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Chapter 2

Analysis of UTILITY

Learning objectives
Total Utility, Marginal Utility, and the Law of Diminishing
Marginal Utility
How Rational Consumers Compare Marginal Utility-to-Price
Ratios for Products in Purchasing Combinations to Maximize
Total Utility
How to Derive the Demand Curve by Observing Behavior
How the Utility-Maximization Model Highlights Income and
Substitution Effects of a Price Change

MARGINAL UTILITY
THEORY

Cardinal Utility Approach

Neo-Classical Approach attributed to Alfred Marshall implies


that utility can be assigned a cardinal number like 1,2, 3 etc.

Ordinal Utility Approach


Indifference Curve Analysis pioneered by Hicks & Allen
consumers can rank their preferences for goods and services

Utility Theory

Utility

Utility Analysis

The want-satisfying power of a good or service

The analysis of consumer decision making


based on utility maximization

Util

A representative unit by which utility is


measured

Chapter 21 - Consumer Choice

MARGINAL UTILITY
THEORY

Utility

Utility is the benefit or satisfaction that a


person gets from the consumption of a good or
service.

Temperature: An Analogy
The concept of utility helps us make predictions
about consumption choices in much the same
way that the concept of temperature helps us
make predictions about physical phenomena.

MARGINAL UTILITY
THEORY

Total Utility

Total utility is the total benefit that a person

gets from the consumption of a good or


service. Total utility generally increases as the
quantity consumed of a good increases.

MARGINAL UTILITY
THEORY

Marginal Utility

Marginal utility is the change in total utility


that results from a one-unit increase in the
quantity of a good consumed

Marginal utility =

Change in total utility


Change in number of units consumed

Law of Diminishing Marginal


Utility
(1)
(2)
(3)
Tacos
Total Marginal
Consumed Utility, Utility,
Per Meal
Utils
Utils

0
1
2
3
4
5
6
7

0
10
18
24
28
30
30
28

]
]
]
]
]
]
]

10
8
6
4
2
0
-2

Marginal Utility (Utils) Total Utility (Utils)

Total Utility

30
TR

20
10
0

Units Consumed Per Meal

Marginal Utility
10
8
6
4
2
0
-2

MU
1

Units Consumed Per Meal

Theory of Consumer Behavior


Consumer

Constraint

Choice and Budget

Rational Behavior
Preferences
Budget Constraint
Prices

Utility

Maximizing Rule

Allocate Money Income so that Last


Dollar Spent on Each Product Yields the
Same Marginal Utility

Theory
of Consumer Behavior
Numerical Example:
Utility-Maximizing Combination of Products A and B
Obtainable with an Income of $10

(1)
Unit of
Product

(2)
Product A:
Price = $1
(b)
Marginal
(a)
Utility
Marginal
Utility, Per Dollar
Utils (MU/Price)

(3)
Product B:
Price = $2
(b)
Marginal
(a)
Utility
Marginal
Utility, Per Dollar
Utils (MU/Price)

First
10
10
24
Second
8
8
20
Third
7
7
18
Compare Marginal Utilities
Fourth
6
6
16
Then Compare Per Dollar - MU/Price
Fifth
5
5
12
Choose the Highest
Sixth
4
4
6
Check Budget - Proceed to Next Item
Seventh
3
3
4

12
10
9
8
6
3
2

Theory of Consumer Behavior

Numerical Example:
Utility-Maximizing Combination of Products A and B Obtainable
with an Income of $10

(1)
Unit of
Product

(2)
Product A:
Price = $1
(b)
Marginal
(a)
Utility
Marginal
Utility, Per Dollar
Utils (MU/Price)

First
10
10
Second
8
8
Third
7
7
Again, Compare Per Dollar - MU/Price
Fourth
6
6
Choose the
Highest
Fifth
5 Has $5
5 Left
Buy One of
Each Budget
Proceed to
Next Item 4
Sixth
4
Seventh
3
3

(3)
Product B:
Price = $2
(b)
Marginal
(a)
Utility
Marginal
Utility, Per Dollar
Utils (MU/Price)

24
20
18
16
12
6
4

12
10
9
8
6
3
2

Theory of Consumer Behavior

Numerical Example:
Utility-Maximizing Combination of Products A and B Obtainable
with an Income of $10

(1)
Unit of
Product

(2)
Product A:
Price = $1
(b)
Marginal
(a)
Utility
Marginal
Utility, Per Dollar
Utils (MU/Price)

First
10
10
Second
8
8
Third
7
7
Fourth
6
6
Again, Compare Per Dollar - MU/Price
FifthB Budget
5 Has $35 Left
Buy One More
4
Proceed toSixth
Next Item 4
Seventh
3
3

(3)
Product B:
Price = $2
(b)
Marginal
(a)
Utility
Marginal
Utility, Per Dollar
Utils (MU/Price)

24
20
18
16
12
6
4

12
10
9
8
6
3
2

Theory of Consumer
Numerical Example:
Utility-Maximizing
Combination of Products A and B Obtainable
Behavior
with an Income of $10

(1)
Unit of
Product

(2)
Product A:
Price = $1
(b)
Marginal
(a)
Utility
Marginal
Utility, Per Dollar
Utils (MU/Price)

First
10
10
Second
8
8
Third
7
7
Fourth
6
6
Fifth
5
5
Again, Compare Per Dollar - MU/Price
Sixth
4
4
Buy One of Each Budget Exhausted
Seventh
3
3

