chapter 7

```CHAPTERS
8
Utility and Demand
Marginal Utility Theory
 The purpose of marginal utility
theory is to explain an individual
household’s demand.
 Marginal utility theory predicts that
individual demand curves slope
downward.
 Therefore, market demand curves
must also slope downward.
Household Consumption
Choices
 Two factors determine a household’s
consumption choices:
 Its budget constraint (how much money
it has to spend and the prices of each
 Its preferences (how much it likes each
good relative to others)
Budget Constraint
 A household’s consumption choices
are constrained by its income and by
the prices of the goods and services
 The limits to a household’s
consumption choices are described
by its budget constraint or
sometimes called its budget line.
Example - Lisa’s
Consumption Possibilities
 Lisa has \$30 per month to spend on
movies and soda.
 Movies cost \$6 each. If she spends
her entire budget on movies, she can
see 5 per month.
 Soda costs \$3 per six-pack. If she
spends her entire budget on soda,
she can drink 10 six-packs a month.
Consumption Possibilities
Movies (\$6)
Soda (\$3)
Expenditure
Possibility Q
a
b
c
d
e
f
0
1
2
3
4
5
(dollars)
0
6
12
18
24
30
Expenditure
Q
10
8
6
4
2
0
(dollars)
30
24
18
12
6
0
Consumption Possibilities
Soda (six-packs per month)
10
a
b
8
c
6
d
4
e
2
f
0
1
2
3
4
5
Movies
(per month)
Consumption Possibilities
Soda (six-packs per month)
10
a
b
8
Each point on line
exhausts the entire
\$30 budget
c
6
d
4
e
2
f
0
1
2
3
4
5
Movies
(per month)
Consumption Possibilities
Soda (six-packs per month)
10
a
b
8
c
Unaffordable
6
d
4
2
Affordable
e
f
0
1
2
3
4
5
Movies
(per month)
Preferences
 The combination of goods and
services a person chooses to
consume from the available choices
on the budget line is determined by
their likes and dislikes — their
preferences.
 The satisfaction a person gets from
consumption is called utility.
Lisa’s Preferences
 How Lisa spends her \$30 per month
depends on her preferences for
movies and soda.
 Each additional movie or soda she
consumes increases her total utility.
Utility Is an Abstract Concept
 We cannot directly observe values
for utility.
 However, each of us knows what we
like and what we dislike.
 We will consume more of the goods
and services we like and less of
those we dislike.
Total Utility
 Total utility is the total benefit or
satisfaction that a person gets from
the consumption of goods and
services.
 Total utility depends on the level of
consumption — more consumption
generally increases total utility.
Lisa’s Total Utility
 The more movies Lisa sees each
month, the greater her total utility
from movies.
 The more soda Lisa drinks each
month, the greater her total utility
from soda.
Marginal Utility
 Marginal utility is the change in total
utility resulting from a one-unit
increase in the quantity of a good
consumed.
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
-
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
50
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
50
38
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
50
38
33
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
50
38
33
29
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
50
38
33
29
25
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
50
38
33
29
25
21
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
50
38
33
29
25
21
18
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
50
38
33
29
25
21
18
15
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
50
38
33
29
25
21
18
15
12
Total Utility and Marginal Utility
Movies
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
50
88
121
150
175
196
214
229
241
250
Marginal utility
50
38
33
29
25
21
18
15
12
9
Diminishing Marginal Utility
 As consumption of a good or service
increases, the incremental (or
marginal) satisfaction we get from
consuming one more unit decreases.
 This decrease is called the principle
of diminishing marginal utility.
Units of utility
Units of utility
Total Utility and Marginal Utility
200
150
100
50
0
50
1
2
3
4
5
Quantity (movies per month)
0
1
2
3
4
5
Quantity (movies per month)
Total
utility
200
150
Units of utility
Units of utility
Total Utility and Marginal Utility
100
50
0
50
1
2
3
4
5
Quantity (movies per month)
0
1
2
3
4
5
Quantity (movies per month)
Total
utility
200
150
Units of utility
Units of utility
Total Utility and Marginal Utility
100
Increasing
total utility...
