TOPIC 3

Consumer Choice:
Maximizing Utility

©2015 Cengage Learning. All Rights Reserved. May not be scanned,

copied or duplicated, or posted to a publicly accessible website, in
whole or in part.
Learning Outcomes
 Define utility and calculate total utility
and marginal utility.
 Define the law of diminishing
marginal utility.
  Explain how consumers’ equilibrium is
achieved.
  Describe the income and substitution
effects of a price change
 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.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Utility Theory

2) Total Utility (TU)

 TU is the total satisfaction a person receives from

consuming a particular quantity of good.
 i.e. Buy 1st good X = 10 utils, 2nd good X = 8 utils, and
3rd good X = 7 utils.

TU for 3 units of good X = (10 + 8 + 7) = 25 utils.

Utility Theory, Total and Marginal
3) Marginal Utility (MU)
 The additional utility gained from consuming an
additional unit of some good.

MU = DTU/DQ

 Example:
Suppose that you receive 50 utils of total utility from
consuming one apple and 80 utils of total utility from
consuming two apples. What is the marginal utility of
the second apple?

MU = DTU/DQ = TU2 – TU1 = 80 – 50

2-1 1
= 30 utils
 LAW OF DIMINISHING
MARGINAL UTILITY
 The marginal utility gained by consuming equal
successive units of a good will decline as the amount
consumed increases.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 LAW OF DIMINISHING
MARGINAL UTILITY
 The marginal utility gained by consuming equal
successive units of a good will decline as the amount
consumed increases.
 The total utility of something can be rising as the
marginal utility of that something is falling.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 TOTAL UTILITY, MARGINAL
UTILITY, AND THE LAW OF
DIMINISHING MARGINAL UTILITY

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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!

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Consumer Equilibrium and
Demand
Initially, PA =
PB = RM1.
The consumer
is in
equilibrium
buying I unit
of good A and
6 unit of good
B.
 Consumer Equilibrium and
Demand
Then PA falls to
RM0.50.
To restore herself to
equilibrium, she
buys more of good A
and less of good B:
MUA MUB .
At the new set of
prices: PA = RM0.50
and PB = RM1 .

This consumer is
back in equilibrium
by purchasing 6
units of good A and
4 units of good B.
Consumer Equilibrium and
Demand
Original Purchase
Good A Good B
12 utils/RM1 = 12 utils/RM1
Price A falls to RM0.50
Good A Good B
12 utils/RM0.5 > 12 utils/RM1
New Purchase
Good A Good B
8 utils/RM0.5 = 16 utils/RM1
Buy more A and less B
This illustrates the inverse relationship between P & Q –
as P for good A decrease, Qd for good A will increase
– ceteris paribus
 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.
 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

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Example
Units of TU of Good Units of TU of Good
Good X X (utils) Good Y Y (utils)
1 20 1 19
2 35 2 32
3 48 3 40
4 58 4 45
5 66 5 49
 If Adam spends RM5 (total) a week on good X and
good Y and if the price of each good is RM1 per unit,
then how many units of each good does he purchase
to maximize utility?
 Solution
Unit of TUx Mux Unit of TUY MUY
Good X PX Good Y Py
0 0 - 0 0 -
1 20 20 1 19 19
2 35 15 2 32 13
3 48 13 3 40 8
4 58 10 4 45 5
5 66 8 5 49 4

STEP 1
MUx/PX = MUY/ P Y 13utils/RM1 = 13 utils/RM1
So Adam buys 3 units of good X and 2 units of good Y to
maximize his total utility; 3Px + 2PY = 3(RM1) + 2(RM1) =
RM5
 Marginal Utility Marginal Utility Marginal Utility
Quantity
for good A for good B for good C

1 22 40 14
2 20 36 12
3 18 34 10
4 16 30 8
5 14 28 6
6 12 24 4

The table above shows the marginal utility of good A, good B and good C
for Carmen:

(i) Carmen has RM38 to spend on these goods. The prices of good A, good
B and good C are RM4, RM6 and RM2 respectively. Identify the
combination of three goods that should be purchased by Carmen to
maximise her utility.

(ii) Based on the answer above, what is the total utility received by Carmen?
Income and Substitution Effects
 The portion of the change in the quantity demanded
that is attributable to a change in its relative price is
referred to as the substitution effect.

 The portion of the change in the quantity demanded

that is attributable to a change in real income,
brought about by a change in absolute price, is
referred to as the income effect
Example A
 Suppose Barbara’s income is RM100 per
week and there are only two goods in the
world, A and B. PA = RM50 and PB = RM25.
Barbara buys 1 unit of good A and 2 units of
good B per week, for a total of 3 units of the
two goods.
 Now, suppose PA falls to RM25, ceteris
paribus. Barbara’s real income has risen
due to the fall in PA. The lower P allows her
to buy more of the two goods. She can buy
2 units of good A and 2 units of good B, for a
total of 4 units of the two goods.
Example B
 Suppose the price of normal good A falls from
RM10 to RM8, ceteris paribus. As a result Qd of
good A rises from 100 units to 143 units.
 Suppose Qd rises from 100 units to 129 units
because the relative price of good A falls
Substitution effect.
 People purchase more 14 units (143 – 129) of
good A because their real incomes have risen.
Income effect.