Modeling Individual Choice Chapter 2

2 Individual Choice Individual Choice in Buying Goods: Theory Individuals want to be as happy as possible. Individuals gain happiness from the consumption of goods / services. The more consumption the better, at least to a satiation point. The happiness we gain becomes less and less as we consume more and more of any good. The “Law of Diminishing Marginal Utility”

Robinson Crusoe - Why?

Assumptions No scarcity No production is necessary No future or sense of time passing No risk or uncertainty

Definitions Utility - Satisfaction Consume - the act of deriving utility Note: not always used up. –Consume pizza - gone –Consume art - still there

Goods Tangible, can be stored – Ex. Food, sneakers Services - intangible, cannot be stored – Ex. Haircut

More Assumptions People know what gives them utility, and can rank items by the utility they receive from an item Rational behavior - utility maximizingRational behavior Assumption - people are rational Rational households consume goods and services in order to derive the maximum utility

New assumption Ceteris paribus, the utility one derives from the consumption of a good decreases with each successive unit consumed Ex. Dying of thirst 1st sip - much utility 2nd sip - less so eventually - no utility

More clearly stated: Ceteris paribus, the utility one derives from the consumption of a good decreases with each successive unit consumed or one experiences diminishing marginal utility

We can make up a unit of utility We’ll call it a util Eventually, as you keep eating you get to the point where you derive no satisfaction At this point, MU=0

M&Ms

12 Utility maximization, marginal utility / total utility / diminishing marginal utility You are given the following information about the utility value of Big Mac's (assuming the burgers are free) number of Big Mac's MU total utility X 2 90 Y 3 Z P 5 0 Q R Use the information above to answer questions 1 -7 keeping the Law Of Diminishing Marginal Utility in mind 1. - the value of X would be _____ 2. - the value of Y would be _____ 3. - the value of Z would be _____ 4. - the value of P would be _____ 5. - the value of Q would be _____ 6. - the value of R would be _____ 7. - a rational consumer would consume HOW MANY Big Mac's ____ = satiation

13 Utility maximization, marginal / total utility You are given the following information about the utility value of Big Mac's (assuming the burgers are free) number of Big Mac's MU total utility X 2 90 Y 3 Z P 5 0 Q R Use the information above to answer questions 1 -7 keeping the Law Of Diminishing Marginal Utility in mind 1. - the value of X would be __100___ 2. - the value of Y would be __190___ 3. - the value of Z would be ___80___ 4. - the value of P would be __275___ 5. - the value of Q would be __275___ 6. - the value of R would be __265___ 7. - a rational consumer would consume HOW MANY Big Mac's _4_ = satiation

MU’s From 3 Different Activities

15 Given no scarcity - I will consume until I satiate my want for good 1 – so I will consume until the marginal utility = 0 utils (Bliss Point). The same would be true for good 2, 3, … Or until MU 1 = MU 2 = MU 3 = … = MU n = 0.

If time were not scarce You could think of the decision rule as MU1 = MU2 = MU3=…= MUn = 0 Unitoftime Unitoftime

Time IS Scarce 7 hours of play – MU=50 3 hours of study – MU=70

How to optimize- The optimal allocation is the one which maximizes utility Do another hour of the choice which gives you the higher marginal utility

A new allocation 6 hours of play – MU=60 4 hours of study – MU=60

2.5.2 Your Decision Rule under Scarcity MU1 = MU2 = MU3=…= MUn = X Unit Unit Where X can be >0 How do people maximize utility in the face of scarcity? Answer: We balance at the Margins!!

2.6 Relaxing Factors of Production Stuff doesn’t just appear like magic for you to consume Endowment- all the natural and human resources from which all goods and services are produced Endowment may not be fixed, but it is finite, so scarcity is an issue

On Factors Factors of production – basic inputs we use to produce, such as Natural resources – in, on or around the earth Labor- human work Together, these first two are called the natural endowment

Capital physical capital (machines) human capital (skills, innate and acquired).

