Walter Nicholson Christopher Snyder: Amherst College

Walter
Nicholson
Amherst College
Christopher
Snyder
Dartmouth College
PowerPoint Slide Presentation | Philip Heap, James Madison
University
2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
1
website, in whole or in part.
CHAPTER
2
Utility
and
Choice
2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
2
whole or in part.
Chapter Preview
Want to develop a theory of choice which we can

use to show how people make choices or decisions.
Two factors influence peoples choices.

1. Preferences: what goods do you like
2. Constraints: how much money do you have, what
are the prices of the goods you buy
Importance of Ceteris Paribus assumption.
2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
Ch.in2whole
3or in part.
Utility
Utility is the pleasure or satisfaction that people get
from their economic activity.
Utility = U(X,Y; other things)
Utility depends on the amount of X and Y and
other things.
Assume that the other things are held constant.
Measuring Utility
Problem with ceteris paribus.
Problem with unit of measurement.
Cardinal vs. ordinal utility.
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4or in part.
Three Assumptions About

Preferences
Complete
Given two options, a person can state which
option they prefer or whether they find both
options equally attractive.
Transitivity
Preferences are internally consistent.
If I prefer A to B, and prefer B to C, then I must
prefer A to C.
More is Better
Economic goods and bads.
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5or in part.
More is Better
Combinations of X and Y in the
green area are preferred to (X*, Y*)
Quantity of Y
per week
(X*, Y*) is preferred to combinations

of X an Y in the red area.
What can you say about these
points?
?
Y*
?
X*
Quantity of X
per week
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6or in part.
Indifference Curves
We want to find a way to compare points in the two ?
regions from the last picture.
Two goods: soft drinks and hamburgers.
Indifference curve
A curve that shows all the combinations of two
goods that give the same level of utility
If you get the same utility you must be indifferent.
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7or in part.
Indifference Curve
Lets say you are indifferent
between A, B, C and D.
Hamburgers
per week
Draw a curve through those points.

Every point gives the same level of
utility.
U1
Soft drinks
per week
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8or in part.
Indifference Curve
What can we say about combination
E?
Hamburgers
per week
What about F?
E
C
U1
Soft drinks
per week
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9or in part.
Indifference Curve
Why does the indifference curve have a negative
slope?
Hamburgers
per week
If you give up hamburgers, you need to

get more soft drinks to still get the same
level of utility.
E
C
U1
Soft drinks
per week
or in part.
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Indifference Curves and the

Marginal Rate of Substitution
The marginal rate of substitution (MRS)
measures the rate at which you are willing to reduce
the consumption of one good to get one more unit of
another good and still remain indifferent.
The absolute value of the slope of the indifference
curve measures the MRS.
or in part.
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MRS
From A to B: the person is willing to
give up 2 burgers to get 1 more
soda.
From B to C: the person is willing to
give up 1 burger to get 1 more soda.
Hamburgers
per week
From C to D: the person is willing to

give up burger to get 1 more
soda.
E
C
U1
Soft drinks
per week
or in part.
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MRS
Do you notice a pattern?
As you consume more and more soda, the number of

burgers you are willing to give up to get one more
soda gets smaller and smaller.
This is known as diminishing marginal rate of
substitution.
People prefer balanced consumption to extremes.
or in part.
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MRS
Suppose we create a basket that is of
A and of B: point G.
Hamburgers
per week
You would prefer 4 burgers and 4

sodas to 6 of one good and 2 of
the other good.
U1
Soft drinks
per week
or in part.
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Indifference Curve Maps

An indifference curve map shows the utility a person
gets from all possible combinations of two goods.
Hamburgers
per week
As you move to the northwest,

utility increases: U3 > U2 > U1
U3
U2
U1
Soft drinks
per week
or in part.
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Four Particular Preferences

A useless good.
More of a useless good neither increases nor
decreases utility.
Smoke
grinders
per week
U1
U2
U3
For a given amount of

food, additional grinders
do not increase utility.
Food per week
or in part.
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An economic bad.
More of an economic bad decreases your utility.
Houseflies
per week
Holding the amount of food

constant, additional flies
reduces utility.
U1
U2
U3
Food per week
or in part.
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Perfect Substitutes
Two goods are perfect substitutes if the MRS is
constant.
In this case the MRS = -1 everywhere
Gallons of
Exxon per
week
Does it always have to be -1?

