Utility theory holds that consumers seek to maximize their total utility through the consumption of goods and services. While total utility increases with consumption, marginal utility - the additional utility from each additional unit - decreases. This principle of diminishing marginal utility is demonstrated through examples showing that the satisfaction gained from each additional taco consumed decreases as more are eaten. The utility maximization rule states that consumers should allocate their income so that the last dollar spent on each good yields the same marginal utility per dollar, thus maximizing total satisfaction from their budget.

1. Marginal Utility

5. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 0 10 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

6. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 0 10 10 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

7. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 0 10 18 10 8 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

8. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 0 10 18 24 10 8 6 0 1 2 3 4 5 6 7 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 1 2 3 4 5 6 7

9. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 4 0 10 18 24 28 10 8 6 4 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

10. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 4 5 0 10 18 24 28 30 10 8 6 4 2 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

11. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 4 5 6 0 10 18 24 28 30 30 10 8 6 4 2 0 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

12. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 4 5 6 7 0 10 18 24 28 30 30 28 10 8 6 4 2 0 -2 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 TU MU 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

13. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 4 5 6 7 0 10 18 24 28 30 30 28 10 8 6 4 2 0 -2 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 TU MU 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 Observe Diminishing Marginal Utility

15. First 10 10 24 12 UTILITY MAXIMIZING COMBINATION How should the $10 income be allocated? 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) $ 10 income

16. First 10 10 24 12 Examine the two marginal utilities 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) UTILITY MAXIMIZING COMBINATION $ 10 income

17. First 10 10 24 12 Examine the two marginal utilities … per dollar 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) UTILITY MAXIMIZING COMBINATION $ 10 income

18. First 10 10 24 12 Decision: Buy 1 Product B for $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) UTILITY MAXIMIZING COMBINATION $ 10 income

19. First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 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) UTILITY MAXIMIZING COMBINATION $ 10 income What next?

20. First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 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) UTILITY MAXIMIZING COMBINATION $ 10 income What next? Buy one of each

21. First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 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) UTILITY MAXIMIZING COMBINATION $ 10 income and then... ($5 left)

22. First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 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) UTILITY MAXIMIZING COMBINATION $ 10 income third unit of product B

23. First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 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) UTILITY MAXIMIZING COMBINATION $ 10 income $3 left...

24. First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 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) UTILITY MAXIMIZING COMBINATION $ 10 income $3 left... Buy both!

25. First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 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) UTILITY MAXIMIZING COMBINATION $ 10 income Income is gone... the last dollar spent on each good gave the same utility (8) per dollar

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

29. Example