(3)
Product B:
Price = $2
(b)
Marginal
(a)
Utility
Marginal
Utility, Per Dollar
Utils (MU/Price)

24
20
18
16
12
6
4

12
10
9
8
6
3
2

Theory of Consumer Behavior

Numerical Example:
Utility-Maximizing Combination of Products A and B Obtainable
with an Income of $10

(1)
Unit of
Product

(2)
Product A:
Price = $1
(b)
Marginal
(a)
Utility
Marginal
Utility, Per Dollar
Utils (MU/Price)

(3)
Product B:
Price = $2
(b)
Marginal
(a)
Utility
Marginal
Utility, Per Dollar
Utils (MU/Price)

First
10
10
Second
8
8
Third
7
7
Fourth
6
6
Fifth
5
5
Final Result At These Prices, Purchase 2
Sixth
4
4
4 of B
Seventh
3
3

24
12
20
10
18
9
16
8
12
6
of Item A and
6
3
4
2

Theory of Consumer Behavior


Algebraic Restatement:

MU of Product A
Price of A
8 Utils
$1

=
=

MU of Product B
Price of B
16 Utils
$2

Optimum Achieved - Money Income is

Allocated so that the Last Dollar Spent on Each


Product Yields the Same Extra or Marginal
Utility

MARGINAL UTILITY
THEORY

This outcome occurs when a person follows the


utility-maximizing rule:
1. Allocate the entire available budget.
2. Make the marginal utility per dollar spent the
same for all goods.

MARGINAL UTILITY
THEORY

Allocate the Available Budget


The available budget is the amount available
after choosing how much to save and how
much to spend on other items.
The saving decision and all other spending
decisions are based on the same utility
maximizing rule that you are learning here and
applying to Tinas decision about how to
allocate a given budget to water and gum.

MARGINAL UTILITY
THEORY

Equalize the Marginal Utility Per Dollar


Spent
Spending the entire available budget doesnt
automatically maximize utility.
Dollars might be misallocatedspend in ways
that dont maximize utility.
Making the marginal utility per dollar spent the
same for all goods gets the most out of a
budget.

Deriving the Demand Curve


Price Per
Unit of B

$2
1

Quantity
Demanded

4
6

Income Effects

Price of Product B

Same Numeric Example:

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).

Substitution EffectsThe tendency of people to substitute cheaper


commodities for more expensive commodities

DB
0

Quantity Demanded of B

Applications and
Extensions

DVDs and DVD Players

The Diamond-Water Paradox

The Value of Time

Medical Care Purchases

Cash and Noncash Gifts

MARGINAL UTILITY
THEORY

Marginal Utility and the Elasticity of


Demand
If, as the quantity consumed of a good
increases, marginal utility decreases quickly,
the demand for the good is inelastic.
The reason is that for a given change in the
price, only a small change in the quantity
consumed of the good is needed to bring its
marginal utility per dollar spent back to
equality with that on all the other items in the
consumers budget.

MARGINAL UTILITY
THEORY

But if, as the quantity consumed of a good


increases, marginal utility decreases slowly,
the demand for that good is elastic.
In this case, for a given change in the price, a
large change in the quantity consumed of the
good is needed to bring its marginal utility per
dollar spent back to equality with that on all
the other items in the consumers budget.

MARGINAL UTILITY
THEORY

The Power of Marginal Analysis


The rule to follow is simple:

If the marginal utility per dollar spent on water


exceeds the marginal utility per dollar spent on gum,
buy more water and less gum.
If the marginal utility per dollar spent on gum
exceeds the marginal utility per dollar spent on
water, buy more gum and less water.

More generally, if the marginal gain from an


action exceeds the marginal loss, take the
action.

EFFICIENCY, PRICE, AND


VALUE

Consumer Efficiency

When a consumer maximizes utility, the


consumer is using her or his resources
efficiently.
Using what youve learned, you can now give the
concept of marginal benefit a deeper meaning.
Marginal benefit is the maximum price a
consumer is willing to pay for an extra
unit of a good or service when total utility
is maximized.

EFFICIENCY, PRICE, AND


VALUE

The Paradox of Value

For centuries, philosophers have been puzzled by


the fact that water is vital for life but cheap
while diamonds are used only for decoration
yet are very expensive.
You can solve this puzzle by distinguishing
between total utility and marginal utility.
Total utility tells us about relative value;
marginal utility tells us about relative price.

EFFICIENCY, PRICE, AND


VALUE

When the high marginal utility of diamonds is


divided by the high price of a diamond, the
result is a number that equals the low marginal
utility of water divided by the low price of
water.
The marginal utility per dollar spent is the same
for diamonds as for water.
Consumer Surplus
Consumer surplus measures value in excess of
the amount paid.

The Demand Curve


Revisited

Marginal utility, total utility, and the


diamond-water paradox

Water is essential to life but cheap.

Diamonds are not essential to life but


expensive.

Chapter 21 - Consumer Choice

27

The Diamond-Water
Paradox

Chapter 21 - Consumer Choice

28

EFFICIENCY, PRICE, AND


VALUE
The demand curve D
shows the demand
for water.
The demand curve
and
the
supply
curve S determine
the price of water at
PW and the quantity
at QW.
The
consumer
surplus from water
is the large blue
triangle.

EFFICIENCY, PRICE, AND


VALUE
The demand curve
and
the
supply
curve S determine
the price of a
diamond at PD and
the quantity at QD.

The
consumer
surplus
from
diamonds is the
small
blue
triangle.