Microeconomics

2.0 Demand

2.1 Utility

Introduction
  The concept of 'utility' was innovated by Jeremy Bentham, founder of the last great school of philosophy to emerge from the Western period known as 'the Enlightenment'.

Unlike the other humanities & social sciences, economic epistemology, i.e., its theory of knowledge, is rooted not in Platonic or Aristotelian idealism but in Epicurean sensationalism.  As noted by Marshall (1920, 628), the most influential successor of Adam Smith (1723-1790) was not an economist but rather Jeremy Bentham (1748-1832), a radical reformer who formalized Utilitarianism as a comprehensive philosophy (Clough 1964, 605).  Bentham’s epistemology is based on the atomic materialism of Epicurus (341-271 B.C.E.).  He acquired this view from the De Rerum Natura (On the Nature of Things) by the Roman Epicurean poet Lucretius (99-55 B.C.E.), whose work, unlike those of Epicurus, survived the fall of the Roman Empire and the censorial fires of the Church.

Like Epicurus, Bentham believed that physical sensation was the foundation of all knowledge.  Knowledge, including preconceptions such as ‘body,’ ‘person,’ ‘usefulness,’ and ‘truth’, form in the material brain as the result of repeated sense-experience of similar objects.  Ideas are formed by analogy between or compounding such basic concepts (O’Keefe 2001). 

For Bentham sense experiences involved a unit measure of pleasure and pain called the ‘utile’ from which the philosophical school of thought known as ‘Utilitarianism’ emerged.  Utiles would eventually, according to Bentham, be subject to physical measurement and he proposed a ‘felicitous calculus’ of human happiness.  One corollary of the utile, however, is that customs, traditions and taste cease to be independent variables.  Compulsory standard education would have children taken at birth from their mothers and placed in state-operated crèches   Each child was born tabula rasa - blank. Bentham believed socializing consumption would ensure everyone’s customs, traditions and taste would eventually become identical and therefore irrelevant. 

In simple terms, Bentham believed that human existence was simply the search for pleasure and the avoidance of pain.  This has been expressed as 'pleasure and pain are the sovereign rulers of the State'. Thus utilitarianism is radically materialistic at root.  In many ways, Bentham makes even the supposedly materialistic Marx look like a softy.  Marx at least admired John Lennon's working class hero.  Bentham, on the other hand, wanted to socialize not just the means of production but also of consumption.  For Bentham the Mao suit or 'GI' issue - one size fits all - was the style of the future.  It was only the terrors of the French Revolution that drew Bentham back from edge of perfect communism.  For Marx, of course, the Revolution was the instrument of change.  In a sense Marx was the son that Bentham never had.

Even aesthetics shrank to analysis of pleasurable sensations evoked by a work of art.  A thing is beautiful because it pleases, it does not please because it is beautiful (Schumpeter 1954, 126-7).  This, combined with Benthamite emphasis on functionality, meant application of artistic effort was “irrational”.  In industrial design and architecture, this aesthetic reached its logical conclusion in the aphorism form follows function, the Bauhaus and the glass and steel towers of the International School of Architecture (Hughes 1981).

Another name for utilitarianism, as defined by Bentham, is 'ethical hedonism'. The search for pleasure was inhibited in Bentham's scheme by the assumption that human beings carried what today we would call genetic ethic of right and wrong - essentially the  Protestant work ethic.   Once that ethic faded, however, we were left with only 'Me-ism': only my pleasure counts, and anything I do to increase it, no matter the pain and suffering to others, does not matter!
    It is ironic that economics should achieve what was most feared by Plato expressed in Book X of The Republic, 2,000 years before Bentham noted: 

We must remain firm in our conviction that hymns to the gods and praise of famous men are the only poetry which ought to be admitted into our State.  For if you go beyond this and allow honeyed muse to enter, either in epic or lyric verse, not law and the reason of mankind, which by common consent have been ever deemed best, but pleasure and pain will be the rulers in our State.

