This document summarizes key concepts related to marginal utility and consumer choice. It defines marginal utility as the additional satisfaction gained from consuming one more unit of a good. The law of diminishing marginal utility states that marginal utility declines as consumption increases. A rational consumer seeks to maximize total utility by equalizing the marginal utility per dollar spent (MU/P ratio) on each good. When price decreases, quantity demanded increases as MU/P rises. The marginal utility approach explains consumer demand and the creation of consumer surplus from market transactions. While exact comparisons of utility across individuals are not possible, approximate comparisons are necessary to evaluate some economic policies.

1. Chapter 5
Marginal Utility and
Consumer Choice
© 2002 South-Western

2. Economic Principles
• Total Utility and Marginal Utility
• Law of Diminishing Marginal Utility
• Relationship Between the Law of Demand
and the Marginal-Utility-To-Price Ratio
• Consumer Surplus
• Difficulties with Interpersonal Comparison
of Utility
2

3. What is Marginal Utility?
Util:
• It is a hypothetical unit used to
measure how much utility a person
obtains from consuming a good.
3

4. What is Marginal Utility?
Utility measures the satisfaction
or enjoyment a person obtains
from consuming a good.
4

5. What is Marginal Utility?
Law of Diminishing Marginal Utility:
• It is the idea that as more of a good is
consumed, the utility a person derives
from each additional unit diminishes.
5

6. What is Marginal Utility?
The implication of someone
experiencing increasing marginal
utility for pizza slices is:
• The next slice of pizza would generate
higher marginal utility than the one before.
6

7. What is Marginal Utility?
The implication of someone
experiencing increasing marginal
utility for pizza slices is:
• When his stomach is full to bursting from
eating so much pizza, the marginal utility
from eating yet another slice would be
higher than for any of the preceding slices.
7

8. What is Marginal Utility?
The implication of someone
experiencing increasing marginal
utility for pizza slices is:
• It is not clear that someone could survive
having increasing marginal utility!
8

9. What is Marginal Utility?
It possible for marginal
utility to become negative.
• For example, if you overeat and feel
ill, then the marginal utility for the
last bit of food you ate is negative.
9

10. What is Marginal Utility?
A rational consumer will not
knowingly pay to buy a unit of
a good that generates negative
marginal utility.
• Presumably something else could be
bought that generates positive marginal
utility.
• Buying something that generates negative
marginal utility is not consistent with
utility maximization.
10

11. EXHIBIT 1 TOTAL UTILITY AND MARGINAL UTILITY
DERIVED FROM CONSUMING T-BONE
STEAKS (UTILS)
11

12. Exhibit 1: Total Utility and Marginal
Utility Derived From Consuming TBone Steaks (Utils)
If marginal utility is declining,
but is still positive, total utility is:
• Total utility increases as long as
marginal utility is positive.
12

13. Exhibit 1: Total Utility and Marginal
Utility Derived From Consuming TBone Steaks (Utils)
If marginal utility is declining,
but is still positive, total utility is:
• In Exhibit 1, total utility reaches its
maximum at five t-bone steaks. Consuming
more than five steaks will reduce total utility.
13

14. EXHIBIT 2A TOTAL AND MARGINAL UTILITY
14

15. EXHIBIT 2B TOTAL AND MARGINAL UTILITY
15

16. Exhibit 2: Total and
Marginal Utility
In Exhibit 2, the curves in
Panel a and b represent:
• The curve in Panel a is the total utility
curve for T-bone steaks.
• Panel a depicts the number of utils, or
the amount of utility, a person gains from
consuming a certain number of steaks.
16

17. Exhibit 2: Total and
Marginal Utility
In Exhibit 2, the curves in
Panel a and b represent:
• Total utility peaks at 81 utils, or 5 steaks.
Each steak consumed beyond 5 reduces
total utility.
17

18. Exhibit 2: Total and
Marginal Utility
In Exhibit 2, the curves in
Panel a and b represent:
• The curve in Panel b is the marginal
utility curve for T-bone steaks.
• The curve depicts the change in total
utility a person derives from consuming
each additional steak.
18

19. Exhibit 2: Total and
Marginal Utility
In Exhibit 2, the curves in
Panel a and b represent:
• When marginal utility is zero, total
utility is maximized.
19

20. What is Marginal Utility?
If water is necessary for life, then
the market price of water so much
lower than for diamonds because:
• Market price reflects marginal utility,
not total utility.
• Due to the law of diminishing marginal utility
and the abundance of water, the marginal
utility of water is lower than for diamonds.
20

21. What is Marginal Utility?
A hypothetical circumstance in
which the marginal utility of
water might exceed the marginal
utility of a diamond:
• If you are lost in the desert and are
severely dehydrated, then your marginal
utility for a gallon of water might exceed
your marginal utility for a diamond.
21

