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Intermediate Microeconomics. Preferences. Consumer Behavior. Budget Set organizes information about possible choices available to a given consumer. Next step is to determine how a consumer will choose among the bundles available in his or her budget set.
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Intermediate Microeconomics Preferences
Consumer Behavior • Budget Set organizes information about possible choices available to a given consumer. • Next step is to determine how a consumer will choose among the bundles available in his or her budget set. • To do so, we make the seemingly obvious assumption that individuals are rational: • Each individual chooses the bundle he or she most prefers among all bundles available in his or her budget set. • Therefore, we need to develop a theory of preferences, that is both flexible and yet restrictive enough to be useful for understanding how choices will change as the economic environment changes.
Theory of Preferences • Consider again a bundle of goods denoted A-{q1A, q2A, …, qnA} • For any given individual and any given bundle A, we want to be able to describe the following sets: • Strictly preferred set – all bundles the individual strictly prefers to A. • Weakly preferred set – all bundles the individual weakly prefers to A (i.e. likes at least as much as A) • Any bundle not in weakly preferred set, the individual must like strictly less than A.
Preferences • 3 axioms in our theory of consumer preferences • Completeness – An individual can weakly rank any two possible bundles. • Reflexivity – A bundle is at least as good as itself. • Transitivity – If a bundle C is strictly preferred to a bundle A, and an individual is indifferent between a bundle A and another bundle D, then the individual must also strictly prefer bundle C to bundle D.
Preferences • Final common assumption - preferences exhibit “non-satiation” or monotonicity. • Weaker version: “more can’t be worse.” • Essentially assumes free-disposal • Stronger version: “more is always better” • Certainly not true at levels (100 donuts does me no better than 99) • For practical purposes though, not bad, as we want to model situations where individuals have to make choices between things they value.
Preferences • Key issue we want to understand and analyze in economics is trade-offs. • e.g. how much of one good is an individual willing to trade-off to consume more of another good? • Our preference axioms allow us to consider such trade-offs via indifference curves. • For any given bundle A, there is an indifference curve that connects A to each bundle B where a given consumer is indifferent between A and B.
Indifference Curves • Characteristics of Indifference Curves • Consider one of your indifference curves between number of chips and ounces of Coke. • Is every possible bundle on an indifference curve? Why or why not? • How many indifference curves are there? • Will slope of indifference curves be positive or negative? How do we know? • Can indifference curves cross? Why or why not? • If A is on a higher indifference curve than B, what does this mean? How do we know this?
Interpreting Indifference Curves q2 q2’ • Indifference curve indicates that at bundle {q1’,q2’}, an individual will be willing to give up Δq2 units of good 2 to increase consumption of good 1 by Δq1. • What happens as Δq1 goes to zero? Δq1 -Δq2 q1 q1’
Interpreting Indifference Curves • Marginal Rate of Substitution (MRS) – the slope of indifference curve at a given point. • MRS indicates an individual’s willingness-to-pay for a marginal increase of one good in terms of the other, at a given bundle. • So how do you interpret an indifference curve when it is very steep at a given bundle (i.e. slope large in magnitude)? • How about when it is relatively flat?
Well-behaved preferences • In addition to our three Axioms and monotonicity, we will also often assume preferences are convex. • Convex preferences - If bundles B-{q1B, q2B} and C-{q1C, q2C} are in weakly preferred set to A, then so will {(q1B+ q1C)/2 , (q2B+ q2C)/2 }. • Intuition: averages are at least as good as extremes, or that individuals prefer to have a combination of goods at moderate levels to lots of one and little of the other (consider chips and coke) • Monotonic and Convex preferences are called well-behaved preferences.
Interpreting Indifference Curves • Consider an indifference curve of following form. • Does it represent convex preferences? • What does this shape reveal about MRS as q1 increases and q2 decreases? • What is intuition? q2 q1
Interpreting Indifference Curves • Diminishing MRS • Implies an individual’s willingness to trade one good for another diminishes the less he has of that good. • Slope of Indifference Curve “decreases” as q1 increases and q2 falls. • Examples: • Chips and Coke? • Coke and a composite good? • Coke and Apple Juice? • What is intuition behind different shapes of indifference curves?
Interpreting Indifference Curves • Perfect substitutes - constant MRS • Examples? • What will indifference curves look like? • Perfect Complements – must consume in fixed proportions, or individual not willing to trade off some of one for more of another, therefore MRS is undefined. • Examples? • What will indifference curves look like? • Are such preferences well-behaved? • Examples of when preferences might not be well-behaved?
Modeling Preferences over Other Types of Goods • Suppose again you work for Doctors Without Borders. • What will your indifference curves look like between “people cured of Tuberculosis” vs. “people cured of AIDS”?
