Price Theory

Lecture 1: Preferences
Consumer Preferences
Definition: Basket

A combination of goods and services that someone might consume.

A basket describes both which goods and services an individual consumes,

and the quantities consumed.
Units
of
Food
We will often consider economies with only
A
40 two goods.

In this case a basket is comprised of food

and clothing.

The basket represented by point A contains

B 20 units of clothing, and 40 units of food.
20
The basket represented by point B contains
30 units of clothing, and 20 units of food.
C
10
The basket represented by point C
contains 10 units of food, and does not
contain any clothing.
20 30 Units of Clothing
Definition: Consumer Preferences

A description of how a consumer would rank (compare the desirability of) any
two possible baskets, assuming the baskets were available to the consumer
at no cost.

In economics we regard preferences as being innate to each individual.

Everyone is different, and no two people share identical preferences.
Every time that you choose one product over another you reveal a preference.

Your preferences will change depending on your circumstances.

Would you like an aspirin?

Your preferences will change over time.

Would you prefer to play on the swings, or drink a cup of coffee?

We usually make three assumptions about a consumers preferences.

Units
of
Food Assumption 1:
Preferences are Complete
A
The first assumption is that a consumer can
rank any two baskets.

There are three ways in which two baskets

can be ranked:

B 1. The consumer prefers basket A to

basket B (written A B).

2. The consumer prefers basket B to

basket A (written B A).

3. The consumer is indifferent between

baskets A and B (written A B).
Units of Clothing
Units
of
Food

A Assumption 2:
Preferences are Transitive

The second assumption is that a consumer

makes choices that are consistent with
each other.
B If a consumer prefers basket A to basket B,
AND the consumer prefers basket B to
basket C, THEN the consumer must prefer
C
basket A to basket C.

(Written: If A B and B C, then A C.)

Units of Clothing
 The assumptions that preferences are complete and transitive are closely
related the concept of rationality.

Without complete and transitive preferences a consumer may not be able to

make a choice when presented with a range of alternatives.

If a consumers preferences are not complete, then there are (at least) two
baskets that the consumer is incapable of comparing.

If a consumers preferences are not transitive, then there are cycles within the
preferences.
Units
of
Food
A cycle exists in a consumers preferences
A whenever there are three baskets such that
A B C A.

Suppose a consumer starts with basket A.

He or she would be happy to swap A for C.
(And may be willing to pay a small amount
to do so.)
B
But the consumer is then willing to swap C
for B, and then wants to swap B for A.
C
In this way, consumers with non-transitive
preferences can be turned into money
pumps.

Units of Clothing
 Quick Quiz
Suppose that there are three possible consumption baskets labeled A, B and
C. Are the following preferences complete and transitive?

A B and B C.

A B, C B and C A.

A B, B C and A C.
Units
of
Food Assumption 3:
More is Better
E D A
The third assumption is that having more of
a good is always better for a consumer.

Basket A is preferred to the six other

F baskets shown here.

Basket A has more food than B and C, and

the same amount of clothing.

G B Basket A has more clothing than D and E,

and the same amount of food.

C Basket A has more food and more clothing

than F and G.
Units of Clothing
Units
of
Food

E D A The more is better assumption does not tell

us everything about a consumers
preferences.

More is better does not tell us how a

F consumer ranks F and B.

Basket F has more food, but less clothing,

than B.
G B
(We dont know how F is ranked against C,
D and E for the same reason.)
C

Units of Clothing
Utility Functions
Definition: Ordinal Ranking

A ranking that indicates whether a consumer prefers one basket to another,

but does not contain quantitative information about the intensity of that
preference.

For a great deal of microeconomic analysis, knowing a consumers ordinal

ranking is sufficient to understand their behaviour.
Definition: Cardinal Ranking

A quantitative measure of the intensity of a preference for one basket over

another.

Understanding a consumers cardinal ranking is essential to understanding

their choices in the presence of uncertainty.
 A utility function assigns a number to each basket of goods and services that
an individual consumes.

For a basket of goods and services A, we write U(A) to indicate the utility that a
consumer derives from consuming the basket.

Bigger is better. The higher the value of U(A), the greater the benefit that a
consumer gains from consuming the basket A.

