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Chapter 3:

Consumer Preferences
and the Concept of Utility

Outline

Introduction
Description of consumer preferences
The Utility functions

Marginal utility and diminishing marginal utility

Indifference Curves
Marginal rate of substitution
Special functional forms
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Introduction

Supply and Demand Models (Ch. 2) are


useful for analyzing economic questions
concerning markets.

How will increasing the real wage affect output?

In these models we summed each individuals


demand to obtain the market demand curve.
But, how do individuals decide what to
consume and how much to consume.

Introduction
We need to develop a model about individual or
consumer behavior
Model is based on:

1.

2.

3.

Individual tastes or preferences determine the amount of


pleasure people derive from goods and services.
(Chapter 3)
Consumers face constraints (budget) that limit their
choices
Consumers maximize their well-being or pleasure from
consumption, subject to the constraints they face.

We want our model to be realistic so we can


predict consumer behavior. But, still as simple as
possible.

Description of Consumer
Preferences
Consumer Preferences tell us how the
consumer would rank any two basket of
goods, assuming these allotments were
available to the consumer at no cost.
baskets or bundles is a collection of goods or
services that an individual might consume.

Properties of Consumer
Preferences

The Assumptions of Consumer


Behavior
1. Complete:Preferences are complete if the

2.
Transitive
:
No illogical
behavior

consumer can rank any two baskets of


goods
A strictly preferred to B (A B )
B strictly preferred to A (B A )
indifferent
between A and B (A B)

Preferences are transitive if a consumer wh


prefers basket A to basket B, and basket B
basket C also prefers basket A to basket C

A B and B C A C NOT C A
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Properties of Consumer
Preferences
3.

Monotonic (more is better) Preferences: are


monotonic if a basket with more of at least one
good and no less of any good is preferred to the
original basket. free disposal cant be worse of
with more
The more is better assumption is also known as the
property of non-satiation.
It assumes are looking at what economists call a
good. Something we want more of
We are not looking at a bad i.e. pollution
We can relax this assumption it is the first two that are
crucial for the analysis

Preferences Examples

Intransitivity and Age


AgeNumberofSubjectsIntransitiveChoices(%)
43983
53382
62382
73578
84068
95257
104552
116537
128123
138141
Adults9913
Source:SeeHirshleifer,JackandD.Hirshleifer,Price Theory and Applications.SixthEdition.Prentice

Hall:UpperSaddleRiver,NewJersey.1998.

Ordinal vs Cardinal Rankings

Ordinal Ranking: gives us information on how a


consumer ranks different baskets of goods. But it
does not say by how much (i.e. 2 times as much)

This is how we view preferences.

Cardinal Rankings: Give us information on the


intensity of the consumer preferences (i.e. they like
basket A 10 times more than basket B).

Would be hard to say I like eating pizza out 10.5 times


more than eating bad Chinese. Putting an exact number to
our preferences is hard! this is why we use ordinal
rankings for consumer preferences

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Ordinal vs Cardinal Example


Students take an exam. After the exam, the
students are ranked according to their
performance. An ordinal ranking lists the
students in order of their performance (i.e.,
Harry did best, Joe did second best, Betty did
third best, and so on). A cardinal ranking
gives the grade of the exam, based on an
absolute grading standard (i.e., Harry got 50,
Joe got 100, so Joe did 2 times better than
Harry).
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Utility Function

Utility Function: measures the level of


satisfaction that a consumer receives from
any basket of goods.
U=F(x1,x2,x3, .., xn), where
the xs are quantities of n
goods that might be
consumed in a period

Utility is an ordinal concept: the precise


magnitude of the number that the function assigns
has no significance.
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Implications
difference in magnitudes of utility have no
interpretation per se utility not comparable
across individuals any transformation of a utility
function that preserves the original ranking of
bundles is an equally good representation of
preferences.
e.g. U = xy vs. U = xy + 2 represent the same
preferences.

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Utility Function (one good


example)
U(y): total
Are the assumptions on
utility of
U(y) = y
muffins
preferences
meet?
1.75

.5

1.5
1.0

B
A

1
2
3
y, weekly consumption of muffins
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Marginal Utility
Marginal Utility: Rate at which total utility
changes as the level of consumption rises.
- Each new muffin makes you happier, but
makes you happier by smaller and smaller
amount.

U U
MUy

Slopeoftheutilitycurve
y y
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Marginal Utility
The marginal utility:of a good, x, is the additional utility
that the consumer gets from consuming a little more of x
when the consumption of all the other goods in the
consumers basket remain constant.
U/x (y held constant) = MUx= U/ x
U/y (x held constant) = MUy = U/ y
orthe marginal utility of x is the slope of the utility
function with respect to x.

