1. 2.0
Modeling Individual Choice

2. Robinson Crusoe - Why?

3. 2.1 This chapter is about individual choice Crusoe is alone
He makes his choices independently
Once we understand independent choice,
we can move to more complex, interdependent choice

4. 2.21 Assumptions No scarcity No production is necessary
No future or sense of time passing
No risk or uncertainty

5. 2.2.2 Definitions Utility - Satisfaction Consume -
the act of deriving utility
Note: not always using up.
Consume pizza - gone
Consume art - still there

6. Goods - tangible, can be stored Ex. Food, sneakers Services -
intangible, cannot be stored
Ex. Haircut

7. 2.2.3 More Assumptions
people know what gives them utility, and can rank items by the utility they receive from an item
Rational behavior -
utility maximizing
Assumption - people are rational

8. Rational households consume goods and services in order to derive the maximum utility

9. 2.3 Diminishing Marginal Utility

10. 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

11. 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

12. 2.32 Marginal and Total Utility
We can make up a unit of utility
we’ll call it a util
Chart on page 20
Eventually, as you keep eating
you get to the point where you derive no satisfaction
At this point, MU=0

13. Example - Big Bowl of M&Ms

15. Marginal Utility with Multiple Choices
Different activities will have different MU lines

16. 2.4 Constructing a decision rule

17. 2.4.1 Initial Decision Rule MU1=MU2=MU3=…=MUn=0
If you can get to the point where you have totally satisfied yourself in all dimensions of consumption,
That is called a bliss point
Absolute maximum utility has been attained

18. This rule is valid only given the strong assumptions we have chosen
While not totally realistic, it gives us a starting point from which to build

19. 2.5 Relaxing the “No Scarcity” Assumption

20. If time were not scarce,
You could think of the decision rule as

21. We will now assume time to be scarce
This is much more realistic
Can’t do everything to satiate yourself
Suppose the only things you have time to do are study and play, and you only have ten hours

22. An initial allocation
7 hours of play – MU=50
3 hours of study – MU=70

23. 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

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

25. What you now have is a new rule
Where X can be >0

26. This new rule describes how people solve
a constrained optimization problem
In other words, how do people maximize utility in the face of scarcity?

27. 2.6 Relaxing the “No production necessary” assumption

28. In reality, 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 produces
Endowment may not be fixed, but it is finite, so scarcity is an issue
(We discover new oil all the time, but there is an ultimate limit)

29. More new terms
Factors of production are allocated to and then combined in processes of production that apply techniques chosen from available technology in order to produce goods and services

30. 2.6.2 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

31. Another factor is capital
“a produced means of production”
More properly called production capital
Physical capital –tools, machines
Human capital – inside yourself, allows you to be more productive – education

32. 2.6.3 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

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

34. 2.6.5 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

35. 2.6.6 Marginal Productivity
The additional output that comes from an additional unit of input is called
the marginal product
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

36. 2.6.7 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

37. To connect the two sides,
we must find out what the utility is for the
last unit of labor towards a given product
this is called the Value of the Marginal Product, or V

38. 2.6.8 How to calculate V

39. You need a marginal product schedule

40. You need a marginal utility schedule

41. Calculating V

42. 2.6.9 Why Value Marginal product eventually falls
V eventually falls because
MU falls from unit 1
MP eventually falls

43. 2.6.10 V and optimization If R.C. had V schedules for each activity,
he could decide on the “optimal” or best allocation of his labor
Because he is rational, he chooses activities that give him the maximum utility

44. V schedules

45. How many hours
To get every last util? 23

46. What if there was a time constraint of 13 hours of daylight?
Answer:
Hunt - 4 hours
Fish - 5 hours
Pick Berries - 2 hours
Pump Water - 2 hours

47. Decision rule
Time is perfectly divisible, so you can always reconfigure with smaller units of time until this works out

48. 2.6.11 The General decision rule
V1=V2=V3=…=Vn=X
X>0

49. 2.6.12 Changing constraints Assume winter comes,
so no berries are available
And there is only 7 hours of daylight

50. Conclusion on V
We are trying to build a model to describe how people make choices
Whether it is done consciously or not, people do allocate their scarce resources according to some process
Given our assumptions, people will follow the rule we have developed

51. 2.7 Relaxing the No Future Assumption

52. 2.7.1 Missiles are on the way
Would this alter your choices?

