http://william-king.www.drexel.edu/top/prin/txt/MUch/equity.htmls Utility Utility is the want satisfying power.

The utility of Good or services is the satisfaction or pleasure one gets from consuming it. Marginal utility It is the extra satisfaction a consumer realizes from consuming additional units of that product. Total Utility It is the total amount of satisfaction or a pleasure a person a person derives from consuming some specific quantity of Goods or Services. OR it is the sum of all marginal utility. Law of Marginal Utility

Diminishing Marginal Utility The "Law of Diminishing Marginal Utility" states that for any good or service, the marginal utility of that good or service decreases as the quantity of the good increases, ceteris paribus. In other words, total utility increases more and more slowly as the quantity consumed increases. For example, the marginal utility of golf clubs might increase until you have a fairly full set. But beyond some threshold, marginal utility will diminish with increasing consumption of any good.

Applications and Extensions The law of marginal utility is closely related to many of our everyday acts and to many of our comparisons of values. Practically all the buying in quantities of consumable goods is governed more or less by this law. In making comparisons the values of certain goods we often fail to arrive at correct conclusions because we ignore the law of marginal utility. To clear the way for correct answer we must first contrast the marginal utility of a good with it total utility. E.g: the marginal utility of gold is much greater than marginal utility of iron; that is, the loss of a unit of gold would be more keenly felt than the loss of a similar unit of iron. The total utility of iron, however, is much greater than the total utility of gold. DVDs and DVDs Players:

The Diamond-Water paradox

As with so many things in economics, this story begins with Adam Smith. Smith considered, and rejected, the idea that demand must be related to "utility." This may seem self-evident: the more useful a thing is, the more satisfaction it gives, the more people would be willing to pay for it.

However, Smith saw a difficulty with this argument. The problem Smith posed has come down to us as the "Paradox of Diamonds and Water." As Smith observed, water is very useful -- indeed it is necessary for life. But water is very cheap. By contrast, diamonds have little utility. They are only useful for adornment. It is possible to do without diamonds entirely, and most people do. Yet diamonds are very costly. This is Smith's "paradox:" if demand depends on the usefulness of the product, then we would expect the more useful product, water, to command the higher price - yet diamonds are more costly. Not only do we know that water is cheaper as a matter of fact, but most people would agree that they would not pay as much for diamonds as for water. Because of this "paradox," Smith came to the conclusion that willingness to pay is not related to utility. To make sense of this strange result, he distinguished between "value in use" and "value in exchange." Value in exchange, he said, is unrelated to usefulness and must be based on other principles. What other principles? It was here that Smith relied on the labor theory of value. For a century, most economists felt that Smith had settled all this -- that value in exchange was based on different principles than value in use and specifically on labor value. Late in the nineteenth century, though, a new generation of economists found an answer to Smith's Paradox of Diamonds and Water, and returned to the idea that demand is based on utility. The Labor Theory of Value had come to play a key role in Marxism, and had a history of its own. We will have to leave this history for the chapter on Marxist economics, and for now go on to show how the New Economists of 1880 answered Smith's paradox.

Utility of Diamonds and Water

The explanation of the Paradox of Diamonds and Water will need a little special terminology. We will use the concept of marginal utility, and marginal utility will play an important part in some of the sections to follow. It is best to begin with an example. In the example, we will assume that a person can buy water or diamonds or both. We assume that the satisfactions she gets from diamonds and from water can be measured in money terms. Following a long tradition in economics we will speak of the amount of satisfaction as the "utility" of diamonds and water. We assume: 1. 2. 3. 4. 5. that her total satisfaction is the sum of the utility of water and the utility of diamonds, that the utility of diamonds increases as she consumes more diamonds, that the utility of water increases as she consumes more water, and that she tries to spend her income in such a way as to get the most satisfaction that she can -- that is, that she "maximizes" utility.

6.Quantity and Utility

7. 8. Suppose that the utility of diamonds and water increase as shown in Table 1.