Therefore, A B implies U(A) > U(B). While the difference U(A) U(B) represents
the intensity of the consumers preference.
 A utility function is complete and transitive.

Because both U(A) and U(B) are numbers, either U(A) > U(B), U(B) > U(A) or
U(A) = U(B).

If U(A) > U(B) > U(C), then it must be the case that U(A) > U(C).

For a utility function to satisfy more is better, it must be the case that if basket A
has at least as much of every good as basket B, and more of at least one good,
then U(A) > U(B).
Utility
U(y) Utility Functions with a Single Good
p To begin with lets consider a utility with a
U(y ) = y
single good, hamburgers.
2.24
2 We can evaluate this consumers utility by
substituting the number of hamburgers
eaten into the utility function.

When 1 hamburger is eaten, the

1 consumers utility is U(1) = 1.

When 4 hamburgers are eaten, the

consumers utility is U(4) = 2.

When 5 hamburgers are eaten, the

consumers utility is U(5) = 2.24.
1 2 3 4 5

Hamburgers (y)
Definition: Marginal Utility

The rate at which total utility changes as the level of consumption rises.

The marginal utility of a good is the slope of the utility function, holding
constant the level of consumption of all other goods.
Utility
U(y)
The marginal utility at a point is represented
p by the slope of a line that is tangent to the
U(y ) = y
utility function at that point.

U
MU y =
y
U
Recall that the slope of a function at a point
is known as its derivative.

dU
MU y =
dy

You will always be provided with a utility

y
functions marginal utilities in this course.

Hamburgers (y)
 Utility
2.24
2
Here, the marginal utility of hamburgers has
p been found by taking the derivative of the
U(y ) = y utility function.
1
Marginal utility is high where the utility
function is steep, and low where the utility
function is flatter.
Marginal Utility When 1 hamburger is eaten, the marginal
utility is 0.5.
0.5 1
MU y = p
2 y When 4 hamburgers are eaten, the
marginal utility is 0.25.
0.25
0.22 When 5 hamburgers are eaten, the
marginal utility is 0.22.

1 2 3 4 5
Hamburgers
 Utility

Marginal utility is positive. For this

p consumer, when it comes to hamburgers
U(y ) = y more is better.

Each hamburger eaten adds to (increases)

this consumers happiness or wellbeing.

Marginal utility is downward sloping. Each

Marginal Utility hamburger eaten creates less additional
benefit than the last.
1
MU y = p
2 y The first hamburger you eat each week
may give you a great deal of enjoyment.

The enjoyment you get from your fourth or

fifth hamburger is likely considerably less.

Hamburgers
Definition: Principle of Diminishing Marginal Utility

The principle that after some point, as consumption of a good increases, the
marginal utility of that good will begin to fall.
 Utility

The assumption that more is better implies

that increased consumption of a good
always increases an individuals wellbeing.

For many goods, including food, alcohol

Positive MU Negative MU and pharmaceuticals, there comes a point
beyond which increased consumption
Marginal Utility reduces wellbeing.

Does this matter?

Probably not. A rational consumer will

choose to consume a quantity with a
positive marginal utility.

Hamburgers
 p
U(x, y ) = xy

Utility (U)
Utility Functions with Two Goods
This graph illustrates a total utility function
with two goods.

Each point on the horizontal plane

corresponds to a consumption basket.

The utility created by this consumption

basket is represented by the hight of the
function at this point.
12
3 For this consumer U(3,12) = 6.
Food (y)
Clothing (x)
 When the utility function is defined in terms
of multiple goods, marginal utilities must be
derived separately for each good.
Utility (U)
To find the marginal utility of good x, treat
the quantity of good y as fixed.

The marginal utility is the slope of a tangent

to the utility function, in the direction of an
increase in x,
U
MU x =
x holding y constant

This is the partial derivative of the utility

function with respect to x,
Food (y) @U
Clothing (x) MU x =
@x
 The marginal utility of good y is found in the
same way.
Utility (U)
Treat the quantity of good x as fixed.

The marginal utility is the slope of a tangent

to the utility function, in the direction of an
increase in y,
U
MU y =
y holding x constant

This is also the partial derivative of the utility

function with respect to y,

Food (y) @U
MU y =
@y
Clothing (x)
Definition: Indifference Curve

A curve connecting a set of consumption baskets that yield the same level of
satisfaction to the consumer.

