Principles of

1
Microeconomics
 Consumer Objectives
· In the Neoclassical economics, the goal of
consumer behavior is utility maximization
[this is consistent with maximization of
Net benefits]
· Consumer choice among various alternatives
is subject to constraints:
· income or budget
· prices of goods purchased
· preferences
Principles of
2
Microeconomics
 Models of Consumer Behavior

· Marginal Utility approach

· cardinal measure of utility
· problem of related goods
· Indifference approach
· ordinal utility
· related goods
· observable behavior

Principles of
3
Microeconomics
Utility Approach to Consumer Behavior

· Need for cardinal measure of utility

· analysis is useful for explaining
behavior
· Total and Marginal utility
· “law of diminishing Marginal Utility”
· Equimarginal rule and utility
maximization
Principles of
4
Microeconomics
Total utility [TU] is defined as the amount of utility an
individual derives from consuming a given quantity of a good
during a specific period of time. TU = f(Q,
preferences, . . .)
Utility TU
Q T 12
0
. . . . . TU

.
1 U
30 10
0

.
2 55 8
0
3 75

.
6
4 90 0
4
5 100 0
2
6 105 0
7 105 1 2 3 4 5 6 7
8 100 Q/ut

Principles of
5
Microeconomics
 Nature of Total Utility
· When more and more units of a good are consumed
in a specific time period, the utility derived tends
to increase at a decreasing rate
· Eventually, some maximum utility is derived and
additional units cause total utility to diminish. As
an example, think of eating “free” hot cakes.
· It is possible for total utility to initially increase
at an increasing rate.

Principles of
6
Microeconomics
 Marginal Utility
· Marginal utility [MU] is the change in total utility
associated with a 1 unit change in consumption.
· As total utility increases at a decreasing rate,
MU declines.
· As total utility declines, MU is negative
· When TU is a maximum, MU is 0 [This is
sometimes called the “Satiation point” or the point
of “absolute diminishing utility.”

Principles of
7
Microeconomics
 Marginal Utility [MU] is the change in total utility [ΔTU]
caused by a one unit change in quantity [ΔQ] ;
MU = ΔT
UΔ
The first unit consumed increases TU
Q by

..
Utility 30. M
The 2cd unit increases TU by
U

..
Q T M 3 25.
ΔQ= U U
ΔTU=3

.. .
1ΔQ= 1 30 0
30 02
ΔTU=2 25
1 2 55 25 0
5 1

.
ΔQ= ΔTU=2
1 3 75 20
0 0 M
4 90 15 U
1Δ 2 3 4 5 6 7
5 100 10 Q/ut
Q
Remember that the MU is associated with the
6 105 5 midpoint between the units as each additional
7 105 0 unit is added.
8 100 -
5
Principles of
8
Microeconomics
TU
The first unit consumed, The MU is the slope of TU or the
12
0
10
ΔQ

max
. . . .
increases TU by 30, ΔTU.
.
T
U
rate of change in TU associated
with a one unit change in quantity.
0
8 TU
. [Using calculus, MU is the change in

.
TU
0 as change in quantity approaches 0.]
6 between the 2cd and For the first

.
0 Δ 30
4 3rd unit: MU = ΔT
Q =
0 units ΔTU = 20 or the U
Δ 1
2 slope of TU is 20.
ΔT ΔT Q
0 The slope of TU is = 30,
U UΔ
1 2 3 4 5 6 7 Q

..
M Q/ut MU is the slope of the
U TU. unit changes TU [ ΔTU] by

..
3 The second
0 25, The slope of TU between the 1

. .M
2 and
0 second unit is 25.

