Diploma in Management Studies

Microeconomics ECO001
Lecture 5 - Utility and Demand
Topics to be discussed:
Household Budget
Total Utility and Marginal Utility
Principle of Diminishing Marginal Utility
The Utility-Maximizing Rule
Ref: Parkin, Chapter 8

Learning Outcomes
After this lecture, students should be able to:
Explain what limits a households
consumption choices
Describe preferences using the concept of
utility and distinguish between total utility and
marginal utility
Explain the marginal utility theory of
consumer choice
Use marginal utility theory to predict the
effects of changing prices and incomes
2

The Households Budget

Consumption Possibilities
A households consumption possibilities
are constrained by its income and the
prices of the goods and services it buys.
A household has a given amount of income
to spend and cannot influence the prices of
the goods and services it buys.
A households budget line describes the
limits to a households consumption
choices.
3

The Households Budget

The figure shows a budget line for movies and
soda. Income = $30, Movie = $6 per unit and
Soda = $3 per unit
The household can
afford all the points
on or below the
budget line.
The household
cannot afford the
points beyond the
budget line.
4

The Households Budget

A relative price is the price of one
good divided by the price of another
good.
The price of a movie is $6 and the price of
soda is $3 a six-pack.
So the relative price of a movie is $6 per
movie divided by $3 per six-pack, which equals
2 six-packs per movie.

A Price Change
A change in the price
of the good on the xaxis changes the
affordable quantity of
that good and changes
the slope of the budget
line.
The figure shows the
rotation of a budget
line after a change in
the relative price of
movies.

Households Real Income

A households real income is the
households income expressed as the
quantity of goods that the household can
afford to buy.
Expressed in terms of soda, Lisas real income
is 10 six-packsthe maximum quantity of sixpacks that she can buy.
Lisas real income equals her money income
($30) divided by the price of a six-pack ($3).
7

Change in Income
An change in the income brings a parallel shift of
the budget line.
The slope of the
budget line doesnt
change because the
relative price
doesnt change.
The figure shows
how the budget line
shifts when income
changes.
8

Preferences and Utility

Preferences
A households preferences determine the
benefits or satisfaction a person receives
consuming a good or service.
The benefit or satisfaction from consuming a
good or service is called utility.

Total Utility
Total utility is the total benefit a person gets
from the consumption of goods. Generally,
more consumption gives more utility.
9

Total Utility
The figure shows a
total utility curve.
Total utility increases
with the
consumption of a
good.

10

Marginal Utility
Marginal utility is the change in total utility that
results from a one-unit increase in the quantity
of a good consumed.
As the quantity consumed of a good
increases, the marginal utility from consuming
it decreases.
We call this decrease in marginal utility as the
quantity of the good consumed increases the
principle of diminishing marginal utility.

11

Marginal Utility
The figure illustrates diminishing marginal utility.

Utility is analogous
to temperature.
Both are abstract
concepts and both
are measured in
arbitrary units
known as utils.

12

Numerical Example: Consuming cones

of ice-cream
Quantity of
product

Total Utility

Marginal Utility

30

30

46

16

55

58

3
13

Maximizing Utility
The key assumption of marginal utility theory
is that the household chooses the
consumption possibility that maximizes total
utility.

The Utility-Maximizing Choice

We can find the utility-maximizing choice by
looking at the total utility that arises from
each affordable combination.
The utility-maximizing combination is called a
consumer equilibrium.
14

Equalizing Marginal Utility Per Dollar

Using marginal analysis, a consumers
total utility is maximized by following the
rule:
Spend all available income and
equalize the marginal utility per dollar
for all goods.
The marginal utility per dollar is the
marginal utility from a good divided by its
price.
15

Utility-Maximizing Rule
An example:
Call the marginal utility of movies MUM .
Call the marginal utility of soda MUS .
Call the price of movies PM .
Call the price of soda PS .
The marginal utility per dollar from seeing
movies is MUM/PM .
The marginal utility per dollar from soda is
MUS/PS.
16

Utility-Maximizing Rule

Total utility is maximized when:

MUM/PM = MUS/PS

17

Maximizing Utility
If MUM/PM > MUS/PS,
then moving a dollar
from soda to movies
increases the total utility
from movies by more
than it decreases the
total utility from soda,
so total utility increases.
Only when MUM/PM =
MUS/PS, is it not
possible to reallocate
the budget and
increase total utility.

18

Maximizing Utility
If MUS/PS > MUM/PM,
then moving a dollar from
movies to soda increases
the total utility from soda
by more than it
decreases the total utility
from movies, so total
utility increases.

Only when MUM/PM =

MUS/PS, is it not possible
to reallocate the budget
and increase total utility.
19

Predictions of Marginal Utility Theory

When the price of a good falls the quantity
demanded of that good increasesthe
demand curve slopes downward.
For example, if the price of a movie falls,
we know that MUM/PM rises, so before the
consumer changes the quantities
consumed, MUM/PM > MUS/PS.
To restore consumer equilibrium (maximum
total utility) the consumer increases the
quantity of movies consumed to drive down
the MUM and restore
MUM/PM = MUS/PS.

