SUMMARY

1. Consumers maximize a measure of satisfaction called utility. Each consumer has a utility function that determines the level of total utility generated by his or her consumption bundle, the goods and services that are consumed. We measure utility in hypothetical units called utils.

2. A good’s or service’s marginal utility is the additional utility generated by consuming one more unit of the good or service. We usually assume that the principle of diminishing marginal utility holds: consumption of another unit of a good or service yields less additional utility than the previous unit. As a result, the marginal utility curve slopes downward.

3. A budget constraint limits a consumer’s spending to no more than his or her income. It defines the consumer’s consumption possibilities, the set of all affordable consumption bundles. A consumer who spends all of his or her income will choose a consumption bundle on the budget line. An individual chooses the consumption bundle that maximizes total utility, the optimal consumption bundle.

4. We use marginal analysis to find the optimal consumption bundle by analyzing how to allocate the marginal dollar. According to the utility-maximizing principle of marginal analysis, at the optimal consumption bundle the marginal utility per dollar spent on each good and service—the marginal utility of a good divided by its price—is the same.

5. Changes in the price of a good affect the quantity consumed in two possible ways: the substitution effect and the income effect. Most goods absorb only a small share of a consumer’s spending; for these goods, only the substitution effect—buying less of the good that has become relatively more expensive and more of goods that are now relatively cheaper—is significant. It causes the individual and the market demand curves to slope downward. When a good absorbs a large fraction of spending, the income effect is also significant: an increase in a good’s price makes a consumer poorer, but a decrease in price makes a consumer richer. This change in purchasing power makes consumers demand less or more of a good, depending on whether the good is normal or inferior. For normal goods, the substitution and income effects reinforce each other. For inferior goods, however, they work in opposite directions. The demand curve of a Giffen good slopes upward because it is an inferior good in which the income effect outweighs the substitution effect. However, data have never confirmed the existence of a Giffen good.