Microeconomics

Module 6: Utility
How Do Consumers Make Choices?

• How do you make the best choice in conditions of scarcity?

• In other words, how do you get the “biggest bang for your buck?”
• Consider questions like:
• Why do people purchase more of something when its price falls?
• Why do people buy more goods and services when their budget increases?
 Consumer Choice and Utility
Table 1. U.S. Consumption Choices in 2015

• Consumer choice: the combination of Average Household

$62,481
goods and services a consumer Income before Taxes
purchases Average Annual
$48.109
• Economists look at what consumers can Expenditures

afford with a budget constraint (or Food at home $3,264

budget line), and the total utility or Food away from home $2,505

satisfaction derived from those choices Housing $16,557

Apparel and services $1,700
Transportation $7,677
Healthcare $3,157
Entertainment $2,504
Education $1,074
Personal insurance and
$5,357
pensions
All else: alcohol, tobacco,
reading, personal care, cash $3,356
 Consumer Choice and the Budget Constraint
• Imagine that José likes to collect T-
shirts and watch movies
• the quantity of T-shirts is shown on the
horizontal axis
• the quantity of movies is on the vertical
axis
• The specific choices along the
budget constraint line show the
combinations of affordable T-shirts
and movies
Utility
Table 2. Total Utility
• Utility: the satisfaction or
Total Movies
happiness a person gets
T-Shirts
Utilit (Quantity
Total from consuming a good or
(Quantity)
y )
Utility service
• José obtains utility from
1 22 1 16 consuming T-shirts and
consuming movies
2 43 2 31 • The second column shows
3 63 3 45 the total utility, or total
amount of satisfaction
4 81 4 58

5 97 5 70

6 111 6 81

7 123 7 91

8 133 8 100
Total Utility

• This is a typical total utility curve showing

an increase in total utility as consumption
of a good increases, though at a
decreasing rate
• Total utility follows the expected pattern:
it increases as the number of movies that
José watches rises
• Calculate total utility by multiplying the
utility of each good by the number of
goods, then adding that together.
• Three T-shirts are worth 63 utils. Two movies
are worth 31 utils.
• Total utility of 94 (63 + 31).
Marginal Utility versus Total Utility
• A choice at the margin is a decision to do a little more or a little less of
something
• Marginal utility is based on the notion that individuals rarely face all-or-
nothing decisions
• The change in total utility from consuming one more or one less of an item
• The marginal utility of a third slice of pizza is the change in satisfaction one gets
when eating the third slice instead of stopping with two
• Marginal thinking: “How much better will I do on an exam if I study for
one more hour?”
Calculating Marginal Utility

• Marginal Utility is equal to the change in total utility divided by the

change in quantity
 Marginal Utility vs. Total Utility
• Marginal utility decreases as
consumption of a good increases
• This is an example of the law
of diminishing marginal utility,
which holds that the additional utility
decreases with each unit added
• Diminishing marginal utility is another
example of the more general law of
diminishing returns
 Rules for Maximizing Utility
• Consumer equilibrium: comparing
the trade-offs between one affordable
combination with all the other
affordable combinations
• that is, the combination of goods and
services that will maximize an
individual’s total utility
• José has income of $56. Movies cost
$7 and T-shirts cost $14. The points
on the budget constraint line show
the combinations of movies and T-
shirts that are affordable
Applying the Rule

• To maximize total utility, spend each dollar on the item which yields the
greatest marginal utility per dollar of expenditure
• José’s first purchase will be a movie. Why?
• José’s choices are to purchase either a T-shirt or a movie
• The first movie gives José more marginal utility per dollar than the first T-shirt, and
because the movie is within his budget, he will purchase a movie first
• José will continue to purchase the good which gives him the highest
marginal utility per dollar until he exhausts the budget
 Rules for Maximizing Utility cont.
Table 1. A Step-by-Step Approach to Maximizing Utility

