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Chapter 3: Consumer Preferences and the Concept of Utility

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2 Outline Introduction Description of consumer preferences The Utility functions Marginal utility and diminishing marginal utility Indifference Curves Marginal rate of substitution Special functional forms

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3 Supply and Demand Models (Ch. 2) are useful for analyzing economic questions concerning markets. How will increasing the real wage affect output? In these models we summed each individuals demand to obtain the market demand curve. But, how do individuals decide what to consume and how much to consume. Introduction

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4 We need to develop a model about individual or consumer behavior Model is based on: 1.Individual tastes or preferences determine the amount of pleasure people derive from goods and services. (Chapter 3) 2.Consumers face constraints (budget) that limit their choices 3.Consumers maximize their well-being or pleasure from consumption, subject to the constraints they face. We want our model to be realistic so we can predict consumer behavior. But, still as simple as possible. Introduction

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5 Description of Consumer Preferences Consumer Preferences tell us how the consumer would rank any two basket of goods, assuming these allotments were available to the consumer at no cost. baskets or bundles is a collection of goods or services that an individual might consume.

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6 1. Complete: Preferences are complete if the consumer can rank any two baskets of goods A strictly preferred to B ( A B ) B strictly preferred to A (B A ) indifferent between A and B (A ≈ B) Preferences are transitive if a consumer who prefers basket A to basket B, and basket B to basket C also prefers basket A to basket C 2. Transitive : A B and B C → A C NOT C A The Assumptions of Consumer Behavior No illogical behavior Properties of Consumer Preferences

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7 3.Monotonic (more is better) Preferences: are monotonic if a basket with more of at least one good and no less of any good is preferred to the original basket. – free disposal can’t be worse of with more The more is better assumption is also known as the property of non-satiation. It assumes are looking at what economists call a ‘good’. Something we want more of We are not looking at a ‘bad’ i.e. pollution We can relax this assumption it is the first two that are crucial for the analysis

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8 Preferences Examples

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9 Age Number of Subjects Intransitive Choices (%) Adults Source: See H irshleifer, Jack and D. Hirshleifer, Price Theory and Applications. Sixth Edition. Prentice Hall: Upper Saddle River, New Jersey Intransitivity and Age

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10 Ordinal vs Cardinal Rankings Ordinal Ranking: gives us information on how a consumer ranks different baskets of goods. But it does not say by how much (i.e. 2 times as much) This is how we view preferences. Cardinal Rankings: Give us information on the intensity of the consumer preferences (i.e. they like basket A 10 times more than basket B). Would be hard to say I like eating pizza out 10.5 times more than eating bad Chinese. Putting an exact number to our preferences is hard! – this is why we use ordinal rankings for consumer preferences

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11 Ordinal vs Cardinal Example Students take an exam. After the exam, the students are ranked according to their performance. An ordinal ranking lists the students in order of their performance (i.e., Harry did best, Joe did second best, Betty did third best, and so on). A cardinal ranking gives the grade of the exam, based on an absolute grading standard (i.e., Harry got 50, Joe got 100, so Joe did 2 times better than Harry).

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12 Utility is an ordinal concept: the precise magnitude of the number that the function assigns has no significance. U=F(x 1,x 2,x 3, ….., x n ), where the x’s are quantities of n goods that might be consumed in a period Utility Function Utility Function: measures the level of satisfaction that a consumer receives from any basket of goods.

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13 difference in magnitudes of utility have no interpretation per se utility not comparable across individuals any transformation of a utility function that preserves the original ranking of bundles is an equally good representation of preferences. e.g. U = xy vs. U = xy + 2 represent the same preferences. Implications

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14 Utility Function (one good example) Are the assumptions on preferences meet? U(y) = y.5 y, weekly consumption of muffins U(y): total utility of muffins A B C

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15 Marginal Utility Marginal Utility: Rate at which total utility changes as the level of consumption rises. - Each new muffin makes you happier, but makes you happier by smaller and smaller amount.

