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The Logic of Individual
Choice:
The Foundation of
Supply and Demand
Chapter 8
© 2003 McGraw-Hill Ryerson Limited
8-2
Utility Theory and
Individual Choice

Economists have an answer to the
question of why people behave as they
do — self interest.
 Economists'
analysis of individual choice
does not deny individual differences.
© 2003 McGraw-Hill Ryerson Limited.
8-3
Utility Theory and
Individual Choice

Using the simple concept of selfinterest, two things determine what
people do:
 The
pleasure people get from doing or
consuming something.
 The price of doing or consuming that
something.
© 2003 McGraw-Hill Ryerson Limited.
8-4
Utility Theory and
Individual Choice
Price is the market's tool to bring
quantity supplied equal to the quantity
demanded.
 Changes in price provide incentives for
people to change what they are doing.

© 2003 McGraw-Hill Ryerson Limited.
8-5
Measuring Pleasure
Economists start with a proposition that
individuals try to get as much pleasure
as possible out of life.
 The goods and services we consume
provide value (satisfaction) to us.

© 2003 McGraw-Hill Ryerson Limited.
8-6
Measuring Pleasure

Individuals want to maximize the
amount of satisfaction they receive
through consuming goods and services.
© 2003 McGraw-Hill Ryerson Limited.
8-7
Measuring Pleasure
Economists use the concept of utility—
the pleasure or satisfaction that one
gets from consuming a good or service.
 A util is a unit created by economists to
“measure” utility.

© 2003 McGraw-Hill Ryerson Limited.
8-8
Utility

Utility serves as the basis of
economists' analysis of individual
choice.

It is personal and individual.
Utility cannot be compared across
individuals.

© 2003 McGraw-Hill Ryerson Limited.
8-9
Total Utility

Total utility refers to the total
satisfaction one gets from consuming a
product.
© 2003 McGraw-Hill Ryerson Limited.
8 - 10
Marginal Utility

Marginal utility refers to the
satisfaction one gets from the
consumption of one additional unit of a
product above and beyond what on has
consumed up to that point.
© 2003 McGraw-Hill Ryerson Limited.
8 - 11
Total Utility and Marginal
Utility
As additional units are consumed,
marginal utility decreases while total
utility increases.
 When marginal utility is zero, total utility
stops increasing.
 Beyond this point, marginal utility is
negative and total utility decreases.

© 2003 McGraw-Hill Ryerson Limited.
8 - 12
Marginal and Total Utility, Fig.
8-1a, p 180
Number of
pizza slices
1
2
3
4
5
6
7
8
9
Total utility
14
26
36
44
50
54
56
56
54
Marginal utility
14
12
10
8
6
4
2
0
-2
© 2003 McGraw-Hill Ryerson Limited.
8 - 13
Marginal and Total Utility, Fig.
8-1b and c, p 180
Total utility
Marginal utility
Utils
Utils
16
70
14
60
12
Total utility
Marginal utility
50
10
40
8
6
30
4
20
2
10
0
1 2 3 4 5 6 7 8 9
0
-2
1 2 3 4 5 6 7 8 9
Slices of pizza per hour
Slices of pizza per hour
© 2003 McGraw-Hill Ryerson Limited.
8 - 14
Diminishing Marginal
Utility

The principle of diminishing marginal
utility states that, at some point, the
marginal utility received from each
additional unit of a good begins to
decrease with each additional unit
consumed.
© 2003 McGraw-Hill Ryerson Limited.
8 - 15
Diminishing Marginal
Utility
This principle does not say you do not
enjoy consuming more of a good.
 It only states that as you consume more
of the good, you enjoy additional units
less than you enjoyed the initial units.

© 2003 McGraw-Hill Ryerson Limited.
8 - 16
Rational Choice and
Marginal Utility
The analysis of rational choice begins
with the premise that rational individuals
want as much satisfaction as they can
get from their available income.
 Rational means that people prefer more
to less and will make choices that give
them as much satisfaction as possible.

© 2003 McGraw-Hill Ryerson Limited.
8 - 17
Rational Choices
In making choices, essentially what you
are doing is buying units of utility.
 Any choice (for the same amount of
money) that does not give you as many
units of utility as possible is an irrational
choice.

© 2003 McGraw-Hill Ryerson Limited.
8 - 18
Rational choices

Since you want to get the most for your
money, you make those choices that
have the highest units of utility per dollar
spent.
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8 - 19
Maximizing Utility

Total utility is maximized when marginal
utility per dollar spent of two goods is
equal.
MUx MUy
=
Px
Py
© 2003 McGraw-Hill Ryerson Limited.
8 - 20
Maximizing Utility

If:
MUx MUy

Px
Py

Choose to consume an additional unit of
good x.
© 2003 McGraw-Hill Ryerson Limited.
8 - 21
Maximizing Utility

If:
MUx MUy

Px
Py

Choose to consume an additional unit of
good y.
© 2003 McGraw-Hill Ryerson Limited.
8 - 22
Maximizing Utility
By substituting the marginal utilities and
prices of goods into these formulas, you
can always decide which good it makes
more sense to consume.
 Consume the one with the highest
marginal utility per dollar.

