MARGINAL UTILITY AND DEMAND:

An explanation of the law of demand and the negatively-sloped

demand curve based on utility analysis and the law of diminishing
marginal utility. The law of diminishing marginal utility states that
marginal utility declines as consumption increases. Because demand
price depends on the marginal utility obtained from a good, price also
declines as consumption increases, meaning price and quantity
demanded are inversely related, which is the law of demand.

Marginal utility and the law of diminishing marginal utility can be used to provide
insight into market demand, the law of demand, and the demand curve. This insight
rests on two propositions.

• One, the law of diminishing marginal utility means that the marginal utility
obtained from consuming a good declines as the quantity consumed
increases.
• Two, the marginal utility of a good underlies the demand price that buyers are
willing and able to pay for a good.

When combined, these two propositions indicate the demand price that buyers are
willing and able to pay for a good declines as
the quantity demanded (and consumed) Edgar Rides the Coaster
increases, which is the law of demand.

Starting with Utility

The graph displayed at the right is Edgar

Millbottom's marginal utility curve for riding
the Monster Loop Death Plunge roller coaster
during a day at the Shady Valley Amusement
Park. By transforming this curve ever so
slightly, Edgar's demand curve for roller
coaster rides can be derived.

But first, consider the marginal utility curve itself.

• The vertical axis measures marginal utility in utils and the horizontal axis
measures quantity in rides on the roller coaster.
• The marginal utility curve has a negative slope, illustrating the law of
diminishing marginal utility.
• Marginal utility curve intersects the horizontal axis at 6 rides. Marginal utility
is positive up to that point, then becomes negative after.

The task at hand is to transform this marginal utility curve into a demand curve. To
do this, though, a little more information is needed.

Adjusting the Rule

According to the rule of consumer equilibrium, people like Edgar buy goods such that
the marginal utility-price ratio for each good is equal, satisfying this equation:
 marginal utility of good 1 = marginal utility of good 2
price of good 1 price of good 2

However, in the derivation of Edgar's demand curve for roller coaster rides, the key
comparison is not between roller coaster rides and ONE other good, but with ALL
other alternatives. The big assumption, therefore, is that Edgar achieves consumer
equilibrium and satisfies this rule of consumer equilibrium for ALL other goods.

If so, then Edgar has a "standard" or "benchmark" marginal utility-price ratio. For
the sake of exposition, suppose that Edgar's benchmark marginal utility-price ratio is
2 utils per dollar. In other words, Edgar purchases all sorts of different goods such
that the last dollar spent on each good generates 2 utils of satisfaction.

It this case, it is possible to specify the rule of consumer equilibrium as:

marginal utility of roller = marginal utility of all other = 2 utils per

coaster rides goods dollar
price of roller coaster rides price of all other goods

If this equation is rearranged just a little, the result is:

marginal utility of roller coaster rides = price of roller coaster rides

2 utils per dollar

The beauty of this equation is that the price that Edgar is willing and able to pay for
roller coaster rides (his demand price) is now The Conversion
connected to the marginal utility derived
from those rides.

Making the Conversion

In terms of the original marginal utility

graph, dividing the marginal utility on the
vertical axis by 2 utils per dollar transforms
the marginal utility curve into a demand
curve. Click the [Demand Curve] button to
make this happen.

Not much changes upon clicking the

[Demand Curve] button. One change is the measurement units on the vertical axis
from utils to dollars. The other change is the elimination of that part of the curve in
the negative range of marginal utility and price (negative prices are not relevant).
Feel fee to click the [Reset] and [Demand Curve] buttons a couple of times to
confirm that not much changes.

Multiple button clicks should serve to emphasize that the marginal utility curve and
the demand curve are closely related, that demand is based on marginal utility, and
that the law of diminishing marginal utility is the foundation for the law of demand.