Chapter 9
CONSUMER THEORY
A more in-depth look at the forces
that shape our demand
** Key Tables and graphs adopted from Hubbard and Obrien Textbook – Pearson Publication**
Consumption
• so far, we have looked at demand/supply, but have
not looked at the true influences of either; we will
focus on demand in this section
• We know that household consumption choices are
limited by:
1) Income available
2) Price of the product
BUDGET CONSTRAINTS
• BUDGET CONSTRAINT: represents the
possible combinations of 2 commodities
that a consumer can purchase, given:
• 1) market price of the products
• 2) consumer's income
This is a consumer’s “consumption possibilities” frontier
PREFERENCES AND UTILITY
Q: What determines your actions in every facet of
life???
A: The notion of "rational self-interest"
- What helps fuel self-interest???
“Benefit vs. price" - get the most benefit you can,
but there is a constraint (income/price)
How does one measure pleasure - "UTILITY"
Utility
• Measure of pleasure or satisfaction one gets
from consuming a product
• - measured in "utils"
So, the consumers objective is to maximize utility
given their budget constraints
Utility
• TOTAL UTILITY (TU) Number of units of
utility a person gets by consuming a given
quantity of the product during a particular time
MARGINAL UTILITY (MU) amount by which an additional
unit of the product increases a consumer's total utility
Why can marginal utility be viewed as more important in the
decision making process than total utility?
LAW OF DIMINISHING MARGINAL UTILITY
Beyond some level of consumption, the marginal utility of a
product will decline as the quantity consumed increases
MAXIMIZING UTILITY
Goal of consumer is to maximize utility
subject to its budget constraint
PROBLEM: How to allocate income among the possible
consumption choices.
Each time I buy a good, what happens?
1) utility increases, but at a declining rate
2) give up opportunity to buy other goods
Marginal Decisions
• Decisions are made “on the margin”
How do we compare the MU of two different goods?
Can we look at just the MU of each product
Gains in utility possible when marginal utility per dollar
of one good exceeds that of another good.
For two goods (X,Y), the consumption decision rule is:
Consume good X as long as its MU/$ is greater or equal to that
of good Y
Decision rule: MUX/ PX  MUY/ PY
Consumption Decision
• As long as MU/ $ is not the same for all
goods, the consumer can reallocate income
to buy more of the goods that have higher
MU/$ than the others.
Consumer Equilibrium and Total Utility
Maximization
• CONSUMER EQUILIBRIUM The
consumer purchases goods until MU/$ is
the same for all goods. When this occurs,
and all available income is spent, total
utility is maximized.
Total Utility is maximized by marginal decisions
Utility and Consumer Decision Making
The Principle of Diminishing Marginal Utility
The figure shows that for the first 5 slices of
pizza, the more you eat, the more your total
satisfaction, or utility, increases.
If you eat a sixth slice, you start to feel ill from
eating too much pizza, and your total utility falls.
Each additional slice increases your utility by less
than the previous slice, so your marginal utility
from each slice is less than the one before.
Panel (a) shows your total utility rising as you eat
the first 5 slices and falling with the sixth slice.
Panel (b) shows your marginal utility falling with
each additional slice you eat and becoming
negative with the sixth slice. The height of the
marginal utility line at any quantity of pizza in
panel (b) represents the change in utility as a
result of consuming that additional slice.
For example, the change in utility as a result of
consuming 4 slices instead of 3 is 6 utils, so the
height of the marginal utility line in panel (b) for
the fourth slice is 6 utils.
The Rule of Equal Marginal Utility per Dollar Spent
Budget constraint The limited amount of
income available to consumers to spend on
goods and services.
Table 9-1
NUMBER OF
SLICES OF
PIZZA
TOTAL UTILITY
FROM EATING
PIZZA
MARGINAL
UTILITY
FROM THE
LAST SLICE
0
0
--
0
0
--
1
20
20
1
20
20
2
36
16
2
35
15
3
46
10
3
45
10
4
52
6
4
50
5
5
54
2
5
53
3
6
51
3
6
52
1
NUMBER OF
CUPS OF
COKE
TOTAL UTILITY MARGINAL UTILITY
FROM
FROM THE
DRINKING COKE
LAST CUP
The Rule of Equal Marginal Utility per Dollar Spent
Table 9-2
(1)
(2)
SLICES MARGINAL UTILITY
OF PIZZA
(MUPIZZA)
(3)
MARGINAL
UTILITY
PER DOLLAR
 MU Pizza

 PPizza



(4)
(5)
CUPS
MARGINAL UTILITY
OF COKE
(MUCOKE)
(6)
MARGINAL
UTILITY
PER DOLLAR
 MU Coke 


 PCoke 
1
20
10
1
20
20
2
16
8
2
15
15
3
10
5
3
10
10
4
6
3
4
5
5
5
2
1
5
3
3
6
3
1.5
6
1
-1
The Rule of Equal Marginal Utility per Dollar Spent
Table 9-3
COMBINATIONS OF PIZZA AND COKE
WITH EQUAL MARGINAL UTILITIES
PER DOLLAR
MARGINAL UTILITY
PER DOLLAR
(MARGINAL UTILITY/PRICE)
TOTAL SPENDING
TOTAL UTILITY
1 slice of pizza and 3 cups of Coke
10
$2 + $3 = $5
20 + 45 = 65
3 slices of pizza and 4 cups of Coke
5
$6 + $4 = $10
46 + 50 = 96
4 slices of pizza and 5 cups of Coke
3
$8 + $5 = $13
52 + 53 = 105
We can summarize the two conditions for maximizing utility:
1.
2.
MU Pizza MU Coke

PCoke
PPizza
Spending on pizza + Spending on Coke = Amount available to be spent
DEMAND CURVE REVISITED
• We've discussed that the law of demand dictates
that the demand curve is downward sloping - here
is another way to prove it
• Use of the law of diminishing marginal returns
and consumer equilibrium to show this.
CRITICISMS OF MARGINAL UTILITY
THEORY
• Utility cannot be observed
• People aren't "smart enough" - aren't
"rational thinkers"
• Forces people to put a $value on goods
KEY TERMS
Key Terms
Behavioral economics
Network externality
Budget constraint
Opportunity cost
Endowment effect
Substitution effect
Income effect
Sunk cost
Law of diminishing marginal utility
Marginal utility (MU)
Utility