Consumer Preferences and the Concept of Utility

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Consumer Preferences and the Concept of Utility

© All Rights Reserved

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You are on page 1of 56

Consumer Preferences

and the Concept of Utility

Outline

Introduction

Description of consumer preferences

The Utility functions

Indifference Curves

Marginal rate of substitution

Special functional forms

2

Introduction

useful for analyzing economic questions

concerning markets.

demand to obtain the market demand curve.

But, how do individuals decide what to

consume and how much to consume.

Introduction

We need to develop a model about individual or

consumer behavior

Model is based on:

1.

2.

3.

pleasure people derive from goods and services.

(Chapter 3)

Consumers face constraints (budget) that limit their

choices

Consumers maximize their well-being or pleasure from

consumption, subject to the constraints they face.

predict consumer behavior. But, still as simple as

possible.

Description of Consumer

Preferences

Consumer Preferences tell us how the

consumer would rank any two basket of

goods, assuming these allotments were

available to the consumer at no cost.

baskets or bundles is a collection of goods or

services that an individual might consume.

Properties of Consumer

Preferences

Behavior

1. Complete:Preferences are complete if the

2.

Transitive

:

No illogical

behavior

goods

A strictly preferred to B (A B )

B strictly preferred to A (B A )

indifferent

between A and B (A B)

prefers basket A to basket B, and basket B

basket C also prefers basket A to basket C

A B and B C A C NOT C A

6

Properties of Consumer

Preferences

3.

monotonic if a basket with more of at least one

good and no less of any good is preferred to the

original basket. free disposal cant be worse of

with more

The more is better assumption is also known as the

property of non-satiation.

It assumes are looking at what economists call a

good. Something we want more of

We are not looking at a bad i.e. pollution

We can relax this assumption it is the first two that are

crucial for the analysis

Preferences Examples

AgeNumberofSubjectsIntransitiveChoices(%)

43983

53382

62382

73578

84068

95257

104552

116537

128123

138141

Adults9913

Source:SeeHirshleifer,JackandD.Hirshleifer,Price Theory and Applications.SixthEdition.Prentice

Hall:UpperSaddleRiver,NewJersey.1998.

consumer ranks different baskets of goods. But it

does not say by how much (i.e. 2 times as much)

intensity of the consumer preferences (i.e. they like

basket A 10 times more than basket B).

more than eating bad Chinese. Putting an exact number to

our preferences is hard! this is why we use ordinal

rankings for consumer preferences

10

Students take an exam. After the exam, the

students are ranked according to their

performance. An ordinal ranking lists the

students in order of their performance (i.e.,

Harry did best, Joe did second best, Betty did

third best, and so on). A cardinal ranking

gives the grade of the exam, based on an

absolute grading standard (i.e., Harry got 50,

Joe got 100, so Joe did 2 times better than

Harry).

11

Utility Function

satisfaction that a consumer receives from

any basket of goods.

U=F(x1,x2,x3, .., xn), where

the xs are quantities of n

goods that might be

consumed in a period

magnitude of the number that the function assigns

has no significance.

12

Implications

difference in magnitudes of utility have no

interpretation per se utility not comparable

across individuals any transformation of a utility

function that preserves the original ranking of

bundles is an equally good representation of

preferences.

e.g. U = xy vs. U = xy + 2 represent the same

preferences.

13

example)

U(y): total

Are the assumptions on

utility of

U(y) = y

muffins

preferences

meet?

1.75

.5

1.5

1.0

B

A

1

2

3

y, weekly consumption of muffins

14

Marginal Utility

Marginal Utility: Rate at which total utility

changes as the level of consumption rises.

- Each new muffin makes you happier, but

makes you happier by smaller and smaller

amount.

U U

MUy

Slopeoftheutilitycurve

y y

15

Marginal Utility

The marginal utility:of a good, x, is the additional utility

that the consumer gets from consuming a little more of x

when the consumption of all the other goods in the

consumers basket remain constant.

U/x (y held constant) = MUx= U/ x

U/y (x held constant) = MUy = U/ y

orthe marginal utility of x is the slope of the utility

function with respect to x.

that the marginal utility falls as the consumer consumes

more of a good

16

Marginal Utility

MU(y):

marginal

utility of

muffins 1.00

.50

must always be positive.

-Diminishing marginal utility

-A positive marginal utility means you like

the good. Otherwise you would get zero or

perhaps negative marginal utility

.25

1 2

3

y, weekly consumption of muffins

17

example)

Indifference

curve

18

Clothing

-2 good graph (keeps it simple)

- Along curve consumer is

indifferent between each of the

bundles of food and clothing

-Same level of utility for bundle

A, B, and C

A

B

C

food

19

Indifference Map:

Clothing

Are indifferent to any bundle along

an

indifference curve. But more is

better so are better

off as

we move

Preference

direction

( happier

away from thethe

origin.

further away from the origin

IC2 for U = 6

IC1 for U=4

Food

20

is the set of all baskets for which the

consumer is indifferent

indifference curves for a consumer, it is an

ordinal ranking.

21

Properties of Indifference

Maps

1. Monotonicity => indifference curves have

negative slope and indifference curves

are not thick

2. Transitivity => indifference curves do not

cross

3. Completeness => each basket lies on only

one indifference curve

22

Properties of Indifferences

Maps

One

4. Averages preferred to

extremes => indifference curves are

bowed toward the origin (convex to

the origin).

23

Monotonicity:

Consumers like both goods.

Clothing

Preferred to A

Less

preferred

To meet

monotonicity:

preference curve

must be in the

these areas:

downward sloping

IC1

Food

24

Monotonicity:

Clothing

If more is preferred to less, IC

cannot be thick. B would be

preferred to A, so could not be

on same CI curve.

