Utility- is the satisfaction you receive from consuming a good or service Total utility is the number of units of utility that a consumer gains from consuming a given quantity of a good, service, or activity during a particular period Utility cannot be measured by an actual scale or standard If utility could be measured, it would not be measuring a characteristic of goods but a particular consumer’s reaction to those goods Total utility generally rises at a decreasing rate. Marginal utility is the amount by which total utility rises with consumption of an additional unit of a good, service, or activity, other things unchanged The Law of Diminishing Marginal Utility is the tendency of marginal utility to decline beyond some level of consumption during a period

Maximizing Utility 1. The budget constraint a. Total spending cannot exceed the budget available b. The budget constraint is the maximum money available for spending c. A simplifying assumption is that only current income can be used for spending; the consumer neither borrows nor saves 2. Applying the marginal decision rule a. The marginal benefit to a consumer of spending another dollar on a good is the marginal utility of that expenditure MB = MU/P b. The marginal cost to a consumer of spending one dollar less on a good is the loss of additional utility that could have been gained from spending that dollar on the good MC = MU/P MB = MC

c. Equilibrium between two goods is reached when the marginal utility per dollar spent is the same for the two goods (the marginal benefit of shifting one dollar into one good is exactly offset by the marginal cost of shifting out of the other good d. The utility maximizing condition states that utility for a given budget when total outlays equal the budget and when the ratios of marginal utilities to price are equal for all goods and services 3. The problem of divisibility a. For the utility-maximizing condition to be met perfectly, all the goods must be completely divisible so that they can be divided meaningfully into dollar amounts b. This divisibility requirement is almost never met in actuality c. The model does predict that consumers will get as close as possible to the utility maximizing condition

Utility Maximization and Demand A. Deriving and Individual’s Demand Curve 1. A price decline in one product makes that good’s ratio of marginal utility to price higher than before and encourages more spending on it. 2. The utility-maximizing condition therefore results in a negatively sloped individual demand curve. 1. A price decline affects all individuals in the market in the same direction even though each individual has potentially unique preferences. 2. The market demand curve is made up of all the individual demand curves B. From individual to Market Demand

C. Substitution and Income Effects 1. A price decline for a product makes that product relatively less expensive 2. A price decline for a product effectively makes consumers of that product richer 3. An income-compensated price change is an imaginary exercise in which we assume that when the price of a good or service changes, the consumer’s income is adjusted so that he or she has just enough to purchase the original combination of goods and services at the new set of prices. 4. The substitution effect of a price change is the change in a consumer’s consumption of a good in response to an income-compensated price change 5. The income effect of a price change is the change in consumption of a good resulting from the implicit change in income because of a price change

D. Normal and Inferior Goods a. The substitution and income effects reinforce each other in the case of normal goods b. The substitution effect contributes to an increase in the quantity demanded because consumers substitute more of the other goods when the price of the normal good decrease. 1. Normal goods c. The income effect of a price decline of a normal good is to increase purchasing power and therefore increase the quantity of the good demanded d. An increase in the price of a normal good results in a decline in quantity demanded through both the substitution and income effects

2. Inferior goods a. When the price of an inferior good falls, consumers will substitute more of the inferior good for other goods because of the substitution effect b. When the price of an inferior good falls, the lower price effectively makes consumers richer, so they purchase less of the good through the income effect c. The substitution and income effect work in opposite directions for inferior goods