Topic Three:

Theory of Utility and Consumer Behavior

 3.1 Concepts and Measurement of Utility

1. Cardinal Utility (Neo-classical – Marshall)

2. Ordinal Utility (Modern – Hicks & Allen)
3.2 Cardinal Utility Theory
• This led the Cardinal Utility Theory to be known as ‘Neo-classical
Utility Theory’ or ‘Marshallian Utility Theory’ of demand

✓ Assumes utility is measurable in units called utils.

✓ 1 util = value of 1 unit of money (assumed constant).

✓ Consumers assign numbers: e.g., chocolate = 10 utils, ice cream

= 5 utils.

✓ Limitations: Utility is psychological → cannot be measured

precisely.

✓ Still useful for basic consumer demand analysis.

 Meaning of Utility
✓ Utility = pleasure, satisfaction, or fulfilment of desire from consuming a
good or service.
✓ In economics, utility refers to the want-satisfying power of a commodity.

Key Characteristics of Utility

❖ Relative, not absolute: depends on individual needs.
✓ Example: Non-smokers get no utility from cigarettes; vegetarians get
no utility from meat; economics books give utility only to interested
readers.
❖ Depends on intensity of desire: stronger need → higher utility.
❖ Depends on complementary goods:
✓ Electricity-based goods (TV, computer, fridge) require electricity.
✓ Petrol is useful only for those who have vehicles.
❖ Ethically neutral:
✓ Independent of moral or social values.
✓ Harmful or socially undesirable goods may still give utility
(e.g., drugs give utility to addicts; beef may satisfy someone even if
socially discouraged).
 Total and Marginal Utility
1. Total Utility (TU)
✓ Defined under cardinal utility (measurable satisfaction).
✓ TU = sum of utilities derived from all units of a commodity
consumed.
✓ If a consumer gets utilities U₁, U₂, U₃, U₄ from 4 units:
TU = U₁ + U₂ + U₃ + U₄
✓ For n units: TUn = U₁ + U₂ + U₃ + … + Un
2. Total Utility for Multiple Goods
✓ When consuming more than one commodity:
TU = TUx + TUy + TUz + … + TUn
✓ (x, y, z, n represent different commodities.)
 Marginal Utility (MU)
❑ Marginal Utility can be defined in three ways:
1. Utility from the Last Unit
✓ MU is the utility obtained from the marginal (last) unit
consumed.
2. Increase in Total Utility
✓ MU is the additional utility gained by consuming one more unit.
✓ Formula: MU = ΔTU / ΔQ
3. Difference Between Total Utilities
✓ MU equals the difference between total utility from n units and
n–1 units: MU = TUn – TUn–1
 ❖ In general, the derivative of a total utility function is the
marginal utility function.
❖ The marginal utility is the slope of the total utility.
MU = dTU/dX
Calculating MU from a TU Function Example: TU(X) = 16 X – X2

MU = dTU/dX = 16-2X
❖When MU is increase, TU increases at increasing rate
❖When MU is decrease positive, TU increases at decreasing rate
❖When MU is zero, TU reaches its maximum point
❖When MU is negative, TU decreases at increasing rate
Q TU MU
0 0 0
1 40 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10
 Law of Diminishing Marginal Utility (DMU)
Definition
✓ As a consumer consumes more units of a commodity within a
given time, the marginal utility (MU) from each additional unit
decreases, assuming all other goods remain constant.

Why MU Falls
1. Utility depends on intensity of need.
2. As consumption increases, urgency of desire decreases →
satisfaction from each additional unit falls.
Example (Sandwiches)
✓ First sandwich gives maximum satisfaction (strong hunger).
✓ Second gives less satisfaction (hunger reduced).
✓ Further sandwiches give progressively lower MU.
✓ TU increases but at a decreasing rate, reflecting falling MU.
 Table 3.1 Total and Marginal Utility
Sandwiches Total Utility (TU) Marginal Utility
0 0 0– 0 = 0
1 30 30 – 0 = 30
2 50 50 – 30 = 20
3 60 60 – 50 = 10
4 65 65 – 60 = 5
5 66 66 – 65 = 1
6 60 60 – 66 =– 6

