utility theory and indifference curves

Consumer TheoryConsumer Theory

Utility TheoryUtility Theory

A theory of how consumers make A theory of how consumers make choices, assuming they are choices, assuming they are

rational and making what are rational and making what are determined to be the best choices determined to be the best choices

given the parameters. given the parameters.

Maximizing UtilityMaximizing Utility

Defining Utility

Indifference CurveIndifference Curve

Parts to learn in this PPT:Parts to learn in this PPT:

Which do you prefer?Which do you prefer?Consumer TheoryConsumer Theory

1.) You make $80,000 in a world where everyone else makes $50,000.

2.) You make $90,000 in a world where everyone else makes $150,000.

Which do you prefer?Which do you prefer?Consumer TheoryConsumer Theory

1.) Drive 10 minutes to save $5 on a $15 pen.

2.) Drive 10 minutes to save $5 on a $500 suit

Ian is Morpheus from the Matrix, 黑客帝国 He will open you mind

Defining Utility

Remember it Remember it is solving this is solving this

paradoxparadox

1.) 1.) Resources are Scarce.Resources are Scarce.

Basic ideas of EconomicsBasic ideas of Economics2.) 2.) Trade - OffsTrade - Offs3.) 3.) Opportunity CostsOpportunity Costs

4.) 4.) Marginal Thinking.Marginal Thinking. - Means an additional one, the measurement from one unit to the next. 最后的东西之一

5.) 5.) Rational ThinkingRational Thinking - People usually exploit - People usually exploit opportunities to make opportunities to make themselves better off.themselves better off.

合理的

And applying And applying all these all these

original ideasoriginal ideas

UtilityUtility

Consumer TheoryConsumer Theory- - Level of satisfaction a

person receives from the consumption of the good.““Happiness”Happiness”

UtilityUtilityConsumer TheoryConsumer Theory

TotalTotal UtilityUtility - is the total benefit that a person gets from the

consumption.

- .The key part The key part to realize to realize

- It generally increases as the quantity consumed of a good increases but at a decreasing

Consumer Theory Marginal Analysis

Consumer Theory Marginal Analysis Increases at a Increases at a decreasing ratedecreasing rate

MarginalMarginal Utility Utility ((MUMU)) - - Additional utility derived from the consumption of one

more unit of a good.

UtilityUtilityTotal UtilityTotal Utility

The marginal utility of the 3rd bottle of

water =

36 units

– 27 units

= 9 units.

The MU curve The MU curve is the slope of is the slope of the TU curvethe TU curve

DiminishingDiminishing MarginalMarginal Utility Utility ((DMUDMU))

- - decline in the marginal utility that person derives

from consuming each additional unit of that

product.

Marginal Utility (MU)Marginal Utility (MU)

UtilityUtilityTotal UtilityTotal Utility

Example Question:Example Question:Diminishing marginal utility means that

an increase in the consumption of a good leads to

a. a decrease in total utility.b. a decrease in marginal utility.

c. an increase in marginal utility.d. no change in marginal utility.

e. an increase in the consumer's budget.

Example Question:Example Question:Diminishing marginal utility means that

an increase in the consumption of a good leads to

b. a decrease in marginal utility.

Example Question:Example Question:

The table above gives Matt's utility from consuming slices of pizza. His marginal

utility from the 3rd slice isa. 27 units.

b. 5 units.c. 9 units.

d. 11 units

Example Question:Example Question:

The table above gives Matt's utility from consuming slices of pizza. His marginal

utility from the 3rd slice is

b. 5 units.

Example Question:Example Question:If Raul's marginal utility per dollar spent

on bread is 25 and the marginal utility per dollar spent on butter is 30,

a. Raul should purchase more butter and less bread to increase his total utility.

b. Raul's marginal utility of butter will fall if he buys more butter.

c. Raul's marginal utility of bread will rise if he buys less bread.

d. Only answer A and answer B are correct.e. Answer A, answer B, and answer C are correct.

Example Question:Example Question:If Raul's marginal utility per dollar spent

on bread is 25 and the marginal utility per dollar spent on butter is 30,

e. Answer A, answer B, and answer C are correct.

Example Question:Example Question:If a consumer's total utility increases when another unit of a good is consumed, which of the following is true? Marginal utility must bea. negative.b. equal to one.c. positive.d. increasing.e. some amount, but more information is needed to determine if marginal utility is positive, negative, or equal to zero.

Example Question:Example Question:If a consumer's total utility increases when another unit of a good is consumed, which of the following is true? Marginal utility must be

c.positive.

