Consumer Choice and
Utility Maximization
What guides consumer decision making?
7
The Theory Behind Consumer Choice
(how consumers make decisions about what to buy)
1. Why is the demand curve downward sloping?
• Income Effect
• Substitution Effect
• Diminishing Marginal Utility
2. What causes quantity demanded and demand to
change?
• PRICES
3. How responsive are consumers to change in price?
• Determinants of elasticity
8
Consumer Behavior
Individuals try to maximize some personal
measure of utility (satisfaction) gained from
consumption.
When we make choices, we usually base them
on an attempt to achieve greater satisfaction.
9
Recall…
Law of Diminishing Marginal Utility
• Utility = Satisfaction
• We buy goods because we get utility from them
• The law of diminishing marginal utility states that the
more you buy of ANY GOOD the less satisfaction
(utils) you get from each new unit.
10
• Any exceptions to this rule?
– Increasing marginal utility Playing the piano
or learning how to snowboard…these things
become more enjoyable as you get better at
them.
11
Utility Maximization Rule
12
Calculate Marginal Utility
# of Slices of
Pizza
0
1
2
3
4
5
6
7
8
Total Utility
(in utils)
0
8
14
19
23
25
26
26
24
Marginal
Utility/Benefit
Utility – a measure of
personal satisfaction
Utils – hypothetical
units of satisfaction
TU
MU =____________
Consumption
How many pizzas would you buy if the price
per slice was $2?
13
Calculate Marginal Utility
# of Slices of
Pizza
0
1
2
3
4
5
6
7
8
Total Utility
(in dollars)
0
8
14
19
23
25
26
26
24
Marginal
Marginal Cost
Utility/Benefit
0
8
6
5
4
2
1
0
-2
$2
$2
$2
$2
$2
$2
$2
$2
$2
How many pizzas would you buy if the price
per slice was $2?
14
Calculate Marginal Utility
# of Slices of
Pizza
0
1
2
3
4
5
6
7
8
Total Utility
(in dollars)
0
8
14
19
23
25
26
26
24
Marginal
Marginal Cost
Utility/Benefit
0
8
6
5
4
2
1
0
-2
You will continue to
consume until
Marginal Benefit =
Marginal Cost
2
2
2
2
2
2
2
2
2
How many pizzas would you buy if the price
per slice was $2?
15
CONSUMER BEHAVIOR
You plan to take a vacation and want to maximize
your utility. Based on the info below, which should
you choose?
Destination
Marginal Utility
(In Utils)
Price
Marginal Utility
Per Dollar
Tahiti
3000
$3,000
1 Util
Chicago
1000
$500
2 Utils
16
CONSUMER BEHAVIOR
You plan to take a vacation and want to maximize
your utility. Based on the info below, which should
you choose?
Destination
Marginal Utility
(In Utils)
Price
Marginal Utility
Per Dollar
Tahiti
3000
$3,000
1 Util
Chicago
1000
$500
2 Utils
Calculating Marginal Utility Per Dollar allows
you to compare products with different prices.
17
$10
Utility Maximization
# Times
Going
Marginal
Utility
(Movies)
1st
2nd
3rd
4th
30
20
10
5
MU/P
(Price =$10)
Marginal
Utility
(Go Carts)
$5
MU/P
(Price =$5)
10
5
2
1
If you only have $25, what combination of
movies and go carts maximizes your utility?
$10
Utility Maximization
# Times
Going
Marginal
Utility
(Movies)
1st
2nd
3rd
4th
30
20
10
5
$5
(Price =$10)
Marginal
Utility
(Go Carts)
(Price =$5)
3
$2
$1
$.50
10
5
2
1
$2
$1
$.40
$.20
MU/P
MU/P
If you only have $25, what combination of
movies and go carts maximizes your utility?
$10
Utility Maximization
# Times
Going
Marginal
Utility
(Movies)
1st
2nd
3rd
4th
30
20
10
5
$5
(Price =$10)
Marginal
Utility
(Go Carts)
(Price =$5)
3
$2
$1
$.50
10
5
2
1
2
$1
$.40
$.20
MU/P
MU/P
If you only have $25, what combination of
movies and go carts maximizes your utility?
$10
Utility Maximization
# Times
Going
Marginal
Utility
(Movies)
1st
2nd
3rd
4th
30
20
10
5
$5
(Price =$10)
Marginal
Utility
(Go Carts)
(Price =$5)
3
2
1
.50
10
5
2
1
2
1
.40
.20
MU/P
MU/P
Utility Maximizing Rule
The consumer’s money should be spent so that the
marginal utility per dollar of each goods equal each
other.
