ECON 356 - Outline Four

Utility and Consumer Choice:  The Utility Function Approach to the Consumer Budgeting Problem

Another way of looking at the consumer choice problem is to represent the consumer's preferences with a utility function instead of with indifference curves.

Utility Function:  Gowdy's Utility = f (different bundles of goods - for example, so much food, so much shelter, etc.)

Theoretically - the function yields a number representing the total utility of the consumer.  For example, one pound of food gives Gowdy 10 "utils", one square foot of shelter gives Gowdy 5 utils, etc.  All of these utils added up gives us the total utility for Gowdy.

Each utility function can therefore be said to represent an indifference curve (since along an indifference curve the utility is constant).  A higher indifference curve represents another utility function where the amount of the goods in the function has increased).

Graph:

Marginal Utility (in standard theory) = change in total utility with additional consumption of a good (how many additional utils does Gowdy get from consuming an addition pound of food?)

Utility Maximization:  In order for a consumer to choose the "optimal" bundle of goods -- he will consume until the marginal utility per dollar spent on both goods is equal.

Example:  suppose that the marginal utility of the last dollar John spends on food is greater than the marginal utility of the last dollar he spends on shelter - so that,  the price of food and shelter are $1/lb and $2/sq yd, respectively, and that the corresponding marginal utilities are 6 and 4.  Why can't John be maximizing his utility?

MU per last $ spent on food = 6  and the Price of food is $1 lb.

MU per last $ spent on shelter = 4 (So for example it is 8 utils/$2) and the Price of shelter is $2 sq. yd

If John bought 1 sq yd less of shelter, he would save $2 and would lose 8 utils (4 utils per $1 spent).  But this would enable him to buy 2 lb more of food, which would add 12 utils, for a net gain of 4 utils.

Now, as John consumes more food, his marginal utility of food declines - and as he buys less shelter, his marginal utility increases.

So John will keep consuming food until he can no longer increase his marginal utility with a dollar spent more than if he spent the dollar on shelter.

All this is saying (in fancy economic language) is that people will buy more (use their money) on things that give them more value!!  Shocking.  Of course we never really know if we have maximized utility or anything else -- that is only theoretical given the problem at hand.

Cardinal vs. Ordinal Utility: 

Remember that we assumed that consumers can rank each possible bundle in order of preference.  This is called the ordinal utility approach to the consumer budgeting problem.  It does not require that people be able to make quantitative statements about how much they like various bundles. 

Earlier -- economists assumed that people could make such statements ("I like A 6.4 times as much as I like B").  Today we call theirs the cardinal utility approach to the consumer choice problem.

Most economists today stick with the ordinal approach.

Bottom line:  YOU CAN'T MEASURE UTILITY!!

Discussion:  "Marginal Utility Is Not Rocket Science"