TOPIC 5

Consumer Choice:
Maximizing Utility

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 THEORY OF CONSUMER CHOICE
 Theory of consumer choice is a study which examines
how a person makes rational decisions when confronted
with scarce resources.

 People make decisions every day. All the decisions we

made are constrained by limited resources. Thus, making
decisions requires trading off one thing against another.

 Because people face trade-offs, making decisions

requires comparing the costs and benefits of alternative
choices.

CH 21 • 2
 UTILITY THEORY
 Utility is a measure of the satisfaction, happiness, or
benefit that results from the consumption of a good.
 Utility is a psychological phenomenon; that implies
the satisfying power of a good or service.
 It differs from person to person, as it depends on a
person’s mental attitude.
 The measurability of utility is always a matter of
contention.

 The two principal theories for the utility are

i. Cardinal utility
ii. Ordinal utility.

CH 21 • 3
UTILITY THEORY

Utility Theory

Cardinal Ordinal

CH 20 • 4
 CARDINAL UTILITY VS ORDINAL UTILITY
Cardinal Utility Ordinal Utility

 The satisfaction derived by

 The satisfaction derived by
the consumers from the
consumption of good or
service can be measured
numerically.
 Approach: Quantitative
 Measured in terms of utils,
i.e. units of utility.
 Based on marginal utility
analysis.
 Based on indifference curve
the consumers from the
consumption of good or
service cannot be measured
numerically.
 Approach: Qualitative
 Measured in terms of
ranking of preferences of a
commodity when compared
to each other.
analysis.
CH 21 • 5
I. CARDINAL UTILITY THEORY
 Total utility (TU) is the total satisfaction a person
receives from consuming a particular quantity of a
good.

 Marginal utility (MU) is the additional utility a person

receives from consuming an additional unit of a
particular good.
 MU is the change in total utility divided by the
change in the quantity consumed of the good
MU = ΔTU/ΔQ

CH 21 • 6
 The Law of Diminishing MU
The MU gained by consuming equal successive units of a
good will decline as the amount consumed increases.

 Relationship between MU and TU

 TU  MU (positive)
 TU max MU=0
 TU   MU (negative)

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Table 1: TU, MU & the Law of Diminishing MU

QUANTITY TOTAL MARGINAL

(UNITS) UTILITY UTILITY
1 21 21
2 41 20
3 59 18
4 74 15
5 85 11
6 91 6
7 91 0
8 85 -6
9 74 -11
8
Figure 1: TU, MU and the Law of Diminishing MU
Utility

91

TU

0 7 Qt

Utility

Qt
0 7 MU

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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
 the marginal utilities per dollar spent on each good
purchased are equal

where the letters A–Z represent all the goods a person buys.

CH 21 • 10
Conditions for consumer equilibrium
(i) MUx = MUy
Px Py
(ii) PxQx + PyQy = I (consumer spend all income)

Example
Income = RM19, Px = RM3, Py =RM2
Assumption
Consumer only used good X & good Y

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 Table 2: Consumer Equilibrium

QT MUx MUx/Px MUy MUy/Py

1 33 11 28 14
2 24 8(A) 24 12
3 18 6(B) 20 10
4 12 4(C) 16 8(A)
5 6 2 12 6(B)
6 3 1 8 4(C)

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 CONSUMER EQUILIBRIUM
(i) Combination A,B & C fulfill condition (i)
(ii) However, only combination B fulfill condition (ii)
(iii) Consumer equilibrium = combination B

Combination A (RM 14)

2 good X (2 × RM3 =RM6)
4 good Y (4 × RM2 =RM8)

Combination B (RM19) *
3 good X (3 × RM3 =RM9)
5 good Y (5 × RM2 =RM10)

Combination C (RM24)
4 good X (4 × RM3 =RM12)
6 good Y (6 × RM2 =RM12)
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Qty Total utility x MUx

1 10 10
2 19 __
3 ___ 8
4 33 __
5 35 __

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 If MUx/Px > MUy/Py
 Consumer will buy more of good X.
 Mux will  & MUx/Px also will 
 Consumer will continue to buy good X until MUx/Px =
MUy/Py.

 If MUy/Py > MUx/Px

 Consumer will buy more of good Y.
 Muy will  & MUy/Py also will 
 Consumer will continue to buy good Y until MUy/Py =
MUx/Px.

