Utility And Demand

Utility and demand:

The law of demand explains why the demand curve is negatively sloped, this law states that demand for a good declines as price rises and increases as prices decline. This law however applies to normal goods given that there are other types of goods that do not obey this law, example inferior and Veblen goods. For inferior goods as the income of consumers increase their demand declines, for example as the income increases for an individual who owns a bicycle he may decide to buy a car rather than buy another bicycle. Veblen goods also violate this law and they are those goods whose demand increases as their prices go up example luxurious products.

 According to neoclassical economists one of the reasons why demand curve is negatively sloped is due to the substitution effect, this refers to a situation where good Z is a close substitute of good T, as the price of good T increases then consumers will purchase good Z which is relatively cheap. For this reason the demand curve for a good will be negatively shaped showing that when the price of a product increases then the demand falls as consumer switch to substitute that are cheaper.

 Income effect also explains the negatively sloped demand curve, the quantity of goods demanded by a consumer will depend on the level of income, a consumer with higher income levels will demand more goods, however the quantity of goods that a consumer will buy is limited by the price of that good, for example a consumer whose income is 1000 and the price of a good is 20 then the maximum quantity of that good the consumer can buy is 50. If the price of the good was increased from 20 to 50 then the maximum quantity of that good that the consumer will buy will be 20. Therefore as the price of a good increases then the consumer experiences a decline in his or her real income, real income being the quantity of goods the consumer can purchase.

 Consumers demand for a good will also depend on the utility they gain from that good, when the utility gained from consuming a unit of a good is high then consumers will demand more of that good, according to the utility theory rational consumers aim at maximising utility by consuming more units, however the consumers will consume more and more units of that good until the marginal utility level is zero. For this reason therefore this explains why from our above example where the additional utility gained after consuming the second glass of water is greater than after consuming the fourth glass of water, marginal utility continues to decline until the value is zero and at this point the consumer cannot consume more of that good.

 Optimal consumption levels by a consumer who consumes two goods is determined using the budget line and indifference curves, indifference curves is a line drawn that depicts combination of two goods that yield the same utility level, the optimal consumption level is the point where the budget line touches the indifference curves. The indifference curve is convex to the origin depicting diminishing marginal utility, marginal utility refers to the increase in level of utility as the consumption of a good increase by one unit.

 Marginal utility concept is based on a number of assumptions, and one is that utility is quantifiable, and utility of one commodity does not influence the utility of another commodity, also that marginal utility of money remains constant. Walsh and Stiglitz interpret marginal utility as the willingness to pay,  this is based on the assumption that utility is quantifiable and consumers are willing to purchase more units of a good if marginal utility is greater than zero.

 According to this theory the additional utility gained declines as more and more units of a good is consumed increase. This explains the shape of the indifference curves which are show below:

The diagram shows indifference curves an individual faces, the assumptions are that the there are only two goods and that the customer aims at maximising utility, ID2(indifference curve 2) indicates higher utility levels than ID1 (indifference curve 1) therefore consumers will prefer ID2, however the budget line determine the optimal level of consumption, the budget line is affected by both the price of the two goods and also the income level of the consumer, budget line 2 indicate a case where the income is higher than for a consumer facing a budget constrain line 1. If a consumer faces a budget line 1 and the price of both goods decline then he shifts to budget line 2, and consumption increases for both goods. Assumptions of diminishing marginal utility are that consumers are rational, this means that the consumers will tend to maximise their utility by consuming more goods.   

 Earlier studies on consumer behaviour such as Karl Marx also introduced the concept of utility and characteristics of goods. According to Marx a good has four characteristics whereby the good has a price, a use value, an exchange value and a value. According to him the value of a good is the amount of labour hours required to produce that product, also that the utility of a product makes its use value and is only realized when a product is consumed or used. The exchange value on the other and is the quantity of other products that the good will exchange for, Marx therefore considered consumer behaviour as a social process where the price of a good depended on the amount of labour hours, he stated that the demand of a product will greatly depend ion its use value but he failed to quantify the use value and therefore the use value only indicated general utility.

 According to Marx the use value or utility of a product depend on the characteristics of that product, the utility value would therefore be determined by the labour hours consumed, however neoclassical economists state that the utility of a product is determined by the buyer, and that the level of demand of a product by a consumer will therefore highly depend on the changes in utility gained which is marginal utility. For this reason therefore the major difference between the use and exchange value of a product and the marginal utility theory is that who determines utility in the market and also the changes that occur in utility gained as quantity of a good consumed increase.