1. Utility Maximization Module KRUGMAN'S MICROECONOMICS for AP* Micro: 1551
Module
Utility Maximization
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

2. What you will learn in this Module:
How consumers make choices about the purchase of goods and services
Why a consumer’s goal is to maximizing utility
Why the principle of diminishing marginal utility applies to the consumption of most goods and services
How to use marginal analysis to find the optimal consumption bundle
The purpose of this module is to introduce the concept of utility and the theory of consumer choice. Students will learn how utility-maximizing consumers choose to purchase bundles of goods and services, given a budget constraint.

3. Maximizing utility
In the Theory of Consumer Choice, consumers’ goal is to maximize their utility.
Why do we demand particular goods and services? Because they make us happy and because we can afford them. Economists refer to this happiness as utility.

4. Utility
Utility: a measure of the satisfaction the consumer derives from consumption of goods and services.
Utility and Consumption – consumption produces utility
The principle of diminishing marginal utility –A law of economics stating that as a person increases consumption of a product - while keeping consumption of other products constant - there is a decline in the marginal utility that person derives from consuming each additional unit of that product.
Utility is a subjective notion in economics, we don’t expect to really measure it, but consumers know when utility is rising or falling, and they know when one choice provides more utility than another.

5. Utility Utility is measured in hypothetical units called “Utils”
A utility function shows the relationship between a consumer’s utility (y axis) and the units of good consumed (x axis)
To maximize total utility, consumers must focus on marginal utility, which is the changes in total utility (satisfaction derived) from each additional unit consumed.
Utility is a subjective notion in economics, we don’t expect to really measure it, but consumers know when utility is rising or falling, and they know when one choice provides more utility than another.

6. Marginal Utility Curve
The marginal utility curve is constructed by plotting points at the midpoint between the numbered quantities, since marginal utility is found as consumption levels change.
The curve slopes downward because each successive unit consumed adds less to total utility.
Example: Cassie’s Clams
Utility of 1st clam is 15
Utility of 2nd clam is 13
Utility of 9th clam is -1
Utility is a subjective notion in economics, we don’t expect to really measure it, but consumers know when utility is rising or falling, and they know when one choice provides more utility than another.

7. Figure Cassie’s Total Utility and Marginal Utility Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

8. Budgets
Budget Constraint – limits the cost of a consumer’s consumption bundle to no more than the consumer’s income.
Consumption Possibilities – the set of all consumption bundles that are affordable, given the consumer’s income and prevailing prices (similar to PPF).
The consumer’s challenge is two-fold:
1. Find the bundles of goods that are affordable, given income and prices, and
Choose the bundle that provides the highest utility.
Consumers want to maximize utility, but must do so within a budget constraint.

9. Budgets
The budget line – shows the consumption bundles available to a consumer who spends all of his income.
The consumer’s challenge is two-fold:
1. Find the bundles of goods that are affordable, given income and prices, and
Choose the bundle that provides the highest utility.
Consumers want to maximize utility, but must do so within a budget constraint.
Good Y B A C
The consumer’s challenge is two-fold:
1. Find the bundles of goods that are affordable, given income and prices, and
Choose the bundle that provides the highest utility.
Good X

10. Figure The Budget Line Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

11. Optimal Consumption
Optimal Consumption Bundle – the consumption bundle that maximizes the consumer’s total utility given his/her budget constraint.
The optimal consumption bundle is the point on the budget line that represents the combination of consumption of the two goods with the highest levels of utility for each good.
The consumer’s challenge is two-fold:
1. Find the bundles of goods that are affordable, given income and prices, and
Choose the bundle that provides the highest utility.
Consumers want to maximize utility, but must do so within a budget constraint.

12. Table Sammy’s Utility from Clam and Potato Consumption Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

13. Table Sammy’s Budget and Total Utility Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

14. Figure Optimal Consumption Bundle Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

15. Spending the Marginal Dollar
Marginal utility is the amount of satisfaction received from each additional unit consumed.
MU per dollar – how much additional utility a consumer receives from each additional dollar spent on a good. Equals the marginal utility divided by the price of the good in dollars. MU/P
Optimal consumption occurs when the MU per dollar of both products are equal.
Formula: MUc = MUp
Pc Pp
c = clams p = potatoes
The “utility maximization rule” says that the consumer should spend all of his income on two goods such that:
MU/P is equal for both (all) goods.
As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of utility per dollar just equals that of the other product.

16. Table Sammy’s Marginal Utility per Dollar Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

17. Figure Marginal Utility per Dollar Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

18. Optimal Consumption Rule
The “utility maximization” or “optimal consumption” rule says that the consumer should spend all of his income on two goods such that:
MU/P is equal for both (all) goods.
As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of utility per dollar just equals that of the other product.
The “utility maximization rule” says that the consumer should spend all of his income on two goods such that:
MU/P is equal for both (all) goods.
As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of utility per dollar just equals that of the other product.