Introduction Principles Consumer Preferences Substitution Utility Exercices

EC2101 - Lecture 1

Younghwan In

National University of Singapore

14 August 2008

I. Introduction
II.1. Consumption Decisions: Principles and Preferences
Introduction Principles Consumer Preferences Substitution Utility Exercices

Microeconomics
• Microeconomics concerns individual decision making and its
collective effect on allocation of a society’s resources
• Individuals: typically consumers and the managers of firms.
• Institutions for allocating resources: centralized or
decentralized? markets (buyers, sellers, prices).
• We assume people are motivated only by material self-interest
(unless stated otherwise).
• Positive versus normative analysis.
• The scientific method:
• Initial observation (data)
• Theorizing (models)
• Identification of additional implications
• Further observation (data) and testing
• Refinement of the theory
• Uses of microeconomics
• Helps make important personal and business decisions.
• Provides tools for understanding and evaluating the effect of
public policies.
Introduction Principles Consumer Preferences Substitution Utility Exercices

Supply and Demand - Market Equilibrium

Bernheim and Whinston p.36.

Introduction Principles Consumer Preferences Substitution Utility Exercices

Supply and Demand - Elasticities

• Suppose that a change in X causes a change in Y .
• Then the elasticity of Y with respect to X is the percentage
change in Y divided by the percentage change in X :

% change in Y
EXY = .
% change in X
• For example, the price elasticity of demand

% change in amount demanded(Q) 100 × (∆Q/Q)

Ed = =
% change in price(P) 100 × (∆P/P)
(∆Q/Q)
=
(∆P/P)
∆Q P
= ( )( ).
∆P Q
Introduction Principles Consumer Preferences Substitution Utility Exercices

Balancing Benefits and Costs

Bernheim and Whinston p.79.

Introduction Principles Consumer Preferences Substitution Utility Exercices

Principles of Decision Making

We assume the following two principles on consumer preferences:
1. The Ranking Principle: A consumer can rank, in order of
preference (though possibly with ties), all potentially available
alternatives.
2. The Choice Principle: Among available alternatives, the
consumer chooses the one that he ranks the highest.

Bernheim and Whinston p.94.

Application 4.1 (Bernheim and Whinston p.94) Netflix.

Introduction Principles Consumer Preferences Substitution Utility Exercices

How Do People Rank Consumption Bundles?

A consumption bundle is the collection of goods that an

individual consumes over a given period.
Now an additional assumption on consumer preferences:
3. The More-is-better Principle: When one consumption
bundle contains more of every good than a second bundle, a
consumer prefers the first bundle to the second.

Bernheim and Whinston p.96.

Introduction Principles Consumer Preferences Substitution Utility Exercices

Indifference Curves

• Indifference curves are used when goods are (or assumed to

be) available in any fraction of a unit.
• Starting with any alternative, an indifference curve shows all
the other alternatives a consumer likes equally well.

Bernheim and Whinston p.98.

Introduction Principles Consumer Preferences Substitution Utility Exercices

Properties of Indifference Curves

1. Indifference curves are thin.

2. Indifference curves do not slope upward.

Bernheim and Whinston p.100.

3. An indifference curve separates bundles that are better from

bundles that are worse than those that are on the indifference
curve.
Introduction Principles Consumer Preferences Substitution Utility Exercices

Properties of Families of Indifference Curves

4. Indifference curves from the same family do not cross.

5. Comparing two bundles, the consumer prefers the one on the
indifference curve further from the origin.

Bernheim and Whinston p.101.

Application 4.2 (Bernheim and Whinston p.102-103) Preferences

for Automobile Characteristics.
Introduction Principles Consumer Preferences Substitution Utility Exercices

Plotting Indifference Curves from a Formula

Bernheim and Whinston p.104.

Introduction Principles Consumer Preferences Substitution Utility Exercices

Goods versus Bads

Bernheim and Whinston p.105.