❖ It may be seen in the table that the total utility reaches its
maximum at 66 utils when 5 sandwiches are consumed.
❖ Here, MU = 1. Consumption of the 6th sandwich yields negative
utility of 6 and therefore total utility starts declining.
 Graphical Illustration
Total Utility (TU) Curve
✓ Based on data from Table 3.1.
✓ TU increases as more sandwiches are consumed.
✓ It rises at a decreasing rate, showing that the extra utility
added from each unit (MU) is falling.
✓ TU reaches its maximum at the 5th unit.
Marginal Utility (MU) Curve
✓ MU declines continuously as consumption increases.
✓ The curve slopes downward, illustrating diminishing
satisfaction from additional sandwiches.
✓ After the 5th sandwich, MU becomes negative → extra
consumption causes disutility (discomfort).
Assumptions of the Law of Diminishing Marginal Utility
The law holds only under certain conditions:
1. Standard Units – Goods consumed must be of uniform size or
quantity (e.g., a cup of tea, a pair of shoes).
2. Unchanged Preferences – Consumer’s tastes or preferences
remain constant during consumption.
3. Continuity of Consumption – Consumption should be
continuous; any breaks must be short.
4. Normal Mental Condition – The consumer’s psychological
and physical state must be stable (no distractions like alcohol).
 Assumptions of Marshallian (Cardinal) Approach:
✓ Rationality: Consumer ranks wants and consumes goods in order
of utility.
✓ Limited Money Income: Spending is constrained by available
income.
✓ Maximization of Satisfaction: Consumer aims to get the highest
total utility.
✓ Cardinal Measurability of Utility: Utility can be measured in
absolute terms; 1 unit of a commodity = money paid.
✓ Diminishing Marginal Utility: Successive units of a good
provide less additional utility.
✓ Constant Utility of Money: Each unit of money has constant
utility (e.g., 1).
✓ Additivity of Utility: Total utility is the sum of utilities from all
goods:
𝑈 = 𝑓 𝑞1 𝑞2 𝑞3 . . . 𝑞𝑛
𝑇𝑈𝑛 = 𝑈1 𝑞1 + 𝑈2 𝑞2 +. . . +𝑈𝑛 𝑞𝑛
 Consumer Equilibrium: One Commodity Case
Scenario:
✓ Consumer has a fixed money income and consumes only one commodity, X.
✓ Both money and commodity X provide utility.
❑ Utility Maximization Rule:
✓ Consumer exchanges money for X as long as:
MUx > MUm (marginal utility of X > marginal utility of money)
✓ Considering price Px and constant MUm:
Consumer equilibrium occurs when:
𝑀𝑈𝑥 = 𝑃𝑥 ⋅ 𝑀𝑈𝑚 (3.1)
or
𝑀𝑈𝑥
=1 (3.2)
𝑃𝑥 ⋅ (𝑀𝑈𝑚 )
✓ At equilibrium, marginal utility per unit of money spent equals for the
commodity.
✓ Graphically:
✓ MUx curve declines due to diminishing marginal utility.
✓ Px(MUm) is a horizontal line showing constant utility of money adjusted
for price.
✓ Maximum satisfaction is achieved where MUx curve intersects Px(MUm).
Graphical Interpretation (One Commodity)
✓ Equilibrium Point (E):
✓ Occurs where the MUx curve intersects
Px(MUm) line.
✓ At this point: MUx = Px(MUm) → maximum
satisfaction is achieved.
✓ Above E:
✓ MUx > Px(MUm) → Consumer can increase
satisfaction by consuming more.
✓ Below E:
✓ MUx < Px(MUm) → Consumer can increase
satisfaction by consuming less.
✓ Conclusion:
✓ Any consumption other than at E gives less
than maximum satisfaction.
✓ Point E represents the consumer’s
equilibrium.
Consumer Equilibrium: General Case – The Law of Equi-
Marginal Utility
1. Concept Overview
✓ In reality, consumers buy many goods, each providing different
marginal utilities (MU).
✓ Some goods have higher MU schedules; others decline faster or
slower.
✓ A rational consumer allocates income to maximize total utility.

2. Consumer Behaviour
✓ The consumer starts purchasing the commodity with the highest
MU, then the next highest, and so on.
✓ He keeps reallocating expenditure between goods as long as doing
so increases total satisfaction.
✓ Equilibrium is achieved when MU per ETB spent is equal across
all goods.
Two-Commodity Case (X and Y)
Equilibrium Conditions
Given prices Px and Py, equilibrium requires:
✓ For X:
𝑀𝑈𝑥 = 𝑃𝑥 𝑀𝑈𝑚
✓ For Y:
𝑀𝑈𝑦 = 𝑃𝑦 𝑀𝑈𝑚

Combined Condition
𝑀𝑈𝑥 𝑀𝑈𝑦
= =1
𝑃𝑥 𝑀𝑈𝑚 𝑃𝑦 𝑀𝑈𝑚
When 𝑀𝑈𝑚 = 1 ,this simplifies to:
𝑀𝑈𝑥 𝑃𝑥
=
𝑀𝑈𝑦 𝑃𝑦
or
𝑀𝑈𝑥 𝑀𝑈𝑦
=
𝑃𝑥 𝑃𝑦
Interpretation:
→ The consumer is in equilibrium when the MU per ETB spent on both goods X
and Y is the same.
General Case: Many Goods

Equilibrium with Multiple Commodities

For goods A to Z, equilibrium requires:
𝑀𝑈𝐴 𝑀𝑈𝐵 𝑀𝑈𝐶 𝑀𝑈𝑍
= = =⋯=
𝑃𝐴 𝑃𝐵 𝑃𝐶 𝑃𝑍
Meaning:
A consumer maximizes satisfaction when each ETB spent on
every good gives the same marginal utility.

