C h a p t e r

Utility Maximization

Learning Objectives If you were to compare the shopping carts of almost any
two consumers, you would observe striking differences.
LO7.1 Define and explain the relationship between Why does Paula have potatoes, peaches, and Pepsi in her
total utility, marginal utility, and the law of
cart, while Sam has sugar, saltines, and 7-Up in his? Why
diminishing marginal utility.
didn’t Paula also buy pasta and plums? Why didn’t Sam
LO7.2 Describe how rational consumers maximize have soup and spaghetti on his grocery list?
utility by comparing the marginal utility-to- In this chapter, you will see how individual consumers
price ratios of all the products they could allocate their incomes among the various goods and ser-
possibly purchase. vices available to them. Given a certain budget, how does a
consumer decide which goods and services to buy? This
LO7.3 Explain how a demand curve can be derived
chapter will develop a model to answer this question.
by observing the outcomes of price changes
in the utility-maximization model.
Law of Diminishing
LO7.4 Discuss how the utility-maximization model
helps highlight the income and substitution Marginal Utility
effects of a price change. LO7.1 Define and explain the relationship between total utility,
marginal utility, and the law of diminishing marginal utility.
LO7.5 Give examples of several real-world The simplest theory of consumer behavior rests squarely on
phenomena that can be explained by applying the law of diminishing marginal utility. This principle, first
the theory of consumer behavior. discussed in Chapter 3, is that added satisfaction declines as a
consumer acquires additional units of a given product. Al-
LO7.6 (Appendix) Relate how the indifference curve though consumer wants in general may be insatiable, wants
model of consumer behavior derives demand for particular items can be satisfied. In a specific span of time
curves from budget lines, indifference curves, over which consumers’ tastes remain unchanged, consumers
and utility maximization. can obtain as much of a particular good or service as they can