Introduction Principles Consumer Preferences Substitution Utility Exercices

Rate of Substitution

• Economic decisions involve trade-offs.

• To determine whether a consumer has made the best choice,
we need to know the rate at which she is willing to make
trade-offs between different goods.

Bernheim and Whinston p.106.

Introduction Principles Consumer Preferences Substitution Utility Exercices

Marginal Rate of Substitution

• The marginal rate of substitution for X with Y ,
MRSXY (= − ∆Y∆X ), is the rate at which a consumer must
adjust Y to maintain the same level of well-being when X
changes by a tiny amount, from a given starting point.
• Tells us how much Y a consumer needs to compensate for
losing a little bit of X .
• Tells us how much Y to take away to compensate for gaining
a little bit of X .

Bernheim and Whinston p.107.

Introduction Principles Consumer Preferences Substitution Utility Exercices

What Determines Rates of Substitution?

1. Differences in tastes across consumers

• Preferences for one good over another affect the slope of an
indifference curve.

Bernheim and Whinston p.109.

Introduction Principles Consumer Preferences Substitution Utility Exercices

What Determines Rates of Substitution?

2. As we move along an indifference curve ...

• People like variety so most indifference curves get flatter as we
move from top left to bottom right.
• MRS declines; the amount of Y required to compensate for a
given change in X decreases.

Bernheim and Whinston p.109.

Introduction Principles Consumer Preferences Substitution Utility Exercices

Why Are Rates of Substitution Important?

• If two people have different MRS ...

• Is mutually beneficial and voluntary trade possible?
• Example 4.3 (Bernheim and Whinston p.111).
Introduction Principles Consumer Preferences Substitution Utility Exercices

Special Case (1): Perfect Substitutes

• Two products are perfect substitutes if their functions are

identical; a consumer is willing to swap one for the other at a
fixed rate.

Bernheim and Whinston p.113.

Introduction Principles Consumer Preferences Substitution Utility Exercices

Special Case (2): Perfect Complements

• Two products are perfect complements if they are valuable

only when used together in fixed proportions.

Bernheim and Whinston p.114.

Introduction Principles Consumer Preferences Substitution Utility Exercices

Utility, Utility Function

• Utility is a numeric value indicating the consumer’s relative

well-being.
• We can describe the value a consumer gets from consumption
bundles mathematically through a utility function. For
example,
U(S, B) = 2S + 5(S × B).
Introduction Principles Consumer Preferences Substitution Utility Exercices

From Preferences (Indiff Curves) to a Utility Function

Bernheim and Whinston p.116.

Introduction Principles Consumer Preferences Substitution Utility Exercices

From a Utility Function to Preferences (Indiff Curves)

Bernheim and Whinston p.117.

Lecture1a.mws.
Introduction Principles Consumer Preferences Substitution Utility Exercices

Ordinal versus Cardinal Utility

• Information about preferences can be ordinal or cardinal.

• Ordinal information allows us to determine only whether one
alternative is better than another.
• Cardinal information reveals the intensity of preferences,
”How much worse or better?”
• In modern microeconomic theory, utility functions are only
intended to summarize ordinal information.
• Another utility function obtained by an order-preserving
transformation of an original utility function represents the
same preferences.
Introduction Principles Consumer Preferences Substitution Utility Exercices

Utility Functions and MRS

• Marginal utility is the change in a consumer’s utility

resulting from the addition of a very small amount of some
good, divided by the amount added.
∆U
MUX = .
∆X
• By itself, the marginal utility of a good does not measure
anything meaningful. However, the ratio of the marginal
utilities for two goods is equal to MRS between them:
MUX
MRSXY = .
MUY
Introduction Principles Consumer Preferences Substitution Utility Exercices

Exercises for Tutorial 1

• In-Text Exercise 4.3 (Bernheim and Whinston p.111-112).

• In-Text Exercise 4.5 (Bernheim and Whinston p.115, 120).
• Exercise 4.2 (Bernheim and Whinston p.121-122).