In the first lesson, we spoke of the concept of marginal analysis. That is, we look at how something changes if we change some other thing a little bit. For example, what will be the effect on sales of raising price a little bit? Or what will be the effect on price of adding some new regulations to a market? We also spoke in Lesson One about the concept of "utility," which is the economist's catch-all term to describe happiness, wealth, value-from-use, and so on. Utility is basically the benefits that derive to a person from using or consuming a product or service, or, more generally, the amount of extra happiness a person gets from making a certain decision and executing that choice. One of the axioms we spoke of is that people are utility maximizers, and every choice that is made is made with the goal of increasing utility.
When we speak of demand in a market, we have to consider just how much utility does a person get from consuming a certain good, at the margin. So, we are considering a process of gradual change: how much utility does a person get from consuming one more unit of a good, and how does this change with further consumption? A great deal of research has been performed on this issue, and it generally backs up what we all know intuitively: the more we have consumed of something, the less value the next unit of consumption holds for us. This is defined as the concept of Declining Marginal Utility. This sounds like a complicated piece of jargon, but it helps to think of what each word means, and the concept becomes easy to grasp.
- "Declining" means "decreasing," or "getting smaller."
- "Marginal," as described above, refers to the effect of enacting some small change, i.e., "at the margin."
- "Utility" refers to the happiness we get from doing something.
String these three definitions together, and what we are saying is that the amount of happiness we get from consuming some good goes down as we consume more of it.
So, what does this mean in the context of a market? Well, to consume a good, we have to give up something to get it. Put simply, we have to buy it. So we give away some money, which can be thought of as a measure of potential utility, for a good that gives us actual utility. Since we want to maximize utility, we will willingly trade money for a good as long as we get more utility from consuming a good than we are giving away to get it. I will restate this, as it is perhaps the key underlying principle of a market economy: if someone gets $5 of happiness from consuming something, they will be happy to pay up to $5 for that good. If the price of the good is $6, then a rational utility maximizer will not buy the good: he is giving away $6 worth of utility to get $5 worth of utility. Nobody will do this willingly - if he has full knowledge of the values of the good and the money.
The concept of declining marginal utility is the foundation of demand-curve modeling, which is one side of our market model. This will be described in more depth in the next section.