Lecture Notes on Utility Theory and Consumer Behavior

Introduction to Utility Theory

• Utility: Ability of something to satisfy needs and wants.
• Utility Functions: Mathematical expressions representing people's preferences.
• Neuroeconomics: Evidence suggests that our brains rank options similar to utility functions.
• Purpose: To rank possibilities and guide choices based on preferences.

Indifference and Utility

• Optimization Principle: People aim for outcomes highly ranked in their preferences.
• Indifference: When multiple options are equally preferred (e.g., choosing a meal from a tempting menu).
• Holding Utility Constant: Allows us to see relationships between goods (e.g., pizza and burgers).
• Graphical Representation: Utility function graph shows trade-offs between goods.

Indifference Curves

• Graphing Indifference Curves:
  • Pizza and burgers example: inverse relationship between them.
  • Curve Shifts: Outward shifts indicate increased utility.
  • Non-Crossing Curves: Indifference curves never cross; different preferences yield different curves.

Types of Preferences

• Substitutes: Goods we choose between (e.g., iPhones vs. Samsungs, Pepsi vs. Coca-Cola).
• Complements: Goods consumed together (e.g., left and right shoes, peanut butter, and jelly).
• Graph Differences:
  • Linear indifference curves for substitutes.
  • L-shaped curves for perfect complements.

Utility, Budget Constraints, and Consumer Behavior

• Optimization Problem: Consumers aim to maximize utility within budget constraints.
• Graphical Model:
  • Budget constraint line shows affordable goods.
  • Indifference curve shows preferred combinations within budget.
  • Tangency point indicates optimal choice.

Comparative Statics and Changes

• Income Changes:
  • Higher income shifts the budget line outward, increasing consumption of goods.
• Price Changes:
  • Increase in price of a good rotates budget line inward.
  • Decrease in price rotates it outward.
  • Impact on consumption depends on whether goods are complements or substitutes.

Conclusion

• Economic Model: Helps predict consumer behavior and reactions to changes.
• Practical Advice: Theory offers insights for market demand and personal decision-making.