Allocation, Techniques, and Technology Allocated – we decide how to use the factors Process of production – transforming the inputs into an good, or service Technique- one way of combining inputs Technology – set of all available techniques

Types of techniques Labor-intensive technique- uses primarily labor Capital-intensive technique – uses primarily capital Firms usually choose the cheapest way

Scale of Production Refers to the size of the process of production Returns to scale – how does a change in scale affect output? Ex. If double inputs – less than doubles the output –decreasing returns to scale If double inputs – doubles the output – constant returns to scale If double inputs - more than doubles the output – increasing returns to scale We assume decreasing returns to scale

Marginal Productivity The additional output that comes from an additional unit of input is called the marginal product (MP) While MP can increase for a while, It will eventually diminish If inputs were free, to maximize production you would use inputs until MP=0 for all inputs

The Law of Diminishing Returns The Law of Diminishing Returns – as a firm uses more and more of a given input such as labor, ceteris paribus on the other inputs, there will come a time when the marginal product of labor will decrease (i.e. Diminishing Marginal Product of Labor).

Value from the marginal product – V So far, we have two independent rules: MU1=MU2=MU3=…=MUn=0 (consumption of free goods) MP1= MP2 = MP3=…=MPn=0 (use of free inputs) Now we need to bridge the two

Labor (HRs)Marginal Product (MP) Rabbits Total Product Rabbits

Marginal Utility Schedule RabbitMU 1 st nd 90 3 rd 80 4 th 70 5 th 60 6 th 50 7 th 40 8 th 30 9 th 20

Calculating V (Marginal Product) LaborRabbits and MUMarginal Product Total Utility 1 st 2 nd 3 rd 4 th 5 th 6th00540

V schedules

Decision rule

Complexity #1 – the Present Versus the Future Consumers: Should I buy and/or work now or later (existence of interest on savings, investment in human capital)? Firms: Should I expand my physical capital by buying this machine (trading current costs versus future benefits)?

2.7 The Future & Choice Intertemporal - across time You have to decide now about things that will have utilities in the future Ex. $100 now or a year from now

Discount Rate The Discount Rate – the rate, in percentage terms, that we are willing to trade off money received one year from now versus money received today. Equivalent amounts received today and in the future are worth more today – need to discount future amounts.

38 The Discount Rate: An Example Suppose you have a choice between $300 today and a higher amount next year. Suppose as well that you decide that you’re indifferent between $300 today and $360 next year. Your discount rate = [($360  $300)/($300)]x100% = 20%

39 Characteristics of the Discount Rate Consumers – depends upon different individual’s utility or preferences. –High Discount Rate: devalues the future sharply, “wants it now”. –Low Discount Rate: more willing to forego the present for the future. Firms – the market interest rate is their ultimate discount rate.

Should I go to college?

Explanation C – College W – work I - Investment cost R – Return Doesn’t have to measured in dollars

College Demographics Why is college full of year olds? Opportunity cost is higher for older students Retirees discount the future more because they have less time left

PV=Present Value When we relax our assumption of no future, then the rule becomes PV1=PV2=…=PVn

44 Incorporating Risk in Economic Decisions We develop expectations of unknown events – our best guess of what we think will happen, then act upon those (right or wrong). We practice risk aversion – of different events with the same expected return, we prefer less risk. Risk & uncertainty

45 Complexity #2 – Risk and Uncertainty Key Issue: future is unknown, affects economic decisions. Risk – unknown events to which we can attach a probability. Uncertainty – absolutely un-thought of events which may end up occurring. Uncertain events which occur become risky events.

Building risk into the decision rule All utilities should be looked at as expected utilities because of risks and uncertainties EPV1=EPV2=…=EPVn EPV parachuting <EPV2 movie NO PARACHUTING

Uncertainty and Choice Advertising – product will bring great utility Shape our perceptions –beauty standards Eating disorders – more prone if high discount rate and low perception of risk