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R. Larry Reynolds 1997

Consumer Objectives
In the Neoclassical economics, the goal of
consumer behavior is utility maximization
[this is consistent with maximization of
Net benefits]
Consumer choice among various alternatives
is subject to constraints:
income or budget
prices of goods purchased
preferences
Fall 97

Principles of

Slide -- 2

Models of Consumer Behavior

Marginal Utility approach
cardinal measure of utility
problem of related goods

Indifference approach
ordinal utility
related goods
observable behavior
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Principles of

Slide -- 3

Utility Approach to Consumer Behavior

Need for cardinal measure of utility
analysis is useful for explaining
behavior
Total and Marginal utility
law of diminishing Marginal Utility
Equimarginal rule and utility
maximization
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Principles of

Slide -- 4

Total utility [TU] is defined as the amount of utility an

individual derives from consuming a given quantity of a good
during a specific period of time. TU = f(Q, preferences, . . .)

Utility

TU

TU

120
100

30
55
75

60

90

40

3
4
5
6
7

100
105
105

100

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80

20

.
1

Principles of

.
2

.
3

.
.
.
.
.

TU

7 Q/ut

Slide -- 5

Nature of Total Utility

When more and more units of a good are consumed
in a specific time period, the utility derived tends
to increase at a decreasing rate
Eventually, some maximum utility is derived and
additional units cause total utility to diminish. As
an example, think of eating free hot cakes.
It is possible for total utility to initially increase
at an increasing rate.

Fall 97

Principles of

Slide -- 6

Marginal Utility
Marginal utility [MU] is the change in total utility
associated with a 1 unit change in consumption.
As total utility increases at a decreasing rate,
MU declines.
As total utility declines, MU is negative
When TU is a maximum, MU is 0 [This is
sometimes called the Satiation point or the point
of absolute diminishing utility.

Fall 97

Principles of

Slide -- 7

Marginal Utility [MU] is the change in total utility [TU]

caused by a one unit change in quantity [Q] ;
MU = TU
Q

Utility
Q=1
Q=1
Q=1

TU MU

1
2
3
4
5
6
7
8

30

TU=30

30

55

TU=25

75

20

90
100
105
105
100

Fall 97

25

TU=20

15
10
5
0
-5

The first unit consumed increases TU by 30.

MU
The 2cd unit increases TU by 25.
30
25
20

..

10

..

1Q2

.. .
MU

Q/ut

Remember that the MU is associated with the

midpoint between the units as each additional
unit is added.

Principles of

Slide -- 8

TU

The first unit consumed, Q

120 increases TU by 30, TU.

100 max TU
80
60
40
20

MU
30
20

The MU is the slope of TU or the

TU rate of change in TU associated
with a one unit change in quantity.

.
.
.
.
.

[Using calculus, MU is the change in TU

as change in quantity approaches 0.]

between the 2cd and 3rd

units TU = 20 or the
slope of TU is 20.

For the first unit:

TU

..

10
1

..
3

Fall 97

Q/ut

. .MU
..
5

30
TU
MU = Q =
1
TU
The slope of TU is
= 30,
Q
MU is the slope of the TU.

The second unit changes TU [ TU] by

25, The slope of TU between the 1 and
second unit is 25.

Where MU = 0, TU is a maximum.
Q/ut

Principles of

Slide -- 9

Consumer Preferences

Both MU and TU are determined by the preferences or

utility function of the individual and the quantity consumed.

Utility cannot be measured directly but individual choices

reveal information about the individuals preferences
Surrogate variables [age, gender, ethnic background,
religion, etc.] may be correlated with preferences.
There is a tendency for TU to increase at a decreasing rate
[MU declines] as more of a good is consumed in a given time
period: i.e. diminishing marginal utility

Fall 97

Principles of

Slide -- 10

Diminishing Marginal Utility

Initially, it may be possible for TU to increase at
an increasing rate. In which case MU will increase
[MU is the slope of TU which is increasing].
Eventually, as more and more of a good are
consumed in a given time period, TU continues to
increase but at a decreasing rate; MU decreases.
This is called the point of diminishing marginal
utility.

Fall 97

Principles of

Slide -- 11

Consumer Choices
If there were no costs associated with choices,
the individual will consume a good until MU = 0 [this
maximizes TU or the total benefits, TB]

Typically, individuals are constrained by a budget

[or income] and the prices they pay for the goods
they consume.
Net benefits are maximized where MB = MC; as

long as the MU or MB of the next unit of good purchased exceeds

the Price or MC, it will increase net benefits

Fall 97

Principles of

Slide -- 12

Society and Individual

The individual will purchase more of a good so long
as their perceived or anticipated MB exceeds the
price they must pay for the good: Buy so long as
MB > P, optimum where, P = MB
From a social perspective that good should only be
produced and sold if the price is greater than or
equal to the MC: Sell so long as P > MC, optimum
where P = MC
Social optimum when MB = P = MC
Fall 97

Principles of

Slide -- 13

Constrained Optimization
Individual choices then become a function of the
price of the good, income [budget], prices of
related goods and preferences.
QX = f (PX , Y, PY, Preferences, . . . )