9.Table 1
Water Gallons 1 2 3 4 5 Utility Diamonds Carats Utility 15 29 42 54 64

1,000,000 1 1,000,100 2 1,000,110 3 1,000,111 4 1,000,111 5

10. Now suppose consumer already has 3 gallons of water but no diamonds. The fourth gallon of water would give her only one additional unit of utility. However, the first diamond would give her 15 units of utility. Thus, she would be willing to spend 15 times as much for a one-carat diamond as for a gallon of water.

11.

Quantity and Utility 14. Table 1

Water Gallons 1 2 3 4 5 Utility Diamonds Carats Utility 15 29 42 54 64

12. 13. Suppose that the utility of diamonds and water increase as shown in Table 1.

1,000,000 1 1,000,100 2 1,000,110 3 1,000,111 4 1,000,111 5

15. Now suppose consumer already has 3 gallons of water but no diamonds. The fourth gallon of water would give her only one additional unit of utility. However, the first

diamond would give her 15 units of utility. Thus, she would be willing to spend 15 times as much for a one-carat diamond as for a gallon of water.

Marginal Utility Tables

Table 2 shows how marginal utility changes with changing consumption of the two goods.

Table 2
Water Total Utility 0 0 1,000,000 1 1,000,000 100 2 1,000,100 10 3 1,000,110 1 4 1,000,112 5 1,000,113 0 54 64 10 42 12 29 13 15 14 Diamonds Total Marginal Utility Marginal Utility Utility 0 15

As we look at the table, we can see that the marginal utility for each good decreases as the consumption of the good increases. Put otherwise, the more diamonds we consumer, the less an additional diamond adds to our total utility. Similarly, the more water we consume, the less an additional gallon of water adds to our total utility. The utility of each good increases as we consumer more of it, but the utility increases at a decreasing rate. The marginal utility is that rate.

Diminishing Marginal Utility 1

This illustrates a general principle that has much wider application in economics. In economics, we speak of a law or principle of diminishing marginal utility. The "Law of Diminishing Marginal Utility" states that for any good or service, the marginal utility of that good or service decreases as the quantity of the good increases, ceteris paribus. In other words, total utility increases more and more slowly as the quantity consumed increases. This is "diminishing returns" from the viewpoint of the consumer, and is a general principle of economics. There might be a threshold before the principle applies. For example, the marginal utility of golf clubs might increase until you have a fairly full set. But beyond some threshold, marginal utility will diminish with increasing consumption of any good. As we will see, there are other applications of "diminishing (marginal) returns" in other branches of microeconomics.

Diminishing Marginal Utility 2

Here is another point in the example, getting back to the Paradox of Diamonds and Water: The marginal utility approach implies that when one commodity is very common, and the other is very scarce, a person would have good reason to pay more for the scarce good. The reason is that marginal utility for any good diminishes as the person consumes more of the good. Thus, if a good is scarce, the average person consumes only a little of it, and the marginal utility is (relatively) high. If the good is plentiful, the average person will have more of it, and so the marginal utility will be (relatively) low. Of course, it was known that a person will pay more for a scarce good, and that's a matter of "common sense." But that "common sense" fact didn't sit well with Smith's idea of a "natural price" -- it seemed to be an exception of some sort. When economists switched to the "marginal utility" approach, the commonsense fact that people will pay more for scarce goods no longer seemed exceptional. Instead, it is a central point of the theory of demand. To make the idea clear, we need to say one more thing. In everyday life, marginal utility depends on the average consumption over a period of time. Take, for example, my marginal utility of pizza. After a couple of slices on a Thursday evening (Thursday is often pizza night) I won't have any more pizza, usually until next week. So my average rate of pizza consumption is roughly two slices a week. We could say that my marginal utility of pizza fluctuates over the week, but for practical purposes, it makes more sense to say that my marginal utility of pizza, per week, depends on the number of slices of pizza I have per week. Marginal utility in that sense determines what I'm willing to pay for pizza.

That is, if we use the marginal utility interpretation. But there are still some problems with marginal utility thinking, of course.