U.
1

. of
0 Where MU = 0, TU is a
maximum.
1 2 3 4 5 6 7
Principles
Q/ut 9
Microeconomics
 Consumer Preferences
· Both MU and TU are determined by the “preferences” or
utility function of the individual and the quantity consumed.
· Utility cannot be measured directly but individual choices
reveal information about the individual’s preferences
· Surrogate variables [age, gender, ethnic background,
religion, etc.] may be correlated with preferences.
· There is a tendency for TU to increase at a decreasing rate
[MU declines] as more of a good is consumed in a given time
period: i.e. “diminishing marginal utility”

Principles of
10
Microeconomics
 Diminishing Marginal Utility
· Initially, it may be possible for TU to increase at
an increasing rate. In which case MU will increase
[MU is the slope of TU which is increasing].
· Eventually, as more and more of a good are
consumed in a given time period, TU continues to
increase but at a decreasing rate; MU decreases.
· This is called the point of “diminishing marginal
utility.”

Principles of
11
Microeconomics
 Consumer Choices
· If there were no costs associated with choices,
the individual will consume a good until MU = 0 [this
maximizes TU or the total benefits, TB]
· Typically, individuals are constrained by a budget
[or income] and the prices they pay for the goods
they consume.
· Net benefits are maximized where MB = MC; as
long as the MU or MB of the next unit of good purchased exceeds
the Price or MC, it will increase net benefits

Principles of
12
Microeconomics
 Society and Individual
· The individual will purchase more of a good so long
as their perceived or anticipated MB exceeds the
price they must pay for the good: Buy so long as
MB > P, optimum where, P = MB
· From a social perspective that good should only be
produced and sold if the price is greater than or
equal to the MC: Sell so long as P > MC, optimum
where P = MC
· Social optimum when MB = P = MC

Principles of
13
Microeconomics
 Constrained Optimization
· Individual choices then become a function of the
price of the good, income [budget], prices of
related goods and preferences.
· QX = f (PX , Y, PY, Preferences, . . . )
· Where:
· PX = price of good X
· Y = income
· PY = prices of related goods
· “preferences” is the individual’s utility function

Principles of
14
Microeconomics
 Utility and Demand

· Individual choice is influenced by:

· QX = f (PX , Y, PY, Preferences, . . . )
· These are the same variables in the
demand function
· The forces that shape the demand
function can be analyzed with utility
analysis
Principles of
15
Microeconomics
The budget constraint can be expressed: B > PxQx + PyQy
The amount of good Y that can be
purchased B
is theamount
The budgetof
divided
good Xby the price of good Py
Y,
that can be For an B = $80,
purchased and Py = $5
is, B
Px Qy For an B = $80,
80 B C and PX = $3
= 16
5 Py
= Any combination
Connecting the two intercepts inside area 0AC
identifies all combinations of can be purchased
goods X &Y that can be for less than
purchased for a budget of $80. A
$80,
Py = $5, and PX = $3. 0 80
= 26.7
B Qx
3 Px
=
Principles of
16
Microeconomics
Consider an individual’s utility preference for 2 goods, X &
Y; If the two goods were
Good X “free,” Good Y
[ or no budget constraint],
Utility the individual would consume Utility
Qx X TUx MUx each good 7until the MU of
units Qy Y TUy MUy
that goodXwas
of good and 0,6 of Y.
1 30 30 1 60 60
2 55 25 2 90 30
Once the goods have a price
3 75 20 and there is a budget 3 11 20
constraint, the individual 0
4 90 15 4 12 10
10 will try to maximize the 0
5 100 5 12
utility from each additional 8
6 105 5 dollar spent. 6 12 8
8
7 105 0 7 120 0-
8 100 - 8 100 -8
5 20
Principles of
17
Microeconomics
 Given the budget constraint, Individuals will attempt to
gain the maximum utility for each additional dollar
spent,
“the marginal dollar.”
For PX = $3, the
Utility MUX MU per dollar MUY Utility
X
PX PY
X
Qx TUx MUx spent on good Qy Y TUy MUy
X is;
1 30 30 10. 12 1 60 60
2 55 25 8.3 6 2 90 30
For PY = $5, the
3 75 20 3 6.6 MUY per dollar 4 3 11 20
0
4 90 15 7 5.0 spent on good 2 4 12 10
0 Y is; 0
5 100 10 3.3 1. 5 128
6 105 5 3 1.6 6
0 6 128 8
7 105 0 7
0 7 120 0-
8 100 - 8 100 -8
5 20
Principles of
18
Microeconomics
Now the preferences of the individuals and the relative prices
of the two goods are displayed in the tables.

