Consumer Preferences chapter 4 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objectives Explain the Ranking Principle and the Choice Principle. Illustrate consumers’ preferences for consumption bundles graphically through indifference curves. Understand the properties and functions of indifference curves. Determine a consumer’s willingness to trade one good for another by examining indifference curves. Explain the concept of utility and compare consumption bundles by calculating the numerical values of a given utility function. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Overview Rational consumers follow two basic decision-making principles Ranking principle Choice principle Consumer preferences can be graphically represented through indifference curves Preferences and indifference curves real a consumer’s willingness to substitute one good for another Economists use the utility function to describe consumer preferences Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Principles of Consumer Choice Preferences tell us about a consumer’s likes and dislikes Ranking principle: a consumer can rank, in order of preference (though possibly with ties), all potentially available preferences Choice principle: among the available alternatives, the consumer selects the one that he ranks the highest Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Ranking Principle Implications Preferences are complete: between any pair of alternatives, a consumer either prefers one to the other or is indifferent between them. A consumer is indifferent between two alternatives if he likes (or dislikes) them equally Preferences are transitive: if the consumer prefers one alternative to a second, and prefers the second alternative to a third, then he also prefers the first alternative to the third. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Consumption Bundles A consumption bundle is the collection of goods that an individual consumes over a given period Consumer choices reflect how a consumer feels about various consumption bundles, rather than how the consumer feels about one good in isolation More-is-better principle: when one consumption bundle contains more of every good than a second bundle, a consumer prefers the first bundle to the second. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Ranking Consumption Bundles – Example Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Indifference Curves An indifference curve shows all consumption bundles that a consumer likes equally well Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Properties of Indifference Curves Indifference curves are thin   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Properties of Indifference Curves Indifference curves are thin ICs do not slope upward   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Properties of Indifference Curves Better-than-A bundles Indifference curves are thin IC do not slope upward The IC that runs through consumption bundle A separates all the better-than-A bundles from the worse-than-A bundles Worse-than-A bundles Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Families of Indifference Curves A family of indifference curves is a collection of indifference curves that represent one individual’s preferences Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Properties of Indifference Curves Indifference curves are thin IC do not slope upward The IC that runs through consumption bundle A separates all the better-than-A bundles from the worse-than-A bundles IC curves from the same family do not cross By the transitive property of the ranking principle, the consumer should be indifferent between B and D By being on the same indifference curve, the consumer is indifferent between A and B.   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Properties of Indifference Curves Indifference curves are thin IC do not slope upward The IC that runs through consumption bundle A separates all the better-than-A bundles from the worse-than-A bundles IC curves from the same family do not cross Consumer prefers bundles on IC furthest from the origin Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Plotting Indifference Curves from a Formula   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Goods vs. Bads A bad is an object, condition, or activity that makes a consumer worse off We can think of a bad as the absence of a good For example, we can think of a student choosing leisure time (a good) instead of study time (a bad) Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Substitution between Goods A consumer can substitute one good for another so that she is indifferent between the two bundles For example, in moving from bundle A to bundle B, Madeline loses 1 pint of yogurt and gains 2 ounces of pizza The rate at which Madeline is willing to substitute for yogurt with pizza is 2 ounces per pint Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Substitution between Goods   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Indifference Curves and the MRS The marginal rate of substitution for frozen yogurt with pizza at bundle A equals the slope of the line drawn tangent to the indifference curve running through point A. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

What Determines Rates of Substitution? Within the same indifference curve, as pizza becomes more scarce and yogurt becomes more plentiful, the MRS for yogurt with pizza falls. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

What Determines Rates of Substitution? Angie likes yogurt relative to pizza more than Marcus To keep Angie indifferent after sacrificing one pint of yogurt, she needs three additional ounces of pizza Compare with Marcus, who would need just ½ ounce of pizza to compensate for one less pint of yogurt Angie’s MRS for yogurt with pizza is higher than Marcus’ MRS Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Why Are Rates of Substitution Important? Mutually beneficial trade depends on the marginal rates of substitution of the individual potentially involved in a trading relationship. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Special Case – Perfect Substitutes Two products are perfect substitutes when their functions are identical, so that a consumer is willing to swap one for the other at a fixed rate. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Special Case – Perfect Complements Two products are perfect complements if they are valuable only when used together in fixed proportions. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Utility   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

From Indifference Curves to Utility Function Same utility value to all points on a single indifference curve. Higher utility values for indifference curves that correspond to higher levels of well-being (further from the origin). Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

From Utility Function to Indifference Curves The indifference curve passing through A consists of all the bundles for which the height of the utility function is the same. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Ordinal vs. Cardinal Utility Ordinal information allows us to determine only whether one alternative is better or worse than another. Cardinal information tells us something about the intensity of those preferences. In modern microeconomic theory, utility functions are only intended to summarize ordinal information, rejecting old cardinal interpretations of utility. Example: if one consumption bundle has a utility value of 10 and a second has a utility value of 5, we know the consumer prefers the first to the second, but it does not necessarily make him twice as happy. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Utility Functions and the MRS Marginal utility is the change in the consumer’s utility resulting from the addition of a very small amount of some good, divided by the amount added. Moving along the same indifference curve, for small changes in X and Y… Replacing (1) into (2)… From the definition of MRS… Replacing (3) into (4)…   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Utility Functions and the MRS The marginal utility associated with a particular good is meaningless, since its unit has no practical meaning. On the other hand, the marginal rate of substitution is the ratio of marginal utilities, and thus it is unit free. If we change the units of the utility function, the MRS remains constant. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Some Special Utility Functions Cobb-Douglas utility functions Quasi-linear utility functions Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Cobb-Douglas Utility Functions   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Cobb-Douglas Utility Functions Two families of indifference curves for Cobb-Douglas utility functions Light red: a = b = 1 Dark red: a = 3 and b = 1 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Quasi-Linear Utility Functions   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Review Consumer theory assumes that consumers rank available bundles and choose the one they rank highest (ranking and choice principles). Consumer preferences can be graphically represented with indifference curves. The marginal rate of substitution varies across consumers according to the relative importance the consumer attaches to the goods in question. Usually the marginal rate of substitution for X with Y declines as X becomes more plentiful and Y becomes more scarce (declining MRS). The concept of utility summarizes everything that is known about a consumer’s preferences. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Looking Forward Next we will introduce the budget line, and how it interacts with the indifference curves to determine the consumer’s best choice and yield the consumer’s demand. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.