Managerial Economics: How to Satisfy the Customer
The famous movie line If you build it, he will come doesn’t work for businesses, and it’s the job of managerial economics to determine whether the customer will purchase the item your company is selling. Consumers compare the amount of satisfaction they receive from a good to its price to determine whether or not it’s worth buying. Ultimately the customer decides whether or not your product is a good deal.
Utility as a common denominator
It’s crucial 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 you 12 utils of satisfaction while an orange gives you 24 utils of satisfaction. Comparing the utils shows that you 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.
How to add happiness
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
This equation indicates the amount of additional satisfaction you receive when you consume an additional dollar’s worth of the good.
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. 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.
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.
|Number of Pizza Slices||Total Utility||Marginal Utility|
|0||0||Marginal utility not yet established|
Note how the total utility for any given number of pizza slices equals the sum of the marginal utilities up to that slice. Also, note how the marginal utility is always the difference in total utility from one slice to the next.