Chapter 2 A Theory of Preferences

Theory of Preferences is based on three ideas regarding individuals: They have consistent preferences. They seek to maximize preferences. They are willing to make tradeoffs between different goods.

Completeness Assumption: Given any two bundles, one of the following is true: - Bundle 1 is preferred to bundle 2 - Bundle 2 is preferred to bundle 1 - Bundle 1 is indifferent to bundle 2

Figure 2.1 Possible consumption bundles

Transitivity Assumption: Given any three bundles: - If bundle 1 is at least as good as bundle 2 and bundle 2 is at least as good as bundle 3, then bundle 1 is at least as good as bundle 3.

Non-satiation Assumption: Given any two bundles, if bundle 1 contains more of one good than bundle 2, and it does not contain less of the other good, then bundle 1 is preferred to bundle 2.

Maximization Assumption: Individuals always make choices that leave them better off.

Figure 2.2 An indifference curve for Eleanor

Continuity Assumption Through any consumption bundle in which the quantity of at least one good is positive, there is a continuous indifference curve.

Figure 2.3 Clem’s indifference curves

Figure 2.4 Slope of an indifference curve

Figure 2.5 An indifference map

Figure 2.6 Impossible indifference curves

Marginal Rate of Substitution The marginal rate of substitution (MRS) is the rate at which someone is willing to trade-off one good for another while maintaining the same level of satisfaction. More precisely, the marginal rate of substitution of good 2 for good 1 at any point (X1,X2), denoted as MRS (X1,X2), is the absolute value of the slope of the indifference curve at that point. (See Figure 2.7).

Figure 2.7 Marginal rate of substitution

Diminishing Marginal Rate of Substitution Note that in Figure 2.7 the MRS diminishes in a movement down the indifference curve. A person whose preferences are shown in Figure 2.7 is less willing to substitute good 2 for good 1 at point B than at point A.

Figure 2.8 Constructing a utility function

Figure 2.9 Different preferences and different indifference curves

Figure 2.10 Perfect substitutes and perfect complements

Figure 2.11 Employee preferences for leisure and income

Figure 2.12 Preferences for current and future consumption

Figure 2.13 The cost of pollution