Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
1

Utility Theory and Individual Choice
 According to economists, we behave the way we do because of rational self interest .
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2

Utility Theory and Individual Choice
 Using this simple theory, two things determine what people do:

The pleasure people get from doing or consuming something.

The price of doing or consuming that something.
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3

Utility Theory and Individual Choice
 Price is the market's tool to bring quantity supplied equal to the quantity demanded.
 Changes in price provide incentives for people to change what they are doing.
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4

Measuring Pleasure
 Economists start with a proposition that individuals try to get as much pleasure as possible out of life.
 The goods and services we consume provide value (satisfaction) to us.
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5

Measuring Pleasure
 Individuals want to maximize the amount of satisfaction they receive through consuming goods and services.
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6

Measuring Pleasure
 Economists use the concept of utility —the pleasure or satisfaction that one gets from consuming a good or service.
 A util is a unit of satisfaction created by economists to “measure” utility.
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7

Utility
 Utility serves as the basis of economists' analysis of individual choice.
 It is personal and individual.
 Utility cannot be compared across individuals.
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8

Total Utility and Marginal Utility
 It is important to distinguish between marginal and total utility.
 Total utility refers to the satisfaction one gets from one’s consumption of a product.
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9

Marginal Utility
 Marginal utility refers to the satisfaction you get from the consumption of one additional unit of a product above and beyond what you have consumed up to that point.
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10

Marginal Utility
 As additional units are consumed, marginal utility decreases while total utility increases.
 When total utility stops increasing, marginal utility is zero.
 Beyond this point, total utility decreases and marginal utility is negative.
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11

Diminishing Marginal Utility
 The principle of diminishing marginal utility – after some point, the marginal utility received from each additional unit of a good will begin to decrease with each additional unit consumed.
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12

Diminishing Marginal Utility
 The principle does not say you do not enjoy consuming more of a good.

For example, as you consume more pizza, you enjoy additional slices less than you enjoyed the initial slices.
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13

Marginal and Total Utility
Pizza slices
1
2
3
4
7
8
5
6
9
Total utility
14
26
36
44
50
54
56
56
54
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Marginal utility
14
12
10
8
2
0
6
4
-2
14

Marginal and Total Utility
70
60
50
40
30
20
10
0
Total utility
Total utility
1 2 3 4 5 6 7 8 9
Slices of pizza per hour
16
14
12
10
8
6
4
2
0
-2
Marginal utility
Marginal utility
1 2 3 4 5 6 7 8 9
Slices of pizza per hour
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15

Rational Choice and Marginal Utility
 Because people face a budget constraint, they must choose among alternatives.
 Rational individuals want as much satisfaction as they can get from their available income.
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16

Rational Choice
 In making choices, you are essentially buying units of utility.
 Any choice that does not give you as many units of utility as possible for the same amount of money is an irrational choice.
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17

Rational Choice
 Since you want to get the most for your money, you make those choices that have the highest units of utility per unit of cost.
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18

Principle of Rational Choice
 According to the basic principle of rational choice you should spend your money on those goods that give you the most marginal utility (MU) per dollar.
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19

Principle of Rational Choice
 If:
MU x
P x

MU y
P y consume an additional unit of good x .
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20

Principle of Rational Choice
 If:
MU x
P x

MU y
P y consume an additional unit of good y .
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21

Principle of Rational Choice
 You can always decide which good it makes more sense to consume.

Substitute the marginal utilities and prices of goods into these formulas.

Consume the one with the highest marginal utility per dollar.
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22

Simultaneous Decisions
 Individuals often face simultaneous decisions.
 As consumption is being varied from one choice to a combination of choices, the marginal utilities of the other choices will fall.
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23

Maximizing Utility
 You vary your consumption until you maximize utility.
 That occurs when the marginal utilities per dollar spent on each of the choices are equal.
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24

Maximizing Utility
 Total utility is maximized when marginal utility per dollar spent of two goods is equal:
MU x
P x

MU y
P y
 You cannot increase your utility by adjusting your choices.
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25

Maximizing Utility
6
7
4
5
2
3
0
1
Q
Hamburgers (P = $2)
TU MU MU/P
0
20
32
38
41
41
36
26
20
12
6
3
0
-5
-10
10
6
3
1.5
0
-2.5
-5
Q
Ice Cream (P = $1)
TU MU MU/P
4
5
6
7
2
3
0
1
0
29
46
53
56
57
57
53
29
17
7
3
1
0
-4
29
17
7
3
1
0
-4
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26

Maximizing Utility
$4
$5
$7
Total $ spent
$1
$2
$9
$10
Purchase?
MU/P
1 st ice cream cone 29
2 nd ice cream cone 17
1 st hamburger 10
3 rd ice cream cone 7
2 nd hamburger 6
3 rd hamburger 3
4 th ice cream cone 3
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MU
29
17
20
7
12
6
3
Total utility =
94 utils
27