Summary of the Law of Equi-Marginal Utility

✓ Consumers allocate income so that MU per ETB is equalized
across all goods.
✓ This ensures maximum total utility from limited income.
✓ Foundation of the cardinal utility approach to consumer
equilibrium.
Derivation of Demand Curve (Cardinal Utility Approach)
✓ The demand curve is derived using the cardinal utility concept for a
single commodity (X).
✓ Consumer equilibrium occurs where:
𝑀𝑈𝑥 = 𝑃𝑥 𝑀𝑈𝑚
✓ As price changes, the consumer adjusts quantity so that MU again
equals the new price.
✓ This provides a direct link between price and quantity demanded.
✓ Marshall first used this equilibrium condition to derive the
individual demand curve.
✓ Plotting the equilibrium quantities for different prices yields a
downward-sloping demand curve
 Drawbacks of the Cardinal Approach
❖ Utility cannot be objectively measured
✓ Cardinal approach assumes utility is measurable in numerical units
(utils), but utility is subjective and cannot be measured objectively.
❖ Assumes marginal utility of money is constant
✓ Unrealistic, because MU of money changes with income, wealth,
and circumstances; hence it cannot reliably measure utility.
❖ Diminishing Marginal Utility is unverified
✓ The law is based on introspection and accepted without empirical
or scientific validation.
❖ Relies on an unrealistic ceteris paribus assumption
• Ignores real-world simultaneous effects such as income effect and
substitution effect.
❖ Oversimplifies the price effect
✓ Treats price effect as purely due to price change, overlooking its
components (income and substitution effects).
1. A consumer gets MU values 40, 30, 20, and 10 from four units of a
good priced at ETB10. Assume MUm = 1.
At what point will the consumer stop buying?
2. A consumer consumes two goods X and Y. Their marginal utilities are:
MUx = 20, Px = ETB 5, MUy = 18, Py = ETB 6. Is the consumer in
equilibrium? If not, what adjustment should be made?
3. A consumer derives MU: 30, 25, 20, 15, 10 from units of a good. Price
= ETB 15 and MUm = 1. How many units will the consumer
purchase? Why?
Ordinal Utility (Modern – Hicks & Allen)

✓ Utility cannot be measured, but can be ranked.

✓ Consumers can say which bundle gives more or
less satisfaction.
✓ Basis for Indifference Curve Analysis.
✓ Considered more realistic and theoretically
sound.
Assumptions of Ordinal Utility Theory
1. Rationality
❑ The consumer is assumed to be a rational economic agent.
✓ He/she aims to maximize total satisfaction (utility) given his/her
income and the prices of goods and services.
✓ He/she is also assumed to have full knowledge of all relevant
information needed to make decisions.
2. Ordinal Utility
❑ The theory assumes that utility can be expressed ordinally, not
cardinally.
✓ This means the consumer can rank his/her preferences (e.g., A is
preferred to B),
✓ but he/she cannot measure the exact amount of satisfaction in
numbers.
3. Transitivity and Consistency of Choice
a) Transitivity
Consumer preferences must be logically ordered.
✓ If the consumer prefers A to B, and B to C, then he must prefer
A to C.
✓ Symbolically: If A > B and B > C, then A > C.
B) Consistency
Consumer choices must be stable over time.
✓ If he prefers A to B at one time, he will not reverse and prefer B
to A at another time.
✓ He should not treat them as equal after previously expressing a
preference.
✓ Symbolically: If A > B, then B ≯ A (B cannot be preferred over
A) and B ≠ A (B cannot be equal to A).
4. Nonsatiation (More is Better)
The consumer is assumed not to have reached saturation for any
good.
✓ More of a good is always preferred to less, as long as it increases
satisfaction.
5. Diminishing Marginal Rate of Substitution (DMRS)
The marginal rate of substitution (MRS) refers to the amount of
good Y a consumer is willing to give up to obtain one more unit of
good X, without changing his total utility.
It is expressed as:
Δ𝑌
𝑀𝑅𝑆 =
Δ𝑋
The assumption states that:
✓ As the consumer substitutes X for Y, the amount of Y he is willing
to sacrifice decreases.
✓ Thus, MRS declines along an indifference curve.
✓ This leads to convex indifference curves.
Meaning and Nature of an Indifference Curve
✓ An indifference curve shows all combinations of two goods that give the
consumer the same level of satisfaction (utility).
✓ The consumer is indifferent between any two points on the curve because
each combination provides equal utility.
✓ Arises because many goods can substitute for each other, allowing the
consumer to choose different mixes.
✓ The consumer may not measure utility, but can rank preferences and
identify combinations that give equal satisfaction.
✓ When combinations with equal utility are listed, we get an indifference
schedule; when plotted, they form an indifference curve.
✓ An indifference curve is also called an Iso-Utility Curve or Equal Utility
Curve.
Table 3.2 Indifference Schedule of Commodities X and Y

Combination Commodity X Commodity Y Utility

a 25 5 u
b 15 7 u
c 10 12 u
d 6 20 u
e 4 30 u
The Indifference Map
✓ A single indifference curve represents combinations of two goods yielding
the same level of satisfaction.
✓ However, the consumer may face many other combinations, each giving
less or more satisfaction than the original curve.
✓ Lower indifference curves represent combinations with less satisfaction.
✓ Higher indifference curves represent combinations with greater
satisfaction.
✓ By plotting multiple indifference curves, we create an indifference map,
showing all possible combinations of two goods at different levels of
satisfaction.
✓ Each curve on the map shows points between which the consumer is
indifferent, and curves further from the origin indicate higher utility.
Characteristics of Indifference Curves
1. Cannot Intersect
✓ Indifference curves never cross; one bundle cannot provide
two different satisfaction levels.

C
A

31

➢ A and C should make the consumer equally happy.

