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Principles of Economics

Consumer Behavior and Utility Maximization

Throughout our lives each of us makes choices that contribute to our happiness.
Economists want to know how we make these choices, because if economists know how
people behave then they may be able to predict how they will react to various events.
(How, for example, will people respond if their taxes are cut? How much more money
will they save? Will they work harder or less hard? What and how much more will they
buy?)

In a nutshell, here’s the prevailing theory: an individual measures the expected benefits of
an action against its costs; the rational consumer makes choices in which the benefits are
high relative to the costs.

Consider this ratio: benefit/cost

The rational individual makes the choices in which this benefit/cost ratio is the highest.

Economists study many different types of choices; three important ones are:
1. How does an individual decide what and how much to buy?
2. How does an individual decide how much to work?
3. How does and individual decide how much to save?

We shall examine these choices more closely below.

But first, a few definitions. How do economists measure happiness?

Utility: means happiness, or well-being

Total utility: is the total amount of happiness experienced by the individual. Economists
usually assume that it is the goal of the individual to maximize her/his total utility.

Marginal utility: is the increase in total utility when 1 more unit of an activity is
undertaken. Example: consider the activity “consuming potato chips.” Here’s a chart
representing a hypothetical individual’s marginal chip utility and total chip utility:

Author: Michael Francis Williams. This material is copyrighted. All rights reserved. 1
 Example: (below, we measure utility in units known as utils)

Potato chips eaten Marginal chip utility Total chip utility

0 -- 0
1 50 50
2 40 90
3 30 120
4 15 135
5 5 140

Diminishing marginal utility: Note from the above table that all 5 of the chips add to the
individual’s total utility (happiness). But the 2nd chip adds less marginal utility than the
1st chip; the 3rd chip adds less utility than the 2nd chip, etc. This is known as the law of
diminishing marginal utility; marginal utility falls as consumption of a good rises.

Enough with the definitions. Let’s look at consumption of goods and services, and try to
develop a rule that the individual can follow to purchase the types and amounts of things
that maximize her/his utility.

Consumption: What and how much of each good should a person buy?

A consumer does not randomly expend her income on haphazard goods and
services; rather, she buys the products which both give her much satisfaction and are
relatively cheap. For example, a vegetarian would definitely NOT spend $1000 for a
pound of hamburger, but she would happily spend five cents for ten pounds of
vegetables.
Economists give structure to these general observations by saying that a "rational"
consumer (a person who can distinguish which products she likes and dislikes, and can
rank them from best to worst) with a limited budget will consume goods and services in
an amount that maximizes her total utility. Mathematically, this utility-maximizing
consumer will purchase the types and amounts of goods and services that yield the
greatest marginal utility per dollar available, until her income is exhausted. When the
consumer follows this purchasing strategy, she will find that after all of her income has
been spent, the marginal utility per dollar of all the products she consumed will be equal.

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To illustrate this economic concept, consider the following simplified example: A

rational consumer has $5 of income, which she can spend on either apples or oranges.
Each apple costs $1, and each orange costs $1. The consumer can gain the following
marginal utility from each fruit:
Apples Consumed Marginal Utility Oranges Consumed Marginal Utility
1 400 1 350
2 300 2 200
3 200 3 150
4 100 4 50
5 50 5 25

(Note that this example is consistent with the law of diminishing marginal utility, in that
as successive units of each good are consumed, the marginal utility of each good is
falling.)
So, the question is, how many of each good should the consumer buy in order to
maximize her total utility? (Note that total utility is the sum of the marginal utilities.)

For example, if the consumer were to spend her entire $5 budget on apples, her total
utility would equal
400 + 300 + 200 + 100 + 50 = 1050 total utils
For another example, if the consumer were to spend her entire $5 on oranges, her total
utility would equal
350 + 200 + 150 + 50 + 25 = 775 total utils
But neither of these examples uses the $5 wisely; there is some other combination of
apples and oranges that provides more total utility!

Utility-maximizing rule: the consumer should purchase the goods available

which give her the highest marginal utility per dollar, until her income is exhausted. The
first fruit she should purchase is an apple, since it is the good available which gives her
the highest utility per dollar:
STEP 1: Buy first apple. It provides 400 utils per dollar (400/$1).
Its marginal utility is 400, so it adds 400 to total utility.
AFTER STEP 1: Total utility equals 400. Income remaining is $4

Next she should buy the first orange, since it now is the good available which
provides the highest marginal utility per dollar. (The first apple is no longer available,
since she's bought that one already in step 1.)

