Utility and Indifference

Curve
Eco 2541
Mr R Mudzanani
2021
 Utility and Choice
• Every day you must make many choices: when to wake up; what to eat;
how much time to spend working, studying, or relaxing; and whether to
buy something or save your money
• Economists investigate all these decisions because they all affect the way
any economy operates.
• The economic theory of choice begins by describing people’s
preferences. This amounts to a complete cataloging of how a person
feels about all the things he or she might do.
• But people are not free to do anything they want— they are constrained
by time, income, and many other factors in the choices open to them.
• Our model of choice must therefore describe how these constraints
affect the ways in which individuals actually are able to make choices
based on their preferences.
Utility
• Def:The pleasure or satisfaction that people get from their economic
activity.
• We use the simple case of a single consumer who receives utility from
just two commodities.
• We will eventually analyze how that person chooses to allocate
income between these two goods.
• Theory of choice The interaction of preferences and constraints that
causes people to make the choices they do.
• Ceteris paribus assumption In economic analysis, holding all other
factors constant so that only the factor being studied is allowed to
change.
 Utility from Consuming Two Goods
• We assume that the person receives utility from these goods and that we can
show this utility in functional notation by
Utility U=(X, Y; other things )
• This notation indicates that the utility an individual receives from consuming X
and Y over some period of time depends on the quantities of X and Y
consumed and on ‘‘other things.’’
• ’These other things might include easily quantifiable items such as the
amounts of other kinds of goods consumed, the number of hours worked, or
the amount of time spent sleeping
• If one of the other things should change , the utility from some particular
amounts of X and Y might be very different than it was before.
• To avoid all the effects of other things we rewrite the equation as follows:
• Utility = U(X,Y)
• All economic analyses impose some form of this ceteris paribus assumption
so that the relationship between a selected few variables can be studied.

Measuring Utility
• It seems that there is no general way to compare the utility that a particular
choice provides to one person to the utility that it provides to someone else.
• Today, economists have largely abandoned the search for a common utility
scale and have instead come to focus on explaining actual observed behavior
using simple models that do not require them to measure utility.
ASSUMPTIONS ABOUT
PREFERENCES
• In order to provide a foundation for our study of utility, we
need to make three assumptions about behavior that seem
quite reasonable.
• These are intended to provide a simple framework for what
we mean when we say people make choices in a rational and
consistent way
Completeness
• Def:The assumption that an individual is able to state which
of any two options is preferred

• When faced with two options, A or B, it seems reasonable

that a person can say whether he or she prefers A to B, or B
to A, or finds them equally attractive.
• In other words, we assume that people are not paralyzed by
indecision—that they can actually state what they prefer
 Transitivity
• Def; The property that if A is preferred to B, and B is preferred to C, then A
must be preferred to C.
• In addition to assuming that people can state their preferences clearly and
completely, we also might expect these preferences to exhibit some sort of
internal consistency.
• That is, we would not expect a person to say contradictory things about what
he or she likes.
• This presumption can be formalized by the assumption that preferences are
transitive. If a person states, ‘‘I prefer A to B’’ and ‘‘I prefer B to C,’’ we would
expect that he or she would also say, ‘‘I prefer A to C.’’A person who instead
stated the contrary (‘‘I prefer C to A’’) would appear to be hopelessly
confused
 More Is Better: Defining an
Economic ‘‘Good’’
• A third assumption we make about preferences is that a person prefers more
of a good to less.
• All points in the darkly shaded area are preferred to the amounts of
X* of good X and Y* of good Y.
• Movement from point X*, Y* to any point in the shaded area is an
unambiguous improvement, since in this area this person gets more
of one good without taking less of another.
• This idea leads us to define an ‘‘economic good’’ as an item that
yields positive benefits to people.
• That is, more of a good is, by definition, better.
• Combinations of goods in the lightly shaded area are definitely
inferior to X*, Y* since they offer less of both goods.
• These three assumptions about preferences are about enough to justify our use
of the simple utility function that we introduced earlier. That is, if people obey
these assumptions, they will make choices in a way consistent with using such a
function
 Indifference Curves
• Def:A curve that shows all the combinations of goods or services that
provide the same level of utility.
• To study voluntary trades, we use the concept of an indifference curve.
• Such a curve shows all those combinations of two goods that provide the
same utility to an individual; that is, a person is indifferent about which
particular combination of goods on the curve he or she actually has.
• The curve U1 shows the combinations of hamburgers and soft drinks that
provide the same level of utility to an individual.
• The slope of the curve shows the trades an individual will freely make.
• For example , in moving from point A to point B , the individual will give up two
hamburgers to get one additional soft drink.
• In other words , the marginal rate of substitution is approximately 2 in this
range.
• Points below U1 (such as F) provide less utility than points on U1. Points above
U1 (such as E) provide more utility than U1.
• For example , the curve shows that he or she would be just as happy with six
hamburgers and two soft drinks per week (point A) as with four hamburgers
and three soft drinks (point B) or with three hamburgers and four soft
drinks(point C).
• The points on U1 all provide the same level of utility ; therefore , he or she
does not have any reason for preferring any point on U1 to any other point.
• Points to the north east of U1 promise a higher level of
satisfaction and are preferred to points on U1.
• Point E (five soft drinks and four hamburgers ) is preferred
to point C because it provides more of both goods.
• Our definition of economic goods assures that combination
E is preferred to combination C.
• Similarly, the assumption of transitivity assures that
combination E is also preferred to combinations A, B, and D
and to all other combinations on U1.
 Indifference Curves and the Marginal Rate of
Substitution

