UTILITY MAXIMIZATION MODEL

The Utility Maximization rule states: consumers decide to allocate their money incomes so that the last dollar spent on each product purchased yields the ... UTILITYMAXIMIZATIONMODEL Thetheoryofconsumerbehaviorusesthelawofdiminishing marginalutilitytoexplainhowconsumersallocatetheirincomes.The utilitymaximizationmodelisbuiltbasedonthefollowingassumptions:1. Consumersareassumedtoberational,tryingtogetthemostvaluefortheir money. 2.Consumers’incomesarelimitedbecausetheirindividualresourcesare limited.Theyfaceabudgetconstraint. 3.Consumershaveclearpreferencesforvariousgoodsandservices,thus theyknowtheirMUforeachsuccessiveunitsoftheproduct. 4.Everyitemhasapricetag.Consumersmustchooseamongalternative goodswiththeirlimitedmoneyincomes. TheUtilityMaximizationrulestates:consumers decidetoallocatetheirmoneyincomessothatthelastdollarspentoneach productpurchasedyieldsthesameamountofextramarginalutility. Thealgebraicstatementisthatconsumerswillallocateincomeinsucha waythat: MUofproductA/priceofA=MUofproductB/PriceofB=MUof productC/priceofC=etc. Itismarginalutilityperdollarspentthatisequalized.Aslong asonegoodprovidesmoreutilityperdollarthananother,theconsumerwill buymoreofthatgood;asmoreofthatproductisbought,itsMUdiminishes untiltheamountofMUperdollarjustequalsthatoftheotherproducts. Inthefollowingexample,itillustratedtheconsumptionpossibilitiesof thisconsumerundervariousincomelevelsatfixedpricesofGoodXandY. GOODX(PRICE=$1) GOODY(PRICE=$2) QUANTITY MU MU/P TLUTILITY QUANTITY MU MU/P TLUTILITY 1 8 8 8 1 10 5 10 2 7 7 15 2 8 4 18 3 6 6 21 3 6 3 24 4 5 5 26 4 4 2 28 5 4 4 30 5 3 1.5 31 6 3 3 33 6 2 1 33 7 2 2 35 7 1 0.5 34 BYFOLLOWINGUTILITYMAXIMIZATIONRULE: MUx/Px=MUy/Py     X Y    Mu/P A 4 1          5 B 5 2          4 C 6 3          3 D 7 4          2 INCOME:       UTILITYSUM     A:X=4,Y=1,$1x4+$2x1=$6 26+10=36 B:X=5,Y=2,$1x5+$2x2=$9 30+18=48 C:X=6,Y=3,$1x6+$2x3=$12 33+24=57 D:X=7,Y=4,$1x7+$2x4=$15 35+28=63   Astheincomeincreases,totalutilityincreasesalso.Therefore,higher incomegroupsinoursocietyusuallyenjoysmoreproductsandhavehigher totalutilitylevels.