Author: Michael Francis Williams. This material is copyrighted. All rights reserved. 3
STEP 2: Buy 1st orange. It provides 350 utils per dollar (350/$1).
Its marginal utility is 350, so it adds 350 to total utility.
AFTER STEP 2: Total utility = 400 + 350 = 750. Income left is $3.

Next she should buy the second apple, since it now is the good available which
provides the most marginal utility per dollar.
STEP 3: Buy 2nd apple. It provides 300 utils per dollar (300/$1).
Its marginal utility is 300, so it adds 300 to total utility.
AFTER STEP 3:Total utility = 400+350+300 = 1050. Income left is $2.

Next she should buy either the third apple or the second orange, since either of
these goods will provide the same (and highest available) utility per dollar. Let's assume
that she buys the third apple.
STEP 4: Buy 3rd apple. It provides 200 utils per dollar (200/$1).
Its marginal utility is 200, so it adds 200 to total utility.
AFTER STEP 4:Total utility=400+350+300+200 = 1250. Income left is $1.

Finally, she should buy the second orange, since it now is the good available
which provides the most marginal utility per dollar.
STEP 5: Buy 2nd orange. It provides 200 utils per dollar (200/$1).
Its marginal utility is 200, so it adds 200 to total utility.
AFTER STEP 5:Total utility=400+350+300+200+200=1450. Income left is $0.

Thus this fictitious consumer has maximized total utility (equal to 1450 utils) by
consuming 3 apples and 2 oranges. Note that she has satisfied the utility maximizing
rule, as we would expect; that is, the marginal utility per dollar of apples at her
consumption of 3 apples is:

Marginal utility of third apple / price of an apple = 200/$1 = 200

and the marginal utility per dollar of oranges at her consumption of 2 oranges is:
Marginal utility of 2nd orange / price of an orange = 200/$1 = 200

So both are the same! Hooray! She's maximizing utility! Zowie!

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More generally:
1) A rational consumer maximizes total utility.
2) This maximization is accomplished by purchasing the types and amounts of
products available which yield the highest marginal utility per dollar.
3) After the utility-maximizing person has exhausted her income, the marginal
utility per dollar of all of the products she consumes will be equal. (This is the "utility-
maximizing rule.")

Applying Utility-Maximization Theory: Test your knowledge of utility-maximization

theory by applying it to specific situations through answering the following questions:
(Answers appear on subsequent pages)

Questions
1. Dr. McCoy has $17 to spend on soda and/or beer and/or wine. Beer costs $2 per unit,
Soda costs $1 per unit, and wine costs $4 per unit.
McCoy's marginal utilities for these beverages are listed below:

Units of Product MU of Soda MU of Beer MU of Wine

1 10 50 60
2 9 40 40
3 8 30 32
4 7 20 24
5 6 16 20
6 5 12 16

a) What combination of beverages should Dr. McCoy purchase in order to maximize total
utility?

b) Calculate Dr. McCoy's total utility.

c) Use the utility-maximizing rule to verify that Dr. McCoy has indeed maximized his
utility.

2. Mr. Spock has purchased shirts and slacks in such a manner that when his income was
exhausted, the marginal utility of shirts is 1000 utils, and the marginal utility of slacks is
2000 utils. Shirts cost $10 a piece; slacks are $25.

a) Has Mr. Spock maximized his total utility? Explain.

b) How should Mr. Spock change his consumption pattern to increase his total utility; i.e.
should he consume more or fewer shirts? More or fewer slacks? Explain.

Author: Michael Francis Williams. This material is copyrighted. All rights reserved. 5
3. Captain Kirk has eaten Twinkies and Ding Dongs in such a manner that when his
income was exhausted, the marginal utility of Twinkies is 100 utils, and the marginal
utility of Ding Dongs is 50 utils. Twinkies are $1 a piece; Ding Dongs are 50 cents.

a) Is Kirk maximizing his total utility? Explain.

b) Now suppose that the price of a Ding Dong falls to 25 cents (while the price of
Twinkies remains the same.) Should Kirk consume more or fewer Ding Dongs as a result
of the price reduction? Explain using the utility maximizing rule.

c) Was Captain Kirk's response in (b) consistent with the Law of Demand? Explain.

d) Can you see now how the Law of Diminishing Marginal Utility is directly related to
the Law of Demand? (That is, that diminishing marginal utility leads to more of a
product being demanded at a lower price?) I hope so. Beam me up, Scotty.

