17.01.
26, 13:11 Preferences, Constraints and Consumer Choice
IT
IT
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CHAPTER 2 / PREFERENCES,
PREFERENCES,
PREFERENCES, CONSTRAINTS
CONSTRAINTS
CONSTRAINTS AND
AND
AND CONSUMER
CONSUMER
CONSUMER CHOICE
CHOICE
CHOICE
2.1 Preferences and Utility
How do individuals take their consumption decisions? The idea behind the theory of consumers’ decisions
that we present in this chapter is very simple: the consumer chooses the preferred combination of goods
among those that he can afford. To make this idea precise, which we do in Section
Section
Section2.3
2.3
2.3,
2.3 we must first
develop the conceptual tools needed to formalize preferences mathematically. This is what we do in this
section and the next.
The object of a consumer’s choice is a consumption bundle, i.e. a list of quantities of the various goods or
services that the individual consumes in a given time interval. For example, if we are interested in discussing
the choice of how to spend evenings out during a month, and the individual only cares about dinner in a
pizzeria and movies at the cinema, a bundle is simply a list of two numbers. Thus, bundle (3, 1) represents
the alternative “three times at the pizzeria and once at the cinema”, bundle (2, 5) the alternative “twice at
the pizzeria and five times at the cinema”, and so on.
Looking at only two goods at a time (from now on we shall call them “good X ” and “good Y ”, denoting
by X and Y also some generic quantities of the goods) allows us to simplify the theory without neglecting
its most important aspects. An important advantage is that we can represent the set of all possible
consumption bundles as a Cartesian plane. A point’s coordinates are the quantities in the bundle represented
by that point. The figure below provides an example.
Cinema
FIGURE 2.1
6
Move the two sliders (or drag
5
then see which bundles are pr
4
Pizza = 2
3 Cinema = 2
2
A
Show bundles preferred
Show bundles to which
1
0 Pizza
0 1 2 3 4 5 6
The example above relies on an implicit hypothesis that we will always assumed satisfied: the consumer can
order coherently all possible bundles (with some possible ex aequo). Two other properties that are satisfied in
the example, and we will always assume, are the following:
Nonsatiation: given any two bundles A and B , if B presents greater quantities of both goods
compared to A, then the consumer prefers B .
Convexity or preference for variety: given any two bundles A and B , if B is preferred to A, then the
bundle C obtained as the average of A and B is also preferred to A.
Looking at Figure 2.1, the first property is easy to verify: given any bundle A, all bundles lying north-east of
A are preferred to A. To verify the second property, consider for instance bundles A = (4, 1) and B =
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(2, 5), which is preferred to A. As required by the preference for variety property, bundle C = (3, 3), the
average of A and B , is also preferred to A.
Divisible Goods and Indifference
The example in Figure 2.1 considers indivisible goods: it is not possible to buy three quarters of a movie or
two and a half pizzas. One consequence of indivisibility is that it is often impossible to change the two
goods’ consumption levels in such a way that the consumer remains indifferent. Take, for instance, bundle
A = (2, 4), and suppose that we add una pizza and subtract some movies. How many movies should we
subtract, to leave the consumer indifferent? This question has no answer: subtracting two is too little,
because bundle (3, 2) is preferred to A, while subtracting three is too much, as A is preferred to (3, 1).
In many other situations, and it is on them that we will almost exclusively focus our attention, choice
regards goods that we can, to a good approximation, consider perfectly divisible. These are goods that one
buys by fractions of kilograms, liters or square meters, like food (and other goods or services) and apartments
for rent. In such situations it is meaninghful to think of every point in the plane as a possible consumption
bundle. It also becomes meaningful to assume that, starting from any bundle A, any variation in the
consumption of one good can be counterbalanced by a variation in the consumption of the other good, in
such a way that the consumer remains indifferent.
Graphically, this means that for every bundle A theree exists an indifference curve, defined as the set of all
bundles that the consumer finds exactly as desirable as A, crossing the entire space of bundles, passing
through bundle A itself, and separating the bundles preferred to A from those to which A is preferred.
