Utility Maximization

Utility and Consumption ▫Concept of utility offers a way to study choices that are made in a more or less rational way. ▫Utility is measured in utils  A utility function shows the relationship between a consumer’s utility and the combination of goods and services

Principle of Diminishing Marginal Utility It is the change in total utility generated by consuming one additional unit of that good or service Principle of Diminishing Marginal Utility states that each successive unit of a good or service adds less to total utility than does the previous unit.

This is illustrated in the marginal utility curve  It shows how marginal utility depends on the quantity of a good or service consumed  It is a downward sloping curve because each additional good or service adds less to total utility than the previous  Some marginal utility curves can be negative, which means it reduces total utility. However not all will be negative

Budgets and Optimal Consumption ▫Budget constraints and budget lines  Consumers always have limited income, this restrains how much they can spend  Budget constraints  Limit the cost of a consumer’s consumption bundle to no more than the consumer’s income

 We call the set of all a consumer’s affordable consumption bundles, consumption possibilities  It is the set of all consumption bundles that are affordable given the consumer’s income and prevailing price.

 The downward sloping line of the graph used to show consumption bundles is called the budget line  It shows the consumption bundles available to a consumer who spends all of his or her income

▫Optimal Consumption Bundle  It is the consumption bundle that maximizes the consumer’s total utility given his or her budget constraints  It will be a consumer at the top of the utility curve

Spending the Marginal Dollar ▫The marginal decision is a question of how to spend the marginal dollar  Or how to allocate an additional dollar between goods x and y in a way that maximizes utility ▫Marginal utility per dollar  Spent on a good or service is the additional utility from spending one more dollar on that good or service ▫Optimal Consumption rule: when a consumer maximizes utility in the face of a budget constraint, the marginal utility per dollar spent on each good or service in the consumption bundle is the same