Understanding marginal utility is important because it is a component of the rational decision-making model. To see how, consider a simple world where there are only two goods available, goods X and Y. (X and Y also represent the quantities consumed of X and Y, respectively.) An equation is used to examine whether a particular combination of X and Y results in utility maximization—the process of choosing the combination of goods that provides the highest possible level of happiness. To maximize utility, individuals must purchase what is best for their needs and happiness, given the resources they have. Consumers earn money and purchase a new couch and thus are made happier. With utility maximizing, the consumers are happy because they purchased the couch, not because they earned money.We can determine whether consumption is optimal by looking at two fairly simple conditions. First, consumption is optimal when the marginal utility of the last unit consumed per dollar spent on that last unit is the same for both of the goods. Mathematically, the condition is represented in the optimality equation a formula to calculate the best consumption possibility. Also known as the equimarginal principle.
The first condition means an individual is behaving optimally when the "bang for the buck" from the last unit of each of the goods is the same. The second condition reflects that if consuming more of the goods makes the consumer happier, it cannot be optimal for the consumer to not spend all of his or her income. Individuals who save most of their money are not behaving optimally because they could be happier if they were using the money on goods instead of saving. Money saved is not optimal for the consumer. A consumer, according to these calculations, would be happier if she spent $5,000 upgrading her car than if she saved the $5,000.
How Consumers Decide What Goods to Consume
If this consumption shift toward the good with the higher utility is applied when the optimality equation does not hold, the two sides of the equation will eventually come into balance as long as diminishing marginal utility is present. This is because, as consumption shifts away from a good, marginal utility (and hence marginal utility per dollar spent) increases, and the opposite is true when consumption shifts toward a good. If a consumer finds more pleasure in buying a smartphone than a laptop, the more the consumer purchases, the less the marginal utility will be (it diminishes because they own the product already). Then the marginal utility for the laptop will grow.
Identifying Optimal Consumption
Consumer Behavior and Marginal Utility
|Quantity of X||MU of X||MU X/P X||Quantity of Y||MU of Y||MU Y/P Y|
Identifying Optimal Consumption
At this point the consumer finds that the optimal way for her to spend all of her $12 is to consume 3 units of X (at $2 each) and 2 units of Y (at $3 each). Note that this consumption does in fact satisfy the condition needed for optimality: the marginal utility per dollar of the last unit of each of the goods is equal.
The Budget Constraint
|Budget||Books Purchased||Movie Tickets Purchased|
Movie tickets: $0
Movie tickets: $6
Movie tickets: $12
Movie tickets: $18
The Budget Constraint
The budget constraint has two notable features. First, the line slopes downward. This represents the fact that the consumer has to give up some of one good to be able to afford more of another. Second, the budget constraint is a straight line. This is because the slope of the curve is determined by the prices of the goods, which remain constant regardless of the quantities consumed. An individual has a $50 monthly allowance for gas for their car. Their budget limits their consumption, so the individual can only buy up to $50 in gas. The individual can only consume up to what they can afford.
Indifference curves have a number of features. First, they slope downward if the goods are actually "goods," or desired by the consumer. This is because a decrease in one good must be offset by an increase in the other in order to maintain the same level of utility, or consumer happiness. If a consumer shopping at a home goods store desires blankets less the more blankets they buy, pillows will likely begin to have a higher utility. Second, indifference curves that are further from the origin represent higher levels of utility, which can be confirmed by the fact that these curves represent greater quantities of both goods. This shows the quality of ordinal values. Higher levels of utility are represented by the direction of the arrow in the diagram. In this feature, the consumer has a higher utility (is happier) with both products, and the location of the curve shifts to the right. Third, indifference curves bend toward the origin when the goods exhibit diminishing marginal utility. Diminishing marginal utility represents a situation where, upon buying an increasing amount of a product, the consumer gains less and less utility from it. Fourth, the curves do not cross each other and do not touch, as a result of the property of ordinal values.
How Consumers Maximize Utility
More generally, the optimal consumption point is located where the budget constraint is tangent to one of the indifference curves—in other words, where the budget constraint touches the indifference curve. This one point of intersection is the combination of the two goods that makes the consumer the happiest, the point on the indifference curve with the highest amount of utility that a consumer can afford. The consumer who has a $40 weekly grocery budget will attempt to spend up to $40, as close to it as they can get, while getting the goods they need.If the consumer's income increases, their budget constraint shifts to the right. This moves them to a new higher indifference curve. Their optimal consumption point is still the point where the consumer receives the highest utility, but it is now on a different higher indifference curve, because the consumer can buy more of both goods.