53. 2.7.2 The future and choice Intertemporal - across time
You have to decide now about things that will have utilities in the future

54. 2.7.3 Discounting the Future
Discount- to diminish value
Economists assume that ceteris paribus, people discount the future relative to the present
Ex. $100 now or a year from now

55. 2.7.4 Discount rates If $100 now equals $150 a year from now,
Your “waiting premium” is 50%
The name for that waiting premium is the discount rate
Higher discount rates diminish the future more than lower ones
There is no right or wrong rate, everyone has there own based on that person’s attitude towards waiting

56. 2.7.5 Changing discount rates
Your discount rate changes as your perception of the future changes
More immediate utility might be preferable

57. 2.7.6 Discount rates and social frames
discount rates are personal, but they are also socially developed
Attitudes about waiting change as we grow up
5 minutes is forever to a little kid
Adults are more willing than kids to wait

58. 2.7.7 Present Value what future utilities are worth right now
Ex. $150 a year from now might have a present value of $100
depending on your discount rate
All future utilities have a present value

59. 2.7.8 An Intertemporal decision rule
Before, when we assumed no future, the rule was
V1=V2=V3=…=Vn=X
Now, since some choices have payoffs into the future, the rule becomes
PV1=PV2=PV3=…=PVn=X
where PV means Present Value

60. 2.7.9 Saving, Investing, and Intertemporal choice
Decision to save or invest depends on discount rates
High discount rates mean little present value to future utilities, so
people with high personal discount rates rates will be less likely to save or invest

61. Should I go to college?

62. Explanation C – College W – work I - Investment cost R – Return
If present value of return is higher than the present value of cost, go to school
If not, go to work
Doesn’t have to measured in dollars

63. 2.7.11 College Demographics Why is college full of 18-22 year olds?
Opportunity cost is higher for older students
Retirees discount the future more because they have less time left

64. 2.7.12 Conclusion on intertemporal choice
When we relax our assumption of no future, then the rule becomes
PV1=PV2=…=PVn

65. 2.8 Relaxing the no risk and uncertainty assumption

66. Risk
negative outcome that you can’t control but can assign a probability to

67. Uncertainty
negative outcome you can not assign a probability to

68. 2.8.2 Building risk into the decision rule
All utilities should be looked at as expected utilities because of risks and uncertainties
EPV1=EPV2=…=EPVn

69. 2.8.3 Risk and Choice PVparachuting > PVmovie But
EPVparachuting < EPVmovie

70. 2.8.4 Uncertainty and Choice
Ex.
Falling objects in NYC

71. 2.8.5 Risk and Learning For kids, most all is uncertainty
Then when something bad happens, an overestimation of risk,
Then eventually a more realistic assessment

72. 2.8.6 Risk as perception Perception of risk affect our choices
We rarely know the actual probability
Lower perception of risk leads to being more likely to engage in unsafe behaviors
Drugs/alcohol affect your perception of risk, usually diminishing or eliminating those perceptions

73. 2.8.7 Risk as perception – a policy case
Police training tape
Why?
Raise perception of that risk of becoming a crooked cop
Governments also try to alter perceptions to promote ideas –
Rosie the Riveter during WWII

74. 2.8.8 Perceptions, Choice and the Media
Advertising – product will bring great utility
Shape our perceptions –beauty standards
Eating disorders – more prone if high discount rate and low perception of risk

75. 2.8.9- 2.8.11 Gender perceptions and choice
Mrs. Seigel
Billy Tipton

76. 2.8.12 On role models Role models affect:
Preferences – without role models, might never consider that career choice
Discount rate – if your role models have high discount rates and value immediate gratification, you might too
Risk – if others blaze the trail for you, less risk for you, then the more likely you make that choice

77. 2.8.13 Social Constructions and Individual Choices
Understand that while choices are individual,
They do occur within a larger social frame
Other social sciences can help us understand the construction of these frames

78. 2.8.14 Perceptions, Individual Choices, Challenge of Policy
The world is really complicated
A web of connections means
a change in one thing may have many other effects
Ex. Drug Policy
Policy is never simple

79. 2.9 Conclusion on Independent Individual Choice
RC’s decisions are perfectly coordinated
He’s the only one involved,
so consumption and production, as well as
saving and investing, are coordinated in his own head
Note : this doesn’t mean that they always work out –
due to risks and uncertainty

80. This perfect coordination separates
The RC world from the real one
Next, we look at a more complex world which
Includes more realistic interdependent choice