1 Intermediate Microeconomics Preferences

2 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 first 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.

3 Theory of Preferences Consider again a bundle of goods denoted A-{q 1 A, q 2 A, …, q n A } 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.

4 Preferences 3 axioms in our theory of consumer preferences 1. Completeness – An individual can weakly rank any two possible bundles. 2. Reflexivity – A bundle is at least as good as itself. 3. 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.

5 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.

6 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.

7 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? If A is on a higher indifference curve than B, what does this mean? How do we know this? Why are indifference curves drawn with a negative slope? Can indifference curves cross? Why or why not?

8 Interpreting Indifference Curves Indifference curve indicates that at bundle {q 1 ’,q 2 ’}, an individual will be willing to give up Δq 2 units of good 2 to increase consumption of good 1 by Δq 1. What happens as Δq 1 goes to zero? q2q2’q2q2’ q1q1 Δq1Δq1 -Δq2-Δq2 q1’q1’

9 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?

10 Well-behaved preferences In addition to our three Axioms and monotonicity, we will also generally assume that weakly preferred sets are convex. Convex preferences – If bundles B-{q 1 B, q 2 B } and C-{q 1 C, q 2 C } are in weakly preferred set to A, then so will the bundle {(q 1 B + q 1 C )/2, (q 2 B + q 2 C )/2 }. For example, consider the bundle {2,2}. Suppose that for some person, both {1,3} and {4,1} are in the weakly preferred set to {2,2}. Then, if this person’s preferences are convex, the bundle {2.5, 2} will also be in the weakly preferred set. 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.

11 Interpreting Indifference Curves Consider an indifference curve of following form. Does it represent convex preferences? What does this shape reveal about MRS as q 1 increases and q 2 decreases? What is intuition? q1q1 q2q2

12 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 q 1 increases and q 2 falls. What is intuition? Examples: Chips and Coke? Coke and a composite good? Coke and Pepsi? What is intuition behind different shapes of indifference curves?

13 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?

14 Interpreting Indifference Curves Consider the following indifference curves. Are they well-behaved? Do they violate any of our axioms? q1q1 q2q2 q1q1 q2q2 q1q1 q2q2

15 Thinking again about assumptions over preferences While our underlying preference axioms and assumptions seem relatively innocuous, they do rule out some potentially interesting issues: Interaction between monetary value and preferences. Peer effects

16 Modeling Preferences over Other Types of Goods Suppose again you work for Doctors Without Borders What will your indifference curves look like between “treating Tuberculosis patients” vs. “treating malaria patients”?