Modeling Individual Choice Chapter 2 Individual Choice in

Modeling Individual Choice Chapter 2

Individual Choice in Buying Goods: Theory • Individuals want to be as happy as possible. Individuals gain happiness from the consumption of goods / services. The more consumption the better, at least to a satiation point. The happiness we gain becomes less and less as we consume more and more of any good. The “Law of Diminishing Marginal Utility” 2

Robinson. Crusoe- Why?

Assumptions • • No scarcity No production is necessary No future or sense of time passing No risk or uncertainty

Definitions • Utility - Satisfaction • Consume - the act of deriving utility • Note: not always used up. – Consume pizza - gone – Consume art - still there

Goods • Tangible, can be stored – Ex. Food, sneakers • Services - intangible, cannot be stored – Ex. Haircut

More Assumptions • People know what gives them utility, and can rank items by the utility they receive from an item • Rational behavior - utility maximizing • Assumption - people are rational • Rational households consume goods and services in order to derive the maximum utility

New assumption • Ceteris paribus, the utility one derives from the consumption of a good decreases with each successive unit consumed • Ex. Dying of thirst 1 st sip - much utility • 2 nd sip - less so • eventually - no utility

More clearly stated: • Ceteris paribus, the utility one derives from the consumption of a good decreases with each successive unit consumed or • one experiences diminishing marginal utility

• We can make up a unit of utility • We’ll call it a util • Eventually, as you keep eating you get to the point where you derive no satisfaction • At this point, MU=0

M&Ms

Utility maximization, marginal utility / total utility / diminishing marginal utility • • • • You are given the following information about the utility value of Big Mac's (assuming the burgers are free) number of Big Mac's MU total utility 1 100 X 2 90 Y 3 Z 270 4 5 P 5 0 Q 6 -10 R Use the information above to answer questions 1 -7 keeping the Law Of Diminishing Marginal Utility in mind 1. - the value of X would be _____ 2. - the value of Y would be _____ 3. - the value of Z would be _____ 4. - the value of P would be _____ 5. - the value of Q would be _____ 6. - the value of R would be _____ 7. - a rational consumer would consume HOW MANY Big Mac's ____ = satiation 12

Utility maximization, marginal / total utility • • • • You are given the following information about the utility value of Big Mac's (assuming the burgers are free) number of Big Mac's MU total utility 1 100 X 2 90 Y 3 Z 270 4 5 P 5 0 Q 6 -10 R Use the information above to answer questions 1 -7 keeping the Law Of Diminishing Marginal Utility in mind 1. - the value of X would be __100___ 2. - the value of Y would be __190___ 3. - the value of Z would be ___80___ 4. - the value of P would be __275___ 5. - the value of Q would be __275___ 6. - the value of R would be __265___ 7. - a rational consumer would consume HOW MANY Big Mac's _4_ = satiation 13

MU’s From 3 Different Activities

Given no scarcity • I will consume until I satiate my want for good 1 – so I will consume until the marginal utility = 0 utils (Bliss Point). The same would be true for good 2, 3, … Or until • MU 1 = MU 2 = MU 3 = … = MUn = 0. 15

If time were not scarce • You could think of the decision rule as MU 1 = MU 2 = MU 3=…= MUn = 0 Unitoftime

Time IS Scarce • 7 hours of play – MU=50 • 3 hours of study – MU=70

How to optimize • The optimal allocation is the one which maximizes utility • Do another hour of the choice which gives you the higher marginal utility

A new allocation • 6 hours of play – MU=60 • 4 hours of study – MU=60

2. 5. 2 Your Decision Rule under Scarcity MU 1 = MU 2 = MU 3=…= MUn = X Unit • Where X can be >0 • How do people maximize utility in the face of scarcity? • Answer: We balance at the Margins!!

2. 6 Relaxing Factors of Production • Stuff doesn’t just appear like magic for you to consume • Endowment- all the natural and human resources from which all goods and services are produced • Endowment may not be fixed, but it is finite, so scarcity is an issue

On Factors • Factors of production – basic inputs we use to produce, such as • Natural resources – in, on or around the earth • Labor- human work • Together, these first two are called the natural endowment

Capital • physical capital (machines) • human capital (skills, innate and acquired).