20

Predictions of Marginal Utility Theory

A change in the price of one good changes the
demand for another good.
Youve seen that if the price of a movie falls,
MUM/PM rises, so before the consumer changes
the quantities consumed, MUM/PM > MUS/PS.
To restore consumer equilibrium (maximum
total utility) the consumer decreases the
quantity of soda consumed to drive up the MUS
and restore MUM/PM = MUS/PS.
21

Predictions
A fall in the price of a
movie increases the
quantity of movies
demanded a
movement along the
demand curve for
movies,
and decreases the
demand for soda
a shift of the
demand curve for
soda.

22

Predictions of Marginal Utility Theory

Now suppose the price of soda rises.
We know that MUS/PS falls, so before the
consumer changes the quantities consumed,
MUS/PS < MUM/PM.
To restore consumer equilibrium (maximum
total utility) the consumer decreases the
quantity of soda consumed to drive up the
MUS and increases the quantity of movies
consumed to drive down MUM. These
changes restore MUM/PM = MUS/PS.
23

Predictions
A rise in the price of
soda decreases the
quantity of soda
demanded a
movement along the
demand curve for soda,
and increases the
demand for movies a
shift of the demand
curve for movies.
24

Rise In Income
When income increases, the demand for a
normal good increases and the demand
for an inferior good decreases.
Consumers will buy more of a good if it is a
normal good
Consumers will less of a good if it is an inferior
good

Maximum utility occurs where the marginal

utility per dollar spend on all goods are
equal
25

Exercise 5.1
400

The marginal utility of the

2nd roller coaster ride is
(A) 25
(B) 50
(C) 75
(D) 100
(E) 200

375
350
300
250
200
150
100

50
1

3
5
4
R o lle r c o a s te r r id e p e r d a y
2

26

Answers to Exercise 5.1

The correct answer is (D)
The total utility of the first roller coaster
ride is 200.
The total utility of the second roller
coaster ride is 300.
So the change in total utility, which is the
marginal utility of the second ride is 100

27

Exercise 5.2
Brian gets 18, 23, and 25 units worth of total
utility from consuming 10, 11, and 12 raw
oysters, respectively, and the price per oyster is
25 cents. Thus, one can infer that Brian

A)
is utility maximizing.

B)
is not utility maximizing.

C)
is experiencing diminishing marginal
utility.

D)
should NOT consume any more
oysters.

E)
has consumed too many oysters.
28

Answers to Exercise 5.2

The correct answer is (C).
The marginal utility of the 11th unit is 5
and the marginal utility of the 12th unit is
2, implying diminishing marginal utility.

29

Exercise 5.3
For two goods, A and B, MUA/PA= 10 and
MUB/PB=12. The consumer should

A) leave their choices as they are.

B) purchase less of A and B.

C) purchase less of A and more of B.

D) purchase more of A and less of B.

E) purchase more of A and B.

30

Answers to Exercise 5.3

The correct answer is (C).
Since MUB/PB is larger than MUA/PA,
spending $1 more on B gives more
utility than spending $1 more on A.
The consumer should buy more B and
less A to maximize total utility.

31

Exercise 5.4
Complete the table below and comment
on the changes in total utility and marginal
utility as consumption of hamburger
increases:
Quantity
0
1
2
3
4

Total Utility
0
103
158
172
165

Marginal Utility
-

32

Answer to Exercise 5.4

The completed table is shown below. Total
utility increases at a decreasing rate and
then decreases. Marginal utility
decreases as consumption of hamburger
increases.
Quantity
Total Utility
Marginal Utility
0
1
2
3
4

0
103
158
172
165

103
55
14
-7

Exercise 5.5

Jessy's marginal utility of watching movies and

marginal utility of eating out each month in
utils are represented in the following table.
M o v ie s / m o n t h
1
2
3
4

M a r g in a l U tility
fr o m M o v ie s
60
50
20
5

E a tin g o u t/m o n th
1
2
3
4

M a r g in a l U t ilit y
fr o m E a tin g o u t
150
140
120
100

She spends $100 every month for

entertainment, the price per movie is $10 and
price per eating out is $20. What is Jessy's
optimal combination of movies and eating out?
34

Answers to Exercise 5.5

Optimal combination is :
(MU/P)M = (MU/P)D
Compute 2 columns of
MU/P for both goods
The possible optimal
combinations are: (1M,
3D) and (2M, 4D)
1M and 3D needs $70
2M and 4D needs $100
Based on the budget, the
optimal consumption
combination is 2 movie
and 4 dinner.

Quantity MU/P
movie

MU/P
dinner

7.5

0.5