, the field of economics has tried to quantify something like utility which might seem to be non quantifiable at all. The law of marginal utility, indifference curves, and budget constraints tried to somehow concretize the concept of satisfaction. For most people, satisfaction is just satisfaction. It is either the individual is satisfied or not. The good which gives the highest satisfaction will be preferred by the consumer. With the knowledge about utility, more quantity does not always mean greater satisfaction. It’s a good thing economics is here to explain what may seem to be simple yet complicated phenomenon. Works Cited Dolan, Edwin and David Lindsey. Economics. 6th ed. Orlando: The Dryden Press, 1991. Economics Basics: Utility. Investopedia. 21 Oct 2008 Indifference Curve Analysis. Biz/ed. 22 Oct 2008 Indifference Curve Analysis. Oxford University Press. 20 Oct. 2008 < http://www.oup.com/uk/orc/bin/9780199296378/01student/advanced/02indifference/> Theory of Consumer Choice. Basic Economics. 22 Oct 2008 http://www.basiceconomics.info/theory-of-consumer-choice.php Utility- Cardinal and Ordinal Utility. Global Oneness. 21 oct 2008 Read More