Understanding Consumer Preferences and Utility in Economics

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

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

3. 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

4. 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

5. 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

6. Intransitivity and Age Age Number of SubjectsIntransitive 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.

7. 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.

8. 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

9. y The "Standard Case" IC1 x

10. y The "Standard Case" Preference direction IC2 IC1 x

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

12. y Monotonicity • A x

13. y Monotonicity Preferred to A • A x

14. y Monotonicity Preferred to A • A Less preferred x

15. y Monotonicity Preferred to A • A Less preferred IC1 x

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

17. 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).

18. 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

19. 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

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

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

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