eaton micro 6e ch02

7/27/2019 Eaton Micro 6e Ch02

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2005 Pearson Education Canada Inc.2.1

Chapter 2

A Theory of Preferences


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Theory of Preferences is based on

three ideas regarding individuals:

1. They have consistent preferences.

2. They seek to maximize preferences.

3. They are willing to make tradeoffsbetween different goods.


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Completeness Assumption:

Given any two bundles, one of thefollowing is true:

- Bundle 1 is preferred to bundle 2

- Bundle 2 is preferred to bundle 1

- Bundle 1 is indifferent to bundle2


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Figure 2.1 Possible consumption bundles


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Transitivity Assumption:

Given any three bundles:

- If bundle 1 is at least as good asbundle 2 and bundle 2 is atleast as good as bundle 3, thenbundle 1 is at least as good asbundle 3.


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Non-satiation Assumption:

Given any two bundles, if bundle 1contains more of one good thanbundle 2, and it does not contain less

of the other good, then bundle 1 ispreferred to bundle 2.


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Maximization Assumption:

Individuals always make choices thatleave them better off.


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Figure 2.2 An indifference curve for Eleanor


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Continuity Assumption

Through any consumption bundle inwhich the quantity of at least onegood is positive, there is a

continuous indifference curve.


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Figure 2.3 Clems indifference curves


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Figure 2.4 Slope of an indifference curve


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Figure 2.5 An indifference map


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Figure 2.6 Impossible indifference curves


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Marginal Rate of Substitution

The marginal rate of substitution (MRS) isthe rate at which someone is willing totrade-off one good for another while

maintaining the same level of satisfaction. More precisely, the marginal rate of

substitution of good 2 for good 1 at anypoint (X1,X2), denoted as MRS (X1,X2), is

the absolute value of the slope of theindifference curve at that point. (SeeFigure 2.7).


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Figure 2.7 Marginal rate of substitution


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Diminishing Marginal Rate

of Substitution

Note that in Figure 2.7 the MRSdiminishes in a movement down theindifference curve.

A person whose preferences areshown in Figure 2.7 is less willing tosubstitute good 2 for good 1 at point

B than at point A.


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Figure 2.8 Constructing a utility function


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Figure 2.10 Perfect substitutes and

perfect complements


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Figure 2.11 Employee preferences for

leisure and income


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Figure 2.12 Preferences for current and

future consumption


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Figure 2.13 The cost of pollution

eaton micro 6e ch02

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