The equimarginal principle states that consumers will choose a combination of goods to maximise their total utility. This will occur where
The consumer will consider both the marginal utility MU of goods and the price.
In effect, the consumer is evaluating the MU/price.
This is known as the marginal utility of expenditure on each item of good.
Example of marginal utility for Goods A and B
|Units||MU good A||MU Good B|
- Suppose the price of good A and good B was £1.
- Then the optimum combination of goods would be quantity of 4.
- Because at quantity of 4 – 16/£1 = 16/£1
Suppose the price of Good A is now £4 and the price of good B is £2.
We divide the MU by the price. This give us:
|Units||MU A/ £4||MU B /£2|
In this case, the consumer is in equilibrium when buying
- 2 units of A (MU A/Price A = 8)
- 4 units of B (MU/ B / price B =8)
Assumptions of marginal utility theory
- Consumers are rational
- Utility can be described in cardinal terms (e.g. monetary units)
- Constant prices and incomes.
- Goods can be split up into small units
Marginal utility and diminishing marginal returns
For most goods, we expect to see diminishing marginal returns. This means the marginal utility of the fifth good tends to be lower than the marginal utility of the first good. The more we buy, the less total utility increases.
Limitations of marginal utility theory
- Difficulty of evaluating utility. When consumers purchase goods, they may have a rough idea of how much utility the good will give, but often they don’t – especially for new goods. In practical terms, consumers can’t give a cardinal (numerical) value to utility
- Consumers don’t have time to work out marginal utility / price. Instead, they often purchase out of habit or gut feeling.
- Consumers are not always rational. For example, we often see over-consumption of demerit goods (goods which give very low marginal benefit). Or consumers may be influenced by advertising and purchase on impulse.
- Numerous goods. In the real world, consumers have fluctuating income, and innumerable goods to choose between. This makes even rough calculations difficult.
- Many goods are related – the utility of a video recorder, depends on the quality of video cassettes.
- Often goods can’t be split up into small portions, e.g. cars.