Walter Nicholson Christopher Snyder

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Presentation transcript:

Walter Nicholson Christopher Snyder 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 website, in whole or in part.

2 Utility and Choice CHAPTER ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in 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 people’s choices. Preferences: what goods do you like 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, in whole or 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. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or 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”. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or 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* ? Quantity of X per week X* ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or 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. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Indifference Curve Let’s 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. A 6 B 4 C 3 D 2 U1 Soft drinks per week 2 3 4 5 6 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Indifference Curve What can we say about combination E? What about F? Hamburgers per week What about F? A 6 B 4 E C 3 D 2 U1 F Soft drinks per week 2 3 4 5 6 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or 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. A 6 B 4 E C 3 D 2 U1 F Soft drinks per week 2 3 4 5 6 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Indifference Curves and the 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 ½ burger to get 1 more soda. A 6 B 4 E C 3 D 2 U1 F Soft drinks per week 2 3 4 5 6 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Indifference Curves and the 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. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Indifference Curves and the MRS Suppose we create a basket that is ½ of A and ½ 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. A 6 G 4 D 2 U1 Soft drinks per week 2 3 4 6 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Four Particular Preferences An economic bad. More of an economic bad decreases your utility. Holding the amount of food constant, additional flies reduces utility. Houseflies per week U1 U2 U3 Food per week ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Four Particular Preferences 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 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Four Particular Preferences 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? 3 U3 2 U2 1 U1 Left shoes 1 2 3 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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? ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Utility Maximization To maximize your utility two conditions must be met: You spend all your income. 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. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Utility Maximization 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 = ½ If you give up one burger, you can get one more soda to keep you indifferent plus you get one more additional soda. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Utility Maximization 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. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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. Ymax – spend all income on good Y Quantity of Y per week Xmax – spend all income on good X Ymax Buy some mix of X and Y and spend all income. Points inside the budget constraint are affordable, but you have money left over. Quantity of X per week Xmax ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Budget Constraint Algebra Rewrite the last equation so that: 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. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Budget Constraint Algebra Suppose you have $100 to spend on burgers and soda: PB = $4 and PS = $2. Write out the budget constraint: 4B + 2S = 100 or S = 50 - 2B If you only buy soda (B = 0), you can buy 50 units. The opportunity cost of one burger is two sodas. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Utility Maximization: A 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. A Quantity of sodas per week ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Utility Maximization: A 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 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Utility Maximization: A 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 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Using The Model of Choice: Differences in Preferences Hamburgers per week Hungry Joe has a relatively strong preference for burgers Extra thirsty Ed is super thirsty Thirsty Theresa has a relatively strong preference for soda. Soft drinks per week ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Using The Model of Choice: Differences in Preferences What indicates each persons’ preference for one good over the other? Hamburgers per week The flatter (steeper) the indifference curve the stronger the preference for the good on the Y-axis (X-axis). Soft drinks per week ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Using The Model of Choice: 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 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Using The Model of Choice: Different Types of Goods An economic bad. Houseflies per week U1 U2 The person buys only food and does not buy the economic bad Food per week ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Using The Model of Choice: Different Types of Goods 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 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Using The Model of Choice: Different Types of Goods Perfect Complements Right shoes The person buys shoes only in pairs. 2 U2 1 U1 Left shoes 1 2 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Numerical Example: Perfect 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? ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Numerical Example: Perfect 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: U(M,C) = Min (2M,C) Consumption ratio: C = 2M Budget constraint: 10M + 2.50C = 30 Plug C = 2M into the budget constraint: 10M + 5M = 30 M = 2 C = 4 ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Willie’s Utility and His Uncle’s Promises Other Goods Willie prefers point A if no promise is made Uncle offers point B: no sin, but higher utility due to more consumption of other goods and services Uncle promised to give the money to Willie once he was “capable of using it wisely”, but he died before paying Budget constraint B C Willie ends up at C with a lower utility compared to A A Willie got paid in the end U3 U2 U1 Sin

Rationing of Tickets Leads to Scalping Other goods Since Super Bowl tickets are rationed at one per consumer, the individual maximizes utility at point B, but would be happier if he or she could be at point A purchasing 4 tickets. Buying two tickets to move to point C is preferable in terms of utility CD is the amount of other goods this consumer is willing to sacrifice for the ability to move to C. B C Income D A U2 U1 Super Bowl tickets 1 2 3 4 5

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”. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Summary 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. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Summary 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. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.