Part Two: Microeconomics
of Product Markets
CHAPTER 5
CONSUMER CHOICE AND
UTILITY MAXIMIZATION
Slides prepared by Dr. Amy Peng, Ryerson University
In this chapter you will learn:
5.1
5.2
5.3
5.4
About total utility, marginal utility, and the
law of diminishing marginal utility
How rational consumers compare marginal
utility-to-price ratios for products in
purchasing combinations of products that
maximize their utility
How a demand curve can be derived by
observing the outcomes of price changes in
the utility-maximization model
How the utility-maximization model helps
highlight the income and substitution effects
of a price change
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5
2
Law of Diminishing Marginal Utility
• Gains in satisfaction decline as
additional units are consumed
• Terminology
– utility is want-satisfying power
• Total Utility and Marginal Utility
– total utility: total amount of satisfaction
– marginal utility: extra satisfaction from
consuming one more unit
graphically examined....
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.1
3
Figure 5-1
Total and Marginal Utility
Tacos
Total Marginal
Consumed Utility
Utility
Total Utility
0
10
18
24
28
30
30
28
©2007 McGraw-Hill Ryerson Ltd.
40
Total utility
0
1
2
3
4
5
6
7
30
20
10
0
0
1
2
3
4
5
6
7
8
Quantity
Chapter 5.1
4
Total and Marginal Utility
0
10
18
24
28
30
30
28
10
Total utility
0
1
2
3
4
5
6
7
40
30
20
10
0
0
1
2
3
4
5
6
7
8
5
6
7
8
Quantity
Marginal Utility
Marginal utility
Tacos
Total Marginal
Consumed Utility
Utility
Total Utility
15
10
5
0
-5 0
1
2
3
4
Quantity
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.1
5
Total and Marginal Utility
Total Utility
Tacos
Total Marginal
Consumed Utility
Utility
10
8
6
4
2
0
-2
Diminishing
Utility
Total utility
0
10
18
24
28
30
30
28
30
20
10
0
0
1
2
3
4
5
6
7
8
5
6
7
8
Quantity
Marginal Utility
Marginal
Marginal utilitiy
0
1
2
3
4
5
6
7
40
15
10
5
0
-5 0
1
2
3
4
Quantity
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.1
6
Marginal Utility and Demand
• If marginal utility falls rapidly for each
successive unit…
• It will take a considerable drop in price to
cause an increase in quantity
demanded…
• So demand is fairly…
• INELASTIC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.1
7
Theory of Consumer Choice
A Typical Consumer…
• Exhibits rational behaviour
• Knows clear-cut preferences
• Is subject to a budget constraint
• Responds to price changes
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.2
8
Utility-Maximizing Rule
• The consumer’s money income should
be allocated so that the last dollar spent
on each product purchased yields the
same amount of extra (marginal) utility
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.2
9
Numerical Example
• First, put the marginal utilities into a perdollar-spent basis
• Decision-making process: at each step,
spend where the marginal utility per
dollar is highest
• Table 5-1
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.2
10
Table 5-1
Product A p=$1
Unit of
product
1st
2nd
3rd
4th
5th
6th
7th
Product B p=$2
Marginal
utility
MU/p
MU
MU/p
10
8
7
6
5
4
3
10
8
24
20
18
16
12
6
4
12
10
©2007 McGraw-Hill Ryerson Ltd.
7
6
5
4
3
Chapter 5.2
9
8
6
3
2
11
Table 5-2
Sequence of Purchases to Achieve Consumer Equilibrium
Spending Product A
MU/p,
MU/p,
Product A Product B
$2
1st
10 1st
12
$3
1
2nd
8 2nd
10
What
will
the
rd
rd
$2
3
7 3 And
9 next?
consumer
buy
$3 first?
1
4th
6 4th
8
5th
5 5th
6
$10
2
th
th
6
4 6
3
7th
3 7th
2
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.2
Product
B
1
1
1
1
4
12
Utility Maximization
• At each step, spend where MU/$ is
highest
• In general, if MU/$ is unequal, spending
should be allocated
– away from the good where MU/$ is low
– toward the good where MU/$ is high
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.2
13
Algebraic Restatement
MU of product A
Price of A
©2007 McGraw-Hill Ryerson Ltd.
=
Chapter 5.2
MU of product B
Price of B
14
Utility Maximization and the Demand Curve
Deriving the Demand Curve
• What if the price of Product B falls to $1?
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.3
15
Table 5-1
Product A p=$1
Unit of
product
1st
2nd
3rd
4th
5th
6th
7th
Product B p= $1
Marginal
utility
MU/p
MU
MU/p
10
8
7
6
5
4
3
10
8
24
20
18
16
12
6
4
24
20
©2007 McGraw-Hill Ryerson Ltd.
7
6
5
4
3
Chapter 5.3
18
16
12
6
4
16
Decision Making Process
MU/p,
Product A
1st ◄ 10
2nd◄ 8
3rd ◄ 7
4th ◄ 6
5th
5
6th
4
7th
3
MU/p,
Product B
1st ◄ 24
2nd◄ 20
3rd ◄ 18
4th ◄ 16
5th ◄ 12
6th ◄ 6
7th
4
©2007 McGraw-Hill Ryerson Ltd.
Spending
$1
$1
$1
$1
$1
$1
$1
$1
$1
$10
Chapter 5.3
Product A
Product B
1
1
1
1
1
1
1
1
1
4
1
6
17
Utility Maximization and the Demand Curve
• When pProduct B = $2
– the quantity demanded is 4
• When pProduct B = $1
– the quantity demanded is 6
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.3
18
Figure 5-2
Deriving an Individual Demand Curve
price
Product B
Price Quantity demanded
$1
6
$2
4
D
$2
$1
4
6
quantity demanded
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.3
19
Utility Maximization and the Demand Curve
• Substitution Effect
– when the price of Product B falls, there is a
substitution of now cheaper B
• Income Effect
– increase in real income increases
consumption of both A & B
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.3
20
Applications and Extensions
•
•
•
•
DVDs and DVD Players
The Diamond-Water Paradox
The Value of Time
Cash and Non-Cash Gifts
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5.4
21
Chapter Summary
 5.1 The Law of Diminishing Marginal
Utility
 5.2 Theory of Consumer Choice
–
Marginal Utility per Dollar
 5.3 Utility Maximization and the Demand
Curve
–
Income and Substitution Effects
 5.4 Applications and Extensions
©2007 McGraw-Hill Ryerson Ltd.
Chapter 5
22