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Consumer Preferences
and the Concept of Utility
Outline
Introduction
Description of consumer preferences
The Utility functions
Indifference Curves
Marginal rate of substitution
Special functional forms
2
Introduction
Introduction
We need to develop a model about individual or
consumer behavior
Model is based on:
1.
2.
3.
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
2.
Transitive
:
No illogical
behavior
A B and B C A C NOT C A
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Properties of Consumer
Preferences
3.
Preferences Examples
Hall:UpperSaddleRiver,NewJersey.1998.
10
Utility Function
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.
13
.5
1.5
1.0
B
A
1
2
3
y, weekly consumption of muffins
14
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
15
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.
Marginal Utility
MU(y):
marginal
utility of
muffins 1.00
.50
.25
1 2
3
y, weekly consumption of muffins
17
18
A
B
C
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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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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
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
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IC1
IC2
B
food
26
Averages Preferred to
Extremes
Clothing
(.5A, .5B)
IC2
IC1
Food
27
IC3
IC4
Complete?
Transitive?
Monotonic?
Preference direction
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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
Marginal Rate of
It is the rate of exchange between goods x and y
Substitution
dy
=Slope of the indifference
dx curve
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32
y
3
Perfect substitutes
No could be in a ratio of 2
to 1 (2 oreo cookies for each
glass of milk
IC1
1
IC2
2
IC3
3
33
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
35
RelativeIncomeandLifeSatisfaction(withinnations)
RelativeIncomePercent>="Satisfied"
Lowestquartile70
8 % more satisfied
Secondquartile78
Thirdquartile82
Highestquartile85
4% more satisfied
3 % more satisfied
36
number of
median
nations
1
score
5.5
$2,000-$4,000
6.6
$4,000-$8,000
7.0
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U ( x, y )
U
U
dU
.dx
.dy 0
x
y
dy U / x
MRS=
dx U / y
Derive
memoriz
e
38
39
40
Implications of this
Indifference curves are negatively-sloped,
bowed out from the origin, preference direction
is up and right
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y
Example:GraphingIndifferenceCurves
Concave: prefer extremes to
averages
Preference direction
IC1
0
IC2
x
42
43
44
y
Example: Graphing Indifference Curves
IC1
x
45
y
Example: Graphing Indifference Curves
Preference direction
IC2
IC1
x
46
MUX = Ax-1y
MUY =
Ax
y-1
MRSx,y =(y)/
(x)
47
Perfect Substitutes: U = Ax + By
Where: A, B positive constants
MUx = A
MUy = B
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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)
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.
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Example:Quasi-linearPreferences
(consumptionofbeverages)
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Example:Quasi-linearPreferences
(consumptionofbeverages)
IC2
IC1
55
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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