Utility MUX MUY Utility

PX PY
Qx X TUx MUx Qy Y TUy MUy
If the objective is
1 30 30 10. 12 1 60 60
to maximize utility
2 55 25 8.3 given prices, 6 2 90 30
3 75 20 3
6.6 preferences, and 3 11 20
4
4 7 budget, spend each 4 0
90 15 5.0 2 12 10
additional $ on the 0
5 10 0
3.3 1. 5
100 good that yields 128
6 105 5 3
1.6 the greater utility 6
0 6 128 8
7 105 0 7
0 for that 7 120 0-
expenditure.
8 100 - 8 100 -8
5 20
Principles of
19
Microeconomics
 Given the preferences of the individual and the relative
prices of the goods [PX = $3, PY = $5], the MU’s for
each dollar spent are:
To maximize TU given a budget of $30,the first
MUX MUY
PX expenditure would logically be for good Y since PY
the MUY for each dollar is 12.
$ The second expenditure is for good X, $
10 √ √ 12
.8.3 3
$ 5
$
√ [MUX $ is greater than MUY $]
The third & fourth expenditures are
√ 6
3 3
$ 5
6.6 √ for √ $ 4
7
5.0 3
$ good X since the MU per dollar spent is 5
√ greater for X than Y. is for is for good 2
0 3 The fifth expenditure
3.3 $ √ Y. 1.
3 Continue to maximize the MU per $ 6
3
1.6 0
spent.
AT THIS POINT YOU HAVE SPENT THE BUDGET OF
7
0
MUX $[Link] , BUY
PX
>P MUX
PX
<PMUY
, BUY Y !
Y X! Y

Principles of
20
Microeconomics
MUX
PX
>MU
P
says that the marginal utility of an additional
Y

Y
dollar spent on good X is greater than that
of
a dollar spent on good Y.

PX
<
MUX MUY indicates that the MU per dollar spent on
PY good
Y exceeds that of a dollar spent on good X.
If the amount spent on the two goods is equal to the
budget
then MUX
PX
>
MUY suggests that the individual should
PY buy
less of Y in order to buy more of X.
PX
<
MUX MUY says to purchase less X to pay for
PY
additional
amounts of Y.
MUX MUY
PX = P Y
is an equilibrium condition!

Principles of
21
Microeconomics
MUX MUY subject to the
PX = P Y constraint:P X + P Y = B
X Y
insures the individual has maximized their total utility
and
has not spent more on the two goods than their budget.
This model can be expanded to include as many goods
as
necessary:
MUX MUY MUZ
PX = PY = P Z = . . . = MUN
PN
subject
to;
PX X + PY Y + Pz Z + . . . + PN N = B
From this information a demand for the goods can
be
constructed.
Principles of
22
Microeconomics
Given the preference functions for goods X and Y,
and the prices of the two goods: PX = $3, PY = $5.
the MU of derived
from each dollar
MUX
Utility of expenditure MUY Utility
P PY
X
Qx TUx MUx
can beX
calculated. Qy Y TUy MUy
1 30 30 10. 12 1 60 60
If the individual is
2 55 25 8.3 maximizing utility, 6 2 90 30
3 75 20 3
6.6 their choices, 3 11 20
4
4 7 constrained by 4 0
90 15 5.0 2 12 10
their preferences, 0
5 10 0
3.3 1. 5
100 the prices and 128
6 105 5 3
1.6 their budget can 6
0 6 128 8
7 105 0 7
0 be shown: 7 120 0-
8 100 - 8 100 -8
5 20
Principles of
23
Microeconomics
 Given prices [PX = $3, PY = $5] and
preferences,
budget [$30], the individual’s choices were:

MUX Five units of X and 3 units of Y were purchased MUY

PX PY
These choices can be shown in the context
of
10 $ √a demand model: √ $ 12
3 PX 5 √ 5

.
.8.3 $ √ $ 6
3 3
$ 5
6.6 √ 4 √ $ 4
7
5.0 3
$ 5 2
√ PX = 3
0 3
$ This point lies on 1.
3.3 √ 2
3 the 6
3
1.6 demand for good X. 0
7 At PX = $3, 1
0
given budget,
1 2 3 4
Py and preferences,
55 6 7
5 units of X are QX/ut of
Principles
purchased. 24
Microeconomics
 Given the individual’s preferences, the price of Y [PY]
and the budget [B = $30], the individual purchased
5 units of X when the price of X [PX ] was $3.

