Review

The state needs to raise money and it has a choice of imposing an excise tax of the same amount on one of two goods: restaurant meals or gasoline.Both the demand and supply of restaurant meals are more elastic than the demand and supply of gasoline.a. If the state wants to minimize the deadweight

loss, which good should be taxed?b. For each good, sketch a diagram that illustrates

the deadweight loss from taxation.

Utility Maximization and Consumer Choice

Module 51

UtilityHow satisfied a person is with a transaction

• In many cases, we can look at $ values, but in most cases we can’t measure it that way

• Utils– made-up units that represent satisfaction– “Happy Points”

Utility FunctionThe relationship between a consumer’s utility and the combination of goods and services he or she consumes (consumption bundle)

• Marginal utility (MU)– The additional satisfaction derived from consuming one

more of something

• Diminishing marginal utility– Generally, as we consume more of a thing we derive

increasingly less satisfaction

Figure 51.1 Cassie’s Total Utility and Marginal UtilityRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers

Budget Constraint

Consumers can’t spend more on goods than their income – this is a constraint

• Consumption possibilities– The set of consumption bundles that are

affordable at a given income level

• Budget line– Kind of a consumer’s PPC!

Figure 51.2 The Budget LineRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers

Table 51.1 Sammy’s Utility from Clam and Potato ConsumptionRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers

Utility Maximization

The goal is to find the consumption bundle that will provide the greatest total utility

• Optimal Consumption Bundle– One way is to calculate total utility (in utils) for

every possible consumption bundle

Table 51.2 Sammy’s Budget and Total UtilityRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers

Figure 51.3 Optimal Consumption BundleRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers

Utility Maximization

Another way, is to look at the how much more utility derives from each dollar spent

• Marginal Utility Per Dollar

MUgood

Pgood

Table 51.3 Sammy’s Marginal Utility per DollarRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers

Figure 51.4 Marginal Utility per DollarRay and Anderson: Krugman’s Economics for AP, First EditionCopyright © 2011 by Worth Publishers

Utility Maximization

It turns out that utility is maximized at the consumption bundle where the marginal utility per dollar for each good is equal

• Optimal Consumption Rule

MuA = MuB

PA

PB

WHY?

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.

If we continue to buy more, the loss of utility from the second product will outweigh the increase in utility from the first

Problems

Use the concept of marginal utility to explain the following:Newspaper vending machines are designed to stay open so that once you have paid for one paper, you could take more than one paper at a time. But soda vending machines, once you have paid for one soda, dispense only one soda at a time.

Problems

Assume you have an income of $100. The price of good X is $5, and the price of good Y is $20a. Draw a correctly labeled budget lineb. At a given consumption bundle, you receive 100 utils

from consuming your last unit of good X and 400 utils from consuming you last unit of good Y. Are you maximizing your utility? Explain.

c. What will happen to the total and marginal utility you receive from consuming good X if you decide to consume another unit of good X. Explain.