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Chapter 2

Chapter 2. Consumers and Their Preferences. Unit of Analysis: Consumption Bundles. Good 2 ( x 2 ). b. 50. 25. a. 12. Good 1 ( x 1 ). 0. 20. 25. 50. The consumption possibility set. Assumptions on consumption possibility sets Divisibility Goods are infinitely divisible

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Chapter 2

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  1. Chapter 2 Consumers and Their Preferences

  2. Unit of Analysis: Consumption Bundles Good 2 (x 2) b 50 25 a 12 Good 1 (x 1) 0 20 25 50

  3. The consumption possibility set • Assumptions on consumption possibility sets • Divisibility • Goods are infinitely divisible • Additivity • It is possible to add consumption bundles • Convexity • It is possible to combine two bundles to produce a third by consuming fractions of them: c=λa+(1-λ)b

  4. A convex set Oranges A (2,4) B (14,2) Apples If A and B are in the budget set, then any combination budget C, where c=λa+(1-λ)b is also in the budget set.

  5. The Budget Line • Income or budget line • Income • Prices for goods

  6. Income constraints b Good 2 (x 2) c d e 6 6=2x1+1x2 a 2 Good 1 (x 1) 0 2 3

  7. Psychological Makeup of Agents • Agents have preferences that satisfy the following rationality assumptions • R = “at-least-as-good-as” • For any three bundles a, b and c • Rationality Assumptions: • Complete Binary Ordering • aRbor bRa or Indifferent between a and • Reflexivity • aRa • Transitivity • If aRb and bRc, then aRc

  8. Utility Functions • Utility: Level of satisfaction from consumption of a bundles • Based on the three rationality assumptions an agent can rank any group of bundles • A Utility function assigns a number to each bundle such that bundles with a higher number are preferred bundles

  9. Examples of Utility Functions • Additive utility function: U=x+y • Multiplicative utility function: U=xy

  10. Psychological Assumptions • Selfishness • Agents care about their consumption • Nonsatiation • More of anything is always better • Convexity of preferences • Indifferent: bundle a and bundle b • Prefer (or indifferent): a combination, c • Bundle c: at least as good as a or b

  11. Nonsatiated preferences b Good 2 (x 2) Ub a Good 1 (x 1) Giving an agent more of any good must raise his utility. All other bundles in area Ub are strictly better than bundle b.

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