• Def:The rate at which an individual is willing to reduce consumption of one

good when he or she gets one more unit of another good. The negative of the
slope of an indifference curve.
• What happens when a person moves from point A (six hamburgers and two
soft drinks) to point B (four hamburgers and three soft drinks)?
• This person remains equally well-off because the two commodity bundles lie
on the same indifference curve.
• This person will voluntarily give up two of the hamburgers that were being
consumed at point A in exchange for one additional soft drink.
• The slope of the curve U1 between A and B is
therefore approximately -2/1=-2.
• That is, Y (hamburgers) declines two units in response
to a one-unit increase in X (soft drinks).
• We call the absolute value of this slope the marginal
rate of substitution (MRS).
• Hence , we would say that the MRS (of soft drinks for
hamburgers) between points A and B is 2.
 Diminishing Marginal Rate of Substitution
• The MRS varies along the curve U1. For points like A , this person has quite a few
hamburgers and is relatively willing to trade them away for soft drinks.
• On the other hand, for combinations such as those represented by point D, this
person has a lot of soft drinks and is reluctant to give up any more hamburgers to
get more soft drinks.
• The increasing reluctance to trade away hamburgers reflects the notion that the
consumption of anyone good (here , soft drinks) can be pushed too far.
• This characteristic can be seen by considering the trades that take place in moving
from point A to B, from point B to C, and from point C to D.
• In the first trade, two hamburgers are given up to get one more soft drink—the
MRS is 2 (as we have already shown).
• The second trade involves giving up one hamburger to get one additional soft drink.
In this trade , the MRS has declined to 1,reflecting an increased reluctance to give
up hamburgers to get more soft drinks.
• Finally , for the third trade , from point C to D , this person
is willing to give up a hamburger only if two soft drinks are
received in return.
• In this final trade, the MRS is ½ (the individual is willing to
give up one-half of a hamburger to get one more soft
drink),which is a further decline from the MRS of the
previous trades.
• Hence , the MRS steadily declines as soft drinks (shown on
the X-axis) increase.
 INDIFFERENCE CURVE MAPS
• Def:A contour map that shows the utility an individual obtains from all
possible consumption options.
• The positive quadrant is full of indifference curves , each of
which reflects a different level of utility.
• Three such curves are illustrated on previous slide.
• Combinations of goods on U3 are preferred to those on U2,
which in turn are preferred to those on U1.
• This is simply a reflection of the assumption that more of a good
is preferred to less , as may be seen by comparing points C, G,
and H.
• All we can say is that utility increases as this person moves to
higher indifference curves.
• That is , he or she would prefer to be on a higher curve rather
than on a lower one.
Self study
• ILLUSTRATING PARTICULAR PREFERENCES Page 64-67.
• A Useless Good.
• An Economic Bad.
• Perfect Substitutes.
• Perfect Complements.
UTILITY MAXIMIZATION: AN
INITIAL SURVEY
• Economists assume that when a person is faced with a choice from
among a number of possible options, he or she will choose the one
that yields the highest utility— utility maximization.
• As Adam Smith remarked more than two centuries ago, ‘‘We are not
ready to suspect any person of being defective in selfishness.’’
• In other words, economists assume that people know their own
minds and make choices consistent with their preferences.
• This section surveys in general terms how such choices are made.
 Choices Are Constrained
• The most important feature of the utility maximization problem is that
people are constrained in what they can buy by the size of their incomes.
• Of those combinations of goods that a person can afford, he or she will
choose the one that is most preferred.
• This most preferred bundle of goods may not provide complete bliss; it may
even leave this person in misery.
• It will, however, reflect the best (utility maximizing) use of limited income.
• All other combinations of goods that can be bought with that limited income
would leave him or her even worse off.
• It is the limitation of income that makes the consumer’s choice an economic
problem of allocating a scarce resource (the limited income) among
alternative end uses.
 The Budget Constraint
• Def:The limit that income places on the combinations of goods that an
individual can buy.
• Those combinations of X and Y that the individual can afford are shown in the
shaded triangle.