➢ B and C should make the consumer equally happy.
➢ This implies that A and B would make the consumer equally happy. But A has
more of both goods compared to C.
2. Indifference curves are downward sloping.
✓ Downward slope ensures that to gain more of one good, the
consumer must give up some of the other to maintain the
same utility.
3. Higher Curves Represent Higher Satisfaction
✓ Curves further from the origin correspond to higher utility;
bundles on higher curves are preferred to those on lower
curves.
4. Represents Only Two Goods
✓ Indifference curves are limited to two goods, as the diagram
uses two axes; more goods require higher dimensions.
 5. Convex to the Origin
✓ Convexity reflects the diminishing marginal rate
of substitution (MRS): the consumer gives up less
of good Y as more of good X is consumed.
Quantity
of Pepsi
Exceptional Types of Indifference Curves:
1. Perfect Substitutes
✓ The shape of an indifference curve reflects the consumer’s willingness to
substitute one good for another.
✓ Perfect substitutes occur when a consumer is willing to replace one good with
another at a constant rate.
➢ The marginal rate of substitution (MRS) is constant.
➢ Example: willing to trade 1 glass of apple juice for 1 glass of orange juice.
✓ Indifference curves for perfect substitutes are straight lines, showing a
constant trade-off.
✓ Example: a consumer indifferent between apple juice and orange juice; MRS =
1.
 Perfect Complements
❖ Perfect complements are goods that are always consumed together in fixed
proportions.
✓ Example: left shoes and right shoes, car and tires
✓ One without the other provides no satisfaction.
❖ The consumer values the goods only as pairs, so extra units of one good alone do
not increase utility.
❑ Marginal Rate of Substitution (MRS) is undefined
✓ MRS = 0 when the consumer has more right shoes than left:
They will not give up any left shoes for additional right shoes.
✓ MRS = ∞ when the consumer has more left shoes than right:
They will give up all extra left shoes to get one more right shoe.
❑ Indifference Curve Shape
✓ Indifference curves for perfect complements are L-shaped.
✓ The kink represents the fixed consumption ratio (e.g., 1 left shoe + 1 right shoe).
✓ The ratio does not necessarily have to be 1:1.
• Example: If a consumer always uses 2 teaspoons of sugar per cup of tea, the
indifference curves remain L-shaped, just aligned to the required 2:1
proportion.
Left shoe

Right shoe
Diminishing Marginal Rate of Substitution
❑ When a consumer chooses different combinations of two goods
that give the same level of satisfaction, they substitute one good
for another.
❑ The rate at which the consumer gives up one good in exchange
for another, while keeping utility constant, is called the Marginal
Rate of Substitution (MRS).
❑ A basic assumption of indifference curve analysis is that the
MRS diminishes.
This means:
✓ As the consumer substitutes more of good X for good Y,
✓ The stock of X increases and the stock of Y falls,
✓ So the amount of Y the consumer is willing to give up for one
more unit of X decreases.

This is similar to the assumption of diminishing marginal utility in

cardinal utility theory.
Measuring Marginal Rate of Substitution (MRS)
❑ Conceptually, the MRS is:
✓The amount of one good a consumer must give up to obtain
one more unit of another good,
✓While keeping total satisfaction unchanged.
❑ Thus, MRSXY can be interpreted as:
✓ Units of Y required to replace one unit of X, or
✓ Units of X required to replace one unit of Y,
as long as total utility remains constant.
 Symbolic Explanation
Let the utility function be:
𝑈=𝑓 𝑋 𝑌
Suppose the consumer substitutes X for Y.
✓ Giving up ∆Y decreases utility by: −Δ𝑌 ⋅ 𝑀𝑈𝑌
✓ Gaining ∆X increases utility by: +Δ𝑋 ⋅ 𝑀𝑈𝑋
For total utility to remain the same:
−Δ𝑌 ⋅ 𝑀𝑈𝑌 + Δ𝑋 ⋅ 𝑀𝑈𝑋 = 0
Δ𝑌 𝑀𝑈𝑋
Rearranging: − =
Δ𝑋 𝑀𝑈𝑌
MRS and the Slope of the Indifference Curve
✓ The term −Δ𝑌/Δ𝑋is the slope of the indifference curve, and it
represents MRS of X for Y.
Δ𝑌 𝑀𝑈𝑋
✓ Similarly: 𝑀𝑅𝑆𝑥,𝑦 = − =
Δ𝑋 𝑀𝑈𝑌

Δ𝑋 𝑀𝑈𝑌
𝑀𝑅𝑆𝑦,𝑥 =− =
Δ𝑌 𝑀𝑈𝑋
Thus: MRS = slope of the indifference curve.
Key Concept: Diminishing MRS
✓ As a consumer substitutes X for Y, the willingness to give up Y
decreases.
✓ This means:
➢ Early substitutions → high sacrifice of Y
➢ Later substitutions → low sacrifice of Y
Movement on IC –ΔY +ΔX MRSₓ,ᵧ = –ΔY/ΔX

