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 Utility from Consuming Two
Goods
ë Assume that person receives utility from
consumption of two goods ³X´ and ³Y,´
which we show in functional notation by

 ^
  ï    

ë Other factors that appear after semicolon
assumed to be held constant.

3
 easuring Utility
ë Two problems affect ability to to measure utility
directly:

ë Because real-world constantly in flux, u


  assumption difficult to impose

ë uo units to measure utility directly

ë However, possible to study choices fairly

completely without direct utility measurement
O
 Assumptions about Utility
ë Basic Properties of Utility Preferences

ë Preferences 

 : assume that
individual can state which of any two options
is preferable.

ë Preferences 
: if A is preferred to B,

and B is preferred to C, then A must be
preferred to C.

º
 ore Is Better: Defining an
Economic ³Good´
ë Economic good: yields positive benefits to
consumer. Thus, more quantity of a good
is always better than less.
ë Figure 2-1: shows all points in the darkly
shaded area preferable to amount X* of good
X and Y* of good Y.
ë ovement into shaded area unambiguously
better since person gets more of one good
without losing any of the other.


 FIGURE 2-1: ore Preferred to Less

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 oluntary Trades, Indifference Curves

ë Fig. 2.1: areas marked with question

marks difficult to compare to X*, Y* since
they involve more of one good but less of
the other.

ë Ê
 one good (such as money) for
another good (such as a candy bar):
essence of demand.

·
 Indifference Curves
ë Curve that shows all combinations of
goods or services that provide same level
of utility.

ë Figure 2-2: horizontal axis measures

quantity of soft drinks consumed by
individual per week; vertical axis
measures the quantity of hamburgers
consumed per week.


 Indifference Curves
ë Curve U1 in Figure 2-2 includes all
hamburgers/soft drink combinations that
yield same utility level.
ë Point A-- hamburgers and 2 soft drinks--
produces same utility as point B--O burgers
and 3 drinks.
ë Since all points on the curve yield same
utility, consumer has no reason to prefer
one point over another.

10
 FIGURE 2-2: Indifference Curve
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Points Above Indifference Curve

ë Figure 2-2, points such as E are above (to

northeast) of U1.
ë Since E has more of both goods than point C,
E is preferred to C (more is better).
ë Because of transitivity, E is preferred to any
point on U1.
ë Points above indifference curve preferred to
points on curve.

12
 FIGURE 2-2: Indifference Curve
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Points Below Indifference Curve

ë Figure 2-2: points such as F are below (to

the southeast) of given indifference curve.
ë Point C is preferred to point F since C
provides more of both goods.
ë Because of transitivity, all points on U1
preferred to point F.
ë Points on indifference curve are preferred to
points below it.
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 FIGURE 2-2: Indifference Curve
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 Slope of Indifference Curve
ë Figure 2-2: from point A to point B, person
willingly gives up two hamburgers to gain
one soft drink, since consumer is equally
happy at either point.

ë Slope of U1: approximately -2 between

points A and B: hamburgers decline by
two units to gain one unit of soft drinks.

1
 Indifference Curves:
arginal Rate of Substitution
ë 2
 # 
!  
 ( RS):
Rate at which individual will reduce
consumption of one good to get one more
unit of other good.
ë easured as negative of indifference curve
slope
ë Figure 2-2: RS between points A and B on U1
(approximately)-2.

1—
 Diminishing arginal Rate of Substitution

ë Fig. 2.3: On indifference curve U1 ,

consumer will only give up one hamburger
to gain one more soft drink between points
B and C.

ë Between points C and D, consumer will

give up only ½ hamburger to gain one
more soft drink.

1·
 FIGURE 2-3:
Consumer Prefers Balanced Consumption
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 Diminishing arginal Rate of Substitution

ë RS diminishes along indifference curve

moving from left to right.
ë Reflects idea that consumers prefer
balanced consumption
ë Figure 2.3: Point G reflects bundle that is
³between´ points A and D.
ë Since it is above U1,point G preferable to any
bundle on indifference curve.

20
 Indifference Curve aps
ë Since every hamburger/ soft drink
combination must yield some level of
utility, every point must have one (and only
one) indifference curve passing through it.
ë è 


shows utility an
individual obtains from all possible
consumption options.
ë Figure 2-O shows three of infinite number of
indifference curves in map.
21
 Labeling Indifference Curves
ë Since utility can not be measured, labeling
indifference curves has no meaning
except to indicate that utility increases
from U1 to U2 and then to U3 in Figure 2-O.

ë In any indifference curve map, all we can

assume is that utility increases as we
move to higher indifference curves.

22
 FIGURE 2-O: Indifference Curve ap
for Hamburgers and Soft Drinks
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 Illustrating Particular Preferences
ë Figure 2-º(a): good on vertical axis
(smoke grinders) is useless, so consumer
only gains utility from more of good on
horizontal axis (food).
ë Figure 2-º(b); good on vertical axis is
economic ³bad´ (houseflies); consumer
only gains utility from consuming less of
bad.
2O
FIGURE 2-º: Illustrations of Specific
Preferences
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 Particular Preferences
ë Figure 2-º(c): two goods are perfect
substitutes--consumer views them as
essentially the same; RS = 1

ë Figure 2-º(d): two goods are perfect

complements--they must be used together
(like left and right shoes) to gain utility.