B

A

food

25

Cross

clothing

IC1

but..by definition of IC,

B indifferent to C

A indifferent to C => B indifferent

to A by transitivity.

Contradiction, B should be preferred

to A.

IC2

B

food

26

Averages Preferred to

Extremes

Clothing

(.5A, .5B)

IC2

IC1

Food

27

graphed

below, are the underlying preferences:

IC1 IC2

y

IC3

IC4

Complete?

Transitive?

Monotonic?

Preference direction

28

graphed

below, are the underlying preferences:

IC1 IC2

y

IC3

Complete? Yes

Transitive? Yes

Monotonic?

No X

Want

as much

IC4

as possible

but dont care about Y: So

same X and more Y are not

B better off, so not

monotonic.

Preference direction

29

Marginal Rate of

Substitution

The marginal rate of substitution:

is the maximum rate at which the consumer

would be willing to substitute a little more of

good x for a little less of good yor

would require in exchange for a decrease in

good y in order to leave the consumer

indifferent between consuming the old basket

or the new basketor

30

Marginal Rate of

It is the rate of exchange between goods x and y

Substitution

MRSx,y=

-y/x

dy

=Slope of the indifference

dx curve

If you like both goods, the MRSx,y will be negative.

31

if the more of good x you have, the

more you are willing to give up to

get

a little of good yor

the horizontal axis and steeper as we move up along the

vertical axis.

Example:TheDiminishingMarginalRateofSubstitution

32

the marginal rate of substitution between x and y is: 1, .

5, 2, or 5? Is the MRS diminishing?

What type of good are

these?

y

3

Perfect substitutes

for each of these?

No could be in a ratio of 2

to 1 (2 oreo cookies for each

glass of milk

IC1

1

IC2

2

IC3

3

33

Graphing an Indifference

y

Curve

Example: Suppose U = xy, graph the utility curve

utility is equal to 10.

2

0

10 = xy

2

34

y

Example: U=20

Preference direction

20 = xy

2

0

10 = xy

2

35

RelativeIncomeandLifeSatisfaction(withinnations)

RelativeIncomePercent>="Satisfied"

Lowestquartile70

8 % more satisfied

Secondquartile78

Thirdquartile82

Highestquartile85

4% more satisfied

3 % more satisfied

SixthEdition.PrenticeHall:UpperSaddleRiver,NewJersey.1998.

36

GNP per

"satisfaction"

capita

< $2,000

number of

median

nations

1

score

5.5

$2,000-$4,000

6.6

$4,000-$8,000

7.0

$8,000-$16,000

14

7.4

SaddleRiver,NewJersey.1998.

37

Marginal Rate of Substitution

MUx(x) + MUy(y) =0 along an IC

MUx/MUy=

-y/x =MRSx,y

U ( x, y )

U

U

dU

.dx

.dy 0

x

y

dy U / x

MRS=

dx U / y

Derive

memoriz

e

38

Marginal Rate of Substitution

indifference curve has a negative slope

(implies monotonicity)

indifference curves are convex to the origin

(implies averages preferred to extremes

39

(where: A and B positive)

MRSx,y = MUx/MUy = 2Ax/2By = Ax/By

Marginal utilities are positive (for positive x and y)

marginal utility of y increases in y

40

Implications of this

Indifference curves are negatively-sloped,

bowed out from the origin, preference direction

is up and right

41

y

Example:GraphingIndifferenceCurves

Concave: prefer extremes to

averages

Preference direction

IC1

0

IC2

x

42

Is more better for both goods? Yes, since

marginal utilities are positive for both.

diminishing? Yes. (For example, as x increases,

for y constant, MUx falls.)

c. What is the marginal rate of substitution

of x for y? MRSx,y = MUx/MUy = y/x

43

A value of x = 0 or y = 0 is inconsistent with any

positive level of utility.

44

y

Example: Graphing Indifference Curves

IC1

x

45

y

Example: Graphing Indifference Curves

Preference direction

IC2

IC1

x

46

1. Cobb-Douglas: U = Axy

where: + = 1; A, , positive constants

MUX = Ax-1y

MUY =

Ax

y-1

MRSx,y =(y)/

(x)

and y not on the total amounts of X and y. So indifference curves

for different levels of Utility look identical to each other no matter

how far away from the origin they are.

47

Perfect Substitutes: U = Ax + By

Where: A, B positive constants

MUx = A

MUy = B

B/A units of y everywhere

(constant MRS).

Note: marginal rate of substitute only depends on the ratio of A

and B not on the total amounts of X and y. So indifference curves

for different levels of Utility look identical to each other no matter

how far away from the origin they are.

48

Example:PerfectSubstitutes(Tylenol,Extra-StrengthTylenol)

Slope = -A/B

IC1

IC2

IC3

x

49

3.PerfectComplements:U=min( x, y)

take

The smaller of the two constants. I.e you want 8 oz

Coffee with one oz of cream U = min( x, 8 y),

where x is cream and y is coffee.

(corner)

50

Example:PerfectComplements(nutsandbolts)

IC1

x

51

Example:PerfectComplements(nutsandbolts)

IC2

IC1

x

52

Quasi-Linear Preferences

U=v(x)+Ay

Where: A is a positive constant.

MUy = A

"The only thing that determines your personal

trade-off between x and y is how much x you

have."

53

Example:Quasi-linearPreferences

(consumptionofbeverages)

quantity of X increase

But does not depend on

quantity of y.

IC1

54

Example:Quasi-linearPreferences

(consumptionofbeverages)

IC2

IC1

vertical line

55

Summary

1. Described consumer preferences without

any restrictions imposed by budget

2. Minimal assumptions on preferences to get

interesting conclusions on demandseem to

be satisfied for most people. (ordinal utility

function)

56

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