a→b –10 2 –5.0

b→c –5 5 –1.0

c→d –4 8 –0.5

d→e –2 10 –0.2

❖Trend: MRS decreases from –5 → –0.2 as we move down the

curve.
❖Implication
✓ Diminishing MRS ⇒ Indifference curves are convex to the
origin.
Why Does the Marginal Rate of Substitution (MRS) Diminish?
1. Goods are not perfect substitutes
✓ Indifference curves slope downward because consumers cannot exchange
goods at a constant rate.
✓ If goods were perfect substitutes, the indifference curve would be a straight
line.
2. Declining marginal utility of the increasing good
✓ As the consumer gets more of X, its additional satisfaction (MUₓ) falls.
✓ As the consumer gets less of Y, its marginal utility (MUᵧ) increases.
✓ Therefore, the consumer becomes less willing to give up Y for extra units of X.
3. Increasing difficulty of sacrifice
✓ When Y becomes scarce, each remaining unit becomes more valuable.
✓ The consumer demands more units of X to compensate for each additional
unit of Y sacrificed.
4. Stock-based behaviour rule
✓ A consumer can easily sacrifice a commodity when its stock is high.
✓ When the stock is low, sacrificing becomes difficult.
✓ Thus:
➢ Large quantity of Y → high willingness to give up Y
➢ Small quantity of Y → low willingness to sacrifice Y
Utility Maximization and Income (budget) constraint

⚫ The budget constraint depicts the limit on the

consumption 'bundles' that a consumer can afford.
◦ People consume less than they desire because their
spending is constrained, or limited, by their income.
⚫ The budget constraint shows the various combinations of
goods the consumer can afford given his or her income
and the prices of the two goods.
⚫ Consumers' spending on consumer goods is constrained
by their incomes:
Income = Px Qx + Py Qy + Pw Qw + ….+Pz Qz
⚫ Whilethe consumer tries to equalize MUx/Px , MUy/ Py,
MUw/Pw,………. and MUz/Pz, to maximize utility total
spending cannot exceed income.

For example, with an income of $1000 Mr X is trying to

decide how much pints of pepsi and how much pizza he
should buy. Let price of pepsi be 2 and price of pizza be 10,
then
Mr X‟s income = 2x50 + 10 x 90 = 1000
Optimal Purchase Mix: Pepsi and Pizza
⚫ The Consumer's Budget Constraint

I = Px.X+ Py.Y

Y =(I/Py) - (Px/Py).X

Y=(1000/2)-(10/2)X Y=500-5X

◦ Any point on the budget constraint indicates the consumer‟s

combination or tradeoff between two goods.
 Quantity
of Pepsi (Y)
I/Py=1000/2
B
500

Slope = -Px/P y = -10/2

= -5

Consumer‟s
budget constraint I/Px=1000/10

A
0 100 Quantity
of Pizza (X)
⚫ The slope of the budget constraint equals the relative price of
the two goods, that is, the price of one good compared to the
price of the other.

⚫ It measures the rate at which theconsumer can trade one

good for the other.

⚫ Assume the budget constraint:

3X+4Y=24.
◦ Y=6- ¾ X the slope is ¾ ,Y intercept is 6, and X intercept
is 8
The intercept is I /p2, I /p1& the slope is –p1/p2 .
⚫ What if income increased?
⚫ The slope would stay the same & the budget constraint would shift out

parallel to the original one.

⚫ Suppose in our example with income of 24 & prices of 3 & 4, income
increased to 36.
Y Our new y-intercept will be 36/4 =9
(0,9)
& the new X-intercept will be 36/3=12.
(0,6)

X
0 (8,0) (12,0)
 Suppose the price of the good on the X-axis increased.
⚫If we bought only the good whose price
increased,we could afford less of it.
⚫ If we bought only the other good,our purchases would

be unchanged.
Y
⚫ So the budget constraint would pivot inward about

theY-intercept.
(0,6) For example, if the price increased
from $3 to $4, our $24 would only
buy 6 units.

0 (6,0) (8,0) X
 Similarly,if the price of the good on the
Y-axis increased, the budget constraint
would pivot in about the X-intercept.
Suppose the price of the 2nd good
Y
increased from $4 to $6. If you bought
only that good, with your $24, your $24
(0,6) would only buy 4 units of it.
(0,4)

0 (8,0) X
 IC and Budget Line for Utility Maximization
Let’s combine our indifference curves & budget constraint
to determine our utility maximizing point.
⚫PointA doesn’t maximize
Y IC3 our utility & it doesn’t require
IC all our income.(It’s below the
IC 1 2
budget constraint.)

0 X
⚫Points B & C spend all our income but they don’t
maximize our utility. We can reach a higher
indifference curve.

Y IC3
IC
IC1 2

C
0 X
⚫ Point D is unattainable. We can’t reach it with our budget.

Y IC3
IC
IC 1 2
D

0 X
⚫ Point E is our utility-maximizing point.
⚫ We can’t do any better than at E.

⚫ Notice that our utility is maximized at the point of tangency

between the budget constraint & the indifference curve.

Y IC3
IC
IC 1 2
⚫ At E MRS = MUx/MUy= Px/Py

0 X
 Recall that,to maximize your utility,you should purchase goods so that
the marginal utility per dollar is the same for all goods.