Considering all possible bundles we will have drawn an infinite family of indifference curves, providing a
complete description of the consumer’s preferences.
The following figure provides an example, assuming X is a generic consumption good (food, clothes,
transportation, etc.) and Y the size of the consumer’s apartment.
Housing (tens of m2 )
FIGURE 2.2
8
Move the two sliders (or drag
then see which bundles are pr
6
Consumption = 4,
Housing = 4,
A Show bundles preferred
4.04
Show bundles to which
0 Consumption (kg)
0 2 4.0
4 6 8
The indifference curves in the figure do not cross each other and they are thin, decreasing, and convex. In
fact, these properties are necessarily satisfied, given our hypotheses:
In the case of divisible goods (housing on vertical axis, a generic consumption good on the horizontal axis) there
is an infinite number of indifference curves. In the figure we represent only those passing through the bundles
Given a bundle A and another bundle B preferred to A, the indifference curve passing through
(1, 1), (2, 2), (3, 3) etc. and the one passing through bundle A. Non satiation implies that the bundles that are
B cannot
preferred intersect
to A are the the
ones lying one passing
north-east through
of the curve . If theAtwo
passingAthrough , whilecurves
those tohad a bundle
which C in common, the
A is preferred
are the ones lying south-west of that curve. Indifference curves that are farther away from the origin therefore
consumer would be indifferente both between A and C and between B and C . Thus, by the
corrispond to higher levels of consumer welfare.
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ordering hypothesis discussed earlier, the consumer would be also indifferent between A and B ,
contradicting the fact that B is preferred to A.
If an indifference curve were "thick" (like in the left graph in the figure below) or had increasing
parts (like in the middle graph of the figure), it would contain two bundles A and B that are
equally desirable (since they lie on the same indifference curve) and such that one lies north-east
of the other. By nonsatiation, this is impossible.
If an indifference curve had concave parts (like in the right graph of the figure below), there
would exist two bundles A and B such that B is preferred to A, but the bundle C obtained as
average of A and B is not preferred to A, contradicting the preference for variety.
FIGURE 2.3
units units units
of Y of Y of Y
B
B B
A
A C
A
units units units
of X of X of X
A "THICK" CURVE A CURVE WITH AN A NON-CONVEX
INCREASING PART CURVE
Nonsatiation
implies that Nonsatiation Preference for
indifference curves implies that variety implies that
cannot be thick. indifference curves indifference curves
cannot have must be convex.
Utility increasing parts.
A quick and intuitive way to represent a consumer’s preferences is by means of a utility function, i.e. a
function associating to each bundle (X, Y ) a number U (X, Y ), in such a way that preferred bundles are
associated with higher utility numbers.
Once we add this third dimension to the space of possible bundles, we can view indifference curves as level
curves: each curve corresponds to a utility level, containing all and only the bundles associated with that
utility level.
The following figure presents an example.
FIGURE 2.4
X = 4,0
Y = 4,0
Show indifference curv
The preferences of the c
the utility function
U (X,
The utility of bundle (4
U (4.0,
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It is important to note that not all functions assigning numbers to consumption bundles are utility functions.
Indeed, it must be the case that bundles with the same utility lie on a thin, decreasing, convex curve.
Moreover, curves corresponding to higher utility must lie farther away from the origin.
Finally, it is important to keep in mind that the unit of measure of utility is completely irrelevant, because
utility is a purely ordinal concept: it allows us to say whether a bundle gives the consumer more or less (or
the same) welfare than another bundle, but it does not provide a measure of how much welfare the consumer
enjoys with one bundle or the other. Looking at Figure
Figure
Figure2.4
2.4
2.4 we see that, if we assume the utility function
U = XY , then bundles (4, 4) e (9, 1) give utility 16 and 9, respectively. These numbers do no mean
anything per se. What is meaningful is that 16 is larger than 9 and hence bundle (4, 4) is preferred to bundle
(9, 1). Indeed, the same preference can be represented, by changing the unit of measure of utility, via the
function U = XY , given that 4 × 4 > 9 × 1. Looking at the graph of the function U = XY we
see that, in fact, the function generates a family of indifference curves identical to the one generated by U =
XY .
