Intermediate Microeconomics and Its Application

1. Walter Nicholson
1
Amherst College
Christopher Snyder
Dartmouth College
PowerPoint Slide Presentation | Philip Heap, James Madison University
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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.
CHAPTER
2
Ut2ility
and
Choice

3. Chapter Preview
Ch. 2 • 3
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• 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.
1. Preferences: what goods do you like
2. Constraints: how much money do you have, what are the
prices of the goods you buy
• Importance of Ceteris Paribus assumption.

4. • 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.
Ch. 2 • 4
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Utility

5. Three Assumptions About Preferences
Ch. 2 • 5
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• 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”.

6. Quantity of Y
per week
Ch. 2 • 6
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*
Quantity of X
per week
?
?
Y
X
*
Combinations of X and Y in the green area are
preferred to (X*, Y*)
(X*, Y*) is preferred to combinations of X an Y
in the red area.
What can you say about these points?
More is Better

7. Indifference Curves
Ch. 2 • 7
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• 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.

8. Hamburger
s
per week
Soft
drinks
per week
6
2 3 4 5
Ch. 2 • 8
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6
4
3
2
Indifference Curve
Let’s say you are indifferent between A, B, C
and D.
those points.
Draw a curve through
A Every point gives the sa
B
C
D U
1
me level of utility.

9. Hamburger
s
per week
6 A
B
C
D
U1
4
3
2
Indifference Curve
E
What can we say about combination E?
What about F?
F
Soft
drinks
per week
6
2 3 4 5
Ch. 2 • 9
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10. Hamburger
s
per week
6 A
B
C
D
U1
4
3
2
Soft
drinks
per week
2 3 4 5 6
Indifference Curve
E
F
Ch. 2 • 10
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Why does the indifference curve have a negative slope?
If you give up hamburgers, you need to get more
soft drinks to still get the same level of utility.

11. Indifference Curves and the Marginal
Rate of Substitution
Ch. 2 • 11
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• 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.

12. Hamburger
s
per week
6 A
B
C
D
U1
4
3
2
Soft
drinks
per week
2 3 4 5 6
Indifference Curves and the MRS
E
F
Ch. 2 • 12
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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.
From C to D: the person is willing to give up ½
burger to get 1 more soda.

13. Indifference Curves and the MRS
Ch. 2 • 13
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• 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.

14. Hamburger
s
per week
6
A
G
D
U1
4
2
Soft
drinks
per week
2 3 4 6
0
You would prefer 4 burgers and 4 sodas to
6 of one good and 2 of the other good.
Suppose we create a basket that is ½ of A and ½ of
B: point G.
Indifference Curves and the MRS
Ch. 2 • 14
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15. Hamburger
s
per week
Ch. 2 • 15
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Soft
drinks
per week
U3
U2
U1
An indifference curve map shows the utility a person gets from all
possible combinations of two goods.
As you move to the northwest, utility
increases: U3 > U2 > U1
Indifference Curve Maps

16. Four Particular Preferences
• A useless good.
– More of a useless good neither increases nor decreases utility.
Food per
week
Smoke grinders
per week U1
Ch. 2 • 16
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U2 U3
For a given amount of food,
additional grinders do not
increase utility.

17. Four Particular Preferences
Food per
week
U3
• 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
Ch. 2 • 17
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18. 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
U1 U2 U3 Gallons of Mobil
per week
Does it always have to be -1?
Ch. 2 • 18
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What if it was quarts of Exxon?

19. Four Particular Preferences
• Perfect Complements:
– Goods are perfect complements if they are consumed
together in fixed proportions.
Right shoes
U1
U2
U3
Left shoes
1
1
2
2
3
Ch. 2 • 19
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3
What if you had three feet: two left and
one right?

20. Utility Maximization
Ch. 2 • 20
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• 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?

21. Utility Maximization
Ch. 2 • 21
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• To maximize your utility two conditions must be met:
1. You spend all your income.
2. 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.

22. Utility Maximization Conditions
Ch. 2 • 22
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• 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.

