The following is an excerpt from Managerial Economics for Dummies. Published under license from John Wiley & Sons, Inc.
Successful businesses satisfy consumer desires. Knowing how consumers decide which desires to satisfy and which to leave unsatisfied is an important component in your managerial decision-making. Consumer theory describes how customers determine the purchases they make. By understanding consumer theory, you can influence customer behavior through pricing strategies such as coupons and gift cards.
Satisfying the consumer
A famous line from the movie Field of Dreams is “If you build it, he will come.” Well, that may have worked in the movie, but it doesn’t work for businesses — “produce it and they will buy” isn’t a certainty. Consumers compare the amount of satisfaction they receive from a good to its price to determine whether or not it’s worth buying. Remember, ultimately the customer decides whether or not your product is a good deal.
Comparing apples and oranges: Utility as a common denominator
You’ve probably heard the expression “You can’t compare apples and oranges.” It’s an absurd expression because of course you can compare apples and oranges, and you probably have. If you ever thought, “Oranges are really expensive this week; maybe I should buy apples instead,” you just compared them. And the produce section manager also compares them all the time. At the very least, the manager has to decide how much space to allocate to displaying oranges and apples. And I suspect that the manager allocates more space to the one that makes the store more money.
It’s crucial for you to recognize that consumers are always comparing different goods. Consumers must decide how much they’re going to buy of each good — how many apples, how many oranges, how many tickets to the baseball game, how many new bicycles . . . the list is never ending.
How much you like apples, oranges, or any other good is based upon the amount of pleasure or satisfaction you get from the good. But instead of using terms like pleasure or satisfaction, economists use the term utility.
Utility is the amount of satisfaction an individual receives from consuming a good.
Economists like to measure everything — even satisfaction. They measure satisfaction using the idea of utils. Thus, an apple might give me 12 utils of satisfaction while an orange gives me 24 utils of satisfaction. Comparing the utils shows that I like the orange twice as much as the apple.
You don’t have to measure everything as precisely as this example indicates. However, using utils makes consumer theory easier to understand.
Adding happiness — at a price
Typically, as you consume a greater quantity of a good, you get more satisfaction. You get satisfaction from the first scoop of ice cream you eat, and you get additional satisfaction from eating a second scoop of ice cream.
Economists call the additional satisfaction or change in satisfaction from an additional unit of the good marginal utility.
Economists also compare your additional satisfaction to the good’s price.
Marginal utility per dollar spent simply equals the good’s marginal utility divided by its price, or MU per dollar = MU/P.
This equation indicates the amount of additional satisfaction you receive when you consume an additional dollar’s worth of the good.
Getting less from more: The law of diminishing marginal utility
So, you really like ice cream. A one-scoop ice cream cone is good, and a two-scoop ice cream cone is better. Because you get additional satisfaction or utility from the second scoop of ice cream, your marginal utility is positive and your total utility increases. If you add a third scoop of ice cream, your total utility may continue to increase, but it’s not likely to increase as much as with the second additional scoop. The third scoop of ice cream tastes good, but you also start to get full, and it starts to melt and make a mess. As a result, your additional satisfaction — your marginal utility — for the third scoop of ice cream is less than for the second scoop. Your marginal utility has begun to decrease. But although your marginal utility — additional satisfaction — has decreased, your total utility is still increasing.
Using utils in the ice cream example can illustrate this idea. Eating a one-scoop ice cream gives you 60 utils of satisfaction. Because this is the first scoop, the total utility and marginal utility are both 60. But one scoop is not quite enough; it leaves you wanting more. Adding a second scoop to your ice cream cone increases your total utility from 60 to 150. Therefore, the marginal utility or additional satisfaction of the second scoop is 90 utils — 150 – 60. To add a third scoop of ice cream increases your total utility to 200 utils. The third scoop tastes good, but it causes a mess. The change in total utility for the third scoop or the marginal utility of the third scoop is 50 — 200 – 150. Thus, the marginal utility of the third scoop, 50, is less than the marginal utility of the second scoop, 90, but the total utlity of the third scoop has increased from 150 to 200.
What happens in the ice cream situation happens with all goods. The first few units you consume tend to give you a lot of satisfaction, but eventually you reach a point where an additional unit gives less additional satisfaction.
This is called diminishing marginal utility and because it always happens, economists call this the law of diminishing marginal utility. The law states that as the quantity consumed of a good increases, eventually a point is reached where the marginal utility of an additional unit of the good decreases.
Suppose you’ve been working hard all day and you’re really hungry. So, you decide to go out to eat rather than stay home and fix dinner. You go to a pizza restaurant with an all-you-can-eat buffet. What a great deal, especially given you’re so hungry.
The first slice of pizza tastes great and you get 20 utils of satisfaction. The second slice tastes even better and you get 30 additional utils of satisfaction.
Your total utility is now 50 utils (20 + 30). The third slice of pizza also tastes good, but not quite as good as the second — your additional satisfaction is only 25 utils. At this point, diminishing marginal utility has set in, because 25 is less than 30. However, note that your total utility is still increasing. It is now 75 utils (20 + 30 + 25).
Diminishing marginal utility continues and by the time you reach the eighth slice of pizza, you’re stuffed. The pizza still tastes good, but your stomach is starting to hurt from all the pizza. At this point, marginal utility becomes negative, and your total utility starts to decrease.
Robert J. Graham is an independent project management consultant and was a senior associate with the Strategic Management Group. He taught at the Wharton School of the University of Pennsylvania and is author of Managerial Economics for Dummies, excerpted above.