Where:
PX = price of good X
Y = income
PY = prices of related goods

preferences is the individuals utility function

Fall 97

Principles of

Slide -- 14

Utility and Demand

Individual choice is influenced by:
QX = f (PX , Y, PY, Preferences, . . . )
These are the same variables in the
demand function
The forces that shape the demand
function can be analyzed with utility
analysis
Fall 97

Principles of

Slide -- 15

B > PxQx + PyQy

The budget constraint can be expressed:

The amount of good Y that can be purchased
is the budget divided by the price of good Y,
The amount of good X
that can be purchased
is,

Qy

Px

B
80
= 16 =
5
Py

Connecting the two intercepts

identifies all combinations of
goods X &Y that can be
purchased for a budget of $80,
Py = $5, and PX = $3.

Fall 97

B
Py

For an B = $80,
and Py = $5
For an B = $80,
and PX = $3

Any combination
inside area 0AC
can be purchased
for less than $80.

B
80
= 26.7 =
3
Px

Principles of

Qx

Slide -- 16

Consider an individuals utility preference for 2 goods, X & Y;

Good X
Utility X
Qx
1
2
3
4
5
6

TUx MUx
30
55
75
90

100
105
105

100

30
25
20
15
10
5
0
-5

Fall 97

If the two goods were free,

[ or no budget constraint],
the individual would consume
each good until the MU of
that good was 0, 7 units
of good X and 6 of Y.
Once the goods have a price
and there is a budget
constraint, the individual
will try to maximize the
utility from each additional
dollar spent.

Principles of

Good Y
Utility Y
Qy
1
2
3
4

TUy MUy
60
90

60
30

110

20

120

10

5
6

128

120

100 - 20

128

8
0
-8

Slide -- 17

Given the budget constraint, Individuals will attempt to

gain the maximum utility for each additional dollar spent,
the marginal dollar.

Utility X
Qx
1
2
3
4
5
6

TUx MUx
30
55
75
90

100
105
105

100

30
25
20
15
10
5
0
-5

Fall 97

MUX
PX
10.
8.33

For PX = $3, the

MUX per dollar
spent on good
X is;

For PY = $5, the

6.67 MU per dollar
Y
5.00 spent on good
3.33 Y is;
1.67
0

Principles of

MUY
PY

Utility Y
Qy

12

3
4

2
1.6
0

5
6

TUy MUy
60
90

60
30

110

20

120

10

128
128
120

8
0
-8

100 - 20

Slide -- 18

Now the preferences of the individuals and the relative prices

of the two goods are displayed in the tables.

Utility X
Qx
1
2
3
4
5
6

TUx MUx
30
55
75
90

100
105
105

100

30
25
20
15
10
5
0
-5

Fall 97

MUX
PX
10.
8.33
6.67
5.00
3.33
1.67
0

MUY
PY
If the objective is
to maximize utility
given prices,
preferences, and
budget, spend each
additional $ on the
good that yields
the greater utility
for that
expenditure.

Principles of

Utility Y
Qy

12

3
4

2
1.6
0

5
6

TUy MUy
60
90

60
30

110

20

120

10

128
128
120

8
0
-8

100 - 20

Slide -- 19

Given the preferences of the individual and the relative

prices of the goods [PX = $3, PY = $5], the MUs for
each dollar spent are:
To maximize TU given a budget of $30,the first
expenditure would logically be for good Y since
the MUY for each dollar is 12.

MUX
PX
10.
8.33

$3
$3

6.67

$3
$3

5.00
3.33
1.67
0

The second expenditure is for good X,

[MUX $ is greater than MUY $]

$3

The third & fourth expenditures are for

good X since the MU per dollar spent is
greater for X than Y.

MUY
PY
$5
$5
$5

The fifth expenditure is for is for good Y.

Continue to maximize the MU per $ spent.

AT THIS POINT YOU HAVE SPENT THE BUDGET OF $30.

MUY
MUX
MUY
MUX

PX

>P

, BUY X !

Fall 97

PX

Principles of

<P

, BUY Y !

Slide -- 20

12
6
4
2
1.6
0

MUX
PX

>MU
P

MUX
PX

<MU
P

says that the marginal utility of an additional

dollar spent on good X is greater than that of
a dollar spent on good Y.
indicates that the MU per dollar spent on good
Y exceeds that of a dollar spent on good X.

If the amount spent on the two goods is equal to the budget

then
MUX MUY suggests that the individual should buy
PY less of Y in order to buy more of X.
PX

>

MUX
PX

<MU
P
Y

says to purchase less X to pay for additional

amounts of Y.

MUX
MUY
is an equilibrium condition!
PX = PY
Fall 97

Principles of

Slide -- 21

MUX
MUY subject to the constraint:
PX = P Y

PX X + PY Y = B

insures the individual has maximized their total utility and

has not spent more on the two goods than their budget.
This model can be expanded to include as many goods as
necessary:

MUX
MUY
MUZ
PX = PY = P Z

= . . . =

subject to;

MUN
PN

PX X + PY Y + Pz Z + . . . + PN N = B

From this information a demand for the goods can be

constructed.