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Answers
1. Dr. McCoy has $17 to spend on soda and/or beer and/or wine. Beer costs $2 per unit,
Soda costs $1 per unit, and wine costs $4 per unit.
McCoy's marginal utilities for these beverages are listed below:

Units of Product MU of Soda MU of Beer MU of Wine

1 10 50 60
2 9 40 40
3 8 30 32
4 7 20 24
5 6 16 20
6 5 12 16

a) What combination of beverages should Dr. McCoy purchase in order to maximize total
utility? One soda, 4 beers, 2 wine

b) Calculate Dr. McCoy's total utility.

10 + 50 + 40 + 30 + 20 + 60 + 40 = 250 utils

c) Use the utility-maximizing rule to verify that Dr. McCoy has indeed maximized his
utility.
MU/p for soda = 10/$1 = 10 utils per dollar
MU/p for beer = 20/$2 = 10 utils per dollar
MU/p for wine = 40/$4 = 10 utils per dollar

2. Mr. Spock has purchased shirts and slacks in such a manner that when his income was
exhausted, the marginal utility of shirts is 1000 utils, and the marginal utility of slacks is
2000 utils. Shirts cost $10 a piece; slacks are $25.

a) Has Mr. Spock maximized his total utility? Explain.

No. MU/p for slacks does not equal MU/p for shirts:
MU/p for slacks = 2000/25 = 80 utils per dollar
MU/p for shirts = 1000/10 = 100 utils per dollar

b) How should Mr. Spock change his consumption pattern to increase his total utility; i.e.
should he consume more or fewer shirts? More or fewer slacks? Explain.

Spock was getting more utils per dollar from shirts—he should have bought more of
them. Meanwhile, he was getting fewer utils per dollar from slacks—he should have
bought fewer of them.

Author: Michael Francis Williams. This material is copyrighted. All rights reserved. 7
3. Captain Kirk has eaten Twinkies and Ding Dongs in such a manner that when his
income was exhausted, the marginal utility of Twinkies is 100 utils, and the marginal
utility of Ding Dongs is 50 utils. Twinkies are $1 a piece; Ding Dongs are 50 cents.

a) Is Kirk maximizing his total utility? Explain.

Yes! MU/p for ding dongs = MU/p for Twinkies

MU/p for ding dongs = 50/.5 = 100 utils per dollar
MU/p for Twinkies = 100/1 = 100 utils per dollar

b) Now suppose that the price of a Ding Dong falls to 25 cents (while the price of
Twinkies remains the same.) Should Kirk consume more or fewer Ding Dongs as a result
of the price reduction? Explain using the utility maximizing rule.

The new MU/p for Ding dongs = 50/.25 = 200 utils per dollar. Ding-dongs are
now a better deal than Twinkies; Kirk should buy more of them.

c) Was Captain Kirk's response in (b) consistent with the Law of Demand? Explain.

Yes. A lower ding-dong price makes Kirk buy more ding-dongs.

d) Can you see now how the Law of Diminishing Marginal Utility is directly related to
the Law of Demand? (That is, that diminishing marginal utility leads to more of a
product being demanded at a lower price?) I hope so. Beam me up, Scotty.
Yes.

Total Utility Graphed

One can use indifference curves to graph a person's prospective total utility levels

An indifference curve represents all combinations of two goods that provide the
individual with an equal level of total utility.

Example: Suppose that we know that each of these combinations of pizza and beer give
Biff a total or 100 utils of utility:

point Units of Units of Total utility

beer pizza
A 100 100 100 utils
B 90 107.3 100 utils
C 80 116 100 utils
D 70 126.8 100 utils

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Example continued: If we graphed the points from the table and connected them, then
we’d get a nice indifference curve that looks like this:

Units of
pizza
consumed

U = 100

Units of beer
consumed

Utility maximization and indifference curves: For any person, she really has an infinite
number of indifference curves—one for each possible utility level. It is generally
desirable for the individual to "get on" the highest indifference curve that she is able to
(given any constraints that she faces); this indicates that she is maximizing her total
utility.

