ECON 251 Module 6: Utility and Consumer Choice

Utility

the happiness/usefulness/enjoyment a consumer gets from consumption (U)

Axioms of preference

assume preferences are complete, ordered, and transitive

Preferences

} means preferred, { means not preferred, ~ means indifferent

Diminishing marginal utility

goes down with each additional good consumed

Marginal utility does not equal marginal benefit

marginal utility is measured in utils, marginal benefit is measured in dollars

How can we make this model more realistic?

add a second good, preferences need to stay rational and reflect preferences for two goods

Goal of utility curve

maximizing your utility subject to a budget constraint

Cobb-Douglas function

U(x,y)= (x^a)(y^b); a+b=1

Utility maximization rule for n>1 goods

choose the bundle of goods where all income is spent and the marginal utility per dollar is equal across all goods; MU(x)/Px = MU(y)/Py = […] = MU(z)/Pz

Marginal rate of substitution

slope of utility curve

MRS(x,y) = -MU(x)/MU(y)

If income increases

budget constraint shifts out

Change in price of one good

budget constraint shifts in

Properties of rational utility curves

convex (u-shaped), reflects DMU for each good, higher value represents a higher level of utility

Perfect complements utility curve

perfect complements create a L-shaped curve

Perfect substitutes utility curve

perfect substitutes create a linear utility curve

Slope of budget constraint

-Px/Py

Slope of utility curve

MRS = -MU(x)/MU(y)

Substitution effect

slide toward the relatively cheaper good to a new point on the SAME utility curve

Income effect

jump to a new budget constraint and a new utility curve

Total effect

income effect + substitution effect