In the hands of Francis Ysidro Edgeworth (1845-1926) Bentham’s felicitous calculus of human happiness was married to Newtonian calculus of motion and reduced to geometric expression subject to mathematical proof in his Mathematical Psychics (Edgeworth 1881).  This geometry and its related calculus permitted erection of what became the Standard Model in economics.  It is important to note that use of calculus defines the Standard Model as mechanical rather than biological in nature, i.e., the calculus of motion, in this case, of human happiness.  It is also important to note that the demand-side of the economic equation came first and flowing from its mathematics and geometry the supply-side was subsequently erected.  Put another way, the consumer's wants, needs and desires precede production of goods & services to satisfy them.  This is called 'consumer sovereignty'.

As we will see the budget (income and prices) constrains maximization of pleasure by the individual consumer yielding a demand curve while the cost constrained profit maximization of the firm yields a supply curve.  When put together in the ‘Marshallian scissors’ of supply and demand, a determinant geometric, mathematically precise equilibrium emerges.  It is an ideology framed by an ‘X’ - the intersection of market supply and demand curves - marking the spot where human happiness is to be found, where, at one and the same time, consumers maximize their self-interest and producers their profits; everyone is happy here - if one accepts certain very strict assumptions.

It is not, however, just the far Left that has concerns about Bentham’s felicitous calculus and the Standard Model.  Joseph Schumpeter called it “the shallowest of all conceivable philosophies of life that stands indeed in a position of irreconcilable antagonism to the rest of them” (Schumpeter 1954, 133).  John Maynard Keynes went further identifying its dangerous ideological flaws:

In fact, before the Republican Revolution, the economy was embedded in society through guilds and a class structure of subordination by birth.  Today, some fear that human society is being embedded into a global economy in which everything is for sale – hearts, kidneys, lungs as well as the entire natural and human built environment – as Karl Polanyi suggested in The Great Transformation (2001).  Such lingering concerns may be genetic fragments of a not quite dead Marxism or remembrances of forgotten roots – equality, fraternity and liberty.  In a way, the Republican Revolution sought political freedom for the individual and in the process spawned the free self-regulating market as its economic corollary.  The Communist Revolution, on the other hand, sought economic freedom for the individual (each according to one’s need) through a centrally controlled command economy and spawned the one-party Leninist state as its political corollary.  Arguably both forms of freedom – political and economic - are required to realize human potential.

1. Terms

a) Utility: a generalized term for the satisfaction obtained by an individual from the 'use' of a product (good or service) measured by the price the individual is willing to pay for the product where:

i - total utility - total satisfaction yielded by the product
ii - marginal utility - the additional utility yielded by an additional unit of the product
iii - diminishing utility - at some level of consumption an additional unit of the product yield less utility than the preceding unit, i.e. utility increases at a decreasing rate
iv - maximizing utility: rational individual will purchase that combination of products or commodities yielding the maximum utility subject to income constraint and prevailing prices

b) Consumption: the use of a product whereby its utility is destroyed, or 'negative production'.

c) Income: payment for work used to purchase products in order to obtain utility.

d) Work: physical or intellectual effort made not for any pleasure derived from itself but rather to earn income to purchase products to obtain utility.

e) Price: the current exchange rate of a product for the utility derived by a consumer.

2. Assumptions

a) Rationality: consumer chooses between alternative commodity combinations to maximize utility assuming -

 i - perfect knowledge, that is, aware of all alternative commodity combinations and their prices

 ii - competence, that is, capable of evaluating the alternatives

 iii - transitivity, that is, if A = B and B = C then A = C (which means that indifference curves do not intersect: see 3(b) below)

b) Ordinality: consumer is able to order commodity combinations by level of utility, 1st, 2nd, 3^rd etc.  Does not require cardinality, that is, the ability to specify the actual numeric level of utility

