Engineering Economics

Course code-SM300
Lecture -6
Consumer Preferences (cont.)

• Basic Assumptions about Preferences:

• These hold true for most people in most situations, thus imposing degree
of Rationality and Reasonableness on Consumer preferences for analysis.
1. Completeness :
Preferences are assumed to be complete. Consumers can compare and rank
all possible baskets.
Thus, given 2 market baskets A and B, a consumer will
– Prefer A to B or
– Prefer B to A or
– Be indifferent between the two,
where indifferent  the person will be equally satisfied with either basket.
• When can the above assumption fail?
Note: These preferences ignore costs. A consumer might prefer pizza
to burger but buy burger because it is cheaper.
2. Transitivity :
Preferences are assumed to be transitive If consumer has preference
such that
Basket A > Basket B > Basket C (where > means “preferred over”)
Basket A > Basket C
[i.e. No Cycles in preferences] Transitivity assumption is necessary for
consumer consistency.
3. More is Better than Less
Goods are assumed to be desirable i.e. to be “Good” Hence,
consumers always prefer more of any good to less. Also it is assumed
that consumers are never satisfied… more is always better even if a
little better. Thus “bads” like pollution are ignored in this analysis.
Indifference Curves

• It is used to show a consumer’s preferences graphically Indifference

Curve represents all combinations of market baskets that provide a
consumer with the same level of satisfaction.
Consumer Preferences (contd.)
Describing
consumer
preferences:
Since more is preferred to less,
comparison of baskets in the
shaded areas easy… Basket A is
clearly preferred to basket G,
while E is clearly preferred to A.

However, A cannot be compared with

B, D, or H without additional
information.
Plotting an indifference curve
An Indifference Curve
What can you say more about
preferences between various
baskets?

It is now clear that B, A and D

are on same indifference curve


Indifference

between

the combinations.

However, this consumer

prefers A to both H and G since
 Indifference Map
Graph containing a set of indifference curve
showing the market baskets among which a consumer is
indifferent .
An Indifference Map
Figure shows three indifference
curves
That form part of indifference map

The entire map includes infinite

number of indifference curves
Indifference Curves in an Indifference Map Cannot Intersect
This is Not Possible Why?

Here consumer is indifferent

Between A, B and D goods basket.

However, as per the assumptions,

B should be preferred over D
since
it has more of both Food and
Clothing
 Violation of assumption…
therefore not possible
Indifference Curves Are Downward Sloping
• This follows from the assumption that more of the good is always
better than the less.
• If indifference curve sloped upwards, then there would exist a
point on the curve where the consumer would be indifferent
between the baskets even if he/she is getting more of both the
goods.

VS
Indifference Curves Are Convex to the origin
• This is another important assumption regarding Indifference
Curves for “Goods”… Is it meaningful?
• Yes… As more and more of one good is consumed, we can expect
the consumer will prefer to give up fewer and fewer units of a
second good to get additional units of the first one!
 Consumers generally prefer balanced market baskets

Increased Increased
Preferenc Preferenc
e e
VS

Note: For analysis “Bads” can be redefined into “Goods” Eg. “No Smog” is “good”
 Marginal rate of substitution
= Maximum amount of a good that a consumer is willing to give up in
order to obtain one additional unit of another good.
The magnitude of the slope of an
indifference curve measures the
consumer’s marginal rate of substitution
(MRS) between two goods.

Here, the MRS between clothing (C) and

food (F) falls from 6 (between A and B)
to 4 (between B and D) to 2 (between D
and E) to 1 (between E and G).
When the MRS diminishes along an
indifference curve, the curve is convex.
 Shapes of indifference curves
The shape of an indifference curve describes the willingness of a
consumer to substitute one good for another. An indifference curve
with a different shape implies a different willingness to substitute.
Perfect Substitutes:
Two goods for which the marginal rate of substitution of one for the
other is a constant.
Eg. Blue ink pen and Dark-blue ink pen for writing notes in class.
Perfect Complements:
Two goods for which the Marginal Rate of
Substitution is zero or infinite.
Eg. Left shoe and Right shoe
How will the Indifference Curves be in above two cases?
 Consumer Preferences (contd.)

Note: The slope of the indifference curves need not be 1 for perfect
substitutes. Eg. If one believes that one 16-megabyte memory chip is
equivalent to two 8-megabyte chips because both combinations have the
same memory capacity
the slope of the indifference curve will be 2(16-Mbyte chip is on x-axis)
 Consumer Preferences Eg.- Designing a New
Automobile
Suppose you work for a leading car company and have to help them plan
new models to introduce.
To find out how much people are willing to pay for various attributes, the
company undertakes a survey,The following are the preference curves for
two different market segments (i.e. groups of consumers), say A & B.

