Utility theory and individual Choice
Utility is the benefit or satisfaction a person receives from consuming a good or a
service.
Total utility is the total amount of satisfaction or pleasure a person derives from
consuming some specific quantity—for example, 10 units—of a good or service.
Marginal utility is the extra satisfaction a consumer realizes from an additional unit of
that product—for example, from the eleventh unit. Alternatively, marginal utility is the
change in total utility that results from the consumption of 1 more unit of a product.
The law of diminishing marginal utility indicates that gains in satisfaction become
smaller as successive units of a specific product are consumed.
Diminishing marginal utility provides a simple rationale for the law of demand.
Hypothetical table Showing the Law of Diminishing Marginal Utility
Relationship of Total Utility and Marginal Utility
Marginal Utility and Demand
The law of diminishing marginal utility explains why the demand curve for a given
product slopes downward.
If successive units of a good yield smaller and smaller amounts of marginal, or
extra, utility, then the consumer will buy additional units of a product only if its
price falls.
The principle of rational choice
The principle of rational choice tells us to spend our money on those goods that
give us the most marginal utility per dollar
If MUx > MUy , choose to consume an additional unit of X
Px Py
If MUx < MUy , choose to consume an additional unit of y
Px Py
Note: Utility maximizing Rule
MUx = MUy
Px Py
An Example of maximizing utility
Suppose consumer (Isaac) is trying
to decide which combination of two
products A and B he should purchase
with his fixed daily income of ¢10.
It is assumed in the table that the
amount of marginal utility received
from additional units of each of the
two products is independent of the
quantity of the other product.
For example, the marginal-utility
schedule for product A is
independent of the amount of B
obtained by the consumer.
An Example of maximizing utility
Our marginal utility-maximizing rule merely requires that
MUA = MUB
PA PB
The table shows that the combination of 2 units of A and 4 of B fulfils these
conditions in that
8 utils = 16 utils = 8
¢1 ¢2
and the consumer’s ¢10 income is spent.
An Example of maximizing utility
The utility-maximizing combination of goods attainable by Isaac is 2 units of A and 4 units of B.
By summing marginal-utility information from columns A and B, we find that Isaac is obtaining
18 (=10 + 8) utils of satisfaction A and 78 (=24+20+18+16) utils of satisfaction from the 4 units of
B. His ¢10, optimally spent, yields 96( =18+78) utils of satisfaction.
Our marginal utility-maximizing rule merely requires that MUA = MUB
PA PB
The table shows that the combination of 2 units of A and 4 of B fulfils these conditions in that
8 utils = 16 utils = 8
¢1 ¢2
and the consumer’s ¢10 income is spent.
The Theory of Consumer Behavior
In real life there are many goods to consume ( eg mangoes, apples, bananas, etc)
For simplicity of exposition we consider only the case of two goods (Apple and
Banana).
Construction of the budget line
The diagram below constructs a budget line for a
given budget of ¢80, ¢2 per unit of X and ¢4 per unit of Y.
Let X= Apple Y=Banana
Make Y the subject
2X + 4Y = 80
4Y = 80 – 2X Y=80/4 - 2/4 X Y=20 – 2/4X
Y= – 2/4X + 20
Y = MX + C
Slope of the budget line M= -2/4= Px/py
Budget equation is 2X + 4Y = 80
X = 0, implies the consumer spends all his income on good Y.
2(0) + 4Y = 80
4Y = 80 Y=20 A(0,20)
Y=0, implies the consumer spends all his income on good x
2X + 4(0) = 80
2X = 80
X = 40 B(40,0)
The (negative of the) slope of the budget constraint is
the ratio of the price of x to the price of y in this case,
px / py = 2/4
Construction of the budget line
A change in consumer income and the budget line
If consumer income increases then the consumer will
be able to purchase higher combinations of goods.
Hence an increase in consumer income will result in a
parallel shift in the budget line. This is illustrated in the
diagram below. Note that the prices of the two goods
have remained the same; therefore, the increase in
income will result in a parallel shift in the budget line.
Assume consumer income increased to ¢100.
The new equation is now 2x + 4y = 100
If consumer income falls then there would be a
corresponding parallel shift to the left to represent a
fall in the potential combinations of the two goods that
can be purchased.
A change in the price of a good and the budget line
If income is held constant, and the price of
one of the goods changes then the slope of
the curve will change. In other words, the
curve will pivot. This is illustrated in the
diagram below.
The reduction of the price of good x from ¢2
to ¢1 means that on a fixed budget of ¢80,
the consumer could purchase a maximum
of 80 units, as opposed to 40. Note that the
price of good y has remained fixed, hence
the maximum point for good y will remain
fixed.
Our new equation becomes x+4y = 80
Numerical Example
Given that the price of x= GHs 2 and y= GHs 4 and income GHs 60
a. Assume consumer income increased to GHs 80. What happens to the budget line.
b. Assume consumer income decreased to GHs 40. What happens to the budget line.
c. Now suppose that both prices becomes 2 times as large. What happens to the budget line.
d. What happens to the budget line if the price of x increases to GHs 3 but the price of Y
remains the same.
e. If the price of good x doubles and the price of y triples, does the budget line becomes
steeper or flatter?
f. If the price of x doubles, the price of y becomes 8 times larger and income becomes 4 times
larger. Write down an equation for the new budget line.
Consumer Preferences
Assumptions About Preferences
The basic assumptions underlying indifference curve analysis are as follows:
1. People can rank market baskets in terms of most desired and least desired. For any two market baskets, A
and B, the consumer must prefer A to B, B to A, or be indifferent between the two.
2. If basket A is preferred to basket B and basket B is preferred to basket C, then basket A also must be
preferred to basket C.
Similarly, if a person is indifferent between A and B and also between B and C, the person also must be
indifferent between A and C. This is called transitivity.
3. People always prefer more of a good to less of it, all other things being equal.
4. The amount of money people will give up to obtain additional units of a given good per time period, while
being made neither worse nor better off by the exchange, will decrease as more of the good is acquired. This is
the assumption of declining marginal rate of substitution of a particular good for expenditures on other goods.
It is also called the principle of declining marginal benefit of a good.
Indifference Curves
An indifference curve is a graph of all combinations of market baskets among
which a person is indifferent.
All points on an indifference curve give the person the same level of satisfaction, or
utility, per month.
The preceding assumptions assure that the indifference curves between monthly
consumption of a particular good, X, and monthly expenditures on other goods Y
will be downward sloping and convex to the origin.
Indifference Schedule Indifference curve
The slope of the indifference curve – The Marginal Rate of Substitution
The slope of the indifference curve is the marginal rate of substitution
The rate at which a consumer substitutes one good for the other is the marginal
rate of substitution.
The marginal rate of substitution between two commodities measures how much
of a commodity the consumer is willing to trade off for the other.
For example, the marginal rate of substitution of mango for orange gives the
number of units of mangoes that will be sacrificed per unit of orange so that the
consumer stays on the same level of satisfaction.
The marginal rate of substitution and the slope of the consumer’s indifference
curves are both identical concepts, both measuring the willingness of the consumer
to substitute one good for another. The marginal rate of substitution diminishes
that means the number of goods sacrificed for another falls.
Indifference Map
The optimum consumption point (Graphical presentation of the equilibrium of the
consumer)
Given the indifference map of the consumer
and his budget line, the equilibrium is
defined by the point of tangency of the
budget line with the highest possible
indifference curve as shown by point e in
the diagram below.
At the point of tangency the slopes of the
budget line (Px /Py) and of the indifference
curve (MRS x,y=MUx / MUy) are equal:
