1. © 2009 Pearson Education Canada 2/1 Chapter 2 A Theory of Preferences

2. © 2009 Pearson Education Canada 2/2 Theory of Preferences is based on three ideas regarding individuals: 1. They have consistent preferences. 2. They seek to maximize preference rankings. 3. They are willing to make tradeoffs between different goods.

3. © 2009 Pearson Education Canada 2/3 Completeness Assumption:  Given any two bundles, one of the following is true: - Bundle 1 is preferred to bundle 2 - Bundle 2 is preferred to bundle 1 - Bundle 1 is indifferent to bundle 2

4. © 2009 Pearson Education Canada 2/4 Figure 2.1 Possible consumption bundles

5. © 2009 Pearson Education Canada 2/5 Transitivity Assumption:  Given any three bundles: - If bundle 1 is at least as good as bundle 2, and bundle 2 is at least as good as bundle 3, then bundle 1 is at least as good as bundle 3.

6. © 2009 Pearson Education Canada 2/6 Nonsatiation Assumption:  Given any two bundles, if bundle 1 contains more of one good than bundle 2, and it does not contain less of the other good, then bundle 1 is preferred to bundle 2.

7. © 2009 Pearson Education Canada 2/7 Maximization Assumption:  Individuals always make choices that leave them better off.

8. © 2009 Pearson Education Canada 2/8 Figure 2.2 An indifference curve for Eleanor

9. © 2009 Pearson Education Canada 2/9 Continuity Assumption  Through any consumption bundle in which the quantity of at least one good is positive, there is a continuous indifference curve.

10. © 2009 Pearson Education Canada 2/10 Figure 2.3 Clem’s indifference curves

11. © 2009 Pearson Education Canada 2/11 Figure 2.4 Slope of an indifference curve

12. © 2009 Pearson Education Canada 2/12 Figure 2.5 An indifference map

13. © 2009 Pearson Education Canada 2/13 Figure 2.6 Impossible indifference curves

14. © 2009 Pearson Education Canada 2/14 Marginal Rate of Substitution  The marginal rate of substitution (MRS) is the rate at which someone is willing to trade-off one good for another while maintaining the same level of satisfaction.  More precisely, the marginal rate of substitution of good 2 for good 1 at any point (x 1,x 2 ), denoted as MRS (x 1,x 2 ), is the absolute value of the slope of the indifference curve at that point. (See Figure 2.7).

15. © 2009 Pearson Education Canada 2/15 Figure 2.7 Marginal rate of substitution

16. © 2009 Pearson Education Canada 2/16 Diminishing Marginal Rate of Substitution  Note that in Figure 2.7 the MRS diminishes in a movement down the indifference curve.  A person whose preferences are shown in Figure 2.7 is less willing to substitute good 2 for good 1 at point B than at point A.

17. © 2009 Pearson Education Canada 2/17 Figure 2.8 Constructing a utility function

18. © 2009 Pearson Education Canada 2/18 Figure 2.9 Different preferences and different indifference curves

19. © 2009 Pearson Education Canada 2/19 Figure 2.10 Perfect substitutes and perfect complements

20. © 2009 Pearson Education Canada 2/20 Figure 2.11 Employee preferences for leisure and income

21. © 2009 Pearson Education Canada 2/21 Figure 2.12 Preferences for current and future consumption

22. © 2009 Pearson Education Canada 2/22 From Figure 2.12 Preferences for current and future consumption  People smooth out their consumption over time in order to raise their level of utility.

23. © 2009 Pearson Education Canada 2/23 Figure 2.13 The cost of pollution

24. © 2009 Pearson Education Canada 2/24 Figure 2.13 The cost of pollution  When consumption contains a bad and a good, the indifference curves are upward sloping.