2
 Income and Utility: A Simple Case
ë When choosing to allocate income
between two goods (e.g., hamburgers and
soft drinks) consumer will:

ë Spend entire income on two goods, and

ë Choose combination of goods for which the

RS (marginal rate of substitution) between
the two goods equals the ratio of their prices.
2—
 Income and Utility: A Simple Case

ë Since both goods (and only these goods)

provide more utility with additional
consumption, consumer will spend entire
income on these goods.

ë Only other alternative: throw income

away--does not increase utility.

2·
 Equality of RS with the Ratio or Prices

ë Suppose individual currently

consumes where RS = 1.
ë Assume price of hamburgers is $1 and
price of soft drinks is $.º0.
ë Yields a price ratio (PH/PS) of
($.º0/$1) = ½.

2
 Equality of RS with Price Ratios

ë Person could give up one hamburger

(freeing $1) and purchase one soft drink
using $.º0.
ë Since RS =1, person would be just as
happy as before giving up burger, but
would now have additional $.º0 to spend±
could thus increase utility.
ë Only way utility cannot be increased
further: when RS = price ratio.
30
 Showing Utility aximization Graphically

ë Individual¶s  

 is limit that

person¶s income places on combinations
of goods and services consumer can buy.

ë Figure 2-: individual has a fixed amount

of income to spend on two goods, X and
Y.

31
 Budget Constraint from Figure 2-
ë If all income is spent on X, Xmax can be
purchased.

ë If all income is spent on Y, Ymax can be

purchased.

ë The line joining Xmax and Ymax represents

various mixed bundles of goods X and Y that
consumer can purchase using all income.

32
 FIGURE 2-: Individual¶s Budget
Constraint for Two Goods
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 FIGURE 2-: Individual¶s Budget
Constraint for Two Goods
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 Budget Constraint
ë Budget line¶s downward slope reflects fact
that more X can be purchased only if less
Y is purchased.

ë If Y is expensive relative to X, budget line

will be relatively flat (Y on vertical axis).

ë If Y is relatively inexpensive compared to

X, budget line will be relatively steep.
3º
 Budget Constraint Algebra
ë Assume individual has I dollars of income
to spend on goods X and Y.

ë Suppose price of X is Px and price of Y is

PY.

ë Total amount spent on X and Y are Px·X

and PY·Y ,respectively.

3
 Budget Constraint Algebra
ë Since all income must be spent on either
X or Y, we have
ë Amount spent on X + Amount spent on Y = I
ë or


ï ï ^ è â


3—
 Budget Constraint Algebra
ë Solving equation 2.3 for Y, to express it in
the standard form for linear equation, we
have

  
ï ^  ë â

 ï
ï

3·
 Budget Constraint Algebra
ë Equation 2.O shows that if all income
spent on Y, I/PY will be purchased, and if
all income is spent on X, I/PX will be
purchased.

ë The slope of budget line (-PX/PY)

represents ||

u|
of X in terms
of foregone Y.

3
 Utility aximization
ë Individual can afford all bundles of X and Y
that fall within budget constraint represented
by shaded area in Figure 2-.

ë Point A is affordable, but not all of the

consumer¶s income would be spent.

ë Point B is affordable, but is not on the highest

indifference curve that the consumer can
reach, so some utility is ³wasted´.

O0
 FIGURE 2-—: Graphic Demonstration
of Utility aximization
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 FIGURE 2-—: Graphic Demonstration
of Utility aximization
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 Utility aximization
ë Fig. 2.—: Point D is on higher indifference
curve than C, but is not affordable given
the budget constraint.

ë Point C, where the consumer chooses X*,

Y* is the affordable point that lies on
(tangent to) highest indifference curve, so
represents utility maximization.

O3
 FIGURE 2-—: Graphic Demonstration
of Utility aximization
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 Utility aximization
ë At point C, all income is spent.
ë At point C, indifference curve U2 lies
tangent to budget line, so
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ë or

^ 2

ï

Oº
 Using The odel of Choice
ë Utility maximization model explains
number of common observations.

ë Figure 2-· provides illustration of why

people with same income choose to spend
in different ways.

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 è#)': Differences in Preferences
Result in Differing Choices

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 Using the odel of Choice
ë Figure 2- shows four indifference curve
maps with budget constraint and utility-
maximizing choice labeled E.
ë Panel (a) shows that people will not buy
useless goods; (b) shows they will not buy
bads.
ë Panel (c) shows that people will buy least
expensive of two perfect substitutes; (d)
shows that perfect complements will be
purchased together.

O·
 FIGURE 2-: Utility- aximizing
Choices for Special Types of Goods
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