Rational Choice and Marginal Utility
 If MUx/Px > MUz/Pz , consume more of good x.
 If MUy/Py > MUz/Pz , consume more of good y.
 When
MU x 
MU y
P x
P y maximizing utility

MU z
P z you are
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28

Rational Choice and Marginal Utility
 The general utility-maximizing rule is that you are maximizing utility when the marginal utilities per dollar are equal across all goods you consume.
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29

Rational Choice and Marginal Utility
 When this principle is met, the consumer has reached his maximum utility, given his income.
 The cost per additional unit of utility is equal for all goods and the consumer is as well off as it is possible to be.
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30

Rational Choice and Marginal Utility
 The rule does not say that the rational consumer should consume a good until its marginal utility reaches zero.
 The consumer does not have enough money to buy all he wants.
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31

Opportunity Cost

is the benefit forgone of the next-best alternative.

It is essentially the marginal utility per dollar you forgo.
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32

Opportunity Cost
 To say MUx/Px > MUy/Py is to say that the opportunity cost of not consuming good x is greater than the opportunity cost of not consuming good y.
 So we should consume more x.
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33

Opportunity Cost
 When all the marginal utilities per dollar spent are equal, the opportunity cost of all the alternatives are equal.
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34

Rational Choice and the Law of
Demand
 The principle of rational choice leads to the law of demand.

When the price of a good goes up, the marginal utility per dollar goes down and we consume less of it.
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35

Rational Choice and the Law of
Demand
 Initially MUx/Px = MUy/Py
 When the price of good y goes up, then
MUx/Px > MUy/Py .
 Our condition for maximizing utility is no longer satisfied.
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36

Rational Choice and the Laws of
Demand and Supply
 To maximize utility now we must:
 consume less of the good whose relative price has risen, thereby raising the marginal utility we get from it, and
 consume more of the good whose relative price has fallen, thereby lowering the marginal utility we get from it.
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37

Rational Choice and the Law of
Demand
 MUx decreases as we buy more good x
(diminishing marginal utility).
 MUy increases as we buy less of good y.
 We are back to a point where MUx/Px =
MUy/Py and we maximize utility.

Consuming more x and less y than before.
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38

Rational Choice and the Law of
Demand
 So when the price of a good goes up, we choose to consume less of that good.
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39

Rational Choice and the Law of
Demand
 Since our demand for a good is an expression of our willingness to pay for it, quantity demanded is related to marginal utility.
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40

Rational Choice and the Law of
Demand
 Quantity demanded rises as price falls, other things constant.
 Quantity demanded falls as price rises, other things constant.
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41


Applying the Theory of Choice to the
Real World
There are limits on the assumptions underlying the theory of rational decisionmaking.
 In reality, people make hundreds of choices every day.
 It is difficult to believe that we are going to apply principles of rational choice to all those decisions.
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42

Cost of Decision Making
 Some decisions are difficult to make because we lack information, or there is some uncertainty involved, or it is a complex decision.
 Each decision requires us to use our limited cognitive ability to receive, process, store and retrieve information.
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43

Cost of Decision Making
 The cost of deciding among hundreds of possible choices leads us to do something irrational.
 That is, do things without applying the rational choice model.
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44

Cost of Decision Making
 A number of economists believe that most people use bounded rationality rather than using the rational choice model.
 Bounded rationality means rationality based on rules of thumb.
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45

Cost of Decision Making
 We employ a variety of simple rules to make some of our decisions:

Price conveys information

Follow the leader

Habit

Custom
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46

Cost of Decision Making

One of these rules of thumb is “you get what you pay for.”
 Higher priced goods tend to be better than lower-priced goods.

We can use this simple rule to make a quick decision – we rely on price to convey information about quality.
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47

Cost of Decision Making

A second rule of thumb is “follow the leader.”
 Sometimes we just do what others are doing.

Clothes manufacturers try to exploit this decision rule with their advertising efforts by convincing us that “everyone” is wearing a particular style.
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48

Habit
 Habit explains a lot of our choices.
 We did the marginal utility calculation some time ago and we continue with the same choice.

We rely on our previous judgment.
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49

Custom
 Employing the rule of custom can ease the burden of decision making.
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50

Maximizing Utility Using Indifference
Curves
 Economists often use graphic representation of the consumer’s choice.
 The problem consists of two parts:

The budget constraint (or the income constraint)

Indifference curves, which represent utility
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51

Graph the Budget Line
 The budget constraint represents all the combinations of two goods that a person can afford to buy with a given income.
 The budget constraint is also called the income constraint, or budget line.
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52

Ella’s Choice
 Ella eats chocolate bars and drinks pop.
 She wants to maximize her utility given her budget constraint.
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53

Budget Constraint
 Chocolate bars cost $1 and pop costs 50 cents a can.
 Ella has $10 to spend.
 She can buy 10 chocolate bars or 20 cans of pop or some combination of both.
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54