MU Raise the price of X [PX ] to $5 and the MUX per

MUXX MUX MUY
PPXX PX $ spent is reduced. PY

.
[$3]
[$5] [$5] Choices about spending the $30 are
10 now: √ $ 12
$ √ The $30 is now spent.
.8.3 $6 PX 5 5

.
6 5 √ √ $ 6
3
5
6.6 55 4 That
Demand 5 4
$ √ √ $
7
4 54 portion 5
5.0 3 of demand At PX = $5, 2
03
3.3 3 ceteris paribus, 1.
2 between $3 and
32 2 $5 3 units of X 6
0
1.6
7 1 MU 1 is mapped! are
01 0 0X MUY
PX = PY 1 2 3 4 5
purchased.
6 7
QX/ut of
Principles
25
Microeconomics
 Demand
· By continuing to change the price of good X
[and holding all other variables, PY , budget or
income and preferences constant,] the rest of
the demand for good X can be mapped.
· All price and quantity combinations on the
demand for X are equilibrium points for
the consumer [They are maximizing utility;
holding all other variables, PY , budget or income
and preferences constant]
Principles of
26
Microeconomics
By changing the price of the good [in this case, good X]
and
holding all other variables [PY , budget or income and
preferences] constant, the demand for the good can be
mapped.
The demand function
is a schedule of the P
X
quantities that
individuals are willing 5
and able to buy at a 4
schedule of prices De
during a specific
3 m
an
period of time, 2 d
ceteris paribus. 1

1 2 3 4 5 6 7
Principles of QX/ut
27
Microeconomics
 The demand function has a negative slope because of the
income and substitution effects.
Income effect: As the price of a good that you buy increases
and money income is held constant, your real income
decreases
and you can not afford
to buy as much as you PX
could before.
Substitution effect: As 5
the price of one good
rises 4
relative to the prices of
De
3 m
other goods, you will tend an
to substitute the good 2 d
that is relatively cheaper 1
for the good that is
relatively more expensive. 1 2 3 4 5 6 7 QX/ut
Principles of
28
Microeconomics
 Income effects
· As the price of a good that you buy
increases, you will have less real income.
· This is the basis of price indices that
measure changes in real income as prices
rise or fall.
· The consumer price index is one of the
indices that is used [currently there is a
debate about how it is calculated].

Principles of
29
Microeconomics
 Substitution Effects
· As the price of a good increases
[decreases] while the prices of other
goods is constant, it becomes
relatively more [less] expensive.
· Individuals would substitute
relatively less expensive goods for
relatively more expensive ones even if
their real income were constant.
Principles of
30
Microeconomics
 CONSUMER SURPLUS
Notice that someone is willing and able to pay $6.80 for the
If the market price [established by S and D]
were
first $3,
[Link] buyer would purchase at $3 even though
they
were willing to pay PX
$6.80 for the first unit.

pl
7
They receive utility

Sup
6.8
that they did not have 0 6

y
to pay for [6.80-3.00].
This is called 5 consume
consumer 4 r
surplus. surplus De
3 m
At market an
equilibrium,
Consumer surplus will be 2 d
the area above the market 1
price and below the demand
function. 1 2 3 4 5 6 7
Principles of QX/ut
31
Microeconomics
 Demand
· Demand functions can be derived from utility
[cardinal measures] or indifference functions
[ordinal measures]
· Normally, demand functions show and inverse
relationship between price and quantity
· a change in price “causes” a change in “quantity
demanded”
· a change in any other variable [income, prices of
related goods, population, preferences, . . .] will
“cause a change in demand” or shift of demand
Principles of
32
Microeconomics