Utility: Meaning, Characteristics and Types | Economics

Meaning of Utility:
The simple meaning of ‘utility’ is ‘usefulness’. In economics utility is the capacity
of a commodity to satisfy human wants.

Utility is the quality in goods to satisfy human wants. Thus, it is said that “Wants
satisfying capacity of goods or services is called Utility.”
In this way utility is measured in terms of money and it is relative. There is
difference between utility and usefulness. A useful commodity may not here utility
of goods depend upon the intensity of wants.

A consumer buys or demands a particular commodity he derives some benefit from

its use. He feels that his given want is satisfied by the use or consumption of the
commodity purchased. Utility is the basis of consumer demand. A consumer thinks
about his demand for a commodity on the basis of utility derived from the
commodity.

Utility depends upon the intensity of want. When a want is unsatisfied or more
intense, there is a greater urge to demand a particular commodity which satisfies a
given want. In modern time utility has been called as ‘expected satisfaction.’
Expected satisfaction may be less or equal to or more than the real satisfaction.

Definition of Utility:
Various economists have defined utility as follows:
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1. According to Prof. Waugh:

“Utility is the power of commodity to satisfy human wants.”

2. According to Fraser:
“On the whole in recent years the wider definition is preferred and utility is
identified, with desireness rather than with satisfyingness.”

Characteristics of Utility:
The following are the important characteristic features of utility:
1. Utility has no Ethical or Moral Significance:
A commodity which satisfies any type of want, whether moral or immoral, socially
desirable or undesirable, has utility, i.e., a knife has utility as a household
appliance to a housewife, but it has also a utility to a killer for stabbing some body.

2. Utility is Psychological:
Utility of a commodity depends on a consumer’s mental attitude and assessment
regarding its power to satisfy his particular want. Thus, utility of a commodity may
differ from person to person. Psychologically, every consumer has his likes and
dislikes and everyone determines his own level of satisfaction.

For instance:
A consumer who is fond of apples may find a high utility in apples in comparison
to the consumer who has no liking for apples. Similarly a strictly vegetarian person
has no utility for mutton or chicken.

3. Utility is always Individual and Relative:

Utility of a commodity varies in different situations in relation to time and place.
Even the same consumer may derive a higher or lower utility for the same
commodity at different times and different places. For example—a person may
find more utility in woolen clothes during the winter than in summer or at Kashmir
than at Mumbai.

4. Utility is not Necessarily Equated with Usefulness:

Utility simply means the ability to satisfy a want. A commodity may have utility
but it may not be useful to the consumer. For instance—A cigarette has utility to
the smoker but it is injurious to his health. However, demand for a commodity
depends on its utility rather than its usefulness. Thus many commodities like
opium liquor, cigarettes etc. have demand because of utility, even though, they are
harmful to human beings.

5. Utility cannot be Measured Objectively:

Utility being a subjective phenomenon or feeling of a consumer cannot be
expressed in numerical terms. So utility cannot be measured cardinally or
numerically. It cannot be measured directly in a precise manner. Professor
Marshall has however, unrealistically assumed cardinal measurement of utility in
his analysis of demand.
6. Utility Depends on the Intensity of Want:
Utility is the function of intensity of want. A want which is unsatisfied and greatly
intense will imply a high utility for the commodity concerned to a person. But
when a wan is satisfied in the process of consumption it tends to experience a
lesser utility of the commodity than before. Such an experience is very common
and it is described as a tendency of diminishing utility experienced with an
increase in consumption of a commodity. In other words, the more of a thing we
have, the less we want it.

7. Utility is Different from Pleasure:

A commodity may have utility but its consumption may not give any pleasure to
the consumer, e.g., medicine or an injection. An injection or medicinal tablet gives
no pleasure, but it is necessary for the patient.

8. Utility is also Distinct from Satisfaction:

Utility and satisfaction, both are though inter-related but they have not been
considered as the same in a strict sense.

Different Types of Utility:

In economics, production refers to the creation of utilities in several ways.

Thus, there are following types of utility:

1. Form Utility:
This utility is created by changing the form or shape of the materials. For
example—A cabinet turned out from steel furniture made of wood and so on.
Basically, from utility is created by the manufacturing of goods.

2. Place Utility:
This utility is created by transporting goods from one place to another. Thus, in
marketing goods from the factory to the market place, place utility is created.
Similarly, when food-grains are shifted from farms to the city market by the grain
merchants, place utility is created.

Transport services are basically involved in the creation of place utility. In retail
trade or distribution services too, place utility is created. Similarly, fisheries and
mining also imply the creation of place utility. Place utility of a commodity is
always more in an area of scarcity than in an area of scarcity than in an area of
abundance e.g., Kashmir apples are more popular and fetch higher prices in Pune
than in Srinagar on account of such place utility

3. Time Utility:
Storing, hoarding and preserving certain goods over a period of time may lead to
the creation of time utility for such goods e.g., by hoarding or storing food-grains
at the time of a bumper harvest and releasing their stocks for sale at the time of
scarcity, traders derive the advantage of time utility and thereby fetch higher prices
for food-grains. Utility of a commodity is always more at the time of scarcity.
Trading essentially involves the creation of time utility.

4. Service Utility:
This utility is created in rendering personal services to the customers by various
professionals, such as lawyers, doctors, teachers, bankers, actors etc.

Can Utility be Measured?

Utility is a psychological concept. This is different for different people. Therefore,
it cannot be measured directly. Professor Marshall has said that “Utility can be
measured and its measuring rod is ‘money. The price which we are ready to pay
for an article is practically its price. Nobody will be prepared to pay more than the
utility which we derive from the article.

For example:
If I am ready to pay Rs. 1500 for a watch and Rs. 2,000 for a Radio. Then I can say
that I derive utility from that watch up to the value of Rs. 1500; and from Radio up
to the value of Rs. 2,000. “The inference which we can draw from the above
example is that the price which we pay for any article is the utility which we derive
from that article.” But Prof. Hicks, Allen and Pareto have not supported Marshall’s
view of measuring utility.

They are of this opinion that measuring of utility is not possible because of the
following reasons:
(i) Utility is personal, psychological and abstract view which cannot be measured
like goods.
(ii) Utility is different for different people. Utility is always changeable and it
changes according to time and place. Therefore, it is difficult to measure such thing
who is of changeable nature.

(iii) Further, measuring material ‘money is not static. Value of money always
changes, therefore, correct measurement is not possible.

Kinds of Utility:
Utility are of three kinds:
(i) Marginal Utility,

(ii) Total Utility,

(iii) Average Utility

(i) Marginal Utility:

Definition:
Marginal utility is the utility derived from the last or marginal unit of consumption.
It refers to the additional utility derived from an extra unit of the given commodity
purchased, acquired or consumed by the consumer.

It is the net addition to total utility made by the utility of the additional or extra
units of the commodity in its total stock. It has been said—as the last unit in the
given total stock of a commodity.

According to Prof. Boulding—”The marginal utility of any quantity of a

commodity is the increase in total utility which results from a unit increase in its
consumption.”

For example:
Suppose Mr. Shanker is consuming bread and he takes five breads. By taking first
unit he derives utility up to 20; second unit 16; third unit 12; fourth unit 8 and from
fifth 2. In this example the marginal unit is fifth bread and the marginal utility
derived is 2. If we will consume only four bread then the marginal unit will be
fourth bread and utility will be 8.

Kinds of Marginal Utility—Marginal utility is of three kinds:

(i) Positive Marginal Utility,

(ii) Zero Marginal Utility,

(iii) Negative Marginal Utility.

It is a matter of general experience that if a man is consuming a particular goods,

then receiving of next unit of goods reduces the utilities of the goods and
ultimately a situation comes when the utility given by the goods become zero and
if the use of the goods still continues, then the next unit will give dis-utility. In
other words it can be said that we will derive “negative utility”.

This can be studied better by the following table:

From the table given above it is clear that up to the consumption of the fifth bread
we receive positive utility; 6th unit is the unit of full satisfaction i.e., Utility derive
from that unit is zero. From 7th unit the utility received will be negative utility.
The table can be represented in shape of diagram as follows: In diagram No. 1 OX
axis (line) shows unit of bread and OY line shows the Marginal Utility received.
From the figure it is clear that from the first unit of bread utility received are 20
which has been shown on the top of the line.
Similarly 2, 3, 4, 5 Unit of bread’s utility is 16, 12, 8, 4 respectively All these have
been shown on OX line which shows positive marginal utility. Utility of the sixth
bread is zero and that of the seventh bread is negative and negative rectangle has
been shown below OX line.

Zero Utility:
When the consumption of a unit of a commodity makes no addition to the total
utility, then it is the point of Zero Utility. In our table the total utility, after the 6th
unit is consumed. This is the point of Zero Utility. It is thus seen that the total
utility is maximum when the Marginal Utility is zero.

Negative Utility:
Negative Utility is that utility where if the consumption of a commodity is carried
to excess, then instead of giving any satisfaction, it may cause dis-satisfaction. The
utility is such cases is negative. In the table given above the marginal utility of the
7th unit is negative.

(ii) Total Utility:

Total Utility is the utility from all units of consumption. According to Mayers—
”Total Utility is the sum of the marginal utilities associated with the consumption
of the successive units.”

For example:
Suppose, a man consumes five breads at a time. He derives from first bread 20
units of satisfaction from 16, from third 12, from fourth 8 and from fifth 4 i.e., total
60 units.
This can be shown by the following table:

(iii) Average Utility:

Average Utility is that utility in which the total unit of consumption of goods is
divided by number of Total Units. The Quotient is known as Average Utility. For
example—If the Total Utility of 4 bread is 40, then the average utility of 3 bread
will be 12 if the Total Utility of 3 bread is 36 i.e., (36 ÷ 3 = 12).

The following table will explain the point clearly:

It is clear from the above table that by the increasing use of any article Marginal
and Average Utility reduces gradually and Total Utility increases only up to that
point where the Marginal Utility comes to zero.

Relation between Total Utility and Marginal Utility:

There is a close relationship between Total Utility and Marginal Utility. As there is
increase in the unit of a particular commodity, the Marginal Utility goes on
diminishing and Total Utility goes on increasing. Total Utility goes on increasing
up to that extent till the Marginal Utility becomes Zero. When Marginal Utility is
zero Total Utility is maximum.
After Zero Marginal Utility comes to negative and the result is that Total
Utility starts reducing relationship between Total Utility and Marginal Utility
can be started as follows:
(i) When Marginal Utility is reducing, the Total Utility will increase so long
Marginal Utility does not become zero.

(ii) When Marginal Utility becomes zero; Total Utility will be maximum.

(iii) After zero when Marginal Utility is negative then there is reduction in Total
Utility.

Relationship between Marginal Utility and Total Utility can be studied from
the following:

From the above table it is clear that up to fourth bread Marginal Utility is positive
and there is no regular increase in the Total Utility. And on fifth bread the
Marginal Utility is zero and on this point the increase in Total Utility stops. This is
point of safety. As Prof. Bounding has said that “Point of full satisfaction and point
of full safety is that point where consumption increases but there is no increase in
Total Utility.” If after fifth bread, extra bread is consumed then there will be dis-
utility and Marginal Utility will be negative. Sixth and seventh bread shows dis-
utility.

The relationship between Marginal Utility and Total Utility will be shown by
diagram as follows:
In both the diagrams OX line shows bread. In diagram No. 1 OY line shows
Marginal Utility and is diagram No. 2 OY line shows Total Utility. As the number
of bread increases Marginal Utility goes on diminishing and Total Utility goes on
increasing—To remember:

(1) Marginal Utility goes on diminishing with the consumption of every additional
unit of bread.

(2) Total Utility goes on increasing with the consumption of every additional unit
but at a diminishing rate.

(3) Marginal Utility is equal to the increase in the Total Utility. Total Utility is the
sum total of the Marginal Utilities derived from all the units consumed.

(4) When Marginal Utility becomes 0, total utility does not increase.

(5) When Marginal Utility becomes negative, Total Utility decreases.

(6) Increase in Total Utility depends on Marginal Utility.

(7) Since Marginal Utility diminishes, Total Utility increases at a diminishing rate.

(8) When Marginal Utility is Zero, Total Utility is maximum.

(9) When Marginal Utility is negative, Total Utility declines.

The Concept of Utility: It’s Meaning, Total Utility and
Marginal Utility !
Although the concept of ‘taste’ and ‘satisfaction’ are familiar for all of
us, it is much more difficult to express these concepts in concrete
terms. For example, suppose you have just eaten an ice-cream and a
chocolate.
 Image Courtesy : teaching.software-carpentry.org/wp-content/uploads/2013/03/concept_map.jpg

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Can you tell how much are you satisfied from each of these items?
Probably you can tell which item you liked more. But, it is very
difficult to express “how much” you liked one over the other. It is
evident, that we need a more quantitative measure of satisfaction. Due
to this reason, economists developed the concept of utility.

Meaning of Utility:
Utility refers to want satisfying power of a commodity. It is the
satisfaction, actual or expected, derived from the consumption of a
commodity. Utility differs from person- to-person, place-to-place and
time-to-time. In the words of Prof. Hobson, “Utility is the ability of a
good to satisfy a want”.

In short, when a commodity is capable of satisfying human wants, we

can conclude that the commodity has utility.

How to Measure Utility?

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After understanding the meaning of utility, the next big question is:
How to measure utility? According to classical economists, utility can
be measured, in the same way, as weight or height is measured. For
this, economists assumed that utility can be measured in cardinal
(numerical) terms. By using cardinal measure of utility, it is possible
to numerically estimate utility, which a person derives from
consumption of goods and services. But, there was no standard unit
for measuring utility. So, the economists derived an imaginary
measure, known as ‘Util’.
Utils are imaginary and psychological units which are used to measure
satisfaction (utility) obtained from consumption of a certain quantity
of a commodity.

Example – Measurement of satisfaction in utils:

Suppose you have just eaten an ice-cream and a chocolate. You agree
to assign 20 utils as utility derived from the ice-cream. Now the
question is: how many utils be assigned to the chocolate? If you liked
the chocolate less, then you may assign utils less than 20.

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However, if you liked it more, you would give it a number greater than
20. Suppose, you assign 10 utils to the chocolate, then it can be
concluded that you liked the ice-cream twice as much as you liked the
chocolate.

One more way to measure utility:

Utils cannot be taken as a standard unit for measurement as it will
vary from individual to individual. Hence, several economists
including Marshall, suggested the measurement of utility in monetary
terms. It means, utility can be measured in terms of money or price,
which the consumer is willing to pay.

In the above example, suppose 1 util is assumed to be equal to Rs. 1.

Now, an ice-cream will yield utility worth Rs. 20 (as 1 util = Rs. 1) and
chocolate will give utility of Rs. 10. This utility of Rs. 20 from the ice-
cream or f I0 from the chocolate is termed as value of utility in terms
of money.
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The advantage of using monetary values instead of utils is that it

allows easy comparison between utility and price paid, since both are
in the same units.

It must be noted that it is impossible to measure satisfaction of a

person as it is inherent to the individual and differs greatly from
person-to-person. Still, the concept of utility is very useful in
explaining and understanding the behaviour of consumer.

Total Utility (TU):

Total utility refers to the total satisfaction obtained from the
consumption of all possible units of a commodity. It measures the
total satisfaction obtained from consumption of all the units of that
good. For example, if the 1st ice-cream gives you a satisfaction of 20
utils and 2ndone gives 16 utils, then TU from 2 ice-creams is 20 + 16 =
36 utils. If the 3rd ice-cream generates satisfaction of 10 utils, then TU
from 3 ice-creams will be 20+ 16 + 10 = 46 utils.
TU can be calculated as:
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TUn = U1 + U2 + U3 +……………………. + Un
Where:

TUn = Total utility from n units of a given commodity

U1, U2, U3,……………. Un = Utility from the 1st, 2nd, 3rd nth unit
n = Number of units consumed
Marginal Utility (MU):
Marginal utility is the additional utility derived from the consumption
of one more unit of the given commodity. It is the utility derived from
the last unit of a commodity purchased. As per given example, when
3rd ice-cream is consumed, TU increases from 36 utils to 46 utils. The
additional 10 utils from the 3rd ice-cream is the MU.
In the words of Chapman, “Marginal utility is addition made to total
utility by consuming one more unit of a commodity”.

MU can be calculated as: MUn = TUn – TUn-1

Where: MUn = Marginal utility from nth unit; TUn = Total utility from n
units;
TUn-1 = Total utility from n – 1 units; n = Number of units of
consumption
MU of 3rd ice-cream will be: MU3 = TU3 – TU2 = 46 – 36 = 10 utils One
More way to Calculate MU
MU is the change in TU when one more unit is consumed. However,
when change in units consumed is more than one, then MU can also
be calculated as:

ATU

MU = Change in Total Utility/ Change in number of units = ∆TU/∆Q

Total Utility is Summation of Marginal Utilities:

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Total utility can also be calculated as the sum of marginal utilities

from all units, i.e.
 TUn= MU1 + MU2 + MU3 +……………………… + MUn or simply,
TU = ∑MU

The concepts of TU and MU can be better understood from the

following schedule and diagram:

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Table 2.1: TU and MU

Ice-creams Marginal Utility (MU) Total Utility (TU)
Consumed

1 20 20

2 16 36

3 10 46

4 4 50

5 0 50

6 -6 44
In Fig. 2.1, units of ice-cream, are shown along the X-axis and TU and
MU are measured along the Y-axis. MU is positive and TU is
increasing till the 4th ice-cream. After consuming the 5th ice-cream, MU
is zero and TU is maximum.
This point is known as the point of satiety or the stage of maximum
satisfaction. After consuming the 6th ice-cream, MU is negative (known
as disutility) and total utility starts diminishing. Disutility is the
opposite of utility. It refers to loss of satisfaction due to consumption
of too much of a thing.
 7.1 The Concept of Utility
Learning Objectives

1. Define what economists mean by utility.

2. Distinguish between the concepts of total utility and marginal utility.
3. State the law of diminishing marginal utility and illustrate it graphically.
4. State, explain, and illustrate algebraically the utility-maximizing condition.

Why do you buy the goods and services you do? It must be because they provide you with
satisfaction—you feel better off because you have purchased them. Economists call this
satisfaction utility.

The concept of utility is an elusive one. A person who consumes a good such as peaches gains
utility from eating the peaches. But we cannot measure this utility the same way we can measure
a peach’s weight or calorie content. There is no scale we can use to determine the quantity of
utility a peach generates.

Francis Edgeworth, one of the most important contributors to the theory of consumer behavior,
imagined a device he called a hedonimeter (after hedonism, the pursuit of pleasure):

“[L]et there be granted to the science of pleasure what is granted to the science of energy; to imagine an
ideally perfect instrument, a psychophysical machine, continually registering the height of pleasure
experienced by an individual…. From moment to moment the hedonimeter varies; the delicate index now
flickering with the flutter of passions, now steadied by intellectual activity, now sunk whole hours in the
neighborhood of zero, or momentarily springing up towards infinity” (Edgeworth, F. Y., 1967).

Perhaps some day a hedonimeter will be invented. The utility it measures will not be a
characteristic of particular goods, but rather of each consumer’s reactions to those goods. The
utility of a peach exists not in the peach itself, but in the preferences of the individual consuming
the peach. One consumer may wax ecstatic about a peach; another may say it tastes OK.

When we speak of maximizing utility, then, we are speaking of the maximization of something
we cannot measure. We assume, however, that each consumer acts as if he or she can measure
utility and arranges consumption so that the utility gained is as high as possible.

Total Utility
If we could measure utility, total utility would be the number of units of utility that
a consumer gains from consuming a given quantity of a good, service, or activity
during a particular time period. The higher a consumer’s total utility, the greater
that consumer’s level of satisfaction.

Panel (a) of Figure 7.1 “Total Utility and Marginal Utility Curves” shows the total
utility Henry Higgins obtains from attending movies. In drawing his total utility
curve, we are imagining that he can measure his total utility. The total utility curve
shows that when Mr. Higgins attends no movies during a month, his total utility
from attending movies is zero. As he increases the number of movies he sees, his
total utility rises. When he consumes 1 movie, he obtains 36 units of utility. When
he consumes 4 movies, his total utility is 101. He achieves the maximum level of
utility possible, 115, by seeing 6 movies per month. Seeing a seventh movie adds
nothing to his total utility.
Figure 7.1 Total Utility and Marginal Utility Curves
 Panel (a) shows Henry Higgins’s total utility curve for attending movies. It rises as the number of movies increases, reaching a
maximum of 115 units of utility at 6 movies per month. Marginal utility is shown in Panel (b); it is the slope of the total utility
curve. Because the slope of the total utility curve declines as the number of movies increases, the marginal utility curve is
downward sloping.

Mr. Higgins’s total utility rises at a decreasing rate. The rate of increase is given by
the slope of the total utility curve, which is reported in Panel (a) of Figure 7.1
“Total Utility and Marginal Utility Curves” as well. The slope of the curve
between 0 movies and 1 movie is 36 because utility rises by this amount when Mr.
Higgins sees his first movie in the month. It is 28 between 1 and 2 movies, 22
between 2 and 3, and so on. The slope between 6 and 7 movies is zero; the total
utility curve between these two quantities is horizontal.

