Utility theory and Indifference curves

Consumer TheoryConsumer Theory
Utility TheoryUtility Theory

A theory of how consumers makeA theory of how consumers make
choices, assuming they arechoices, assuming they are
rational and making what arerational and making what are
determined to be the best choicesdetermined to be the best choices
given the parameters.given the parameters.

Maximizing UtilityMaximizing Utility
Defining Utility
Indifference CurveIndifference Curve
Parts to learn in this PPT:Parts to learn in this PPT:

Which do you prefer?Which do you prefer?
1.) You make $80,000 in a world where
everyone else makes $50,000.
2.) You make $90,000 in a world where
everyone else makes $150,000.

Which do you prefer?Which do you prefer?
1.) Drive 10 minutes to save $5 on a $15 pen.
2.) Drive 10 minutes to save $5 on a $500
suit

Ian is Morpheus from the Matrix, 黑客帝国 He will open you
mind

Remember it isRemember it is
solving thissolving this
paradoxparadox

1.)1.) Resources are Scarce.Resources are Scarce.
Basic ideas of EconomicsBasic ideas of Economics
2.)2.) Trade - OffsTrade - Offs
3.)3.) Opportunity CostsOpportunity Costs
4.)4.) Marginal Thinking.Marginal Thinking. - Means an additional one, the
measurement from one unit to
the next. 最后的东西之一
5.)5.) Rational ThinkingRational Thinking - People usually exploit- People usually exploit
opportunities to makeopportunities to make
themselves better off.themselves better off.
合理的
And applying allAnd applying all
these original ideasthese original ideas

UtilityUtility
-- Level of satisfaction a person
receives from the consumption of
the good.““Happiness”Happiness”

UtilityUtility
TotalTotal UtilityUtility - is the total benefit that a person
gets from the consumption.
- .
The key part toThe key part to
realizerealize
- It generally increases as the
quantity consumed of a good
increases but at a decreasing rate.

Consumer Theory Marginal Analysis

{{

{{
Increases at aIncreases at a
decreasing ratedecreasing rate

MarginalMarginal UtilityUtility ((MUMU)) -- Additional utility derived from
the consumption of one more unit
of a good.
UtilityUtility
Total UtilityTotal Utility

{{
The marginal utility
of the 3rd bottle of
water =
36 units
– 27 units
= 9 units.

{{
The MU curve isThe MU curve is
the slope of the TUthe slope of the TU
curvecurve

DiminishingDiminishing MarginalMarginal
UtilityUtility ((DMUDMU))
-- decline in the marginal utility
that person derives from
consuming each additional unit of
that product.
Marginal Utility (MU)Marginal Utility (MU)
UtilityUtility
Total UtilityTotal Utility

Example Question:Example Question:
Diminishing marginal utility means that an
increase in the consumption of a good leads to
a. a decrease in total utility.
b. a decrease in marginal utility.
c. an increase in marginal utility.
d. no change in marginal utility.
e. an increase in the consumer's budget.

Diminishing marginal utility means that an
increase in the consumption of a good leads to
b. a decrease in marginal utility.

The table above gives Matt's utility from
consuming slices of pizza. His marginal utility
from the 3rd slice is
a. 27 units.
b. 5 units.
c. 9 units.
d. 11 units

The table above gives Matt's utility from
consuming slices of pizza. His marginal utility
from the 3rd slice is
b. 5 units.

If Raul's marginal utility per dollar spent on
bread is 25 and the marginal utility per dollar
spent on butter is 30,
a. Raul should purchase more butter and less bread to
increase his total utility.
b. Raul's marginal utility of butter will fall if he buys
more butter.
c. Raul's marginal utility of bread will rise if he buys less
bread.
d. Only answer A and answer B are correct.
e. Answer A, answer B, and answer C are correct.

If Raul's marginal utility per dollar spent on
bread is 25 and the marginal utility per dollar
spent on butter is 30,
e. Answer A, answer B, and answer C are correct.

If a consumer's total utility increases when
another unit of a good is consumed, which of the
following is true? Marginal utility must be
a. negative.
b. equal to one.
c. positive.
d. increasing.
e. some amount, but more information is needed
to determine if marginal utility is positive,
negative, or equal to zero.

If a consumer's total utility increases when
another unit of a good is consumed, which of the
following is true? Marginal utility must be
c. positive.

If Joan consumes 1 dinner roll, she has total
utility of 15; if she consumes 2, she has total
utility of 37; and if she consumes 4, she has total
utility of 45. What is the marginal utility of the
fourth dinner roll consumed?
a. 124 units of utility
b. 45 units of utility
c. 11.25 units of utility
d. 8 units of utility
e. 37 units of utility

If Joan consumes 1 dinner roll, she has total
utility of 37; and if she consumes 4, she has total
utility of 45. What is the marginal utility of the
fourth dinner roll consumed?
d. 8 units of utility

UtilityUtility
-- Level of satisfaction a person
receives from the consumption of
a product.
MarginalMarginal UtilityUtility
-- Additional utility derived from
the consumption of one more unit
of a product.
DiminishingDiminishing MarginalMarginal
UtilityUtility
-- decline in the marginal utility
that person derives from
consuming each additional unit of
that product.
TotalTotal UtilityUtility - is the total benefit that a person
gets from the consumption.

