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Chapter 4
Principles and Preferences
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics
Principles of decision-making
Consumer preferences
Substitution between goods
Utility
4-2
Building Blocks of Consumer Theory
Preferences tell us about a consumer’s likes and dislikes
A consumer is indifferent between two alternatives if she likes (or dislikes) them equally
The Ranking Principle: A consumer can rank, in order of preference, all potentially available alternatives
The Choice Principle: Among available alternatives, the consumer chooses the one that he ranks the highest
4-3
The Consumer’s Problem
Consumer’s economic problems is to allocate limited funds to competing needs and desires over some time period
Chooses a consumption bundleShould reflect preferences over various bundles,
not just feelings about any one good in isolationDecision to consume more of one good is a
decision to consume less of another
4-4
Principles of Consumer Decision-Making
The More-is-better Principle: When one consumption bundle contains more of every good than a second bundle, a consumer prefers the first bundle to the second
Transitivity: if a > b and b > c, then a > c.
4-5
Indifference Curves
Use when goods are (or assumed to be) available in any fraction of a unit
Represent alternatives graphically or mathematically rather than in a table
Starting with any alternative, an indifference curve shows all the other alternatives a consumer likes equally well
4-6
Properties of Indifference Curves
Thin
Do not slope upward
Separates bundles that are better from bundles that are worse than those that are on the indifference curve
4-8
Families of Indifference Curves
Collection of indifference curves that represent the preferences of an individual
Do not crossComparing two bundles, the consumer
prefers the one on the indifference curve further from the origin
4-10
Formulas for Indifference Curves
More complete and precise to describe preferences mathematically
For example, can write a formula for a consumer’s indifference curves
Formula describes an entire family of indifference curves
Each indifference curve represents a particular level of well-being
Higher levels of well-being are on indifference curves further from the origin
4-13
Figure 4.6: Plotting Indifference Curves
Formula for indifference curves is B = U/S (Starting from U=B*S)
U is well-being, or “utility”
To find a particular curve, plug in a value for U, then plot the relationship between B and S
4-14
Substitution Between Goods
Economic decisions involve trade-offsTo determine whether a consumer has
made the best choice, we need to know the rate at which she is willing to make trade-offs between different goods
Indifference curves provide that information
4-15
Rates of Substitution
Consider moving along an indifference curve, from one bundle to another
This is the same as subtracting units of one good and compensating the consumer for the loss by adding units of another good
Slope of the indifference curve shows how much of the second good is needed to make up for the decrease in the first good
4-16
Figure 4.8: Rates of Substitution
Look at move from bundle A to C
Consumer gains 1 soup; gains 2 bread
Willing to substitute for soup with bread at 2 ounces per pint
4-17
Marginal Rate of Substitution
The marginal rate of substitution for X with Y, MRSXY, is the rate at which a consumer must adjust Y to maintain the same level of well-being when X changes by a tiny amount, from a given starting point
Tells us how much Y a consumer needs to compensate for losing a little bit of X
Tells us how much Y to take away to compensate for gaining a little bit of X
XYMRSXY
4-18
What Determines Rates of Substitution?
Differences in tastesPreferences for one good over another affect the
slope of an indifference curve (weights attached to each good in the utility function)
Implications for MRSStarting point on the indifference curve
People like variety so most indifference curves get flatter as we move from top left to bottom right
Link between slope and MRS implies that MRS declines; the amount of Y required to compensate for a given change in X decreases
4-20
Formulas for MRS
MRS formula tells us the rate at which a consumer will exchange one good for another, given the amounts consumed
Every indifference curve formula has an MRS formula that describes the same preferences
Indifference curves: B=U/S; MRSSB=B/S
4-23
Perfect Substitutes and Complements
Some special cases of preferences represent opposites ends of the substitutability spectrum
Two products are perfect substitutes if their functions are identical; a consumer is willing to swap one for the other at a fixed rate
Two products are perfect complements if they are valuable only when used together in fixed proportions
Note that the goods do not have to be exchanged one-for-one!
4-24
Sample Problem 1 (4.3):
Gary has two children, Kevin and Dora. Each one consumes “yummies” and nothing else. Gary loves both children equally. For example, he is equally happy when Kevin has two yummies and Dora has three, or when Kevin has three yummies and Dora has two. But he is happier when their consumption is more equal. Draw Gary’s indifference curves. What would they look like if he loved one child more than the other?
Utility
Summarizes everything that is known about a consumer’s preferences
Utility is a numeric value indicating the consumer’s relative well-being
Recall that the consumer’s goal is to benefit from the goods and services she uses
Can describe the value a consumer gets from consumption bundles mathematically through a utility function
BSSBSU 52, 4-28
Utility Functions and Indifference Curves
Utility functions must assign the same value to all bundles on the same indifference curve
Must also give higher utility values to indifference curves further from the origin
Can start with information about preferences and derive a utility function
Or can begin with a utility function and construct indifference curves
Can also think of indifference curves as “contour lines” for different levels of utility
4-29
Deriving Indifference Curves from a Utility Function
For each bundle, the utility correspond to the height of the utility “hill”
The indifference curve through A consists of all bundles for which the height of the curve is the same
4-31
Sample Problem 2:
For example assume preferences are described by the following utility function:U = X1/2Y1/2
To plot an indifference curve for this utility function, first isolate Y: U2 = XYY = U2 /X
Then pick some level of utility. Let’s set U = 25
Utility Functions and Indifference Curves
Thus, Y = 5/XWhen X = 1, Y = 25When X = 2, Y = 12.5When X = 3, Y = 8.33When X = 4, Y = 6.25When X = 5, Y = 5And so on…
Describe the indifference curves for the following utility functions:U = X + YU = min(X,Y)
Ordinal vs. Cardinal Utility
Information about preferences can be ordinal or cardinal
Ordinal information allows us to determine only whether one alternative is better than another
Cardinal information reveals the intensity of preferences, “How much worse or better?”
Utility functions are intended to summarize ordinal information
Scale of utility functions is arbitrary; changing scale does not change the underlying preferences
4-34
Marginal Utility
To make a link between MRS and utility, need a new concept
Marginal utility is the change in a consumer’s utility resulting from the addition of a very small amount of some good, divided by the amount added
XUMU X
4-35
Utility Functions and MRS
Small change in X, X, causes utility to change by MUXX
Small change in Y, Y, causes utility to change by MUYY
If we stay on same indifference curve, then –Y/X =MUXMUY
Y
XXY MU
MUMRS
4-36
Marginal Rate of Substitution
Let’s find the MRS for each of the following utility functions:U = X1/2Y1/2;
MUX=(1/2)X-1/2Y1/2 and MUY =(1/2) X1/2Y-1/2
U = X1/3Y2/3
MUX=(1/3)X-2/3Y2/3 and MUY =(2/3) X1/3Y-1/3
U = X + YMUX = Y and MUY = X
Sample Problem 3 (4.14):
Latanya likes to talk on the telephone. We can represent her preferences with the utility function U(B,J) = 18B + 20J, where B and J are minutes of conversation per month with Bill and Jackie, respectively. If Latanya plans to use the phone for one hour to talk with only one person, with whom would she rather speak? Why? What is the formula for her indifference curves?