Marginal Utility
The amount by which total utility rises with consumption of an additional unit of a
good, service, or activity, all other things unchanged, is marginal utility. The first
movie Mr. Higgins sees increases his total utility by 36 units. Hence, the marginal
utility of the first movie is 36. The second increases his total utility by 28 units; its
marginal utility is 28. The seventh movie does not increase his total utility; its
marginal utility is zero. Notice that in the table marginal utility is listed between
the columns for total utility because, similar to other marginal concepts, marginal
utility is the change in utility as we go from one quantity to the next. Mr. Higgins’s
marginal utility curve is plotted in Panel (b) of Figure 7.1 “Total Utility and
Marginal Utility Curves” The values for marginal utility are plotted midway
between the numbers of movies attended. The marginal utility curve is downward
sloping; it shows that Mr. Higgins’s marginal utility for movies declines as he
consumes more of them.
Mr. Higgins’s marginal utility from movies is typical of all goods and services.
Suppose that you are really thirsty and you decide to consume a soft drink.
Consuming the drink increases your utility, probably by a lot. Suppose now you
have another. That second drink probably increases your utility by less than the
first. A third would increase your utility by still less. This tendency of marginal
utility to decline beyond some level of consumption during a period is called
the law of diminishing marginal utility. This law implies that all goods and
services eventually will have downward-sloping marginal utility curves. It is the
law that lies behind the negatively sloped marginal benefit curve for consumer
choices that we examined in the chapter on markets, maximizers, and efficiency.
One way to think about this effect is to remember the last time you ate at an “all
you can eat” cafeteria-style restaurant. Did you eat only one type of food? Did you
consume food without limit? No, because of the law of diminishing marginal
utility. As you consumed more of one kind of food, its marginal utility fell. You
reached a point at which the marginal utility of another dish was greater, and you
switched to that. Eventually, there was no food whose marginal utility was great
enough to make it worth eating, and you stopped.
What if the law of diminishing marginal utility did not hold? That is, what would
life be like in a world of constant or increasing marginal utility? In your mind go
back to the cafeteria and imagine that you have rather unusual preferences: Your
favorite food is creamed spinach. You start with that because its marginal utility is
highest of all the choices before you in the cafeteria. As you eat more, however, its
marginal utility does not fall; it remains higher than the marginal utility of any
other option. Unless eating more creamed spinach somehow increases your
marginal utility for some other food, you will eat only creamed spinach. And until
you have reached the limit of your body’s capacity (or the restaurant manager’s
patience), you will not stop. Failure of marginal utility to diminish would thus lead
to extraordinary levels of consumption of a single good to the exclusion of all
others. Since we do not observe that happening, it seems reasonable to assume that
marginal utility falls beyond some level of consumption.

Maximizing Utility
Economists assume that consumers behave in a manner consistent with the
maximization of utility. To see how consumers do that, we will put the marginal
decision rule to work. First, however, we must reckon with the fact that the ability
of consumers to purchase goods and services is limited by their budgets.

The Budget Constraint

The total utility curve in Figure 7.1 “Total Utility and Marginal Utility
Curves” shows that Mr. Higgins achieves the maximum total utility possible from
movies when he sees six of them each month. It is likely that his total utility curves
for other goods and services will have much the same shape, reaching a maximum
at some level of consumption. We assume that the goal of each consumer is to
maximize total utility. Does that mean a person will consume each good at a level
that yields the maximum utility possible?
The answer, in general, is no. Our consumption choices are constrained by the
income available to us and by the prices we must pay. Suppose, for example, that
Mr. Higgins can spend just $25 per month for entertainment and that the price of
going to see a movie is $5. To achieve the maximum total utility from movies, Mr.
Higgins would have to exceed his entertainment budget. Since we assume that he
cannot do that, Mr. Higgins must arrange his consumption so that his total
expenditures do not exceed his budget constraint: a restriction that total spending
cannot exceed the budget available.

Suppose that in addition to movies, Mr. Higgins enjoys concerts, and the average
price of a concert ticket is $10. He must select the number of movies he sees and
concerts he attends so that his monthly spending on the two goods does not exceed
his budget.

Individuals may, of course, choose to save or to borrow. When we allow this

possibility, we consider the budget constraint not just for a single period of time
but for several periods. For example, economists often examine budget constraints
over a consumer’s lifetime. A consumer may in some years save for future
consumption and in other years borrow on future income for present consumption.
Whatever the time period, a consumer’s spending will be constrained by his or her
budget.

