The Analysis of Consumer

Choice
Dr. Roshini Jayaweera
Department of Economics
Faculty of Social Sciences
University of Kelaniya
The Concept of Utility
The Concept of Utility
• Why do you buy the goods and services you do? It must be
because they provide you with satisfaction—you feel better off
because you have purchased them. Economists call this
satisfaction utility.
• The concept of utility is an elusive one. A person who consumes a
good such as peaches gains utility from eating the peaches.
• There is no scale we can use to determine the quantity of utility a
peach generates.
• When we speak of maximizing utility, then, we are speaking of the
maximization of something we cannot measure.
• We assume that each consumer acts as if he or she can measure
utility and arranges consumption so that the utility gained is as
high as possible.
Total Utility
• If we could measure utility, total utility would be the number of
units of utility that a consumer gains from consuming a given
quantity of a good, service, or activity during a particular time
period.
• The higher a consumer’s total utility, the greater that consumer’s
level of satisfaction.
• This Figure shows the total utility
Henry Higgins obtains from watching
movies.
• The total utility curve shows that when
Mr. Higgins attends no movies during a
month, his total utility from attending
movies is zero.
• As he increases the number of movies
he sees, his total utility rises.
• When he consumes1 movie, he obtains
36 units of utility.
• When he consumes 4 movies, his total
utility is 101.
• He achieves the maximum level of utility
possible, 115, by seeing 6 movies per
month.
• Seeing a seventh movie adds nothing to
his total utility.
• Mr. Higgins’s total utility rises at a
decreasing rate.
• The rate of increase is given by the
slope of the total utility curve.
• The slope of the curve between 0
movies and 1 movie is 36 because
utility rises by this amount when
Mr. Higgins sees his first movie in
the month.
• It is 28 between 1 and 2 movies, 22
between 2 and 3, and so on.
• The slope between 6 and 7 movies
is zero; the total utility curve
between these two quantities is
horizontal.
Marginal Utility
• The amount by which total utility rises with consumption of an
additional unit of a good, service, or activity, all other things
unchanged, is marginal utility.
• The first movie Mr. Higgins sees increases his total utility by 36 units.
Hence, the marginal utility of the first movie is 36.
• The second increases his total utility by 28 units; its marginal utility is
28.
• The seventh movie does not increase his total utility; its marginal utility
is zero.
• Notice that in a table, marginal utility should be listed between the
columns/raws for total utility because, similar to other marginal
concepts, marginal utility is the change in utility as we go from one
quantity to the next.
Marginal Utility
• The values for marginal utility are plotted midway between the
number of movies attended.
• The marginal utility curve is downward sloping; it shows that Mr.
Higgins’s marginal utility for movies declines as he consumes
more of them.
• This tendency of marginal utility to decline beyond some level of
consumption during a period is called the law of diminishing
marginal utility.
• This law implies that all goods and services eventually will have
downward-sloping marginal utility curves. It is the law that lies
behind the negatively sloped marginal utility curve.
The Budget Constraint
• The total utility curve in the above Figure shows that Mr. Higgins achieves the maximum total
utility possible from movies when he sees six each month.
• We assume that the goal of each consumer is to maximize total utility. Does that mean a
person will consume each good at a level that yields the maximum utility possible?
• The answer, in general, is no.
• Our consumption choices are constrained by the income available to us and by the prices
we must pay.
• Suppose, for example, that Mr. Higgins can spend just $25 per month for entertainment and
that the price of going to see a movie is $5.
• To achieve the maximum total utility from movies, Mr. Higgins would have to exceed his
entertainment budget.
• Since we assume that he cannot do that, Mr. Higgins must arrange his consumption so that
his total expenditures do not exceed his budget constraint: a restriction that total spending
cannot exceed the budget available.
• Suppose that in addition to movies, Mr. Higgins enjoys concerts, and the average price of a
concert ticket is $10.He must select the number of movies he sees and concerts he attends
so that his monthly spending on the two goods does not exceed his budget.
• To simplify our analysis, we shall assume that a consumer’s spending in any one period is
based on the budget available in that period. In this analysis consumers neither save nor
borrow.
Applying the Marginal Decision Rule
• Because consumers can be expected to spend the budget they
have, utility maximization is a matter of arranging that spending to
achieve the highest total utility possible.
• If a consumer decides to spend more on one good, he or she must
spend less on another in order to satisfy the budget constraint.
• The marginal decision rule states that an activity should be
expanded if its marginal benefit exceeds its marginal cost.
• The marginal benefit of this activity is the utility gained by
spending an additional $1 on the good.
• The marginal cost is the utility lost by spending $1 less on another
good.
Applying the Marginal Decision Rule
• How much utility is gained by spending another $1 on a good? It is the
marginal utility of the good divided by its price. The utility gained by
spending an additional dollar on good X, for example, is

• This additional utility is the marginal benefit of spending another $1 on

the good.
• Suppose that the marginal utility of good X is 4 and that its price is $2.
Then an extra $1 spent on X buys 2 additional units of utility
(MUX/PX=4/2=2).
• If the marginal utility of good X is 1 and its price is $2, then an extra $1
spent on X buys 0.5 additional units of utility (MUX/PX=1/2=0.5).
Applying the Marginal Decision Rule
• The loss in utility from spending $1 less on another good or service is
calculated the same way: as the marginal utility divided by the price.
• The marginal cost to the consumer of spending $1 less on a good is the loss
of the additional utility that could have been gained from spending that $1 on
the good.
• Suppose a consumer derives more utility by spending an additional $1 on
good X rather than on good Y:

• The marginal benefit of shifting $1 from good Y to the consumption of good X

exceeds the marginal cost.
• In terms of utility, the gain from spending an additional $1 on good X exceeds
the loss in utility from spending $1 less on good Y.
• Consumers can increase utility by shifting spending from Y to X.
Applying the Marginal Decision Rule
• As the consumer buys more of good X and less of good Y, however,
the marginal utilities of the two goods will change.
• The law of diminishing marginal utility tells us that the marginal
utility of good X will fall as the consumer consumes more of it; the
marginal utility of good Y will rise as the consumer consumes less
of it. The
• In terms of the marginal decision rule, the consumer will have
achieved a solution at which the marginal benefit of the activity
(spending more on good X) is equal to the marginal cost:
Utility maximization condition
• We can extend this result to all goods and services a consumer
uses

• The above equation states the utility-maximizing condition.

• Utility is maximized when total outlays equal the budget available
and when the ratios of marginal utilities to prices are equal for all
goods and services.