Choice and Indifference
Marginal Utility vs. Price
  1. Rational behavior requires one to compare the anticipated utility of each expenditure with its cost. 
  2. To maximize utility, the consumer should choose that good which delivers the most marginal utility per dollar.
Utility Theory
  • Economists assume the higher the satisfaction a good or service provides, the more a consumer will pay.
  • Utility - The pleasure or satisfaction obtained from a good or service.
  • There is an important distinction between total utility and marginal utility:
    • Total Utility - The amount of satisfaction obtained from entire consumption of a product.
    • Marginal Utility – The change in total utility obtained by consuming one additional (marginal) unit of a good or service.
  •                            change in total utility
         marginal utility  =  -------------------------
                                 change in quantity

  • Law of Diminishing Marginal Utility – the marginal utility of a good declines as more of it is  consumed in a given time period.
    • The law of diminishing utility applies to short time periods
    • As long as marginal utility is positive, total utility must be increasing
Utility Maximization
  • Consumers choose the optimal consumption - the mix of consumer purchases that maximizes the utility attainable from available income.
  • Formula
                                     MUX     MUY
       Utility Maximizing Rule  ==>  ----- = -----
                                      PX      PY
  • If a person could get more utility per dollar by buying good X, then they should continue to buy good X until the ratios are equal.  Only then will utility be maximized.
Indifference Curves
  • indifference curves depict the alternative combinations of goods and services that yield equal satisfaction
  • an indifference map is the set of indifference curves that depicts all possible levels of utility attainable from various combinations of goods and services
Utility Maximization
  • we assume that all consumers strive to maximize their utility
  • higher indifference curves are more expensive thus we are faced with budget constraints 
  • the objective is to reach the highest indifference curve given our budget constraint  ==>  optimal consumption 
    • the indifference curve that is tangent to our budget constraint curve represents optimal consumption
  • the slope of the budget constraint curve represents the relative price for the 2 goods  (also known as the rate of market exchange)
  • the slope of the indifference curve is called the marginal rate of substitution
  • rate of market exchange = marginal rate of substation

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this page is maintained by Reed Fisher
last updated January 15, 2011