Topic

Outline

§  Budget Sets and Budget Constraints

§  Consumer Preferences
§  The best feasible choice of consumption
§  Applications
Consumer Choice II
PREFERENCES:UTILITY
 Rationality in Economics

§  Behavioral Postulate:
A decisionmaker always chooses its most
preferred alternative from its set of
available alternatives.
§  So to model choice we must model
decisionmakers preferences.
 Preference Relations
§  Comparing two different consumption
bundles, x and y:
ú  strict preference: x is more preferred than is y.
ú  weak preference: x is as at least as preferred as
is y.
ú  indifference: x is exactly as preferred as is y.
 Preference Relations

§  Strict preference, weak preference and

indifference are all preference relations.
§  Particularly, they are ordinal relations; i.e.
they state only the order in which bundles
are preferred.
 Preference Relations
≺"
§  denotes strict preference;
≺"
x y means that bundle x is preferred
strictly to bundle y.
 Preference Relations
≺"
§  denotes strict preference;
≺"
x y means bundle x is preferred strictly to
bundle y.
§  ∼ denotes indifference; x ∼ y means x and y
are equally preferred.
 Preference Relations
≺"
§  denotes strict preference so
≺"
x y means that bundle x is preferred
strictly to bundle y.
§  ∼ denotes indifference; x ∼ y means x and y
are equally preferred.
§  ≻" denotes weak preference;
~
§  x ≻" y means x is preferred at least as much
~
as is y.
 Preference Relations

§  x ≻" y and y ≻" x imply x ∼ y.

~ ~
 Preference Relations

§  x≻" y and y ≻" x imply x ∼ y.

~ ~
 Assumptions about Preference
Relations
§  Completeness: For any two bundles x
and y it is always possible to make the
statement that either
x ≻" y
or ~
y ≻" x.
~
 Assumptions about Preference
Relations
§  Reflexivity: Any bundle x is always at
least as preferred as itself; i.e.

x ≻"
~
x.
 Assumptions about Preference
Relations
§  Transitivity: If
x is at least as preferred as y, and
y is at least as preferred as z, then
x is at least as preferred as z; i.e.

x≻" y and y ≻" z x ≻"

z.
~ ~ ~
 Utility Functions
§  Formal way to represent preferences
§  A utility function U(x) represents a preference relation
if and only if:
≺"
x x U(x ) > U(x )

≺"
x x U(x ) < U(x )

x ∼ x U(x ) = U(x ).
§  Utility is an ordinal (i.e. ordering) concept, i.e. if U(x) =
6 and U(y) = 2 then bundle x is strictly preferred to
bundle y, but not necessarily preferred three times as
much as is y.
 Indifference Curves

§  Take a reference bundle x . The set of all

bundles equally preferred to x is the
indifference curve containing x ; the set of
all bundles y ∼ x .
§  Since an indifference curve is not
always a curve a better name might be an
indifference set .
 Indifference Curves

x2 x ∼x ∼x
x

x1
 Indifference Curves

x2
≺" ≺"
z x y
x

x1
 Indifference Curves
I1 All bundles in I1 are
x2
x strictly preferred to
all in I2.
z
I2

All bundles in I2 are

y strictly preferred to
I3
all in I3.
x1
 Indifference Curves

x2
WP(x), the set of
x bundles weakly
preferred to x.

I(x) I(x )

x1
Utility Functions & ICs

x2 ≺"
(2,3) (2,2) ∼ (4,1)

Is U(x1,x2) = x1x2 a suitable

utility function to represent
these bundles?

U≡6
U≡4

x1
 Perfect Substitution Indifference
Curves
x2
x1 + x 2 = 5
13
x1 + x 2 = 9
9
x1 + x2 = 13
5
V(x1,x2) = x1 + x2.

5 9 13 x1
All are linear and parallel.
 Extreme Cases of Indifference Curves;
Perfect Complements
x2
45o Each of (5,5), (5,9)
and (9,5) contains
5 pairs so each is
equally preferred.
9
5 I1

5 9 x1
 Extreme Cases of Indifference Curves;
Perfect Complements
x2
45o Since each of (5,5),
(5,9) and (9,5)
contains 5 pairs,
each is less
9 I2 preferred than the
bundle (9,9) which
5 I1 contains 9 pairs.