Marginal Utility and Demand

The marginal utility approach resolves the "paradox of diamonds and water." There is no paradox: the scarcer good, diamonds, have the higher marginal utility, even though water gives the greater total utility. This opens the way to develop a theory of demand based on utility. But we aren't there yet. Demand is a relation between money price and quantity purchased. So far, using our example, we have seen why a person might give up a large amount of water to get a diamond. That's not quite the same as giving up a large amount of money for a diamond. So one step we need to take is to translate from the barter of goods for goods to the exchange of goods for money. Let's check that out, next.

From Utility to Benefits

Now let's take a closer look at the idea of maximization of utility, and see in a little more detail how to make the transition from utility, in undefined subjective units, to benefits, measured in dollars. As a start, we will look at the cokes and burgers example in terms of utility. Let's suppose that Joe Blow is going to lunch, thinking of eating burgers and drinking cokes. Here, for the example, are Joe's utility numbers for cokes and burgers.
Table 3 -- Total Utility of Burgers and Cokes Burgers Cokes 1 100 2 150 3 170 4 180 65 75 80 80

Looking at the table, we see the quantity of burgers or cokes in the column at the left, and the total utility gained from consuming that quantity of burgers in the second column, and from that quantity of cokes in the third column. There is a hidden simplifying assumption here -- we are assuming that the utility of burgers doesn't depend directly on the consumption of cokes, and vice versa. That's unrealistic, of course, but making the example realistic would mean we would have to use calculus to go through it -- and we would come out with the same answer, for our trouble. So we will go ahead with the simplifying assumption. With that in mind: suppose that Joe consumes two burgers and three cokes. (OK, Joe is really hungry!) How much utility would that give him? The burgers give 150 units of utility and 3 cokes give 80 units of utility, for a total of 230 units of utility. But Joe can do better than that

Marginal Utility of Cokes and Burgers

The idea is that people act "as if" they were maximizing the utility they get from spending their limited income on burgers and cokes. In other words, they try to "allocate" that limited income between burgers and cokes efficiently -- in such a way as to give the greatest utility. We remember that "marginal" approaches have a lot to do with efficient allocation and maximizing anything. So, we will want to figure the marginal utilities of burgers and cokes. In order to "maximize," our rational consumer will need to get the most out of every dollar spend. So we will also compute the quotient of marginal utility divided by price -- that is, the marginal utility per dollar spent on burgers and cokes. We will assume that a coke costs $1 and a burger costs $2.
Table 4 Burgers Cokes

Total Total Utility Marginal Utility Marginal MU/P MU/P Utility Utility 0 0 100 1 100 50 65 0 65 65

50 2 150 20 3 170 10 4 180

25 75 10 80 5 80

10

10

For example, we see that when Joe goes from one burger to two, that increases his utility from 100 to 150 units, so his marginal utility is 50. But since the burger costs him $2, he is increasing his utility only by 25 units per dollar spent.

Optimum Spending
Let's use that information to answer the following question: Suppose a consumer has $8 to spend for lunch, utility described by tables A1 and A2, and wants to maximize the utility of lunch. How many burgers and how many cokes would he buy? We can think it through this way: The first dollar will bring 65 units of utility if it is spent on a coke, only fifty if it is spent on a (half of) a burger, so the consumer will buy at least one coke. The second coke will yield only 10 units of utility, though, whereas $2 spent on burgers will yield 50 units per dollar for the first burger and 25 per dollar for the second burger. So at least 2 burgers will be bought. That leaves $3. These will yield 10 units of utility per dollar on either good, so the consumer will purchase a third burger and a second coke for the last three dollars. The total utility of 245 units cannot be improved upon.

Equimarginal Principle

Sounds like a pretty hungry consumer. The example illustrates a key point, though. The "optimal" number of burgers and cokes is a combination such that the quotient MU/P is the same for each of the goods purchased. That is, a dollar gives the same marginal utility regardless which good it is spent on. This is an instance of a very general principle in economics, called the equimarginal principle. It has many more applications of it in other parts of microeconomics. Let's restate that precisely: Equimarginal Principle (for maximization of utility) In order to maximize the utility derived from a given income, it is necessary to allocate the spending among different goods and services in such a way that the marginal utility of each good or service consumed, divided by its price, is the same as the quotient of marginal utility divided by price for every other good consumed.

