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Lecture 3 - Theory of the
Consumer; Preferences
Consumer preferences: Notations and preference
relations
Assumptions on preference relations
Indifference curves as a graphical representation
of consumer preferences.
Assumptions for well behaved indifference curves
Marginal Rate of Substitution
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Consumption bundles
Give a complete list of goods and services that are
involved in the consumer choice problem.
In other words, consumers pick from among
consumption bundles.
While we assume that the consumption bundle is
complete, we usually represent the bundle in
terms of two goods.
We can represent consumption bundles as (x
1
,x
2
)
or by X.
We assume that consumers can rank
consumption bundles as to their
desirability.
consumers prefer one good over the other in
the sense that they would choose one bundle
over another given the opportunity
the idea of preference is based on the idea of
behavior
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We use the following symbols to denote
these rankings:
Strict preference
The consumer definitely wants the X bundle
rather than the Y bundle.
The consumer always chooses X over Y when X
is available.
) , ( to ) , ( prefers strictly Consumer
) , ( ) , (
preference Strictly
2 1 2 1
2 1 2 1
y y x x
y y x x

Indifference
Indifference means that the consumer would be
equally satisfied consuming bundle X or bundle
Y.
When both X and Y are available, consumer
would choose either bundle
) , ( and ) , ( between t indifferen is Consumer
) , ( ~ ) , (
~ ce Indifferen
2 1 2 1
2 1 2 1
y y x x
y y x x
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Weakly prefers
Consumer prefers or is indifferent between
) , ( ) , (
preference Weak
2 1 2 1
y y x x

( ) ( )
2 1 2 1
, and , y y x x
Relations between these rankings:
If a consumer weakly prefers X to Y and weakly
prefers Y to X, then the consumer is indifferent
between X and Y.
If a consumer thinks that X is at least as good as Y
and Y is at least as good as X, then the consumer
must be indifferent between the two bundles.
) , ( ~ ) , ( then ), , ( ) , ( and ) , ( ) , ( If
2 1 2 1 2 1 2 1 2 1 2 1
y y x x x x y y y y x x
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If the consumer thinks that X is at least
better than Y but is not indifferent between
X and Y, then the consumer must strictly
prefer X to Y.
) , ( ) , ( then ), , ( ~ ) , ( not and ) , ( ) , ( If
2 1 2 1 2 1 2 1 2 1 2 1
y y x x x x y y y y x x
Complete
any two bundles can be compared, and
consumers can make a choice between any
two bundles
Reflexive: Any bundle is at least as good
as itself
both or ) , ( ) , ( or ) , ( ) , ( Either
2 1 2 1 2 1 2 1
x x y y y y x x
) , ( ) , (
2 1 2 1
x x x x
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Transitive
If X is as good as Y, and Y is as good as Z, then X is
at least as good as Z
) , ( ) , ( then ), , ( ) , ( and ) , ( ) , ( If
2 1 2 1 2 1 2 1 2 1 2 1
z z x x z z y y y y x x
We represent preferences graphically by
indifference curves or indifference sets
Indifference curve/set through a bundle
consists of all consumption bundles that leave
the consumer indifferent to a given bundle Fig 1
i.e., the set of all bundles equally preferred to a
reference bundle x is the indifference curve
containing x; the set of all bundles y ~ x.
Weakly preferred set- all consumption bundles
that are weakly preferred to a specific bundle
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x
2
x
1
x
x
x ~ x ~ x
x
x
2
x
1
z x y
p p
x
y
z
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x
2
x
1
x
All bundles in I
1
are
strictly preferred to
all in I
2
.
y
z
All bundles in I
2
are
strictly preferred to
all in I
3
.
I
1
I
2
I
3
x
2
x
1
I(x)
x
I(x)
WP(x), the set of
bundles weakly
preferred to x.
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x
2
x
1
WP(x), the set of
bundles weakly
preferred to x.
WP(x)
includes
I(x).
x
I(x)
x
2
x
1
SP(x), the set of
bundles strictly
preferred to x,
does not
include
I(x).
x
I(x)
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Indifference curves representing distinct levels of
preference do not cross.
Intersecting indifference curves violate the transitivity
assumption about preferences.
Suppose X is preferred to Y but indifferent to Z, Y is
indifferent to Z and the axiom of transitivity implies that
X is indifferent to Y which is not the case
x
2
x
1
x
y
z
I
1
I
2
From I
1
, x ~ y. From I
2
, x ~ z.