Paradox of ValueParadox of Value
For centuries, philosophers have been puzzled
by the fact that water is vital for life but cheap
while diamonds are used only for decoration
yet are very expensive.

{{
These graphsThese graphs
have the answerhave the answer

"The word VALUE, it is to be observed, has two different meanings,
and sometimes expresses the utility of some particular object, and
sometimes the power of purchasing other goods which the
possession of that object conveys. The one may be called 'value in use
;' the other, 'value in exchange.' The things which have the greatest
value in use have frequently little or no value in exchange; and on the
contrary, those which have the greatest value in exchange have
frequently little or no value in use. Nothing is more useful than
water: but it will purchase scarce any thing; scarce any thing can be
had in exchange for it. A diamond, on the contrary, has scarce any
value in use; but a very great quantity of other goods may frequently
be had in exchange for it."

"The word VALUE, it is to be observed, has two different meanings,
and sometimes expresses the utility of some particular object, and
sometimes the power of purchasing other goods which the
possession of that object conveys. The one may be called 'value in use
;' the other, 'value in exchange.' The things which have the greatest
value in use have frequently little or no value in exchange; and on the
contrary, those which have the greatest value in exchange have
frequently little or no value in use. Nothing is more useful than
water: but it will purchase scarce any thing; scarce any thing can be
had in exchange for it. A diamond, on the contrary, has scarce any
value in use; but a very great quantity of other goods may frequently
be had in exchange for it."
So the translateSo the translate
in simplerin simpler
English…English…

"The word VALUE,, has two different meanings,
Value in Use – the utility of it
Value in Exchange – the purchasing power of other
goods
Sometimes these have almost no relationship with
each other.
Nothing is more useful than water: but it will buy
almost nothing.
A diamond, has almost no any value in use to most
people; but you can buy a lot of stuff with it.

You can solve this puzzle by distinguishing
between total utility and marginal utility.
The total utility of water is substantially
higher than its marginal utility and price
The total utility of diamonds is close to
their marginal utility and price

Evaluating the Market Equilibrium
Market EQ:
P = 30
Q = 15
Total surplus
= CS + PS
Is the market
EQ efficient?
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
S
D
CS
PS
D
S
Another wayAnother way
to thinkto think
about itabout it

0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
D
Water has veryWater has very
highhigh total utilitytotal utility butbut
lowlow marginal utilitymarginal utility
S
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
D
S
DiamondsDiamonds total utilitytotal utility
andand marginal utilitymarginal utility
are closer togetherare closer together
Marginal utilityMarginal utility determines the pricedetermines the price

You can solve this puzzle by distinguishing
between total utility and marginal utility.
Total utility -tells us about relative value
Marginal utility - tells us about relative price
When the high marginal utility of diamonds is
divided by the high price of a diamond,
the result is;
a number that equals the low marginal utility of
water divided by the low price of water.
The marginal utility per dollar spent is the
same for diamonds as for water.

Maximizing Total UtilityMaximizing Total Utility
Consumer (Consumer ( MUMU )Theory)Theory
- The goal of a consumer is to
allocate the available budget
in a way that maximizes
total utility.
The by choosing the point on
the budget line at which the
sum of the utilities obtained
from all goods is as large as
possible.

{{
Option two: drink many cases of soda

Eat
Each row ofEach row of
the tablethe table
shows ashows a
combinationcombination
of moviesof movies
and soda thatand soda that
uses all $40.uses all $40.
Total Budget is $40 dollars a
month on these two goods

Eat

Eat
WhatWhat
combinationscombinations
should beshould be
bought tobought to
maximizemaximize
utility?utility?

Eat
Sure, youSure, you
could add upcould add up
the totals,the totals,
but that isbut that is
difficult withdifficult with
lots of items.lots of items.
EconomistsEconomists
care aboutcare about
the margins!the margins!

utility-maximizing rule: :
1. Allocate the entire available budget.
2. Make the marginal utility per dollar
equal for all goods.

