10

The Rational Consumer

Revised by Vitaly Terekhov

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

WHAT YOU WILL LEARN IN THIS CHAPTER

• WHAT IS BEHIND the individual and market DEMAND

• How consumers choose to spend their income on goods and
services?
• Why consumers makes choices by maximizing the utility, a
measure of satisfaction form consumption?
• Why does the principle of diminishing marginal utility accurately
describe consumer behavior for most goods and services?
• What is the optimum consumption bundle, and why do we use
marginal analysis to determine it?
• What the income and substitution effects are and what is their effect
on consumers’ choices?

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

1
 UTILITY AND CONSUMPTION

• We suppose that each individual is trying to maximize

satisfaction gained from consumption.
• Utility is the measure of satisfaction from consumption.
• An individual’s consumption bundle is the collection of
all the goods and services consumed by that individual.
• An individual’s utility function gives the total utility
generated by his or her consumption bundle.
• Util a unit of utility.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

DIMINISHING MARGINAL UTILITY

• Marginal utility (MU) is the change in utility from

consuming an additional unit.
• Diminishing marginal utility is the fact that each
additional unit of a good adds less to utility than the
previous unit.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

2
 Is Marginal Utility Really Diminishing?

Are all goods really subject to diminishing marginal

utility? Of course not; there are a number of goods for
which, at least over some range, marginal utility is
surely increasing.

Examples are:
Rock climbing, which involves more fear than enjoyment at the start, but
then becomes pleasurable after its mastered.

People who are not accustomed to drinking coffee find it bitter.

If you need two rolls of wallpaper to finish a room, the marginal utility of
the second roll is larger than that of the first roll.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

LEARN BY DOING: DISCUSSION QUESTION 1

• Discuss: If food is pleasurable, why wouldn’t a person eat

all the food in an all-you-can-eat buffet?
• Does eating more and more at the buffet increase the
total utility?
• Does eating more and more at the buffet increase the
marginal utility?

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

3
CASSIE’S TOTAL UTILITY AND MARGINAL UTILITY
Figure 10-1

• U increases as
consumption
increases
• MU decreases
with consumption
Each additional egg roll
increases the total
satisfaction but gives
Cassie less additional
utility than the previous
egg roll.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

Table 10.1, Sammy’s Utility from Egg Roll and Coke Consumption, Page 301

Table 10-1: Sammy’s Utility from Egg Roll and Coke Consumption

Utility from egg Utility from egg Utility from Coke Utility from Coke
roll consumption: roll consumption: consumption: consumption:
Quantity of egg Utility from egg Quantity of Coke Utility from Cokes
rolls rolls (utils) (bottles) (utils)
0 0 0 0
1 15 1 11.5
2 25 2 21.4
3 31 3 29.8
4 34 4 36.8
5 36 5 42.5
6 47.0
7 50.5
8 53.2
9 55.2
10 56.7

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

4
 LEARN BY DOING: PRACTICE QUESTION 1

• Assume that the marginal utilities for the first three units of a
good consumed are 200, 150, and 125, respectively. The total
utility when two units are consumed is:
a) 150.
b) 200.
c) 350.
d) 475.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

LEARN BY DOING: PRACTICE QUESTION 1

(Answer)

• Assume that the marginal utilities for the first three units of a
good consumed are 200, 150, and 125, respectively. The total
utility when two units are consumed is:
a) 150.
b) 200.
c) 350. (correct answer)
d) 475.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

5
 BUDGET CONSTRAINTS AND BUDGET LINES
• Because the amount of money a consumer can
spend is limited, a decision to consume more
of one good is also a decision to consume less
of some other good.
• A budget constraint requires that the cost of a
consumer’s consumption bundle be no more than
the consumer’s income.
Exp on egg rolls + Exp on Coke < Total Income

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

BUDGET CONSTRAINTS AND BUDGET LINES

• A consumer’s consumption possibilities are the
set of all consumption bundles that can be
consumed given the consumer’s income and
prevailing prices.
• A consumer’s budget line shows the consumption
bundles available to a consumer who spends all
his or her income.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

6
 GRAPHING THE BUDGET LINE
Sammy has a weekly income of $20; he spends all of it on egg rolls and Coke.
Egg rolls cost $4 per roll, and Coke costs $2 per bottle.