The principle of diminishing marginal utility:states


that the marginal utility falls as the consumer consumes
more of a good
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Marginal Utility
MU(y):
marginal
utility of
muffins 1.00

.50

-If more is always better: marginal utility


must always be positive.
-Diminishing marginal utility
-A positive marginal utility means you like
the good. Otherwise you would get zero or
perhaps negative marginal utility

.25
1 2
3
y, weekly consumption of muffins
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Utility function (2 good


example)
Indifference
curve

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Indifference Curve (IC)


Clothing
-2 good graph (keeps it simple)
- Along curve consumer is
indifferent between each of the
bundles of food and clothing
-Same level of utility for bundle
A, B, and C

A
B
C

IC1 for U=4


food

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Indifference Map:
Clothing
Are indifferent to any bundle along
an
indifference curve. But more is
better so are better
off as
we move
Preference
direction
( happier
away from thethe
origin.
further away from the origin
IC2 for U = 6
IC1 for U=4
Food

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Indifference Curves and Map

An Indifference Curve or Indifference Set:


is the set of all baskets for which the
consumer is indifferent

An Indifference Map: illustrates a set of


indifference curves for a consumer, it is an
ordinal ranking.

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Properties of Indifference
Maps
1. Monotonicity => indifference curves have
negative slope and indifference curves
are not thick
2. Transitivity => indifference curves do not
cross
3. Completeness => each basket lies on only
one indifference curve

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Properties of Indifferences
Maps
One

more assumption usually is made:

4. Averages preferred to
extremes => indifference curves are
bowed toward the origin (convex to
the origin).

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Monotonicity:
Consumers like both goods.
Clothing

Preferred to A

Less
preferred

To meet
monotonicity:
preference curve
must be in the
these areas:
downward sloping

IC1
Food

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Monotonicity:
Clothing
If more is preferred to less, IC
cannot be thick. B would be
preferred to A, so could not be
on same CI curve.

B
A

IC1 for U=4


food

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Indifference Curves Cannot


Cross
clothing

IC1

Suppose that B preferred to A.


but..by definition of IC,
B indifferent to C
A indifferent to C => B indifferent
to A by transitivity.
Contradiction, B should be preferred
to A.

IC2
B

food

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Averages Preferred to
Extremes
Clothing

(.5A, .5B)

IC2

IC1
Food

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Example: For the indifference curves


graphed
below, are the underlying preferences:
IC1 IC2
y

IC3

IC4

Complete?
Transitive?
Monotonic?

Preference direction

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Example: For the indifference curves


graphed
below, are the underlying preferences:
IC1 IC2
y

IC3

Complete? Yes
Transitive? Yes
Monotonic?
No X
Want
as much

IC4

as possible
but dont care about Y: So
same X and more Y are not
B better off, so not
monotonic.
Preference direction

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Marginal Rate of
Substitution
The marginal rate of substitution:
is the maximum rate at which the consumer
would be willing to substitute a little more of
good x for a little less of good yor

It is the increase in good x that the consumer


would require in exchange for a decrease in
good y in order to leave the consumer
indifferent between consuming the old basket
or the new basketor
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Marginal Rate of
It is the rate of exchange between goods x and y
Substitution

that does not affect the consumers welfareor

It is the negative of the slope of the indifference cur


MRSx,y=
-y/x

dy
=Slope of the indifference
dx curve

(for a constant level of preference)


If you like both goods, the MRSx,y will be negative.

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An indifference curve exhibits a diminishing rate of substitution:


if the more of good x you have, the
more you are willing to give up to
get
a little of good yor

The indifference curves get flatter as we move out along


the horizontal axis and steeper as we move up along the
vertical axis.
Example:TheDiminishingMarginalRateofSubstitution

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Example: For the following indifference curves, what is


the marginal rate of substitution between x and y is: 1, .
5, 2, or 5? Is the MRS diminishing?
What type of good are
these?

y
3

Perfect substitutes

Does the MRS need to be 1


for each of these?

No could be in a ratio of 2
to 1 (2 oreo cookies for each
glass of milk
IC1
1

IC2
2

IC3
3

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Graphing an Indifference
y
Curve
Example: Suppose U = xy, graph the utility curve
utility is equal to 10.

2
0

10 = xy
2

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y
Example: U=20

Preference direction

20 = xy
2
0

10 = xy
2

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RelativeIncomeandLifeSatisfaction(withinnations)

RelativeIncomePercent>="Satisfied"
Lowestquartile70

8 % more satisfied

Secondquartile78
Thirdquartile82
Highestquartile85

4% more satisfied
3 % more satisfied

Source:Hirshleifer,JackandD.Hirshleifer,Price Theory and Applications.