Marginal Gain and Loss of

Try Which Has Total Utility Utility, Compared with Conclusion
Previous Choice
4 T-shirts and 0 81 from 4 T-shirts + 0
Choice 1: P – –
movies from 0 movies = 81
Loss of 18 from 1 less T-shirt,
3 T-shirts and 2 63 from 3 T-shirts + 31 but gain of 31 from 2 more
Choice 2: Q Q is preferred over P
movies from 0 movies = 94 movies, for a net utility gain
of 13
Loss of 20 from 1 less T-shirt,
2 T-shirts and 4 43 from 2 T-shirts + 58 but gain of 27 from two more
Choice 3: R R is preferred over Q
movies from 4 movies = 101 movies for a net utility gain of
7
Loss of 21 from 1 less T-shirt,
1 T-shirt and 6 22 from 1 T-shirt + 81 but gain of 23 from two more
Choice 4: S S is preferred over R
movies from 6 movies = 103 movies, for a net utility gain
of 2
Loss of 22 from 1 less T-shirt,
0 T-shirts and 8 0 from 0 T-shirts + 100 but gain of 19 from two more
Choice 5: T S is preferred over T
movies from 8 movies = 100 movies, for a net utility loss of
3
Decision Making by Comparing Marginal Utility
• How José could use the following thought process (if he thought in utils) to make
his decision regarding how many T-shirts and movies to purchase:
• Step 1: From Table 1, José can see that the marginal utility of the fourth T-shirt is
18. If José gives up the fourth T-shirt, then he loses 18 utils
• Step 2: Giving up the fourth T-shirt, however, frees up $14 (the price of a T-
shirt), allowing José to buy the first two movies (at $7 each)
• Step 3: José knows that the marginal utility of the first movie is 16 and the
marginal utility of the second movie is 15. Thus, if José moves from point P to
point Q, he gives up 18 utils (from the T-shirt), but gains 31 utils (from the
movies)
• Step 4: Gaining 31 utils and losing 18 utils is a net gain of 13. This is just
another way of saying that the total utility at Q (94 according to the last column
in Table 1) is 13 more than the total utility at P (81)
• Step 5: So, for José, it makes sense to give up the fourth T-shirt in order to buy
two movies
A Rule for Maximizing Utility
• This process of decision making described previously suggests a rule to
follow when maximizing utility
• Since the price of T-shirts is not the same as the price of movies, it’s not
enough to just compare the marginal utility of T-shirts with the marginal
utility of movies
• We need to control for the prices of each product
• We can do this by computing and comparing marginal utility per dollar of
expenditure for each product
• Marginal utility per dollar is the amount of additional utility José
receives given the price of the product
 Income Changes and Consumption Choices
• The graph shows Jazmin’s budget
constraint
• Concert tickets are $50 each and going to a
bed-and-breakfast is $200 per night
• Jazmin has $1,000 per year to spend
between these two choices:
• Jazmin could spend all of her budget on
concert tickets, in which case she could buy
$1000/$50 = 20 concert tickets
• She could spent all of her budget on nights
at a bed-and-breakfast, in which case she
could afford $1000/200 = 5 nights
 A Rise in Income
• What if Jazmin’s income rises to $2,000
per year?
• All choices on the upper left of the new
budget constraint that are to the left of the
vertical dashed line involve less of the good
on the horizontal axis but much more of the
good on the vertical axis
• All choices to the right of the vertical
dashed line and above the horizontal
dashed line have more consumption of both
goods
• All choices that are to the right of the
vertical dashed line but below the horizontal
dashed line involve less of the good on the
vertical axis but much more of the good on
the horizontal axis
How Changes in Income Affect Consumer Choices

• Goods and services are called normal goods if a rise in income leads to
a rise in the quantity consumed of that good and a fall in income leads to
a fall in quantity consumed
• Depending on Jazmin’s preferences, a rise in income could cause consumption of
one good to increase while consumption of the other good declines
• Goods where demand declines as income rises (or conversely, where the
demand rises as income falls) are called inferior goods.
• An inferior good occurs when people trim back on a good as income rises
How Price Changes Affect Consumer Choices

