Utility Theory

• Rational economic agents

  Look to maximize their benefit
• Rational economic agents

  • Firms (maximizing profits)
  • Governments (maximizing social welfare)
  • Workers (maximizing welfare at work)
  • Consumers (maximizing utility)
• Utility


  Satisfaction derived from consumption
• Table showing total utility and marginal utility from drinking cups of Coca-Cola

  • Total utility increases at a decreasing rate
  • Marginal utility decreases as more cups are consumed
  • Marginal utility becomes negative after 5 cups
• Marginal utility


  The extra utility gained from consuming one more unit
• Average utility

  Total utility divided by quantity consumed
• As quantity consumed increases


  Marginal utility decreases
• The law of diminishing utility states that as more quantity is consumed, the marginal utility derived from each extra unit decreases
• Total utility


  The sum of all the marginal utilities
• Total utility is maximized where marginal utility is equal to zero
• If price = utility


  Rational consumer will consume up to the point where marginal utility = price
• The marginal utility curve is the demand curve
• When price increases


  Quantity demanded decreases
• When price decreases


  Quantity demanded increases
• The downward sloping demand curve comes from the law of diminishing marginal utility