⚫ If there were just two goods, that means that MU1/P1 = MU2/P2
⚫ Multiplying both sides by P1/MU2, we have MU1/MU2 = P1/P2 .
⚫ The expression on the right is the negative of the slope of the budget
constraint.
⚫ The expression on the left is the negative of the slope of the
indifference curve.
⚫ So the slope of the indifference curve must be equal to the slope of the
budget constraint.
⚫ If at a particular point,two functions have the same slope,they are tangent
to each other.
▪ That means your utility-maximizing consumption
levels are where your indifference curve is tangent to
the budget constraint.

▪ This is the same conclusion we reached using our graph.

▪ This occurs at the point where the highest indifference curve

and the budget constraint are tangent. It is where marginal rate
of substitution equals the relative price (the slope of IC equals
the slope of budget constraint)
❖ Recall that to maximize utility a consumer would set:
(MUx/Px) = (MUy/Py)
❖ If Px increases this equality would be disturbed:

(MUx/Px) < (MUy/Py)

❖ To return to equality the consumer must adjust his/her

consumption. (N.B. the consumer cannot change prices, and
he/she has an income constraint.)
❖ What are the consumer's options?
 (MUx/Px) < (MUy/Py)

• In order to make the two sides of the above inequality

equal again, given that Px and Py could not be
changed, we would have to increase MUx and
decrease MUy.
• We can increase MUx by reducing X and decrease MUy
by increasing Y.
Example: I f TU = 10X + 24Y – 0.5 X2 – 0.5Y2, the prices of the
two goods are 2 and 6, and we have $44, how much should you
consume of each good?

⚫ Taking the derivatives of TU, we

have MU1 =
10 – X and MU2 = 24 – Y
⚫ Since MU1/MU2 = P1/P2 ,we have
(10 – X) /(24 – Y) = 2 /6 ,
or 60 – 6 X = 48 – 2Y , or
6X – 2Y = 12 .
⚫ This is an equation with two unknowns.
⚫ Our budget constraint provides us with a 2nd equation.
⚫ Combining the two equations,we can solve for X &Y.
⚫ The budget constraint is 2X + 6Y = 44 .
❖ So our two equations are
6X – 2Y = 12 and 2X + 6Y = 44
⚫ Multiplying the second equation by 3 yields
6X + 18Y = 132 .
⚫ Now we have 6X + 18Y = 132
6X – 2Y = 12
--------------------
So, 20Y = 120
and Y= 6.
⚫ Plugging 6 forY in the 2nd equation yields 6X – 12 = 12,
or 6X = 24.
So, X = 4.
 Let’s see if all this works.
⚫ We had $44,the prices were 2 & 6,and
MU1 = 10 – X & MU2 = 24 – Y.
We bought 4 units of the 1st good & 6 of the 2nd good.
⚫ First,did we spend exactly what we had?

⚫ We spent (2)(4) + (6)(6) = 8 + 36 = 44 Good.

⚫ Is the marginal utility per dollar the same for both goods?
⚫ For the 1st good:MU1/P1 = (10 – X)/2 = (10-4)/2= 3
⚫ For the 2nd good: MU2/P2 = (24 – Y)/6 = (24-6)/6= 3
⚫ So they’re equal and things look fine.
 Lagrangian Method
⚫ Assume we want to maximize the utility function
U= f(x1,x2) subject to the budget constraint I=x1p1+x2p2.
⚫ Now,rearrange the budget constraint as I-x1p1-x2p2=0 then
multiply both sides by a constant λ .
⚫ (I-x1p1-x2p2)=0then add this to the objective function.
⚫ L= f(x1, x2)+ λ (I-x1p1-x2p2)
⚫ Derivate this function with respect to x1,x2,and λ .
 Lagrangian
⚫ F.O.C.s are (First Order Conditions)

Derivative of L w.r.t. x1

Derivative of L w.r.t. x2

Derivative of L w.r.t. λ

◼ These F.O.C.s along with the three variables can be solved

simultaneously for optimal levels of x1*, x2*, and λ*
◼ In terms of second-order-condition (S.O.C.), Diminishing
MRS axiom is sufficient to ensure a maximum
 Implications of the [Link] Condition
⚫ Rearranging first two [Link] yields
◦ ∂U /∂ x1 = λ*p1
◦ ∂U /∂ x2 = λ*p2
⚫ Taking the ratio gives
𝜕𝑈/𝜕𝑥1 𝑀𝑈1 𝑝1
= = 𝑀𝑅𝑆 𝑥2 for 𝑥1 =
𝜕𝑈/𝜕𝑥2 𝑀𝑈2 𝑝2

◼ For maximizing utility, how much a household is willing to

substitute x2 for x1 is set equal to economic rate of substitution,
p1/p2
◼ Result is identical to tangency condition for utility
maximization between budget line and indifference curve
 ⚫ From F.O.C.s, this marginal utility per dollar condition is derived by
solving for λ* in first two equations

◼ At utility-maximizing point, each commodity should

yield same marginal utility per dollar
▪ Each commodity has an identical marginal-benefit to marginal-
cost ratio
 Some Interpretations
⚫ Lagrange multiplier,λ,is a common benefit cost ratio for all the
x’s:
◦ λ = Marginal benefit of xi
Marginal cost of xi

⚫λ is often called the'shadow price', which measures the price

of an additional unit of xi.
 The n-Good Case

⚫ The individual’s objective is to maximize

utility = U(X1,X2,…,Xn)
subject to the budget constraint
I = P1X1 + P2X2 + … + PnXn

