Chapter 4
Principles and Preferences
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Last Chapter Review
During the last chapter, we looked at the
basic concepts concerning…
Maximizing benefits less costs
Thinking on the margin
Marginal Benefit vs. Cost
Sunk costs and decision-making
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Main Topics
Today’s class is the beginning of material that
may be new to you. This, and the next 10
chapters involve the principles of economic
decision making.
Today will deal with decisions by consumers
concerning the goods they purchase.
Topics covered:
Principles of decision-making
Consumer preferences
Substitution between goods
Utility
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Building Blocks of Consumer
Theory
To start our class, we will first
contemplate the food in front of us….
Peperos
Chips
Coke
Which products are the “best”?
Which of these products do you like best?
Worst? Equally well?
How much of each would you like me to
give you?
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Building Blocks of Consumer
Theory
Preferences tell us about a consumer’s likes
and dislikes due to personal, emotional or
intangible reasons.
A consumer is indifferent between two
alternatives if she likes (or dislikes) them
equally
Assumptions of consumer behavior…
The Ranking Principle: A consumer can rank, in
order of preference, all potentially available
alternatives (ties are also possible)
The Choice Principle: Among available alternatives,
the consumer chooses the one that he ranks the
highest
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The Consumer’s Problem
A consumer’s economic problem is to allocated
limited funds to competing needs and desires
over some time period
Chooses a consumption bundle
The collection of goods that an individual consumes
over a given period (hour/day/month/etc)
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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Principles of Consumer DecisionMaking
Madeline likes to
eat at a
restaurant that
only serves
bread and water.
Which bundle is
her first
choice…second
…last? Why?
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Principles of Consumer DecisionMaking
What about your preferences between
pepero and chips?
How would you build a table similar to
that of soup/bread?
Are there any combinations that you like
equally?
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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
Which points
are liked
equally as
much as A?
Which are
not as good?
Which are
better?
WHY?
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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
Why?
Think
about
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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Properties of Indifference Curves
To reiterate….there are 5 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
Indif. curves from the same family do not
cross
Comparing any two bundles, the consumer
prefers the one on the indifference curve
further from the origin
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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” (more later in
lecture)
To find a particular
curve, plug in a value
for U, then plot the
relationship between
B and S
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Indifference Curves - Practice
See p104, In-Text Exercise.
Julie likes Coke and Pepsi.
Indifference curve formula is C=U-1.2P
Draw some of the indif. Curves.
Which bundle does she prefer
1 liter of Coke and no Pepsi
Or 1 liter of Pepsi and no Coke?
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Indifference Curves - Practice
 See p104, In-Text Exercise.
 Solve for U, thereby making a utility function.
 Before C=U-1.2P so now U = C + 1.2P
 Now, we can plug the two bundles into the utility
function to compare them.
 U(C, P) = C + 1.2P
 U(1, 0) = 1 + 1.2(0) = 1
 U(0, 1) = 0 + 1.2(1) = 1.2
 Since the bundle consisting of
one liter of Pepsi and no Coke
provides the greater level of utility,
Judy prefers this bundle.
 Judy gets more “value” or utility
from Pepsi than Coke. Hence 6
Cokes = 5 Pepsis
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Goods and Bads
A bad is an object, condition or activity
that makes a consumer worse off.
Here are 2 different indiv. curve sets.
Which contains a bad?
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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 loses 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 wellbeing when X changes by a tiny amount, from a
given starting point
MRSXY   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
Marginal Rate of
Substitution for soup
with bread at bundle
A
MRSSB=-B/S=-3/2
or -1.5 ounces of
bread for 1 pint of
soup
What about the MRS
for bread with soup?
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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
Demonstrates that
people like variety.
We will say than an
indif. curve has a
declining MRS if it
becomes flatter as
we move along the
curve from the NW
to the SE
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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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Importance of MRS
Assists in determining whether different
people will trade.
If trade will result in a mutually beneficial
situation, people will make the exchange.
This mutually beneficial situation is
determined by the peoples’ MRS.
