Chapter 7. Utility Maximization

Chapter 7Utility MaximizationCopyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Law of Diminishing Marginal UtilityLaw of diminishing marginal utilityAs consumption of a good or service increases, the marginal utility obtained from each additional unit of a good or service decreasesExplains downward sloping demand curveLO1TerminologyUtility is the satisfaction one gets from consuming a good or serviceNot the same as usefulnessSubjectiveDifficult to quantifyLO1Total Utility and Marginal UtilityUtil is one unit of satisfaction or pleasureTotal utility is the total amount of satisfactionMarginal utility is the extra satisfaction from an additional unit of the goodMU = ΔTU/ΔQLO1Theory of Consumer BehaviorRational behaviorPreferencesBudget constraintPricesLO2Utility Maximizing RuleConsumer equilibriumConsumer allocates his or her income so that the last dollar spent on each product yields the same amount of extra (marginal) utilityAlgebraically, MU of product A MU of product B Price of A Price of B=LO2Income and Substitution EffectsIncome effectThe impact a price change has on a consumer’s real incomeSubstitution effectThe impact a price change on a product’s relative expensivenessLO4Applications and ExtensionsNew productsiPadDiamond-water paradoxOpportunity cost and timeMedical care purchasesCash and noncash giftsLO5