1) Consumer choice theory examines how consumers maximize utility given budget constraints. Utility is the satisfaction derived from consuming goods and services, though it cannot be directly measured. 2) Consumers face diminishing marginal utility as consumption increases, and seek to equalize marginal utility per dollar across goods. 3) Consumer equilibrium occurs when marginal utility per dollar is equal for all goods purchased, maximizing total utility for the budget. A change in price alters the equilibrium as consumers substitute goods to restore optimal satisfaction levels.

1. Consumer Choice Theory
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2. Consumer choice theory
• Utility is the satisfaction or
pleasure derived from consumption
of a good or service.
• Actual measurement of utility is
impossible, but economists assume
it can be measured by a fictitious
unit called the util.
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3. • Cardinal Utility Theory – Utility can be
quantified.
• Ordinal Utility Theory – Utility cannot be
quantified. Consumers can only rank their
preferences.
• Total utility (TU) is the total level of
satisfaction derived from all units of a good or
service consumed.
• Marginal utility (MU) is the change in total
utility from a one unit change in the quantity of
a good or service consumed.
3

4. Diminishing Marginal Utility
8 Marginal Utility
6
4
2 MU
Q
1 2 3 4 4

5. Total Utility
16 Utils TU
12
8
4
Q
1 2 3 4 5

6. Even though water provides a greater
utility than diamonds, why are
diamonds more expensive?
DIAMOND-WATER PARADOX
- Water is plentiful in most of the
world, so its marginal utility is low,
hence its price is also low
- Diamonds are scarce, so its
marginal utility is high, hence its
price is high
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7. Marginal Utility of Diamonds
8 S
Marginal Utility
6
4
2 MU
Q
1 2 3 4 7

8. Marginal Utility of Water
8 S
Marginal Utility
6
4
2 MU
Q
1 2 3 4 8

9. • The law of diminishing marginal
utility states that marginal utility of a
good or service eventually declines as
consumption increases.
• Consumer equilibrium is the
condition of reaching the maximum
level of satisfaction, given a budget,
when the marginal utility per dollar
spent on each good purchased is equal.
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10. • Consumer equilibrium and the law
of diminishing marginal utility can
be used to derive a downward-
sloping demand curve.
• When the price of a good falls,
consumer equilibrium no longer
holds because the marginal utility
the marginal utility per dollar for the
good rises.
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11. • To restore equilibrium, the
consumer must increase
consumption.
• As the quantity demanded
increases, the marginal utility falls
until equilibrium is again achieved.
• Thus, the price falls and the
quantity demanded rises, as
predicted by the law of demand
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12. Consumer Equilibrium
MU A MU B MU Z
1.
price A
= price B = price Z
1. Total expenditure = Budget
 If the marginal utility per last dollar
spend on each good is equal and the
entire budget is spent, total utility is
maximized.
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13. If the marginal utility per last
dollar spend on each good is equal
and the entire budget is spent, total
utility is maximized.
When the price of a normal
good falls, the income effect and
the substitution effect combine to
cause the quantity demanded to
increase.
13

14. • The income effect and the
substitution effect are
complementary explanations for the
law of demand.
• When the price changes, these
effects work in combination to
change in the quantity demanded in
the opposite directions.
14

15. Income effect and substitution effect
• As the price falls, the consumer
substitutes the cheaper the cheaper good
for other goods that are now relatively
more expensive. This is the substitution
effect.
• Also, as the price falls, real purchasing
power increases, causing an increase in
the consumer’s willingness and ability
to purchase a good or service. This is
the income effect.
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16. ORDINAL UTILITY THEORY
• Utility cannot be quantified
• Consumers can only rank their
preferences
• E.g. Hani gets a higher utility from
consuming an orange than an apple
• Uses indifference curve analysis
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17. INDIFFERENCE CURVE ANALYSIS
• Uses two types of curves:
2. Indifference Curve (IC) is a curve that shows
various combinations of two goods that give a
consumer the same level of satisfaction
3. Budget Line (BL) is a line that shows various
combinations of two goods that can be bought
by a consumer, given a certain level of income
and prices of the two goods
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18. INDIFFERECE CURVE
Y
8 A Point Units of Y Units of X
A 8 4
6 B B 6 6
C 4 9
C D 2 15
4 7
D
2
IC
46 8 15 X 18

19. INDIFFERENCE MAP and CHARACTERISTICS
OF IC
• Indifference Map is a diagram that contains a
number of indifference curves.
• Characteristics of IC:
3. Downward sloping from left to right
4. Convex to origin
5. The farther away an IC from the origin, the
higher the level of satisfaction
6. Indifference curves cannot intersect each other
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20. The Law of Diminishing Marginal Rate of
Substitution (MRS)
• MRS is the amount of one good a consumer is
willing to sacrifice in order to obtain one more
unit of another good.
• The Law of DMRS states that the rate at which a
consumer is willing to trade one good for
another falls as he has fewer and fewer of the
first good.
• The Law of DMRS is the reason why an IC is
normally convex to origin.
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21. BUDGET LINE (BL)
• BL shows various combinations of two
goods that can be bought by a consumer,
given his income and prices of the two
goods.
• Example: next slide 
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22. Budget Line
Assume: Income = RM30.00
Price of Banana = RM2.00
Price of Orange = RM3.00
Combinations Banana Orange
A 15 0
B 12 2
C 9 4
D 6 6
E 3 8
F 0 10
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23. CONSUMER EQUILIBRIUM
• Consumer equilibrium is achieved when
the consumer purchases the combination
that gives him the highest level of
satisfaction, given his income and the
prices of the two goods.
• CE is achieved at the point where IC is
tangent to BL where price ratio = MRS
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