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Consumer Choice: Maximizing
Utility
Definition….
• 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 received from
consuming a particular quantity of a good.
• Marginal Utility: The additional utility a person
receives from consuming an additional unit of a
good.
Demand for Mogu-Mogu
Think
• Diamonds vs. Water
– Total Utility versus marginal utility
• Goods change as we become more familiar with them…
• Interpersonal utility comparisons.
– We often do compare marginal utility of additional income across different income levels, but it is not always appropriate…
Normally
• Income is limited!
– You have to make trade-offs in purchasing
different goods…
• Example:
– To buy 1 more Justin Bieber CD at Php375,
need to give up something else, i.e., 3
Starbucks Lattes at Php125 each….
• The trade-off occurs ―rationally” because
you know how much you value each of
these goods.
6
The Budget Constraint• Virtually all individuals must face two facts of economic life
– Have to pay prices for the goods and services they buy
– Have limited funds to spend
• A consumer’s budget constraint identifies which combinations of
goods and services the consumer can afford with a limited
budget
• Budget line is the graphical representation of a budget constraint
– The price of one good relative to the price of another
– The slope of the budget line indicates the spending trade-off
between one good and another
• Amount of one good, that must be sacrificed in order to
buy more of another good
7
The Budget Constraint
A
B
G
H
Number of Concerts
per Month
Number of Movies per
Month
15
12
9
6
3
1 2 3 4 5
With Php1500 per month, Iego can afford 15 movies and no concerts, . . .
12 movies and 1Sarah geronimo concert or any other combination on the budget line.
Points below the line are also affordable.
But not points
above the line.
D
F
E
C
8
Changes in the Budget Line
• Changes in income – Increase in income will shift the budget line upward
(and rightward)
– A decrease in income will shift the budget line downward (and leftward)
– Shifts are parallel
• Changes in price– In each case, one of the budget line’s intercepts will
change, as well as its slope• When the price of a good changes, the budget line rotates
– Both its slope and one of its intercepts will change
9
Shifting of the Budget Line
1. An increase in income shifts
the budget line rightward, with
no change in slope.
(a)
Number of Concerts per
Month
5
15
15
Number of Movies per Month
30
10
10
Changes in the Budget Line
2. A decrease in the price of
movies rotates the budget line
upward.
(b)
Number of Concerts per
Month
5
15
15
Number of Movies per Month
30
11
Changes in the Budget Line
3. while a decrease in the price of
concerts rotates it rightward.
Number of Concerts per
Month
5
15
15
Number of Movies per Month
30
(c)
12
Rationality(Indifference Curve)
• One common denominator– People have preferences
– We assume that you can look at two alternatives and state either that you prefer one to the other or
• That you are entirely indifferent between the two—you value them equally
• Another common denominator– Preferences are logically consistent, or transitive
• When a consumer can make choices, and is logically consistent, we say that she has rational preferences
• Rationality is a matter of how you make your choices, and not what choices you make– What matters is that you make logically consistent choices
13
More Is Better
• We generally feel that more is better
• The model of consumer choice is designed for preferences that satisfy the ―more is better‖ condition
– It would have to be modified to take account of exceptions
• The consumer will always choose a point on the budget line
– Rather than a point below it
14
Theories
• Theories of consumer decision making– Marginal utility
– Indifference curve• Both assume that preferences are rational
• Both assume that consumer would be better off with more of any good
• Both theories come to same general conclusions about consumer behavior
• Our goal is to describe and predict how consumers are likely to behave in markets– Rather than describe what actually goes on in their
minds
15
Marginal Utility
• Marginal utility of an additional unit
– Change in utility derived from consuming an
additional unit of a good
• The law of diminishing marginal utility, as
defined by Alfred Marshall (1842-1924)
states that
– Marginal utility of a thing to anyone diminishes
with every increase in the amount of it he/she
already has
16
Total And Marginal Utility
Total Utility
Marginal Utility
Utils302010
Mogu-Mogu per Week1 2 3 4 5 6
Utils605040
70
302010
Mogu-Mogu per Week1 2 3 4 5 6
1. The change in total utility from one more bottle . . .
2. is called the marginal utility of an additional bottle.
3. Marginal utility falls as more bottles are consumed.
17
Budget Constraint and Preferences
(Marginal Utility)
• If we combine information about preferences (marginal utility values) with information about what is affordable (the budget constraint)
– Can develop a useful rule to guide us to an individual’s utility-maximizing choice
• Highest possible utility will be point at which marginal utility per PESO is the same for both goods
18
Consumer Decision Making
A
B
C
D
EG
F
15
12
9
6
3
1 2 3 4 5 Number of Concerts per
Month
Number of Movies per
Month15
P
MU 40,
P
MU
movies
movies
concerts
concerts
20P
MU 20,
P
MU
movies
movies
concerts
concerts
35P
MU 15,
P
MU
movies
movies
concerts
concerts
19
Budget Constraint and Preferences
(Marginal Utility)
• For any two goods x and y, with prices Px and
PY, whenever MUx / Px > MUY / PY, a consumer is
made better off shifting away from y and toward x
– When MUY / PY > MUX / PX, a consumer is made
better off by shifting spending away from x and toward
y
• Leads to an important conclusion
– A utility-maximizing consumer will choose the point on
the budget line where marginal utility per peso is the
same for both goods (MUX / PX = MUY / PY)
– At that point, there is no further gain from reallocating
expenditures in either direction
20
Budget Constraint and Preferences
(Marginal Utility)
• No matter how many goods there are to
choose from, when the consumer is doing
as well as possible
– It must be true that MUX / PX = MUY / PY for
any pair of goods x and y
– If this condition is not satisfied, consumer will
be better off consuming more of one and less
of the other good in the pair
Consumer Equilibrium
• Occurs when the
consumer has spent
all income and the
marginal utilities per
peso spent on each
good purchased are
equal.