139
140 PART THREE Consumer Behavior

afford. But the more of that product they obtain, the less they shows the total utility associated with each level of consump-
want still more of it. tion of tacos. Column 3 shows the marginal utility—the
Consider durable goods, for example. A consumer’s de- change in total utility—that results from the consumption of
sire for an automobile, when he or she has none, may be very each successive taco. Starting at the origin in Figure 7.1a, ob-
strong. But the desire for a second car is less intense; and for serve that each of the first five units increases total utility
a third or fourth, weaker and weaker. Unless they are collec- (TU), but by a diminishing amount. Total utility reaches a
tors, even the wealthiest families rarely have more than a maximum with the addition of the sixth unit and then declines.
half-dozen cars, although their incomes would allow them to So in Figure 7.1b marginal utility (MU) remains positive
purchase a whole fleet of vehicles. but diminishes through the first five units (because total util-
ity increases at a declining rate). Marginal utility is zero for
Terminology the sixth unit (because that unit doesn’t change total utility).
Marginal utility then becomes negative with the seventh unit
Evidence indicates that consumers can fulfill specific wants and beyond (because total utility is falling). Figure 7.1b and
with succeeding units of a product but that each added unit table column 3 reveal that each successive taco yields less
provides less utility than the last unit purchased. Recall that a extra utility, meaning fewer utils, than the preceding taco.1
consumer derives utility from a product if it can satisfy a That is, the table and graph illustrate the law of diminishing
want: Utility is want-satisfying power. The utility of a good marginal utility.
or service is the satisfaction or pleasure one gets from con-
suming it. Keep in mind three characteristics of this concept:
Marginal Utility and Demand
∙ “Utility” and “usefulness” are not synonymous.
The law of diminishing marginal utility explains why the de-
Paintings by Picasso may offer great utility to art
mand curve for a given product slopes downward. If succes-
connoisseurs but are useless functionally (other than for
sive units of a good yield smaller and smaller amounts of
hiding a crack on a wall).
marginal, or extra, utility, then the consumer will buy addi-
∙ Utility is subjective. The utility of a specific product tional units of a product only if its price falls. The consumer
may vary widely from person to person. A lifted pickup for whom Figure 7.1 is relevant may buy two tacos at a price
truck may have great utility to someone who drives off- of $1 each. But because he or she obtains less marginal utility
road but little utility to someone unable or unwilling to from additional tacos, the consumer will choose not to buy
climb into the rig. Eyeglasses have tremendous utility to more at that price. The consumer would rather spend addi-
someone who has poor eyesight but no utility to a tional dollars on products that provide more utility, not less
person with 20-20 vision. utility. Therefore, additional tacos with less utility are not
∙ Utility is difficult to quantify. But for purposes of worth buying unless the price declines. (When marginal util-
illustration we assume that people can measure ity becomes negative, Taco Bell would have to pay you to
satisfaction with units called utils (units of utility). For consume another taco!) Thus, diminishing marginal utility
example, a particular consumer may get 100 utils of supports the idea that price must decrease in order for quan-
satisfaction from a smoothie, 10 utils of satisfaction tity demanded to increase. In other words, consumers behave
from a candy bar, and 1 util of satisfaction from a stick in ways that make demand curves downsloping.
of gum. These imaginary units of satisfaction are
convenient for quantifying consumer behavior for
explanatory purposes. QUICK REVIEW 7.1
✓ Utility is the benefit or satisfaction a person receives
Total Utility and Marginal Utility from consuming a good or a service.
Total utility and marginal utility are related, but different, ideas. ✓ The law of diminishing marginal utility indicates that
Total utility is the total amount of satisfaction or p­ leasure a gains in satisfaction become smaller as successive
person derives from consuming some specific quantity—for units of a specific product are consumed.
­example, 10 units—of a good or service. M ­ arginal utility is the ✓ Diminishing marginal utility provides a simple ratio-
extra satisfaction a consumer realizes from an additional unit of nale for the law of demand.
that product—for example, from the eleventh unit. Alterna-
tively, marginal utility is the change in total utility that results
from the consumption of 1 more unit of a product. 1
Technical footnote: In Figure 7.1b we graphed marginal utility at half-units.
Figure 7.1 (Key Graph) and the accompanying table For example, we graphed the marginal utility of 4 utils at 3 1/2 units because
demonstrate the relation between total utility and marginal “4 utils” refers neither to the third nor the fourth unit per se but to the
utility. The curves reflect the data in the table. Column 2 ­addition or subtraction of the fourth unit.
 KEY GRAPH
FIGURE 7.1 Total and marginal utility. Curves TU and MU are graphed from the data in
30 the table. (a) As more of a product is consumed, total utility increases at a diminishing rate,
reaches a maximum, and then declines. (b) Marginal utility, by definition, reflects the changes
TU in total utility. Thus marginal utility diminishes with increased consumption, becomes zero
when total utility is at a maximum, and is negative when total utility declines. As shown by
the shaded rectangles in (a) and (b), marginal utility is the change in total utility associated
with each additional taco. Or, alternatively, each new level of total utility is found by adding
Total utility (utils)

20
marginal utility to the preceding level of total utility.

(1) (2) (3)

Tacos Total Marginal
Consumed Utility, Utility,
10 per Meal Utils Utils
0 0
] 10
1 10
]   8
2 18
]   6
3 24
]   4
4 28
0 1 2 3 4 5 6 7 ]   2
5 30
Units consumed per meal ]   0
6 30
(a) ] −2
Total utility 7 28

10
Marginal utility (utils)

8
6
4
2
0
–2
MU
1 2 3 4 5 6 7
Units consumed per meal
(b)
Marginal utility

QUICK QUIZ FOR FIGURE 7.1

1. Marginal utility: 3. When marginal utility is zero in graph (b), total utility in graph (a) is:
a. is the extra output a firm obtains when it adds another unit of a. also zero.
­labor. b. neither rising nor falling.
b. explains why product supply curves slope upward. c. negative.
c. typically rises as successive units of a good are consumed. d. rising, but at a declining rate.
d. is the extra satisfaction from the consumption of 1 more unit of 4. Suppose the person represented by these graphs experienced a
some good or service. ­diminished taste for tacos. As a result the:
2. Marginal utility in Figure 7.1b is positive, but declining, when total a. TU curve would get steeper.
utility in Figure 7.1a is positive and: b. MU curve would get flatter.
a. rising at an increasing rate. c. TU and MU curves would shift downward.
b. falling at an increasing rate. d. MU curve, but not the TU curve, would collapse to the horizontal
c. rising at a decreasing rate. axis.
d. falling at a decreasing rate.
Answers: 1. d; 2. c; 3. b; 4. c

