ECON 2020 Priniciples of Microeconomics: Chapter 7: Utility Maximization

ECON 2020
Priniciples of Microeconomics
Chapter 7: Utility Maximization
Hyeon Joon Shin

Assistant Professor of Economics
The Falls School of Business, Anderson University
Semester II, 2014-15
Shin (FSB, Anderson Univ.)
1 / 19
Understanding Consumer Behavior

2 / 19

Problem
Why do business people have to understand consumer behavior?
2 / 19

Problem
Each rm produces its good or service and sell it to consumers in order
to maximize its prot.
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Problem
Consumers purchase their optimal bundle set among many goods and
services.
2 / 19

Problem
services.
When a rms good or service is not chosen by consumers anymore, the
rm should go out of business.
2 / 19

Problem
services.
Thus, each rm has to keep abreast of trends in consumer demand to
survive in businees and maximize its prot.
2 / 19

Problem
services.
Thus, each rm has to keep abreast of trends in consumer demand to
survive in businees and maximize its prot.
Therefore, understanding the microeconomics of consumer behavior is
the rst step in managing rms.
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Basic Assumptions of Consumer Theory
3 / 19

Utility The satisfaction that each consumer obtains from
consuming goods and services
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Rational Behavior Each consumer is a rational, self-interested person
who tries to use his/her income to obtain the maximum
utility from consuming goods and services.
3 / 19

Preferences Each consumer has clear-cut preferences for certain
goods and services that are available in the market.
3 / 19

Preferences Each consumer has clear-cut preferences for certain
goods and services that are available in the market.
Each rational and self-interested consumer prefers a certain good or
service that gives him/her higher utility to other goods or services.
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Basic Assumptions of Consumer Theory (contd)
4 / 19

Budget Constraint The limited income that each consumer spends on
goods and services.
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goods and services.
Each consumer uses all his/her income up for his/her consumption,
without borrowing or saving.
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goods and services.
Prices The prices of goods and services are determined by the

market supply and demand.
4 / 19

goods and services.

Each consumers choice cannot aect the prices.
4 / 19

goods and services.

Each consumers choice cannot aect the prices.
Theorem
Given the prices of goods and services, each consumer chooses the optimal
bundle set that maximizes his/her utility, subject to his/her budget
constraint.
4 / 19
Utility
Denition
5 / 19
Utility
Denition
Utility Consumerssatisfaction obtained from consumption
5 / 19
Utility
Denition
Utility is not a synonym for "usefulness."
5 / 19
Utility
Denition
Example
A ticket to a Colts game gives us utility, but it is useless functionally.
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Utility
Denition
Example
The utility of a good or service may vary from person to person.
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Utility
Denition
Example
Example
An economics textbook may have greater utility to business students than
to medical students.
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Utility
Denition
Example
Example
Utility is assumed to be measure with units called utils.
5 / 19
Utility
Denition
Example
Example
Utility is assumed to be measure with units called utils.
Example
You may get 100 utils from a donation and 50 utils from a Colts game.
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Utility
The Law of Diminishing Marginal Utility
6 / 19
Utility

Total Utility The total amount of utility obtained from consuming
some specic quantity of a good or service.
6 / 19
Utility

Marginal Utility The extra amount of utility obtained from consuming
an additional unit of a good or service.
6 / 19
Utility

Marginal utility is the change in total utility that results from the
consumption of one more unit of a good or service.
6 / 19
Utility

Marginal utility is the change in total utility that results from the
consumption of one more unit of a good or service.
Theorem
As a consumer increases consumption of a good or service, the marginal
utility of that good or service declines.
6 / 19
Utility
The Law of Diminishing Marginal Utility (contd)
7 / 19
Utility
Total and Marginal Utility of Consuming Taco (Figure 7.1)
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Utility
As more of a product is consumed, total utility increases at a

diminishing rate, reaches a maximum, and then declines.
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Utility
As more of a product is consumed, total utility increases at a