Individual Demand
To get a theory of demand, we have to answer the question: at a certain price of burgers (or any other commodity) how much will the consumer buy? And how will that amount change as the price changes? We can think of this in terms of opportunity cost. The opportunity cost of a dollar spent on burgers is the utility that dollar would have obtained if it had been spent on any other good. The person will keep increasing his spending on burgers as long as the marginal utility per dollar spent on burgers is greater than the opportunity cost. In other words, Joe cannot increase his spending on burgers without cutting back on his purchases of something else. So Joe will not increase his spending on burgers unless the next burger gives him more utility than the other goods and services he will have to give up to get it. (By the way, saving is not an exception. If Joe saves, Joe is using the money he saves to buy something -- a financial asset that he can use to buy some consumer good in the future. So: if Joe cuts back on his saving to guy a burger, it must be because the burger, now, gives him more utility than the good or service he would otherwise buy in the future. Cutting back on cokes now or on saving, it's all the same -- Joe won't do it unless he gets more utility from the burger.)

Two more point follow from this. Joe may not buy any burgers at all. No burgers will be bought unless the marginal utility per dollar is greater than the opportunity cost for the first burger. On the other hand, Joe will almost certainly not spend all his income on burgers, either. Remember the law of diminishing marginal utility. Each additional burger will give Joe less utility -- and so, sooner or later, he will find that the utility he gets is less than the utility of the alternative he has to give up. Diminishing marginal utility assures us that the demand for burgers will be limited. This leads us back to the equimarginal principle: spending on burgers will increase until the marginal utility per dollar spent on burgers is equal to the opportunity cost, that is, the marginal utility per dollar spent on other goods. This opportunity cost is often called "the marginal utility of money" or the "marginal utility of income." Here's a reason: if Joe were to get his hands on one more dollar of income, and spend it on other goods and services, the utility he would get is the same as what he would give up if he cut back on spending on those other goods and services to buy more burgers. But for our purposes, it is the opportunity cost that matters -- the "marginal utility of income" is also the opportunity cost of an additional dollar spent on burgers -- or on any other good or service. But now let's see what happens when the price of burgers rises.

Consumer Benefit
We can use the opportunity-cost approach to convert the utility of burgers to dollar terms. This conversion is used in economics for cost-benefit analysis. Remember that (in our burgers-andcokes example) the opportunity cost of a dollar spent on burgers is the marginal utility of cokes divided by the price of cokes. That's 10 units of utility, after Joe has bought one coke. The equimarginal principle tells us that, to maximize utility, Joe will allocate his income so that MUburgers/priceburgers = MUcokes/pricecokes The right-had side is the opportunity cost, so we will substitute it in. We get:

And a little algebra, we get

And the price of burgers, on the left-hand side of that equation, is the maximum that the individual would pay for the first, second, third (and so on) burgers. It thus (also) gives us a measure of the utility of burgers in monetary terms; and in still other words, it tells us the total benefit of one, two, three, four or however many burgers.

Total Benefits of Burgers

Here's a table that shows the result of this conversion. In the first column we see the number of burgers consumed, in the second the total utility from burgers as before, in the third, the opportunity cost, and in the fourth, the quotient -- the benefit from consuming burgers, measured in money.

Table 5 -- Total Benefit of Burgers in Money Terms

Burgers 1 2 3 4 Oppor- Total Total tunity Benefit Utility Cost in $ 100 150 170 180 10 10 10 10 10 15 17 18

In ordinary terms (for example) this table tells us that three burgers give Joe Blow as much utility as other goods and services (such as cokes) that he could buy with 17 dollars. So 17 dollars is the money measure of his subjective benefit from burgers. Of course, if the opportunity cost of 10 were to change, then the whole schedule of benefits from different quantities of burgers would shift -- and that might happen, if, for example, the price of cokes were to change. But that should come as no surprise. We know that a change in the price of some goods and services would change the purchasing power of income, and it makes sense

(to me, anyway) that the "marginal utility of income" would change when the purchasing power of the income changes.