SixthEdition.PrenticeHall:UpperSaddleRiver,NewJersey.1998.

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Absolute Income and Life Satisfaction (across nation


GNP per
"satisfaction"
capita
< $2,000

number of

median

nations
1

score
5.5

$2,000-$4,000

6.6

$4,000-$8,000

7.0

Source:Hirshleifer,JackandD.Hirshleifer,Price Theory and Applications.SixthEdition.PrenticeHall:U


$8,000-$16,000
14
7.4
SaddleRiver,NewJersey.1998.

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Marginal Utility and


Marginal Rate of Substitution
MUx(x) + MUy(y) =0 along an IC
MUx/MUy=
-y/x =MRSx,y

U ( x, y )
U
U
dU
.dx
.dy 0
x
y
dy U / x
MRS=
dx U / y

Derive

memoriz
e

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Marginal Utility and


Marginal Rate of Substitution

Positive marginal utility implies the


indifference curve has a negative slope
(implies monotonicity)

Diminishing marginal utility implies the


indifference curves are convex to the origin
(implies averages preferred to extremes

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Example: U = Ax2+By2; MUx=2Ax; MUy=2By


(where: A and B positive)
MRSx,y = MUx/MUy = 2Ax/2By = Ax/By
Marginal utilities are positive (for positive x and y)

Marginal utility of x increases in x;


marginal utility of y increases in y

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Implications of this
Indifference curves are negatively-sloped,
bowed out from the origin, preference direction
is up and right

Indifference curves intersect the axes

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y
Example:GraphingIndifferenceCurves
Concave: prefer extremes to
averages

Preference direction

IC1
0

IC2
x

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Example: U= (xy).5;MUx=y.5/2x.5; MUy=x.5/2y.5


Is more better for both goods? Yes, since
marginal utilities are positive for both.

b. Are the marginal utility for x and y


diminishing? Yes. (For example, as x increases,
for y constant, MUx falls.)
c. What is the marginal rate of substitution
of x for y? MRSx,y = MUx/MUy = y/x

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Do the indifference curves intersect the axes?


A value of x = 0 or y = 0 is inconsistent with any
positive level of utility.

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y
Example: Graphing Indifference Curves

IC1
x

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y
Example: Graphing Indifference Curves

Preference direction

IC2
IC1
x

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Special Functional Forms


1. Cobb-Douglas: U = Axy
where: + = 1; A, , positive constants

MUX = Ax-1y
MUY =

Ax

y-1

MRSx,y =(y)/
(x)

Note: marginal rate of substitute only depends on the ratio of X


and y not on the total amounts of X and y. So indifference curves
for different levels of Utility look identical to each other no matter
how far away from the origin they are.

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Perfect Substitutes: U = Ax + By
Where: A, B positive constants

MUx = A
MUy = B

MRSx,y = A/B so that 1 unit of x is equal to


B/A units of y everywhere
(constant MRS).
Note: marginal rate of substitute only depends on the ratio of A
and B not on the total amounts of X and y. So indifference curves
for different levels of Utility look identical to each other no matter
how far away from the origin they are.

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Example:PerfectSubstitutes(Tylenol,Extra-StrengthTylenol)

Slope = -A/B

IC1

IC2

IC3

x
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3.PerfectComplements:U=min( x, y)

where: , are a positive constant. And min means


take
The smaller of the two constants. I.e you want 8 oz
Coffee with one oz of cream U = min( x, 8 y),
where x is cream and y is coffee.

So x/y = / =1/8 =fixed proportions

MRSx,y is 0 or infinite or undefined


(corner)
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Example:PerfectComplements(nutsandbolts)

IC1

x
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Example:PerfectComplements(nutsandbolts)

IC2
IC1

x
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Quasi-Linear Preferences
U=v(x)+Ay
Where: A is a positive constant.

MUx = v(x) = V(x)/x=dV/dx, where small


MUy = A
"The only thing that determines your personal
trade-off between x and y is how much x you
have."

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Example:Quasi-linearPreferences
(consumptionofbeverages)

MRS diminishes at the


quantity of X increase
But does not depend on
quantity of y.
IC1

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Example:Quasi-linearPreferences
(consumptionofbeverages)

IC2
IC1

ICs have same slopes on any


vertical line

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Summary
1. Described consumer preferences without
any restrictions imposed by budget
2. Minimal assumptions on preferences to get
interesting conclusions on demandseem to
be satisfied for most people. (ordinal utility
function)

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