Consumers’ preferences

ECO61
Udayan Roy
Fall 2008
 Goods bundles

Origi
n
 Preferences
• Consumers have preferences that they can
use to compare different goods bundles
• The preferences may be over goods bundles
consumed by oneself or over goods bundles
consumed by someone else
– For example, a parent may have preferences
over various bundles of food and clothing bought
by the parent but consumed by a child
Assumptions about Preference
Orderings
• Completeness: the consumer is able to rank all
possible bundles of goods and services.
– For any two bundles A and B, the consumer knows
whether A is better, or B is better, or they are equally
good
• Transitivity: for any three bundles A, B, and C, if
A is at least as good as B and B is at least as good
as C, then A is at least as good as C.
• These two assumptions imply the ranking
principle
 The Ranking Principle
• A consumer can rank, in order of
preference, all potentially available
alternatives
Assumption: More-Is-Better
• Other things equal, more of a good is
preferred to less.
– We ignore goods that are harmful or
poisonous, for which more is not better
than less. Such goods are jokingly
referred to as ‘bads’
 Indifference W is worse than A. Z
is better than A. So,
on the line joining W
and Z, there must
Z2 exist a goods bundle
such as B that the
D consumer considers
equally good as A.
By using this logic
repeatedly, we can
W2
find many other
bundles—such as B,
C, and D—that are
equally
Indeed, good as A.
for any
consumption
bundle, it is
possible to find
other bundles that
are equally good

Origi
n
 An Indifference Curve
An indifference curve
is a set of
consumption bundles
that the consumer
prefers equally
K is inferior and L is
superior to the
bundles on the
indifference curve

Origi
n
Part of an Indifference Map

Origi
n
 Properties of Indifference
Maps
1. Bundles on indifference curves farther
from the origin are preferred to those
on indifference curves closer to the
origin.
2. There is an indifference curve through
every possible bundle.
3. Indifference curves cannot cross.
4. Indifference curves slope downward.
 Impossible Indifference
Curves
• Lisa is indifferent
B, Burritos per semester

between e and a, and

also between e and b…
– so by transitivity she
should also be indifferent
between a and b…
– but this is impossible,
e since b must be
b preferred to a given it
a I1 has more of both goods.
I0

Z, Pizzas per semester

 Impossible Indifference
Curves
• Lisa is indifferent

B, Burritos per semester

between b and a
since both points
are in the same b
indifference
curve…
– But this
contradicts the a
“more is better”
assumption. Can I
you tell why?
– Yes, b has more
of both and hence
it should be Z, Pizzas per semester
preferred over a.
Impossible Indifference Curves
Substitution Between Goods
• Economic decisions involve trade-offs
• Indifference curves provide
information on the amount of one
good that the consumer is willing to
give up to gain a unit of another
good

4-14
 Rates of Substitution
• Consider moving along an indifference
curve, from one bundle to another
• This is the same as taking away units of
one good and compensating the consumer
for the loss by adding units of another
good
• Slope of the indifference curve shows how
much of the second good is needed to
make up for a loss of the first good

4-15
 Figure 4.8: Rates of
Substitution
• Look at the move
from bundle A to C
• Consumer loses 1
soup (∆ S = -1); gains
2 bread (∆ B = +2)
• A and C are equally
desirable
• Slope of indifference
curve = ∆ B/∆ S = -2
• Consumer is willing to
substitute for soup
with bread at 2
ounces per pint

4-16
 Marginal Rate of
Substitution
• The marginal rate of substitution for X with Y,
MRSXY , is the rate at which a consumer must adjust Y to
maintain the same level of well-being when X changes
by a tiny amount, from a given starting point

MRS XY = − ∆Y ∆X
MRS XY = −slope of indifference curve
• Tells us how much Y a consumer needs to compensate
for losing a little bit of X, per unit of X
• Tells us the maximum amount of Y a consumer would
be willing to pay per additional unit of X
• That is, MRSXY is the consumer’s willingness to pay Y
for a unit of X

4-17
 Figure 4.9: Marginal Rate of
Substitution
• Slope = ∆ B/∆ S = 3/(-2) =
-3/2
• MRSSB = -∆ B/∆ S=-3/(-2) = 3/2
• The slope—and its negative, the
MRS—at bundle A can be
approximated by the slope of the
line AD, or the line AE, or the line
AF, etc.
• But the precise value is obtained
from the slope of the line that is
tangent to the indifference curve
at bundle A.