Allocation, Techniques, and Technology • Allocated – we decide how to use the factors • Process of production – transforming the inputs into an good, or service • Technique- one way of combining inputs Technology – set of all available techniques

Types of techniques • Labor-intensive technique- uses primarily labor • Capital-intensive technique – uses primarily capital • Firms usually choose the cheapest way

Scale of Production • Refers to the size of the process of production • Returns to scale – how does a change in scale affect output? • Ex. If double inputs – less than doubles the output –decreasing returns to scale • If double inputs – doubles the output – constant returns to scale • If double inputs - more than doubles the output – increasing returns to scale • We assume decreasing returns to scale

Marginal Productivity • The additional output that comes from an additional unit of input is called the marginal product (MP) • While MP can increase for a while, It will eventually diminish • If inputs were free, to maximize production you would use inputs until MP=0 for all inputs

The Law of Diminishing Returns • The Law of Diminishing Returns – as a firm uses more and more of a given input such as labor, ceteris paribus on the other inputs, there will come a time when the marginal product of labor will decrease (i. e. Diminishing Marginal Product of Labor).

Value from the marginal product – V • So far, we have two independent rules: • MU 1=MU 2=MU 3=…=MUn=0 (consumption of free goods) • MP 1= MP 2 = MP 3=…=MPn=0 (use of free inputs) • Now we need to bridge the two

Labor (HRs) Marginal Product Total Product (MP) Rabbits 1 1 1 2 2 3 3 3 6 4 2 8 5 1 9 6 0 9

Marginal Utility Schedule Rabbit 1 st 2 nd 3 rd 4 th 5 th 6 th 7 th 8 th 9 th MU 100 90 80 70 60 50 40 30 20

Calculating V (Marginal Product) Labor Rabbits and MU Marginal Total Utility Product 100 1 st 1@100 2 nd 2@90+3@80 170 270 3 rd 4@70+5@60+6@50 180 450 4 th 7@40+8@30 70 520 5 th 9@20 20 540 6 th 0 0 540

V schedules

Decision rule

Complexity #1 – the Present Versus the Future • Consumers: Should I buy and/or work now or later (existence of interest on savings, investment in human capital)? • Firms: Should I expand my physical capital by buying this machine (trading current costs versus future benefits)?

2. 7 The Future & Choice • Intertemporal - across time • You have to decide now about things that will have utilities in the future • Ex. $100 now or a year from now

Discount Rate • The Discount Rate – the rate, in percentage terms, that we are willing to trade off money received one year from now versus money received today. • Equivalent amounts received today and in the future are worth more today – need to discount future amounts.

The Discount Rate: An Example • Suppose you have a choice between $300 today and a higher amount next year. Suppose as well that you decide that you’re indifferent between $300 today and $360 next year. • Your discount rate = [($360 $300)/($300)]x 100% = 20% 38

Characteristics of the Discount Rate • Consumers – depends upon different individual’s utility or preferences. – High Discount Rate: devalues the future sharply, “wants it now”. – Low Discount Rate: more willing to forego the present for the future. • Firms – the market interest rate is their ultimate discount rate. 39

2. 7. 10 Should I go to college?

Explanation • • C – College W – work I - Investment cost R – Return • Doesn’t have to measured in dollars

College Demographics • Why is college full of 18 -22 year olds? Opportunity cost is higher for older students • Retirees discount the future more because they have less time left

PV=Present Value • When we relax our assumption of no future, then the rule becomes PV 1=PV 2=…=PVn

Incorporating Risk in Economic Decisions Risk & uncertainty • We develop expectations of unknown events – our best guess of what we think will happen, then act upon those (right or wrong). • We practice risk aversion – of different events with the same expected return, we prefer less risk. 44

Complexity #2 – Risk and Uncertainty • Key Issue: future is unknown, affects economic decisions. • Risk – unknown events to which we can attach a probability. • Uncertainty – absolutely un-thought of events which may end up occurring. • Uncertain events which occur become risky events. 45

Building risk into the decision rule • All utilities should be looked at as expected utilities because of risks and uncertainties EPV 1=EPV 2=…=EPVn • EPV parachuting <EPV 2 movie • NO PARACHUTING

Uncertainty and Choice • Advertising – product will bring great utility Shape our perceptions –beauty standards Eating disorders – more prone if high discount rate and low perception of risk