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16 The marginal utility:of a good, x, is the additional utility that the consumer gets from consuming a little more of x when the consumption of all the other goods in the consumer’s basket remain constant. U/ x (y held constant) = MU x =∂ U/∂ x U/ y (x held constant) = MU y =∂ U/∂ y …or…the marginal utility of x is the slope of the utility function with respect to x. The principle of diminishing marginal utility : states that the marginal utility falls as the consumer consumes more of a good Marginal Utility

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17 Marginal Utility y, weekly consumption of muffins MU(y): marginal utility of muffins If more is always better: marginal utility must always be positive. -Diminishing marginal utility -A positive marginal utility means you like the good. Otherwise you would get zero or perhaps negative marginal utility

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18 Utility function (2 good example) Indifference curve

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19 IC 1 for U=4 food Clothing Indifference Curve (IC) -2 good graph (keeps it simple) - Along curve consumer is indifferent between each of the bundles of food and clothing -Same level of utility for bundle A, B, and C A B C

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20 IC 1 for U=4 IC 2 for U = 6 Food Clothing Preference direction ( happier the further away from the origin Are indifferent to any bundle along an indifference curve. But more is better so are better off as we move away from the origin. Indifference Map:

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21 Indifference Curves and Map An Indifference Curve or Indifference Set: is the set of all baskets for which the consumer is indifferent An Indifference Map: illustrates a set of indifference curves for a consumer, it is an ordinal ranking.

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22 Properties of Indifference Maps 1. Monotonicity => indifference curves have negative slope …and… indifference curves are not “thick” 2. Transitivity => indifference curves do not cross 3. Completeness => each basket lies on only one indifference curve

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23 One more assumption usually is made: 4. Averages preferred to extremes => indifference curves are bowed toward the origin (convex to the origin). Properties of Indifferences Maps

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24 IC 1 Food Clothing Preferred to A A Less preferred To meet monotonicity: preference curve must be in the these areas: downward sloping Monotonicity: Consumers like both goods.

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25 IC 1 for U=4 food Clothing Monotonicity: A B If more is preferred to less, IC cannot be thick. B would be preferred to A, so could not be on same CI curve.

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26 food clothing A B IC 1 IC 2 C Suppose that B preferred to A. but..by definition of IC, B indifferent to C A indifferent to C => B indifferent to A by transitivity. Contradiction, B should be preferred to A. Indifference Curves Cannot Cross

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27 IC 2 Food Clothing A B (.5A,.5B) IC 1 Averages Preferred to Extremes

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28 Example: For the indifference curves graphed below, are the underlying preferences: Complete? Transitive? Monotonic? x y IC 1 IC 2 IC 3 IC 4 Preference direction 0

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29 Example: For the indifference curves graphed below, are the underlying preferences: Complete? Yes Transitive? Yes Monotonic? No x y IC 1 IC 2 IC 3 IC 4 Preference direction 0 Want as much X as possible but don’t care about Y: So same X and more Y are not better off, so not monotonic. A B

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30 Marginal Rate of Substitution The marginal rate of substitution: is the maximum rate at which the consumer would be willing to substitute a little more of good x for a little less of good y…or… It is the increase in good x that the consumer would require in exchange for a decrease in good y in order to leave the consumer indifferent between consuming the old basket or the new basket…or…

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31 It is the rate of exchange between goods x and y that does not affect the consumer’s welfare…or… It is the negative of the slope of the indifference curve: MRS x,y = - y/ x (for a constant level of preference) =Slope of the indifference curve Marginal Rate of Substitution If you like both goods, the MRSx,y will be negative.

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32 The indifference curves get flatter as we move out along the horizontal axis and steeper as we move up along the vertical axis. An indifference curve exhibits a diminishing rate of substitution: if the more of good x you have, the more you are willing to give up to get a little of good y…or… Example: The Diminishing Marginal Rate of Substitution

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33 Example: For the following indifference curves, what is the marginal rate of substitution between x and y is: 1,.5, 2, or 5? Is the MRS diminishing? x0 y IC IC 2 IC 3 What type of good are these? Perfect substitutes Does the MRS need to be 1 for each of these? No could be in a ratio of 2 to 1 (2 oreo cookies for each glass of milk

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34 Example: Suppose U = xy, graph the utility curve if utility is equal to = xy x y Graphing an Indifference Curve

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35 Example: U=20 10 = xy 20 = xy x y Preference direction

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36 Relative Income and Life Satisfaction (within nations) Relative Income Percent > ="Satisfied" Lowest quartile 70 Second quartile 78 Third quartile 82 Highest quartile 85 Source: Hirshleifer, Jack and D. Hirshleifer, Price Theory and Applications. Sixth Edition. Prentice Hall: Upper Saddle River, New Jersey % more satisfied 4% more satisfied 3 % more satisfied

