Chapter 7 Utility Maximization Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Law of Diminishing Marginal Utility • Law of diminishing marginal utility • As consumption of a good or service increases, the marginal utility obtained from each additional unit of a good or service decreases • Explains downward sloping demand curve LO1 7-2 Terminology • Utility is the satisfaction one gets from consuming a good or service • Not the same as usefulness • Subjective • Difficult to quantify LO1 7-3 Total Utility and Marginal Utility • Utility is one unit of satisfaction or pleasure • Total utility is the total amount of satisfaction • Marginal utility is the extra satisfaction from an additional unit of the good • MU = ΔTU/ΔQ LO1 7-4 Theory of Consumer Behavior • • • • LO2 Rational behavior Preferences Budget constraint Prices 7-5 Utility Maximizing Rule • Consumer equilibrium • Consumer allocates his or her income so that the last dollar spent on each product yields the same amount of extra (marginal) utility • Algebraically, MU of product A Price of A LO2 = MU of product B Price of B 7-6 Income and Substitution Effects • Income effect • The impact a price change has on a consumer’s real income • Substitution effect • The impact a price change on a product’s relative expensiveness LO4 7-7 Applications and Extensions • • • • • • LO5 New products iPad Diamond-water paradox Opportunity cost and time Medical care purchases Cash and noncash gifts 7-8 Indifference Curve Analysis • Alternative to theory of utility maximization • Difficult to measure utility • Use rankings or order of preference for products • Takes into account the consumer’s budget • Derive a demand curve LO6 7-9 The Budget Line • Budget Line • Combinations of two products a consumer can purchase with their money income • Slope • Ratio of the price of B to the price of A • Location varies with income changes • Location varies with price changes LO6 7-10 Indifference Curves • Indifference Curve • Combinations of two products that yield the same amount of total utility • The consumer is indifferent as to which combination to purchase • Downsloping • Convex to the origin • Reflects the Marginal Rate of Substitution LO6 7-11 The Indifference Map • Indifference map • Series of indifference curves where each curve reflects different amounts of utility • Each successive curve outward reflects a higher level of utility LO6 7-12 Equilibrium at Tangency • The consumer’s equilibrium position • Indifference curve is tangent to the budget line • Utility is maximized • MRS equals the ratio of the price of B to the price of A LO6 7-13