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In-Text Exercise 4.3
Kate (M&M) and Antonio (MD) swapped
8 M&Ms for 5 Milk Duds
What is the MRS for each party?
If each person believed that 2 M&Ms = 1
Milk Dud, would they still have made the
trade?
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In-Text Exercise 4.3
 Since Kate gave up eight M&Ms for five Milk Duds, we know that she
values Milk Duds more than M&Ms. Her MRS for Milk Duds with M&Ms
must be greater or equal to 1.6 (M&Ms / Milk Duds = 8 / 5 = 1.6). This
means that Kate believes that one Milk Dud is a perfect substitute for at
least 1.6 M&Ms. For example, if she believed that one Milk Dud was
worth 2 M&Ms she would have still made this trade, because she’s giving
up less than she would be willing to. On the other hand, if she believed
one Milk Dud was worth fewer than 1.6 M&Ms, say 1.5, then she would
not make this trade because she would be paying more for Milk Duds
than she is willing to.
 Since Antonio willingly gave up five Milk Duds for eight M&Ms, he
probably believes that eight M&Ms have a greater value than five Milk
Duds or, equivalently, he probably believes that 1.6 M&Ms have a greater
value than one Milk Dud. Therefore, Antonio’s MRS for Milk Duds with
M&Ms is at most 1.6, but it is most likely less. If his MRS were equal to 1,
so that he thought one M&M was the same as one Milk Dud, then he
would definitely make this trade with Kate. However, if his MRS were
greater than 1.6, say 2, so that he believed that it took two M&Ms to equal
one Milk Dud, then Antonio would not accept only eight M&Ms for his five
Milk Duds; he would require ten.
 In summary, Kate’s MRS>= 1.6 while Antonio’s MRS<= 1.6.
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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!
Examples?
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Figure 4.12: Perfect Substitutes
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Figure 4.13: Perfect Complements
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Neutrals
Goods are neutral
goods if the
consumer doesn’t
care about it.
Ie. Pepperoni and
sausage on our
pizza. I only care
about the amount of
sausage. Don’t care
about the pepperoni.
Bads
A bad is an object, condition or activity
that makes a consumer worse off.
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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 which assigns a
utility value to each consumption bundle.
U S , B   2S  5S  B 
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Utility Functions and Indif. 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 corresponds 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?”
Difficulty in measuring this kind of utility
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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Summary
Principles of Decision Making
Ranking / Choice Principles
Consumer Preferences
Need to compare Consumption Bundles
Consumers prefer more to less
Indif. curves are thin and never slope up
I.C. that runs through a bundle separates all
better alternatives from all other options.
I.C. from the same family never cross.
For every bad, there is an assoc. good.
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Summary
Substitution between goods
MRS varies from one consumer to another
according to the relative importance the
consumer attaches to the goods in question.
MRS for X with Y declines as X becomes
more plentiful and Y more scarce.
Whether people trade depends upon their
MRS
I.C. for perfect substitutes is a straight line
and L-shaped for complements
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Summary
Utility
Summarizes everything that is known about
a consumer’s preferences
Can create a utility function from a family of
I.C. by assigning the same utility value to all
bundles on the same curve. Higher value
curves correspond to higher levels of wellbeing.
Utility usually used to for ordinal (not
cardinal) information
By itself, marginal utility doesn’t measure
anything meaningful. The ratio though is
equal to equiv. MRS
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Problems
1. Binch Cookies vs. Chips
What is your MRS between the two?
2. After reading this chapter, a student
complains, “What I like and dislike isn't
always the same; it depends on my
mood.” Is this a problem with consumer
preference theory? Why or why not?
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Problems
2. After reading this chapter, a student
complains, “What I like and dislike isn’t
always the same; it depends on my
mood.” Is this a problem with consumer
preference theory? Why or why not?
No. This is not a problem with consumer
preference theory. Consumer preference
theory does not require that preferences
never change (such as with mood). What it
does require is that, at any given time, a
consumer can rank all possible alternatives
(though possibly with ties).
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