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Utility Maximization
THE LAW OF DEMAND
A Closer Look…
The Income Effect
A lower price frees income
for additional purchases -
and vice versa
The Substitution Effect
A lower price relative to other
goods attracts new buyers -
and vice versa
LAW OF DIMINISHING
MARGINAL UTILITY
• Utility Defined
• Subjective Nature
• Difficult to Quantify
Total Utility
Marginal Utility
graphically examined..
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30
0 1 2 3 4 5 6 7
0 1 2 3 4 5 6 7
8
2 18
0 1 2 3 4 5 6 7
8
2 18
6
3 24 0 1 2 3 4 5 6 7
8
2 18
6
3 24 0 1 2 3 4 5 6 7
4
4 28
Units consumed per meal
8
2 18
6
3 24 0 1 2 3 4 5 6 7
4
4 28
Units consumed per meal
8
2 18
6
3 24 0 1 2 3 4 5 6 7
4
4 28
Units consumed per meal
8
2 18
6
3 24 0 1 2 3 4 5 6 7
4
4 28
Units consumed per meal
0 0
20
Observe
10 Diminishing
1 10 10
8
2 18 Marginal
6
3 24 0 1
Utility
2 3 4 5 6 7
4
4 28
Units consumed per meal
First 10 10 24 12
First 10 10 24 12
First 10 10 24 12
First 10 10 24 12
Decision: Buy 1
Product B for $2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth What
6 next?
6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth What
6 next?
6 16 8
Fifth 5 5 12 6
Buy one of each
Sixth 4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth
and
5
then...
5 12 6
Sixth ($5 left)
4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth third
5 unit
5 of
12 6
Sixth product
4 4 B 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6
$3 left... 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6
$3 left... 6 16 8
Fifth 5 5 12 6
Buy
Sixth both!
4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)
First 10 10 24 12
Second 8 8 20 10
Third 7
Income is gone... 7 18 9
Fourth
the last dollar 6spent on6 16 8
each good gave the same
Fifth 5 5 12 6
utility (8) per dollar
Sixth 4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
MU of product A MU of product B
Price of A
= Price of B
8 Utils 16 Utils
$1
= $2
UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule
and Curve
Given from the previous example schedule:
• Preferences or Tastes
• Money Income
• Prices of Other Goods
UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule
and Curve
Create a demand schedule from the
purchase decisions as the price of
the product is varied ...
Price per unit of B Quantity Demanded
$2 4
1 6
Graphically…
UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule
and Curve
DB
0
4 6
Quantity Demanded of Good B
UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule
and Curve
Income
$2
and
Price per unit of Good B
Substitution Effects
Revisited
1
DB
0
4 6
Quantity Demanded of Good B
APPLICATIONS AND EXTENSIONS