Utility Theory

Theory of Consumer Behavior

To introduce the theory of consumer behavior, it helps to think for a moment about
your own behavior as a consumer…

Imagine you have K100 to spend this week:

In the table below, identify
• 5 goods or services you would spend your money on.
• The approximate price of each product, and
• The quantity you would buy

Item Price Quantity

Questions:
1. How did you decide which items to put in your
“basket”?
2. Is your basket identical to your classmates? Why or
why not?
3. How would a change in the price of one of the items
affect the quantity you buy?
4. How would a change in your budget affect the
composition of your basket?
Chances are, every member of your class had entirely different goods in his or her
table than you did. Precisely WHY every individual consumes a different “basket of
goods” from every other individual in a market economy can be understood by the
following:
• Every consumer behaves rationally: Consumers try to get the "most for their
money" to maximize their total utility
• Every consumer has different preferences: Consumers have clear cut
preferences and can determine how much marginal utility they get from
consuming more units of a product
• Every consumer is under a budget constraint: All consumers face a budget
constraint, therefore must make decisions about what they buy based on their
limited budget
• Every product has a price: Every product has a price, so consumers must weigh
their purchasing decisions based on their marginal utility from consumption and
the price of the goods they consume
 Total Utility and Marginal Utility
• Total utility (TU) is the total satisfaction a consumer derives from
consuming a given quantity of a good.
• Total utility will generally increase as total consumption of particular
good increases, until the consumer has “had too much” of the good,
when total utility will begin to decline.
• Marginal utility (MU) is a change in utility that a consumer enjoys from
consuming additional units of a good.
• The law of diminishing marginal utility states that;
• As consumption of a good increases, the marginal utility decreases.
Quantity Total utility (utils) Marginal Utility
(Scoops of
Ice cream) Total utility
0 0 -
increases with an
increase in
1 30 30 quantity.
2 50 20 However,
3 60 10 additional utility
decreases as
4 65 5 successive units
consumed
5 68 3 increases
6 68 0
 The Law of Diminishing Marginal Utility
The greater the level of consumption of a particular
good, the less utility consumers derive from each
additional unit of the good.
Consider the total and marginal utility one derives from
consuming ice cream. Notice the following:
• The first scoop provides you with 5 utils, so TU = 5 at
Q=1
• Additional scoops of ice cream provide you with less
and less additional happiness. Nothing tastes quite as
good as that first scoop! MU declines beyond the first
scoop, but TU continues to increase, until…
• The fourth scoop: At four scoops your TU is
maximized, but the 4th scoop provided you with no
additional utility.
• Beyond four scoops, you’ve “had too much”. TU
begins decreasing while MU becomes negative.
The Utility Maximization Rule
With the law of diminishing marginal utility in mind, we must now determine how a
consumer should decide what to buy. Assume the following:
• You have a budget of K20 that you wish to spend entirely on two goods
• The two goods you are trying to decide between are Oranges (O) and Mangoes (M)
• The price of Oranges (O) is K5 and the price of Mangoes (M) is K2

To determine how many of each good you should buy, you must consider the utility
each good provides. Consider the table below. First, calculate the MU at each level of
consumption
Oranges = K5 Mangoes = K2
Quantity
TU MU TU MU
1 10 5
2 18 9
3 24 12
4 28 14
5 30 15
The Utility Maximization Rule
At first glance, it may appear that you should spend all your money on Oranges, because they
clearly provide more total utility than Mangoes. But this would be a mistake, because Oranges
also cost more than Mangoes. Instead, there is a simple rule to follow to maximize utility:
The Utility Maximization Rule: To maximize your total utility, you should instead consume the
combination of good that maximizes your marginal utility per dollar (Kwacha) spent, so that:

With this rule in mind calculate the marginal utility per dollar spent on Oranges and Manogoes:

Oranges = K5 Mangoes = K2
Quantity
TU MU MU/P TU MU MU/P
1 10 10 5 5
2 18 8 9 4
3 24 6 12 3
4 28 4 14 2
5 30 2 15 1
The Utility Maximization Rule
Now we can study the table to determine how you should spend your K20 to maximize your
total utility. Of course, if you had no budget constraint, you would consume 5 Oranges AND 5
Mangoes, but this would cost you K35, more than you have to spend. So choices must be made
Oranges = K5 Mangoes = K2
Quantity
TU MU MU/P TU MU MU/P
1 10 10 2 5 5 2.5

2 18 8 1.6 9 4 2

3 24 6 1.2 12 3 1.5

4 28 4 0.8 14 2 1
At 2O and 3M, you’ve maximized your total
5 30
utility given your limited budget 2of K20. 0.4 15 1 0.5

How to decide what to buy: The goal for consumers is to always maximize marginal utility per dollar.
• You should buy a Mango first, giving you a MU/K of 2.5. Remaining budget = K18
• Next you should buy a second Mango, which gives you an MU/K of 2. Remaining budget = K16
• Next you should buy an Orange, which gives you an MU/K of 2. Remaining budget = K11
• A 2nd Orange will now give you an MU/K of 1.6, compared to 1.5 for a 3 rd Mango. Remaining budget =K6
• A 3rd Mango now gives you an MU/K of 1.5, compared to 1.2 for a 3rd Orange: Remaining budget = K4
• Based on the utility maximization rule, you should buy 2o and 3m, where MUo/Po=MUm/Pm
The Utility Maximization Rule Practice Problem
Assume you have a budget of K36 to spend on Pizzas and Hamburgers. Pizzas cost K8 and
hamburgers cost K4. Complete the table below and answer the questions that follow

Pizza: =K8 Hamburgers: =K4

Quantity
TU MU MU/P TU MU MU/P
1 16 24
2 28 44
3 36 56
4 40 64
5 42 68
1. Identify the combination of Pizzas and hamburgers you should purchase. Explain your reasoning.
2. With the prices of pizzas and hamburgers remaining constant, assume that your budget increases to K60. Identify each
of the following:
a. The new combination of pizzas and hamburgers the consumer will purchase.
b. The total utility the consumer will enjoy with this combination
3. With your budget remaining at K60, assume the price of pizzas increases to K16 each. Identify each of the following.
a. The combination of pizzas and hamburgers the consumer will purchase
b. The consumer's total utility at this combination