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Chapter 2 A Theory of Preferences

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Theory of Preferences is based on three ideas regarding individuals:


1. 2. 3.

They have consistent preferences. They seek to maximize preferences. They are willing to make tradeoffs between different goods.

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Completeness Assumption:
Given

any two bundles, one of the following is true:


- Bundle 1 is preferred to bundle 2 - Bundle 2 is preferred to bundle 1 - Bundle 1 is indifferent to bundle 2

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Figure 2.1 Possible consumption bundles

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Transitivity Assumption:
Given

any three bundles: - If bundle 1 is at least as good as bundle 2 and bundle 2 is at least as good as bundle 3, then bundle 1 is at least as good as bundle 3.

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Non-satiation Assumption:
Given

any two bundles, if bundle 1 contains more of one good than bundle 2, and it does not contain less of the other good, then bundle 1 is preferred to bundle 2.

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Maximization Assumption:
Individuals

always make choices that leave them better off.

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Figure 2.2 An indifference curve for Eleanor

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Continuity Assumption
Through

any consumption bundle in which the quantity of at least one good is positive, there is a continuous indifference curve.

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Figure 2.3 Clems indifference curves

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Figure 2.4 Slope of an indifference curve

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Figure 2.5 An indifference map

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Figure 2.6 Impossible indifference curves

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Marginal Rate of Substitution


The marginal rate of substitution (MRS) is the rate at which someone is willing to trade-off one good for another while maintaining the same level of satisfaction. More precisely, the marginal rate of substitution of good 2 for good 1 at any point (X1,X2), denoted as MRS (X1,X2), is the absolute value of the slope of the indifference curve at that point. (See Figure 2.7).

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Figure 2.7 Marginal rate of substitution

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Diminishing Marginal Rate of Substitution


Note

that in Figure 2.7 the MRS diminishes in a movement down the indifference curve. A person whose preferences are shown in Figure 2.7 is less willing to substitute good 2 for good 1 at point B than at point A.

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Figure 2.8 Constructing a utility function

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Figure 2.9 Different preferences and different indifference curves

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Figure 2.10 Perfect substitutes and perfect complements

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Figure 2.11 Employee preferences for leisure and income

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Figure 2.12 Preferences for current and future consumption

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Figure 2.13 The cost of pollution

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