Therefore y ~ z.
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x
2
x
1
x
y
z
I
1
I
2
From I
1
, x ~ y. From I
2
, x ~ z.
Therefore y ~ z. But from I
1
and I
2
we see y z, a
contradiction.
p
Since indifference curves are a way to describe
preferences, then reasonable preferences can be
described by indifference curves.
To construct indifference curves ask - for a given
change in good 1, how does the consumption of good
2 have to change so that the consumer is indifferent
between the old consumption level and the new
consumption level?
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When more of a commodity is always
preferred, the commodity is a good.
If every commodity is a good then
indifference curves are negatively sloped.
Good 2
Good 1
Two goods
a negatively sloped
indifference curve.
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Bads
A bad is a commodity that the consumer doesnt like
Assume that there is some tradeoff between the two
goods
Suppose a bundle X with x
1
as the good and x
2
as the
bad. To keep a consumer on the same indifference
curve, we have to give him more of good 1 in order to
compensate him for having to put up with the bad
Bads are represented by upward sloping indifference
curves
The direction of increasing preference is down and to
the right, toward the direction of increased
consumption of the good and toward decreased
consumption of the bad
Good 2
Bad 1
One good and one
bad a
positively sloped
indifference curve.
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Perfect substitutes
If a consumer is willing to substitute one good for
another at a constant rate, then we consider the two
goods as perfect substitutes.
For perfect substitutes, indifference curves have a
constant slope.
Since only the total quantities matter, the direction of
increasing preference is to the right.
x
2
x
1
8
8
15
15
Slopes are constant at - 1.
I
2
I
1
Bundles in I
2
all have a total
of 15 units and are strictly
preferred to all bundles in
I
1
, which have a total of
only 8 units in them.
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Perfect complements
Goods that are consumed together in fixed proportions.
The indifference curves for perfect complements are L-
shaped, with the vertex occurring where the ratio of the
amount of good 1 to the amount of good 2 are at the
fixed proportion
Direction of increasing preferences is up and to the
right. Increasing both the quantities of both goods will
move the consumer to a more preferred condition.
x
2
x
1
I
1
45
o
5
9
5 9
Each of (5,5), (5,9)
and (9,5) contains
5 pairs so each is
equally preferred.
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x
2
x
1
I
2
I
1
45
o
5
9
5 9
Since each of (5,5),
(5,9) and (9,5)
contains 5 pairs,
each is less
preferred than the
bundle (9,9) which
contains 9 pairs.
Neutral
Neutral goods are goods that the consumer
dont care about.
the indifference curves are vertical lines
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x
2
x
1
Satiation point or bliss point most preferred bundle of
goods
Represented by
The closer the consumer is to that bundle, the better off
he is in terms of preferences.
Points nearer the bliss points lie on higher indifference
curves while those that are farther lie on lower
indifference curves
Indifference curve has a negative slope when he has too
little or too much of both goods.
Indifference curve has a positive slope when he has too
much of one of the goods.
Direction of preference is toward the bliss point.
) , (
2 1
x x
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x
2
x
1
Satiation
(bliss)
point
x
2
x
1
B
e
t
t
e
r
Satiation
(bliss)
point
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x
2
x
1
B
e
t
t
e
r
Satiation
(bliss)
point
We will limit our analysis to that region
where we have less of what we want. Most
likely, people are below rather than above
their bliss points.
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Discrete goods consumption is usually in integer
units
preferences can still be represented as continuous
variables by a suitable redefinition of the good in
question, e.g., number of automobiles (discrete) vs.
hours spent in a car (continuous).
If not then preferences can still be represented by
indifference curves and weakly preferred set
Points with the same color are bundles that are indifferent
to one another
Vertical lines represent bundles that are at least as good
Continuou
s good
Discrete good
0 1 2 3 4
Indifference curves
are collections of
discrete points.
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Monotonicity
This assumption just states that more is
better
If X is a bundle of goods and Y is a bundle of
goods with at least as much as both goods
and more of one, then Y is preferred to X.
X Y
x y x y y y x x
: then
, and , such that ) , ( ), , ( bundles two Suppose
2 2 1 1 2 1 2 1
> =
Monotonicity implies that indifference curves
have a negative slope.
From a bundle X, moving up and to the right implies
moving to a more preferred position
Moving down and to the left implies moving to a less
preferred position
If we are moving to an indifferent position, then we
must be moving rightward and down and or moving
leftward and up.
