Arnold - Econ13e - ch20 Consumer Choice Maximizing Utility and Behavioral Economics

CHAPTER
20
CONSUMER
CHOICE:
MAXIMIZING
ECONOMICS UTILITY AND
Roger A. Arnold • Thirteenth Edition
BEHAVIORAL
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or
ECONOMICS
duplicated, or posted to a publicly accessible website, in whole or in part.
©Sashkin/Shutterstock
20-1 Utility Theory
20-2 Consumer Equilibrium and Demand
20-3 Behavioral Economics
2
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. ©SashkinShutterstock
Theory of Consumer Behaviours
● How consumer purchase various goods and services

with his/her limited recourses (income)
● Useful for understanding the demand side of the
market.
● Theory of Consumer Behaviours
• The Cardinal Utility Theory (TUC)
• The Ordinal Utility Theory (TUO)
3
Theory of Consumer Behaviours
● The Cardinal Utility Theory (TUC)

 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 (TUO)

 Utility is measurable in an ordinal sense (compare). Ordinal
utility approach - does not assign values, instead works with
a ranking of preferences.
4
5
20-1 Utility Theory :The Cardinal Utility Theory (TUC)
• 20-1a Utility: Total and Marginal

• Utility: A measure of the satisfaction, happiness, or benefit
that results from the consumption of a good
• Util: An artificial construct used to measure utility
• Total Utility: The total satisfaction a person receives from
consuming a particular quantity of a good
• Marginal Utility: The additional utility a person receives
from consuming an additional unit of a good
6
20-1 Utility Theory (3 of 5)
• 20-1b Law of Diminishing Marginal Utility

• Law of Diminishing Marginal Utility: The marginal
utility gained by consuming equal successive units of a
good will decline as the amount consumed increases
• This law is illustrated in Exhibit 1
• 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
7
EXHIBIT 1
Total Utility, Marginal Utility, and the Law of Diminishing Marginal
Utility
8
Total Utility and Marginal Utility
Total
Unit of Marginal
Utility
Good X Utility (Util)
(Util)
0 0 0
1 4 4
2 7 3
3 8 1
4 8 0
5 7 -1
• TU, in general, increases with Q
• At some point, TU can start falling with Q (see Q = 5)
• If TU is increasing, MU > 0
• From Q = 1 onwards, MU is declining  principle of

diminishing marginal utility  As more and more of a
good are consumed, the process of consumption will (at
some point) yield smaller and smaller additions to utility
9
Relationship between TU & MU
● When the total utility increase,

Marginal utility decrease
● When the total utility

maximum, marginal utility = 0
● When the total utility begins to
decrease, the
marginal utility = negative (-ve)
10
20-2 Consumer Equilibrium (1 of 3)
● So far, we have assumed that any amount of goods and services are
always available for consumption
● In reality, consumers face constraints (income and prices):

• Limited consumers income or budget
• Goods can be obtained at a price
11
20-2 Consumer Equilibrium and Demand (1 of 3)
• The following analysis is based on the assumption that

individuals seek to maximize utility
• 20-2a Equating Marginal Utilities per Dollar
• Consumer Equilibrium: The equilibrium that occurs when
– the consumer has spent all of his or her income and
– the marginal utilities per dollar spent on each good purchased
are equal:
• Marginal utility per dollar (price): additional utility derived

from spending the next price (RM) on the good
12
20-2 Consumer Equilibrium (1 of 3)
● Example:
– I = 30
– PA=2
– PB=6
● The TU, MU and MU/P was
● What is the combination of A and B that

maximize consumer utility
13
Numerical Illustration
QA TUA MUA MUA QB TUB MUB MUB

PA PB
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
14
Consumer Equilibrium
15
16
20-2 Consumer Equilibrium and Demand (2 of 3)
• 20-2b Maximizing Utility and the Law of Demand

• Suppose a consumer of oranges and apples is in
equilibrium, so is maximizing utility
• Now, suppose the price of Pizza falls; the consumer will
attempt to restore equilibrium by buying more Pizza
– This behavior is consistent with the law of demand
• Maximization of utility is consistent with the law of
demand
17
The Ordinal Approach
● Economists believe that utility is measurable in an ordinal sense