Budget Line
Chocolate bars
10
8
6
4
2
0
Income = $10
Slope = - P pop
/P chocolate
2 4 6 8 10 12 14 16 18 20 22
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= - ½
Cans of pop
55

Budget Line
 The slope of the budget line is the ratio of the prices of the two goods.
 The slope changes when the prices change.
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56

Budget Line Rotates
Chocolate bars
10
8
6
4
2
0
Income = $10
Pop Price = $1
Slope = - P
= - 1
2 4 6 8 10 12 14 16 18 20 22
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pop
/P chocolate
Cans of pop
57

Indifference Curve
 Indifference curve – a curve that shows combinations of goods amongst which an individual is indifferent.
 The slope of the indifference curve is the ratio of marginal utilities of the two goods.
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58

Graph the Indifference Curve
 Indifference curves are downward sloping and bowed inward.
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59

Indifference Curve
 Ella is equally as well off (her utility is the same) from consuming bundles A, B, C, D or
E.
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60

Indifference Curve
Chocolate bars
20
16
12
8
4
A
B
C
D E
|Slope|= MU pop
/MU chocolate bars
= MRS of pop for chocolate bars
U
Indifference curve
0
2 4 6 8 10 12 14 16 18 20 22
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Cans of pop
61

Marginal Rate of Substitution
 The slope of the indifference curve is called the marginal rate of substitution (MRS).
 Marginal rate of substitution – the rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations.
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62

Marginal Rate of Substitution
 The slope is bowed inward, indicating that the
MRS is decreasing as Ella’s bundles contain more of the good on the horizontal axis.
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63

Marginal Rate of Substitution
 The reason for decreasing MRS is that as
Ella gets more and more of one good, she is willing to give up lots of it to get more of the relatively scarce good.
|Slope| = MU pop
/MU chocolate
= MRS
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64

Marginal Rate of Substitution
 Law of diminishing marginal rate of substitution – for each additional unit of a good, the smaller the amount of the other good needed to be given up to keep you on your original indifference curve.
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65

Mapping of Indifference Curves
 Ella will have a whole group of indifference curves, each representing a different level of utility.
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66

Mapping of Indifference Curves
Chocolate bars
20
16
12
8
4
0
A
B
C
D
E
U
1
U
2
U
3
2 4 6 8 10 12 14 16 18 20 22
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Cans of pop
67

Mapping of Indifference Curves
 The bundles of goods forming indifference curve U
3 give Ella higher utility than bundles along U
2
.
 The bundles of goods forming indifference curve U
1 give Ella less utility than bundles along U
2
.
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68

Utility Maximization
 Since more is preferred to less, Ella is better off with the indifference curve that is farthest to the right.
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69

Indifference Curves Cannot Cross
 If indifference curves crossed, it would violate the “more-is-preferred-to-less” principle.
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70

Indifference Curves Cannot Cross
Chocolate bars
20
16
12
8
4
A is preferred to B
A
B
D
B is indifferent to C
C
U
1
U
2
C is preferred to D
0
Thus,
A is preferred to D.
2 4 6 8 10 12 14 16 18 20 22
????
Cans of pop
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71

Maximizing Utility
 The goal for a consumer is to get to the highest indifference curve possible, given her income constraint.
 More is preferred to less.
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72

Maximizing Utility
 Ella will maximize her utility by consuming on the highest indifference curve possible, given her budget constraint.
 The best combination is the point where the indifference curve and the budget line are tangent.
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73

Maximizing Utility
Chocolate bars
20
16
12
8
4
0
Slope= -MU pop
/MU chocolate bars
Slope= -P
2 4 6 8 10 12 14 16 18 20 22
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pop
/P chocolate bars
Cans of pop
74

Maximizing Utility
 The best combination is the point where the slope of the budget line equals the slope of the indifference curve.
P pop
P
Choc

MU pop
MU
Choc so that
MU
Choc
P
Choc

MU pop
P pop
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75

Maximizing Utility
 In other words, utility is maximized when the slopes of the budget constraint and the indifference curve are equal.
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76

Income Expansion Path
 Income expansion path (IEP) traces all the best (utility-maximizing) choices a consumer makes as income changes.
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77

Income Expansion Path
Good Y
Good Y
IEP
IEP
U
3
U
3
U
2
U
1 a) Normal good
U
2
Good X
U
1 a) Inferior good
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Good X
78

Engel Curves
 An Engel curve plots all the best choices a consumer makes against INCOME .

It is an income-quantity relationship
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79

Engel Curves
Quantity
Demanded
Income elastic normal good
(luxury)
X
1
Income inelastic normal good
(necessity)
X
2
Inferior good
X
3
Income
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80

Price Expansion Path
 Price expansion path (PEP) traces all the best choices of a consumer as the relative price changes.
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81

Price Expansion Path
Good Y
B/Py
U
1
PEP
U
2
B/(Px)
1
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B/(Px)
2 Good X
82

End of Chapter 7
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83