© 2010 Pearson Addison-Wesley

Preferences A household’s preferences determine the benefits or satisfaction a person receives consuming a good or service. The benefit or satisfaction from consuming a good or service is called utility. Total Utility Total utility is the total benefit a person gets from the consumption of goods. Generally, more consumption gives more utility. Maximizing Utility

© 2010 Pearson Addison-Wesley Table 8.1 provides an example of total utility schedule. Total utility from a good increases as the quantity of the good increases. For example, as the number of movies seen in a month increases, total utility from movies increases. Maximizing Utility

© 2010 Pearson Addison-Wesley Marginal Utility Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. As the quantity consumed of a good increases, the marginal utility from consuming it decreases. We call this decrease in marginal utility as the quantity of the good consumed increases the principle of diminishing marginal utility. Maximizing Utility

© 2010 Pearson Addison-Wesley Table 8.1 provides an example of marginal utility schedule. Marginal utility from a good decreases as the quantity of the good increases. For example, as the number of movies seen in a month increases, marginal utility from movies decreases. Maximizing Utility

© 2010 Pearson Addison-Wesley Figure 8.1(a) shows a total utility curve for soda. Total utility increases with the consumption of a soda increases. Maximizing Utility

© 2010 Pearson Addison-Wesley Figure 8.1(b) illustrates diminishing marginal utility. As the quantity of soda increases, the marginal utility from soda diminishes. Maximizing Utility

© 2010 Pearson Addison-Wesley The key assumption of marginal utility theory is that the household chooses the consumption possibility that maximizes total utility. The Utility-Maximizing Choice We can find the utility-maximizing choice by looking at the total utility that arises from each affordable combination. The utility-maximizing combination is called a consumer equilibrium. Maximizing Utility

© 2010 Pearson Addison-Wesley Table 8.2 shows Lisa’s utility- maximizing choice. Lisa has $40 a month to spend on movies and soda. The price of a movie is $8 and the price of soda is $4 a case. Each row of the table shows a combination of movies and soda that exhausts Lisa’s $40. Maximizing Utility

© 2010 Pearson Addison-Wesley Lisa chooses the combination that gives her the highest total utility. Lisa maximizes her total utility when she sees 2 movies and drinks 6 cases of soda a month. Lisa gets 90 units of utility from the 2 movies and 225 units of utility from the 6 cases of soda. Maximizing Utility

© 2010 Pearson Addison-Wesley Choosing at the Margin A consumer’s total utility is maximized by following the rule: Spend all available income. Equalize the marginal utility per dollar for all goods. The marginal utility per dollar is the marginal utility from a good divided by its price. Maximizing Utility

© 2010 Pearson Addison-Wesley The Utility-Maximizing Rule: Call the marginal utility of movies MU M. Call the marginal utility of soda MU S. Call the price of movies P M. Call the price of soda P S. The marginal utility per dollar from seeing movies is MU M /P M. The marginal utility per dollar from soda is MU S /P S. Maximizing Utility

© 2010 Pearson Addison-Wesley Total utility is maximized when: MU M /P M = MU S /P S Table 8.3 shows why the utility-maximizing rule works. The combination is each row is affordable (costs $40). In row C, MU M /P M = MU S /P S = 5. Maximizing Utility

© 2010 Pearson Addison-Wesley If MU M /P M > MU S /P S, then spend less on soda and more on movies. MU M decreases and MU S increases. Only when MU M /P M = MU S /P S, is it not possible to reallocate the budget and increase total utility. Maximizing Utility