Which attribute will you focus on for designing the new car models for
each of the Market Segments?
 Consumer Preferences Eg.- Designing a New
Automobile
Ans:

For market segment A, as compared to market segment B, attribute

“Acceleration” is more important since the market segment is
willing to give up more of space to get little more of acceleration.
• Note:
• The scale and units of the two attributes are the same for the
indifference maps of Market Segments A & B.
• If the indifference curve (or slope) is steep, then MRS(marginal rate
of substitution) is high, this means the consumer is willing to give up
a lot of good y for an additional unit of x.
• If the indifference curve (or Slope) is flat, then the MRS is low.
Utility functions and indifference
curves
• Consumer theory relies on the assumption that consumers can provide only
relative rankings of market baskets.
• Yet, it is often useful to assign numerical values to individual baskets.
• In the language of economics, the concept of utility refers to the numerical
score representing the satisfaction that a consumer gets from a market
basket. i.e., utility is a device used to simplify the ranking of market baskets.
Utility Function - A utility function is a formula that assigns a level of utility to
each market basket.
Eg. If the utility function for food (F) and clothing (C) is U(F,C) = F + 2C,
calculate utility for market basket
(i) 8 units of food, 3 units of clothing and
(ii) 6 units of food and 4 units of clothing and
(iii) 4 units of food and 4 units of clothing.
Also comment on the findings.
• Ans.
(i) U(8,3) = 8 + 2*3 = 14
(ii) U(6,4) = 6 + 2*4 = 14
(iii) U(4,4) = 4 + 2*4 = 12
• Baskets (i) and (ii) are on same utility curve and they are preferred
over (iii) Let another utility function be U(F,C) = FC… then all the
utility curves would be such that their product would be equal to the
value of FC.
• Suppose U(F,C) = 25… then some of the market baskets on this
indifference curve would be (5,5), (10,2.5), (2.5,10) and so on…
Another indifference curve could be at U(F,C) = 50 or U(F,C) =100.
• How will the indifference map look like?
Cardinal Utility Function =
Utility function describing by how much one market basket is
preferred to another.
• However, in real world we have no way of telling whether a person gets
twice as much satisfaction from one market basket as from another.
• Nor do we know whether one person gets twice as much satisfaction as
another from consuming the same basket.
• Hence, for understanding consumer behavior, Ordinal rather than
Cardinal Utility Function is considered.
• Ordinal Utility Function = Utility function that generates a ranking of
market baskets in order of most to least preferred. It does not indicate
by how much one is preferred to another.
 Budget constraint
Budget Constraints = Constraints that consumers face as a result
of limited incomes.
• Budget Line All combinations of goods for which the total
amount of money spent is equal to income.
• Consider that you have a fixed amount of income, I, that can
be spent on food and clothing.
• Let F = amount of food purchased and C = amount of clothing.
Let the prices of the two goods be PF and PC ., then PF F =
amount of money spent on food and PCC = amount of money
spent on clothing such that PF F + PCC = I (ignoring savings) If
price of food = $1 per unit and price of clothing is $2 per unit
and the weekly income is $80 then the Budget line becomes F +
2C = 80…
How will the graph look like?
 Budget constraint (continue)

The slope of the budget line (measured between points B and D) is

−PF/PC = −10/20 = −1/2
 Effects of Changes in Income and Prices

Effects of change
In income: An Increase
or decrease in income will
Shift the budget line

A change in income (with prices unchanged) causes the budget line

to shift parallel to the original line (L1).
 Effects of changes in Price and Income

A change in the price of one good (with income unchanged) causes

the budget line to rotate about one intercept.
 Consumer choices
Given preferences and budget constraints, and assuming that consumers
make this choice in a rational way-- that they choose goods to maximize
the satisfaction they can achieve, given the limited budget available to
them, the maximizing market basket must satisfy two conditions:
1) It must be located on the budget line
2) It must give the consumer the most preferred combination of goods
and services.

Maximum satisfaction by choosing market basket A.

At this point, the budget line and indifference curve U2
are tangent, and no higher level of satisfaction (e.g.,
market basket D) can be attained.
 Consumer choices (continue)
The basket which maximizes satisfaction must lie
on the highest indifference curve that touches the budget
line.
Point A is the point of tangency between indifference curve U2 and
the budget line.
At A, slope of the budget line = slope of the indifference curve.
For the indifference curve, at point A, the slope of the tangent can be
defined as, ∆C/∆F = negative of MRS i.e. – MRS
i.e. MRS = -
∆C/∆F
For the budget line, at point A the slope can be defined as,
Y-intercept/ X-intercept = - (I/PC) / (I/PF) = - PF/PC = ∆C/∆F
Therefore, we can say that satisfaction is maximized
(given the
budget constraint) at the point where
Total utility v/s Marginal utility
Total Utility (TU) = The amount of satisfaction received from all the
units of a good or service consumed.
Marginal Utility (MU) = The additional satisfaction
obtained from consuming one additional unit of a good or
service.
Law of Diminishing Marginal Utility
It states that the amount of extra or marginal utility declines as a
person consumes more and more of a good. Eg.
Total Utility and Marginal Utility (Contd.)