Intermediate Microeconomics
Preferences
1
Consumer Behavior

Budget Set organizes information about possible choices
available to a given consumer.

Next step is to determine how a consumer will choose
among the bundles available in his or her budget set.

To do so, we make the seemingly obvious assumption that
individuals are rational:


Each individual chooses the bundle he or she most prefers
among all bundles available in his or her budget set.
Therefore, we first need to develop a theory of preferences,
that is both flexible and yet restrictive enough to be useful for
understanding how choices will change as the economic
environment changes.
2
Theory of Preferences

Consider again a bundle of goods denoted A-{q1A, q2A, …, qnA}

For any given individual and any given bundle A, we want to be
able to describe the following sets:



Strictly preferred set – all bundles the individual strictly prefers to A.
Weakly preferred set – all bundles the individual weakly prefers to A
(i.e. likes at least as much as A)
Any bundle not in weakly preferred set, the individual must like
strictly less than A.
3
Preferences

3 axioms in our theory of consumer
preferences
1.
2.
3.
Completeness – An individual can weakly rank
any two possible bundles.
Reflexivity – A bundle is at least as good as
itself.
Transitivity – If a bundle C is strictly preferred
to a bundle A, and an individual is indifferent
between a bundle A and another bundle D, then
the individual must also strictly prefer bundle C
to bundle D.
4
Preferences

Final common assumption - preferences exhibit
“non-satiation” or monotonicity.


Weaker version: “more can’t be worse.”
 Essentially assumes free-disposal
Stronger version: “more is always better”
 Certainly not true at levels (100 donuts
does me no better than 99)
 For practical purposes though, not bad,
as we want to model situations where
individuals have to make choices
between things they value.
5
Preferences

Key issue we want to understand and analyze in
economics is trade-offs.
 e.g. how much of one good is an individual
willing to trade-off to consume more of
another good?

Our preference axioms allow us to consider
such trade-offs via indifference curves.
 For any given bundle A, there is an
indifference curve that connects A to each
bundle B where a given consumer is
indifferent between A and B.
6
Indifference Curves

Characteristics of Indifference Curves

Consider one of your indifference curves
between number of chips and ounces of Coke.

Is every possible bundle on an indifference
curve? Why or why not?

How many indifference curves are there?

If A is on a higher indifference curve than B,
what does this mean? How do we know this?

Why are indifference curves drawn with a
negative slope?

Can indifference curves cross? Why or why not?
7
Interpreting Indifference Curves
q2
Δq1
q2’
-Δq2
q1’


q1
Indifference curve indicates that at bundle {q1’,q2’},
an individual will be willing to give up Δq2 units of
good 2 to increase consumption of good 1 by Δq1.
What happens as Δq1 goes to zero?
8
Interpreting Indifference Curves

Marginal Rate of Substitution (MRS) –
the slope of indifference curve at a given
point.

MRS indicates an individual’s willingnessto-pay for a marginal increase of one good
in terms of the other, at a given bundle.

So how do you interpret an indifference
curve when it is very steep at a given
bundle (i.e. slope large in magnitude)?

How about when it is relatively flat?
9
Well-behaved preferences

In addition to our three Axioms and monotonicity, we will also
generally assume that weakly preferred sets are convex.

Convex preferences –

If bundles B-{q1B, q2B} and C-{q1C , q2C} are in weakly preferred set to A,
then so will the bundle {(q1B+ q1C)/2 , (q2B+ q2C)/2 }.
For example, consider the bundle {2,2}.

Suppose that for some person, both {1,3} and {4,1} are in the weakly
preferred set to {2,2}.

Then, if this person’s preferences are convex, the bundle {2.5, 2} will
also be in the weakly preferred set.
Intuition: averages are at least as good as extremes, or that individuals prefer to
have a combination of goods at moderate levels to lots of one and little of the
other (consider chips and coke)



Monotonic and Convex preferences are called well-behaved
preferences.
10
Interpreting Indifference Curves

Consider an indifference curve of following form.
q2



q
1
Does it represent convex preferences?
What does this shape reveal about MRS as q1
increases and q2 decreases?
What is intuition?
11
Interpreting Indifference Curves

Diminishing MRS





Implies an individual’s willingness to trade one good
for another diminishes the less he has of that good.
Slope of Indifference Curve “decreases” as q1
increases and q2 falls.
What is intuition?
Examples:

Chips and Coke?

Coke and a composite good?

Coke and Pepsi?
What is intuition behind different shapes of
indifference curves?
12
Interpreting Indifference Curves

Perfect substitutes - constant MRS



Perfect Complements – must consume in
fixed proportions, or individual not willing
to trade off some of one for more of
another, therefore MRS is undefined.



Examples?
What will indifference curves look like?
Examples?
What will indifference curves look like?
Are such preferences well-behaved?
13
Interpreting Indifference Curves

Consider the following indifference curves.

Are they well-behaved? Do they violate any
of our axioms?
q2
q2
q1
q2
q1
q1
14
Thinking again about assumptions over preferences

While our underlying preference axioms
and assumptions seem relatively
innocuous, they do rule out some
potentially interesting issues:

Interaction between monetary value and
preferences.

Peer effects
15
Modeling Preferences over Other Types of Goods

Suppose again you work for Doctors
Without Borders

What will your indifference curves look like
between “treating Tuberculosis patients” vs.
“treating malaria patients”?
16