50
50
50
0
1
2
3
4
5
Quantity (movies per month)
0
1
2
3
4
5
Quantity (movies per month)
Total
utility
200
150
Units of utility
Units of utility
Total Utility and Marginal Utility
100
Increasing
total utility...
50
…and diminishing
marginal utility
50
50 38
0
1
2
3
4
5
Quantity (movies per month)
0
1
2
3
4
5
Quantity (movies per month)
Total
utility
200
150
Units of utility
Units of utility
Total Utility and Marginal Utility
100
Increasing
total utility...
50
…and diminishing
marginal utility
50
50 38
33
0
1
2
3
4
5
Quantity (movies per month)
0
1
2
3
4
5
Quantity (movies per month)
Total
utility
200
150
Units of utility
Units of utility
Total Utility and Marginal Utility
100
Increasing
total utility...
50
…and diminishing
marginal utility
50
50 38
33
0
1
2
3
4
5
Quantity (movies per month)
0
1
2
29
3
4
5
Quantity (movies per month)
Total
utility
200
150
Units of utility
Units of utility
Total Utility and Marginal Utility
100
Increasing
total utility...
50
…and diminishing
marginal utility
50
50 38
33
0
1
2
3
4
5
Quantity (movies per month)
0
1
2
29
3
25
4
5
Quantity (movies per month)
Total
utility
200
150
Units of utility
Units of utility
Total Utility and Marginal Utility
100
Increasing
total utility...
50
…and diminishing
marginal utility
50
Marginal
utility
50 38
33
0
1
2
3
4
5
Quantity (movies per month)
0
1
2
29
3
25
4
5
Quantity (movies per month)
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
-
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
75
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
75
42
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
75
42
36
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
75
42
36
28
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
75
42
36
28
25
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
75
42
36
28
25
19
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
75
42
36
28
25
19
18
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
75
42
36
28
25
19
18
17
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
75
42
36
28
25
19
18
17
16
Total Utility and Marginal Utility
Soda
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total utility
0
75
117
153
181
206
225
243
260
276
291
Marginal utility
75
42
36
28
25
19
18
17
16
15
Maximizing Utility
 A household’s income and the prices
it faces limit the total utility it can
obtain.
 We assume that households
consume the quantities of goods and
services that maximize total utility.
 People must make hard choices
because wants exceed resources.
The Utility-maximizing
Choice
 A consumer equilibrium is a situation
in which a consumer has allocated
his or her income in the way that,
given the prices of goods and
services, maximizes his or her total
utility.
Lisa's Affordable
Combinations
Movies
Soda
Quantity
per month Total utility
Total utility
from movies
and soda
Total utility
Six-packs
per month
a
0
0
291
10
b
1
50
260
8
c
2
88
225
6
d
3
121
181
4
e
4
150
117
2
f
5
175
0
0
Lisa's Affordable
Combinations
Movies
Soda
Quantity
per month Total utility
a
0
0
b
1
c
Total utility
from movies
and soda
291
Total utility
Six-packs
per month
291
10
50
260
8
2
88
225
6
d
3
121
181
4
e
4
150
117
2
f
5
175
0
0
Lisa's Affordable
Combinations
Movies
Soda
Quantity
per month Total utility
Total utility
from movies
and soda
Total utility
Six-packs
per month
a
0
0
291
291
10
b
1
50
310
260
8
c
2
88
225
6
d
3
121
181
4
e
4
150
117
2
f
5
175
0
0
Lisa's Affordable
Combinations
Movies
Soda
Quantity
per month Total utility
Total utility
from movies
and soda
Total utility
Six-packs
per month
a
0
0
291
291
10
b
1
50
310
260
8
c
2
88
313
225
6
d
3
121
181
4
e
4
150
117
2
f
5
175
0
0
Lisa's Affordable
Combinations
Movies
Soda
Quantity
per month Total utility
Total utility
from movies
and soda
Total utility
Six-packs
per month
a
0
0
291
291
10
b
1
50
310
260
8
c
2
88
313
225
6
d
3
121
302
181
4
e
4
150
117
2
f
5
175
0
0
Lisa's Affordable
Combinations
Movies
Soda
Quantity
per month Total utility
Total utility
from movies
and soda
Total utility
