How customers decide what to buy

It is human dreams and goals which provide the motive force for market processes. Economics depends, for its understanding of market processes, upon the alert purposefulness, the purposeful alertness, of human beings. In these processes the controlling principle is goal-motivated discovery.
– Israel M. Kirzner 1992

Everyone likes to eat. Eating is good for us. The enjoyment of eating is built into our biological makeup by nature. If we did not eat, we would die.

If eating is so good for us, therefore, why don’t we eat all the time? Why do we stop after we finish the dessert? Because we are full, that’s why. When we finish eating, we go on to something else: reading, watching TV, sleeping, or working. A few hours later, we are ready to eat again.

There is an important economic principle at work here: each additional unit of something that we acquire (a second hamburger, another potato, or the next diet-coke) is less important to us than the previous unit. It is called the law of diminishing marginal utility. It applies to everything.

Let us assume that you are married. Your family acquires its first car. Wonderful. Transportation. Freedom. But if you take the car to work, how will your husband get to his work? The family acquires a second car. Again wonderful. But not as wonderful as the first car. Why not? Well, you soon realize that owning a car means insurance, taxes, repairs, parking costs. Your husband likes to fix cars. He buys a third family car which he plans to fix up and sell. Not so wonderful. Parts of cars begin to appear in the back yard and in the basement.

What is happening is that the satisfaction you got from the first car was in some way greater than the additional satisfaction you got from the second car, and much greater than the satisfaction derived from the third car. It’s called diminishing marginal utility. The word “marginal” means a small increase or decrease.

How can you measure utility or satisfaction? You can’t. There are no units for it. Economists have tried over the years to quantify utility (some invented a unit called “utils”) but all attempts have ended in failure, for a simple reason: utility is subjective and personal. It exists only in your mind. I can’t know what is in your mind, much less measure it. And you can’t measure what is in my mind.

But the fact that you can’t measure marginal utility does not mean that the concept has no validity. It exists. It is a universal experience which we all share in different ways. We can state this in terms of a universal law:

Marginal utility is defined as the extra subjective utility or satisfaction derived from the consumption (or acquisition) of one additional unit of a product or service.

As the number of units consumed (or acquired) increases, the marginal utility experienced from each additional unit, as compared to the utility derived from the previous unit, tends to decrease.

What lies behind marginal utility is the concept of subjective ranking of alternatives that goes on in everyone’s minds all the time. When you go to supermarket and wander down the aisles, you are exposed to thousands of opportunities to buy things. Few of us has unlimited income, or unlimited storage space. So we have to make choices. Perhaps, on a given Thursday afternoon shopping trip, you have a list of what you need or want:

  • A roast for the weekend
  • 10 lbs of potatoes
  • 2 packages of frozen vegetables
  • 1 gallon of ice cream
  • 1 gallon of milk
  • 1 frozen apple pie
  • 3 low calorie frozen dinners
  • 1 jar of instant coffee

But, suppose that for some reason, you don’t have much money this Thursday. You have money for only about half of what you originally wanted. How do you choose what to buy? You will rank the things on your list in order of your personal (subjective) marginal utility. The list might come out like this:

  • 1 quart of milk
  • 1 jar of instant coffee
  • 5 lbs of potatoes
  • 2 packages of frozen vegetables
  • 3 low calorie frozen dinners
  • 1 more quart of milk
  • 5 more lbs of potatoes
  • A roast for the weekend
  • 1 more quart of milk
  • 2 quarts of ice cream
  • 1 frozen apple pie
  • 1 more quart of milk
  • 2 more quarts of ice cream

See what has happened? You need some milk. But you don’t need a whole gallon, if you have no coffee. You need the potatoes, but if money is limited, you will get only half the potatoes, and get some other things that give you more usefulness.

Looking at the milk alone, therefore, you can see a ranking of the utility from each quart. The first is essential. The second quart is not as essential, but still more important than many of the other things on your list.

Diagramming Marginal Utility
Let’s draw a diagram of the decreasing marginal utility of the milk to you:

Let us rank these quarts of milk in your subjective order:

Quarts Acquired       Marginal Utility

  • 1st                 High
  • 2nd                Somewhat high
  • 3rd                 Average
  • 4th                 Low average
  • 5th                 Low
  • 6th                 Very low

You will notice no numbers in the utility ranking. The human mind does not rank sensations (satisfaction) by numbers. We can make choices. We can say “I like L more than M”.