⚫ Set up the Lagrangian:

L = U(X1,X2,…,Xn) + (I-P1X1- P2X2-… - PnXn)
⚫ First-order conditions:
L/ X 1 = U/ X 1 - P1 = 0
L/ X 2 = U/ X 2 - P2 = 0

•
•
•
L/ Xn = U/ Xn - Pn = 0
L/ = I - P1X1 - P2X2 - … - PnXn = 0
⚫ For any two goods,
U / Xi Pi
U / Xj Pj
• This implies that at the optimal
allocation of income
Pi
MRS ( X i for X j )
Pj
Utility Maximization Using Lagrangian Method Utility Function
𝑈 𝑋 𝑌 = 𝑋 𝛼 𝑌𝛽
Budget Constraint
𝑃𝑋 𝑋 + 𝑃𝑌 𝑌 = 𝐼
Lagrangian
𝐿 = 𝑋 𝛼 𝑌𝛽 + 𝜆 𝐼 − 𝑃𝑋 𝑋 − 𝑃𝑌 𝑌
First-Order Conditions
𝜕𝐿
= 𝛼𝑋 𝛼−1 𝑌𝛽 − 𝜆𝑃𝑋 = 0
𝜕𝑋
𝜕𝐿
= 𝛽𝑋 𝛼 𝑌𝛽−1 − 𝜆𝑃𝑌 = 0
𝜕𝑌
𝜕𝐿
= 𝐼 − 𝑃𝑋 𝑋 − 𝑃𝑌 𝑌 = 0
𝜕𝜆
⚫ First-orderconditions imply:
( X -1Y )/PX = ( X Y -1)/PY =
⚫ From this:

Y/ X = PX/PY
⚫ This means PYY =( / )PXX
⚫ Since + = 1:
PYY = ( / )PXX = [(1- )/ ]PXX
⚫ Substituting into the budget constraint:
I = PXX + [(1- )/ ]PXX = (1/ )PXX
⚫ Solving for X yields
I
X*
PX
• Solving for Y yields
I
Y*
PY
• The individual will allocate percent of his
income to good X and percent of his
income to good Y
How Changes in Income Affect the Consumer’s
Choices
⚫ An increase in income shifts the budget
constraint outward.
⚫ Since px/py does not change,the MRS will stay constant
◦ The consumer is able to choose a better combination of
goods on a higher IC.
 Effect of an increase in income

Quantity
of Pepsi New budget constraint

1. An increase in income shifts the

budget constraint outward . . .

New optimum

3. . . . and
Pepsi
Initial
consumption.
optimum I2

Initial
budget
I1
constraint

0 Quantity
of Pizza
2. . . . raising pizza consumption . . .
 Normal versus Inferior Goods
⚫ Normal Goods
◦ If a consumer buys more of a good when his or her
income rises,the good is called a normal good.
◦ A good xi for 𝑤ℎ𝑖𝑐ℎ 𝑥𝑖/ 𝐼 0 over some range of
income is a normal good in that range
⚫ Inferior Goods
◦ If a consumer buys less of a good when his or her
income rises,the good is called an inferior good.
◦ A good xi for 𝑤ℎ𝑖𝑐ℎ 𝑥𝑖/ 𝐼 < 0 over some range of
income is an inferior good in that range
Properties of Normal and Inferior Goods
⚫ Income elasticity is positive for normal goods,
negative for inferior goods
⚫ Slope of income-consumption curve shows
whether a good is normal or inferior
⚫ No good can be inferior at all levels of income
 An Inferior Good
Quantity
of Pepsi
New budget constraint

1. When an increase in income shifts the

3. . . . but budget constraint outward . . .
Initial
Pepsi
optimum
consumption
falls, making
Pepsi an New optimum
inferior good.

Initial
budget I2
I1
constraint
0 Quantity
of Pizza
2. . . . pizza consumption rises, making pizza a normal good . . .

80
 Two Normal Goods
⚫ As income increases,the budget constraint
shifts out & we are able to reach higher &
higher IC’s.
Y IC3 ⚫ The points of tangency are at higher &
IC2
higher levels of consumption of both
IC1 goods.
Y3
C

Y2
B
A
Y1

X1 X2 X3 X
81
 Income-Consumption Curve
⚫ The curve that traces out these points is
called the income- consumption curve
(ICC).
⚫ ICC: for a good is the set of optimal
Y IC3
IC 2 bundles traced on an indifference map as
income varies (holding the prices of X
IC1 andY constant).
Y3 C

Y2 B

Y1
A

X1 X2 X3 X
82
⚫ For two normal goods, ICC slopes upward.
⚫ It may be convex, concave, or linear.

83
 One Normal Good & One Inferior Good
⚫ Suppose the good on the horizontal axis is normal & the
one on the vertical axis is inferior.
⚫ Then X will rise &Y will fallas income increases.
Y

IC1 IC2
IC3

Y1 A B
Y2 C
Y3

X1 X2 X3 X
 Income-Consumption Curve
⚫ The result is a downward sloping income-consumption curve.