Utility-maximizing rule example: :
marginal utility of movies
= MUM
marginal utility of soda
= MUS
price of movies
= PM
price of soda
= PS
marginal utility per dollar from
seeing movies
= MUM/PM
marginal utility per dollar
from soda
= MUS/PS

Utility-maximizing rule example: :
Total utility is
maximized when:
MUM/PM = MUS/PS

Eat
Total utility
is
maximized
when:
MUM/PM
=
MUS/PS

-- Where is it not possible to switch
any expenditure and increase
total utility
Equimarginal PrincipleEquimarginal Principle
equation =equation =
==
MU
P
A
A
MU
P
B
B
MU
P
C
C
== …… ==
MU
P
N
N
MUMU = Marginal Utility= Marginal Utility
PP = Price= Price
AA,, BB,, CC,, NN = different products= different products
So the marginalSo the marginal
utility of eachutility of each
thing shouldthing should
equalequal

equation =equation = MU
P
A
A
The fun of this…The fun of this…

==
MU
P
A
A
MU
P
B
B
equals the fun ofequals the fun of
this…this…

==
MU
P
A
A
MU
P
B
B
MU
P
C
C
==
this…this…

==
MU
P
A
A
MU
P
B
B
MU
P
C
C
== …… ==
MU
P
N
N
this.this.

To summarize thus far:To summarize thus far:

-- Where is it not possible to switch
any expenditure and increase
total utility
Equimarginal PrincipleEquimarginal Principle
==
MU
P
A
A
MU
P
B
B
MU
P
C
C
== …… ==
MU
P
N
N
MUMU = Marginal Utility= Marginal Utility
PP = Price= Price
AA,, BB,, CC,, NN = different products= different products

- shows consumption bundles that
give the consumer the same level
of satisfaction.
Marginal Rate ofMarginal Rate of
SubstitutionSubstitution
- the rate at which a consumer
is willing to trade one good for
another.

- shows consumption bundles that
give the consumer the same level
of satisfaction.
4 qualities of the curve:
1.) Indifference curves are downward-sloping.
3.) Indifference curves cannot cross
2.) Higher indifference curves are preferred to
lower ones.
4.) Indifference curves are bowed inward

Quantity
of Soda
Quantity
of Movies
I1
One of Ian’s
indifference curves
B
A
A, B, and all other
bundles on I1 make
Ian equally happy
- he is indifferent
between them.
- doesn’t matter which
combine to buy, brings
same satifaction

Quantity
of Soda
Quantity
of Movies
I1
One of Ian’s
indifference curves
B
A
1.) Indifference curves
are downward-
sloping.
If the quantity of
soda is reduced,
the quantity of
movies must be
increased to keep
Ian equally happy.

Quantity
of Soda
Quantity
of Movies
One of Ian’s
indifference curves
2.) Higher indifference
curves are preferred
to lower ones.
I2
Ian prefers every
bundle on I2 (like C)
to every bundle on I1
(like A).
He prefers every
bundle on I1 (like A)
to every bundle on I0
(like D).
I1
I0
D
D
C
A
I0
I1
I2

Quantity
of Soda
Quantity
of Movies
One of Ian’s
indifference curves
cannot cross.
D
I1
B
C
I4
A
Suppose they did.
Ian should prefer
B to C, since B has
more of both goods.
Yet, Ian is indifferent
between B and C:
He likes C as much as A
(both are on I4).
He likes A as much as B
(both are on I1).

Quantity
of Soda
Quantity
of Movies
One of Ian’s
indifference curves
are bowed inward.
D
I1
1
1
6
2
A
B
Ian is willing to
give up more
movies for soda
if he has few
soda (A) than if
he has many (B).

another.
Can view this all alongCan view this all along
the slope of thethe slope of the
indifference curveindifference curve

Quantity
of Soda
Quantity
of Movies
One of Ian’s
indifference curves
D
I1
1
1
6
2
A
B
MRS = slope of
indifference curve
MRS =
MRS =
Ian’s MRS is the
amount of movies he
would substitute for
another soda.
MRS falls as you move
down along an
indifference curve.

another.
Two extreme examples:
- two goods with straight-line
indifference curves (constant MRS)
Perfect substitutes
((MRSMRS))
- two goods with
right-angle indifference curves
Perfect complements

One Extreme Case:One Extreme Case: Perfect SubstitutesPerfect Substitutes
Example: nickels & dimes
Consumer is always
willing to trade
two nickels
(5 cents) for one dime
(10 cents).

THE THEORY OF CONSUMER CHOICE
Another Extreme Case:Another Extreme Case: Perfect ComplementsPerfect Complements
Example: Left
shoes, right shoes
{7 left shoes, 5
right shoes}
is just as good as
{5 left shoes, 5
right shoes}

Less Extreme Cases:Less Extreme Cases:
Close SubstitutesClose Substitutes andand Close ComplementsClose Complements
Quantity
of Coke
Quantity
of Pepsi
Indifference
curves for close
substitutes are
not very bowed
Indifference
curves for close
substitutes are
not very bowed
Quantity
of hot dogs
Quantity
of hot
dog buns
Indifference
curves for
close
complements
are very
bowed
Indifference
curves for
close
complements
are very
bowed

Next is figuring out the budget line to
know exactly how much to buy

The EndThe End
Thank youThank you 

Utility theory and Indifference curves

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Utility theory and Indifference curves

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