141
142 PART THREE Consumer Behavior

Theory of Consumer Behavior money income so that the last dollar spent on each product
yields the same amount of extra (marginal) utility. We call this
LO7.2 Describe how rational consumers maximize utility by the utility-maximizing rule. When the consumer has “bal-
comparing the marginal utility-to-price ratios of all the products
anced his margins” using this rule, he has achieved consumer
they could possibly purchase.
equilibrium and has no incentive to alter his expenditure pat-
In addition to explaining the law of demand, the idea of di-
tern. In fact, any person who has achieved consumer equilib-
minishing marginal utility explains how consumers allocate
rium would be worse off—total utility would decline—if there
their money incomes among the many goods and services
were any alteration in the bundle of goods purchased, provid-
available for purchase.
ing there is no change in taste, income, products, or prices.
Consumer Choice and the Budget Constraint Numerical Example
For simplicity, we will assume that the situation for the typi- An illustration will help explain the utility-maximizing rule.
cal consumer has the following dimensions. For simplicity we limit our example to two products, but the
∙ Rational behavior The consumer is a rational person, analysis also applies if there are more. Suppose consumer
who tries to use his or her money income to derive the Holly is analyzing which combination of two products she
greatest amount of satisfaction, or utility, from it. should purchase with her fixed daily income of $10. Let’s
Consumers want to get “the most for their money” or, suppose these products are apples and oranges.
technically, to maximize their total utility. They engage Holly’s preferences for apples and oranges and their
in rational behavior. prices are the basic data determining the combination that
will maximize her satisfaction. Table 7.1 summarizes those
∙ Preferences Each consumer has clear-cut preferences
data, with column 2a showing the amounts of marginal utility
for certain of the goods and services that are available in
she will derive from each successive unit of A (apples) and
the market. Buyers also have a good idea of how much
with column 3a showing the same thing for product B (or-
marginal utility they will get from successive units of
anges). Both columns reflect the law of diminishing marginal
the various products they might purchase.
utility, which, in this example, is assumed to begin with the
∙ Budget constraint At any point in time the consumer second unit of each product purchased.
has a fixed, limited amount of money income. Since
each consumer supplies a finite amount of human and Marginal Utility per Dollar To see how the utility-­
property resources to society, he or she earns only maximizing rule works, we must put the marginal-utility
limited income. Thus, as noted in Chapter 1, every ­information in columns 2a and 3a on a per-dollar-spent basis.
consumer faces a budget constraint, even consumers A consumer’s choices are influenced not only by the extra
who earn millions of dollars a year. Of course, this
budget limitation is more severe for a consumer with an
TABLE 7.1 The Utility-Maximizing Combination of Apples and Oranges
average income than for a consumer with an Obtainable with an Income of $10*
extraordinarily high income.
∙ Prices Goods are scarce relative to the demand for (2) (3)
them, so every good carries a price tag. We assume that Apple (Product A): Orange (Product B):
Price = $1 Price 5 = $2
the price of each good is unaffected by the amount of it
(b) (b)
that is bought by any particular person. After all, each (a) Marginal (a) Marginal
person’s purchase is a tiny part of total demand. Also, (1) Marginal Utility Marginal Utility
because the consumer has a limited number of dollars, Unit of Utility, per Dollar Utility, per Dollar
he or she cannot buy everything wanted. This point Product Utils (MU/Price) Utils (MU/Price)
drives home the reality of scarcity to each consumer. First 10 10 24 12
Second 8 8 20 10
So the consumer must compromise; he or she must choose
Third 7 7 18 9
the most personally satisfying mix of goods and s­ ervices.
Fourth 6 6 16 8
Different individuals will choose different mixes.
Fifth 5 5 12 6
Sixth 4 4 6 3
Utility-Maximizing Rule Seventh 3 3 4 2
Of all the different combinations of goods and services a con-
sumer can obtain within his or her budget, which specific *It is assumed in this table that the amount of marginal utility received from
­additional units of each of the two products is independent of the quantity of the
combination will yield the maximum utility or satisfaction? To other product. For example, the marginal-utility schedule for apples is indepen-
maximize satisfaction, the consumer should allocate his or her dent of the number of oranges obtained by the consumer.
 CHAPTER 7 Utility Maximization 143