Fall 97

Principles of

Slide -- 22

Given the preference functions for goods X and Y,

and the prices of the two goods: PX = $3, PY = $5.
the MU of derived
from each dollar
MU
MUY
X
Utility X
Utility Y
of expenditure
PX
PY
can
be
calculated.
Qy TUy MUy
Qx TUx MUx
1
2
3
4
5
6

30
55
75
90

100
105
105

100

30
25
20
15
10
5
0
-5

Fall 97

10.
If the individual is
8.33 maximizing utility,
6.67 their choices,
constrained by
5.00
their preferences,
3.33 the prices and
1.67 their budget can
be shown:
0

Principles of

12

3
4

2
1.6
0

5
6

60
90

60
30

110

20

120

10

128
128
120

8
0
-8

100 - 20

Slide -- 23

Given preferences, prices [PX = $3, PY = $5] and

budget [$30], the individuals choices were:
MUX
PX
10.
8.33
6.67
5.00
3.33
1.67
0

Five units of X and 3 units of Y were purchased

These choices can be shown in the context of
a demand model:
$3
$5

PX 5
$3
$5

$3

4
$5
$3

PX = 3
This point lies on the
$3

2
demand for good X.

1
At PX = $3,
given budget,
Py and preferences,
1 2
5 units of X are purchased.

Fall 97

Principles of

55

QX/ut
Slide -- 24

MUY
PY
12
6
4
2
1.6
0

Given the individuals preferences, the price of Y [PY]

and the budget [B = $30], the individual purchased
5 units of X when the price of X [PX ] was $3.
MU
MUXX

PPXX

[$3]
[$5]

[$5]

10. 6
8.33
5

$5 6
$5 5

6.67
4
5.00
3
3.33
2
1.671
0 0

Raise the price of X [PX ] to $5 and the MUX per

$ spent is reduced.

MUX
PX

Choices about spending the $30 are now:

$5 4

PX

The $30 is now spent.

5
4

2
1
MU
0X
PX

MUY

Fall 97

PY

Demand

That
portion
of demand
between $3 and $5
is mapped!

Principles of

$5

12

$5

$5

At PX = $5,
ceteris paribus,
3 units of X are
purchased.
6

MUY
PY

QX/ut
Slide -- 25

2
1.6
0

Demand
By continuing to change the price of good X
[and holding all other variables, PY , budget or
income and preferences constant,] the rest of
the demand for good X can be mapped.

All price and quantity combinations on the

demand for X are equilibrium points for
the consumer [They are maximizing utility;

holding all other variables, PY , budget or income

and preferences constant]
Fall 97

Principles of

Slide -- 26

By changing the price of the good [in this case, good X] and
holding all other variables [PY , budget or income and
preferences] constant, the demand for the good can be
mapped.

The demand function

is a schedule of the P
X
quantities that
individuals are willing 5
and able to buy at a
4
schedule of prices
3
during a specific
2
period of time,
ceteris paribus.
1

De
m

Fall 97

Principles of

an
d
7

QX/ut

Slide -- 27

The demand function has a negative slope because of the

income and substitution effects.
Income effect: As the price of a good that you buy increases
and money income is held constant, your real income decreases
and you can not afford
to buy as much as you
PX
could before.
Substitution effect: As
the price of one good rises
relative to the prices of
other goods, you will tend
to substitute the good
that is relatively cheaper
for the good that is
relatively more expensive.

5
4

De
m

3
2
1
1

Fall 97

an
d

Principles of

QX/ut

Slide -- 28

Income effects
As the price of a good that you buy
increases, you will have less real income.
This is the basis of price indices that
measure changes in real income as prices
rise or fall.
The consumer price index is one of the
indices that is used [currently there is a
debate about how it is calculated].
Fall 97

Principles of

Slide -- 29

Substitution Effects
As the price of a good increases
[decreases] while the prices of other
goods is constant, it becomes
relatively more [less] expensive.
Individuals would substitute relatively
less expensive goods for relatively
more expensive ones even if their real
income were constant.
Fall 97

Principles of

Slide -- 30

CONSUMER SURPLUS

At market equilibrium,
Consumer surplus will be
the area above the market
price and below the demand
function.

Fall 97

Sup

7
They receive utility
6.80
that they did not have
6
to pay for [6.80-3.00].
5
This is called consumer
4
surplus.

pl y

Notice that someone is willing and able to pay $6.80 for the
first unit. If the market price [established by S and D]
were $3, the buyer would purchase at $3 even though they
were willing to pay
$6.80 for the first unit. PX

consumer
surplus

De
m

3
2

an
d

1
1

Principles of

QX/ut

Slide -- 31

Demand
Demand functions can be derived from utility
[cardinal measures] or indifference functions
[ordinal measures]
Normally, demand functions show and inverse
relationship between price and quantity
a change in price causes a change in quantity
demanded
a change in any other variable [income, prices of
related goods, population, preferences, . . .] will
cause a change in demand or shift of demand
Fall 97

Principles of

Slide -- 32