Example Question:Example Question:If Joan consumes 1 dinner roll, she has total utility of 15; if she consumes 2, she has total utility of 27; if she consumes 3, she has total utility of 37; and if she consumes 4, she has total utility of 45. What is the marginal utility of the fourth dinner roll consumed?a. 124 units of utilityb. 45 units of utilityc. 11.25 units of utilityd. 8 units of utilitye. 37 units of utility

Example Question:Example Question:If Joan consumes 1 dinner roll, she has total utility of 15; if she consumes 2, she has total utility of 27; if she consumes 3, she has total utility of 37; and if she consumes 4, she has total utility of 45. What is the marginal utility of the fourth dinner roll consumed?

d. 8 units of utility

UtilityUtility

person receives from the consumption of a product.

MarginalMarginal UtilityUtility- - Additional utility derived

from the consumption of one more unit of a product.

DiminishingDiminishing MarginalMarginal UtilityUtility

product.

consumption.

Paradox of ValueParadox of ValueConsumer TheoryConsumer Theory

For centuries, philosophers have been puzzled by the fact that water is vital for life but cheap while diamonds are used

only for decoration yet are very expensive.

These graphs These graphs have the have the answeranswer

"The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some

particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called 'value in use ;' the other, 'value in

exchange.' The things which have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce any thing;

scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in

exchange for it."

"The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some

particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called 'value in use ;' the other, 'value in

exchange.' The things which have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce any thing;

scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in

exchange for it."So the translate So the translate in simpler in simpler English…English…

"The word VALUE,, has two different meanings,

Value in Use – the utility of itValue in Exchange – the purchasing power of other goods

Sometimes these have almost no relationship with each other.Nothing is more useful than water: but it will buy almost nothing. A diamond, has almost no any value in use to most people; but you can buy a lot of stuff with it.

You can solve this puzzle by distinguishing between total utility and marginal utility.

The total utility of water is substantially higher than its marginal

utility and priceThe total utility of diamonds is close

to their marginal utility and price

Evaluating the Market EquilibriumMarket EQ: P = 30 Q = 15Total surplus = CS + PS

Is the market EQ efficient?

0 5 10 15 20 25 30

Another Another way to way to think think

about itabout it

0 5 10 15 20 25 30

Water has very high Water has very high total utility total utility but low but low marginal utilitymarginal utility

0 5 10 15 20 25 30

Diamonds Diamonds total utility total utility and and marginal utility marginal utility are closer togetherare closer together

Marginal utility Marginal utility determines the pricedetermines the price

You can solve this puzzle by distinguishing between total utility and marginal utility.

Total utility -tells us about relative valueMarginal utility - tells us about

relative priceWhen the high marginal utility of

diamonds is divided by the high price of a diamond,

the result is;a number that equals the low marginal

utility of water divided by the low price of water. The marginal utility per dollar spent

is the same for diamonds as for water.

Defining Utility

Maximizing Total UtilityMaximizing Total Utility

Consumer ( Consumer ( MU MU )Theory )Theory - The goal of a consumer

is to allocate the available budget in a way that maximizes

total utility.

The by choosing the point on the budget line at which the sum of the

utilities obtained from all goods is as large as

possible.

Ian has 40 dollars!

Option one: go to the movies

Option two: drink many cases of soda

Consumer ( Consumer ( MUMU )Theory )Theory

Each row Each row of the table of the table shows a shows a combinatiocombination of movies n of movies and soda and soda that uses that uses all $40.all $40.

Total Budget is $40 dollars a month on

these two goods

Consumer ( Consumer ( MUMU )Theory )Theory Total Budget is $40 dollars a month on

these two goods

What What combinatiocombinations should ns should be bought be bought to to maximize maximize utility?utility?

these two goodsSure, you Sure, you could add could add up the up the totals, but totals, but that is that is difficult difficult with lots of with lots of items. items. Economists Economists care about care about the the margins!margins!

utility-maximizing rule: :1. Allocate the entire available

budget.2. Make the marginal utility per

dollar equal for all goods.

Utility-maximizing rule example: :

marginal utility of movies = MUM

marginal utility of soda

= MUS price of movies = PM

price of soda = PS

marginal utility per dollar from seeing movies

= MUM/PM

marginal utility per dollar from soda

= MUS/PS

Total utility is maximized when:

MUM/PM = MUS/PS

these two goods

EatTotal Budget is $40 dollars a month on

these two goodsTotal utility is

maximized when:

MUM/PM =

MUS/PS

EatTotal Budget is $40 dollars a month on

these two goodsTotal utility is

maximized when:

MUM/PM =

MUS/PS

these two goods

- - Where is it not possible to switch any expenditure and

increase total utility

Equimarginal PrincipleEquimarginal Principle

equation equation = = ==

C== …… ==

MUMU = Marginal Utility = Marginal Utility

PP = Price = Price

AA, , BB, , CC, , NN = different products = different products

Maximizing Total UtilityMaximizing Total UtilityConsumer ( Consumer ( MUMU )Theory )Theory

So the So the marginal utility marginal utility of each thing of each thing should equalshould equal

equation equation = =

AThe fun of The fun of

this…this…

equals the fun equals the fun of this…of this…

C== …… ==

equals the fun equals the fun of this.of this.