• MUA/PA=MUB/PB=MUC/PC
=
……………MUZ/PZ
housing
food
recreation
education
other
transport.
entertain.
A B
22
Changes In Income
• A rise in income—with no change in
price—leads to a new quantity demanded
for each good
– Whether a particular good is normal (quantity
demanded increases) or inferior (quantity
demanded decreases) depends on the
individual’s preferences
• As represented by the marginal utilities for each
good, at each point along the budget line
23
Effects of an Increase in Income
1. When Iego's income rises to Php3000, his budget line shifts outward.
H'
H''
H
30
27
15
12
9
6
3
1 2 3 4 5 6 7 8 9 10 Number of Concerts per Month
Number of Movies per
Month
2. If his preferences are as given in the table, he'll choose point H
3.But different marginal
utility numbers could
lead him to H' or H''
A
B
C
D
E
F
24
Changes In Price
• A drop in the price of concerts rotates the
budget line rightward, pivoting around its
vertical intercept
• The consumer will select the combination
of movies and concerts on his budget line
that makes him as well off as possible
– Will be combination at which marginal utility
per dollar spent on both goods is the same
25
Deriving the Demand Curve
JD
D
JK
2. If the price falls to Php100, Iego's budget line rotates rightward, and he choose point J.
3. And if the price drops to Php50, he chooses point K.
Price per Concert
30
105
3 7 10 Number of Concerts per Month
15
6
3 5 15 300
108
7 10
Number of Movies per
Month K
4. The demand curve shows the quantity Iego chooses at each price.
1. When the price of concerts is Php300, point D is best for Iego.
26
The Individual’s Demand Curve
• Curve showing quantity of a good or
service demanded by a particular
individual at each different price
• In theory, an individual’s demand curve
could slope upward
27
Substitution Effect
• Substitution effects
– As the price of a good falls, the consumer substitutes that good
in place of other goods whose prices have not changed
• Substitution effect of a price change arises from a
change in the relative price of a good
– And it always moves quantity demanded in the opposite direction
to the price change
• When price decreases (increases), substitution effect works to
increase (decrease) quantity demanded
28
Income Effect
• Income effect– As price of a good decreases, the consumer’s purchasing power
increases, causing a change in quantity demanded for the good
• Income effect of a price change arises from a change in purchasing power over both goods– A drop (rise) in price increases (decreases) purchasing
power
• Income effect can work to either increase or decrease the quantity of a good demanded, depending on whether the good is normal or inferior
29
Combining Substitution and Income
Effect
• A change in the price of a good changes
– Relative price of the good (the substitution
effect) and
– Overall purchasing power of the consumer
(the income effect)
30
Normal Goods
• Substitution and income effects work
together
– Causing quantity demanded to move in
opposite direction of price
• Normal goods must always obey law of demand
31
Inferior Goods
• Substitution and income effects of a price
change work against each other
– Substitution effect moves quantity demanded in the
opposite direction of the price
– While income effect moves it in same direction of
price
– But since substitution effect virtually always
dominates
• Consumption of inferior goods will virtually always obey law
of demand
32
AGAIN, Income and Substitution
Effects
Price Decrease:
P
Purchasing Power
QD
QD
QD
if normal
if inferior
Substitution Effect
UltimateEffect
(Almost Always)
QD
Price Increase:
P QD
QD
QD
if normal
if inferior
Substitution Effect
QD
Purchasing Power
AGAIN, Utility
• Total utility–Total satisfaction from a specific
quantity
• Marginal utility–Extra satisfaction from an
additional unit
• Law of diminishing marginal utility –Explains downward sloping
demand 7-33
AGAIN,Utility Graphically
0
10
20
30
10
8642
0-2
1 2 3 4 5 6 7
1 2 3 4 5 6 7
To
tal U
tility
(U
tils
)M
arg
inal
Uti
lity
(U
tils
)
(1)Tacos
ConsumedPer Meal
(2)Total
Utility,Utils
(3)Marginal
Utility,Utils
0
1
2
3
4
5
6
7
0
10
18
24
28
30
30
28
]]]]]]]
10
8
6
4
2
0
-2
TU
MU
Total Utility
Marginal Utility
Units Consumed Per Meal
Units Consumed Per Meal
7-34
AGAIN, Consumer Behavior
• Key dimensions of the consumer problem
–Rational behavior
–Preferences
–Budget constraint
–Prices
7-35
AGAIN, Theory of Consumer
Behavior
• Find utility maximizing combination of goods
• Utility maximizing rule
–Allocate income
–Last peso spent on each good yields same marginal utility
–Marginal utility per peso
7-36