MUx = MUy
Px
Py
# Times
Going
Marginal
Utility
(Movies)
1st
2nd
3rd
4th
30
20
10
5
(Price =$10)
Marginal
Utility
(Go Carts)
(Price =$5)
3
2
1
.50
10
5
2
1
2
1
.40
.20
MU/P
MU/P
If you only have $25, what combination of movies and go carts maximizes
your utility?
22
Utility Maximizing Rule
The consumer’s money should be spent so that the
marginal utility per dollar of each goods equal each
other.
MUx = MUy
Px
Py
Assume apples cost $1 each and oranges cost $2 each. If the
consumer has $7, identify the combination that maximizes utility. 23
APPLES
TU
MU
ORANGES
MU/$1
TU
MU
MU/$2
0
0
0
1
20
20
20
1
30
30
15
2
35
15
15
2
50
20
10
3
45
10
10
3
65
15
7.5
4
50
5
5
4
75
10
5
5
52
2
2
5
80
5
1
Utility Maximizing Rule
The utility maximizing rule assumes that you always
consume where MU/P for each product is equal
8 =
1
4
x
8x = 4
0.50 = x
25
Aside from utility, individuals also have to consider the
additional costs of other resources (opportunity cost)
that must be given up.
A consumer has an income of $1,000 per month to
spend on pizza and pepsi. The price of a pizza is
$10 and the price of a pint of pepsi is $2.
If the consumer spends all of his income on pizza, he
can buy ______
100 pizzas per month. If the consumer
spends all of his income on pints of Pepsi, he can
buy ______
500 pints per month.
budget constraint - the limit on the consumption
bundles that a consumer can afford given
their income and the prices of the goods
Draw the budget constraint
line for this consumer
• The slope of the budget
constraint line equals
the relative price of the
two goods (1 pizza can
be traded for 5 pints of
Pepsi).
500
100
What would happen to
this budget constraint
line if the consumer’s
income increases?
500
What would happen to
this budget constraint
line when the price of
pepsi decreases?
100
Indifference curve - a curve that shows consumption
bundles that give the consumer the same level of
satisfaction.
• A consumer is indifferent between two bundles of goods and
services if the two bundles suit his tastes equally well.
marginal rate of
substitution: the rate at
which a consumer is
willing to trade one good
for another. The rate at
which a consumer is
willing to trade one good
for the other depends on
how much of each good he
is already consuming
The consumer is indifferent among points A, B, and C.
But what about point D?
• The consumer would like to
end up on the highest
possible indifference curve,
but he must also stay within
his budget.
• The highest indifference
curve the consumer can
reach is the one that just
barely touches the budget
constraint. The point where
they touch is called the
optimum.
The consumer would prefer point A, but he cannot afford
that bundle because it lies outside of his budget constraint.
The consumer could afford bundle B, but it lies on a lower
indifference curve and therefore provides less satisfaction.
30
Suppose the price of Pepsi falls from $2 to $1.
income effect: moves the budget constraint and the
change in consumption that results when a price change
moves the consumer to a higher or lower indifference
curve.
Thus the income effect will make the consumer want to
buy more of both goods.
substitution effect: the change in consumption
that results when a price change moves the
consumer along a given indifference curve to a
point with a new marginal rate of substitution.
the substitution effect will tend to make the
consumer want to purchase more Pepsi and less
pizza.
If the consumer spends his entire income on Pepsi, he will now be able to buy 1,000 pints
instead of only 500. Thus, the end point of his budget constraint moves from point B to point D.
The slope of the budget constraint changes as well. Because the price of Pepsi has fallen, the
relative price of the two goods has changed. The consumer can now trade a pizza for 10 pints of
Pepsi instead of 5. Therefore, the budget constraint has become steeper
31
The movement from point A to point B
is the substitution effect; the movement
from point B to point C is the income
effect.
32
Practice!
Nic Ha is a diligent student who loves getting As but he also
loves watching movies. Nick is awake 100 hours a week, and
studying and watching movies are his only activities. Nick
must study 20 hours a week for each A he earns. Each movie
is 2 hours long.
a. Draw Nic’s budget constraint line to show the number of As he
can earn and the number of movies he can watch. Assume he is
happiest when he has 3 As. Draw an indifference curve that
marks his optimum choice of studying and watching movies.
How many movies can he watch?
Next semester, Nic has decided to take Calc BC with Mrs.
Moon, and now he is required to spend 25 hours a week to
maintain an A.
b. Draw a new budget constraint. How will this affect the number of
hours he studies and the number of movies he will watch.
33
As
5
a.
b.
50
Nick can watch 20 movies if he wants 3 As
movies
Since the cost of an A increased, Nick will have to study more and
watch fewer movies. If Nick still wants 3 As, he will only be able
watch 12.5 movies
34