To summarize thus To summarize thus far:far:

UtilityUtility

person receives from the consumption of a product.

MarginalMarginal UtilityUtility- - Additional utility derived

from the consumption of one more unit of a product.

DiminishingDiminishing MarginalMarginal UtilityUtility

product.

consumption.

Consumer ( Consumer ( MU MU )Theory )Theory - The goal of a consumer

is to allocate the available budget in a way that maximizes

total utility.

The by choosing the point on the budget line at which the sum of the

utilities obtained from all goods is as large as

possible.

Total utility is maximized when:

MUM/PM = MUS/PS

- - Where is it not possible to switch any expenditure and

increase total utility

Equimarginal PrincipleEquimarginal Principle

C== …… ==

MUMU = Marginal Utility = Marginal Utility

PP = Price = Price

AA, , BB, , CC, , NN = different products = different products

Maximizing Total UtilityMaximizing Total UtilityConsumer ( Consumer ( MUMU )Theory )Theory

Defining Utility

Consumer Theory Consumer Theory

- shows consumption bundles that give the consumer the same level of satisfaction.

Marginal Rate Marginal Rate of of SubstitutionSubstitution

- the rate at which a consumer

is willing to trade one good for another.

- shows consumption bundles that give the consumer the same level of satisfaction.

4 qualities of the curve:1.) Indifference curves are downward-sloping.

3.) Indifference curves cannot cross

2.) Higher indifference curves are preferred to lower ones.

4.) Indifference curves are bowed inward

Quantity of Soda

Quantity of Movies

One of Ian’s indifference curves

A, B, and all other bundles on I1 make Ian equally happy

- he is indifferent between them.

- doesn’t matter which combine to buy, brings

same satifaction

Quantity of Soda

Quantity of Movies

1.) Indifference curves are downward-

sloping.

If the quantity of soda is reduced,

the quantity of movies must be

increased to keep Ian equally happy.

Quantity of Soda

Quantity of Movies

2.) Higher indifference curves are preferred

to lower ones.

Ian prefers every bundle on I2 (like C) to every bundle on I1

(like A). He prefers every

bundle on I1 (like A) to every bundle on I0

(like D).

Quantity of Soda

Quantity of Movies

3.) Indifference curves cannot cross.

Suppose they did.Ian should prefer B to C, since B has more of both goods.Yet, Ian is indifferent

between B and C:He likes C as much as A

(both are on I4).

He likes A as much as B (both are on I1).

Quantity of Soda

Quantity of Movies

4.) Indifference curves are bowed inward.

Ian is willing to give up more

movies for soda if he has few

soda (A) than if he has many (B).

Consumer Theory Consumer Theory - the rate at which a

consumer is willing to trade one good

for another.

Can view this all Can view this all along the slope of along the slope of

the indifference the indifference curve curve

Quantity of Soda

Quantity of Movies

MRS = slope of indifference curve

Ian’s MRS is the amount of movies he would substitute for

another soda.

MRS falls as you move down along an

indifference curve.

Consumer Theory Consumer Theory - the rate at which a

consumer is willing to trade one good

for another.Two extreme examples:

- two goods with straight-line indifference curves (constant

Perfect substitutes

((MRSMRS))

- two goods with right-angle indifference curves

Perfect complements

One Extreme Case: One Extreme Case: Perfect Perfect SubstitutesSubstitutes

Example: nickels & dimes

Consumer is always willing to trade

two nickels (5 cents) for one dime

(10 cents).

THE THEORY OF CONSUMER CHOICE

Another Extreme Case: Another Extreme Case: Perfect Perfect ComplementsComplements

Example: Left shoes, right shoes

{7 left shoes, 5 right shoes}

is just as good as {5 left shoes, 5

right shoes}

Less Extreme Cases: Less Extreme Cases: Close Substitutes Close Substitutes and and Close Close ComplementsComplements

Quantity of Coke

Quantity of Pepsi

Indifference curves for close substitutes are not very bowed

Quantity of hot dogs

Quantity of hot

dog buns

Indifference curves for

close complements

are very bowed

Next is figuring out the budget line to know exactly how much to

The EndThe EndThank you Thank you

utility theory and indifference curves

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