Simple Economics on the Web

 Your handy guide to economics


Utility Maximization

A simple model of consumer behavior

This is the interaction of the two value systems just described - bundles of goods valued in money terms and the same bundles of goods valued in utility terms using your utility function. Specifically, we can ask:

Among all the bundles of goods you can afford, which bundle gives you the highest utility as measured by your utility function.

When the problem is graphed, this utility maximizing bundle will occur at a point of tangency between the budget line and some indifference curve. At this point of tangency, the indifference curve and the budget constraint are touching and they have the same slope – i.e. they do not cross each other. Draw this condition and you will see that if the indifference curve crossed the budget line, some slightly higher indifference curve would also be affordable – i.e. the crossing point wouldn’t be a utility maximum. 

In the graph below, select the first price set – $1.00 per gallon of gasoline and $2.00 per wrap. Use the red dot to move along the budget line and see how utility varies even though all bundles on the budget line cost the same. Verify that the point on of tangency is the utility maximizing point.

Repeat this exercise as for the price of wraps = $1.00 and again at $0.50. Note how the ratio of gallons of gasoline/wraps changes as the price of wraps changes

By repeating utility maximization for different wrap prices (with the price of gasoline held constant), you are calculating the points that form  your personal demand curve for wraps

 

Created by Frank Levy and Myounggu Kang
Last Updated on September 26, 2003