FPM (Term I): Microeconomics

Lecture #2

25th June 2013

Budgets, and Preferences

Lecture #2: Lecturer: Scribe: 25th June 2013 Arnab Mukherji Dr. None

Preferences

So far we have been discussing how the set of feasible bundles, or the budget set, changes with dierent price income situations as well as under rationing. Taxation is really like a price change unless its a lump-sum tax, in which case it is like income shrinking. However, it is time to return to our original and more complicated question of identifying the scale that we are going to use to identify if we are doing the best possible. It turns out that no formal scale is needed to be able to identify the best possible commodity bundle in the budget, all we need to be able to say is if the consumer prefers a commodity bundle over another, the dimension of preference itself is not important. We formalize this notion of preferring a commodity bundle over another with the following notions of preference.
A B B Indierence: for any two commodity bundles A = (xA 1 , x2 ) and B = (x1 , x2 ), if

the consumer is equally satised with A as with B , then we say that the consumer is indierent between the two commodity bundles A and B and we denote this as
A B B A B or (xA 1 , x2 ) (x1 , x2 )

Strict Preference: for any two commodity bundles A and B , if the consumer prefers bundle A to bundle B then we say that A is preferred to B and we denote this as A
A B or (xA 1 , x2 ) B ( xB 1 , x2 ).

FPM (Term I): Lecture #2 Weak Preference: for any A and B , if the consumer is indierent between A and B or may prefer A to B then we say that the consumer weakly prefers A to B and denote it as A
A B or (xA 1 , x2 ) B (xB 1 , x2 ). Weak preference essentially rules out

the possibility for the consumer to prefer B over A. Now we have a language to talk about preference over a pair of commodity bundles, or more generally on a set of consumption bundles. We still havent made any assumptions about consumers preferences on the commodity space. These are simply denitions detailing when a consumer is indierent between A and B or strongly, or weakly prefers A over B . So far we have not made any assumption about the pattern of preferences over the budget set, and one can have all kinds of weird inconsistent preferences. We make some simple and arguable credible that are sucient to drive or generate consistent preference over budget sets. These are known as the axioms of consumer theory:
A B B Complete : For any two commodity bundles A = (xA 1 , x2 ) and B = (x1 , x2 ) it must

be the case that the consumer can identify if he likes A more than B (i.e. A or B more than A (i.e B A), or is indierent between A and B (i.e A B ). A. B and B

B ),

Reexive : Any commodity is at least as good as itself: i.e. A

Transitive : For any three commodity bundles A, B, and C , if A then A B.

When all three properties hold, then the preferences are said to be ordered, since these axioms are sucient to allow us to rank all commodity bundles (not necessarily uniquely, as there may be ties). Reexivity is the least problematic in terms of credibility as all it says is that a good is as good as itself. Completeness requires the consumer to not only know all the possible combinations of goods, but it also requires the person to have a preference over all these bundles, and most criticisms about its credibility are centered on the information and processing of such information; but even this is usually not the source of criticism for utility theory. Much of the criticism centers on the transitivity axiom since it rules out all kinds of cycles in behavior, such as A being preferred to B being

FPM (Term I): Lecture #2

preferred to C being preferred to A. A lot of people show examples of human behavior that violate this axiom, nding examples violating the other two axioms are much rarer. However, violations of even the transitivity assumption is relatively rare and it usually is an assumption that theory of the best usually makes since without it there wouldnt be any best choice but an entire collection of bundles. We shall talk about this more when we talk about revealed preference which has stronger empirical foundations.

These axioms allow us to talk about preferences over the budget set in a very clear fashion. For any point (x1 , x2 ) we can classify all commodity bundles into either being in the set of weakly better than consumption bundles, or not. One classies the shape of these indierence curves on the basis of the properties of these three sets. The bundles on the boundary of this set - specically, the set of points on the boundary of the weakly preferred to set is called the indierence curve.

One of the immediate outcomes, largely due to the property of transitivity, is that indierence curves representing dierent levels of preferences cannot cross. Anyone want to do the argument?

Well-Behaved Preference : The axioms of preference impose no great structure on the nature of preferences that are permissible for the consumer. Thus, we have the case of goods being perfect substitutes, for example consider choices over a pair of jeans made by Lee and a pair made by Levis, or the case of goods being perfect complements, for example dhosa and sambar. Additionally, we have mostly been thinking of cases where we implicitly assume that higher consumption values are consistent with higher preference also sometimes called, more is better assumption. It could well be that we have a case of a bad - for example, pollution, or the case of a neutral where we dont really care for more or less of a good. Finally we have the case of satiation - where the consumer has a bliss-point any deviations from which lead to a loss in utility.

FPM (Term I): Lecture #2

We make a few assumptions to rule out these cases: Monotonicity: The idea captures the notion that more is better: thus, if we are looking at two commodity bundles A = (x1 , x2 ) and B = (x1 + , x2 ), then it must be the case that B A; ruling out A B . This idea is also another manifestation

of the idea that we are essentially concerned with the idea of decision making in a world of scarcity and not one in which we are largely satiated. The Strictly Preferred to set is a convex set. Does anyone remember the denition of a convex set? The idea is that averages are preferred to extreme values always. Discuss the dierence between strict convexity and weak convexity. An important implication of the Monotonicity assumption is that the indierence curve must be downward sloping. How would we show this? Together the two assumption, in addition to the axioms of preference, imply that the indierence curves are well-behaved i.e. we see downward sloping indierence curves (also called indierence levels, surfaces, etc.). Marginal Rate of Substitution The Marginal Rate of Substitution (M RS ) for an indifference curve is simply the slope of the tangent line at that point; as discussed, this is also known as the derivative of the the indierence curve. M RS is short for the Marginal Rate of Substitution of x1 for x2 and should usually be written as M RSx1 ,x2 to be exactly right; however, we will be sloppy and continue with M RS to minimize notational complication and speciy it should there be any confusion. Is the MRS a positive number or a negative number?

Thus, wed dene the MRS as: M RS = lim x2 x1 0 x1 (1)

What does the MRS capture? The indierence curve is a set of points that the consumer is indierent between, thus, the MRS at a point captures the amount of x1

FPM (Term I): Lecture #2

that the person is willing to give up for an additional amount of x2 so that his utility remains unchanged. If one is willing to think of this as a rate of exchange, then the MRS captures the rate of exchange of one good for another. Now, recall that the set of preferred bundles for each commodity bundle is convex. If the set of preferred bundles is strictly convex, then we have the case of diminishing Marginal Rate of Substitution of x1 for x2 ... intuitively it suggests that at higher and higher levels of x1 the consumer is likely to part with larger and larger amounts of x1 for the same marginal increment in x2 . The slope is declining (in absolute value) as we look at the slope for higher values of x1 .