This document discusses consumer utility theory and how consumers make choices to maximize utility. It introduces concepts like total utility, marginal utility, diminishing marginal utility, and the principle that consumers will allocate their income in a way that equalizes marginal utility per dollar spent. It also examines how changes in a good's price can impact consumer choices through substitution and real income effects. Graphs and examples are provided to illustrate utility maximization and how it determines consumer demand.

1. 1
Chapter 4
Theory of Consumer
Behavior

2. 2
Utility Theory
Utility
– The want-satisfying power of a good or service
Utility Analysis
– The analysis of consumer decision making based on
utility maximization
Util
– A representative unit by which utility is measured

3. Change in number of units consumed
3
Utility Theory
Marginal Utility
– The change in total utility due to a one-unit
change in the quantity of a good or service
consumed
Marginal Utility =
Change in total utility
Total Utility
– Sum-total of satisfaction which a consumer
receives by consuming various units of
commodity.

4. 4
Total and Marginal Utility
of Downloading and Listening to Digital
Music Albums

5. 5
Total and
Marginal Utility
of Downloading
and Listening
to Digital
Music Albums
Total utility is
maximized...
…where marginal
utility equals zero.

6. 6
Graphical Analysis
Observations
– Marginal utility falls as more is consumed.
– Marginal utility equals zero when total utility is
at its maximum.

7. 7
Diminishing Marginal Utility
Law of Diminishing Marginal Utility
– The principle that as more of any good or
service is consumed, its extra benefit declines
– Increases in total utility from consumption of a
good or service become smaller and smaller as
more is consumed during a given time period.

8. Optimizing Consumption Choices
Consumer Optimum
8
– A choice of a set of goods and services that
maximizes the level of satisfaction for each
consumer, subject to limited income

9. Total and Marginal Utility from Consuming
Music Album Downloads and Sandwiches on
9
an Income of $26

10. Total and Marginal Utility from Consuming
Music Album Downloads and Sandwiches on
10
an Income of $26

11. (1)
Time
Period
(2)
(TU)
Music
Album
(3)
(MU)
(4)
(MU per $
Spent)
Price=$5
(5)
Time
Period
(6)
(TU)
Sandwich
(7)
(MU)
(8)
(MU per
$ Spent)
Price=$3
0 0 ---- ----- 0 0 ____ _____
1 50 50 10 1 25 25 8.3
2 95 45 9 2 47 22 7.3
3 135 40 8 3 65 18 6.0
4 171 36.5 7.3 4 80 15 5.0
5 200 28.5 5.7 5 89 9 3.0
11

12. Total and Marginal Utility from Consuming
Music Album Downloads and Sandwiches on
12
an Income of $26

13. 13
Optimizing Consumption
Choices
A consumer’s money income should be
allocated so that the last dollar spent on
each good purchased yields the same
amount of marginal utility (when all
income is spent), because this rule yields
the largest possible total utility.

14. 14
Optimizing Consumption
Choices
Law of Equi-marginal Utility
– The rule of equal marginal utilities per dollar
spent
• A consumer maximizes personal satisfaction when
allocating money income in such a way that the last
dollars spent on good A, good B, good C, and so on,
yield equal amounts of marginal utility.

15. 15
Optimizing Consumption
A little math
– The rule of equal marginal utilities per dollar
spent
Choices
MU of good A
Price of good A =
MU of good B
Price of good B
MU of good Z
= ... = Price of good Z

16. (1)
Time
Period
(2)
(TU)
Music
Album
(3)
(MU)
(4)
(MU per $
Spent)
Price=$5
(5)
Time
Period
(6)
(TU)
Sandwich
(7)
(MU)
(8)
(MU per
$ Spent)
Price=$3
0 0 ---- ----- 0 0 ____ _____
1 50 50 10 1 25 25 8.3
2 95 45 9 2 47 22 7.3
3 135 40 8 3 65 18 6.0
4 171 36.5 7.3 4 80 15 5.0
5 200 28.5 5.7 5 89 9 3.0
16

17. 17
How a Price Change Affects
Consumer Optimum
Income = $26
Qd = 4
MUd
Pd
36.5
5
= = 7.3
Qs = 2 MUs
Ps
22
3
= = 7.3

