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2.
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Preferences
What people like What people can afford Do they choose randomly or do they behave in way that allows them to achieve the highest possible well-being?
Preference Relations
A preference relation , , describes an individual's attitude towards alternatives
It is a binary relation on the set of possible alternatives For instance, someone can prefer A to B or the opposite and another person may be indifferent between A and B
Axiom 1:Completeness
if A is preferred to B, and B is
preferred to C, then A is preferred to C:
Axiom 3: Continuity
Consumer Preferences
Consumer preferences can be represented graphically using indifference curves
Indifference curves represent all combinations of market baskets that the person is indifferent to
Graph the points with one good on the x-axis and one good on the y-axis
Plotting the points, we can make some immediate observations about preferences
More is better
The consumer prefers A to all combinations in the yellow box, while all those in the pink box are preferred to A.
Points such as B & D have more of one good but less of another compared to A
Indifferent between points B, A, & D E is preferred to points on U1 Points on U1 are preferred to H&G
Indifference Maps
To describe preferences for all combinations of goods/services, we have a set of indifference curves an indifference map
Indifference curves further away from the origin are better, i.e. higher utility
Indifference Map
B is preferred to D A is indifferent to B & D B must be indifferent to D but that cant be true if B is preferred to D
Indifference Curves
The shapes of indifference curves describe how a
consumer is willing to substitute one good for another
Indifference Curves
Clothing 16
A
Observation: The amount of clothing given up for 1 unit of food decreases from 6 to 1
14
12
-6 1 -4
10
8 6 4 2 1
B D
1 -2
1 -1
E
1
G
Food
y1
y2
Quantity of x
x1 x2
16
14
12
-6 1 -4
MRS = 6
MRS L
SF
10
8 6 4 2 1 2
B D
1 -2
1 -1 1
MRS = 2 E
G
1000 of Square Feet House Size
Convexity
If the indifference curve is convex, then the combination (x1 +
x2)/2, (y1 + y2)/2 will be preferred to either (x1,y1) or (x2,y2)
This implies that well-balanced bundles are preferred to bundles that are heavily weighted toward one commodity
Perfect substitutes
Perfect complements
Perfect Substitutes
Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant
Perfect Complements
Two goods are perfect complements when the indifference curves for the goods are shaped as right angles
Summary (1)
Summary (2)
The negative of the slope of the indifference curve measures the marginal rate of substitution (MRS)
Required Reading