CHAPTER 21

Consumer Choice:
Maximizing Utility
and Behavioral
Economics

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 INTHISLECTU
RE  The Diamond-Water Paradox
 The Law of Diminishing Marginal Utility
 Consumer Equilibrium
 Marginal Utility Analysis and the Law of
Demand

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 DIAMOND-WATER PARADOX

 The paradox: Water is cheap and diamonds are

expensive!
 The observation that things that have the greatest
value in use sometimes have little value in exchange
and things that have little value in use sometimes
have the greatest value in exchange.
 How can this be explained???
 Utility theory provides a solution!

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 UTILITY THEORY

 Utility is a measure of the satisfaction,

happiness, or benefit that results from the
consumption of a good.
 A util is an artificial construct used to
measure utility.
 Total utility is the total satisfaction a person
receives from consuming a particular quantity
of a good.
 Marginal utility is the additional utility a
person receives from consuming an additional
unit of a particular good.

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 LAW OF DIMINISHING
MARGINAL UTILITY
 The marginal utility gained by consuming equal
successive units of a good (digunakan secara
berturutan)- will decline as the amount consumed
increases.
 The total utility of something can be rising as the
marginal utility of that something is falling.

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 TOTAL UTILITY, MARGINAL
UTILITY, AND THE LAW OF
DIMINISHING MARGINAL UTILITY

Both total utility and marginal utility are

expressed in utils.
Marginal utility is the change in total
utility divided by the change in the
quantity consumed of the good, MU =
ΔTU/ΔQ.
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 TOTAL UTILITY, MARGINAL
UTILITY, AND THE LAW OF
DIMINISHING MARGINAL UTILITY

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 LAW OF DIMINISHING MARGINAL
UTILITY – APPLICATION
 The law of diminishing marginal utility is based on
the idea that if a good has a variety of uses but only 1
unit of the good is available, then the consumer will
use the first unit to satisfy his or her most urgent
want.
 If 2 units are available, the consumer will use the
second unit to satisfy a less urgent want.

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 INTERPERSONAL UTILITY
COMPARISON
● Comparing the utility one person receives
from a good, service, or activity with the
utility another person receives from the same
good, service, or activity.

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 NO INTERPERSONAL UTILITY
COMPARISON
● Caution: The utility obtained by one person
cannot be scientifically or objectively
compared with the utility obtained from the
same thing by another person because utility
is subjective.

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 DIAMOND-WATER PARADOX
RESOLVED
 The total utility of water is high because water is
extremely useful.
 The total utility of diamonds is low in comparison
because diamonds are not as useful as water.
 The marginal utility of water is low because water is
so plentiful that people end up consuming it at low
marginal utility.
 The marginal utility of diamonds is high because
diamonds are so scarce that people end up consuming
them at high marginal utility.
 Do prices reflect total or marginal utility? Marginal
utility.

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 1. State and solve the diamond-water paradox.
The paradox is that water, which is essential to life, is cheap, and
diamonds, which are not essential to life, are expensive. The solution
to the paradox depends on knowing the difference between total and
SELFTEST
marginal utility and the law of diminishing marginal utility. By saying
that water is essential to life and that diamonds are not essential to life,
we signify that water gives us high total utility relative to diamonds.
But then, if water gives us greater total utility than diamonds do, why
isn’t the price of water greater than that of diamonds.
(continued)

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 Price isn’t a reflection of total utility; it is a reflection of marginal
utility. The marginal utility of water is less than that of diamonds.
This answer raises another question: How can the total utility of
water be greater than that of diamonds, but the marginal utility of
SELFTEST
water be less than that of diamonds?
The answer is based on the fact that water is plentiful and
diamonds are not and on the law of diminishing marginal utility.
There is so much more water than diamonds that the next
(additional) unit of water gives us less utility (lower marginal
utility) than the next unit of diamonds.

A: Diamonds are consumed at

high marginal utility: water is
consumed at low marginal utility

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 2. If total utility is falling, what does this
imply for marginal utility? Give an
arithmetical example to illustrate your
SELFTEST
answer.
If total utility declines, marginal utility must be…

….something that takes utility away from us (or gives us

disutility) is called a bad.

