Theory of Consumer Choice

How Consumers Make Choices under

Income Constraints?

Utility
Utility was thought of as a numeric measure
of a persons happiness.
Bentham (1823, p. 3): 'By utility is meant that
property in any object, whereby it tends to
produce benefit, advantage, pleasure, good or
happiness . . . '
'Utility' is roughly synonymous with
'satisfaction,'
'well-being,'
'welfare,'
'happiness,' 'pleasure,' etc.

 the theory of consumer behavior has been

reformulated entirely in terms of consumer
preferences, and utility is seen only as a way
to describe preferences.
A utility function is a way of assigning a
number to every possible consumption
bundle such that more-preferred bundles get
assigned larger numbers than less-preferred
bundles.

Two Approaches to Measure Utility

Cardinal Approach: Utility can be quantified.
(Generally done by using money as measuring
unit). Alfred Marshall is the proponent of
cardinal approach
Ordinal Approach: It is based on ranking or
ordering
satisfaction
derived
from
consumption of goods and services. Ordinal
numbers are not quantifiable. R G D Allen, J R
Hicks, P A Samuelson

Total Utility and Marginal Utility

Marginal utility is the utility a consumer
derives from the last unit of a consumer good
she or he consumes (during a given
consumption period)
Total utility is the total utility a consumer
derives from the consumption of all of the
units of a good or a combination of goods
over a given consumption period.

Total and Marginal Utility

of Listening to Digital Music Albums

Total Utility
of Listening to Digital Music Albums

The Law of Diminishing Marginal Utility

Over a given consumption period, the more of a good a
consumer has, or has consumed, the less marginal utility an
additional unit contributes to his or her overall satisfaction
(total utility).
Alternatively, we could say: over a given consumption
period, as more and more of a good is consumed by a
consumer, beyond a certain point, the marginal utility of
additional units begins to fall.
Marshall, The additional benefit which a person derives
from a given increase of his stock of a thing diminishes with
every increase of the stock that he already has.

Assumptions
1. Cardinal measurement of utility: Expressing utility
numerically
2. Ceteris Paribus: Factors influencing consumption are
constant i.e. price, income, prices of related products,
taste, fashion, preferences etc.
3. Rationality: Consumers are rational i.e. attempt to
maximize satisfaction.
4. Constant marginal utility of money
5. Continuity in consumption
6. Homogeneity of products under consideration
7. Standard units of consumption

Marginal Utility
Listening to Digital Music Albums

10

Total and
Marginal Utility
of Downloading
and Listening
to Digital
Music Albums

Total utility is
maximized...

where marginal
utility equals zero.

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Utility Maximizing Rules

A rational consumer would buy an additional unit
of a good as long as the perceived dollar value of
the utility of one additional unit of that good (say,
its marginal dollar utility) is greater than its
market price.
The Two-Good Rule
MUI
MUH
--------- = ---------$PI
$PH

Utility Maximization under An

Income constraint
Consumers spending is constrained by their incomes:
Income = Px Qx + Py Qy + Pw Ow + .+Pz Qz
While the consumer tries to equalize MUx/Px , MUy/
Py, MUw/Pw,. and MUz/Pz , to maximize her
utility and her total spending cannot exceed her
income.

Total and Marginal Utility from Consuming Music

Album Downloads and Sandwiches on an Income of
$26

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Total and Marginal Utility from Consuming Music

Album Downloads and Sandwiches on an Income of
$26

15

Total and Marginal Utility from Consuming Music

Album Downloads and Sandwiches on an Income of
$26

16

Optimizing Consumption Choices

A consumers money income should be
allocated so that the last dollar spent on each
good purchased yields the same amount of
marginal utility (when all income is spent),
because this rule yields the largest possible
total utility.

17

Optimizing Consumption
Choices
The rule of equal marginal utilities per dollar spent
A consumer maximizes personal satisfaction when
allocating money income in such a way that the last
dollars spent on good A, good B, good C, and so on,
yield equal amounts of marginal utility.

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Optimizing Consumption
Choices
The rule of equal marginal utilities per dollar spent

MU of good A
Price of good A

MU of good B
=

Price of good B

MU of good Z
= ... =

Price of good Z

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How a Price Change Affects Consumer

Optimum
Recall from earlier table, Income = $26

Qd = 4

MUd
36.5
= 7.3
=
Pd
5

Qs = 2

MUs
22
=
Ps
3

= 7.3

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How a Price Change Affects Consumer

Optimum
Assume Price of Music Falls to $4

Qd = 4

MUd
36.5
= 9.125
=
Pd
4

Qs = 2

MUs
22
=
Ps
3

= 7.3

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How a Price Change Affects Consumer

Optimum
Assume Price of Music Falls to $4

Now
Result

MUd
MUs
>
Pd
Ps
Buy more downloads
and MUd falls

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How a Price Change Affects Consumer

Optimum
Consumption decisions are summarized in the
law of demand
The amount purchased is inversely related to
price.

A consumers response to a price change

At higher consumption rate, marginal
utility falls.

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Digital Music Download Prices and

Marginal Utility

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How a Price Change Affects Consumer

Optimum
The Substitution Effect
The tendency of people to substitute cheaper
commodities for more expensive commodities

The Principle of Substitution

Consumers
and
producers
shift
away
from goods and resources that become priced
relatively higher in favor of goods and resources
that are now priced relatively lower.
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How a Price Change Affects Consumer

Optimum
Purchasing Power
The value
and services

of

money

for

buying

goods

Real-Income Effect
The change in peoples purchasing power that occurs
when, other things being constant, the price of one
good that they purchase changes

When that price goes up (down), real income, or

purchasing power, falls (increases).
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Diamond-Water Paradox
Diamond-water paradox the observation
that essential goods are often lower priced
than non-essential goods.
The price of a good is equal to the marginal
utility of the last unit consumed.
A person consumes many units of water. The
last unit of water consumed have a very low
marginal utility.

Diamond-Water Paradox
A person consumes few diamonds. The last
diamond consumed has a high price and
provides high marginal utility.
Water is more valuable than diamonds in
terms of total utility, but diamonds have a
higher marginal utility, and thus a higher price.
Marginal utility, not total utility, determines
how much people are willing to pay.

Significance of the Law

Foundation to other laws i.e. law of demand,
consumption etc.
Distinguishes between use value and
exchange value. For e.g. water- diamond
paradox.
Used in public finance: Basis for progressive
taxation i.e. tax rate increasing with income.
Support to socialism: Redistribution of income
in favor of poor.

Exceptions

Collections i.e. antiques

Consumption of intoxicants
Reading & writing
Music and poetry

Limitations

Utility is not quantifiable

Ceteris Paribus may not always hold
Marginal utility of money is not constant
Existence of indivisible goods and durables i.e.
TV, refrigerator etc.
Too many assumptions i.e. unrealistic

Consumer Surplus
The difference between what a consumer is
willing to pay for an addition unit of a good
and the market price that he/she actually pays
is referred to as consumer surplus.
The area between the demand curve and the
price (line) measures the total consumer
surplus.

Consumer Surplus
P

Price

D
Qx
0