Choices

• The theory of consumer preferences is based

fundamentally on choices
– The steak dinner or the salad bar
Preferences – Major in Economics or Engineering
– Save money for retirement or take that vacation to Maui

ECON 370: Microeconomic Theory • We say a consumer Prefers bundle A to bundle B if:
– Assuming both are feasible
Summer 2004 – Rice University – And all else being equal (¡cēterīs paribus!)
Stanley Gilbert – She would choose bundle A instead of bundle B

Econ 370 - Consumer Preferences 2

Preference Relations Indifference Curves

• Consumers can compare two different • An indifference curve (level set)
consumption bundles, x and y: – Take a reference bundle x´
– strict preference: x ≻ y – Indifference curve: set of all bundles y ∼ x´
• “x is strictly preferred to y”
– weak preference: x ≿ y Good x2
• “x is at least as good as y” (Weakly) Preferred Set
– indifference: x ~ y
x z
• These are ordinal (not cardinal) relations
– Only order alternative bundles Indifference Curve
y
– Do not specify magnitude of preference differences
Good x1

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 Assumptions about Preferences Indifference Curves Cannot Intersect

We usually assume preferences meet the following assumptions:

From I1, x ∼ y
x2 I2
A1 Completeness: All bundles can be ranked. I1 From I2, x ∼ z

A2 Transitivity: If x ≿ y and y ≿ z, then x ≿ z. Implies: y ∼ z , but y ≻ z

x
A3 Non-Satiation: More is always better. y
z
A4 Convexity: The “better-than” set is convex.
x1
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Non-Satiation Convexity

Two points on the same

indifference curve
x2 x2 I1
Strictly
Draw a line drawn between
Better
y b the two points

c Any point on that line will

Strictly x be at least as good
Worse
a Mathematically:
z αa + (1 – α)b ≿ a ~ b

x1 x1
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 Non-Convex Examples Comments about Assumptions
• Assumptions A1 & A2 are essential to our concept of
rationality
x2 • Preferences that also meet Assumptions A3 & A4 are
I1 I3 called Well Behaved.
– Non-Satiation
• This clearly does not apply in the real world
• We can usually get away with it because people will generally choose
a consumption bundle in the region where more is still better (Why?).
• Important exception: ‘Bads’
– Convexity
• There is no fundamental reason why preferences should meet this
I2 • Again, it is mathematically convenient
• It also turns out not to matter much if it is not met
x1
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Examples of Preferences Perfect Substitutes

• Examples that meet our assumptions: • Tastes:
– Perfect Substitutes – If consumer always regards commodities 1 and 2 as
– Perfect Complements equivalent,
– then commodities are Perfect Substitutes.
• Examples that do not meet our assumptions – Only total amount of two commodities in bundles
– ‘Bads’ determines their preference rank-order.
• (But, we can turn a bad into a good…)
– Satiation • Indifference Curves:
– Straight Lines

• Example
– Brand-Name v. Generic Flour

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 Perfect Complements Discrete Goods
• Tastes: • A commodity is infinitely divisible if it can be
– If consumer always consumes commodities 1 and 2 in fixed acquired in any quantity (water, cheese).
proportions,
– Then, commodities are Perfect Complements.
• A commodity is discrete if it comes in indivisible
– Only number of pairs of two commodities determines (cars, refrigerators).
preference rank-order of bundles.
• Indifference curves for discrete goods
• Indifference Curves: – Suppose commodity 1 is infinitely divisible (gas)
– “L-Shaped” Indifference curves – Suppose commodity 2 is discrete (cars)

• Example
– Coffee and sugar

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Marginal Rate of Substitution (MRS) Marginal Rate of Substitution

MRS = rate at which the

x2 x2 consumer is willing to
MRS at x’x’ is slope of
exchange commodity 2
indifference curve at x’x’
for a small amount of
x’ dx2 dx2 x’ commodity 1.
MRS =
dx1 dx1

x1 x1
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 MRS and Indifference Curves
• Two goods: IC has negative slope
– I.e., MRS < 0

• If (and only if) prefs. are strictly convex:

– MRS always increases with x1 (becomes less
negative)

• MRS decreases (becomes more negative)

as x1 increases ⇒ nonconvex preferences

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