“How much more?”

“A lot more.” — or “A little more.”

The Marginal Utility of Money

Everything that you buy has a price. You have to give up something (probably money) to get it. Because money is universal in modern society, we can measure the cost of most things that we might want to buy in terms of money. It gives us an external objective way of classifying goods and services. When you go to the supermarket, therefore, you are using two different overlapping methods for deciding what to buy:

 subjective ranking of the value of possible items to buy

 subjective ranking of the value to us of the money we still retain

Both of these factors enter into every purchase decision. Money in your wallet or bank account, or your wallet is a good which has subjective marginal utility for you too. Every time you buy something, you have less money left. Eventually the marginal utility to you of the money left will exceed the marginal utility to be gained by buying anything else. You will stop buying — at least until you get some more money, or something cheap or exciting to buy comes along.

Marginal Utility per Dollar

We have two things tugging at us when we make each purchase decision: desire to acquire the good because of the marginal utility that it represents to us, and concern at having to sacrifice the marginal utility of the dollars we will have to surrender. We will stop buying when, in our own mind these two marginal utilities are about equal.

But we have something else tugging at us: other goods and services that we need and want. How do we decide between a quart of milk and a jar of instant coffee?

For one thing, milk is cheaper than coffee. So the utility of the money sacrificed for a quart of milk is less than that given up for the coffee. This would argue in favor of the milk. But your rating of the utility of the coffee may be much higher than that of the milk or the money — you may already have some milk, and have no coffee at all.

The result of all of this thinking has to be your personal satisfaction: removal of uneasiness: the thought that you have spent your money wisely and gotten the best group of things that you could, in the circumstances. This means that, for you, you stop buying when the marginal utility of all the things that you would consider buying but haven’t bought yet (available purchase opportunities) is equal to the marginal utility you feel from keeping whatever money you have left.

Another way of saying this is that when you complete your purchases, your marginal utility per dollar of everything that you might consider buying is about equal. We can frame that into a law of equal marginal utilities per dollar:

Each possible good is purchased up to the point where the subjective marginal utility per dollar is about equal to the subjective marginal utility per dollar of every other possible good.

Notice the word subjective in this law. This is your own personal ranking of utilities, and goods. Mine is different. Which is better or more correct? Answer: neither. In a free society, everyone makes his own decisions. You will often hear people complaining that someone else’s spending priorities are all wrong: too much on fast foods and cigarettes, not enough on wholesome food and literature. They itch to jump in and control other people’s spending habits to match their own personal value systems. Once they gain this power, freedom in society will go out the window.

To sum up the “law of consumer action”: As you spend money on some good, the marginal utility to you of each new unit that you acquire declines, while the marginal utility of the money you are giving up to buy the goods increases. When they are equal, you stop buying.

This is the way that the demand schedule for each product for each individual is determined.

Why does the marginal utility to you of the remaining money in your bank account go up as you spend more and more of it? Simply because, if you have a lot of money, you can afford to waste some of it on unnecessary luxuries. If you are down to your last few dollars, you will be much more cautious. The marginal utility of these last few dollars is much greater for you when you had very little than it was when you had plenty of dollars in the bank. So, until your income goes up, or you get your next paycheck, each time you buy something (and use up some of your remaining money) the utility to you of the remaining money goes up. It may get so high that you will be unwilling to buy anything at all: the money becomes a safety net which is more important to you than any product you could possibly buy with it.

Considering all possible goods that you could buy, you will normally spend money on the thing that will give you the most utility per dollar at the moment. As soon as you make the purchase, the utility of another similar unit will be less (because your stock of these items has just gone up). The utility (to you) of the money you will have to give up to buy another will be more (because your stock of money has just gone down).

