ECN 203 - Chapter 2:

Individual Choice

 Purpose: Develop a model to describe how individuals make choices….allocate scarce resources.

 Start with a simple model, then allow for more complex decisions.

 Assumption that always holds: Individuals are rational -- always make the best choice.

Key Concepts of the Model

 Total Utility (TU) – an individual’s total satisfaction/ happiness

- Utils: measure of utility.

 Marginal Utility (MU) – a change in TU resulting from a change in the quantity (Q)…… Formula: MU = ΔTU/ΔQ.

 Diminishing MU – an assumption that MU diminishes with additional units consumed.

Ex.1: Decision with One Option (No Scarcity)

 Following table shows the total utility Jack derives from each slice of pizza he eats.

 Determine Jack’s marginal utility for each slice of pizza. Fill in MU column.

 If pizza is free, when should Jack stop eating pizza?

Decision Rule with One Option (No Scarcity)

 Jack should consume pizza up to the point where his TU is maximized (no utility left to gain from the
additional unit).

 Decision rule: MU=0 (making a decision at the margin).

 Referred to as satiation or bliss point.

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Ex. 2: Decision With N Options (No Scarcity)

Following graphs represent the MU for each hour spent doing two activities:

- Which activity is initially more satisfying?

- Which activity is more sustainable overtime?

- How should you allocate your time if your time is not scarce?

Ex. 2: Decision With N Options (N=2)

MU of Activity 1 MU of Activity 2
90
81
80 70 80
65 64 62
59
55
60 50 60 50
43

40 40 30
25
15
20 20
0
0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Figure 2A and 2B

(Hours on Horizontal Axes; MU on Vertical Axes)

Decision Rule with N Choices (No Scarcity)

 If time is not scarce, consume until fully satiated from each choice:

MU1/hr=0 & MU2/hr=0 & MU3/hr=0 &...& MUn/hr=0

 If consuming a good, $ replaces hr: MU1/$=0 & MU2/$=0 &...& MUn/$=0

Decision rule:

MU1.= MU2=MU3=………=MUn=0. (Note: Can drop unit of resource)

Ex. 2: Decision With N Options and Scarcity

 Must find optimal allocation -- allocation of scarce resources that maximizes one’s total utility.

 Back to Ex. 2: Suppose you have only 10 hours to spend between both activities. Find the optimal
allocation of your 10 hours.

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Decision Rule with N Choices and Scarcity

 Equal Marginal Principle – the best allocation is always found where the marginal utilities are equal
across options.

 Decision Rule:

MU1/unit = MU2/unit =…...= MUn/unit = X.

Note: X>0 implies scarcity; may drop X and unit.

Adding Production into Decision Model

 How should we use our productive resources (such as labor)?

 Point of production: We produce to consume and consume to maximize utility. Thus, we produce to
maximize our utility.

 Must decide optimal allocation of our productive resources.

Ex. 3: Calculating Value of the Marginal Product

Max goes fishing every weekend.

 Table A: Marginal product for each of his labor hours spent fishing

 Table B: Max’s marginal utility derived from each fish he consumes

 Table C: Fill in Max's value of the marginal product (V) for each hour spent fishing.
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Decision Rule: Production of One Good

 In ex. 3, there is only one good (fish) to produce. Assuming Max does not face scarcity, his only
decision is when to stop fishing.

 Decision Rule: V=0

Produce until the value for an additional unit of a productive resource equals zero

Ex. 4: Decision to Produce N Options

On camping trips, Jane does the following daily tasks: fishes, chops firewood, gathers berries, and
pumps water. If Jill is not constrained by time, then:

VFish= VBerries= Vfirewood=Vcooks=0.

Use the information in the table on next slide to find her bliss point.

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Decision Rule with Production (No Scarcity)

 If Jill does not face scarcity, then she needs to decide when to stop producing.

 Jill will stop at the point where there is no additional utility to be gained.

 Decision Rule:

V1= V2= V3=…………..= Vn=0.

Ex. 4: Produce N Options and Scarcity

Back to Ex. 4:

• Is it reasonable to believe Jill can reach her satiation point each day?

• If Jill is constrained by 13 hours of daylight, how will she allocate her time?

• What if Jill has 14 hours of daylight?

Several Options, Production, and Scarcity

 The optimal allocation is reached when there is no other opportunity that offers higher utility.

 Decision rule:

V1= V2= V3=………..= Vn=X (X>0).

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  If constraints change, must find a new allocation.

Decisions with Future Consequences

 Our important decisions in life tend to be intertemporal -- have consequences across time, such as
the decision to go college.

 Two concepts aid in decisions that affect our future: Present Value and Discount rate.

Decisions with Future Consequences

 Present Value (PV) -- value of future utility put into today’s value -- allows comparisons across time.

 Discount rate (DR)– measures one’s willingness to wait for future utility.

-- Low DR - more willing to wait.

-- High DR - less willing to wait.

 Discount rate can change overtime.

Decision Rule For Intertemporal Choices

Decision rule:

PV1 = PV2 = PV3 =……….= PVn.

 V: value of marginal product – utility derived from each unit of a productive resource

 P: present value – today’s value of future utility

Adding Risk to the Decision Rule

 Risks (E) -- events that may affect one’s decision; given the individual’s perceived probability

 Decision rule:

EPV1 = EPV2 = EPV3 =……= EPVn.

“Expected Present Value”

V: value of MP – utility derived from resources

P: present value – value of future utility

E: expected – adjustment for perceived risk