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ECO101
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Lecture notes of 6 pages for the course ECO101H1 at U of T (ECO101 Notes)
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6.1 Marginal utility and consumer choice- Utility is the satisfaction that a consumer receives from consuming some good or service
- All economic decisions are based on maximizing utility
- Full utility is the total satisfaction resulting from the consumption of a product
- Marginal utility additional satisfaction resulting from consuming one more unit of that
product
Diminishing marginal utility
- Law of diminishing marginal utility the utility that any consumer derives from
successive units of a particular product consumed over some period of time diminishes as
total consumption of the product increases
Utility schedules and graphs
- Total utility increases while marginal utility decreases as consumption increases
Maximizing utility
- Consumers seek to maximize their total utility subject to the constraints they face like
income and market prices
The consumer’s maximizing decision
- Keep an economy with juice and burrito in mind and we are trying to maximize utility
- Maximizing utility is when MUa = MUb
- A utility maximizing consumer allocates expenditures so that the marginal utility from
the last dollar spend on each product is equal
- Keep in mind that if buying juice gives her 3 utilities and burritos 1, she shall buy less
burritos and rather spend more on juice
- But when she buys less of burritos their MU goes up and when she buys too much of
juices their MU comes down until they eventually equal one another
- The condition required for consumers to be maximizing utility for any pair of products is,
An alternative interpretation
- If we rearrange the formula we see,
, - The right side shows the relative price of the 2 products and is determined by the market
which means we have very little control over it
- Left side is the relative ability of the 2 products and is determined by the quantities of
different products bought which determined MU
Is this realistic?
- No consumer actually stands in a store and compares MU’s, this theory is just for us that
predicts how consumers will act
- When economists say that consumers will make the decision that maximizes their utility
they are predicting that humans are rational which is not the case
Consumer demand curve
- What happens when there is a change in the price of a product? (use the juice and burrito
example)
- Let's say that the price of juice rises, and we now have this,
- Since the higher price of juice destabilizes the equality, and by the law of diminishing
marginal utility, we know what when price of something goes up, you consume less of it,
which increases its marginal utility
- So MU Juice increases and therefore equals out the equation again.
Market demand curves
- Market demand shows the relationship between the products price and the quantity
demanded
6.2 - Income and substitution effects of price changes
- We now consider tristan who loves to eat ice cream
- A decrease in the price of ice cream would cause tristan to have more incentive to buy
more ice cream and with all other prices constant, a fall in the relative price of ice cream,
causing tristan to substitute away from other products towards ice cream
- It would also cause tirstan to buy more ice cream since price dropped and he has greater
purchasing power or real income (income expressed in terms of purchasing power of
money income) to spend on all products
The substitution effect
- When the price of something falls, the quantity is unchanged and in order to maximize
utility Tristan must increase his consumption of ice cream (decreasing its marginal
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