CONSUMER CHOICE:
MAXIMIZING UTILITY AND
BEHAVIOURAL ECONOMICS
EXAMPLE
Number of Apples Total Utility Marginal Utility
1 10 10
2 19 9
3 27 8
30
25
20 Total Utility
15
10 Marginal
Utility
5
0
1 2 3
LAW OF DIMINISHING MARGINAL UTILITY
The law of Diminishing Marginal Utility states
that for a given time period, the marginal utility
gained by consuming equal successive units of a
good will decline as the amount consumed
increases.
In other words, the number of utils gained by
consuming the second unit (which is greater than
the number gained by the third, which is greater
than the number gained by the fourth, and so on)
Total utility increases and marginal utility falls
TOTAL UTILITY, MARGINAL UTILITY, AND
THE LAW OF DIMINISHING UTILITY
LAW OF DIMINISHING MARGINAL UTILITY
(CONT)
The law of diminishing marginal utility is based
on the idea that if a good has a variety of uses
but only one unit of the good is available, then
the consumer will use the first unit to satisfy his
or her most urgent want.
Note: The law only talks about comparing the
same person’s utility of consuming successive
units of a good. It does not compare or allow for
comparison between different people.
THE MILLIONAIRE AND THE PAUPER:
WHAT THE LAW SAYS AND DOESN’T SAY
Who gets more utility from one more dollar, a
poor man or a millionaire?
Interpersonal Utility Comparison: Comparing the
utility from a good, service or activity with the
utility another person receives from the same
good, service or activity.
The utility obtained by one person cannot be
scientifically or objectively compared with the
utility obtained from the same thing by another
person because utility is subjective.
THE DIAMOND-WATER PARADOX
Goods have both total utility and marginal utility. Water, for example, is extremely useful;
we can’t live without it. We would expect its total utility (its total usefulness) to be
high, but its marginal utility to be low because water is relatively plentiful. As the law of
diminishing marginal utility states, the utility of successive units of a good diminishes as
its consumption increases. In short, water is immensely useful, but there is so much of it
that individuals place relatively little value on another unit of it.
In contrast, diamonds are not as useful as water. We would expect the total utility of
diamonds to be lower than that of water, but their marginal utility to be high. Because
there are relatively few diamonds in the world, the consumption of diamonds (in contrast
to water consumption) takes place at relatively high marginal utility. Diamonds,
which are rare, are used only for their few valuable uses. Water, which is plentiful, gets
used for its many valuable uses and for its not so valuable uses (e.g., spraying the car with
the hose for two more minutes even though you are 99 percent sure that the soap is fully
rinsed off).
So the total utility of water is high because water is extremely useful. The total utility
of diamonds is comparatively low because diamonds are not as useful as water. The
marginal utility of water is low because water is so plentiful that people consume it at low
marginal utility. The marginal utility of diamonds is high because diamonds are so scarce
that people consume them at high marginal utility.
Prices therefore reflect marginal utility, not total utility.
CONSUMER EQUILIBRIUM AND DEMAND
What does consumer or individual aim to
maximize by consuming goods and services given
the constraints of positive prices and budget?
Equating Marginal Utilities per Dollar
Suppose we have the following information:
Quantity Marginal Price Marginal Utility per
Utility 𝑀𝑈
Dollar ( )
𝑃𝑟𝑖𝑐𝑒
Oranges 10 30 $1 30
Apples 10 20 $1 20
CONSUMER EQUILIBRIUM AND DEMAND
𝑀𝑈𝑂 𝑀𝑈𝐴
>
𝑃𝑜 𝑃𝐴
What would you do as a consumer?
A consumer is in equilibrium when he derives the
same marginal utility per dollar for all goods.
Consumer Equilibrium: Equilibrium occurs when
the consumer has spent all income and the
marginal utilities per dollar spend on each good
purchased are equal.
At consumer equilibrium, TU is maximized.
So the consumer’s marginal (last) dollar spent on apples
returns 20 utils per dollar, and
his marginal (last) dollar spent on oranges returns 30 utils
per dollar. The ratio MUO/PO
(O oranges) is greater than the ratio MUA/PA (A apples):
If the consumer found himself in this situation one week, he
would redirect his purchases
of apples and oranges the next week. He would think: “If I
buy an orange, I receive
more utility [30 utils] than if I buy an apple [20 utils]. It’s
better to buy 1 more orange
with $1 and 1 less apple. I gain 30 utils from buying the
orange, which is 10 utils more
than if I buy the apple.”
As the consumer buys 1 more orange and 1 less apple,
however, the marginal utilityof oranges falls (recall what the
law of diminishing marginal utility says about consumer
consuming fewer apples). Because the consumer has bought 1 more
orange and 1 less
apple, he now has 11 oranges and 9 apples. At this new combination of
goods,
MUO 25 utils
MUA 25 utils
PO $1
PA $1
Now, the ratio MUO/PO equals the ratio MUA/PA. The consumer is
getting exactly the
same amount of utility (25 utils) per dollar from each of the 2 goods. There
is no way
for the consumer to redirect his purchases (buy more of 1 good and less of
another good)
and have more utility. Thus the consumer is in equilibrium. In short, a
consumer is in
equilibrium when he or she derives the same marginal utility per dollar
for all goods. The
condition for consumer equilibrium is
MAXIMIZING UTILITY AND THE LAW OF
DEMAND
Given the equilibrium condition and price of
oranges falls, what happens to this condition?
The consumer will attempt to restore
equilibrium by buying more oranges.
This behavior—buying more oranges
when the price of oranges falls—is
consistent with the law of demand.