utility that successive apples will yield but also by how many utility that Holly can obtain. It cost her only $5 [= (1 × $1) +
dollars (and therefore how many oranges) she must give up to (2 × $2)], so she has $5 remaining, which she can spend to
obtain additional apples. achieve a still higher level of total utility.
The rational consumer must compare the extra utility from Examining columns 2b and 3b again, we find that Holly
each product with its added cost (that is, its price). Switching should spend the next $2 on a third orange because marginal
examples for a moment, suppose that you prefer a pizza whose utility per dollar for the third orange is 9 compared with 8 for
marginal utility is, say, 36 utils to a movie whose marginal utility the second apple. But now, with 1 apple and 3 oranges, she is
is 24 utils. But if the pizza’s price is $12 and the movie costs only again indifferent between a second apple and a fourth orange
$6, you would choose the movie rather than the pizza! Why? because both provide 8 utils per dollar. So Holly purchases
Because the marginal utility per dollar spent would be 4 utils for 1 more of each. Now the last dollar spent on each product
the movie (= 24 utils/$6) compared to only 3 utils for the pizza provides the same marginal utility per dollar (8), and Holly’s
(= 36 utils/$12). You could see two movies for $12 and, assum- money income of $10 is exhausted.
ing that the marginal utility of the second movie is, say, 16 utils, The utility-maximizing combination of goods attainable
your total utility would be 40 utils. Clearly, 40 units of satisfac- by Holly is 2 apples and 4 oranges. By summing marginal-
tion (= 24 utils + 16 utils) from two movies are superior to utility information from columns 2a and 3a, we find that
36 utils from the same $12 expenditure on one pizza. Holly is obtaining 18 (= 10 + 8) utils of satisfaction from the
To make the amounts of extra utility derived from differ- 2 apples and 78 (= 24 + 20 + 18 + 16) utils of satisfaction
ently priced goods comparable, marginal utilities must be put from the 4 oranges. Her $10, optimally spent, yields 96
on a per-dollar-spent basis. We do this in columns 2b and 3b (= 18 + 78) utils of satisfaction.
by dividing the marginal-utility data of columns 2a and 3a by Table 7.2 summarizes our step-by-step process for maxi-
the prices of apples and oranges—$1 and $2, respectively. mizing Holly’s utility. Note that we have implicitly assumed
that Holly spends her entire income. She neither borrows nor
Decision-Making Process Table 7.1 shows Holly’s prefer- saves. However, saving can be regarded as a “commodity” that
ences on a unit basis and a per-dollar basis as well as the price yields utility and can be incorporated into our analysis. In fact,
tags of apples and oranges. With $10 to spend, in what order we treat it that way in problem 4 at the end of this chapter.
should Holly allocate her dollars on units of apples and oranges
to achieve the highest amount of utility within the $10 limit im- Inferior Options Holly can obtain other combinations of
posed by her income? And what specific combination of the two apples and oranges with $10, but none will yield as great a
products will she have obtained at the time she uses up her $10? total utility as do 2 apples and 4 oranges. As an example, she
Concentrating on columns 2b and 3b in Table 7.1, we find can obtain 4 apples and 3 oranges for $10. But this combina-
that Holly should first spend $2 on the first orange because its tion yields only 93 utils, clearly inferior to the 96 utils pro-
marginal utility per dollar of 12 utils is higher than the first vided by 2 apples and 4 oranges. True, there are other
apple’s 10 utils. But now Holly finds herself indifferent about combinations of apples and oranges (such as 4 apples and
whether to buy a second orange or the first apple because the 5 oranges or 1 apple and 2 oranges) in which the marginal util-
marginal utility per dollar of both is 10 utils per dollar. So she ity of the last dollar spent is the same for both goods. But all
buys both of them. Holly now has 1 apple and 2 oranges. such combinations either are unobtainable with Holly’s lim-
Also, the last dollar she spent on each good yielded the same ited money income (as 4 apples and 5 oranges) or do not ex-
marginal utility per dollar (10). But this combination of ap- haust her money income (as 1 apple and 2 oranges) and
ples and oranges does not represent the maximum amount of therefore do not yield the maximum utility attainable.