AGAIN, Numerical ExampleCombinations of apples and oranges obtainable with an income of Php10
(1)Unit of
Product
(a)Marginal
Utility,Utils
(a)Marginal
Utility,Utils
(b)Marginal
UtilityPer Peso
(MU/Price)
(b)Marginal
UtilityPer Peso
(MU/Price)
(2)Apple (product A)
Price = 1
(3)Orange (product B)
Price = 2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Compare marginal utilities
Then compare per peso - MU/Price
Choose the highest
Check budget - proceed to next item 7-37
Numerical ExampleCombinations of apples and oranges obtainable with an income of Php10
(1)Unit of
Product
(a)Marginal
Utility,Utils
(a)Marginal
Utility,Utils
(b)Marginal
UtilityPer Peso
(MU/Price)
(b)Marginal
UtilityPer Peso
(MU/Price)
(2)Apple (product A)
Price = 1
(3)Orange (product B)
Price = 2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Again, compare per peso - MU/Price
Choose the highest
Buy one of each – budget has Php5 left
Proceed to next item 7-38
Numerical ExampleCombinations of apples and oranges obtainable with an income of Php10
(1)Unit of
Product
(a)Marginal
Utility,Utils
(a)Marginal
Utility,Utils
(b)Marginal
UtilityPer Peso
(MU/Price)
(b)Marginal
UtilityPer Peso
(MU/Price)
(2)Apple (product A)
Price = 1
(3)Orange (product B)
Price = 2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Again, compare per peso - MU/Price
Buy one more orange – budget has Php3 left
Proceed to next item 7-39
Numerical ExampleCombinations of apples and oranges obtainable with an income of Php10
(1)Unit of
Product
(a)Marginal
Utility,Utils
(a)Marginal
Utility,Utils
(b)Marginal
UtilityPer Peso
(MU/Price)
(b)Marginal
UtilityPer Peso
(MU/Price)
(2)Apple (product A)
Price = 1
(3)Orange (product B)
Price = 2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Again, compare per peso - MU/Price
Buy one of each – budget exhausted7-40
Numerical ExampleCombinations of apples and oranges obtainable with an income of Php10
(1)Unit of
Product
(a)Marginal
Utility,Utils
(a)Marginal
Utility,Utils
(b)Marginal
UtilityPer Peso
(MU/Price)
(b)Marginal
UtilityPer Peso
(MU/Price)
(2)Apple (product A)
Price = 1
(3)Orange (product B)
Price = 2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Final result – at these prices,
purchase 2 apples and 4 oranges 7-41
Algebraic Generalization
MU of product A
price of A
MU of product B
price of B=
8 Utils
Php1
16 Utils
Php2=
Optimum Achieved – Money income
is allocated so that the last peso spent on
each product yields the same extra or
marginal utility
43
Consumers in Markets
• Since market demand curve tells us
quantity of a good demanded by all
consumers in a market
– Can derive it by summing individual
demand curves of every consumer in
that market
44
From Individual To Market Demand
Number of Mogu-MoguBottles per Week
c
4 12
Dan
Price
4
0
3
2
1
C'
Alvir
Price
0 6 12
4
3
2
1
C''
Marj
Price
0 10 20
4
3
2
1
+ + =
45
From Individual To Market Demand
A
C
B
D
E
Market Demand Curve
Price
4
3
2
1
3 10 27 44
Number of Mogu-Mogu Bottles per Week
46
Consumer Theory in Perspective:
Extensions of the Model
• Problems– The simple model ignores uncertainty
– Imperfect information
– People can spend more than their incomes in any given year by borrowing funds or spending out of savings
• You might think consumer theory always regards people as relentlessly selfish– In fact, when people trade in impersonal markets, this
is mostly true• People try to allocate their spending among different goods
to achieve the greatest possible satisfaction
Who cares about this?
(Beyond Econ Class in Pisay)• Companies, like P&G,
realize that people have limited budgets. They want to maximize consumer utility with THEIR products….– Adjust product qualities to
change utility to consumer.
– Adjust prices
• Methods– Focus groups
– Test markets
– Advertising
– Packaging
– Reformulations…
P&G Product Family
Limits to Utility Theory
• Utility theory assumes people are:
– Rational, self-interested, & consistent.
• In recent years, many limitations to utility theory
in economics have been noted by psychologists
and economists.
– These affect different kinds of transactions
differently….
– Probably have little effect on buying and selling
everyday things….
Inconsistent behavior?• Spite: In experiments, some people have been
observed to spend money to reduce the money other people have won…– In a study, 62% of the participants made themselves
worse off in order to make someone else worse off.
• Compartmentalizing: People often treat money differently depending on the circumstances:
• Endowment Effect: We value things we are endowed with more than things we don’t have…– Coffee mugs: 15 to sell; 10 to buy.