What if it was quarts of Exxon?
U1
U2
U3
Gallons of
Mobil per
week
or in part.
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Perfect Complements:
Goods are perfect complements if they are
consumed together in fixed proportions.
Right shoes
What if you had three feet: two

left and one right?
U3
U2
U1
1
Left
shoes
or in part.
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19
Utility Maximization
Faced with a choice from among a number of goods,

how do you choose the one that gives you the
highest utility.
Your decision is constrained by your income and the

prices of the goods you can buy.
Assume you have $100 per week to spend on

burgers and soda.
How do you allocate the $100 in order to maximize

your utility?
or in part.
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To maximize your utility two conditions must be

met:
1. You spend all your income.
2. MRS is equal to the price ratio.
Why does the second condition have to hold?

. Suppose that right now the MRS = 1. To remain
indifferent, you would be willing to give up 1
burger to get 1 soda.
or in part.
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Conditions
Why does the second condition have to hold?

Suppose that right now the MRS = 1. To remain
indifferent, you would be willing to give up 1
burger to get 1 soda.
If the price of soda is $1 and the price of a burger
is $2.00. MRS = 1 > PS/PB =
If you give up one burger, you can get one more
soda to keep you indifferent plus you get one
more additional soda.
or in part.
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Conditions
So when MRS > PS/PB you can increase your utility by

buying less burgers and more soda.
What if the MRS < PS/PB?
Therefore, only when MRS = price ratio are you
maximizing utility.
or in part.
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23
Utility Maximization: A
Graphical View
Start by showing the budget constraint: this

shows the limit that income places on the
combinations of goods that can be bought.
Quantity of Y
per week
Ymax
Ymax spend all income on good Y

Xmax spend all income on good X
Buy some mix of X and Y and
spend all income.
Points inside the budget

constraint are affordable, but you
have money left over.
Xmax
Quantity of X
per week
or in part.
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Budget Constraint Algebra

Assume you have I dollars of income to spend on
goods X and Y.
Px and PY are the prices of goods X and Y.
Since all income must be spent:
Total amount spent on X and Y = Total Income
Px X + Py Y = I
or in part.
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25

Rewrite the last equation so that:
PX
Y
PY
I
X
PY
If all income spent on Y, you buy I/PY units.

If all income is spent on X, you buy I/PX units.
The slope of budget line (-PX/PY) represents the
opportunity cost of X in terms of foregone Y.
or in part.
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Suppose you have $100 to spend on burgers and
soda: PB = $4 and PS = $2.
Write out the budget constraint:
4B + 2S = 100or S = 50 - 2B
If you only buy soda (B = 0), you can buy 50 units.
The opportunity cost of one burger is two sodas.
or in part.
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27
Graphical View
Given the budget constraint, we now want to add an

indifference curve.
Quantity of
burgers
per week
Are you maximizing utility at point A?

No. You are not spending all your
income.
Quantity of
sodas
per week
or in part.
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Graphical View
Are you maximizing utility at point B?
Quantity of
burgers
per week
No. The MRS (the slope of the

indifference curve) > price ratio (the
slope of the budget constraint)
You could buy less burgers and more
soda and end up on a higher indifference
curve at point C.
B
C
A
Quantity of
sodas
per week
or in part.
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Graphical View
So at point C, you are maximizing utility
Quantity of
burgers
per week
1. You are on the budget constraint: all

income is spent.
2. The indifference curve is tangent to
the budget constraint: MRS = price ratio.
B
C
A
Quantity of
sodas
per week
or in part.
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Using The Model of Choice:

Differences in Preferences
Hamburger
s per week
Hungry Joe has a relatively strong preference

for burgers
Thirsty Theresa
has a relatively
strong
preference for
soda.
Extra thirsty Ed is
super thirsty
Soft drinks
per week
or in part.
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Differences in Preferences
Hamburger
s per week
What indicates each persons

preference for one good over
the other?
The flatter (steeper) the
indifference curve the stronger
the preference for the good on
the Y-axis (X-axis).
Soft drinks
per week
or in part.
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Different Types of Goods
A useless good.
Smoke
grinders
per week
U1
U2
The person buys only food and

does not buy the useless good
Food per week
or in part.
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An economic bad.
Houseflies
per week
U1
U2
The person buys only food and

does not buy the economic
bad
Food per week
or in part.
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Perfect Substitutes
Gallons of
Exxon per
week
The person buys only Exxon gas since it

costs less per gallon (steep budget
constraint)
U1
U2
Gallons of
Mobil per
week
or in part.
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35

