Consumer Behavior and utility

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 The Budget Line
The budget constraint shows the various combinations of the
two goods that the consumer can afford.

In a budget constraint, the quantity of one good is measured

on the horizontal axis and the quantity of the other good is
measured on the vertical axis.

Each point on the budget line has to exhaust all the available
budget.
Ahmed has a total of $56
to spend. T-shirts cost $14
and movies cost $7.
Each point on the budget
line has to exhaust all $56
of budget. The easiest
way to find these points is
to plot the intercepts and
connect the dots.
 at point R, Ahmed buys 2 T-shirts and 4 movies. This costs
him:
T-Shirts @ $14 x 2 = $28
Movies @ $7 x 4 = $28
Total = $24 + $28 = $56

Any point within the budget line is feasible. Ahmed can spend
less than $56, but this is not optimal as he can still buy more
goods.
budget line’s slope or price ratio: can use either Px/PY or
QY/QX to find the slope.
Ahmed’s budget line can shift and pivot. For example, if
Ahmed’s budget drops from $56 to $42, the budget line
will shift inward, as he is unable to purchase the same
number of goods as before
In addition to income changes, sometimes the prices of
movies and T-shirts rises and falls. Suppose, from our
original budget of $56, movies double in price from $7 to
$14.
 THE LAW OF DEMAND
A Closer Look…
The Income Effect
A lower price frees income for additional purchases
- and vice versa

The Substitution Effect

A lower price relative to other goods attracts new
buyers - and vice versa
 Utility

Utility is the satisfaction one gets from consuming a

good or service
• Not the same as usefulness
• Subjective
• Difficult to quantify

LO1
 Marginal Utility

Util is one unit of satisfaction or pleasure

Total utility is the total amount of satisfaction
Marginal utility is the extra satisfaction from an
additional unit of the good MU = ΔTU/ΔQ

LO1
 Assumptions of the Law
1. The law of diminishing marginal utility is based on the
cardinal measurement of utility.
2. Utility is measured in terms of money. The law assumes that
the marginal utility of money is constant.
3. There should not be any time gap between the consumption
of one unit and the other unit.
4. The units of the commodity are homogeneous.
5. The consumer is assumed to be a rational economic man.
He has the knowledge about the market.
 Law of Diminishing Marginal Utility

As consumption of a good or service increases, the

marginal utility obtained from each additional unit of
the good or service decreases
Explains downward sloping demand

LO1
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)

per meal Utils Utils
20
0 0
1 10 10

0 1 2 3 4 5 6 7

Units consumed per meal

Marginal Utility (utils)

10
8
6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
 TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)

per meal Utils Utils
20
0 0
10
1 10 10

0 1 2 3 4 5 6 7

Units consumed per meal

Marginal Utility (utils)

10
8
6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
 TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)

per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
0 1 2 3 4 5 6 7

Units consumed per meal

Marginal Utility (utils)

10
8
6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
 TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)

per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
6
3 24 0 1 2 3 4 5 6 7

Units consumed per meal

Marginal Utility (utils)

10
8
6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
 TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)

per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
6
3 24 0 1 2 3 4 5 6 7

4
4 28
Units consumed per meal

Marginal Utility (utils)

10
8
6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
 TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)

per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
6
3 24 0 1 2 3 4 5 6 7

4
4 28
Units consumed per meal

Marginal Utility (utils)

10
2 8
5 30 6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
 TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)

per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
6
3 24 0 1 2 3 4 5 6 7

4
4 28
Units consumed per meal

Marginal Utility (utils)

10
2 8
5 30 6
0 4
6 30 2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
 TOTAL AND MARGINAL UTILITY
TU
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)

per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
6
3 24 0 1 2 3 4 5 6 7

4
4 28
Units consumed per meal

Marginal Utility (utils)

10
2 8
5 30 6
0 4
6 30 2
-2 0
MU
7 28 -2
1 2 3 4 5 6 7
Units consumed per meal
 TOTAL AND MARGINAL UTILITY
TU
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)

per meal Utils Utils

0 0
20
Observe
10 Diminishing
1 10 10

8
2 18 Marginal
6
3 24 0 1
Utility
2 3 4 5 6 7

4
4 28
Units consumed per meal

Marginal Utility (utils)

10
2 8
5 30 6
0 4
6 30 2
-2 0
MU
7 28 -2
1 2 3 4 5 6 7
Units consumed per meal
 The relationship between total utility and
marginal utility

1. When total utility increases at diminishes rate, marginal

utility diminishes.
2. When total utility is maximum, marginal utility becomes
zero.
3. When total utility decreases, marginal utility becomes
negative.
 Utility Maximizing Rule

The consumer’s money income should

be allocated so that the last dollar spent
on each product yields the same
amount of extra (marginal) utility.

illustrated...
 The Law of Equi Marginal Utility
1. The law of equi marginal utility explains as to how a
consumer distributes his limited income among various
commodities
2. He will spend his income in such away that the last rupee
spent on each of the commodity gives him the same
marginal utility.
3. Therefore, this law is known as the Law of Equi-Marginal
Utility.
 The Law of Equi Marginal Utility
4. In order to get maximum satisfaction out of his limited
income, the consumer carefully weighs the satisfaction
obtained from each rupee that he spends. If he thinks that a
rupee spent on one commodity has greater utility than
spending it on another commodity, he will go on to spend his
money on the former till the satisfaction derived from the last
rupee spent in the two cases equal
The law of equi-marginal utility has been stated by
Marshall as follows “If a person has a thing which can be
put to several uses, he will distribute it among the uses in
such a way that it has the same marginal utility in all”.
To make the amounts of extra utility derived from
differently priced goods comparable, marginal utilities
must be put on a per-dollar-spent basis.
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12

How should the $10

income be allocated?
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12

Examine the two

marginal utilities
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12

Examine the two

marginal utilities
…per dollar
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12

Decision: Buy 1
Product B for $2
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth What
6 next?
6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth What
6 next?
6 16 8
Fifth 5 5 12 6
Buy one of each
Sixth 4 4 6 3
Seventh 3 3 4 2
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth
and
5
then...
5 12 6
Sixth ($5
4 left)
4 6 3
Seventh 3 3 4 2
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth third
5 unit
5 of
12 6
Sixth product
4 4 B 6 3
Seventh 3 3 4 2
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6
$3 left... 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6
$3 left... 6 16 8
Fifth 5 5 12 6
Buy
Sixth both!
4 4 6 3
Seventh 3 3 4 2
 UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils utils
(MU/price) (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7
Income is gone... 7 18 9
Fourth
the 6
last dollar spent on6 16 8
each good gave the same
Fifth 5 5 12 6
utility (8) per dollar
Sixth 4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION

Algebraic Restatement of the

Utility Maximization Rule

MU of product A MU of product B

Price of A
= Price of B

8 Utils 16 Utils

$1
= $2
 UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule and Curve

Basic determinants of demand are:

• Preferences or Tastes
• Money Income
• Prices of Other Goods
 UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule and Curve
Create a demand schedule from the
purchase decisions as the price of the
product is varied ...

Price per unit of B Quantity Demanded

$2 4
1 6
Graphically…
 UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule
and Curve

Price per unit of Good B

$2

DB
0
4 6
Quantity Demanded of Good B
 UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule
and Curve
Income and

Price per unit of Good B

$2

Substitution Effects
Revisited 1

DB
0
4 6
Quantity Demanded of Good B
income effect is the impact that a change in the price of a
product has on a consumer’s real income and
consequently on the quantity demanded of that good.

In contrast, the substitution effect is the impact that a

change in a product’s price has on its relative
expensiveness and consequently on the quantity
demanded