Utility Maximization & Consumer Behavior

• This study guide covers utility maximization, consumer behavior, and indifference curves.

Terminology

• Utility is satisfaction from a good or service, and is a subjective measurement that is difficult to quantify.
• Utility is measured in utils, where one util equals one unit of satisfaction or pleasure.
• Total utility is the total amount of satisfaction.
• Marginal utility is the extra satisfaction from an additional unit of a good.
• MU = ΔTU/ΔQ, where MU is marginal utility, TU is total utility, and Q is quantity.

Law of Diminishing Marginal Utility

• The law states that as consumption of a good or service increases, the marginal utility from each additional unit decreases.
• The law of diminishing marginal utility explains the downward-sloping demand curve.

Theory of Consumer Behavior

• Rational behavior is the assumption that consumers try to derive the greatest satisfaction from their income.
• Preferences exist where each consumer has preferences for certain goods/services and how much marginal utility they might get from consuming more units.
• A budget constraint exists where at any time, consumers have a limited amount of money to spend.
• Prices exist where every good has a price that is unaffected by the amount purchased by the consumer.

Utility Maximizing Rule

• The question is: Of all the possible combinations of goods and services a consumer can attain within their budget, which specific combination will yield the maximum utility or satisfaction?
• Consumers should allocate their income so the last dollar spent on each product yields the same amount of extra (marginal) utility to maximize satisfaction.
• MU of product A / Price of A = MU of product B / Price of B is the utility-maximization rule.
• It is impossible to compare utilities apples to oranges, but marginal utility per dollar can be compared by dividing the marginal utility of the good by its price.
• If MUa/Pa > MUb/Pb, select good A.
• If MUa/Pa = MUb/Pb, be indifferent and select both goods.

Steps to Maximize Utility

• Use the MU/price condition to select consumption of products given consumer income.
• Select product A if MUa/Pa > MUb/Pb.
• Be indifferent and select both products if MUa/Pa = MUb/Pb.
• Find the profit-maximizing combinations of total utility from both goods.

Utility Maximization and the Demand Curve

• Basic determinants of an individual's demand are preferences/tastes, income, and prices of other goods.
• Understanding the utility-maximizing rule helps in seeing why price and quantity demanded are inversely related.

Income and Substitution Effects

• The income effect is the impact a price change has on a consumer's real income and, consequently, on the quantity demanded of the good.
• The price of a good falling frees up income, which can be used to buy more of one or both goods.
• The substitution effect is the impact a price change has on a product's relative expensiveness.
• The price of a certain product falling decreases its relative expensiveness
• More of that item is purchased rather than another relatively more expensive substitute, eg Coke and Pepsi.

Indifference Curve Analysis

• Indifference curve analysis is an alternative to utility maximization theory.
• It is difficult to measure utility.
• Preferences for products are ranked or ordered.
• It takes into account the consumer's budget.
• This helps to derive a demand curve.

The Budget Line

• A budget line is a schedule/curve demonstrating various combinations of two products a consumer can purchase within their income.
• A budget line can also be referred to as the consumer's budget constraint.
• Increased income shifts the budget line to the right.
• Decreased income shifts the budget line to the left.
• A change in the price of one/both goods also influences the location of the budget line.
• An increase (decrease) in the price of one product will shift the budget line down (out), reflecting the ability to buy fewer (more) products.
• The prices of both goods increasing (decreasing) shifts the budget line left (right), reflecting the loss (increase) in the ability to purchase.
• The slope is the ratio of the price of B to the price of A.

Indifference Curves

• It consists of combinations of two products that yield the same total utility.
• The consumer is indifferent when purchasing a combination
• They are downward sloping where more of one product means there are fewer units of the other to maintain total utility.
• It is convex to the origin.
• The indifference map is a series of indifference curves where each curve reflects different amounts of utility.
• Indifference curves cannot cross and as one moves away from the origin, the level of utility increases.
• The consumers equilibrium consists of where the indifference curve is tangent to the budget line, which means that it is maximized.
• MRS = PB/PA, where MRS equals the ratio of the price of B to the price of A.