Marginal Benefit
As usual, we will be interested in the marginal benefit. As we did in the main text of this chapter, we can define the marginal benefit in parallel as we did the marginal utility:

That is, as near as we can approximate, the marginal benefit is the additional benefit from increasing consumption by one unit. For example, using the table in the previous overhead, when consumption of burgers is increased from 2 burgers to 4, we have total benefit = 18-15 = 3 and burgers = 4-2 = 2, so the marginal benefit for the range of 2 to 4 burgers is 3/2=1.5.

Marginal Benefit of Burgers

Let's see how the marginal benefit of burgers varies as the consumer eats more burgers in our example:

Table 6: Marginal Benefit of Burgers

Burgers 0 Total Benefit Marginal Opportunity Marginal Utility Cost Benefit 0 100 1 10 50 2 3 15 17 20 10 2 10 5 10 10

10 4 18

10

Looking over the table, we see that there are two ways to get the marginal benefit schedule for burgers -- we can take the difference in total benefits from one to two burgers, or from two to three burgers, and so on; (as we did in the main text of the chapter) or we can divide the marginal utility of burgers by the opportunity cost or so-called "marginal utility of income." Either way, we get the same result. That's important, because it means that the marginal benefit schedule we have here is the same as the marginal benefit derived in the main text of the chapter. And we already know that the marginal benefit schedule is the demand schedule. Putting that idea to work, we may say: If the price of a burger goes up from $1.98 to $4.98, Joe Blow will cut his demand for burgers back from three to two. In short, we have used Joe's utility numbers to get his demand curve for burgers. But the numbers themselves have only played a background role. What is important for this chapter is not whether a burger gives Joe 15 or 20 units of utility, but rather the fact that a burger gives him more or less utility than the other goods and services he could buy for the same money. It's the more or less that counts. We don't have to worry about measuring the utility numbers at all. That's good, because not everybody finds utility numbers a reasonable concept. There are some problems with the whole utility approach -- at least, some economists believe there are. Let's take a look at the problems.

Another Reasonable Dialog

Now let's put this into context -- the context of the 200 year reasonable dialog that is economics. We can express it as a dialog between a skeptic (perhaps a student) and a committed neoclassical economist: Skeptic: I don't see how a "theory of demand" is possible. People demand different goods and services for all sorts of different reasons. NE: The economist's strategy is to abstract from all that. What all goods and services have in common is that they give the consumer satisfaction -- "utility" -- and our theory of demand is built on just that. Skeptic: That doesn't sound very promising! Can you say anything worthwhile at that level of abstraction? NE:

That's just what the utility approach does, and it shows that we can say important things without worrying about all the reasons why people buy things. At the least, it gets rid of the Paradox of Diamonds and Water -- a wrong turn that confused economists for 100 years. That's pretty important, abstract as it is. It brings the idea of "marginal" utility to the fore. As we'll see, that has many more applications in microeconomics, and a few in macroeconomics as well. And it gets us started in the practical business of cost-benefit analysis. We're going to follow up that lead next. Skeptic: OK, I guess that proves the trick can be done -- but at what price, if you will excuse the expression! I have some problems with this whole utility approach. NE: Tell me what they are. Skeptic: What bothers me the most is this whole idea that the person's total satisfaction can be expressed as a number. I know that idea came from philosophy -- from the founder of Utilitarianism, Jeremy Bentham, to be specific -- and that some of the early neoclassical economists were followers of his, so they weren't bothered by that numerical stuff. But I think they were hasty -- it bothers me. NE: It bothered some of them, too, and it didn't take long for some of them to come up with alternative. It turns out that all we really need is consistent preferences. That is, suppose the consumer prefers five gallons of water and one diamond to fifty gallons of water and two diamonds. As long as those preferences are consistent, we can just use the preferences -- no utility numbers -- to get a theory of demand. Once again, we have to translate from barter (diamonds for water) to money exchange (diamonds for money). But once we do that, the theory is the same. So far as demand theory is concerned, it doesn't matter which approach we choose. Of course, there are a lot of technical details there we aren't going to go into in this introductory course. Skeptic: I'm supposed to trust you on that, huh? NE: You could sign up for Econ 201, Intermediate Microeconomic Theory. That's where we go into all these details. Or we could go ahead and look at the preference approach here. Skeptic: Let's do it! Ok, most of my students aren't really that enthusiastic -- but some are. Let's do it, anyway.