3. Mechanisms

a) Utility Function

                U = f (x, y) where:

i - U is the utility derived from consuming commodity combinations of x and y

ii - U is assumed to be continuous (and has first- and second-order partial derivatives) or there is continuity of commodity combinations of x and y, that is, there is an infinite number of combinations yielding the same level of utility, U is a dense set

iii - U is not unique, that is, any utility number - U' - assigned to a given commodity combination indicates only that it is preferable or superior to all combinations with a lower number and inferior to those with a higher number, in other words, U' does not possess any cardinal meaning

iv - U is defined for consumption within a specified timeframe - long enough to allow substitution among existing commodity combinations but short enough to insure constancy of taste

b) Indifference Curve:
    For any level of utility - U'  = f (x, y) - there is a locus of commodity combinations which graphically form an indifference curve, that is, all combination yield the same level of utility - U' meaning the consumer is 'indifferent' to any combination on the curve.  Usually an indifference curve is 'convex' in shape reflecting the fact that an increase in x can only be obtained by a reduction in y, and vice versa (MBB 10th Fig. 6.2A; MBB 11th Fig. A5-2; BP 4th Fig. 9.3; 5th Fig. 8.3).  The amount of y that is traded off to obtain an increase in x but maintaining the same level of utility is called the marginal rate of substitution, i.e., MUy/MUx (MBB not displayed; PB 4th Fig. 9.4; 5th 8.4).  Furthermore, in a sense, the 'f' in U = f (x, y) and 'f' is your taste function which is obviously different than mine or any other consumer and is reflected by different shape of indifference curves and different MRSs.  Anyone's indifference map will, for normal goods, be convex (opening away) from the origin.  The reason is diminishing marginal utility, i.e., at some point you are unwilling to give up x for any more y.  This is the point of inflection for the indifference curve.   The transitivity assumption ensures that curves do not intersect but rather rise higher and higher.

c) Budget Line:

Given a specific level of income, a budget line shows all commodity combinations of x and and y that can be purchased by a consumer, i.e, .I = PxX + PyY.  One cannot consume above it (not attainable given income and prices) and it would be irrational to consume below it and pocket the cash.  Happiness in this model is only derived from the consumption of goods & services purchased on the market.  Saving money does not count other than as a 'good & service' that increases future consumption by 'selling' money for interest.  The maximum amount of x or y one can afford given income and prices is shown as the intercepts of the budget line and the respective axes.

If income goes up (and x and y are normal goods) a new higher budget line will be available to the consumer parallel to the original. 

If the price of x decreases then the angle of the budget line changes and the intercept increases, that is, the consumer can buy more x with the same income (MBB Fig. 6.1A ; PB 4th Fig. 8.1 or  9.1; 5th Fig 7.1 or 8.1). 

The slope of the budget line is also the negative of the price ratio, i.e., - Px/Py.  Thus the price ratio is NOT the slope of the line which would be Py/Px (rise over run).  This formulation of the price ratio is a 'convention' or tradition in economics.  However, it also represents the 'relative price' of x and y at a given point in time, i.e., how many units of x can be bought with one unit of y at current prices, e.g., $1.00/50 cents = a relative price of '2'.

d) Equilibrium:
    The commodity combination which maximizes a consumer's utility is the one on the budget line tangent to the highest indifference curve.   In rare cases - a corner solution - an individual will consume none of a commodity x because no amount of x is worth the cost.  In such cases the consumer's maximum utility is obtained on the y -axis that is no x is consumed.
    Equilibrium occurs where the Budget Line just touches (is tangent to) the highest attainable indifference curve (MBB not displayed; PB 4th Fig. 9.4; 5th 8.4).  This equilibrium  or 'best affordable point' (MBB 10th Fig.6.4A; MBB 11th Fig. A5-2; PB 4th Fig. 9.6; 5th 8.6) satisfies the following conditions:

• Marginal Rate of  Substitution (MRS = MUy/MUx) equals the slope of the Budget Line or its negative, the price ratio - (Px/Py)

• therefore in equilibrium MUy/MUx = - Px/Py

• at this point the 'rationale' consumer has equated the MU per dollar of each commodity consumed, i.e. MUx/Px = MUy/Py  (MBB not displayed; PB 4th Fig. 8.3; 5th Fig. 7.3).

Consumers will tend to remain at this point (or be 'in equilibrium') as long as taste, income and prices remain fixed.  This is called the 'initial equilibrium'.  We will now change these assumption one by one and see what happens to equilibrium.