utility index

1. Microeconomics
Module 6: Utility

2. 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?

3. Consumer Choice and Utility
• Consumer choice: the combination of goods
and services a consumer purchases
• Economists look at what consumers can
afford with a budget constraint (or budget
line), and the total utility or satisfaction
derived from those choices
Table 1. U.S. Consumption Choices in 2015
Average Household Income
before Taxes
$62,481
Average Annual Expenditures $48.109
Food at home $3,264
Food away from home $2,505
Housing $16,557
Apparel and services $1,700
Transportation $7,677
Healthcare $3,157
Entertainment $2,504
Education $1,074
Personal insurance and pensions $5,357
All else: alcohol, tobacco,
reading, personal care, cash
contributions, miscellaneous
$3,356

4. 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

5. Utility
Table 2. Total Utility
T-Shirts
(Quantity)
Total
Utility
Movies
(Quantity)
Total
Utility
1 22 1 16
2 43 2 31
3 63 3 45
4 81 4 58
5 97 5 70
6 111 6 81
7 123 7 91
8 133 8 100
• Utility: the satisfaction or
happiness a person gets from
consuming a good or service
• José obtains utility from
consuming T-shirts and
consuming movies
• The second column shows
the total utility, or total amount
of satisfaction

6. 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).

7. 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?”

8. Calculating Marginal Utility
• Marginal Utility is equal to the change in total utility divided by the change in quantity

9. 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

10. 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

11. 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

12. Rules for Maximizing Utility cont.
Try Which Has Total Utility
Marginal Gain and Loss of Utility,
Compared with Previous Choice
Conclusion
Choice 1: P
4 T-shirts and 0
movies
81 from 4 T-shirts + 0
from 0 movies = 81
– –
Choice 2: Q
3 T-shirts and 2
movies
63 from 3 T-shirts + 31
from 0 movies = 94
Loss of 18 from 1 less T-shirt, but
gain of 31 from 2 more movies,
for a net utility gain of 13
Q is preferred over P
Choice 3: R
2 T-shirts and 4
movies
43 from 2 T-shirts + 58
from 4 movies = 101
Loss of 20 from 1 less T-shirt, but
gain of 27 from two more movies
for a net utility gain of 7
R is preferred over Q
Choice 4: S 1 T-shirt and 6 movies
22 from 1 T-shirt + 81
from 6 movies = 103
Loss of 21 from 1 less T-shirt, but
gain of 23 from two more movies,
for a net utility gain of 2
S is preferred over R
Choice 5: T
0 T-shirts and 8
movies
0 from 0 T-shirts + 100
from 8 movies = 100
Loss of 22 from 1 less T-shirt, but
gain of 19 from two more movies,
for a net utility loss of 3
S is preferred over T
Table 1. A Step-by-Step Approach to Maximizing Utility

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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)

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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?

30. 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?