The Preference Approach to Marginal Benefit and Consumer Demand

Economists, like many other people, have been a bit skeptical about the idea that a person's satisfactions could be measured in a number, as the "utility" idea assumes. Twentieth-century economists have usually thought instead of "preference." Surprisingly, perhaps, the discussion of "consumers' preferences" can get quite technical and mathematical. We will instead take it at an intuitive level to get the flavor of the idea. Think of a restaurant that sells barbecued chicken wings by the wing and french fries by the piece. The prices will be 45c a wing and 3c a piece of fried potatoes. (I don't know of a restaurant that sells wings and fries this way, but it will be ok for the example. I do know some restaurants that will sell you steak by the ounce, though, so maybe there really is one somewhere that sells wings by the wing.) Let's consider some alternative menus that John Doe could choose: no wings, one wing, two wings, and no fries, fifteen pieces of fries, or thirty pieces of fries. taking all possible combinations, we have 3x3 = 9 alternative lunches. Utility thinking says that each combination will give John a definite amount of utility. The preference approach says that, while John's satisfaction from consuming wings and fries may not be measurable as a number, John will be able to say whether he prefers two wings and fifteen pieces of fries to one wing and thirty pieces of fries. In general, John will be able to rank the alternatives as more or less preferable. Let's suppose John's ranking of the nine alternatives looks like this:
Table 7 wings 0 0 1 2

eighth seventh fifth fourth third first

fries 15 sixth

30 fourth second

This ranking illustrates some ideas from the preference approach.

First, preference is an order-ranking, not a number. This ranking from first preference to ninth applies specifically to these nine alternatives. If we were to consider more alternatives, the rankings might change, but in relative terms, they would be the same -- no wings and 15 fries will always be ranked ahead of one wing and no fries. Second, John's preferences are applied to combinations of the two goods. It is not that John prefers wings to fries. Rather, John prefers one wing with thirty fries to two wings with fifteen fries, and also prefers one wing with fifteen fries to two wings with no fries. These combinations are often called "market baskets" in economics, with the idea that the basket contains specific amounts of two or more goods.

Third, given the amount of one good, more of the other good is preferred to less. For example, if John has one wing, 30 fries rank higher (second) than 15 (fourth). There could be limits to this, of course. If John is choosing the menu for a single meal, he might get full and prefer less to more. But, in more realistic examples, there will always be other goods beside wings and fries that John can spend his money on. So, even if John couldn't possibly eat another wing or another fry, there will be some goods that he does prefer more of, rather than less. That's good enough. Fourth, notice that 1 wing and 15 fries is in a tie with no wings and 30 fries for fourth place. When two alternatives come up with the same ranking, we say the consumer is "indifferent" between them, and that the two alternatives are "indifferent choices" or "indifferent alternatives." This "indifference" relationship is not something to be "indifferent" about! It proves to be a very useful idea in the preference approach.

Now let's see how what this means when John spends his money.

Preference and the Consumer's Spending Decision

Now, let's see how John's preferences influence his spending. We'll need to keep using Table 7 so here it is again:
Table 7 wings 0 0 1 2

eighth seventh fifth fourth third first

fries 15 sixth

30 fourth second

Suppose that John has $1.35 to spend for his lunch. John can afford 2 wings and 15 fries or 1 wing and 30 fries (or one wing and 5 fries or one wing and no fries or no wings and 15 fries). These alternatives rank third and second, so John's "rational" choice is 1 wing and 30 fries. This is the choice that John most prefers, within his budget. By choosing it, we might say, John is "maximizing his preference." That's an awkward phrase, but it will have to do: in the preference

approach, we say that a rational consumer maximizes her or his preferences within the limit of her or his budget. It's almost as simple as that. But, of course, there are some important details to keep in mind -because they help to bridge the gap between the preference approach and the marginal benefits approach.

