Consumer Preferences and the Concept of Utility Lecture # 04b Consumer Preferences and the Concept of Utility Lecturer: Martin Paredes

Outline Definition of Consumer Preferences Indifference Curves The Marginal Rate of Substitution The Utility Function Marginal Utility Some Special Functional Forms

Consumer Preferences Definition: Consumer Preferences tell us how the consumer would rank any two allotments of goods (also called baskets or bundles), assuming they were available to the consumer at no cost. Assumptions: Completeness Transitiveness Monotonicity

Completeness Definition: Preferences are complete if the consumer can rank any two baskets of goods. For any two bundles A and B, the consumer has three possibilities: Prefer A to B A  B Prefer B to A B  A Indifferent between A and B A ~ B

Transitiveness Definition: Preferences are transitive if the consumer makes choices that are consistent with each other Consider three bundles: A, B, C Suppose he prefers A to B A  B Suppose he prefers B to C B  C Then he must prefer A to C A  C

Intransitivity and Age Age Number of Subjects Intransitive Choices (%) 4 39 83 5 33 82 6 23 82 7 35 78 8 40 68 9 52 57 10 45 52 11 65 37 12 81 23 13 81 41 Adults 99 13 Source: See Hirshleifer, Jack and D. Hirshleifer, Price Theory and Applications. Sixth Edition. Prentice Hall: Upper Saddle River, New Jersey. 1998.

Monotonicity Definition: Preferences are monotonic if a basket with more of one good is preferred to the original basket. Notes: Assumes all other goods in basket remain the same Also called more is better, since having more of one good is better for the consumer.

Indifference Curves Definition: An Indifference Curve is the set of all baskets for which the consumer is indifferent Definition: An Indifference Map illustrates the set of indifference curves for a particular consumer  

y The "Standard Case" IC1 x

y The "Standard Case" Preference direction IC2 IC1 x

Properties of Indifference Maps: Completeness Each basket lies on only one indifference curve Monotonicity Indifference curves have negative slope Indifference curves are not “thick”

y Monotonicity • A x

y Monotonicity Preferred to A • A x

y Monotonicity Preferred to A • A Less preferred x

y Monotonicity Preferred to A • A Less preferred IC1 x

Indifference Curves are NOT Thick y Indifference Curves are NOT Thick B • • A IC1 x

Properties of Indifference Maps: 3. Transitivity Indifference curves do not cross 4. Averages preferred to extremes Indifference curves are bowed toward the origin (convex to the origin).

Indifference Curves Cannot Cross y Indifference Curves Cannot Cross Suppose a consumer is indifferent between A and C Suppose that B preferred to A. IC1 • B • A C • x

Indifference Curves Cannot Cross y Indifference Curves Cannot Cross It cannot be the case that an IC contains both B and C Why? because, by definition of IC the consumer is: Indifferent between A & C Indifferent between B & C Hence he should be indifferent between A & B (by transitivity). => Contradiction. IC2 IC1 • B • A C • x

Averages Preferred to Extremes y Averages Preferred to Extremes A • • IC1 B x

Averages Preferred to Extremes y Averages Preferred to Extremes A • (.5A, .5B) • • IC1 B x

Averages Preferred to Extremes y Averages Preferred to Extremes A • (.5A, .5B) • IC2 • IC1 B x