FACULTY OF BUSINESS ADMINISTRATION

ECONOMICS I
ECN101
[Handout]
C h a p t e r E i g h t

8 UTILITY AND DEMAND

Utility and Demand

• Economists assume that people behave to make themselves as well off as possible.
• Consumption possibilities tell us what the consumer can afford to buy given a limited
income and the prices of the goods and services they are considering.
• Preferences are reflected in the discussion of utility maximization

I. Consumption Choices
• Consumption possibilities are all the things a consumer can afford to buy.
1. The Budget Line
• The limits of consumption possibilities are illustrated
with a budget line.
• The budget line marks the boundary between those
combinations of goods and services that the
consumer can afford to buy and those that it cannot
afford.
• The budget line shown illustrates the possible
combinations of pizza and books that a consumer
with $50 income could purchase if the price of
pizzas were $10 and the price of books were $10.
• The budget line constrains choices: Points on the
budget line and inside the budget line are affordable
and within the consumer’s consumption possibilities.
Points beyond the budget line are not affordable.

Changes in Consumption Possibilities

• Consumption possibilities change when income or prices change.
• An increase in income shifts the budget line rightward without changing its slope.
• A change in the price of one of the goods changes the intercept on its axis and changes the
slope of the budget line.
• These changes are used again in the alternate consumer choice model in chapter 9.

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2. Preferences
• The choice a consumer makes depends on preferences.
Total utility Quantity of Total Quantity Total
• Total utility is the total benefit that a person movies utility of books utility
gets from the consumption of goods and 0 0 0 0
services. As more of a good or service is 1 24 1 20
consumed, total utility increases. 2 44 2 30
• The table provides an example of utility from 3 72 3 38
consuming movies and paperback books in a 4 80 4 44
given week. 5 84 5 48
6 86 6 50
Marginal Utility
• Marginal utility is the change in total utility that Quantity of Total Marginal
results from a one-unit increase in the quantity of a movies utility utility
good consumed. The table shows the marginal utility 0 0 -
from movies. 1 24 24
• When a good generates value, it has a positive 2 44 20
marginal utility. Total utility increases as the quantity 3 72 18
consumed increases. 4 80 8
Diminishing Marginal Utility
• Diminishing marginal utility is the principle that as more of a good or service is consumed,
its marginal utility decreases. In the table the marginal utility diminishes as more movies are
consumed.

II. Utility-Maximizing Choice

• A consumer’s choices influence the total level of his or her utility because different
combinations of goods generate different amounts of utility. The key assumption of marginal
utility theory is that the household consumes the combination that maximizes its utility.
• We have to combine the constraint imposed by the budget line with the consumer’s
preferences to find the combination of products that gives the consumer the maximum available
utility.

Consumer Equilibrium
• Consumer equilibrium occurs when a situation in which a consumer has allocated all available
income in a way that maximizes utility given the prices of the products.

A Spreadsheet Solution
• The most direct way to find the quantity of Quantity of Total Quantity Total
goods and services is to make a table with the movies utility of books utility
choices available. Suppose the price of a movie 0 0 0 0
is $8, the price of a book is $4, and the 1 24 1 20
consumer has income of $24. 2 44 2 30
• Calculate the combinations of products 3 72 3 38
that exhaust the available income given the 4 80 4 44
prices of the goods. In the table, the 5 84 5 48
consumer can afford (3 movies/0 books),
6 86 6 50
(2 movies/2 books), (1 movie/4 books), and
(0 movies/6 books). While the consumer can also afford the combinations of products inside

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 the budget line, the smaller quantities associated with those points would have less utility
than the points on the budget line.
• From the utility figures given for each product, calculate the total utility from the
combination of the two products. In the same order as the affordable combinations above,
these total utilities are 72, 74, 68, and 50. Emphasize that it is total utility from the
combination of the two products that the consumer is trying to maximize.
• Select the combination that gives the maximum total utility, (2 movies/2books for total
utility of 74) in this case.
• While in a model we might calculate the total utility from all the possible combinations of
products and then select the combination with the highest utility, this is not a likely approach for
consumers in practice.
• A more natural way to find the consumer equilibrium is to use marginal analysis to make the
decision.

Choosing at the Margin

• A consumer’s utility is maximized when the consumer spends all available income and equalizes
marginal utility per dollar for all goods. The marginal utility per dollar is the marginal utility
from a good divided by its price.
• If the consumer is left Marginal Marginal
with money to spend, Quantity Marginal utility per Quantity Marginal utility per
opportunities for of utility dollar of books utility dollar
increasing utility are movies
left unused, so the 1 22 2.75 1 15 4.75
consumer can only be 2 18 2.25 2 9 2.25
maximizing utility 3 13 1.63 3 7 1.75
when all available
4 6 0.75 4 5 1.25
income is spent.
5 3 0.38 5 3 0.75
• The table to the right
has the marginal utility schedules that are computed from the total utility schedules in the table
above. (The marginal utilities are the averages of the two adjacent marginal utilities for each
quantity.) Given the price of a movie of $8, the price of a paperback book of $4, the table also has
the marginal utility per dollar schedules. Assume the consumer has $24 to allocate between
movies and books. To maximize utility, the individual buys 2 movies and 2 books because that
combination of movies and books spends all the available income and sets the marginal utility
per dollar from a movie equal to that from a book. (Both equal 2.25.)
• The rule to spend all income and equalize marginal utility per dollar from each good maximizes
utility because anytime the marginal utility per dollar from one good exceeds that of another
good, the consumer can increase his or her total utility by spending a dollar less on the good
with the lower marginal utility per dollar and spending the dollar on the good with the higher
marginal utility per dollar.

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The Power of Marginal Analysis
• The goal of maximizing utility does not require a computer and spreadsheet, but simply
comparing the marginal utility per dollar of each of the products.
• In the example the person’s choice between movies and books, the person maximizes his or her
utility where the marginal utility per dollar from movies is equal to the marginal utility per dollar
from books. Mathematically, this is represented by the equation:
MUMovie MUBook
=
PMovie PBook

Utility Maximization Conclusion (2 Conditions)

1. The marginal utility per dollar for the 2 goods should be equal.

2. The quantities chosen with their prices should equal to the income.
(Income = Expenditure) →

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