diminishing rate, reaches a maximum, and then declines.
As more of a product is consumed, marginal utility continues to
decrease, reaches zero at the maximum of total utility, and turns to be
negative.
7 / 19
Utility
8 / 19
Utility
8 / 19
Utility
Problem
Using graphs, illustrate how total utility and marginal utility change as the
consumption of taco changes.
8 / 19
Utility
Problem
Using graphs, illustrate how total utility and marginal utility change as the
consumption of taco changes.
Total Utility Curve and Marginal Utility Curve:
8 / 19
Utility Maximization
Utility-Maximizing Rule
9 / 19
Theorem
When the prices of goods and services are given, each consumer chooses
the optimal bundle set that maximizes his/her utility, subject to his/her
budget constraint.
9 / 19
Theorem
budget constraint.
Utility-Maximizing Rule To maximize utility, each consumer should
allocate his/her income so that the last dollar spent on
each good yields the same amount of marginal utility.
9 / 19
Theorem
budget constraint.
Problem
For simplicity, suppose there are only two goods, apple and orange. What
is meant by this utility-maximizing rule? How does this rule work?
9 / 19
Theorem
budget constraint.
Problem
1
The sum of dollars spent on two goods should be equal to income.
9 / 19
Theorem
budget constraint.
Problem
1
2
The sum of dollars spent on two goods should be equal to income.

Marginal utilities per dollar of two goods should be equal.
9 / 19
Marginal Utility per Dollar
10 / 19
Problem
A pizza will give you 36 utils and cost you $12. A movie which costs you
$6 will give you 24 utils. What do you choose, a pizza or a movie?
10 / 19
Problem
If you are rational, you would choose the movie rather than the pizza!
10 / 19
Problem
The marginal utility per dollar spent on the movie would be 4 utils
utils
= 24 $6
.
10 / 19
Problem
utils
= 24 $6
.
The marginal utility per dollar spent on the pizza would be 3 utils
utils
= 36$12
.
10 / 19
Problem
utils
= 24 $6
.
utils
= 36$12
.
The rational consumer must compare the marginal utility from each
product with its added cost.
10 / 19
Problem
utils
= 24 $6
.
utils
= 36$12
.
The rational consumer must compare the marginal utility from each
product with its added cost.
To make the amounts of marginal utility derived from dierently priced
goods comparable, marginal utilities must be put on a per-dollar-spent
basis.
10 / 19
Utility Maximization: A Numerical Example
11 / 19
Utility Maximization: A Numerical Example
Problem
(1) Find all possible combinations of apples and oranges obtainable with
an income of $10.
11 / 19
Utility Maximization: A Numerical Example (contd)
12 / 19
Problem
(2) Find the utility-maximizing combination among them, using the
utility-maximizing rule.
12 / 19
13 / 19
Problem
(3) Make sure if your utility-maximizing combination achieves the highest
total utility.
13 / 19
Algebraic Generalization
14 / 19
The utility-maximizing rule can be represented by the following two
equations:
(1)
(PA QA ) + (PB QB ) = I
MUB of QB
MUA of QA
=
PA
PB
(2)
14 / 19
equations:
(1)
(PA QA ) + (PB QB ) = I
MUB of QB
MUA of QA
=
PA
PB
(2)
PA = Price of A
14 / 19
equations:
(1)
(PA QA ) + (PB QB ) = I
MUB of QB
MUA of QA
=
PA
PB
(2)
PA = Price of A
PB = Price of B
14 / 19
equations:
(1)
(PA QA ) + (PB QB ) = I
MUB of QB
MUA of QA
=
PA
PB
(2)
PA = Price of A
PB = Price of B
QA = Quantity of A
14 / 19
equations:
(1)
(PA QA ) + (PB QB ) = I
MUB of QB
MUA of QA
=
PA
PB
(2)
PA = Price of A
PB = Price of B
QA = Quantity of A
QB = Quantity of B
14 / 19
equations:
(1)
(PA QA ) + (PB QB ) = I
MUB of QB
MUA of QA
=
PA
PB
(2)
PA = Price of A
PB = Price of B
QA = Quantity of A
QB = Quantity of B
I = Income
14 / 19
Algebraic Generalization (contd)
15 / 19
We found out that the utility-maximizing combination of apples and
oranges with an income of $10 is:
15 / 19
2 apples and 4 oranges.
15 / 19
Case (1): If the consumer spent $10 on 0 apples and 5 oranges, then
MUB of QB
MUA of QA
>
PA
PB
15 / 19
MUB of QB
MUA of QA
>
PA
PB
The consumer should consume more apples and less oranges to
maximize utility.
15 / 19
MUB of QB
MUA of QA
>
PA
PB
maximize utility.
Case (2): if the consumer spent $10 on 4 apples and 3 oranges, then
MUA of QA
MUB of QB
<
PA
PB
15 / 19
MUB of QB
MUA of QA
>
PA
PB
maximize utility.
Case (2): if the consumer spent $10 on 4 apples and 3 oranges, then
MUA of QA
MUB of QB
<
PA
PB
The consumer should consume less apples and more oranges to
maximize utility.
15 / 19
Utility Maximization and the Demand Curve

