1. Principles and Preferences
Chapter 4
Principles and Preferences

2. Main Topics Principles of decision-making Consumer preferences
Substitution between goods
Utility

3. Principles of Decision Making
Predicting consumers’ choices.
Why do consumers make different choices?
All are related to Preferences.

4. 1st assumption about consumer behavior: The Ranking Principle: A consumer can rank in order of preferences, all available alternatives.
A consumer is indifferent between 2 alternatives if he likes them both equally.

5. The 2nd assumption:
The Choice Principle: Among all available alternatives, the consumer selects the one that he ranks the highest.
this means that the consumer always attempts to achieve the highest level of satisfaction.

6. Consumer Preferences Decisions are tend to be interrelated:
the enjoyment of one activity usually depends on other activities.
when spending money on one good, there is less money to spend on other goods. Consumption bundle: a collection of goods an individual consumes over a given period.

7. Ranking Consumption Bundles
Only the consumer who can rank his own consumption bundles.
The 3rd Principle of consumer decision making: The “More preferred to Less” Principle: When one consumption bundle contains more of every good than a second bundle, a consumer prefers the 1st bundle t the 2nd.

8. SOUP
X’S ALTERNATIVES AND PREFERENCES 11 7 3 1 13 8 4 2 15 9 6 5 16 14 12 10 3 2
BREAD 1 1 2 3
NOTE: 1 IS THE HIGHEST

9. SOUP
X’S ALTERNATIVES AND PREFERENCES 11 7 3 1 13 8 4 2 15 9 6 5 16 14 12 10 3 2
1st BEST?
2nd BEST?
LEAST PREFERRED BUNDLE?
BREAD 1 1 2 3

10. SOUP
X’S ALTERNATIVES AND PREFERENCES 11 7 3 1 13 8 4 2 15 9 6 5 16 14 12 10 3 2
BREAD 1
X GENERALLY PREFERS SOUP TO BREAD
MPL??? 1 2 3

11. SOUP
X’S ALTERNATIVES AND PREFERENCES 11 7 3 1 13 8 4 2 15 9 6 5 16 14 12 10 3 2
BREAD 1
X GENERALLY PREFERS SOUP TO BREAD 1 2 3
IN-TEXT-EXERCISE 4.1

12. Building Blocks of Consumer Theory
Preferences tell us about a consumer’s likes and dislikes
A consumer is indifferent between two alternatives if she likes (or dislikes) them equally
The Ranking Principle: A consumer can rank, in order of preference, all potentially available alternatives
The Choice Principle: Among available alternatives, the consumer chooses the one that he ranks the highest

13. The Consumer’s Problem
Consumer’s economic problems is to allocate limited funds to competing needs and desires over some time period
Chooses a consumption bundle
Should reflect preferences over various bundles, not just feelings about any one good in isolation
Decision to consume more of one good is a decision to consume less of another

14. Principles of Consumer Decision-Making
The More-is-better Principle: When one consumption bundle contains more of every good than a second bundle, a consumer prefers the first bundle to the second
Transitivity: if a > b and b > c, then a > c.

15. Indifference Curves
Use when goods are (or assumed to be) available in any fraction of a unit
Represent alternatives graphically or mathematically rather than in a table
Starting with any alternative, an indifference curve shows all the other alternatives a consumer likes equally well

16. Figure 4.1: Identifying Alternatives and Indifference Curves

17. Properties of Indifference Curves
Thin
Do not slope upward
Separates bundles that are better from bundles that are worse than those that are on the indifference curve

18. Figure 4.2: Indifference Curves Ruled Out by the More-is-better Principle

19. Families of Indifference Curves
Collection of indifference curves that represent the preferences of an individual
Do not cross
Comparing two bundles, the consumer prefers the one on the indifference curve further from the origin

20. Figure 4.3: A Family of Indifference Curves

21. Figure 4.4: Indifference Curves Do Not Cross

22. Formulas for Indifference Curves
More complete and precise to describe preferences mathematically
For example, can write a formula for a consumer’s indifference curves
Formula describes an entire family of indifference curves
Each indifference curve represents a particular level of well-being
Higher levels of well-being are on indifference curves further from the origin

23. Figure 4.6: Plotting Indifference Curves
Formula for indifference curves is B = U/S (Starting from U=B*S)
U is well-being, or “utility”
To find a particular curve, plug in a value for U, then plot the relationship between B and S

24. Substitution Between Goods
Economic decisions involve trade-offs
To determine whether a consumer has made the best choice, we need to know the rate at which she is willing to make trade-offs between different goods
Indifference curves provide that information

