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7/17/14  

Utility and Consumers
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PROFESSOR PAUL OYER
DAY 2

Today
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—  Utility (Indifference Curves)
—  Budget Constraints
—  Consumer Demand and Labor Supply

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7/17/14   Indifference Curves 3 —  “Utility” is an (admittedly abstract) measure of how happy a person is. It goes up when a person gets more of a good she values and/ or can trade for something she values ¡  We generally assume a person’s utility goes up when he has more money. Indifference Curves 4 Finance Skills “Jane” – Happier “Jane” – a REALLY happy version “Jane” – base Utility Income This Year 2   . though we think of the marginal utility of a dollar as diminishing ¡  —  We can use an indifference curve to represent how a person is willing to trade off two goods in such a way that her utility (her overall happiness) is unaffected.

7/17/14   Indifference Curves Finance Skills 5 “Fred” – a Finance Geek “Jane” Income This Year Gas and Walmart Walmart Purchases 6 “Fred” – the Public Transportation type “Jane” Gasoline 3   .

After Gas Price Increase Original Budget Line Gasoline Indifference Curves and Work Money 8 “Fred” – workaholic “Jane” Leisure (Time NOT Working) 4   .7/17/14   Gas and Walmart Walmart Purchases 7 Consumption of BOTH goods goes down (in this case).

so he eats fewer of them. #2) $50K $60K $70K After-Tax Income 5   .7/17/14   Problem 3-2 in Chapter 5 9 The tax raises the cost of burgers.U. Original Budget Line 60 Initial Utility New Utility (Less Happy) 30 20 60 Cigarettes 120 Diminishing Returns 10 Utility Burgers 40 Marginal Utility #2 Marginal Utility #1 Marginal Utility of $10 is higher if income is $50K (M. #1) than if income is $60K (M.U.

7/17/14   Risk Aversion 11 Utility Utility of Earning $60K with certainty EXPECTED utility is higher when earning $60K for sure than when earning $60K on average but with some risk Utility of 50/50 chance of Earning $100K and $20K $20K $100K After-Tax Income $60K Problem 5-3 in Chapter 5 12 New Constraint – Cannot be to the left of this line Original Budget Line Consumption Goods 240 Initial Utility New Utility (Less Happy) 100 80 Leisure 14 16 24 6   .

—  Utility goes up with wealth. that lowers the marginal utility of a dollar spent on it which generally lowers consumption as alternatives look better by comparison.7/17/14   Problem 5-3 in Chapter 5 13 —  This problem shows an important principle – choice is good. —  So she cannot be better off (and is probably worse off). When the price of one thing changes. consumption but marginal utility typically falls with these things ¡  We will later see that this leads to risk aversion —  Consumers equate the marginal utility of a dollar spent on each good they consume ¡  ¡  Doing otherwise would mean they could be “happier” if they consumed more of something and less of another thing. income. —  Presumably. if working only 8 hours was best. she would have been doing it already. 7   . —  Labor and leisure can be thought of as consumption goods that get traded off against other goods. —  She cannot continue to do what she is choosing to do. Wrap Up 14 —  Indifference curves capture consumer preferences ¡  They usually “curve” because of the law of diminishing returns – we prefer more of things but also like variety.