Preference is Relative
Remember, the preference rankings are really relative to the alternatives John is considering. If the only two alternatives are 1 wing and 30 fries or two wings and 15 fries, then 1 wing and 30 fries ranks first and 2 wings and 15 fries ranks second among those limited alternatives. What we know (and what John knows) is the relative preference ranking between the two alternatives: 1 wing and 30 fries is preferable 2 wings and 15 fries. Let's see what happens if John is allowed to consider still more alternatives -- he can choose 0, 1, 2, or 3 wings. We'll show that in a new table, Table 8; but to make it easy for you to compare them we will put the two tables side by side:
Table 7 wings 0 0 1 2 0 0 tenth 1 ninth Table 8 wings 2 3

eighth seventh fifth fourth third first

seventh sixth fifth third first

fries 15 sixth

fries 15 eighth sixth 30 sixth

30 fourth second

fourth second

Since we have more alternatives to rank, some of the ranks are different, but the relative rankings are the same. Check that: for example, 2 wings and 15 fries ranks below 1 wing and 30 fries in each table.

But we have more information In Table 8. We now know that 2 wings and 30 fries ranks above 3 wings and 15 fries, which we didn't know before.

More Indifference
Let's take a closer look at Table 8:
Table 8 wings 0 0 tenth 1 ninth 2 3

seventh sixth fifth third first

fries 15 eighth sixth 30 sixth

fourth second

Looking again, we see another tie. Now we have a three-way tie. No wings and 30 fries, 1 wing and 15 fries, and 3 wings and no fries are all tied for 6th place. These three menus, together, form what preference theory calls an "indifference curve" -- a linking of all the combinations of goods and services that come up with the same ranking in a person's preference ranking. This "indifference" conception helps us to relate the preference approach to the marginal-benefit approach. What is the marginal benefit of the first wing? We can get that by traveling along the indifference curve corresponding to sixth place. By definition, the marginal benefit is the money value of the other goods John would give up to get that wing. Since John is indifferent between no wings and 30 fries (on the one hand) and 1 wings and 15 fries (on the other hand) we can conclude that John would give up 15 fries to get that first wing -- no more and no less. So John's marginal benefit from one wing is the market value of 15 fries, that is, 45 cents. What is the marginal benefit of the second wing? We don't know, exactly, from this information. We would need to try more alternatives until we find one that ties in rank with 1 wing and 15 fries. But we can approximate, using the formula MB benefits/ wings. Notice that John Doe would give up all 30 fries to get all 3 wings. So the total benefit of 3 wings is the market value of 30 fries, 90 cents. Moving from 1 wing and 15 fries to 3 wings and no fries, we have benefits of 90-45=45 cents and wings of 2, so MB 45/2 = 22.5 cents. We see that John Doe experiences diminishing marginal benefits of consuming wings -- just as we would think. Notice, we are still applying the good old "opportunity cost" concept. To say that John is indifferent between no wings and 30 fries (on the one hand) and 3 wings and no fries (on the other hand) is to say that 30 fries is an opportunity cost John is willing to give up to get 3 wings.

There is one thing we need to be cautious about. It turns out that the marginal benefit will be different if we start out from a different place. For example, suppose we started out with just 15 fries and no wings. We can see that John would NOT give 15 fries for that first wing -- that would reduce him from eighth place in his preference ranking to ninth. So the marginal benefit of the first wing will be somewhat less than the 45 cents it was when John could start from 30 fries. This should not be a surprise, though. We can look at it from three points of view, and they all agree that the Marginal Benefits SHOULD depend on the starting point. First, starting from just 15 fries, John is going to be hungrier, so it might make sense if he wants to fill up a little more on fries. Second, John is richer in the first example than in the second -- starting from 30 fries is starting from 90 cents, while starting from 15 fries is starting from 45 cents. The richer people are, the more they usually are willing to pay for the goods they buy -- and we are measuring benefits in terms of the person's willingness to pay. Finally, we remember that the marginal benefit curve is the individual demand curve. When a person's income or wealth drops, their demand for most goods and services will decrease, and that's what has happened here -starting off from less income, the demand for wings is less.