Total Utility Cannot be Measured

The utility we are talking about is marginal utility: an extra amount of satisfaction from a specific action (acquiring an additional unit of a good or service). Marginal utility cannot be quantified — it cannot be represented by numbers. For this reason, total utility cannot be determined by adding up all the marginal utilities. This situation squares with reality. Can you add the satisfaction you get from playing one more game of golf with the satisfaction of eating an apple the next day plus the satisfaction of having your car washed, and come up with a meaningful total? Of course not. They are entirely different things which are quite unrelated. They all cost money, of course, so you can add up their dollar cost. But to add the utility involved — even in our own heads — makes no sense at all.

Some economists try to add up utility, and have developed an elegant computational system called “indifference curves” based on the summing of marginal utilities to create total utility. It is an interesting game, but it is based on two false premises:

 Marginal utilities can be added together to get total utility.

 Consumers can be “indifferent” in their attitude towards various courses of action (“Shall I buy six shirts or ten roast beef dinners? They both seem pretty good to me. They give me equal satisfaction. Give me either one.”) Marginal utility is the product of an action, not inaction or indifference.

Consumer’s Surplus

What we have discovered so far is that everything you own has a marginal utility for you; and that each additional unit has less marginal utility than the previous unit. Let’s relate this situation to the prices of goods.

During most of human history, spices, particularly pepper, were essential to the good life. This is because pepper was used to preserve meat from spoiling, and to mask the taste of rotten meat when it is eaten. Before the days of refrigeration, everyone — from kings to peasants — knew the value of spices. They were grown in India and the Far East, but not grown in Europe. Traders became fabulously wealthy bringing back spices from the Orient. People paid top dollar — or top ducat — for spices, so valuable were they considered by the people at the time.

But once you have enough pepper to preserve and mask the smell of your meat, who needs more? Once the Europeans learned the secret of growing their own pepper, and flooded the market, the price came down fast. What cost thousands of ducats an ounce before, later sold for only a ducat or two after it became plentiful. Consumers were getting what is called consumer’s surplus:

Consumer’s surplus is defined as the extra value that consumers receive when paying a low price for commodities which they would willingly have paid much more for if the commodities were scarce.

Consumer’s surplus occurs with almost any good or service. Water is a good example. If you were dying of thirst in the desert, you would pay $1,000 for a quart of water — after all, if you die, what good is the $1,000 to you? But living in the United States today, you pay only a few cents a gallon for water. You waste a lot of it. Here is your consumer’s surplus:

You pay the same price for all of your water — a few cents a gallon. You pay, therefore, the same price for the first glass of water that you do for the last one. This means that you gain a lot of value from this first glass without having to pay for it. All of us in modern civilization benefit from consumer’s surplus every day in the products we buy, the roads we travel on, the services we receive. It is the result of all of the investment that has taken place in the past, plus the division of labor today that produces millions of units of steel, wheat, clothing, computers, telephones and services for a fraction of what the same things cost our grandparents in their youth.

The Paradox of Value

Adam Smith was bothered by a problem: “Why does water, which is essential to life, cost very little, but diamonds, which have little useful value, cost a great deal?” The answer is that total utility does not exist — or at least, cannot be measured. Only marginal utility determines prices. Diamonds are expensive because they are very scarce. The marginal utility of the first diamond is very high — and for most of us, the first one may be the only one. The marginal utility of the first gallon of water is also high — but fortunately we all of us have thousands of gallons available to us every year, so the marginal utility of the last gallon used is very low. Water companies sell their product for what the least useful unit sells for, not the most useful unit.

The more there is of something, the less satisfaction we get out of the last little bit that we consume of it. We pay the same price for all units — which is to say, we pay only the price of the last unit consumed.

Where the Demand Curve Comes From

Now that we understand marginal utility, we can better understand the downward sloping demand curve. Demand curves slope down because marginal utility diminishes, the more units we consume. If marginal utility were flat — the same with every unit consumed — the demand curve would be flat also. Marginal utility is a universal law. It applies to businesses and consumers as well as to governments. It underlies much of economic theory which is essential to free market economics.

