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CHAPTER

5 Consumer
Theory
Choice

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 INTRODUCTION

Consumer Choice Theory is important in

economic activities because producers are
always competing with each other to get
consumers to buy their products. Consumer
Choice Theory further explains the existing
behaviour of consumers.

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 THEORY OF UTILITY
Utility means satisfaction gained by the customer
from the consumption of goods and services.
Utility is defined as affordability of the consumer
to consume goods and services that will give
satisfaction to the customer.

Theory of Utility: Satisfaction received by the

consumer or pleasure from consuming a good is
a basis to make a choice of goods and to value
goods. Economists term this satisfaction as utility.

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 TYPES OF UTILITY
There are two approaches of utility, which
are ordinal and cardinal utility.
1) Cardinal Approach
Utility is measured using the unit called
“utils”. For example, drinking one glass
of lemonade will give 2 unit of utils and a
cup of coffee will give 1unit of utils.

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 TYPES OF UTILITY (CON’T)

2) Ordinal Approach
Satisfaction cannot be measured. An
ordinal measure means that the exact
number does not matter, but rather the
relationship between those numbers
matter.

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 CARDINAL UTILITY THEORY
Cardinal Utility Theory is an approach that says
that utility can be measured using the unit “utils”.
For example, eating bread gives 8 utils, while
eating biscuit gives 4 utils, which means bread
gives twice as many utils compared to biscuit.
When the level of utility is associated with the
consumers willingness to pay. The higher the
price, the higher the satisfaction will be.

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 TOTAL UTILITY(TU)

*Total utility (TU) is the total satisfaction

that a person gains from the consumption
of goods and services.

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 MARGINAL UTILITY (MU)
*Marginal utility (MU) is the change in total
utility derived from consuming extra one unit
of the same goods and services. The formula
to calculate the marginal utility as follows:

Change in Total Utility

MU =
Change in Quantity

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 TOTAL UTILITY
AND MARGINAL UTILITY

Based on the table above, MU of the 1 st unit is

equal to TU.
When we add up the MU until the
consumption of the 6th unit, we will get 72 utils,
which is equals to the total utility of that unit.
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 LAW OF DIMINISHING
MARGINAL UTILITY
*Law of Diminishing Marginal Utility
shows decreasing amount of marginal
utility by consuming additional units of
the same good, ceteris paribus.

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 LAW OF DIMINISHING
MARGINAL UTILITY (CON’T)

This law states that the marginal utility

curve is downward sloping and the total
utility curve will become flatter.
The TU curve is equal to the slope of the
MU curve.

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 CONSUMER EQUILIBRIUM
WITH ONE GOOD
One of the way to maximize satisfaction from our limited
income is to measure utils with the value of money. So,
the unit utils become value of consumption.
Marginal utility (MU) becomes the amount of money that
a consumer is willing to pay in order to get an extra unit
of good. If the consumer is willing to pay RM1 for a can of
soft drink, the MU of the can of soft drink will be
MU=RM1.
Herewith, when consumption only involves one good,
then consumer will maximize satisfaction when marginal
utility of consumption of that good equal to price.
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 CONSUMER EQUILIBRIUM WITH
TWO GOODS OR MORE
In real life, consumers can choose a variety of
goods and services.
When the consumer needs to divide his income
for two or more goods, equilibrium is obtained
when
MUn MUn = Marginal Utility of goods
Where
Pn P = price of goods
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 ORDINAL UTILITY THEORY

In this approach, the satisfaction received by

the consumer can’t be quantitatively stated.
This approach states that different goods that
are consumed by consumers bring different
levels of satisfaction.

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 INDIFFERENCE CURVE
ANALYSIS
Consumer’s preferences allow an individual
to choose among different goods and
services.
*An indifference curve shows the
combination of consumption that yield the
same amount of satisfaction or utility.

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 THE BUDGET CONSTRAINT

This is a set of basket that a

consumer can purchase with a
limited amount of income.

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 COMBINING THE INDIFFERENCE
CURVE AND THE BUDGET LINE

By combining the indifference curve and

the budget line, we can determine the
market basket that the consumer will
actually choose.

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 *Utility Maximizing Rule
Def.: Consumer allocates his or her
income so that the last dollar spent on
each product yields the same amount
of extra (marginal) utility (when all
income is spent)
Algebraically
=
MU of product A MU of product B
Price of A Price of B

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 Numerical Example
The Utility Maximizing Combination of Apples and Oranges Obtainable with an
Income of $10
(2) (3)
Apple (Product A): Oranges (Product B):
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility per Marginal Utility per
Unit of Utility, dollar Utility, dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh
Microeconomics 3 3 4 2
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 Decision-Making Process
Sequence of Purchases to Achieve Consumer Equilibrium, Given the data in
Table 6.1

Marginal
Choice Utility
Number Potential Choices per Dollar Income Remaining
1 First Apple 10 $10 – [($1 x 1) + ($2 x 2)] =
Second Orange 10 $5

2 Second Apple 8 $10 – [($1 x 2) + ($2 x 4)] =

Fourth Orange 8 $0

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 Numerical Example 2
If the price of orange drop to $1 then recalculate the table with an Income of $10

(2) (3)
Apple (Product A): Oranges (Product B):
Price = $1 Price = $1
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility per Marginal Utility per
Unit of Utility, dollar Utility, dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 24
Second 8 8 20 20
Third 7 7 18 18
Fourth 6 6 16 16
Fifth 5 5 12 12
Sixth 4 4 6 6
Seventh
Microeconomics 3 3 4 4
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Deriving the Demand Curve(previous slide)

$2

Orange Quantity

Price of Orange
Price Demand
$2 4
1 6
$1

DO
0
4 6
Quantity Demanded of Oranges
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