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Consumer Preferences and the Concept of Utility Chapter 3

3.1 Representations of Preferences


Market Basket A collection of goods and services that an individual may consume. Baskets
may include different levels of the same goods, or different goods altogether.
Consumer preferences Tell us how an individual would rank any two baskets, assuming that
the baskets were available at no cost. E.g. 1 basket might have 7 jeans and 2 shorts, and
another might have 2 jeans and 7 shorts.
Assumptions about consumer preferences;
1. Preferences are complete
- Meaning that consumers are able to rank any two baskets
2. Preferences are transitive
- Means that the consumer makes choices that are consistent with each other. I.e.
if A>B, and B>C, then A>C
3. More is better
Ordinal Ranking Ranking that indicates whether a consumer prefers one basket to another,
but doesnt contain quantitative information about the intensity of the preference
Cardinal Ranking A quantitative measure of the intensity of a preference for one basket over
another. Often easier for consumers to answer a question about ordinal ranking than cardinal.

3.2 Utility Functions


The three assumptions allow us to represent preferences with a utility function. A utility
function measures the level of satisfaction that a consumer receives from any basket of goods.
Marginal Utility The rate at which total utility changes as the level of consumption rises. The

marginal utility for good y is = . The marginal utility is the first derivative of the utility

function, or the slope of the tangent line to the utility graph
Principle of diminishing marginal utility:
- Total and marginal utility cannot be plotted on the same graph because the vertical
axis on the total utility graph is the utility from consuming the good, while the
marginal utility graphs has a vertical axis of marginal utility from consuming the
good.
- The principle states that after some point, as consumption of a good increases, the
marginal utility will begin to fall.
Preferences with multiple goods: marginal utility, indifference curves, and MRS:
When looking at multiple goods, the Marginal Utility looks at how the level of satisfaction
changes for good x at different levels of consumption, while holding the other good, good y,
at a constant level of consumption.
Indifference Curves A curve connecting a set of consumption baskets that yield the same
level of satisfaction to the consumer. What different combinations of goods lead to the same
level of utility.
Properties of indifference curves:
1. When the consumer likes both good (when MUx and MUy are both positive), all the
indifference curves have a negative slope
2. Indifference curves cannot intersect
- Each curve represents a set of combinations of goods that give a specific level of
utility. Different curves, different levels of utility. If two curves intersected, the
intersection point would represent a combination of goods with two different levels
of utility
3. Every consumption basket lies only on one indifference curves
- ADD NOTES
4. Indifference curves are not thick
- See picture below

Marginal Rate of Substitution The rate at which the consumer will give up one good to get
more of another, holding the level of utility constant. When both goods have positive marginal
utilities, the marginal rate of substitution is the slope of the indifference curve. The marginal
rate of substitution of x for y (MRSx,y), is the rate at which the consumer is willing to give up y
in order to get more of x, holding utility constant. It is the slope of the indifference curve
because the slope shows how much of good x needs to be given up to get more good y along
the indifference curve (the slope). Therefore the MRS is the first derivative of the indifference
curve. On a graph with x on the horizontal axis and y on the vertical axis, MRSx,y at any point
is the negative of the slope of the indifference curve. We can also express the MRS for any
basket as a ratio of the marginal utilities of the goods. When considering two goods, the
change in consumer utility will be:
= () + ()

However, must =0, because as you move along any point on the indifference line, utility
remains unchanged.
Therefore:
0 = () + ()

And therefore:
() = ()

We can now solve for the slope of the indifference curve (/) by rearranging the above
equation.

= = ,

Lastly, since we know that MRSx,y is the negative of the slope of the indifference curve, we
observe that the in the equation above, the left hand side becomes negative while the right
becomes positive, meaning that:

= ,

Why is the MRS the ratio of the two marginal utilities:


- Because the MRS is the same as the slope of the indifference curves, and the ratio
of the marginal utilities shows how much of each good the consumer is willing to
give up in order to get the other good (i.e. the slope of the indifference curve)
Diminishing Marginal Rate of Substitution For many goods, MRSx,y diminishes as the amount
of x increases along an indifference curve. This is because as you have more of one good and
less of another, you are willing to give up more of one good in order to get less of the other. If
you have 100 glasses of lemonade and 2 glasses of orange juice, you would be willing to give
up a lot of lemonade for a relatively small amount of orange juice. This explains why the
indifference curve becomes flatter.