Figure 10-2

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

Table 10.1, Sammy’s Utility from Egg Roll and Coke Consumption, Page 301

Table 10-1: Sammy’s Utility from Egg Roll and Coke Consumption

Utility from egg Utility from egg Utility from Coke Utility from Coke
roll consumption: roll consumption: consumption: consumption:
Quantity of egg Utility from egg Quantity of Coke Utility from Cokes
rolls rolls (utils) (bottles) (utils)
0 0 0 0
1 15 1 11.5
2 25 2 21.4
3 31 3 29.8
4 34 4 36.8
5 36 5 42.5
6 47.0
7 50.5
8 53.2
9 55.2
10 56.7

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

7
 OPTIMAL CONSUMPTION BUNDLE

Table 10-2: Sammy’s Budget and Total Utility

Consumption Quantity of Utility from Quantity of Utility from Total utility

bundle egg rolls egg rolls Coke (bottles) Cokes (utils) (utils)
(utils)

A 0 0 10 56.7 56.7
B 1 15 8 53.2 68.2
C 2 25 6 47.0 72.0

D 3 31 4 36.8 67.8
E 4 34 2 21.4 55.4
F 5 36 0 0 36.0

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

OPTIMAL CONSUMPTION BUNDLE

Figure 10-3

The optimal consumption

bundle is the one that
maximizes a consumer’s
total utility given his or her
budget constraint.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

8
 SPENDING THE MARGINAL DOLLAR

• We can find optimal consumption choice by

choosing the bundle at which total utility is
maximized.
• But we can use marginal analysis instead, turning
it into a “how much” problem.
• We ask if the consumer can make himself better
off by spending a little bit more on either good.
• To answer this question, we must calculate the
marginal utility per dollar.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

MARGINAL UTILITY PER DOLLAR

• Marginal utility is the additional utility the
consumer gets from consuming one more unit of
a good or service.
• The marginal utility per dollar spent on a good
or service is the additional utility from spending
one more dollar on that good or service.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

9
 MARGINAL UTILITY PER DOLLAR

• To find the marginal utility per dollar, we must

divide the marginal utility of the good by its price.
• Marginal utility per dollar declines as the quantity
of that good consumed rises, due to diminishing
marginal utility.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

Table 10.3, Sammy’s Marginal Utility per Dollar, Page 305

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

10
GRAPHING MARGINAL UTILITY PER DOLLAR

Sammy’s optimal
consumption bundle
is at point C, where
his marginal utility
per dollar spent on
egg rolls, MUr /Pr,
is equal to his
marginal utility per
dollar spent on
Cokes, MUc /Pc

Figure 10-4

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

ACCOUNTING FOR BOTH MU AND PRICE

WHEN COMPARING UTILITY FROM
CONSUMPTION
• The general rule: compare the MU and the price for all
goods, and then adjust your spending toward the
goods that give you MORE marginal utility per dollar.
• Example: PGUM = $0.25, PICE CREAM = $1.00
MUGUM = 1, MUICE CREAM = 2
• What can you do to increase total utility?
• MUGUM/PGUM > MUICE CREAM/PICE CREAM, so buy more gum!
Gum makes you happier, dollar for dollar, than ice cream.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

11
ADJUSTING TOWARD THE OPTIMAL BUNDLE

If, however, MUICE CREAM/PICE CREAM > MUGUM/PGUM, then you

should buy more ice cream.
The optimal consumption bundle is always where
MUA/PA = MUB/PB = … = MUZ/PZ
(subject to budget constraints) for all goods.
If marginal utility per dollar is higher for ice cream than for
gum, buying more ice cream and less gum would increase
his total utility.
If marginal utility per dollar on gum is higher, he can increase
his utility by spending less on ice cream and more on gum.
If he has chosen his optimal consumption bundle, his
marginal utility per dollar on ice cream and gum must be
equal.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