5 9 x1
 Perfect Complementarity
Indifference Curves
x2
45o
W(x1,x2) = min{x1,x2}

8 min{x1,x2} = 8

5 min{x1,x2} = 5
3 min{x1,x2} = 3

3 5 8 x1
All are right-angled with vertices on a ray
from the origin.
 Indifference Curves for Discrete
Commodities
§  A commodity is infinitely divisible if it can
be acquired in any quantity; e.g. water or
cheese.
§  A commodity is discrete if it comes in unit
lumps of 1, 2, 3, … and so on; e.g.
aircraft, ships and refrigerators.
 Indifference Curves for Discrete
Commodities
§  Suppose commodity 2 is an infinitely
divisible good (gasoline) while commodity
1 is a discrete good (aircraft). What do
indifference curves look like?
 Indifference Curves With a Discrete
Good
Gas-
oline Indifference curves
are collections of
discrete points.

0 1 2 3 4 Aircraft
 Well-Behaved Preferences

§  A preference relation is well-behaved if

it is
ú  monotonic and convex.
§  Monotonicity: More of any commodity is
always preferred (i.e. no satiation and
every commodity is a good).

§  Convex: “mixtures” of goods preferred to

extremes
 Cobb-Douglas Utility Functions
§  Any utility function of the form
U(x1,x2) = x1a x2b

with a > 0 and b > 0

§  Have we seen this one before?
ú  U(x1,x2) = x1x2 (i.e., a= 1 and b = 1)
§  Other examples
ú  U(x1,x2) = x11/2 x21/2 (a = b = 1/2)
ú  V(x1,x2) = x1 x23 (a = 1, b = 3)
ú  Note: a & b tell you much goods 1 and 2 respectively
matter for your satisfaction
Cobb-Douglas Indifference Curves
x2

U(x1,x2) : x1a x2b = k

Curves are hyperbolic,
asymptoting to, but never
touching any axis.

x1
 Marginal Utility
§  Marginal means incremental .
§  The marginal utility of a good i (say a donut)
is the rate at which your total utility changes
when you have one more unit, i.e.
∂U
MU i =
∂xi
§  Example: U(x1,x2) = x1 x22
ú  MU1 = x22
ú  MU2 = 2x1 x2



 Marginal Rate of Substitution
§  The general equation for an indifference curve is
U(x1,x2) ≡ k, where k is a utility level (constant)
§  Totally differentiating this identity gives
∂U ∂U
dx1 + dx2 = 0
∂ x1 ∂ x2
§  What does this give us (in plain English)?


§  MRS: Rate at which a consumer is willing to
“trade-off” one good for another.

 Marginal Rate of Substitution
§  The general equation for an indifference curve is
U(x1,x2) ≡ k, where k is a utility level (constant)
§  Totally differentiating this identity gives
∂U ∂U
dx1 + dx2 = 0
∂ x1 ∂ x2
§  How do we get MRS (hint: it is the slope of IC)?

dx2 ∂U / ∂ x1
=−
dx1 ∂U / ∂ x 2
§  i.e. MRS = -MU1/MU2

Optimal Bundle: ‘Well-behaved’ pref.
•  At A(x1*,x2*), we know that:
x2 Slope(IC) = Slope of BC

•  -MU1/MU2 = -p1/p2

A •  ...or, at A: MU1/p1 = MU2/p2

x 2*
•  In plain English, the ‘bang for
the buck’ from the last penny
spent on each good must be
the same
x 1* x1
• What if that’s not true? Say
MU1/p1 < MU2/p2
•  Spend less on 1 and more on 2
 Perfect Substitutes
Optimal bundle is a
x2 ‘Corner’ Solution. Why?
MRS = -1
(MU1/p1)< (MU2/-/p2) for
all quantities of goods 1
and 2
Slope = -p1/p2 >1 with p1 > p2

x1
 Summary: Finding Optimal Bundle
§  Check to see if the preferences are one of the
special cases.
§  If yes, figure out the optimal bundle on a
case-by case basis.
§  If they are well-behaved, then figure out
ú  MRS
ú  Price ratio
ú  Find Bundle for which MRS=Price ratio( good 1 : 2)