16 / 19

Assume that, other things being equal, the price of oranges falls to $1.
16 / 19

Marginal utilities per dollar of oranges will double.
Unit
1
2
3
4
5
6
7
Apple (Price = $1)

MU
MU/$
10
10
8
8
7
7
6
6
5
5
4
4
3
3
Orange (Price = $1)

MU
MU/$
24
24
20
20
18
18
16
16
12
12
6
6
4
4
16 / 19

Marginal utilities per dollar of oranges will double.
Unit
1
2
3
4
5
6
7
Apple (Price = $1)

MU
MU/$
10
10
8
8
7
7
6
6
5
5
4
4
3
3
Orange (Price = $1)

MU
MU/$
24
24
20
20
18
18
16
16
12
12
6
6
4
4
Problem
Find the utility-maximizing combination of apples and oranges, and nd
out how the price decrease in oranges changes the utility-maximizing
quantity of oranges.
16 / 19

Utility Maximization and the Demand Curve (contd)
17 / 19

Lets derive an individual demand curve for oranges:
17 / 19

Lets derive an individual demand curve for oranges:
By looking at the individual demand for oranges, we can make sure of

the law of demand.
17 / 19

Substitution Eect and Income Eect
18 / 19

This increase in the quantity demanded of oranges can be explained by
two eects: substitution eect and income eect.
18 / 19

Substitution Eect The eect of a change in the relative price of

oranges to apples on a change in the quantity demanded
of oranges
18 / 19


of oranges
When the price of oranges falls from $2 to $1, the relative price of
oranges to apples also falls from $2 to $1.
18 / 19


of oranges
After this relative price change,
MUA of QA
MUB of QB
<
.
PA
PB
18 / 19


of oranges
After this relative price change,
MUA of QA
MUB of QB
<
.
PA
PB
This caused the consumer to switch his/her consumption from apples
toward oranges.
18 / 19
Substitution Eect and Income Eect (contd)
19 / 19

Income Eect The eect of a change in the price of oranges on the
consumers real income and thus on the quantity
demanded of oranges
19 / 19

demanded of oranges
When the price of oranges falls from $2 to $1,
(PA
QA ) + (PB
QB ) < I .
19 / 19

demanded of oranges
When the price of oranges falls from $2 to $1,
(PA
QA ) + (PB
QB ) < I .
This real income increase caused the consumers to buy more oranges.
19 / 19

ECON 2020 Priniciples of Microeconomics: Chapter 7: Utility Maximization

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ECON 2020 Priniciples of Microeconomics: Chapter 7: Utility Maximization

Cargado por

Copyright:

Formatos disponibles

ECON 2020

Hyeon Joon Shin

Semester II, 2014-15

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Basic Assumptions of Consumer Theory

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Basic Assumptions of Consumer Theory

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Basic Assumptions of Consumer Theory

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Basic Assumptions of Consumer Theory

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Basic Assumptions of Consumer Theory

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Prices The prices of goods and services are determined by the

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Understanding Consumer Behavior

Prices The prices of goods and services are determined by the

Shin (FSB, Anderson Univ.)