25. Rates of Substitution
Consider moving along an indifference curve, from one bundle to another
This is the same as subtracting 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 the decrease in the first good

26. Figure 4.8: Rates of Substitution
Look at move from bundle A to C
Consumer gains 1 soup; gains 2 bread
Willing to substitute for soup with bread at 2 ounces per pint

27. 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
Tells us how much Y a consumer needs to compensate for losing a little bit of X
Tells us how much Y to take away to compensate for gaining a little bit of X

28. Figure 4.9: Marginal Rate of Substitution
MRSSB=-∆B/∆S=-3/2

29. What Determines Rates of Substitution?
Differences in tastes
Preferences for one good over another affect the slope of an indifference curve (weights attached to each good in the utility function)
Implications for MRS
Starting point on the indifference curve
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

30. Figure 4.10: Indifference Curves and Consumer Tastes

31. Figure 4.11: MRS along an Indifference Curve

32. Formulas for MRS
MRS formula tells us the rate at which a consumer will exchange one good for another, given the amounts consumed
Every indifference curve formula has an MRS formula that describes the same preferences
Indifference curves: B=U/S; MRSSB=B/S

33. Perfect Substitutes and Complements
Some special cases of preferences represent opposites ends of the substitutability spectrum
Two products are perfect substitutes if their functions are identical; 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
Note that the goods do not have to be exchanged one-for-one!

34. Figure 4.12: Perfect Substitutes

35. Figure 4.13: Perfect Complements

36. Sample Problem 1 (4.3):
Gary has two children, Kevin and Dora. Each one consumes “yummies” and nothing else. Gary loves both children equally. For example, he is equally happy when Kevin has two yummies and Dora has three, or when Kevin has three yummies and Dora has two. But he is happier when their consumption is more equal. Draw Gary’s indifference curves. What would they look like if he loved one child more than the other?

37. Utility
Summarizes everything that is known about a consumer’s preferences
Utility is a numeric value indicating the consumer’s relative well-being
Recall that the consumer’s goal is to benefit from the goods and services she uses
Can describe the value a consumer gets from consumption bundles mathematically through a utility function

38. Utility Functions and Indifference Curves
Utility functions must assign the same value to all bundles on the same indifference curve
Must also give higher utility values to indifference curves further from the origin
Can start with information about preferences and derive a utility function
Or can begin with a utility function and construct indifference curves
Can also think of indifference curves as “contour lines” for different levels of utility

39. Figure 4.14: Representing Preferences with a Utility Function

40. Sample Problem 2:
For example assume preferences are described by the following utility function:
U = X1/2Y1/2
To plot an indifference curve for this utility function, first isolate Y:
U2 = XY
Y = U2 /X
Then pick some level of utility. Let’s set U = 25

41. Utility Functions and Indifference Curves
Thus, Y = 5/X
When X = 1, Y = 25
When X = 2, Y = 12.5
When X = 3, Y = 8.33
When X = 4, Y = 6.25
When X = 5, Y = 5
And so on…
Describe the indifference curves for the following utility functions:
U = X + Y
U = min(X,Y)

42. Ordinal vs. Cardinal Utility
Information about preferences can be ordinal or cardinal
Ordinal information allows us to determine only whether one alternative is better than another
Cardinal information reveals the intensity of preferences, “How much worse or better?”
Utility functions are intended to summarize ordinal information
Scale of utility functions is arbitrary; changing scale does not change the underlying preferences

43. Marginal Utility
To make a link between MRS and utility, need a new concept
Marginal utility is the change in a consumer’s utility resulting from the addition of a very small amount of some good, divided by the amount added

44. Utility Functions and MRS
Small change in X, ∆X, causes utility to change by MUX∆X
Small change in Y, ∆Y, causes utility to change by MUY∆Y
If we stay on same indifference curve, then –∆Y/∆X =MUX/MUY

45. Marginal Rate of Substitution
Let’s find the MRS for each of the following utility functions:
U = X1/2Y1/2;
MUX=(1/2)X-1/2Y1/2 and MUY =(1/2) X1/2Y-1/2
U = X1/3Y2/3
MUX=(1/3)X-2/3Y2/3 and MUY =(2/3) X1/3Y-1/3
U = X + Y
MUX = Y and MUY = X

46. Sample Problem 3 (4.14):
Latanya likes to talk on the telephone. We can represent her preferences with the utility function U(B,J) = 18B + 20J, where B and J are minutes of conversation per month with Bill and Jackie, respectively. If Latanya plans to use the phone for one hour to talk with only one person, with whom would she rather speak? Why? What is the formula for her indifference curves?