Consumer Choice: Maximizing Utility Ch. 18, R.A. Arnold, Economics 9th Ed

Utility Theory In this chapter we study the household (or consumer) Remember: Households consume goods (e.g. food) since it gives them utility (satisfaction or benefit or happiness) Assumption: The aim of households is to maximize utility i.e. They want to obtain the highest amount of utility from their limited income (or resource) Utils: The unit of utility. It is used to measure utility. E.g. If drinking tea gives you 10 utils and drinking coffee gives you 8 utils. It means you get more satisfaction (utility) from tea as compared to coffee

Marginal Utility and Total Utility Marginal Utility (MU): The (additional) utility obtained from one additional (extra) unit of a good. E.g. the marginal utility of the 1st cup of tea is 10 utils. The marginal utility of the 2nd cup is 9 utils. Total utility from 2 cups = 10 + 9 = 19 utils When we say households want to maximize utility we mean they want to maximize the total utility (i.e. obtain the highest amount of utils)

Law of Diminishing Marginal Utility The marginal utility (MU) gained by consuming equal successive units of a good will decline as the amount consumed (Q) increases during a given period of time. In symbols: if Q ↑ then MU ↓ (if Q ↓ then MU ↑ ), ceteris paribus This law explains why the first cup of tea gives us more satisfaction than the second one. The MU1st cup = 10 and MU2nd cup = 9. What could be MU3rd cup ? Answer: MU3rd cup < MU2nd cup

Consumer Equilibrium: Maximizing Utility Here, we analyse how a household (consumer) maximizes utility Constraint of household: limited (fixed) income (budget) We are assuming that the household is consuming all of their income on 10 apples and 10 oranges per week. The price (P) of each apple = $1 and the price (P) of each orange = $1. (What is the households total income per week?) Also given, MU oranges = 30 utils and MU apples = 20 utils i.e. the utility obtained from the 10th apple is 20 utils and 10th orange is 30 utils

**According to Economic theory consumers make purchasing decisions by comparing the marginal utility per dollar from different goods (MU ÷ P)** Here we can see, (MU orange ÷ P orange ) > (MU apple ÷ P apple) This means the household can get more marginal utility per dollar from oranges as compared to apples. So the household buys more oranges to increase their total utility. But since they are consuming all of their limited income, they have to reduce the consumption of apples, to buy more oranges.

Continued If the household buys more oranges then we know the MU from oranges will fall (Law of Diminishing Marginal Returns). Here when the household buys 1 more orange, MU from orange falls to 25 utils. And as they buy 1 less apple, MU from apples increases to 25 utils. Now, (MU orange ÷ P orange ) = (MU apple ÷ P apple). The household is maximizing its utility and they have no further incentive to change their consumption (they are in equilibrium). At equilibrium they are consuming 11 oranges and 9 apples.

Maximizing Utility and the Law of Demand At the end of last slide, the household had reached equilibrium and it was maximizing utility i.e. (MU from oranges ÷ P of oranges) = (MU from apples ÷ P of apples) Now, if the price of apple falls then, (MU from oranges ÷ P of oranges) < (MU from apples ÷ P of apples) So the household increases their consumption of apples (since they get more marginal utility per dollar from apples) and reduces their consumption of oranges. This is consistent with the theory of demand which tells us if P of a good (apple) falls then the quantity demanded of (apple) rises.