Review
Of course, this example is unrealistic. The numbers are too small -- "real men" order wings by the dozen. Much more important, we have many more alternatives than we could list in a table, and we have to choose among combinations of many more than two goods, and time plays a role, so that I can average my dozen wings this week with my two dozen next week to consume an average of 1.5 dozen a week. All the same, the example has illustrated some key points about the preference approach:

We don't need numerical measures of utility. It is enough if consumers can rank the alternatives they face in terms of better and worse, or first, second, third and so on. We know that people can do that, because they do it when they choose among those alternatives. By choosing they reveal their preferences. The alternatives are not the goods and services themselves, but different combinations of goods and services -- different lunches or "market baskets." The rankings have to be consistent in several ways: more is preferred to less (perhaps up to a limit), and any two market baskets are ranked in the same way no matter what other alternative market baskets are included in the ranking. There are some other, more technical consistency requirements that we will not go into now. All the same, two or more market baskets can be ranked as a tie. Then we say the consumer is "indifferent" between them. That doesn't mean he doesn't care about the goods and services -- it means he will give up one of the two market baskets willingly in exchange for the other. This is important because it helps us to apply the opportunity cost approach to estimate his marginal benefits and thus his demand for any good or service.

Perhaps this is enough to make it clear that we really can do it -- we can express an individual's subjective benefits from consuming goods and services in terms of money. And that was a big step forward in the Reasonable Dialog of Economics. This is, of course, no more than a taste of the preference approach. A good intermediate microeconomics course would go into a lot more detail, with some very careful diagrams. I'll go on with an application of preference thinking to equity in income distribution and job assignments -- a topic economists don't often get into and, frankly, pretty far afield from most other texts -- and then come back with the basics of the intermediate level, diagrammatic approach to preference, which is covered in a good many introductory texts as well. But, in Essential principles of Economics, these are all advanced topics, and you can skip out and go on to the next chapter any time without losing the thread.

Explanations Here is another point in the example, getting back to the Paradox of Diamonds and Water: The marginal utility approach implies that when one commodity is very common, and the other is very scarce, a person would have good reason to pay more for the scarce good. The reason is that marginal utility for any good diminishes as the person consumes more of the good. Thus, if a good is scarce, the average person consumes only a little of it, and the marginal utility is (relatively) high. If the good is plentiful, the average person will have more of it, and so the marginal utility will be (relatively) low. Of course, it was known that a person will pay more for a scarce good, and that's a matter of "common sense." But that "common sense" fact didn't sit well with Smith's idea of a "natural price" -- it seemed to be an exception of some sort. When economists switched to the "marginal utility" approach, the commonsense fact that people will pay more for scarce goods no longer seemed exceptional. Instead, it is a central point of the theory of demand. To make the idea clear, we need to say one more thing. In everyday life, marginal utility depends on the average consumption over a period of time. Take, for example, my marginal utility of pizza. After a couple of slices on a Thursday evening (Thursday is often pizza night) I won't have any more pizza, usually until next week. So my average rate of pizza consumption is roughly two slices a week. We could say that my marginal utility of pizza fluctuates over the week, but for practical purposes, it makes more sense to say that my marginal utility of pizza, per week, depends on the number of slices of pizza I have per week. Marginal utility in that sense determines what I'm willing to pay for pizza. That is, if we use the marginal utility interpretation. But there are still some problems with marginal utility thinking, of course.

Marginal Utility and Demand

The marginal utility approach resolves the "paradox of diamonds and water." There is no paradox: the scarcer good, diamonds, have the higher marginal utility, even though water gives the greater total utility. This opens the way to develop a theory of demand based on utility. But we aren't there yet. Demand is a relation between money price and quantity purchased. So far, using our example, we have seen why a person might give up a large amount of water to get a diamond. That's not quite the same as giving up a large amount of money for a diamond. So one step we need to take is to translate from the barter of goods for goods to the exchange of goods for money. Let's check that out, next.