In economics, we spend a lot of time on the basics of supply and demand. For an example, if the price of espressos falls, the quantity demanded of espressos increases. This is simply the law of demand at work.
Where does this result come from? It comes from all of us, each analyzing the different choices that we have.
But how exactly do we choose what to buy? Each day, we face thousands of choices.
Let’s say you start your morning at Starbucks. You look at their menu, and notice they don’t just sell espressos. You can buy a Grande Iced Vanilla Chai Latte, a Tall Peppermint Mocha, or a Venti Iced Skinny Hazelnut Macchiato. You can ask for sugar-free syrup, an extra shot, light ice, no whip.
As absurd as it may seem, they actually offer over 80,000 different combinations of drinks. And that is just drink options at one coffee shop.
Each day, your choices are nearly endless!
At the grocery store, you are choosing between an orange and a banana – at a coffee shop, an espresso, or a peppermint mocha – on your phone, it’s a game, or music.
And at each decision you make, you are instinctively thinking at the margin. And this is key.
Each good we decide to buy provides us with some value. Economists call this “utility.” And you may think of it as satisfaction or happiness. The increase in value or satisfaction from buying an additional good is its marginal utility.
So how much more do you enjoy two espressos compared to one? That difference – it’s your marginal utility.
If you add up the marginal utilities of each espresso, you get your total utility. Goods have diminishing marginal utility. Each additional good brings less utility, less satisfaction, than the previous one.
Think of how awesome that first espresso is first thing in the morning. When you compare the marginal utility of that first espresso with the price, it’s a no brainer – you get it!
Put another way, the benefits of the espresso exceed the cost. The second one, it’s maybe okay, and gives you enough utility to be worth the price, so you buy it.
However, the marginal utility of the second espresso is lower than that of the first. And maybe, if you love espressos, that third one still provides you with enough utility to be worth the price.
How about a fourth one? What if the price dropped? Would you buy that fourth espresso? The utility you get from that fourth espresso – if it is so low that you think it’s not worth the price, then no, you won’t buy it.
There are others who might be induced to buy their first or second espresso from the price drop. So, the quantity of espressos demanded – it goes up on aggregate.
But you didn’t change your espresso consumption. This is you, thinking and acting at the margin.
Of course, prices matter a great deal, but they are not the only thing that determines what you buy.