Perfect Complements
Right shoes
The person buys shoes only in pairs.
U2
U1
1
Left
shoes
or in part.
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Numerical Example: Perfect

Substitutes
Example 1: You have to decide whether to buy

Exxon gas or Mobil gas. You have $30. The price of
Exxon gas is $3 and the price of Mobil gas is $3.25.
Since the goods are identical you will only buy gas
at the lowest price. Therefore, you will buy 10
gallons of Exxon gas.
Note that if the goods are perfect substitutes you do
not necessarily buy the good with the lowest price.
If you get enough extra utility from the more
expensive good, you may end up buying that good.
or in part.
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37

Complements
Example 1: You have to buy pairs of shoes. Left

and right shoes each cost $10, and you have $60 to
spend.
What are your possible options?
What would you do?
or in part.
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Complements
Example 2: Each time you go to the movies you

buy 2 bags of popcorn. The price of popcorn is
$2.50 and the price of a movie ticket is $10. You
have $30.
Utility function:
Consumption ratio:
Budget constraint:
U(M,C) = Min (2M,C)

C = 2M
10M + 2.50C = 30
Plug C = 2M into the budget constraint:

5M = 30
M=2
C=4
10M +
or in part.
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Some Generalizations
So far we have considered fairly simple choice
problems.
More than two goods.
Complicated budget constraints: volume discounts,
tie-in sales, rationing.
Composite goods: food and housing, X and all other
goods.
or in part.
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40
Summ
ary
People make choices in order to maximize their
utility or happiness.
An indifference curve shows the different
combinations of two goods that a person views as
equally attractive: gets the same utility.
The slope of the indifference curve the MRS
measures the rate at which a person is willing to
substitute one good for another.
or in part.
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Summ
ary
Peoples choices are constrained in what they can
purchase by their income and the prices of the
goods.
A person will maximize their utility by: 1) spending
all their income, and 2) choose the mix of goods for
which the MRS is equal to the price ratio.
or in part.
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42

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Walter

Want to develop a theory of choice which we can

Two factors influence peoples choices.

Importance of Ceteris Paribus assumption.

Three Assumptions About

(X*, Y*) is preferred to combinations

Draw a curve through those points.

If you give up hamburgers, you need to

Indifference Curves and the

Indifference Curves and the

From C to D: the person is willing to

Indifference Curves and the

Do you notice a pattern?

As you consume more and more soda, the number of

Indifference Curves and the

You would prefer 4 burgers and 4

Indifference Curve Maps

As you move to the northwest,

Four Particular Preferences

For a given amount of

Food per week

Four Particular Preferences

Holding the amount of food

Food per week

Four Particular Preferences

Does it always have to be -1?

Four Particular Preferences

What if you had three feet: two

Faced with a choice from among a number of goods,

Your decision is constrained by your income and the

Assume you have $100 per week to spend on

How do you allocate the $100 in order to maximize

To maximize your utility two conditions must be

Why does the second condition have to hold?

Why does the second condition have to hold?

So when MRS > PS/PB you can increase your utility by

Start by showing the budget constraint: this

Ymax spend all income on good Y

Points inside the budget

Budget Constraint Algebra

Budget Constraint Algebra

If all income spent on Y, you buy I/PY units.

Budget Constraint Algebra

Given the budget constraint, we now want to add an

Are you maximizing utility at point A?

No. The MRS (the slope of the

1. You are on the budget constraint: all

Using The Model of Choice:

Hungry Joe has a relatively strong preference

Using The Model of Choice:

What indicates each persons

Using The Model of Choice:

The person buys only food and

Food per week

Using The Model of Choice:

The person buys only food and

Using The Model of Choice:

The person buys only Exxon gas since it

Using The Model of Choice:

The person buys shoes only in pairs.

Numerical Example: Perfect

Example 1: You have to decide whether to buy

Numerical Example: Perfect

(X, Y) is preferred to combinations