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37 Source: Hirshleifer, Jack and D. Hirshleifer, Price Theory and Applications. Sixth Edition. Prentice Hall: Upper Saddle River, New Jersey Absolute Income and Life Satisfaction (across nations) GNP per number of median "satisfaction" capita nations score < $2, $2,000-$4, $4,000-$8, $8,000-$16,

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38 MU x ( x) + MU y ( y) = 0 …along an IC… MU x /MU y = - y/ x = MRS x,y memorize Derive Marginal Utility and Marginal Rate of Substitution

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39 Marginal Utility and Marginal Rate of Substitution Positive marginal utility implies the indifference curve has a negative slope (implies monotonicity) Diminishing marginal utility implies the indifference curves are convex to the origin (implies averages preferred to extremes

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40 Marginal utilities are positive (for positive x and y) Example: U = Ax 2 +By 2 ; MU x =2Ax; MU y =2By (where: A and B positive) MRS x,y = MU x /MU y = 2Ax/2By= Ax/By Marginal utility of x increases in x; marginal utility of y increases in y

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41 Implications of this… Indifference curves are negatively-sloped, bowed out from the origin, preference direction is up and right Indifference curves intersect the axes

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42 Example: Graphing Indifference Curves IC 1 IC 2 x y Preference direction 0 Concave: prefer extremes to averages

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43 Example: U= (xy).5 ;MU x =y.5 /2x.5 ; MU y =x.5 /2y.5 Is more better for both goods? Yes, since marginal utilities are positive for both. b. Are the marginal utility for x and y diminishing? Yes. (For example, as x increases, for y constant, MU x falls.) c. What is the marginal rate of substitution of x for y? MRS x,y = MU x /MU y = y/x

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44 Do the indifference curves intersect the axes? A value of x = 0 or y = 0 is inconsistent with any positive level of utility.

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45 Example: Graphing Indifference Curves IC 1 x y

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46 Example: Graphing Indifference Curves IC 1 IC 2 x y Preference direction

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47 1. Cobb-Douglas: U = Ax y where: + = 1; A, , positive constants MU X = Ax -1 y MU Y = Ax y -1 MRSx,y = ( y)/( x) Note: marginal rate of substitute only depends on the ratio of X and y not on the total amounts of X and y. So indifference curves for different levels of Utility look identical to each other no matter how far away from the origin they are. Special Functional Forms

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48 Perfect Substitutes: U = Ax + By Where: A, B positive constants MU x = A MU y = B MRS x,y = A/B so that 1 unit of x is equal to B/A units of y everywhere (constant MRS). Note: marginal rate of substitute only depends on the ratio of A and B not on the total amounts of X and y. So indifference curves for different levels of Utility look identical to each other no matter how far away from the origin they are.

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49 Example: Perfect Substitutes (Tylenol, Extra-Strength Tylenol) x0 y IC 1 IC 2 IC 3 Slope = -A/B

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50 3. Perfect Complements: U = min( x, y) where: , are a positive constant. And min means take The smaller of the two constants. I.e you want 8 oz of Coffee with one oz of cream U = min( x, 8 y), where x is cream and y is coffee. So x/y = / =1/8 =fixed proportions MRS x,y is 0 or infinite or undefined (corner)

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51 Example: Perfect Complements (nuts and bolts) x0 y IC 1

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52 Example: Perfect Complements (nuts and bolts) x0 y IC 1 IC 2 /

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53 U = v(x) + Ay Where: A is a positive constant. MU x = v’(x) = V(x)/ x=dV/dx, where small MU y = A "The only thing that determines your personal trade-off between x and y is how much x you have." Quasi-Linear Preferences

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54 Example: Quasi-linear Preferences (consumption of beverages) x y 0 IC 1 MRS diminishes at the quantity of X increase But does not depend on quantity of y.

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55 Example: Quasi-linear Preferences (consumption of beverages) IC’s have same slopes on any vertical line x y 0 IC 2 IC 1

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56 Summary 1. Described consumer preferences without any restrictions imposed by budget 2. Minimal assumptions on preferences to get interesting conclusions on demand…seem to be satisfied for most people. (ordinal utility function)

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