18. 18
How a Price Change Affects
Consumer Optimum
Assume Price of Music Falls to $4
Qd = 4
MUd
Pd
36.5
4
= = 9.125
Qs = 2 MUs
Ps
22
3
= = 7.3

19. 19
How a Price Change Affects
Consumer Optimum
Assume Price of Music Falls to $4
Now MUd
Pd
>
MUs
Ps
Result Buy more downloads
and MUd falls

20. Digital Music Download Prices
20
and Marginal Utility

21. 21
How a Price Change Affects
Consumer Optimum
Consumption decisions are summarized in
the law of demand
– The amount purchased is inversely related to
price.
A consumer’s response to a price change
– At higher consumption rate, marginal
utility falls.

22. UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
First 10 10 24 12
How should the $10
income be allocated?

23. UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
First 10 10 24 12
Examine the two
marginal utilities

24. UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
First 10 10 24 12
Examine the two
marginal utilities
…per dollar

25. UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
First 10 10 24 12
Decision: Buy 1
Product B for $2

26. UTILITY MAXIMIZING COMBINATION
$ 10 income
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth What 6 next?
6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
Unit of
product
Product A:
Price = $1
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)

27. UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth What 6 next?
6 16 8
Fifth Buy 5 one 5 of each
12 6
Sixth 4 4 6 3
Seventh 3 3 4 2

28. UTILITY MAXIMIZING COMBINATION
$ 10 income
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth and 6 then...
6 16 8
Fifth 5 ($5 left)
5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
Unit of
product
Product A:
Price = $1
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)

29. UTILITY MAXIMIZING COMBINATION
$ 10 income
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth third 5 unit 5 of
12 6
Sixth product 4 4 B
6 3
Seventh 3 3 4 2
Unit of
product
Product A:
Price = $1
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)

30. UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth $3 left...
6 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)

31. UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth $3 left...
6 6 16 8
Fifth Buy both!
5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)

32. UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
First 10 10 24 12
Second 8 8 20 10
Third Income is gone...
7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
the last dollar spent on
each good gave the same
utility (8) per dollar
Product B:
Price = $2
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)
Marginal
utility,
utils
Marginal
utility per
dollar
(MU/price)

33. UTILITY MAXIMIZING COMBINATION
Algebraic Restatement of the
Utility Maximization Rule
MU of product A
Price of A
MU of product B
Price of B =
8 Utils
$1
16 Utils
$2 =

34. UTILITY MAXIMIZATION AND
THE DEMAND CURVE
• Preferences or Tastes
• Money Income
• Prices of Other Goods

35. 35
How a Price Change Affects
Consumer Optimum
The Substitution Effect
– The tendency of people to substitute cheaper
commodities for more expensive commodities
– Consumers and producers shift away
from goods and resources that become priced
relatively higher in favor of goods and
resources that are now priced relatively lower.

36. 36
How a Price Change Affects
Consumer Optimum
Real-Income Effect
– The value of money for buying goods
and services
– The change in people’s purchasing power that
occurs when, other things being constant, the
price of one good that they purchase changes
– When that price goes up (down), real income,
or purchasing power, falls (increases).

37. The Demand Curve Revisited
Question
– How is the demand curve derived?
Answer
– By presuming income, tastes, expectations, and
37
the price of related goods are not changing as
the price of the good changes

38. 38
Summary
Total utility versus marginal utility
– Total utility is total satisfaction from
consumption.
– Marginal utility is the additional satisfaction
from consuming an additional unit.
Law of diminishing marginal utility
– Marginal utility ultimately decides as a person
consumes more and more of a good or service.

39. 39
Summary
The consumer optimum
– Occurs when the marginal utility per dollar
spent on the last unit consumed is equalized
The substitution effect of a price change
– A person will substitute among goods by
buying less of a good when its price increases.

40. 40
Summary
The real-income effect of a price change
– A price change affects the purchasing power of
an individual’s available income.
Why the price of diamonds exceeds the
price of water even though people cannot
long survive without water
– Marginal utility, not total utility, determines
how much people are willing to pay.