TABLE 7.2 Sequence of Purchases to Achieve Consumer Equilibrium, Given the Data in Table 7.1
Choice Marginal Utility   Income
Number Potential Choices per Dollar Purchase Decision Remaining

1 First apple 10 First orange for $2 $8 = $10 − $2

First orange 12
2 First apple 10 First apple for $1 $5 = $8 − $3
Second orange 10   and second orange for $2
3 Second apple   8 Third orange for $2 $3 = $5 − $2
Third orange   9
4 Second apple   8 Second apple for $1 $0 = $3 − $3
Fourth orange   8   and fourth orange for $2
144 PART THREE Consumer Behavior

If the equation is not fulfilled, then some reallocation of the

CONSIDER THIS . . .
consumer’s expenditures between A and B (from the low to the
There’s No high marginal-utility-per-dollar product) will increase the con-
Accounting for sumer’s total utility. For example, if the consumer spent $10 on
Taste 4 of A (apples) and 3 of B (oranges), we would find that
In 2015, the federal MU of A of 6 utils MU of B of 18 utils
government started <
Price of A of $1 Price of B of $2
requiring restaurants
to print calorie counts Here the last dollar spent on A provides only 6 utils of satis-
next to menu items. faction, while the last dollar spent on B provides 9 (= 18/$2).
Source: © Letterberry/Shutterstock.com
The regulation was in- So the consumer can increase total satisfaction by purchasing
tended to help consumers make healthful choices. In partic- more of B and less of A. As dollars are reallocated from A to
ular, it was assumed that if they could see how many calories B, the marginal utility per dollar of A will increase while the
each item contained, consumers would consume fewer total marginal utility per dollar of B will decrease. At some new
calories. They would opt for salads instead of milkshakes.
combination of A and B the two will be equal and consumer
But a funny thing happened when the new rules went
into effect. Some people started consuming more calories.
equilibrium will be achieved. Here that combination is 2 of A
They did so because their preferences were not what policy­ (apples) and 4 of B (oranges).
makers expected. Instead of trying to maximize the amount
of healthfulness per dollar of money spent, they instead
chose to maximize the number of calories per dollar of Utility Maximization and the
money spent. Their preferences were such that when it
came to maximizing utility, what they wanted was the maxi-
Demand Curve
mum number of calories, not the maximum amount of LO7.3 Explain how a demand curve can be derived by observing
health. So when the new regulations provided them with the outcomes of price changes in the utility-maximization model.
calorie counts, they went for milkshakes instead of salads Once you understand the utility-maximizing rule, you can
and double cheeseburgers instead of chicken skewers. easily see why product price and quantity demanded are in-
The lesson learned? Know what people are trying to versely related. Recall that the basic determinants of an indi-
maximize before you attempt to alter their behavior. vidual’s demand for a specific product are (1) preferences or
tastes, (2) money income, and (3) the prices of other goods.
The utility data in Table 7.1 reflect our consumer’s prefer-
ences. We continue to suppose that her money income is $10.
Algebraic Generalization And, concentrating on the construction of an individual de-
Economists generalize the utility-maximizing rule by saying mand curve for oranges, we assume that the price of apples,
that a consumer will maximize her satisfaction when she allo- now representing all “other goods,” is still $1.
cates her money income so that the last dollar spent on product
A, the last on product B, and so forth, yield equal amounts of Deriving the Demand Schedule and Curve
additional, or marginal, utility. The marginal utility per dollar We can derive a single consumer’s demand schedule for
spent on A is indicated by the MU of product A divided by the oranges by considering alternative prices at which oranges
price of A (column 2b in Table 7.1), and the marginal utility might be sold and then determining the quantity the consumer
per dollar spent on B by the MU of product B divided by the will purchase. We already know one such price-quantity com-
price of B (column 3b in Table 7.1). Our utility-­maximizing bination in the utility-maximizing example: Given tastes,
rule merely requires that these ratios be equal for the last dollar income, and the prices of other goods, Holly will purchase
spent on A and the last dollar spent on B. Algebraically, 4 oranges at $2.
MU of product A MU of product B Now let’s assume the price of oranges falls to $1. The
= ­marginal-utility-per-dollar data of column 3b in Table 7.1 will
Price of A Price of B
double because the price of oranges has been halved; the new
And, of course, the consumer must exhaust her available in- data for column 3b are (by coincidence) identical to the data in
come. Table 7.1 shows us that the combination of 2 units of A column 3a. The doubling of the MU per dollar for each succes-
(apples) and 4 of B (oranges) fulfills these conditions in that sive orange means that the purchase of 2 apples and 4 oranges
8 utils 16 utils is no longer an equilibrium combination. By applying the same
= reasoning we used previously, we now find that Holly’s utility-
$1 $2
maximizing combination is 4 apples and 6 oranges. As sum-
and the consumer’s $10 income is all spent. marized in the table in Figure 7.2, Holly will purchase
 CHAPTER 7 Utility Maximization 145

