ECONOMICS 10A

1PREFERENCES Chapter 3Learning goals for todayUnderstanding common assumptions of consumer preferencesRepresenting a preference set through indifference curvesGoing through examples dealing with consumer preferences2Consumer PreferencesConsumption bundles are lists of goods and services that the consumer makes a choice about how much to consume.Consider a simple example in which a consumer consumes 2 apples and 5 bananas:The consumption bundle (xa,xb) is (2,5).xa = amount of apples consumedxb = amount of bananas consumed

34The Commodity PlaneGraphical representation of 2 apples, 5 bananasApples (xa)Bananas (xb) 2 5 (2, 5)5Multiple CommoditiesTwo goods represented asOrdered pair (x1,x2) in commodity plainOften sufficient for thinking about trade-offs, ceteris paribus. But sometimes we need more.What about 3 goods?Ordered triple (x1,x2,x3) in commodity 3-space

What about n goods?Ordered n-tuple (x1,x2, , xn) in commodity n-space

(x1,x2,x3)5Consumer PreferencesPreferences describe how consumers rank different consumption bundlesGiven any two consumption bundles, (x1,x2) and (y1,y2), the consumer can tell us whetherhe strictly prefers one to the other: (x1,x2) f (y1,y2)orhe is indifferent between the bundles: (x1,x2) ~ (y1,y2) orhe weakly prefers one to the other: (x1,x2) (y1,y2)

6~f Helpful NotationStrictly prefers f (also written >)Indifferent ~Weakly prefers(also written )Examples 1 apple and 1 orange ~ 2 apples2 apples now f 2 apples tomorrowFlows vs. stocksWe will more often be concerned with flows (2 apples per week)

7~f -If something is strictly preferred then it is also weakly preferred7Consumer PreferencesNote:1. If (x1,x2) (y1,y2) and (y1,y2) (x1,x2), then (x1,x2)~(y1,y2)

2. If (x1,x2) (y1,y2) but we also know that (x1,x2)~(y1,y2) is not true, then (x1,x2)f(y1,y2)

8~f ~f ~f Assumptions about PreferencesCompletenessAny two bundles can be compared(x1,x2) (y1,y2) or(y1,y2) (x1,x2) orboth, in which case the consumer is indifferent

ReflexivityAny bundle is at least as good as itself(x1,x2) (x1,x2)

9~f ~f ~f Assumptions about PreferencesTransitivityIf (x1,x2) (y1,y2) and (y1,y2) (z1,z2), then (x1,x2) (z1,z2)10~f ~f ~f 10QuestionIs it reasonable to have a situation where (x1,x2) f (y1,y2) and (y1,y2) f (x1,x2)?

YesNoI am indifferent between a) and b)

11Indifference CurvesIndifference curves are graphical representations of preferences.We can draw an indifference curve (IDC) through any consumption bundle we wantThe IDC through a consumption bundle consists of all bundles of goods that leave the consumer indifferent to the given bundle12Indifference CurvesIDC-bundles indifferent to(x1,x2)x2x1x2x1Weakly Preferred Set13-recall if something is strictly preferred it is also weakly preferred13Indifference CurvesIf we make no further assumptions about preferences, the IDCs can take peculiar shapesBut even at this level of generality, we can state an important principle of IDCs:IDCs represent distinct levels of preference and therefore cannot cross

14Indifference Curvesx2x1xzyThe diagram shows us that:x~z & z~y x~y which is clearly not the case1516QuestionIs A preferred to B?

YesNoMakes no senseAB17QuestionCan indifference curves cross?Yes, intersecting indifference curves do not violate any of the assumptions about preferencesNo, intersecting indifference curves violate assumptions about preferencesExamples of preferencesPerfect SubstitutesPerfect ComplementsBadsNeutralsSatiationDiscrete Goods181. Perfect SubstitutesTwo goods are perfect substitutes if the consumer is willing to substitute one good for the other at a constant rate19IDCSlope = -1x2x1Diagram AIDCSlope = -2x2x1Diagram B1. Perfect SubstitutesIDCs have a constant slopeDifferent goods have different rates of substitution:Want one of good 2 to give up one unit of good 1 to remain equally happy (diagram a) Want two of good 2 to give up one unit of good 1 to remain equally happy (diagram b)202. Perfect Complements L-shaped indifference curvesComplements are consumed in fixed proportions, but not necessarily at a one to one rate2 spoons of sugar to 1 cup of coffee1 part Jack Daniels Whiskey to 3 parts Coca-Cola212. Perfect ComplementsLeftshoesRightshoes22Goods that are always consumed together in fixed proportions are perfect complementse.g. Right and left shoes

More on preferences next timeMake sure to learn the first two examples we did todayThis may help in learning the other examples we cover in the next lecture23Important learning pointsIndifference curves tell us ordering of preferencesMake sure to know how to solve different kinds of problems dealing with preferencesComing soonWe will combine budget constraint and preference concepts to solve constrained optimization problems

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