Constraints facing the individual

No individual can attain an infinitely high level of utility. This is because each individual
faces some barriers, or constraints, that limit her feasible choices. Generally one faces
time constraints and income constraints. In addition, one must usually buy the things that
one consumes.

We shall often ignore (explicitly, anyway) the time constraint and consider only the
income constraint

Income constraint: specific example

Consider Bozo, who can buy two goods, cheese and donuts, at price $5 per unit of cheese
and $2 per unit of donuts. Suppose that Bozo has $100 of income
.
Bozo’s budget constraint can be written

5(units of cheese) + 2(units of donuts) = 100

For ease of graphing, we can solve this equation for units of donuts:

Author: Michael Francis Williams. This material is copyrighted. All rights reserved. 9
 Units of donuts = 100/2 – (5/2)(units of cheese)

Hence Bozo’s income constraint is a negatively-sloped line with vertical intercept

50 and slope –2.5:

donuts

50

20 cheese

Interpretation of the income constraint. With her limited income, the individual
can only afford to consume combinations of goods on or inside the budget
constraint. (By "inside the budget constraint," I mean between it and the origin.)
This is sometimes called the feasible area.

Utility Maximization Graphed

The highest indifference curve that one can "get on" must have at least one of its points in
the feasible area. Usually, in fact, it only has 1 point in the feasible area.

Example :

U=Umax

X
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Now let’s look at another choice facing the individual—how much to work

How much to work? The income-leisure tradeoff

Suppose that you decide to take an hour off from work, and as a result you don’t get paid
for that hour.
Your benefit: You got to enjoy an hour of leisure
Your cost: Lost wages

In general, the benefit of not working is the leisure that you enjoy; the cost is lost wages.

Simplified example: Consider Cracko T. Parrot. He has 200 hour per month; for each
hour, he can either work, earning $20 per hour, or not work, gaining leisure.

Here are some combinations of earned income and leisure that he, Cracko T. Parrot can
choose from:

hours of 0 50 100 150 200

leisure
earned $4000 $3000 $1500 $1000 $0
income

If we graphed the above (5) points and connected them with a straight line, then we’d
have Cracko’s income-leisure constraint:

income

4000

200 leisure hours

How does one react to a change in wage? Income vs. substitution effects

Suppose that you can pick how many hours that you work. Now, your take home wage
per hour rises (perhaps due to a nice tax cut from G.W. Bush). Will you work more or

Author: Michael Francis Williams. This material is copyrighted. All rights reserved. 11
fewer hours? Oh, what a dilemma! You are being pushed in two directions by two
different effects:

1. The income effect. You can now work fewer hours and still have the same total take
home pay that you had when your wage was low. This effect makes you want to work
fewer hours.

2. The substitution effect. The reward for an hour of work is now higher than before.
This effect makes you want to work more hours.

The overall effect is the combination of the income effect and the substitution effect. For
some people, the income effect will dominate; these people will work fewer hours. For
other people, the substitution effect will dominate; these people will work more hours.

Now let’s look at one more important choice: how much to save.

How much to save? The intertemporal budget constraint

A dollar saved can be spent later along with the interest that is earned. That’s the
dilemma: when you save a dollar, you give up the chance to buy stuff today while you
gain the chance to buy stuff later.

Simplified example: Consider Jim Nasium. He has $2000; each dollar he can spend now
or save, earning 10% interest. (He has no other money.)

Here are some combinations of spending now and spending later that he, Jim Nasium,
can choose from:

spending $0 $500 $1000 $1500 $2000

now
spending $2200 $1650 $1100 $550 $0
later

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If we graphed the above (5) points and connected them with a straight line, then we’d
have Jim’s intertemporal budget constraint:

spending
later
2200

2000 spending now

How does one react to a change in interest rates? Income vs. substitution effects

Suppose that the interest rate that you can earn rises (perhaps due to a nice tax cut from
G.W. Bush). Will you save more or fewer dollars? Oh, what a dilemma! You are being
pushed in two directions by two different effects:

1. The income effect. You can now save fewer dollars and still have the same amount to
spend later that you had when your interest rate was low. This effect makes you want to
save less.

2. The substitution effect. The reward for a dollar of savings is now higher than before.
This effect makes you want to save more.

The overall effect is the combination of the income effect and the substitution effect. For
some people, the income effect will dominate; these people will save less. For other
people, the substitution effect will dominate; these people will save more.

Author: Michael Francis Williams. This material is copyrighted. All rights reserved. 13