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ECON1268 Price Theory - Lecture 2-1
ECON1268 Price Theory - Lecture 2-1
ECON1268 Price Theory - Lecture 2-1
Price Theory
Lecture 2 - Utility
Topics for today's lecture . . .
1. Preferences & consumption
2. Utility functions
3. Indifference curves
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Preferences & consumption
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Consumption
Understanding consumer behaviour begins with describing
the available alternatives. Each of us consumes many
different goods and services, including:
• Food
• Clothing
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Consumption 2
• Entertainment
• Utilities
• Housing
• Transport
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Definition: Consumption basket
A combination of goods and services that an individual might
consume.
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Food & clothing
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Exercise: More is better
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The problem with preferences . . .
Describing a consumer's preferences over consumption
baskets can be difficult.
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Definition: Ordinal ranking
A ranking that indicates whether a consumer prefers one
basket to another, but does not contain quantitative
information about the intensity of that preference.
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Definition: Cardinal preferences
A quantitative measure of the intensity of a preference for one
basket over another.
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Utility functions
A utility function assigns a number to every possible basket of
goods and services.
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Utility functions with a single good
Consider a utility function with a single
good x, representing the quantity of
hamburgers consumed.
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Marginal utility
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Marginal utility 2
• When 1 hamburger is eaten, the marginal utility (slope) is
1/2.
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Marginal utility & more is better
The following statements
are equivalent:
• The utility function is
upward sloping (in the
direction of an increase in
x).
• The marginal utility of
good x is positive.
• The more is better
assumption is satisfied
for good x. 23
Definition: Principle of diminishing marginal utility
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The principle of diminishing marginal utility
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Indifference curves
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Utility functions with two goods
This graph illustrates a
total utility function with
two goods:
• Food (good x).
• Clothing (good y ).
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The marginal utility of x
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The marginal utility of x 2
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The marginal utility of y
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The marginal utility of y 2
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Quiz 1
• Suppose that a consumer's preferences over food (good x)
and clothing (good y ) are represented by the utility function
. The associated marginal utilities are,
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Quiz 1 2
(a) both food and clothing.
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Quiz 2
• Suppose that a consumer's preferences over food (good x)
and clothing (good y ) are represented by the utility function
. The associated marginal utilities are,
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Quiz 2 2
(a) both food and clothing.
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Definition: Indifference curves
A curve connecting a set of consumption baskets that yield
the same level of utility to the consumer.
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Indifference curves
An indifference curve is a
line indicating all points on
the utility function at the
same level.
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Flattening the utility function
Consider the indifference
curve corresponding to
utility U = 4.
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Exercise: Indifference curves 2
1. Will the indifference curves for this utility function intersect
the x-axis? Briefly explain. (Hint: Consider the indifference
curve corresponding to a utility of 12.)
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1. Indifference curves slope down
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1. Indifference curves slope down (another way)
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1. Indifference curves slope down (another way) 2
consumer to a higher
level of utility.
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2. Indifference curves do not intersect
implying that .
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3. Indifference are not thick
If
an indifference curve is
thick then we can pick a
basket A at the bottom
edge of the curve.
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3. Indifference are not thick 2
More is better implies B
A, therefore A
and B cannot lie on the
same indifference
curve.
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Quiz 3
Suppose E and F lie on
the same indifference
curve, and that the more
is better assumption is
satisfied.
Which basket(s)
CANNOT lie on the
same indifference curve
as E and F?
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Quiz 3 2
(a) B only.
(b) B and C.
(c) C and D.
(d) B, C and D.
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Definition: Marginal rate of substitution
•The
rate at which units of x are exchanged for units of y along
the indifference curve.
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Advanced: Deriving the marginal rate of substitution
•The
rate at which total utility changes with consumption of
goods x and y is given by the total differential,
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Advanced: Deriving the marginal rate of substitution 2
•Substituting
for and rearranging, gives us,
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Definition: Diminishing marginal rate of substitution
The diminishing
assumption
implies a consumer
would prefer a more
even mix of food and
clothing, over either
extreme.
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Exercise: Sketching indifference curves
•Suppose
that a consumer's preferences over food (good x)
and clothing (good y ) are represented by the utility function .
The associated marginal utilities are,
and
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Exercise: Sketching indifference curves 2
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Special utility functions
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Perfect substitutes
Two goods are perfect
substitutes if the marginal
rate of substitution is
constant.
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Perfect complements
Twogoods are perfect
complements when a
consumer wants to
consume them in fixed
proportions.
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Exercise: Interpreting indifference curves
indifference curves?
2. Which of our
assumptions concerning
consumer preferences
have been violated
here?
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Questions?
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