Six-packs
per month
a
0
0
291
291
10
b
1
50
310
260
8
c
2
88
313
225
6
d
3
121
302
181
4
e
4
150
267
117
2
f
5
175
0
0
Lisa's Affordable
Combinations
Movies
Soda
Quantity
per month Total utility
Total utility
from movies
and soda
Total utility
Six-packs
per month
a
0
0
291
291
10
b
1
50
310
260
8
c
2
88
313
225
6
d
3
121
302
181
4
e
4
150
267
117
2
f
5
175
175
0
0
Lisa's Affordable
Combinations
Movies
Soda
Quantity
per month Total utility
Total utility
from movies
and soda
Total utility
Six-packs
per month
a
0
0
291
291
10
b
1
50
310
260
8
c
2
88
313
225
6
d
3
121
302
181
4
e
4
150
267
117
2
f
5
175
175
0
0
Equalizing Marginal Utility
Per Dollar Spent
 The allocation that maximizes total
utility will also make the marginal
utility per dollar spent on each good
equal for all goods.
 The marginal utility per dollar spent
is the marginal utility obtained from
the last unit of a good consumed
divided by the price of the good.
Maximizing Total Utility
 Total utility is maximized when all the
consumer’s income is spent and
when the marginal utility per dollar
spent is equal for all goods.
 If all income is not spent, utility could
be improved by spending more.
Therefore, the consumer will spend
all income.
Lisa Maximizes Utility
 She spends all her income and
MUmovies/ Pmovies = MUsoda/ Psoda
 Equivalently:
MUmovies/MUsoda = Pmovies/ Psoda
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Soda (\$3 per six-pack)
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
-
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
-
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
-
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
6.33
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
-
Equalizing Marginal Utilities
per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
6.33
5.50
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
-
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
6.33
5.50
4.83
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
-
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
6.33
5.50
4.83
4.17
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
-
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
6.33
5.50
4.83
4.17
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
5.00
-
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
6.33
5.50
4.83
4.17
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
5.00
5.67
-
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
6.33
5.50
4.83
4.17
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
5.00
5.67
6.33
-
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
6.33
5.50
4.83
4.17
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
5.00
5.67
6.33
9.33
-
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
6.33
5.50
4.83
4.17
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
5.00
5.67
6.33
9.33
14.00
-
Equalizing Marginal Utilities
Per Dollar Spent
Movies (\$6 each)
Quantity
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
utility
Marginal per dollar
utility
spent
0
50
38
33
29
25
8.33
6.33
5.50
4.83
4.17
Soda (\$3 per six-pack)
Marginal
Quantity utility
10
8
6
4
2
0
15
17
19
28
42
0
Marginal
utility
per dollar
spent
5.00
5.67
6.33
9.33
14.00
-
Lisa Maximizes Utility
 She spends all her income and
MUmovies/ Pmovies = MUsoda/ Psoda
(38/6) = (19/3)
= 6.33
 Equivalently:
MUmovies/MUsoda = Pmovies/ Psoda
(38/19) = (6/3)
=2
Why the Marginal Utility
Rule Maximizes Total Utility
Case I
 If the ratio of marginal utility to price
is higher for movies than for soda,
Lisa can increase total utility by
consuming less soda and more
movies.
 If MUmovies/ Pmovies > MUsoda/ Psoda then
the next movie provides more
satisfaction per dollar than a soda.
Why the Marginal Utility
Rule Maximizes Total Utility
Case II
 If the ratio of marginal utility to price
is lower for movies than for soda,
Lisa can increase total utility by
consuming more soda and less
movies.
 If MUmovies/ Pmovies < MUsoda/ Psoda then
the next soda provides more
satisfaction per dollar than a movie.