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CONSUMER EQUILIBRIUM & THE LAW OF DEMAND

Law of demand: P  Qd , P  Qd 

 Assumption: There are two goods, A & B.

 The price of both good A & good B is $1.
 The consumer is in equilibrium buying 1 unit of good A & 6
units of good B
 MUA/PA = MUB/PB (12 utils/$1.00 = 12 utils/$1.00)

 Suppose the price of good A  to $0.50.

 This changes the situation to the following MUA/PA >
MUB/PB (12 utils /$0.50 > 12 utils /$1.00)

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 To restore herself to equilibrium, she buys more of good A &
less good B.
 As she does this. The MU of good A  (from 12 utils to 8 utils)
& MU of good B  (from 12 utils to 16 utils)
 At the new set of prices, $0.50 for A and RM1.00 for B, the
consumer is back in equilibrium when she purchases 6 units
of good A & 4 units of good B.
 MUA/PA = MUB/PB (8 utils /$0.50 = 16 utils /$1.00)

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II. ORDINAL UTILITY THEORY (Through
budget constraint & indifference curve)

The Budget Constraint (BC)

 BC is all the combinations or bundles of two goods a
person can purchase, given a certain money income
and prices for the two goods.
 Suppose Abu has a monthly income of $1200 (the
price of X = $100 & the price of Y = $80)
 Abu can spend his total income on X, he can spend
his total income on Y or he can spend part of his
income on X & part on Y.
 If Abu spends his total income on X, he can purchase
a maximum of 12 units ($1200/$100).

CH 21 • 18
 If Abu spends his total income on Y, he can purchase a
maximum of 15 units ($1200/$80).
 Locating these two points on a two-dimensional
diagram & then drawing a line between them gives us
Abu’s budget constraint.
 The absolute value of the slope represents the relative
prices of the two goods X & Y.
 The slope, or Px/Py is equal to $100/$80 = 1.25,
indicating that the relative price of 1 unit of X is 1.25
units of Y.

(Refer Exhibit 1)

CH 21 • 19
Appendix C Exhibit 1 The Budget Constraint

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Changes in the Budget Constraint (Price)
 A change in the price of good X or good Y will
change the slope of the budget constraint.

 Example 1
 Px  from $100 to $60.
 With this change, the maximum number of units
of good X purchasable with an income of $1200 
from 12 to 20.
 As a result, the budget constraint resolves away
from the origin as shown in Exhibit 2(a).
 More bundles of the two goods are available
after Px  than before.

CH 21 • 21
 Changes in the Budget Constraint (Price)

 Example 2
 Px  from $100 to $150.
 With this change, the maximum number of units
of good X purchasable with an income of $1200 
from 12 to 8.
 As a result, the budget constraint resolves toward
the origin as shown in Exhibit 2(a).
 Less bundles of the two goods are available after
Px  than before.

 In sum, a change in the price of either good

changes the slope of the budget constraint, with
the result that relative prices & the number of
bundles available to the individual also change.
CH 21 • 22
Appendix C Exhibit 2 Changes in the Budget Constraint

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 Changes in the Budget Constraint (Income)
 A change in income will change the position of
the budget constraint while the slope remains
constant.

 Example 1
 Abu’s income  from $1200 to $1600.
 With this change, the maximum number of
purchasable units of X  from 12 to 16.
 The maximum number of purchasable units of Y 
from 15 to 20.
 The budget constraint shifts rightward (away from the
origin) & is parallel to the old budget constraint.
 As a consequence, the number of bundles available
to Abu’s .
CH 21 • 24
 Changes in the Budget Constraint (Income)

 Example 2
 Abu’s income  from $1200 to $800.
 With this change, the maximum number of
purchasable units of X  from 12 to 8
 The maximum number of purchasable units of Y 
from 15 to 10.

 The budget constraint shifts leftward (toward the

origin) & is parallel to the old budget constraint.
 As a consequence, the number of bundles available
to Abu’s .

