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
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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
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The Consumer’s Problem
Consumer’s economic problems is to allocated
limited funds to competing needs and desires
over some time period
Chooses a consumption bundle
Should reflect preferences over various
bundles, not just feelings about any one good
in isolation
Decision to consume more of one good is a
decision to consume less of another
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Principles of Consumer DecisionMaking
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
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
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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
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Figure 4.1: Identifying Alternatives
and Indifference Curves
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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
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Figure 4.2: Indifference Curves Ruled Out by the
More-is-better Principle
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Families of Indifference Curves
Collection of indifference curves that
represent the preferences of an individual
Do not cross
Comparing two bundles, the consumer
prefers the one on the indifference curve
further from the origin
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Figure 4.3: A Family of
Indifference Curves
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Figure 4.4: Indifference Curves
Do Not Cross
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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
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Figure 4.6: Plotting Indifference
Curves
Formula for
indifference curves is
B = U/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
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Substitution Between Goods
Economic decisions involve trade-offs
To 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
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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
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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
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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
MRS XY   Y X
 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
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Figure 4.9: Marginal Rate of
Substitution
MRSSB=-B/S=-3/2
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What Determines Rates of
Substitution?
Differences in tastes
Preferences for one good over another affect the
slope of an indifference curve
Implications for MRS
Starting 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
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Figure 4.10: Indifference Curves
and Consumer Tastes
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Figure 4.11: MRS along an
Indifference Curve
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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
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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!
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Figure 4.12: Perfect Substitutes
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Figure 4.13: Perfect Complements
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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
U S , B  2S  5S  B
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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
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Figure 4.14: Representing
Preferences with a Utility Function
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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
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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
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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
MU X  U X
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Utility Functions and MRS
MRS XY
MU
X

MU Y
Small change in X, X, causes utility to
change by MUXX
Small change in Y, Y, causes utility to
change by MUYY
If we stay on same indifference curve,
then –Y/X =MUX/MUY
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