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 3. When would the total utility of a good and
the marginal utility of a good be the same?
The total utility and the marginal utility of a good are the same
SELFTEST
for the ____ unit of the good consumed.

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 CONSUMER EQUILIBRIUM

 The analysis is based on the assumption that

individuals seek to maximize utility.
 Occurs when the consumer has spent all income and
the marginal utilities per dollar spent on each good
purchased are equal:

where the letters A–Z represent all the goods a

person buys.
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 Consumer Equilibrium
• Suppose:
• MU oranges = 30 utils
• MU apples = 20 utils
• Price of oranges = $1
• Price of apples = $1

Q: Does consumer reach equilibrium?

Equilibrium Conditions:
= MUA/PA= MUB/PB
A: ??
17
Consumer Equilibrium

Teori Gelagat Pengguna

18
 Consumer Equilibrium

• MU oranges = 12.5 utils

• MU apples = 25 utils
• P oranges = $0.50
• P apples = $1
Q: Does consumers reach equilibrium?
A: ??

Teori Gelagat Pengguna

19
 MARGINAL UTILITY ANALYSIS AND
THE LAW OF DEMAND
 Marginal utility analysis can be used to illustrate the
law of demand, which states that price and quantity
demanded are inversely related, ceteris paribus.
 Eg: Starting from consumer equilibrium in a world
containing only two goods, A and B, a fall in the
price of A will cause MUA /PA to be greater than
MUB /PB.
 As a result, the consumer will purchase more of good
A to restore herself to equilibrium

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 Theories of Consumer Choice
• Utility Concepts:
– The Cardinal Utility Theory
• Utility is measurable in a cardinal sense
• cardinal utility - assumes that we can assign values
for utility, e.g., derive 100 utils from eating a slice
of pizza
– The Ordinal Utility Theory
• Utility is measurable in an ordinal sense
• ordinal utility approach - does not assign values,
instead works with a ranking of preferences.
 The Cardinal Approach

• Law of Diminishing Marginal Utility (Return)  =  As more and

more of a good are consumed, the process of consumption
will (at some point) yield smaller and smaller additions to
utility

• When the total utility maximum, marginal utility = 0

• When the total utility begins to decrease, the

marginal utility = negative (-ve)

• Let’s draw a figure!

 EXAMPLE
TU

Number Total Marginal

Purchased Utility Utility

0 0 0 Qty
MU Consumed
1 4 4

2 7 3

3 8 1

4 8 0
Qty
Consumed
5 7 -1
Consumer Equilibrium
Some simplifying assumptions
 Numerical Illustration
Qx TUX MUX MUx QY TUY MUY MUy
Px Py
1 30 30 15 1 50 5
2 39 2 105 55 5.5
3 45 6 3 148
4 50 5 4 178
5 54 5 198
6 56 1 6 213 15

Assume Px = RM2 & Py=RM10, try to find 2 potential

equilibrium !
 • 2 potential optimum positions
• Combination A:  X = 3 and Y = 4
• TU = TUX + TUY = 45 + 178 = 223

• Combination B:  X = 5 and Y = 5
– TU = TUX + TUY = 54 + 198 = 252

Qx TUX MUX MUx QY TUY MUY MUy

Px Py
1 30 30 15 1 50 50 5
2 39 9 4.5 2 105 55 5.5
3 45 6 3 3 148 43 4.3
4 50 5 2.5 4 178 30 3
5 54 4 2 5 198 20 2
6 56 2 1 6 213 15 1.5
Cont.
• Presence of 2 potential
equilibrium positions
suggests that we need to
consider income. To do so let
us examine how much each
consumer spends for each
combination.
• Expenditure per combination
– Total expenditure = PX X +
PY Y
– Combination A: 3(2) +
4(10) = 46
– Combination B: 5(2) +
5(10) = 60
• Scenarios:
– If consumer’s
income = 46, then
the optimum is given
by combination A. .…
Combination B is not
affordable
– If the consumer’s
income = 60, then
the optimum is given
by Combination
B….Combination A is
affordable but it
yields a lower level
of utility
 The Ordinal Approach

Economists following the lead of Hicks,

Slutsky and Pareto believe that utility is
measurable in an ordinal sense--the
utility derived from consuming a good,
such as X, is a function of the quantities
of X and Y consumed by a consumer.
U = f ( X, Y )
 Cont.
 Ordinal Utility Theory 
– Can be measured in qualitative, not quantitative, but
only lists the main options (indifference
curves & budget line).