22. French Cuisine and Marginal
Utility
Many courses, each with small portions
of food (French cuisine), may generate
more utility than one course with a
large portion of food because:
• One large portion will drive down marginal
utility.
• Marginal utility is high for the whole meal.
22

23. EXHIBIT 3 MARGINAL UTILITIES OF CLOTHES AND
AMUSEMENT GOODS (UTILS)
23

24. Exhibit 3: Marginal Utilities of Clothes
and Amusement Goods (Utils)
Based on the utility data in Exhibit
3, a rational consumer will select the
best combination of clothes and
amusement goods:
• By sequentially picking units of clothing
and amusement goods that generate the
largest MU/P.
24

25. EXHIBIT 4 MARGINAL-UTILITY-TO-PRICE RATIOS OF
CLOTHES AND AMUSEMENT GOODS (MU/P)
25

26. Exhibit 4: Marginal-Utility-to-Price
Ratios of Clothes and Amusement
Goods (MU/P)
If a unit of clothes and amusement
goods both cost $10, and if you have
$80 to spend, the rational consumer
will spend her money:
• MU/P is equal when three units of
clothes and five units of amusement
goods are purchased (MU/P = 1.4).
26

27. Marginal-Utility-to-Price
Ratio
Marginal-utility-to-price ratio:
• The ratio is calculated by dividing
the marginal utility of a good by the
price of the good -- MU/P.
27

28. Marginal-Utility-to-Price
Ratio
The MU/P equalization principle:
• A person’s total utility is maximized
when the ratios of marginal utility to
price for the last unit of each of the goods
consumed are equal.
28

29. Marginal-Utility-to-Price
Ratio
The MU/P equalization principle:
• MU/P measures marginal utility per dollar
spent.
• Total utility will be maximized (within the
constraints of a limited budget) when each
individual purchase generates the largest
possible MU/P.
29

30. Marginal-Utility-to-Price
Ratio
The MU/P equalization principle:
• A rational and fully-informed consumer will
always shift a dollar from a good whose MU/P
is lower to one whose MU/P is higher, if such a
shift is possible.
30

31. Marginal-Utility-to-Price
Ratio
The MU/P equalization principle:
• The principle is based on consumer behavior.
• Consumers will always arrange their
sequence of choices among goods starting with
the highest MU/P and running down to exhaust
an expenditure budget.
31

32. Marginal-Utility-to-Price
Ratio
The MU/P equalization principle:
• The consumer choice process is in
equilibrium when:
• There is no longer any incentive for
the consumer to rearrange her
purchases. is equal for the last unit
• The MU/P
of each good or service consumed.
32

33. EXHIBIT 5 COMPARING MU/Ps AFTER A 20-PERCENTOFF SALE ON CLOTHES
33

34. Exhibit 5: Comparing MU/Ps After a 20
Percent Off Sale on Clothes
The MU/P of clothes changes
when there is a 20 percent off
sale on clothes by:
• MU/P for each unit of clothing rises when
price is reduced by 20 percent.
• This will cause a rational
consumer to consume more clothes.
34

35. EXHIBIT 6 COMPARING MU/Ps AFTER A 50-PERCENTOFF SALE ON CLOTHES
35

36. Exhibit 6: Comparing MU/Ps After a 50
Percent Off Sale on Clothes
An additional reduction in the price
of clothing will change all of the
MU/Ps for clothing, and thus change
a rational consumer’s consumption
of clothing.
• If the price of clothes falls again, from $8
to $5, the quantity of clothing demanded
increases from four to six units.
36

37. EXHIBIT 7 THE DEMAND CURVE FOR CLOTHES
37

38. Exhibit 7: The Demand Curve for
Clothes
When the price of clothing falls
from $10 to $8 to $5, which of the
following occurs:
• Quantity demanded remains the same.
• Quantity demanded falls from 6 to 4 to 3.
• Quantity demanded rises from 3 to 4 to 6.
38

39. Exhibit 7: The Demand Curve for
Clothes
When the price of clothing falls
from $10 to $8 to $5, which of the
following occurs:
• Quantity demanded remains the same.
• Quantity demanded falls from 6 to 4 to 3.
• Quantity demanded rises from 3 to 4 to 6.
39

40. MU/P Equalization Principle
and the Law of Demand
Changes in the marginal-utilityto-price ratio are caused by:
• A change in the marginal utility of a good
or a change in the price of a good changes
the marginal-utility-to-price ratio, and
therefore changes quantity demanded.
40

41. MU/P Equalization Principle
and the Law of Demand
The relationship between the MU/P
Principle and the Law of Demand:
• If the price of a good falls:
• MU/P rises.
• The rational consumer will increase her
consumption of that good.
• Increase in quantity demanded (movement
along the demand curve).
41

42. MU/P Equalization Principle
and the Law of Demand
The relationship between the MU/P
Principle and the Law of Demand:
• If consumer preference for a good decreases:
• MU/P declines.
• The rational consumer will reduce
consumption.
• The demand curve shifts to the left (since
consumer preference is a non-price factor).
42