CH 21 • 25
 CHANGE IN PRICE
ON THE BUDGET CONSTRAINT LINE

• If the price of fruits falls, the new budget constraint line is obtained
by rotating the original budget line L1 outward to L2, pivoting from
the vertical axis-intercept. On the other hand, when the price of
fruits doubles, the budget line rotates inward toline L3.
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 CHANGE IN INCOME
ON THE BUDGET CONSTRAINT LINE

• if income is doubled from RM80 to RM160, the budget constraint line

shifts outward, from budget line L1 to L2. Likewise, if income is cut in half
from RM80 to RM40, then the budget constraint line shifts inward, from
L1 to L3,
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 Indifference Curve

Indifference Set
 A group of bundles of two goods that give an individual
equal total utility.

Indifference Curve
 The curve that represents an indifference set and that
shows all the bundles of two goods giving an individual
equal total utility.

(Refer Exhibit 3)

CH 21 • 28
Appendix C Exhibit 3 An Indifference Set and an Indifference
Curve

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 Characteristics of Indifference Curves
i. Indifference Curves Are Downward Sloping
 Indifference curves are downward sloping because
a person has to get more of one good to maintain
the same level of satisfaction (utility) when giving
up some of another good.

 For example:
 Point A: 8 milk, 3 orange juice
 Point B: 5 milk, 4 orange juice

CH 21 • 30
ii. Indifference Curves Are Convex to the Origin
 The slope of an indifference curve diminishes
(becomes flatter) as we move down and to the
right along a given indifference curve.
 This is consistent with the notion of diminishing
marginal utility.
 As we our consumption of one good, the MU of
that good .
 As a result, the more of one good a consumer has,
the more of it he is willing to give up to get another
unit of the good he has less of.

CH 21 • 31
 For example, at 8 units of milk (point A), the
individual is willing to give up 3 units of milk to get
an additional unit of orange juice (and thus move to
point B).

 However, at point B, where she has 5 units of milk,

she is willing to give up only 2 units of milk to get an
additional unit of orange juice (and thus move to
point C).

 Finally, at point C, with 3 units of milk, she is now

willing to give up only 1 units of milk to get an
additional unit of orange juice.

CH 21 • 32
 Marginal rate of substitution (MRS) is the amount
of one good an individual is willing to give up to
obtain an additional unit of another good and
maintain equal total utility.
 For example, MRS = 3 units of milk for 1 unit of
orange juice in the area between point A and B.

 MRS = absolute value of the slope of the IC

 MRS = MUx @ changes x

MUy changes y

CH 21 • 33
iii. Indifference Curves Farther from the Origin
Are Preferable Because They Represent Larger
Bundles of Goods
 An indifference curve map plots several indifference
curves on the same diagram.
 As we move away from the origin, each successive
indifference curve represents a higher level of total
utility & is, therefore, preferable to any curve closer
to the origin.
 For example, at point B, there is the same amount of
orange juice as at point A but more milk (point B
which is on I2 is therefore preferable than point A.

(See Exhibit 5)
Appendix C Exhibit 5 An Indifference Map

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iv. Indifference Curves Do Not Cross (Intersect)
 Indifference curves do not cross because individual’s
preferences exhibit transitivity.
 Transitivity: The principle whereby , if A is preferred to
B and B is preferred to C, then A is preferred to C
 For example, point A lies on both indifference curve I1
and I2. This means that the individual is indifferent
between A & B and between A & C.
 But individuals prefer more to less (when it comes to
good) & thus would prefer C to B.
(See Exhibit 6)
Appendix C Exhibit 6 Crossing Indifference Curves Are
Inconsistent with Transitive Preferences

37
 CONSUMER EQUILIBRIUM
 Exhibit 7 combines the indifference map (IC) with the
individual’s budget constraint in order to determine the
optimal (equilibrium) bundle of goods X & Y.

 Consumer equilibrium exists at point E where:

i. The slope of the budget constraint =the slope of IC
ii. Budget constraint is tangent to an IC
 Px/Py = MUx/Muy
 Mux/Px = Muy/Py
Appendix C Exhibit 7 Consumer Equilibrium

39
 QUESTIONS (CONSUMER EQUILIBRIUM)

1. Diagram the following budget constraint: income =RM12,

price of good X=RM1.00 & price of good Y = RM1.50.

2. Calculate the quantity of good Y at the equilibrium point

(budget constraint is tangent to an indifference curve) if
the quantity of good X = 6 units.
PxQx + PyQy = Y
1(6) + 1.5(Qy) = 12
1.5Qy = 6
Qy = 4

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Qt good Y

[Y/Py=8]

e
4
IC

0 6 [Y/Px =12] Qt good X

41