• Sergei chooses between purchasing

baseball bats and cameras
• What would happen if there is a A price
increase for baseball bats?
• It would have no effect on the ability to
purchase cameras, but it would reduce the
number of bats Sergei could afford to buy
• This causes the budget constraint to rotate
inward, as if on a hinge, from the vertical
axis
How a Change in Price Affects Consumption
Choices
• The substitution effect occurs when a price changes and consumers have an
incentive to consume less of the good with a relatively higher price and more of
the good with a relatively lower price
• The income effect is that a higher price means, in effect, the buying power of
income has been reduced (even though actual income has not changed), which
leads to buying less of the good (when the good is normal)
• Both effects can occur simultaneously
 The Foundations of the Demand Curve
• The points on the budget constraint
show the combinations of housing and
a composite good of everything else
that are affordable
• The consumer equilibrium occurs at
Point M
• An increase in the price of housing will
not change the quantity of “everything
else” that the consumer is able to buy
• If the consumer were to spend their
entire budget on “everything else,”
they could still afford the amount
shown by the vertical axis of the
budget constraint
The Foundations of Demand
Curve cont.
• The other three budget constraints
represent successively higher prices for
housing of P1, P2, and P3
• As the budget constraint rotates in, and in,
and in again, we label the utility-
maximizing choices M1, M2, and M3, and the
quantity demanded of housing falls from
Q0 to Q1 to Q2 to Q3
• As the price of housing rises, the budget
constraint rotates clockwise (inward), and
the quantity consumed of housing
falls, ceteris paribus (meaning, with all
other things being the same)
 Indifference Curves
• An indifference curve shows
all combinations of goods that provide
an equal level of utility or satisfaction
• Each indifference curve (Ul, Um, and Uh)
represents one level of utility
• The indifference curve Um has four
points labeled on it: A, B, C, and D
• Consider Lilly’s preferences for the
tradeoffs that she faces in her two main
relaxation activities: eating doughnuts
and reading paperback books
 The Shape of an Indifference Curve
• Since an indifference curve represents a set of choices that have the same level
of utility, Lilly must receive an equal amount of utility
• She would also receive the same utility from any of the unlabeled intermediate
points along this indifference curve
• Indifference curves have a roughly similar shape in two ways:
1. They are downward sloping from left to right
2. They are convex with respect to the origin. In other words, they are steeper on the left
and flatter on the right
• The downward slope of the indifference curve means that Lilly must trade off less
of one good to get more of the other, while holding utility constant
The Field of Indifference Curves

• Each indifference curve represents the choices that provide a single level
of utility
• Every level of utility will have its own indifference curve
• Lilly’s preferences will include an infinite number of indifference curves
lying nestled together on the diagram
• These arguments about the shapes of indifference curves and about
higher or lower levels of utility do not require any numerical estimates of
utility
The Individuality of Indifference Curves

• Each person determines his or her own preferences and utility

• While indifference curves have the same general shape—they slope
down, and the slope is steeper on the left and flatter on the right—the
specific shape of indifference curves can be different for every person
• People seek the highest level of utility, which means that they wish to be
on the highest possible indifference curve, but people are limited by their
budget constraints
Maximizing Utility at the Highest Indifference
Curve
• Say that books cost $6, doughnuts are 50
cents each, and that Lilly has $60 to spend
• The choice of F with five books and 100
doughnuts is highly desirable, since it is on
the highest indifference curve Uh
• However, it is not affordable given Lilly’s
budget constraint
• The choice of H with three books and 70
doughnuts on indifference curve Ul is a
wasteful choice
• Lilly will always prefer a choice on the
budget constraint itself
Behavioral Economics: An Alternative Viewpoint

• People sometimes make decisions that seem “irrational” and not in their
own best interest
• People’s decisions can seem inconsistent from one day to the next and
they even deliberately ignore ways to save money or time
• Behavioral economists argue that the traditional method, meaning that
people take all available information and make consistent and informed
decisions that are in their best interest omits something important:
people’s state of mind
• Behavioral economics seeks to enrich our understanding of decision-
making by integrating the insights of psychology into economics
Irrational Consumer Behavior
• Traditional economists also assume human beings have complete self control
• Some examples of irrational consumer behavior:
• Buying cigarettes by the pack instead of the carton, which will save money
• Purchase locks for their refrigerators
• Overpay on taxes to force the saving of money
• Another area that seems illogical is the idea of mental accounting, or putting
dollars in different mental categories where they take different values
• Economists typically consider dollars to be fungible, or having equal value
to the individual, regardless of the situation
Quick Review
• What is utility and its connection to consumer behavior?
• How do you calculate the total utility of a collection of goods and
services?
• What is the difference between total and marginal utility?
• Contrast and compute marginal utility and total utility
• Why does maximizing utility require that the last unit of each item
purchased must have the same marginal utility per dollar?
• How do you calculate the utility-maximizing choice?
• How do changes in income and price affect consumer choices?
• What is the difference between the the substitution effect and the income
effect?
• How are demand curves derived from consumer equilibrium?
More Quick Review

• What is the purpose, use, and shape of indifference curves?

• How does one indifference curve differ from another?
• How do you find the consumer equilibrium using indifference curves and a
budget constraint?
• What is behavior economics?
• What are some examples of irrational decision-making?