4-18
 What Determines Rates of
Substitution?
• Tastes
– Preferences for one good over another affect the
slope of an indifference curve and MRS
• Starting point on the indifference curve; the
initial goods bundle
– People like variety. So most indifference curves get
flatter as we move from top left to bottom right
– Link between slope and MRS implies that MRS
declines; the amount of Y required to compensate
for a given change in X decreases as X increases
• One gets bored with X as consumption of X increases.
Therefore, one needs less Y to compensate for a unit loss
of X

4-19
Figure 4.10: Indifference Curves
and Consumer Tastes

4-20
 Preferences and time
• To a non-economist, food is food is food.
• To an economist, “food delivered this year” and “food
delivered next year” are different goods
 Preferences and chance
• To an economist, “food delivered tomorrow if it is sunny”
and “food delivered tomorrow if there is a hurricane” are
different goods
Figure 4.11: MRS along an
Indifference Curve

4-23
 Perfect Substitutes and
Complements
• Two products are perfect substitutes if
their functions are identical; in such a
case, a consumer is willing to swap one for
the other at a fixed rate
• Two products are perfect complements
if they are valuable only when used
together in fixed proportions

4-24
Figure 4.12: Perfect
Substitutes
MRSRE =
½

4-25
Figure 4.13: Perfect
Complements

4-26
 Utility
• Recall that under the completeness and
transitivity assumptions, the ranking
principle is true:
– the consumer can rank all bundles
according to her preference
• Therefore, the consumer can assign a
number to each bundle such that the
numbers assigned to the bundles
represent the consumer’s preferences
• The number assigned to a bundle is
called its utility
 Utility functions
• If the utility numbers assigned by a
consumer to the various consumption
bundles can be represented by a
mathematical formula, that formula is
called a utility function
• Example:
– Consider two goods, food and clothing and let
the quantities consumed be F and C.
– Then, the formula U(F,C) = F × C can be used
to assign a number to any bundle. (For
example, if F = 11 and C = 3, then U = 33.)
– And if the assigned numbers agree with the
consumer’s preference ranking, then the
formula is a utility function.
 CONSUMER PREFERENCES

• Utility and Utility Functions

● utility Numerical score representing the satisfaction that a
consumer gets from a given market basket.

● utility function Formula that assigns a level of utility to individual

market baskets.

Utility Functions and Indifference Curves

A utility function can be

represented by a set of
indifference curves, each
with a numerical
indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50,
and 100, respectively)
associated with the utility
function:
u(F,C) =
FC
Indifference Curves for the Utility
Function
U=F× S
 Marginal Utility

• Marginal utility is the increase in a

consumer’s utility resulting from the
addition of a very small amount of
some good, per unit of the good

MU X = ∆U ∆X

4-31
 MU and MRS
• Consider changes in
consumption, ∆ X and
∆ Y, that leave utility
unchanged
• A small change in X,
∆ X, causes utility to
change by MUX∆ X
MU X ∆X + MU Y ∆Y = 0
• Small change in Y, ∆ Y,
causes utility to change
by MUY∆ Y MU X ∆X = − MU Y ∆Y
• If we stay on same MU X
indifference curve, then
MUX∆ X + MUY∆ Y = 0. ∆X = −∆Y
Therefore, MU Y
MU X ∆Y
=− = MRS XY
MU Y ∆X 4-32
 (a) Utility

Utility and

U, Utils
350 Utility function, U (10, Z)

Marginal Utility
250 ∆ U = 20
230 ∆U
MU Z =
• As Lisa consumes ∆Z=1 ∆Z
more pizza, holding
her consumption of
burritos constant at
10, her total utility,
U, increases…
– and her marginal 0 1 2 3 4 5 6 7 8 9 10
utility of pizza, MUZ, (b) Marginal Utility
Z, Pizzas per semester

decreases (though it
remains positive).
MUZ, Marginal utility of pizza
130

• Marginal utility is the

slope of the utility
function as we hold
the quantity of the
other good constant.
20
MUZ

0 1 2 3 4 5 6 7 8 9 10
Z, Pizzas per semester
 Ordinal utility
• The indifference map of the utility function U = XY
will look identical to the indifference map of the
utility function V = (XY)2 = U2 or of the utility
function W = (XY)2 + 12 = U2 + 12
• That is, the way a utility function ranks various
goods bundles is unchanged if the utility numbers
given to every bundle are transformed in an
order-preserving manner
• The utility numbers themselves are unimportant
• Only the implied rankings are important
 Ordinal utility
• As was just claimed, the indifference map
of the utility function U = XY will look
identical to the indifference map of the
utility function V = (XY)2 = U2 or of the
utility function W = (XY)2 + 12 = U2 + 12
• In particular, MRSXY at any goods bundle
will be unaffected if the utility numbers
given to every bundle are transformed in
an order-preserving manner
Figure 4.12: Perfect
Substitutes
Utility function: U = 2E
+R
MRSRE = ½

4-36
 Figure 4.13: Perfect
Complements
Utility function: U = min{R, L}

4-37
 Quasi-linear utility
• U = f(X) + Y
– Example: U = X0.5 + Y
Y • MRSXY depends on X but
not on Y
• That is, at any value of X,
all indifference curves
have the same slope
• As all indifference curves
are parallel to each
other, the vertical
distance between any
two indifference curves is
always the same
• We will see later why this
X utility function is
significant