23. Utility Maximization Conditions
Ch. 2 • 23
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• So when MRS > P /P you can increase your utility by buying less
S B
burgers and more soda.
• What if the MRS < P /P ?
S B
• Therefore, only when MRS = price ratio are you maximizing utility.

24. 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.
Quantity of Y
per week
Ch. 2 • 24
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Quantity of X
per week
Xma
x
Ymax
Ymax – spend all income on good Y
Xmax – spend all income on good X
Buy some mix of X and Y and spend all
income.
Points inside the budget constraint are
affordable, but you have money left over.

25. Budget Constraint Algebra
Ch. 2 • 25
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• Assume you have I dollars of income to spend on goods X and Y.
• P and P are the prices of goods X and Y.
x Y
• Since all income must be spent:
– Total amount spent on X and Y = Total Income
– Px X + Py Y = I

26. Budget Constraint Algebra
• Rewrite the last equation so that:
• If all income spent on Y, you buy I/P units.
Y
• If all income is spent on X, you buy I/P units.
X
X Y
• The slope of budget line (-P /P ) represents the opportunity cost
of X in terms of foregone Y.
Ch. 2 • 26
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27. Budget Constraint Algebra
Ch. 2 • 27
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B
• Suppose you have $100 to spend on burgers and soda: P = $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.

28. Utility Maximization: A Graphical View
• Given the budget constraint, we now want to add an indifference
curve.
Quantity of
burgers
per week
Quantity of sodas
per week
A
Ch. 2 • 28
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Are you maximizing utility at point A?
No. You are not spending all your income.

29. Utility Maximization: A Graphical View
Quantity of
burgers
per week
Quantity of sodas
per week
Are you maximizing utility at point B?
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
Ch. 2 • 29
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30. Utility Maximization: A Graphical View
Quantity of
burgers
per week
Quantity of sodas
per week
B
C
A
Ch. 2 • 30
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So at point C, you are maximizing utility
1.You are on the budget constraint: all income is
spent.
2.The indifference curve is tangent to the budget
constraint: MRS = price ratio.

31. Hamburgers
per week
Soft drinks
per week
Hungry Joe has a relatively strong preference for burgers
Thirsty Theresa has
a relatively strong
preference for soda.
Extra thirsty Ed is super
thirsty
Ch. 2 • 31
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UsingTheModel of Choice:Differences
in Preferences

32. Hamburgers
per week
Ch. 2 • 32
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Soft drinks
per week
UsingTheModel of Choice:Differences
in Preferences
What indicates each persons’ preference
for one good over the other?
The flatter (steeper) the indifference
curve the stronger the preference for
the good on the Y-axis (X-axis).

33. UsingTheModel of Choice:Different
Types of Goods
• A useless good.
Food per
week
Smoke grinders
per week U1
U2
The person buys only food and does
not buy the useless good
Ch. 2 • 33
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34. UsingTheModel 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
Ch. 2 • 34
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35. UsingTheModel of Choice:Different
Types of Goods
• Perfect Substitutes
Gallons of
Exxon per week
U1 U2 Gallons of Mobil
per week
The person buys only Exxon gas since it costs less
per gallon (steep budget constraint)
Ch. 2 • 35
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36. UsingTheModel of Choice:Different
Types of Goods
• Perfect Complements
Right shoes
Left shoes
1
2
1
2
The person buys shoes
U
2
U
1
only in pairs.
Ch. 2 • 36
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37. Numerical Example: Perfect Substitutes
Ch. 2 • 37
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• 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.

38. Numerical Example: Perfect Complements
Ch. 2 • 38
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• 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?

39. Numerical Example: Perfect Complements
Ch. 2 • 39
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• 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:
– Consumption ratio:
– Budget constraint:
U(M,C) = Min (2M,C)
C = 2M
10M + 2.50C = 30
– Plug C = 2M into the budget constraint:
– M = 2
– C = 4
10M + 5M = 30

40. Some Generalizations
Ch. 2 • 40
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• 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”.

41. Summary
Ch. 2 • 41
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• 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.

42. Summary
Ch. 2 • 42
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• 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.