 Rational human beings will choose to maximize

the utility by selecting the highest utility
 Difference consumers, difference utilities.
 Indifference Curve (IC)

• Curve where the points represent a

combination of items when the consumer at
indifference situation (satisfaction).
• Axes: both axes refer to the quantity of
goods
• For the combination that produces a
higher level of satisfaction, the curves shift
to the right (IC2) from the first curve (IC1)
• In contrast, the curves  shift to the left (IC3)
 Indifference Curve (IC)

Goods y

 IC3
IC2
IC1

Goods x

33
 Properties Of Indifference Curve

• Downward sloping  from left to right: This shows an

increase in quantity of certain good.
• Convex to the origin: the marginal rate
of substitution (MRS) decreased
– MRS = quantity of goods Y willing to substitute  to
obtain one unit of goods X & this substitution is to
maintain its position at the same level of satisfaction
• Do not cross (intersect): consumer preferences transitive
– Eg : Quantities X and Y for the combination of A> a
combination of B;   utility A> B *
When cross = C, so the utility A = C & B = C; 
 utility A = B = C. This is not transitive as above *
• Different ICs show different level of satisfaction. Far from
the origin, the higher the satisfaction.
IC curves can not intersect
Goods Y

C A IC1

B
IC2

Goods X
 Budget line (BL)-garis belanjawan
• Line showing all combinations of items can be
purchased for a particular level of income (M) ;
M =PxQx + PyQy
• The slope depends on the prices of
goods X and Y, the slope = Px/Py
• Slope -ve: to use more goods X, Y should reduce &
vice versa

• In the X-axis, when the quantity Y = 0, all M used
to purchase X; M = PxQx Qx =M/Px

• At the Y axis, when the quantity X = 0, all M used
to purchase Y; M = PyQy Qy =M/Py
Factors Shift The  Budget Line

Changes in prices of goods X

Goods Y • When  price of good
X increases, the quantity of good
X is reduced (by maintaining the
quantity of Y) & vice versa.
 Points on the X axis shifted to the
left (a small quantity of X)

Goods X
 Factors Shift The  Budget Line

• Changes in the price of goods Y

Goods Y
• When the price
of Y increases, the quantity Y is
reduced (by maintaining the
quantity of X) & vice versa
 Point on Y axis move to
the bottom (small quantity in Y)

Goods X
 Factors Shift The Budget Line
• When M increases, QX and QY 
can be bought even more, a
point on the X axis shifted to
Changes in income the right & 
• a point on
the Y axis move on; & 
Goods Y • Vice versa when M decreases.

Income
Income

Goods X
 CONSUMER EQUILIBRIUM
• With income (M) some combination of goods
that consumers choose the highest satisfaction
• Satisfied the same curves and budget lines are
connected
• The point where the curve IC and BL tangent
• Slope IC = BL
• Consumer choice influenced by income
• Increased income, increased consumer equilibriu
m point
 • With income (M) some combination
MAXIMIZE CONSUMER SATISFACTION of goods that consumers choose the highest
satisfaction
• Satisfied the
same curves and budget lines are connected
• The point where the curve IC and
BL tangent
Y • Slope IC = BL
M
• Consumer choice influenced by income
• Increased income, increased consumer 
F
C equilibrium point
Indifference Curves (IC)

E Budget line (BL)

IC1
B
IC2
A D
IC3

IC4

O
M1
X

CONSUMER EQUILIBRIUM
CONSUMER EQUILIBRIUM

Bagaimana keseimbangan boleh berubah?

Brg y
3 factors:
1.
M 2.
3.

 IC3
IC2
IC1
M1 x

42
 Conclusion
• There are two types of utility theory:
– Cardinal  TU and MU
– Ordinal  curve IC and BL
• Equilibrium and utility maximization can be either TUC or TUO
• Demand curve can be derived from consumer equilibrium concept.
• How?