To simplify our analysis, we shall assume that a consumer’s spending in any one
period is based on the budget available in that period. In this analysis consumers
neither save nor borrow. We could extend the analysis to cover several periods and
generate the same basic results that we shall establish using a single period. We
will also carry out our analysis by looking at the consumer’s choices about buying
only two goods. Again, the analysis could be extended to cover more goods and
the basic results would still hold.

Applying the Marginal Decision Rule

Because consumers can be expected to spend the budget they have, utility
maximization is a matter of arranging that spending to achieve the highest total
utility possible. If a consumer decides to spend more on one good, he or she must
spend less on another in order to satisfy the budget constraint.

The marginal decision rule states that an activity should be expanded if its
marginal benefit exceeds its marginal cost. The marginal benefit of this activity is
the utility gained by spending an additional $1 on the good. The marginal cost is
the utility lost by spending $1 less on another good.

How much utility is gained by spending another $1 on a good? It is the marginal

utility of the good divided by its price. The utility gained by spending an additional
dollar on good X, for example, is

This additional utility is the marginal benefit of spending another $1 on the good.

Suppose that the marginal utility of good X is 4 and that its price is $2. Then an
extra $1 spent on X buys 2 additional units of utility (MUX/PX=4/2=2). If the
marginal utility of good X is 1 and its price is $2, then an extra $1 spent on X buys
0.5 additional units of utility (MUX/PX=1/2=0.5).

The loss in utility from spending $1 less on another good or service is calculated
the same way: as the marginal utility divided by the price. The marginal cost to the
consumer of spending $1 less on a good is the loss of the additional utility that
could have been gained from spending that $1 on the good.

Suppose a consumer derives more utility by spending an additional $1 on good X

rather than on good Y:
Equation 7.1

The marginal benefit of shifting $1 from good Y to the consumption of good X

exceeds the marginal cost. In terms of utility, the gain from spending an additional
$1 on good X exceeds the loss in utility from spending $1 less on good Y. The
consumer can increase utility by shifting spending from Y to X.

As the consumer buys more of good X and less of good Y, however, the marginal
utilities of the two goods will change. The law of diminishing marginal utility tells
us that the marginal utility of good X will fall as the consumer consumes more of
it; the marginal utility of good Y will rise as the consumer consumes less of it. The
result is that the value of the left-hand side of Equation 7.1 will fall and the value
of the right-hand side will rise as the consumer shifts spending from Y to X. When
the two sides are equal, total utility will be maximized. In terms of the marginal
decision rule, the consumer will have achieved a solution at which the marginal
benefit of the activity (spending more on good X) is equal to the marginal cost:
Equation 7.2

We can extend this result to all goods and services a consumer uses. Utility
maximization requires that the ratio of marginal utility to price be equal for all of
them, as suggested in Equation 7.3:
Equation 7.3

Equation 7.3 states the utility-maximizing condition: Utility is maximized when

total outlays equal the budget available and when the ratios of marginal utilities to
prices are equal for all goods and services.

Consider, for example, the shopper introduced in the opening of this chapter. In
shifting from cookies to ice cream, the shopper must have felt that the marginal
utility of spending an additional dollar on ice cream exceeded the marginal utility
of spending an additional dollar on cookies. In terms of Equation 7.1, if good X is
ice cream and good Y is cookies, the shopper will have lowered the value of the
left-hand side of the equation and moved toward the utility-maximizing condition,
as expressed by Equation 7.1.

The Problem of Divisibility

If we are to apply the marginal decision rule to utility maximization, goods must be
divisible; that is, it must be possible to buy them in any amount. Otherwise we
cannot meaningfully speak of spending $1 more or $1 less on them. Strictly
speaking, however, few goods are completely divisible.

Even a small purchase, such as an ice cream bar, fails the strict test of being
divisible; grocers generally frown on requests to purchase one-half of a $2 ice
cream bar if the consumer wants to spend an additional dollar on ice cream. Can a
consumer buy a little more movie admission, to say nothing of a little more car?
In the case of a car, we can think of the quantity as depending on characteristics of
the car itself. A car with a compact disc player could be regarded as containing
“more car” than one that has only a cassette player. Stretching the concept of
quantity in this manner does not entirely solve the problem. It is still difficult to
imagine that one could purchase “more car” by spending $1 more.
Remember, though, that we are dealing with a model. In the real world, consumers
may not be able to satisfy Equation 7.3 precisely. The model predicts, however,
that they will come as close to doing so as possible.