Substitution Effect

When the price of a commodity goes up, people will buy less of it, and substitute something else. When hamburger goes up in price, people buy chicken. For a business, when an input, such as labor, goes up in price, the business will substitute some other input, such as machinery, for the workers. This is the most commonly understood effect of price increases. The more advanced our civilization becomes, the greater number of substitutes there are for any commodity. Before 1600 we had firewood. After 1600 people had coal. After 1889 we had oil and gas. Since 1950 we have nuclear power. The availability of substitutes means that the demand for products is more elastic.
There is an opposite phenomenon to the substitution effect. It is the income effect:

Income Effect

If the price of hamburger goes up, and you keep buying it anyway, because you like hamburger, then you will buy less chicken because you have less income left after buying the more expensive hamburger. This is called the income effect. Price rises have the effect of reducing your real income — particularly when the price of something that you have to buy (like gasoline, or electricity) goes up. When oil prices zoomed during the 2010, we had a nationwide recession. One reason was that the oil price increase, through the income effect, reduced the real income of most Americans. They had less money left over after paying for gasoline and heating oil to spend on other goods and services. As a result, the sales of other commodities went down, companies had to lay workers off, and the real GDP suffered.

So every time prices change, we have both the substitution effect, and the income effect creating changes in what commodities are bought by consumers. Which is the stronger in any situation will depend on the commodity, the relative prices, and the mood of the consumers. Here again, there are no universal laws — only tendencies which vary with each situation.

External Qualities of Goods

People often make the mistake of thinking that some measurable quality of a good or service should be important in determining the objective usefulness or satisfaction of ownership to consumers. For example, a hard cover book is more costly to manufacture than a soft cover book. Let’s say that it costs twice as much. Therefore, some would say, consumers would get twice as much marginal utility from a hard cover book.

Of course, this is not the case at all. Some people want a book because it will look well in their living room bookcase. They might want a handsome hard cover binding. Others want the book to read on a trip. Here, the virtue of a light, paper binding make the soft cover book more satisfying to them.

No matter how you try, it is impossible to create objective external numbers or values which determine the subjective utility derived by people from their purchases. This is also true of business purchases. One company may insist on purchasing only Dell personal computers because they believe them to be longer wearing, and to project a higher class image to the general public. Another company may purchase only unknown “clone” computers because they are half the price of Dell, and do the same job. Which is right? There is no answer. It is important to realize, however, that in both cases, the decision is not being made by a “company” but by one or more people within the company who derive some personal utility from the purchase.

Another way of making the same point is to say that the law of marginal utility does not deal with objective use-value but with subjective use-value. It does not deal with the physical qualities of products, but with the relevance of the products to the well-being of the person making the decision, based on the state of his affairs at the time. It does not deal with the objective value of things which can be measured or looked up in a book, but with the subjective value of the services which the purchaser expects to get from them.

Why is it important to realize that you cannot quantify the utility of goods to others in an objective way? Because we are always trying to do exactly that. Have you ever said (or heard someone else say):

 “Go ahead and take the pumpkin. The farmer has so many he will never miss it.”

 “It is OK to tax the rich at higher rates, because money doesn’t mean as much to them.”

 “Welfare mothers should not be allowed to buy wine when their children don’t have enough to eat.”

In each of these sentences, we are making judgments about the marginal utility of individual goods to other people. Yet, objectively, we have to admit that we cannot know what is in other people’s minds. We cannot determine their values.

Marginal Utility under Government Control

When the government provides goods or services, marginal utility is not supposed to be considered. In such cases (public schools, post office deliveries, police protection), how do we determine what services to provide? The answer is that a government administrator or committee decides what people should have, — what is good for them — and tries to provide that. The individual preferences of individual people just get in the way of orderly administration of the service and are deliberately ignored.

This is the system in socialist countries like Cuba or North Korea. But citizen’s subjective marginal utility is also ignored by government officials the United States. In the public schools, for example, school administrators and committees decide what courses shall be taught, who will be hired to teach them, what the standards of the schools should be, and to which schools the children must go. If individual parents express their consumer preference for one school over another, one teacher over another or one course content over another, they are told, of necessity, to mind their own business. Bus systems are set up to move students miles from their homes to achieve racial balance, and parents are forced, by law, to send their children where the administrators have decided that they must be sent, and to be taught what is good for them.