• If , as we usually assume , the individual prefers more than less of every good , the
outer boundary of this triangle is the relevant constraint where all of the available
funds are spent on either X or Y.
• The slope of this straight boundary is given by -Px/Py.
• Figure shows the combinations of two goods (which we will call simply X and Y)
that a person with a fixed amount of money to spend can afford.
• If all available income is spent on goodX , the number of units that can be
purchased is recorded as Xmax in the figure.
• If all available income is spent on Y , Ymax is the amount that can be bought. The
line joining Xmax to Ymax represents the various mixed bundles of goods X and Y
that can be purchased using all the available funds.
• Combinations of goods in the shaded area below the budget line are also
affordable, but these leave some portion of funds unspent, so these points will not
be chosen
• The downward slope of the budget line shows that any person can afford to
buy more X only if Y purchases are cut back.
• The precise slope of this relationship depends on the prices of the two goods.
• If Y is expensive and X is cheap , the line will be relatively flat because
choosing to consume one less Y will permit the purchasing of many units of X
(an individual who decides not to purchase a new designer suit can instead
choose to purchase many pairs of socks).
• Alternately, if Y is relatively cheap per unit and X is expensive, the budget line
will be steep.
• Reducing Y consumption does not permit very much more of good X to be
bought.
• All of these relationships can be made more precise by using a bit of algebra.
Budget-Constraint Algebra
• Suppose that a person has I dollars to spend on either good X or good Y.
• Suppose also that Px represents the price of good X and Py the price of
good Y.
• The total amount spent on X is given by the price of X times the amount
purchased (Px . X). Similarly, (Py . Y)represents total pending on good Y.
Because the available income must be spent on either X or Y, we have
Amount spent on X + Amount spent on Y =I
or Px.X+Py.Y=I
To study the features of this constraint , we can solve this equation for Y
so that the budget line has the standard form for a linear equation Y=
a+bX
This equation gives Y= -(Px/Py)X+I/Py
• First, notice that the Y-intercept of the budget constraint is given by I/PY. This
shows that if X=0, the maximum amount of Y that can be bought is
determined by the income this person has and by the price of Y.
• For example , if I=$100,and each unit of Y costs $5,the maximum amount that
can be bought is 20 (=I/PY =$100/$5).
• Now consider the slope of the budget contraint , which is -Px/Py.
• This slope shows the opportunity cost (in terms of good Y) of buying one
more unit of good X.
• The slope is negative because this opportunity cost is negative—because this
person’s choices are constrained by his or her available budget, buying more
X means that less Y can be bought.
• The precise value of this opportunity cost depends on the prices of the
goods. If Px= $4 and Py =$1, the slope of the budget constraint is -4
(=-Px/Py=-$4/$1) —every additional unit of X bought requires that Y
purchases be reduced by 4 units.
Numerical example
• Suppose that a person has $30 to spend on hamburgers(X) and soft drinks (Y) and
suppose also that Px=$3, Py =$1.50. This person’s budget constraint would then be
Px.X+Py.Y =I
3X+1.5Y=30

Solve this equation for Y

Notice that this equation again shows that this person can buy 20 soft drinks with his
or her $30 income because each drink costs $1.50.
The equation also shows that the opportunity cost of buying one more hamburger is
two soft drinks.
 Utility Maximization
• A person can afford all bundles of X and Y that satisfy his or her budget
constraint.
• From among these, he or she will choose the one that offers the greatest
utility.
• The budget constraint can be used together with the individual’s indifference
curve map to show this utility maximization process
• Point C represents the highest utility that can be reached by this individual,
given the budget constraint.
• The combination X*, Y* is therefore the rational way for this person to use
the available purchasing power.
• Only for this combination of goods will two conditions hold: All available
funds will be spent, and the individual’s psychic rate of trade-off (marginal
rate of substitution)will be equal to the rate at which the goods can be
traded in the market (Px/Py). Therefore Px/Py= MRS
• This person would be irrational to choose a point such as A ; he or she can
get to a higher utility level (that is, higher than U1) just by spending some of
the unspent portion of his or her income
Self Reading
• Using the Model of choice
• Numerical examples