FIGURE 7.2 Deriving an individual demand curve. The consumer when purchasing 2 apples and 4 oranges because
represented by the data in the table maximizes utility by purchasing 4 oranges
at a price of $2. The decline in the price of oranges to $1 disrupts the MU of apples of 8 MU of oranges of 16
=
consumer’s initial utility-maximizing equilibrium. The consumer restores Price of apples of $1 Price of oranges of $2
equilibrium by purchasing 6 rather than 4 oranges. Thus, a simple price-quantity
schedule emerges, which locates two points on a downsloping demand curve. But after the price of oranges declines from $2 to $1,
MU of apples of 8 MU of oranges of 16
<
Price of apples of $1 Price of oranges of $1
Clearly, the last dollar spent on oranges now yields greater util-
ity (16 utils) than does the last dollar spent on apples (8 utils).
$2 This will lead Holly to switch, or substitute, purchases away
from apples and toward oranges so as to restore consumer equi-
librium. This substitution effect contributes to the inverse rela-
Price per orange

tionship between price and quantity that is found along her

demand curve for oranges: When the price of oranges declines,
the substitution effect causes Holly to buy more oranges.
What about the income effect? The decline in the price of
1
oranges from $2 to $1 increases Holly’s real income. Before
the price decline, she maximized her utility and achieved con-
sumer equilibrium by selecting 2 apples and 4 oranges. But at
the lower $1 price for oranges, Holly would have to spend
only $6 rather than $10 to buy that particular combination of
Do
goods. That means that the lower price of oranges has freed up
$4 that can be spent on buying more apples, more oranges, or
0
4 6 more of both. How many more of each fruit she ends up buy-
Quantity demanded of oranges ing will be determined by applying the utility-maximizing rule
to the new situation. But it is quite likely that the increase in
Price per Orange Quantity Demanded real income caused by the reduction in the price of oranges
$2 4 will cause Holly to end up buying more oranges than before
1 6 the price reduction. Any such increase in orange purchases is
referred to as the income effect of the reduction in the price of
oranges and it, too, helps to explain why demand curves are
downward sloping: When the price of oranges falls, the in-
6 oranges when the price of oranges is $1. Using the data in this come effect causes Holly to buy more oranges.
table, we can sketch the downward-sloping demand curve for
oranges, Do, shown in Figure 7.2. This exercise, then, clearly
links the utility-maximizing behavior of a consumer and that QUICK REVIEW 7.2
person’s downsloping demand curve for a particular product.
✓ The theory of consumer behavior assumes that, with
limited income and a set of product prices, consum-
Income and Substitution Effects ers make rational choices on the basis of well-defined
preferences.
LO7.4 Discuss how the utility-maximization model helps
highlight the income and substitution effects of a price change. ✓ A consumer maximizes utility by allocating income so
Recall from Chapter 3 that the income effect is the impact that the marginal utility per dollar spent is the same
for every good purchased.
that a change in the price of a product has on a consumer’s
real income and consequently on the quantity demanded of ✓ A downsloping demand curve can be derived by
changing the price of one product in the consumer-
that good. In contrast, the substitution effect is the impact
behavior model and noting the change in the utility-
that a change in a product’s price has on its relative expen- maximizing quantity of that product demanded.
siveness and consequently on the quantity demanded. Both
✓ By providing insights on the income effect and substi-
effects help explain why a demand curve such as that in tution effect of a price decline, the utility-­maximization
Figure 7.2 is downsloping. model helps explain why demand curves are
Let’s first look at the substitution effect. Recall that be- downsloping.
fore the price of oranges declined, Holly was in equilibrium