Consumer Preferences and Indifference Curves

• Individual preferences dictate the amount of pleasure derived from consuming goods and services
• Consumers' choices are limited by constraints
• Consumers aim to maximize well-being or pleasure from consumption, within their constraints

Properties of Consumer Preferences

• Completeness: Consumers can compare and rank any two bundles of goods, leading to a preference for one over the other, or indifference
• Transitivity: Consumer preferences are consistent, so if Bundle Z is preferred to Bundle Y, and Bundle Y to Bundle X, then Bundle Z is also preferred to Bundle X
• More is better: Having more of a commodity is better than having less, also known as nonsatiation

Goods vs Bads

• Good: A commodity for which more is preferred to less at some level of consumption
• Bad: Something for which less is preferred, like pollution

Indifference Curve

• It shows a set of all bundles of goods that a consumer finds equally desirable

Indifference Maps

• It presents a set of indifference curves, summarizing a consumer's tastes or preferences

Properties of Indifference Maps

• Bundles on indifference curves further from the origin are more desirable than those closer to the origin
• There is an indifference curve through every possible bundle
• Indifference curves cannot cross
• Indifference curves have a downward slope

Impossible Indifference Curves

• Indifference curves cannot cross, otherwise this violates transitivity and the "more is better" principle
• They cannot slope upwards because that contradicts the principle that "more is better"
• Indifference curves cannot be thick

Willingness to Substitute

• Marginal Rate of Substitution (MRS) represents the maximum amount of a good a consumer will sacrifice for one more unit of another good
• MRS equals dP/dB
• MRS is the slope of the indifference curve

MRS and Indifference Curve Convexity

• From bundle a to bundle b the MRS= -3
• MRS from a to b is same slope of the indifference curve between those two points
• From bundle b to bundle c, the MRS equals -2

MRS and Indifference Curve Concavity

• Moving from bundle a to bundle b, Lisa is willing to give up 2 pizzas for 1 burger
• Moving from b to c she is willing to give up 3 pizza's for 1 burger

Diminishing Marginal Rate of Substitution

• The marginal rate of substitution approaches zero when moving down and to the right along an indifference curve

Curvature of Indifference Curves

• Casual observation suggests most people's indifference curves are convex

Exceptions to Indifference Curve Convexity

• Perfect substitutes: Consumers are completely indifferent between goods
• Perfect complements: Consumers want to consume goods in fixed proportions

Perfect Substitutes

• Bill views Coke and Pepsi as perfect substitutes
• Indifference curves are straight, parallel lines with a MRS (slope) of -1
• Bill is willing to exchange one can of Coke for one can of Pepsi

Perfect Complements

• When a person has only one piece of waffle, the person receives the same utility from it and one scoop of ice cream
• Consumers will receive the same utility as from it and two or three scoops

Imperfect Substitutes

• The standard-shaped, convex indifference curve lies between the two extreme examples
• Convex indifference curves show that a consumer views two goods as imperfect substitutes

Utility

• A set of numerical values reflects the relative rankings of various bundles of goods

Utility Function

• It defines the relationship between utility values and every possible bundle of goods

Utility Function example

• An increase from 9 burgers and 16 pizzas to 13 burgers and 13 pizzas increases total utility from 12utils to 13utils

Marginal Utility

• Marginal utility is the extra utility a consumer gets from consuming the last unit of a good
• The function slope represents the quantity of the other good remaining constant

Marginal Utility of good Z

• MUz = ΔU/ΔZ

Utility and Marginal Utility example

• As more pizza consumption increases, the total utility also increases
• The marginal utility of pizza decreases though it remains positive

Utility and Marginal Rates of Substitution

• MRS is the negative ratio of the marginal utility of another pizza to the marginal utility of another burger
• MRS = dB/dZ = - (MUz / MUB)

Budget Constraint

• The budget line is the bundles of goods that can be bought if the entire budget is spent on those goods at given prices
• Opportunity Set: All the bundles a consumer can buy, encompassing those within and on the budget constraint

Budget Constraint Equation

• If all budget Y is spent on Pizza (Z) and Burgers (B): pBB + pZZ = Y

Budget Constraint example

• To solve budget constraints for Burgers (B): B = (Y - PzZ) / PB
• At pz = $1, pB = $2, and Y = $50, the equation becomes: B = ($50 - $1 x Z) / $2 = 25 - 0.5Z

The Slope of the Budget Constraint

• Budget Constraint Equation: B = Y/PB - PZ/PB x Z
• The slope of the budget line is also the marginal rate of transformation (MRT)
• MRT refers to the rate at which a consumer can trade burgers for pizza in the marketplace

Changes in the Budget Constraint

• An increase in pizza prices will cause an increase in opportunity loss, as the price required to purchase has gone up
• An income increase shifts the budget line to the right, increasing opportunity for future consumption

Consumer Maximization: Interior Solution

• Points along high indifference curves are unaffordable
• Some points along indifference curves are simply not preferable
• Bundle e is called the consumer's optimum, and they are optimized
• A consumer has no incentive to change their behavior regarding substituting one good for another at the consumer optimum

Maximizing Utility

• The budget constraint and the indifference curve have the same slope at the point e where they touch
• MRS = MUZ/MUB = PZ/PB = MRT