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Lecture 6

ECONO-2202 Lecture Notes - Lecture 6: Marginal Utility, Indifference Curve, Demand Curve


Department
Economics
Course Code
ECONO-2202
Professor
Iqbal
Lecture
6

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LECTURE NOTES
Introduction
A. Learning objectives After reading this chapter, students should be able to:
Define and explain the relationship between total utility, marginal utility, and the law of diminishing
marginal utility.
Describe how rational consumers maximize utility by comparing the marginal utility-to-price ratios of all
the products they could possibly purchase.
Explain how a demand curve can be derived by observing the outcomes of price changes in the utility-
maximization model.
Discuss how the utility-maximization model helps highlight the income and substitution effects of a price
change.
Give examples of several real-world phenomena that can be explained by applying the theory of
consumer behavior.
(Appendix) Relate how the indifference curve model of consumer behavior derives demand curves from
budget lines, indifference curves, and utility maximization.
Americans spend trillions of dollars on goods and services each yearmore than 95 percent of their
after-tax incomes, yet no two consumers spend their incomes in the same way. How can this be
explained?
Why does a consumer buy a particular bundle of goods and services rather than others? Examining
these issues will help us understand consumer behavior and the law of demand.
Why do consumers often times appear to make irrational decisions? Exploration of behavioral
economics and prospect theory will provide a better understanding of these kinds of decisions.
Law of Diminishing Marginal Utility
A. Although consumer wants in general are insatiable, wants for specific commodities can be
fulfilled. The more of a specific product that consumers obtain, the less they will desire more units of
that product. This can be illustrated with almost any item. The text uses the automobile example, but
houses, clothing, and even food items work just as well.
Utility is a subjective notion in economics, referring to the amount of satisfaction a person gets from
consumption of a certain item.
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.

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Figure 7.1 (Key Graph) and the accompanying table illustrate the relationship between total and
marginal utility.
Total utility increases as each additional taco is purchased through the first five, but utility rises at a
diminishing rate since each taco adds less and less to the consumer’s satisfaction.
At some point, marginal utility becomes zero and then even negative at the seventh unit and beyond. If
more than six tacos were purchased, total utility would begin to fall. This illustrates the law of
diminishing marginal utility.
Theory of consumer behavior uses the law of diminishing marginal utility to explain how consumers
allocate their income.
A. Consumer choice and the budget constraint:
Consumers are assumed to be rational, i.e., they are trying to get the most value for their money.
Consumers have clear-cut preferences for various goods and services and can judge the utility they
receive from successive units of various purchases.
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.
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.
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.
Table 7.1 provides a numerical example of this for an individual named Holly with $10 to spend. Follow
the reasoning process to see why 2 units of apples and 4 of oranges will maximize Holly’s utility, given
the $10 spending limit.
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.
Table 7.2 summarizes the step-by-step decision-making process the rational consumer will pursue to
reach the utility-maximizing combination of goods and services attainable.
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