© 2003 McGraw-Hill Ryerson Limited.
8 - 23
Maximizing Utility and
Equilibrium

When the ratios of the marginal utility to
price of goods are equal, you are
maximizing utility.
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8 - 24
Maximizing Utility

If:
MUx MUy

Px
Py
You’re in equilibrium.
 You cannot increase your utility by
adjusting your choices.

© 2003 McGraw-Hill Ryerson Limited.
8 - 25
Maximizing Utility, Table 8-1, p 182
Hamburgers (P = $2)
Ice Cream (P = $1)
Q
TU
MU MU/P
Q
TU
0
1
2
3
4
5
6
7
0
20
32
38
41
41
36
26
20 10
12
6
6
3
3 1.5
0
0
-5 -2.5
-10 -5
0
1
2
3
4
5
6
7
0
29
46
53
56
57
57
53
MU
29
17
7
3
1
0
-4
MU/P
29
17
7
3
1
0
-4
© 2003 McGraw-Hill Ryerson Limited.
8 - 26
Maximizing Utility, Table 8-2, p 183
Total $
spent
Purchase?
MU/P
MU
$1
1 ice cream cone
29
29
$2
2nd ice cream cone
17
17
$4
1 hamburger
10
20
$5
3rd ice cream cone
7
7
$7
2nd hamburger
6
12
$9
3rd hamburger
3
6
$10
4th ice cream cone
3
3
Total utility =
94 utils
© 2003 McGraw-Hill Ryerson Limited.
8 - 27
Rational Choice and
Marginal Utility
The same principle applies if more than
two goods are consumed:
 If MUx/Px > MUz/Pz, consume more of
good x.
 If MUy/Py > MUz/Pz, consume more of
good y.

© 2003 McGraw-Hill Ryerson Limited.
8 - 28
Rational Choice and
Marginal Utility

The general utility-maximizing rule is
that you are maximizing utility when the
marginal utilities per dollar are equal
across all goods you consume.
© 2003 McGraw-Hill Ryerson Limited.
8 - 29
Rational Choice and
Marginal Utility
MUx MUy MUz


 When
Px
Py
Pz you are
maximizing utility.
© 2003 McGraw-Hill Ryerson Limited.
8 - 30
Rational Choice and
Marginal Utility
When this principle is met, the
consumer is in equilibrium.
 The cost per additional unit of utility is
equal for all goods and the consumer is
as well off as it is possible to be.

© 2003 McGraw-Hill Ryerson Limited.
8 - 31
Rational Choice and
Marginal Utility
The rule does not say that the rational
consumer should consume a good until
its marginal utility reaches zero.
 Consumers do not have enough money
to reach this point, as they face an
income constraint.

© 2003 McGraw-Hill Ryerson Limited.
8 - 32
Opportunity Cost

Opportunity cost is the benefit forgone of
the next-best alternative.



It is essentially the marginal utility per dollar you
forgo.
To say MUx/Px > MUy/Py is to say that the
opportunity cost of not consuming good x is
greater than the opportunity cost of not
consuming good y.
So we consume x.
© 2003 McGraw-Hill Ryerson Limited.
8 - 33
Opportunity Cost

When all the marginal utilities per dollar
spent are equal, the opportunity cost of
all the alternatives are equal.
© 2003 McGraw-Hill Ryerson Limited.
8 - 34
Rational Choice and the
Laws of Demand

The principle of rational choice leads to
the law of demand.
 When
the price of a good goes up, the
marginal utility per dollar from that good
goes down and we demand less of it.
© 2003 McGraw-Hill Ryerson Limited.
8 - 35
Rational Choice and the Law
of Demand
Initially MUx/Px = MUy/Py
 When the price of good y goes up, then
MUx/Px > MUy/Py.
 Our condition for maximizing utility is no
longer satisfied.
 So when the price of a good goes up,
we would choose to consume less of
that good.

© 2003 McGraw-Hill Ryerson Limited.
8 - 36
Rational Choice and the Law
of Demand
Our utility maximizing rule is no longer
satisfied
 We should now buy more of good x

© 2003 McGraw-Hill Ryerson Limited.
8 - 37
Rational Choice and the Law
of Demand
MUx decreases as we buy more x
(diminishing marginal utility) and
 MUy increases as we buy less of the
good y
 We are back at a point where MUx/Px =
MUy/Py and we maximize utility (but we
now consume less x and more y than
before the price increase).

