Chapter 7 Utility Maximization

Define and explain the relationship between total utility, marginal utility, and the law of diminishing marginal utility.

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Describe how rational consumers maximize utility by comparing the marginal utility-to-price ratios of all the products they could possibly purchase.

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Discuss how the utility-maximization model helps highlight the income and substitution effects of a price change.

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Explain how a demand curve can be derived by observing the outcomes of price changes in the utility-maximization model.

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What is the equation for Marginal Utility

Change in Total Utility / Change in QTY

How are consumers rational?

Consumers are assumed to be rational, i.e. they are trying to get the most value for their money.

Explain how Consumers maximize their available resources (income)

Consumers' incomes are limited because their individual resources are limited. Thus, consumers face a budget constraint. (As we saw with the individual budget line in Chapter 1)Goods and services have prices and are scarce relative to the demand for them. Consumers must choose among alternative goods with their limited money incomes.

Explain how utility maximization relates to the demand curve

Determinants of an individual's demand curve are tastes, income, and prices of other goods. Deriving the demand curve can be illustrated using item B, (Oranges) in Table 6.1 and considering alternative prices at which B (Oranges) might be sold. At lower prices, using the utility-maximizing rule, we see that more will be purchased as the price falls.

Explain how consumers observe utility in terms of decision making in the market place

It is marginal utility per dollar spent that is equalized; that is, consumers compare the extra utility from each product with its cost. As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of utility per dollar just equals that of the other product.

What is the algebraic statement explaining the decision making process of obtaining the most utility for various products

MU of product A (Apples)/price of A (Apples) = MU of product B(Oranges)/price of B (Oranges) = etc

Explain the meaning of Marginal Utility and Diminishing Marginal Utility

Marginal utility refers to the extra utility a consumer gets from one additional unit of a specific product. In a short period of time, the marginal utility derived from successive units of a given product will decline. This is known as diminishing marginal utility.

Explain Marginal Utility

Measure of the extra satisfaction one gets from an additional unit

Explain Total Utility

Total amount of satisfaction

Explain the utility maximization rule and how it pertains to consumer's decision making

Utility maximizing rule explains how consumers decide to allocate their money incomes so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility. 1. A consumer is in equilibrium when utility is "balanced (per dollar) at the margin." When this is true, there is no incentive to alter the expenditure pattern unless tastes, income, or prices change.

Explain how the The utility maximizing rule helps to explain the substitution and income effect

When the price of an item declines, the consumer will no longer be in equilibrium until more of the item is purchased and the marginal utility of the item declines to match the decline in price. More of this item is purchased rather than another relatively more expensive substitute. 2. The income effect is shown by the fact that a decline in price expands the consumer's real income and the consumer must purchase more of this and other products until equilibrium is once again attained for the new level of real income.