This theory will explain how consumers allocate their money among all goods and services which are available on the market.
Consumer Choice and Budget Constraint
Rational behavior- Consumers are rational individuals who try to spend their money and to get maximum amount of satisfaction. They want to maximize Total Utility (TU) they get.
Preferences- Each consumer has different preferences. We assume that buyers have a good idea of how much marginal utility they will get after each unit of good or service they purchase.
Budget Constraints– At any period of time consumers have a limited quantity of money, because they can provide society only a limited amount of human and property resources. Economists call this fact budget constraint (budget limitation). Even these people who own millions of dollars face budget constraint, but it is not severe as at that people who have low incomes.
Prices– Since all goods are scarce relative to demand of them they carry a price tag. Each person purchases are minuscule relative to total demand, because they have relatively small amount of income, so that consumers may buy only a limited amount of goods.
Consumers must choose the most satisfying mix of goods and services. Different consumers will choose different combinations of items.
From all possible combinations of goods and services, which are available for their budget, consumers must choose the mix that offers them maximum utility. But which combination yields more utility?
In order to maximize satisfaction, consumers should allocate their incomes so that the last dollar spent on each product offers the same MU (marginal utility).This is called Utility Maximization rule.
Marginal Utility per Dollar
A rational consumer must compare the extra-utility with its cost (price). Suppose you prefer coffee which is 18 UT (units of Utility, at least I call them like that) to a tea whose MU is 6 UT. Coffee’s price is 6$ but price of tea is 1$. Even if coffee provides more total UTs, but when we make a ratio between MU and price we see that coffee offers 3UT/$ but tea gives us 6UT/$. So tea offers more satisfaction than does coffee. To calculate the amount of extra-utility derived from each product we should put MU on per dollar basis.