● 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.
18
The Ordinal Approach- Indifference Curve (IC)
● An indifference curve is
the locus of different
combinations of two good
giving the same level of
satisfaction.
● Axes: both axes refer to
the quantity of goods
19
The Ordinal Approach- Indifference Curve (IC)
● An indifference map is
a set of ICs showing the
preference of an
individual.
20
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
● Different ICs show different level of satisfaction.
• Far from the origin, the higher the 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 *
21
Downward sloping from left to right

● Keeping utility constant, along an IC, a
basket with more units of good X must have
fewer units of good Y.
● Slope of an IC of two goods (= Δ Y/ Δ X)

must be negative.
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
● The substitution is to maintain its

position at the same level of satisfaction
22
● Higher indifference curve

represents higher satisfaction.
● This is because the combinations
lying on higher indifference curve
contain more of either one or both
goods and more is always
preferred to less. More is
preferred to Less Indifference
map
23
Do not cross (intersect)

● Along IC1: point B = point C
● Along IC2: point B = point E
● What is the utility of point B, =

IC1 or IC2?
● U of the intersection point 

logical contradiction
24
OTHER SHAPES OF INDIFFERENCE
CURVES
X and Y are perfect substitutes X and Y are perfect compliment
•ICs are right-angled
•ICs are downward sloping straight

lines.
Good Y (Apple Jus) Good Y (left shoes)
U3>U2>U1
U3
U2
U1
45 U3>U2>U1
Good X (Orange Jus) Good X (right sh
0 U1 U2 U3 0 o
CH 21 • 25
Budget Line
● Line showing all combinations
of items can be purchased for a
particular level of income (I) ;
• I =Px.Qx + Py.Qy
● Straight-line and downward sloping
• to use more goods X, Y should reduc
e & vice versa
• The slope depends on the prices of
goods X and Y, the slope = Px/Py
• In the X-axis, when the
quantity Y = 0, all I used to purchase
X; I = Px.Qx  Qx =M/Px
• At the Y axis, when the
quantity X = 0, all I used to
purchase Y; M = Py.Qy  Qy
=M/Py
26
BUDGET LINE (BL): FEATURES
● Point A:
Y Expenditure <
Income
● Point B:
 Expenditure =
C
B
 Income
A

● Point C:
0 Expenditure >
X Income
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CH 21 • 27
Budget Line Equation
XPX + YPY = I
Expenditure Expenditure on Money income

on good X good Y of the consumer
28
Budget Line Equation
29
● With income (I), 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: MUx/MUy =Px/Py
● Consumer choice influenced by income
● Increased income, increased consumer equilibrium point
30
Equilibrium conditions
1. The consumer
equilibrium must lie on
the BL.
2. The consumer
equilibrium is the
tangency point at which
the slope of IC equals
the slope of BL.
31

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CHAPTER

20-2 Consumer Equilibrium and Demand

20-3 Behavioral Economics

● How consumer purchase various goods and services

● The Cardinal Utility Theory (TUC)

● The Ordinal Utility Theory (TUO)

• 20-1a Utility: Total and Marginal

• 20-1b Law of Diminishing Marginal Utility

• TU, in general, increases with Q

• At some point, TU can start falling with Q (see Q = 5)

• From Q = 1 onwards, MU is declining  principle of

● When the total utility increase,

● When the total utility

● In reality, consumers face constraints (income and prices):

• The following analysis is based on the assumption that

• Marginal utility per dollar (price): additional utility derived

● The TU, MU and MU/P was

● What is the combination of A and B that

QA TUA MUA MUA QB TUB MUB MUB

2 39 9 4.5 2 105 55 5.5

• 20-2b Maximizing Utility and the Law of Demand

● Economists believe that utility is measurable in an ordinal sense

● Downward sloping from left to right:

● Convex to the origin: the marginal rate of substitution (MRS) decreased

● Do not cross (intersect): consumer preferences transitive

Downward sloping from left to right

● Slope of an IC of two goods (= Δ Y/ Δ X)

● MRS = quantity of goods Y willing to

● The substitution is to maintain its

● Higher indifference curve

Do not cross (intersect)

● Along IC2: point B = point E

● What is the utility of point B, =

● U of the intersection point 

•ICs are downward sloping straight

Expenditure Expenditure on Money income

● With income (I), combination of goods that consumers

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