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x
2
x
1
x
Better bundles
Worse bundles
Convexity
Assumes that averages are preferred to extremes
The distance from X to the average bundle is just a
fraction t of the distance from the X bundle to the Y
bundle along the line that connects the two bundles.
) , ( ) ) 1 ( , ) 1 ( ( : Then
) , ( ~ ) , ( Assume
1 0 weight, a be Let t
2 1 2 2 1 1
2 1 2 1
x x y t tx y t tx
y y x x
t
+ +
s s
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Geometrically, it means that the bundles
weakly preferred to X is a convex set.
A convex set has the property that if you take
any two points in the set and draw a line
segment connecting these two points, then the
line segment is entirely in the set.
Reason for assuming convex preferences-
most goods are consumed together
Example of nonconvex preferences- two goods that
somebody might not prefer to consume together.
Strictly convex - Assumes that the
weighted average of two bundles is
strictly preferred to the two extreme
bundles.
convex preferences- indifference curves
may have flat spots
strictly convex preferences have rounded
indifference curves
indifference curves for perfect substitutes
are convex but not strictly convex.
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x
2
y
2
x
1
y
1
x
y
z =(tx
1
+(1-t)y
1
, tx
2
+(1-t)y
2
)
is preferred to x and y
for all 0 < t < 1.
x
2
y
2
x
2
+y
2
2
x
1
y
1
x
1
+y
1
2
x
y
z =
x+y
2
is strictly preferred
to both x and y if
t=.50
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x
2
y
2
x
1
y
1
x
y
Preferences are strictly convex
when all mixtures z
are strictly
preferred to their
component
bundles x and y.
z
x
y
z
Preferences are
weakly convex if at
least one mixture z
is equally preferred
to a component
bundle.
x
z
y
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x
2
y
2
x
1
y
1
z
The mixture z
is less preferred
than x or y.
x
2
y
2
x
1
y
1
z
The mixture z
is less preferred
than x or y.
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Marginal rate of substitution slope
of the indifference curve. The slope
denotes the rate at which the
consumer is just willing to substitute
one good for another.
Suppose we take a little bit of good 1, Ax
1
from the
consumer and give him Ax
2
, an amount that is just
sufficient to put him back on his indifference curve
The ratio Ax
2
/Ax
1
is the rate at which the consumer
is willing substitute good 2 for good 1.
If we think of the changes as very small changes, then
the ratio measures the marginal rate of substitution
of good 2 for good 1. As Ax
1
gets smaller, the ratio
approaches the slope of the indifference curve
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x
2
x
1
MRS at x is
lim {Ax
2
/Ax
1
}
Ax
1
0
= dx
2
/dx
1
at x
Ax
2
Ax
1
x
x
2
x
1
dx
2
dx
1
dx
2
= MRS dx
1
so, at x, MRS is
the rate at which the consumer is
only just willing to exchange
commodity 2 for a small amount of
commodity 1.
x
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x
2
x
1
x
MRS at x is the slope of the
indifference curve at x
MRS is typically a negative number. Monotonic
preferences imply that indifference curves have a
negative slope.
Marginal rate of substitution measures the rate at
which the consumer is just on the margin of trading
or not trading. At any rate of exchange other than
the MRS, the consumer would want to trade one
good for another. If the rate of exchange equals the
MRS, then the consumer stays put.
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x
2
x
1
x
E
Other interpretation of the MRS: Slope of the
indifference curve can also be interpreted as the
marginal willingness to pay
Using the concept of a composite good or spending
on all other goods - interpretation is how many
pesos you are willing to give up spending on other
goods in order to increase consumption of one good.
marginal willingness to pay is different from what
you have to pay
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Behavior of the MRS
MRS for different preferences
perfect substitutes = constant MRS
perfect complements = MRS is zero or infinity
neutrals = MRS is everywhere infinite, you
cannot compensate one for consuming an
extra good because he doesnt care about the
other good
Since monotonicity of preferences implies that
slope of indifference curves are negative - then
MRS always involves reducing the consumption
of one good in order to get more of another
Convexity, in particular strict convexity, implies
that the slope of indifference curves decreases in
absolute value as we increase x
1
.
Diminishing marginal rates of substitution rate at
which a person is willing to trade good 1 for good 2
decreases as we increase the amount of good 1
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Good 2
Good 1
MRS = - 5
MRS = - 0.5
MRS always increases with x
1
(becomes less
negative) if and only if preferences are strictly
convex.