IC1 IC2
IC3

Y1 A B
Y2 C
Y3

X1 X2 X3 X
 Engel Curve ⚫ The Engel Curve shows the
quantity of a good purchased at
each income level.
Income
⚫ Engel curve: curve that plots
the relationship between the
quantity of X consumed and
income.
C
⚫ The graph has income on the
I3
B vertical axis and the quantity of
I2 A the good on the horizontal.
⚫It slopes up for normal goods &
I1
down for inferior goods.
X1 X2 X3
An Individual Consumer’s Engel Curve
Engel Curves for Soup and Potatoes
Engel Curves for DifferentTypes of Goods
How Changes in Prices Affect Consumer’s Choices

⚫ A fall in the price of any good rotates the budget

constraint outward and changes the slope of the budget
constraint.
⚫ A change in the price of a good alters the slope of the budget
constraint (px/py)
◦ Consequently,it changes the MRS at the consumer’s utility-maximizing
choices.
 Change in Price

Quantity
of Pepsi

New budget constraint

1,000 D

New optimum
B 1.A fall in the price of Pepsi rotates
500
the budget constraint outward . . .
3. . . . and
raising Pepsi Initial optimum
consumption.
Initial I2
budget I1
constraint A
0 100 Quantity
of Pizza
2. . . . reducing pizza consumption . . .
 Income and Substitution Effects of a Price Change

⚫ A price change has two effects on consumption.

◦ An income effect
◦ A substitution effect
⚫ The Income Effect
◦ The income effect is the change in consumption that results
when a price change moves the consumer to a higher or
lower indifference curve.
◦ The price change alters the individual’s real income and therefore he
must move to a new indifference curve
⚫ The Substitution Effect
◦ The substitution effect is the change in consumption that
results when a price change moves the consumer along an
indifference curve to a point with a different marginal rate of
substitution.
◦ Even if the individual remained on the same indifference curve when the
price changes,his optimal choice will change

because the MRS must equal the new price ratio.

 Income and Substitution Effects: Graphical illustration
Quantity
of Pepsi

New budget constraint

C New optimum
Income
effect B
Initial optimum
Initial
Substitution
budget
effect
constraint A
I2

I1
0 Quantity
Substitution effect of Pizza

Income effect
⚫A Change in Price: Substitution Effect
◦ A price change first causes the consumer to move
from one point on an indifference curve to another on
the same curve.
🞄 Illustrated by movement from point A to point B.
⚫A Change in Price: Income Effect
◦ After moving from one point to another on the
same curve, the consumer will move to another
indifference curve.
🞄 Illustrated by movement from point B to point
C.
95
 Sign of substitution effect (SE)
SE is always negative,that is,if price decreases,the substitution
effect makes quantity to increase and [Link] why:
1) Assume px decreases,so: px1 < px0

2) MRS(x0,y0)= Px0/Py0 & MRS(x1,y1)= px1 /py0

1 and 2 implies that:
MRS(x1,y1)<MRS(x0,y0)
As the MRS is decreasing in x,this means that x has increased,
that is:x1>x0
96
Table1 Income and Substitution EffectsWhen the Price of Pepsi Fall

97
 Price and the Shape of the Demand Curve
The two effects of a price change:

❖ Income effect:
✓ Normal good (-)
✓ Inferior goods (+)
❖ Substitution effect
❖ Buying less X and substituting it withY until the optimizing
condition is restored (-)

❑ As Px increases, Qx decreases

98
 Price Changes for Normal Goods
⚫ If a good is normal,substitution and income effects
reinforce one another
❖ when price falls,both effects lead to a rise in quantity
demanded
❖ when price rises,both effects lead to a drop in quantity
demanded
✓ Both income effect and substitution effect are negative.
✓ Overall effect is negative

99
 Price Changes for Inferior Goods
⚫ If a good is inferior,substitution and income effects
move in opposite directions (-ve and
+ve respectively)
⚫ The combined effect is indeterminate
◦ when price rises, the substitution effect leads to a drop in quantity
demanded, but the income effect is opposite
◦ when price falls,the substitution effect leads to a rise in quantity
demanded,but the income effect is opposite
100
 Giffen’s Paradox
⚫ If the income effect of a price change is
strong enough,
there could be a positive relationship between price and
quantity demanded
➢ an increase in price leads to a drop in real income
➢ since the good is inferior,a drop in income causes quantity
demanded to rise

101
 The Effect of Changes in Price
⚫ Price-consumption curve (PCC): the set of optimal
bundles traced on an indifference map as the price of
X varies (holding income and the priceY constant).

102
103
 Exercises
⚫ Derive Marginal Utilities, check whether diminishing marginal
utility holds, and compute MRS for the following functions.
◦ U = 4X1/2Y1/2
◦ U = X2Y2
⚫ For the following utility functions derive average and marginal
utility functions,find the value of X at which total utility is
maximum, and the value of X at which average utility is
maximum
⚫ U=27X2-3X3
⚫ U=15X+6X2-X 3

104
 Exercises…
⚫ Given the following budget constraints and utility functions,
find utility maximizing combinations of X andY,and the
maximum level of utility.
a) 10X+30Y=360 (Budget constraint), U=X3/4Y1/4 (utility
function)
b) X+Y=10 (Budget constraint), U=XY (utility function)
⚫ What do you think are exceptions to the law of diminishing
marginal utility?
⚫ Read about “The Revealed PreferenceApproach”

105