Suppose, for simplicity, that Mary Andrews consumes only apples, denoted by the letter A, and oranges, denoted by the letter O. Apples cost $2 per pound and oranges cost $1 per pound, and her budget allows her to spend $20 per month on the two goods. We assume that Ms. Andrews will adjust her consumption so that the utility-maximizing condition holds for the two goods: The ratio of marginal utility to price is the same for apples and oranges. That is,
Here MUA and MUO are the marginal utilities of apples and oranges, respectively. Her spending equals her budget of $20 per month; suppose she buys 5 pounds of apples and 10 of oranges.
Now suppose that an unusually large harvest of apples lowers their price to $1 per pound. The lower price of apples increases the marginal utility of each $1 Ms. Andrews spends on apples, so that at her current level of consumption of apples and oranges
Ms. Andrews will respond by purchasing more apples. As she does so, the marginal utility she receives from apples will decline. If she regards apples and oranges as substitutes, she will also buy fewer oranges. That will cause the marginal utility of oranges to rise. She will continue to adjust her spending until the marginal utility per $1 spent is equal for both goods:
Suppose that at this new solution, she purchases 12 pounds of apples and 8 pounds of oranges. She is still spending all of her budget of $20 on the two goods [(12 x $1)+(8 x $1)=$20].
Figure 7.2 Utility Maximization and an Individual's Demand Curve
Mary Andrews's demand curve for apples, d, can be derived by determining the quantities of apples she will buy at each price. Those quantities are determined by the application of the marginal decision rule to utility maximization. At a price of $2 per pound, Ms. Andrews maximizes utility by purchasing 5 pounds of apples per month. When the price of apples falls to $1 per pound, the quantity of apples at which she maximizes utility increases to 12 pounds per month.
It is through a consumer's reaction to different prices that we trace the consumer's demand curve for a good. When the price of apples was $2 per pound, Ms. Andrews maximized her utility by purchasing 5 pounds of apples, as illustrated in Figure 7.2 "Utility Maximization and an Individual's Demand Curve". When the price of apples fell, she increased the quantity of apples she purchased to 12 pounds.
Notice that, in this example, Ms. Andrews maximizes utility where not only the ratios of marginal utilities to price are equal, but also the marginal utilities of both goods are equal. But, the equal-marginal-utility outcome is only true here because the prices of the two goods are the same: each good is priced at $1 in this case. If the prices of apples and oranges were different, the marginal utilities at the utility maximizing solution would have been different. The condition for maximizing utility - consume where the ratios of marginal utility to price are equal - holds regardless. The utility-maximizing condition is not that consumers maximize utility by equating marginal utilities.