Consumer Preferences

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

Properties of Consumer Preferences

• Completeness allows consumers to compare and rank any two bundles, preferring one or being indifferent.
  • A consumer can prefer Bundle A over Bundle B
  • A consumer can prefer Bundle B over Bundle A
  • A consumer is indifferent between A and B when they are equally good
• Transitivity means a consumers preferences are consistent: If one bundle is preferred over a second, and the second over a third, then the first is preferred over the third.
  • If Bundle Z is prefered over Bundle Y and Bundle Y is prefered over Bundle X, then Bundle Z is prefered over Bundle X
• More is better means that more of a commodity is better than less, assuming all else is equal, known as nonsatiation.
  • A "good" is a commodity where more is preferred over less, at least at certain consumption levels.
  • A "bad" is something where less is preferred over more, like pollution.

Preference Maps

• An Indifference Curve is a set of goods bundles that a consumer finds equally desirable.
• An Indifference Map is a complete set of indifference curves summarizing consumer tastes/preferences.
• Bundles on indifference curves further from the origin are preferred.
• An indifference curve exists for every possible bundle.
• Indifference curves cannot intersect.
• Indifference curves slope downwards.

Impossible Indifference Curve

• Indifference curves cannot cross because it volates known properties.
  • Lisa is indifferent between e and a, and also between e and b
  • By transitivity, she should also be indifferent between a and b
  • Bundble b must be preferred to a given it has more of both goods, so it contradicts known properties
• Indifference curves cannot slope upward, as this contradicts the "more is better" assumption.
  • Lisa being indifferent between b and a since both points are in the same indifference curve is not true.
  • Point b has more of both and hence it should be preferred over a.
• Indifference curves have no thickness.

Willingness to Substitute

• Marginal Rate of Substitution (MRS) is the maximum amount of one good a consumer will give up for one more unit of another
  • MRS is the same as the slope of the indifference curve
  • MRS = dP/dB
• MRS along an Indifference curve is convex to the origin: From bundle a to bundle b the MRS is -3
  • This is the same as the slope of the indifference curve between those two points.
• From b to c, MRS = -2
  • This is the same as the slope of the indifference curve between those two points.
• Diminishing marginal rate of substitution means it approaches zero when moving down and to the right on a curve

Curvature of Indifference Curves

• Casual observation says most people's indifference curves are convex.
• Perfect substitutes are goods that consumers are completely indifferent about.
• Perfect complements are goods that a consumer wants to consume in fixed proportions.

Perfect Substitutes

• Bill views Coke and Pepsi being perfect substitutes resulting in straight, parallel lines with an MRS (slope) of −1.
• Bill is willing to exchange one can of Coke for one can of Pepsi.

Perfect Complements

• If she has only one piece of waffle, she gets as much pleasure from it and one scoop of ice cream, a.
  • As from it and two scoops, d, or as from it and three scoops, e.

Imperfect Substitutes

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

Utility and Utility Functions

• Utility is a set of numerical values reflecting the relative rankings of different goods bundles.
• A Utility function is the relationship between utility values and every possible bundle of goods.

Utility - Example

• Question: Would Lisa be happier if she had Bundle x with 9 burgers and 16 pizzas or Bundle y with 13 of each?
• Answer: The utility she gets from x is 12utils, and from y is 13utils
  • Therfore she prefers y to x, U = BZ

Marginal Utility

• Marginal utility is the extra satisfaction a consumer gets from consuming the last unit of a good.
  • Marginal utility is the slope of the utility function, with the quantity of the other good held constant.
  • Marginal Utility of good Z is MUz = ΔU/ΔZ
• As Lisa consumes more pizza, holding her consumption of burgers constant at 10, her total utility, U, increases.
  • And her marginal utility of pizza, MUz, decreases (though it remains positive).
  • Marginal utility is the slope of the utility function as we hold the quantity of the other good constant.
• MRS is the negative ratio of the marginal utility of another pizza to the marginal utility of another burger.

Budget Constraint

• Budget line (or budget constraint) refers to the bundles of goods you can buy if you spend all your budget, at the given prices
• The opportunity set is all the bundles a consumer can buy, inside the budget constraint, and on the budget constraint

Budget Constraint Functions

• If Lisa spends all her budget, Y, on pizza and burgers, then pBB + pZZ = Y -pBB is the amount she spends on burgers and pZZ is the amount she spends on pizzas. -This equation is her budget constraint, it shows that her expenditures on burgers and pizza use up her entire budget.
• Burgers that can be bought is: -PB B + PZ Z = Y -PB B = Y − PZ Z -B = (Y − PZ Z)/PB

An Example

• From previous slide we have: B= (Y − PZ Z)/PB
• If pZ = $1, pB = $2, and Y = $50, then: B = ($50 − ($1 Z ))/$2 = 25 − 0.5Z
• With a graph, if points a, b, c, d are plotted, opportunity set exists within the lines.
• The slope of the budget line is also called the marginal rate of transformation (MRT)
  • MRT = B/Z

Allocations of a $50 Budget

• Allocations of a $50 Budget Between Burgers include:
  • Bundle a 25 Burgers and 0 Pizza
  • Bundle b 20 Burgers and 10 Pizza
  • Bundle c 10 Burgers and 30 Pizza
  • Bundle d 0 Burgers and 50 Pizza

Changes in Budget Constraints

• If the Price of Pizzas increase it Changes the Budget Constraint
  • If the price of Pizza doubles, (increases from $1 to $2) the slope of the budget line increases
  • The area that represents some bundles she can no longer afford
• If income increases it Changes the Budget Constraint
  • If Lisa’s income increases by $50 the budget line shifts to the right (with the same slope!)
  • The area that represents some new bundles she can now afford!
• Given a consumer, Lisa, and her potential to maximize her consumption
  • Would lisa be able to consume any bundle along I3
  • Lisa does not have enough income to afford any bundle along the line -Would lisa be able to consume any bundle along I1
  • She could afford bundles d, c, and a but would prefer something on I3
  • For instance bundle e is a Consumer optmimum
    • If Lisa is consuming this bundle, she has no incentive to change her behavior by substituting one good for another
• The budget constraint and the indifference curve share the slope at e where they touch: MRS=MUZ/MUB=PZ/PB=MRT