Marginal utility per dollar spent
(units of utility per dollar)
Equalizing Marginal Utilities
Per Dollar Spent
16.00
12.00
8.33
6.33
5.67
4.00
Movies
0
Soda
10
Possibility a
1
8
b
2
6
c
3
4
d
4
2
e
5
0
f
Marginal utility per dollar spent
(units of utility per dollar)
Equalizing Marginal Utilities
Per Dollar Spent
16.00
12.00
8.33
6.33
5.67
4.00
MUm
Pm
Movies
0
Soda
10
Possibility a
1
8
b
2
6
c
3
4
d
4
2
e
5
0
f
Marginal utility per dollar spent
(units of utility per dollar)
Equalizing Marginal Utilities
Per Dollar Spent
MUs
Ps
16.00
12.00
8.33
6.33
5.67
4.00
MUm
Pm
Movies
0
Soda
10
Possibility a
1
8
b
2
6
c
3
4
d
4
2
e
5
0
f
Marginal utility per dollar spent
(units of utility per dollar)
Equalizing Marginal Utilities
Per Dollar Spent
MUs
Ps
16.00
12.00
Case II
Utility gain
from more
soda and
fewer movies
Maximum
total utility
8.33
6.33
5.67
4.00
Movies
0
Soda
10
Possibility a
Case I
Utility gain
from more
movies and
less soda
1
8
b
2
6
c
MUm
Pm
3
4
d
4
2
e
5
0
f
Consuming Only Sodas
Marginal utility per dollar spent
(units of utility per dollar)
MUs
Ps
Movies
0
Soda
10
Possibility a
MUm
Pm
1
8
b
2
6
c
3
4
d
4
2
e
5
0
f
Marginal utility per dollar spent
(units of utility per dollar)
Consuming Only Movies
Movies
0
Soda
10
Possibility a
MUm
Pm
MUs
Ps
1
8
b
2
6
c
3
4
d
4
2
e
5
0
f
The Power of
Marginal Analysis
 The method we have used to
maximize Lisa’s utility is an example
of marginal analysis.
 By comparing marginal gain with
marginal loss, we can guarantee that
total utility is maximized.
New Ways of Explaining Consumer Choices
Behavioral Economics
Behavioral economics studies the ways in which
limits on the human brain’s ability to compute and
implement rational decisions influence economic
behavior—both the decisions that people make
and the consequences of those decisions for the
way markets work.
There are three impediments to rational choice:
 Bounded rationality
 Bounded willpower
 Bounded self-interest
New Ways of Explaining Consumer Choices
Bounded Rationality
Bounded rationality is rationality that is
limited by the computing power of the
human brain.
Faced with uncertainty, consumers
cannot rationally make choices and
methods such as rules of thumb, listening
to the views of others, or gut instinct.
New Ways of Explaining Consumer Choices
Bounded Willpower
Bounded will-power is the less-than-perfect
willpower that prevents us from making a
decision that we know, at the time of
implementing the decision, we will later regret.
New Ways of Explaining Consumer Choices
Bounded Self-Interest
Bounded self-interest is the limited self-interest
that sometimes results in suppressing our own
interests to help others.
Main applications are in finance where
uncertainty is the key factor and savings where
future is the key factor.
New Ways of Explaining Consumer Choices
One behavior observed by behavioral
economists is more general and might
The Endowment Effect
The endowment effect is the tendency for
people to value something more highly
simply because they own it.
New Ways of Explaining Consumer Choices
Neuroeconomics
Neuroeconomics is the study of the activity of
the human brain when a person makes an
economic decision.
Different decisions appear to activate different
areas of the brain. Some decisions are made
 In the pre-frontal cortex where memories are stored
and data analyzed and where decisions might be
deemed rational.
 In the hippocampus where memories of anxiety and
fear are stored and where decisions might be
deemed irrational.
New Ways of Explaining Consumer Choices
Controversy
Should economics focus on explaining
the decisions we observe or should it
focus on what goes on inside people’s