What would be the effect of allowing parents to choose where their children should go to school, and what they should be taught? In the opinion of many school administrators, it would destroy the public school system. Children would desert the poor schools and flock to the good ones. This would waste valuable public resources (the deserted schools), put lifetime career teachers out of work, and result in overcrowding at the good schools. Recognition of consumer demand is inconsistent with any government run system, whether it is public schools, hospitals, defense, welfare or the postal system.

Conclusion

People decide what to buy because of their own personal subjective marginal utility of possible products and their money supply. What lies behind the law of downward sloping demand is the law of diminishing marginal utility. A consumer will buy a product until the marginal utility of the next product he might buy is equal to, or less than, the marginal utility of the money he would have to give up to get it. If the price falls, then the utility he would gain by one more purchase is now greater than the utility of the money given up, so he will buy another. As soon as he does so, the marginal utility of the next possible unit will be less than the last one. If it is still higher (for him) than the utility of the money given up, he will buy again.

The process is logical, understandable, and subjective. We know it is true. It always takes place. But we cannot measure it or quantify it. It is something that happens in people’s minds.

Summary

1. The utility or satisfaction derived from acquisition or ownership of goods or services is based on the total number of such goods that you own. As you acquire each additional unit, the extra satisfaction or utility which you subjectively derive from this extra (marginal) unit, is less than what you got from acquiring the last unit. This universal truth is called the law of diminishing marginal utility.

2. Diminishing marginal utility applies to money as well as to goods. Every time you sacrifice some money to buy something, you are losing some utility which you enjoyed from having the money.

3. The law of consumer action states that when the marginal utility you expect to get from purchasing the next unit of a good is less than or equal to the marginal utility you will have to give up to acquire it, you will stop buying.

4. Where several possible purchases are involved, you will make your next purchase of that good which you expect will give you the most satisfaction per dollar, as compared with all or your other available possibilities.

5. The substitution effect says that when the price of a good goes up, you will attempt to buy less of it, and instead, to buy more of some substitute good. The more substitutes there are, the more flat (elastic) is the demand curve for the product. The substitution effect will result in more purchases of other goods.

6. The income effect is the opposite of the substitution effect. When the price of a good (with a relatively inelastic demand) goes up, you may continue to purchase the good, but will then have less income left over for purchase of other goods. The income effect will result in less purchases of other goods.

7. The law of equal marginal utilities per dollar states that each possible good is purchased up to the point where the subjective marginal utility per dollar is about equal to the subjective marginal utility per dollar of every other possible good.

8. The law of consumer action says that as you spend money on a good, the marginal utility to you of each new unit that you acquire declines, while the marginal utility of the money that you have to give up to buy the goods increases. When they are equal, you stop buying.

9. Consumer’s Surplus is defined as the extra value that consumers receive when paying a low price for commodities that they would willingly have paid much more for if the commodities had been scarce.

10. The paradox of value asks why diamonds are expensive and water, which is so useful, is so cheap. The answer is that we pay for diamonds or water only what the last marginal unit purchased is worth to us. We use so much water that the last unit acquired has very little utility to us, and hence, we are willing to pay very little for it.

11. The demand curve is based on the diminishing marginal utility curves of the consumers who buy products. Businesses, like consumers, experience utility, and frame their purchases accordingly. It is individuals within each business that make the decisions for the business, and they are doing so based on their personal perception of the utility of the purchase.

12. Marginal Utility is subjective and cannot be quantified or totaled. It is not based on external qualities of goods, but on subjective anticipation of satisfaction by each purchaser thinking of himself and his family or company.

13. Diminishing marginal utility is logical, understandable, and subjective. We know it is true. It always takes place. But we cannot measure it or quantify it. It is something that happens in people’s minds.

14. Marginal utility must be ignored in a socialist system like the American public school system. It would be impossible to run the current school system if parents were given a choice on schools and content. Marginal utility is a useful concept only in the free market.

About Arthur Middleton Hughes

Arthur is currently Vice President of The Database Marketing Institute based in Fort Lauderdale, FL. Arthur is the author of 11 books, the latest of which is Strategic Database Marketing 4th Edition (McGraw-Hill 2012). A BA graduate of Princeton with an MPA in Economics and Public Affairs, Arthur taught economics at he University of Maryland for 32 years. He is an Austrian Economist.
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