FIGURE 2.5
X = 4,0
Y = 4,0
Show indifference curv
The preferences of the c
the utility function
U (X, Y
The utility of bundle (4
U (4.0,
Economists use many types of utility functions. In these notes we will limit ourselves to functions of the
form
U = (X + σ)α (Y + σ)β
where α > 0 and β > 0 are subjective parameters reflecting the importance that the consumer gives to
goods X and Y , respectively, while σ ⩾ 0 reflects the substitutability between the two goods (we discuss
substitution between goods in the next section). It is worth noting that the family of indifference curves
generated (and hence the preference represented) by a utility function of this type depend on α and β only
through the ratio α/β , i.e. the relative importance of the two goods. For instance, a consumer with
preferences represented by U = (X + 1)2 (Y + 1) is identical to one with preferences represented by U =
(X + 1)4 (Y + 1)2 or by U = (X + 1)(Y + 1)0.5 .
Figure
The figure below gives three examples (Alice’s preferences, the same as those in Figure 2.2
Figure2.2
2.2,
2.2 are represented
by the utility function U = XY , whose graph is depicted in Figure
Figure
Figure2.4
2.4
2.4).
2.4
FIGURE 2.6
units units units
of Y A of Y A of Y A
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B B B
2 2 2
units units units
of X of X of X
1 4 1 4 1 4
ALICE ( 𝛼 = 1, 𝛽 = 1, 𝜎 = BRUNO ( 𝛼 = 2, 𝛽 = 1, 𝜎 CARMEN ( 𝛼 = 1, 𝛽 = 1,
0) =0) 𝜎=5)
Drag bundles A and Drag bundles A and Drag bundles A and
B to see which one B to see which one B to see which one
Alice prefers. Bruno prefers. Carmen prefers.
Alice is indifferent Bruno prefers B to Carmen prefers A
between A and B . A. to B .
U (1, 8) = 1 × 8 = U (1, 8) = 12 × U (1, 8) = (1 +
As the
8 figure shows, not all 8 =consumers
8 who prefer
5) ×variety
(8 + 5)and
= 78have nonsatiated preferences are equal. For
example,
U (4, 2)Alice
= 4 ×is 2indifferent
= between 2 bundles (1, 8) and (4, 2). In other words, starting from bundle (1, 8)
U (4, 2) = 4 × U (4, 2) = (4 +
she 8would be willing to give 2 = up
32 six units of Y to
5) have
× (2 + 5) =more
three 63 units of X . Bruno instead prefers (4, 2) to
(1, 8), so he would be willing to give up more than six units of Y to have three more units of X . Carmen, on
the contrary, prefers (1, 8) to (4, 2), so she would be willing to give up less than six units of Y to have three
more units of X .
Carmen’s preferences differ from Alice’s and Bruno’s also along another important dimension. Between a
bundle with positive quantities of both goods (an interior bundle) and a bundle where the quantity of some
good is zero, Alice always prefers the first, and the same holds for Bruno. This is due to the fact that with
Cobb-Douglas preferences (σ = 0) the indifference curve passing through an interior bundle never touches
the axes. Carmen’s indifference curves, instead, touch the axes. Carmen can be indifferent between an
interior bundle and a bundle where the quantity of one good is zero, or even prefer the latter bundle, as long
as the quantity of the other good is large enough. This is due to the fact that Carmen’s utility function has
σ > 0.
As we shall see in the remainder of the chapter, a consumer’s willingness to exchange one good with the
other plays a crucial role in the consumer’s decisions.
NEXT: SUBSTITUTION
SUBSTITUTION
SUBSTITUTION BETWEEN
BETWEEN
BETWEEN GOODS
GOODS
GOODS
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