© 2003 McGraw-Hill Ryerson Limited.
8 - 38
Rational Choice and the Law
of Demand

Quantity demanded rises as price falls,
other things constant.

Quantity demanded falls as price rises,
other things constant.
© 2003 McGraw-Hill Ryerson Limited.
8 - 39
Rational Choice and the Law
of Demand

The above shows the relationship
between marginal utility and the price
we are willing to pay.
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8 - 40
Rational Choice and the Law
of Demand

Since our demand for a good is an
expression of our willingness to pay for
it, quantity demanded is related to
marginal utility.
© 2003 McGraw-Hill Ryerson Limited.
8 - 41
Maximizing Utility Using
Indifference Curves
Economists often use graphic
representation of the consumer’s
choice.
 The problem consists of two parts:

 The
budget constraint (or the income
constraint) and
 Indifference curves, which represent utility
© 2003 McGraw-Hill Ryerson Limited.
8 - 42
Graphing the Budget Line

The budget constraint represents all
the combinations of two goods that a
person can afford to buy with given
income.
 The
budget constraint is also called
the income constraint, or budget line.
© 2003 McGraw-Hill Ryerson Limited.
8 - 43
Jaz’s Budget Line

Jaz has $10 and buys chocolate and
pop whose prices are $1 and $0.50
respectively.
© 2003 McGraw-Hill Ryerson Limited.
8 - 44
Graphing the Budget Line, Fig.
8-2, p 187
Chocolate bars
10
8
Slope= - Ppop/Pchocolate
=-½
Income = $10
6
4
2
0
2 4 6 8 10 12 14 16 18 20 22
Cans of pop
© 2003 McGraw-Hill Ryerson Limited.
8 - 45
The Indifference Curve

An indifference curve represents all
the combinations of the two goods
amongst which an individual is
indifferent.
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8 - 46
The Indifference Curve

Jaz is equally as well off (her utility is
the same) from consuming bundles A,
B, C, D or E.
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8 - 47
Jaz’s Indifference Curve, Fig. 8-3a,
p 188
Chocolate bars
|Slope|= MUpop/MUchocolate bars
= MRS of pop for chocolate bars
20
16
12
8
4
0
A
B
C
Indifference curve
D
E
U
2 4 6 8 10 12 14 16 18 20 22
Cans of pop
© 2003 McGraw-Hill Ryerson Limited.
8 - 48
The Indifference Curve
The slope of the indifference curve is
called the marginal rate of substitution
(MRS)
 The slope is bowed inward, indicating
that MRS is decreasing as Jaz’s
bundles contain more of the good on
the horizontal axis.

© 2003 McGraw-Hill Ryerson Limited.
8 - 49
The Indifference Curve

The reason for decreasing MRS is that
as Jaz gets more and more of one
good, she is willing to give up lots of it to
get more of the relatively scarce good.
|Slope| = MUpop/Muchocolate = MRS
© 2003 McGraw-Hill Ryerson Limited.
8 - 50
A Map of Indifference
Curves
The bundles of goods forming
indifference curve U3 give Jaz higher
utility than bundles along U2,
 While the bundles of goods forming
indifference curve U1 give Jaz less utility
than bundles along U2.

© 2003 McGraw-Hill Ryerson Limited.
8 - 51
A Map of Indifference
Curves, Fig. 8-3b, p 188
Chocolate bars
20
16
12
8
4
0
A
B
C
D
E
U1
U3
U2
2 4 6 8 10 12 14 16 18 20 22
Cans of pop
© 2003 McGraw-Hill Ryerson Limited.
8 - 52
Combining Indifference
Curves and Budget Line
The goal for a consumer is to get as
high on an indifference curve as
possible, given her income constraint.
 More is preferred to less.

© 2003 McGraw-Hill Ryerson Limited.
8 - 53
Combining Indifference
Curves and Budget Line, Fig. 8-4, p
189
Chocolate bars
20
Slope= -MUpop/Muchocolate bars
16
12
8
4
0
K
G
U3
Slope= -Ppop/Pchocolate bars
U1
2 4 6 8 10 12 14 16 18 20 22
Cans of pop
© 2003 McGraw-Hill Ryerson Limited.
8 - 54
Combining Indifference
Curves and Budget Line

At the point D, Jaz maximizes her utility
when:
MUpop/Muchocolate bars = Ppop/Pchocolate bars
© 2003 McGraw-Hill Ryerson Limited.
8 - 55
Combining Indifference
Curves and Budget Line

In other words, utility is maximized
when the slopes of the budget
constraint and the indifference curve are
equal.
© 2003 McGraw-Hill Ryerson Limited.
The Logic of Individual
Choice:
The Foundation of
Supply and Demand
End of Chapter 8
© 2003 McGraw-Hill Ryerson Limited