Transcript 2 2015-2 Utility Makes Me Happy IC

Utility makes me happy…
Hedonism and the beginnings of
Demand Curves
Hedonism implies that more is
preferred to less of a “good” but there
is no “satiation” point so the pursuit is
un-ending.
Utility is Ordinal not Cardinal
• Economists used to think that utility was
scientifically measureable as a cardinal* unit of
satisfaction called a util.
• In the “Utopian” movement several attempts
were made to measure utils but all failed.
• With the marginal revolution the existence of a
fixed “bliss” point became less important and so
we now have settled on an ordinal** system of
measurement.
• *Cardinal means countable. i.e. 1..2..3
• **Ordinal means rankable i.e. first..second..third
Utility Maximization
• We assume that an economic agent always maximizes
utility in the current period.
• This means that utility will rise as a the agent acquires
more of a “good” but at some point that will diminish and
become flat and some have even argued that the “good”
may eventually become a “bad”. (Too much of a good
thing!!!)
• This is called the Law of Diminishing Marginal Utility.
• The utility is achieved by trading goods off against other
goods (represented by money) and as a result utility is
like a contour going up the side of a mountain.
Graphics of Utility Maximization
•
For A*B* we have utility U* For A’ B’ we have Utility U’ so U’ is preferred to
U*
Utility
All Other Goods
(B)
B’
U’
B*
U*
A*
A’
The Good Analyzed
(A)
Indifference Curves
https://upload.wikimedia.org/wikipedia/commons/6/6e/Indifference_curve_example.png
Utility Contours in 3 Dimensions
https://upload.wikimedia.org/wikipedia/commons/6/6e/Indifference_curve_example.png
Utility Contours for Two Goods
https://upload.wikimedia.org/wikipedia/commons/6/6e/Indifference_curve_example.png
Indifference Mapping
https://upload.wikimedia.org/wikipedia/commons/6/6e/Indifference_curve_example.png
Analytics of Utility Maximization
•
•
•
•
•
•
•
•
For U* we have a trade off of A*/B* and for U’ we have a trade off of A’/B’.
These are the prices of A in terms of B.
If A*/B*=A’/B’ then the utility curve is a straight line
If A*/B* < A’/B’ the utility curve is diminishing as we move along it.
If A*/B* > A’/B’ then utility is increasing as we move along it.
Because we observe that A*/B* < A’/B’ we support that utility delivers
decreasing marginal returns.
This means that when we let all other goods be represented as money and
we plot only two dimensions we have utility contours that are “concave with
respect to the origin” and that each contour is represents a level of utility
increasingly higher as we move away from the origin.
Moreover any point along that curve is “indifferent” to any other point such
that the agent is just as happy with a combination of A” B” as with A’B’ if they
are both on the same “indifference curve”.
But A^B^ is preferred to either A’B’ or A”B” if A^B^ is on a higher indifference
curve.
Indifference curves
•
A’B’ = A”B” because they are on indifference curve I but A^B^ is >A’B’ and A^B^>A”B”
because A^B^ is on indifference curve II
All Other Goods
(B)
B’
B^
B”
II
I
A’
A”
A^
The Good Analyzed
(A)
The Link to the Demand Curve
• As we change the price of one good in terms of another and use
money as the measure we can plot the quantity of the analyzed
good A versus its price.
• Note as the price of Good A increases we can get more of Good B
for each level of utility as a result the quantity of A falls as it’s price
increases. Thus the demand curve is downward sloping.
[If the demand curve were upward sloping it would imply that as the
price rises we would see greater quantity consumed and that would
perhaps work for a “snob” good.]
[Note also that we could consume more of A and B if income rose. If
income increases as we consume more that is called a ”normal”
good. If it falls as income increases we call it an “inferior” good,
We will deal only with “normal” goods.]
Maximizing Utility and Prices
https://upload.wikimedia.org/wikipedia/commons/6/6e/Indifference_curve_example.png
At the initial level of Utility more of Good
X (2.6) is purchased than of Good Y
(2.4 ) even though they have exactly the
same price. For the same level of Utility
if the consumer spent all of the money
on Good Y, 4.0 units could be
purchased. Similarly if the consumer
spent all of the money on Good X, 4.0
units could be purchased. Therefore the
prices must be the same.
If prices change then the consumer can
purchase more of Good X to make
themselves better off (have more utility)
and can now buy 3.6 units of Good X
even though they still only purchase 2.4
units of Good Y. This is a net benefit (1.0
units of Good X) arising from a price
change in an alternative good.
Perfect Substitutes
https://upload.wikimedia.org/wikipedia/commons/6/6e/Indifference_curve_example.png
Here Good X and Good Y are perfect substitutes for each other
because utility is the same regardless of the combinations that
are consumed event though the quantities are different as before.
Prices can still affect consumption as in the case when Good X
becomes cheaper and the consumer purchases 3.0 units of Good X
for a net benefit of. 5 units of Good X. Utility increases as a result an
consumer may eventually substitute out of Good Y entirely as the pric
falls. This is sometimes referred to as a leading benefit.
Perfect Complements
https://upload.wikimedia.org/wikipedia/commons/6/6e/Indifference_curve_example.png
Here one unit of Good Y requires one unit of Good X
in order to generate utility for the consumer.
Prices changes can still affect purchasing as when the
price of Good X falls. The initial bundle was 2.4 units of eac
but after the price change the consumer buys an additional
units. This does not raise utility , however, and this and is
Sometimes referred to as a deferred benefit if Good X can
stored for future consumption.
The Demand Curve
• This is a record of the quantity of a good demanded from the market
as the price changes. It is downward sloping and has several key
elements.
• There is reservation price at which a good is offered for sale for the
very first time.
• There is also a saturation quantity at which the market will not pay
anything at all for the good.
• The demand cure represents both the ability of consumers to
demand a product from the market and also the willingness (based
on preferences) to pay any price between the reservation price and
the saturation quantity.
• This is the total surplus that consumers dedicate to this market. It is
the implicit value based on how good A is valued in terms of all
other goods B. If such a trade off were not made there would be no
market at all for good A so the price of A is a “true” reflection of the
value of A within the economy when each individual preference
choice of each individual consumer is simply added up,
Demand Curve
Price of A
Reservation Price
Economic Surplus
Saturation Quantity
Quantity of A
Importance of Demand Curves
• Knowing the nature of the demand curve
allows consumers to budget, producers to
organize and also suppliers to participate
in the market.
• The Demand Curve is the target for
business to pursue.