ADJUSTING TOWARD THE OPTIMAL BUNDLE

If, however, MUICE CREAM/PICE CREAM > MUGUM/PGUM, then you

should buy more ice cream.
The optimal consumption bundle is always where
MUA/PA = MUB/PB = … = MUZ/PZ
(subject to budget constraints) for all goods.
If marginal utility per dollar is higher for ice cream than for
gum, buying more ice cream and less gum would increase
his total utility.
If marginal utility per dollar on gum is higher, he can increase
his utility by spending less on ice cream and more on gum.
If he has chosen his optimal consumption bundle, his
marginal utility per dollar on ice cream and gum must be
equal.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

12
 PITFALLS

• Marginal comparison:
– Production decisions set the marginal benefit of some activity equal
to its marginal cost.

– Consumption decisions set the marginal utility per dollar equal for
each good.

– Unlike producers, consumers face budget constraints. Consuming

more of one good requires consuming less of another.

– The right marginal decision sets the marginal utility per dollar equal
for each good (the “bang per buck” is the same across all goods).
Only then is there no way to rearrange consumption and get more
utility from one’s budget.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

LEARN BY DOING: PRACTICE QUESTION 5

• An increase in the price of good X while holding income

and the price of good Y constant will:
a) increase the marginal utility provided by good X.
b) increase the marginal utility per dollar spent on good Y.
c) decrease the marginal utility per dollar spent on good X.
d) reduce the individual’s preference for good X.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

13
 LEARN BY DOING: PRACTICE QUESTION 5
(Answer)

• An increase in the price of good X while holding income

and the price of good Y constant will:
a) increase the marginal utility provided by good X.
b) increase the marginal utility per dollar spent on good Y.
c) decrease the marginal utility per dollar spent on good
X. (correct answer)
d) reduce the individual’s preference for good X.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

THE DEMAND CURVE AND SUBSTITUTION

EFFECT

• Optimal consumption rule: a consumer chooses a

consumption bundle for which the marginal utility per dollar
spent on all goods is the same.
• If the price rises, the marginal utility per dollar spent on the
good falls, and the consumer can increase his or her utility by
buying less of this good and more of other goods.
• The substitution effect (of a change in the price of a good) is
the change in the quantity consumed of that good as the
consumer substitutes the good that has become relatively
cheaper for the good that has become relatively more
expensive.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

14
THE DEMAND CURVE AND INCOME EFFECT

• The income effect (of a change in the price of a good) is the

change in the quantity consumed of a good that results from a
change in the consumer’s purchasing power (or real income)
due to the change in the price of the good:
– A change in the price of a good effectively changes a
consumer’s REAL income.
– For most goods, the income effect has no significant effect on
consumption. Most market demand curves slope downward
because of the substitution effect.
– When it matters at all, income effect reinforces the substitution
effect.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

GIFFEN GOODS

• In the case of an inferior good, the income and

substitution effects work in opposite directions.
• Giffen good: a very rare inferior good for which the income
effect outweighs the substitution effect and the demand curve
slopes upward.
– Example: Irish potatoes, an inferior good that took up so
much of an average person’s income that when potato
prices rose, purchasing power dropped, and they had to
buy more potatoes.

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

15
HOUSING PRICES FROM COAST TO
COAST in mid 2000s
House Type Victoria, B.C. St. John’s,
Newfoundland

Standard Condo 170,000 137,000

Townhouse 238,000 98,000

Detached Bungalow 298,000 135,000

Standard Two- 325,000 190,000

Storey

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

HOUSING PRICES
Suppose that you would move from St. John’s
to Victoria. What are your housing decisions?
1. Downsize (Higher housing prices will lead to smaller
housing)
2. Buy the same size house, and spend more of your
budget at housing

What is the possible substitution effect of higher

housing prices?
Is there any significant income effect?

Krugman, Microeconomics:
Krugman,
Canadian
Economics,
Edition, 6e,
4e, © 2020
2021 Worth Publishers

16