Utility and Consumption

The notion of “utility,” or satisfaction, is generally used to explain how consumers choose among different consumption options. The law of diminishing marginal utility holds that the amount of additional satisfaction consumers get from consuming each additional unit of a good or service decreases with each unit consumed. Because consumers get less and less satisfaction from additional units, they become less and less willing to pay the market price for each additional unit; therefore, consumers buy more when prices fall and less when prices rise. This inverse relationship explains why the demand curve is negatively sloped.

Understanding the law of diminishing marginal utility allows one to understand the equimarginal principle, which holds that maximum satisfaction or utility occurs when the marginal utility per last dollar spent on a good or service is exactly the same as the marginal utility per last dollar spent on any other good or service. If, for example, the consumption of an additional unit of good A yielded more marginal utility per dollar than the consumption of an additional unit of other goods, to maximize satisfaction individuals should spend less money on the other goods and consume more of good A until the marginal utility per dollar of good A falls to the same marginal utility per dollar of the other goods. Conversely, if good B yielded less marginal utility per dollar than the common level, consumers would buy less of good B and more of other goods until the marginal utility per last dollar of good B rose to that of the common level.

Another way of thinking about satisfaction involves indifference curves, which show how consumers react to different combinations of products. On a graph of indifference curves, one good appears on the x axis and the other good appears on the y axis. At any point along a given curve, consumers are equally satisfied with the combination of products – each point brings the same level of utility. Superimposing an income curve over a set of indifference curves shows all the different combinations of the two goods and/or services a consumer can purchase with a fixed budget. Consumers maximize their satisfaction when their income curve barely runs tangent to the highest indifference curve. If the price of good Y falls and the price of good X stays constant, the point of tangency changes, and satisfaction increases as consumers can buy more of good Y and reach higher indifference curves. If the price of good Y rises, satisfaction decreases as consumers are forced to move to lower indifference curves. Moreover, the diminishing marginal rate of substitution explains that, all else constant, the rate at which an individual must give up one good increases in order to obtain additional units of the other good. Good Y must therefore become relatively cheaper in order for individuals to be persuaded to take a little more of good Y in exchange for less of good X.

Indifference curves and marginal utility theory both show that to maximize total satisfaction, a consumer’s ratio of marginal utility to price must be the same for all goods and services. Consumers therefore demand more when prices fall and less when prices rise; as a result, the demand curve is negatively sloped. Conceptually, this phenomenon can be explained two different ways. If the price falls, the substitution effect holds that consumers tend to increase consumption because the good has become relatively cheaper than similar goods and consumers will get more satisfaction per dollar at the lower price. The income effect explains that when prices fall and consumers’ income stays the same, real income increases. In effect, consumers are wealthier, so they can buy a greater amount of the cheaper good and, for that matter, other goods. (Conversely, if the price rises, the substitution effect holds that consumers buy less, because the good has become relatively more expensive compared to similar goods. The income effect holds that consumers consume less because they are, in real terms, less wealthy.)