43. MU/P Equalization Principle
and the Law of Demand
The relationship between the MU/P
Principle and the Law of Demand:
• If consumer income increases:
• The consumer can pursue a lower MU/P.
• The consumer can afford to increase
consumption.
• An increase in the demand for normal goods.
43

44. MU/P Equalization Principle
and the Law of Demand
A downward-sloping demand
curve is consistent with the law
of diminishing marginal utility.
• Diminishing marginal utility
means that MU/P declines as
quantity consumed increases.
44

45. MU/P Equalization Principle
and the Law of Demand
A downward-sloping demand
curve is consistent with the law
of diminishing marginal utility.
• A consumer’s willingness-topay falls as quantity consumed
increases.
45

46. Are White Rats Rational
Consumers?
There is evidence that lab rats
make consumer choices based
on MU/P.
• Economists Battalio and Kagel found
that white lab rats respond to price and
income changes in a manner consistent
with economic theory.
46

47. The MU/P Guide to
Auction Bidding
MU/P can help guide auction bidding:
• If a particular MU/P is guaranteed by
buying something outside of the auction,
and if the marginal utility from the auction
good is known, then you can figure out
your maximum auction price.
47

48. Creating Consumer
Surplus
Consumer surplus:
• The difference between the maximum price a
person would be willing to pay for a good or
service, and the price the person actually pays.
• Most consumers receive some consumer
surplus from a transaction.
48

49. Creating Consumer
Surplus
When market price falls,
consumer surplus increases.
49

50. Creating Consumer
Surplus
If the price of a good is greater
than amount a consumer is willing
to pay for that good, the consumer
surplus will be negative if the
consumer buys the good.
50

51. Creating Consumer
Surplus
A rational consumer will not
purchase a good that generates
negative consumer surplus.
• A rational consumer will prefer zero
consumer surplus (no purchase) to
negative consumer surplus.
51

52. EXHIBIT 8 THE MARKET FOR HORSEBACK RIDING
52

53. Exhibit 8: The Market for
Horseback Riding
Exhibit 8 depicts the demand and
supply curves for horseback riding.
The concept of consumer surplus
applies to horseback riding:
• At a price of $6, all consumers with a
willingness-to-pay value of $6 or more will
purchase a horseback ride.
• These consumers receive consumer surplus.
53

54. Exhibit 8: The Market for
Horseback Riding
Exhibit 8 depicts the demand and
supply curves for horseback riding.
The concept of consumer surplus
applies to horseback riding:
• Some consumer may be willing to pay
$10 for a horseback ride.
• This consumer will receive $(10-6) = $4
of consumer surplus.
54

55. Exhibit 8: The Market for
Horseback Riding
Exhibit 8 depicts the demand and
supply curves for horseback riding.
The concept of consumer surplus
applies to horseback riding:
• A consumer who has a willingness-to-pay
value less than $6:
• This consumer has a negative consumer
surplus.
• A rational consumer will not choose to
purchase a ride.
55

56. EXHIBIT 9 CONSUMER SURPLUS ON THE HORSEBACKRIDING MARKET
56

57. Exhibit 9: Consumer Surplus on
the Horseback-Riding Market
Kim’s consumer surplus from
horseback riding is:
• $(15-6) for the first ride.
• $(12-6) for the second ride.
• $(9-6) for the third ride.
• $(6-6) for the fourth ride.
• These sum to $(9+6+3+0) = $18.
57

58. Exhibit 9: Consumer Surplus on
the Horseback-Riding Market
Tony’s consumer surplus
from horseback riding is:
• $(10-6) for the first ride.
• $(8-6) for the second ride.
• $(6-6) for the fourth ride.
• These sum to $(4+2+0) = $6.
58

59. Exhibit 9: Consumer Surplus on
the Horseback-Riding Market
Randy’s consumer surplus
from horseback riding is:
• $(9-6) for the first ride.
• $(6-6) for the fourth ride.
• These sum to $(3+0) = $3.
59

60. Exhibit 9: Consumer Surplus on
the Horseback-Riding Market
If Kim, Tony and Randy represent the
entire market demand for horseback
riding, the total consumer surplus is:
• $18 (Kim) + $6 (Tony) + $3 (Randy)
= $27 in consumer surplus
60

61. Interpersonal
Comparisons of Utility
An interpersonal comparison of utility:
• It is a comparison of the marginal
utilities that different people derive
from a good or a dollar.
61

62. Interpersonal
Comparisons of Utility
Is it actually possible to compare the
satisfaction that different people
derive from a good or a dollar?
• It is not possible to make an exact
comparison of different peoples’
utility.
62

63. Interpersonal
Comparisons of Utility
Is it actually possible to compare the
satisfaction that different people
derive from a good or a dollar?
• Policies such as those aimed at poverty
alleviation rely on society being able to make
approximate or reasonable comparisons of
utility across different people.
63