Each level of utility has a corresponding indifference curve.

 p
U(x, y ) = xy

We can illustrate indifference curves on the

Utility (U) U=6 three dimensional graph of a total utility
function.

An indifference curve is a line indicating all

U=4 points on the utility function at the same
level (or height).

Higher indifference curves correspond to

U = 2 higher levels of utility.

We can only illustrate a few indifference

curves at a time.
Food (y)
Clothing (x)
Food (y)
p
U(x, y ) = xy

Consider the indifference curve

8
corresponding to utility U = 4.

6 The indifference curves for lower levels of

utility lie below and to the left.

4 U=6 The indifference curves for higher levels of

utility lie above and to the right.
2 U=4
U=2
2 4 6 8 Clothing (x)
Food (y)

Using only the more is better assumption,

we can derive four important properties of
indifference curves.

1. Indifference curves have negative slopes.

Pick any point on the indifference curve.

More is better tells us that the consumer

A prefers basket A to any basket that is
below and to the left.

More is better tells us that the consumer

U1
prefers any basket that is above and to the
right, over basket A.

Clothing (x)
Food (y)

We can understand this feature another

way, by considering the marginal utilities of
C B
the two goods.

If the consumer likes both goods then both

goods have positive marginal utilities
(MUx > 0 and MUy > 0).

Consuming more of one good makes the

A consumer better off, raising the consumer
U2
to a higher level of utility.

U1 To return to the original indifference curve,

this increase must be offset by a decrease
in the consumption of the second good.

Clothing (x)
Food (y)
U2
2. Indifference curves cannot intersect.

B More is better tells us that B A.

This means that the utility of baskets on the

indifference curve U2, is higher than the
A
utility of baskets on U1.

Now consider the baskets C and D.

More is better tells us that D C. But this

means that U1 > U2.
D
U1
3. Every consumption basket lies on one,
C and only one, indifference curve.

Clothing (x)
Food (y)

4. Indifference curves are not thick.

If an indifference curve is thick then we can

pick a basket A at the bottom edge of the
curve.

We can also pick a basket B that is above

B A, and to the right, but still on the same
indifference curve.

A Since basket B has more of both goods

U1
than basket A, the more is better
assumption tells us that B A.

Clothing (x)
Food (y)

A Quick Quiz

Consider this set of consumption baskets.

B Suppose that baskets E and F lie on the

E same indifference curve, and that the
consumers preferences satisfy the more is
better assumption.
F
C
Which of the remaining consumption
basket(s) A, B, C or D cannot lie on
D
the same indifference curve as baskets E
and F?

Clothing (x)
Marginal Rate of Substitution
Food (y) Consider the tradeoffs that occur as we
move down, along an indifference curve.

As consumption of good y falls, an

individual must gain units of good x to
maintain a constant level of utility.

The rate at which units of x are exchanged

for units of y, along the indifference curve,
is known as the marginal rate of
A substitution.
y
The marginal rate of substitution is the
negative of the slope of the indifference
U1 curve.

x y @y
MRS x,y = or MRS x,y =
x @x
Clothing (x)
 We can state the marginal rate of substitution in terms of marginal utilities.

The change in total utility brought about by a small change in consumption is

approximately,

U = MU x x + MU y y

Along an indifference curve utility is constant therefore U = 0. Rearranging this

expression then gives us,

y MU x
MRS x,y = =
x MU y
Definition: Diminishing Marginal Rate of Substitution

A feature of consumer preferences for which the marginal rate of substitution

of one good for another good diminishes as the consumption of the first good
increases along an indifference curve.

Diminishing marginal rate of substitution implies that indifference curves get

flatter as we move down along the curve.
Coke (y)
Suppose consumption baskets consist of
burgers and cans of Coke.

Moving from basket A to B, the consumer

A is willing to trade 2 cans of Coke for an
4 additional burger.

3 At A the consumer has lots of Coke but

only one burger. It is likely that the marginal
B utility of the fourth Coke is low, while the
2 marginal utility of an additional burger is
high.
C
1 U1 Moving from basket B to C, the consumer
is only willing to give up a can of Coke for
an additional two burgers.
1 2 3 4 Burgers (x)
Questions?