Rationality in Economics
Behavioral Postulate:
A decision-maker chooses his or her
most preferred alternative from what is
available.
So to model choice we must model
decision-makers’ preferences.
Strict preference, weak preference and
indifference are all ordinal relations; i.e.
they state only the order in which
bundles are preferred.
Agenda – Preferences
The Preference Relation – what the
consumer prefers
Basic Consistency Assumptions About
Preferences
Completeness, Reflexivity, Transitivity
How to Represent Preferences with
Indifference Curves
Assumptions about Well-Behaved
Preferences
Monotonicity and Convexity
Marginal Rate of Substitution (MRS)
Preference Relations
x y: the consumer strictly prefers
x to y (x is better than y, y is less
preferred than x).
x y: the consumer equally prefers
x and y (is indifferent between x and
y, x is just as good as y).
x y: the consumer weakly prefers
x to y (x is at least as good as y).
Either x y, or x y.
Agenda – Preferences
The Preference Relation – what the
consumer prefers
Basic Consistency Assumptions About
Preferences
Completeness, Reflexivity, Transitivity
How to Represent Preferences with
Indifference Curves
Assumptions about Well-Behaved
Preferences
Monotonicity and Convexity
Marginal Rate of Substitution (MRS)
Assumptions About Preferences
Completeness: For any two bundles
x and y it is always possible to state
either that
x y
or that
y x.
Assumptions About Preferences
Reflexivity: Any bundle x is always
weakly preferred to itself; i.e.
x x.
Assumptions About Preferences
Transitivity: If
x is at least as good as y, and
y is at least as good as z, then
x is at least as good as z; i.e.
x y and y z x z.
Agenda – Preferences
The Preference Relation – what the
consumer prefers
Basic Consistency Assumptions About
Preferences
Completeness, Reflexivity, Transitivity
How to Represent Preferences with
Indifference Curves
Assumptions about Well-Behaved
Preferences
Monotonicity and Convexity
Marginal Rate of Substitution (MRS)
Indifference Curves
For a reference bundle x’, the set of
all bundles equally preferred to x’ is
the indifference curve (IC)
containing x’; the set of all bundles
y ~ x’.
Since an indifference “curve” is not
always a curve, a better name might
be an indifference “set”.
Indifference Curves
x2 x’ ~ x” ~ x”’
x’
x”
x”’
x1
Indifference Curves
x2
x
z z x y
x1
Indifference Curves
All bundles on the
x2 red indifference
x curve are strictly
preferred to all the
z bundles on the black
curve.
All bundles on the
y black indifference
curve are strictly
preferred to all the
x1 bundles on the
green curve.
Indifference Curves
x2
The set of bundles
x weakly preferred to
x includes the
indifference curve
through x.
x1
Indifference Curves
x2
The set of bundles
x strictly preferred to
x does not include
the indifference
curve through x.
x1
Indifference Curves Cannot Cross
x2 The black curve tells us
x ~ y, and x z and y z.
The green curve tells us
x ~ z, and therefore y ~ z,
x a contradiction.
y
z
x1
Slopes of Indifference Curves
If the consumer prefers more of a
commodity to less, the commodity is
a good.
If every commodity is a good, then
indifference curves are negatively
sloped.
Slopes of Indifference Curves
Good 2
Two goods yield
negatively sloped
indifference curves.
Good 1
Slopes of Indifference Curves
If the consumer prefers less of a
commodity to more, then the
commodity is a bad.
Slopes of Indifference Curves
Good 2 One good and one
bad yield positively
sloped indifference
curves.
Bad 1
Extreme Cases of Indifference
Curves; Perfect Substitutes
If a consumer always regards units
of goods 1 and 2 as equivalent, then
the goods are perfect substitutes,
and only the total amount of the two
goods in bundles determines their
preference rank-ordering.
Extreme Cases of Indifference
Curves; Perfect Substitutes
x2 Bundles on the green
IC all have a total of
15
15 units and are
strictly preferred to all
8 bundles on the red IC
which have a total of
only 8 units in them.
8 15 x1
Slopes of these ICs are all constant at -1.
Extreme Cases of Indifference
Curves; Perfect Complements
If a consumer always consumes
goods 1 and 2 in fixed proportion
(e.g. one-to-one), then the goods are
perfect complements and only the
number of pairs of units of the two
goods determines the preference
rank-order of bundles.
Extreme Cases of Indifference
Curves; Perfect Complements
x2
45o Each of (5,5) , (5,9)
and (9,5) contains
5 pairs so each is
equally preferred.
9
5
5 9 x1
Extreme Cases of Indifference
Curves; Perfect Complements
x2
45o Since each of (5,5),
(5,9) and (9,5)
contains 5 pairs,
each is less
9 preferred than the
bundle (9,9) which
5
contains 9 pairs.
5 9 x1
Agenda – Preferences
The Preference Relation – what the
consumer prefers
Basic Consistency Assumptions About
Preferences
Completeness, Reflexivity, Transitivity
How to Represent Preferences with
Indifference Curves
Assumptions about Well-Behaved
Preferences
Monotonicity and Convexity
Marginal Rate of Substitution (MRS)
Well-Behaved Preferences
A preference relation is “well-
behaved” if it is
monotonic and convex.
Monotonicity: More of any
commodity is always preferred (i.e.
no satiation and every commodity is
a good).
Well-Behaved Preferences
Convex Set: a set such that the line
segment connecting any two points
in the set is itself contained entirely
in the set.
Well-Behaved Preferences –
Convexity
Preferences are (weakly) convex if
for any indifference curve, the line
segment connecting any two weakly
preferred consumption bundles
consists entirely of weakly preferred
consumption bundles.
Well-Behaved Preferences –
Convexity
x’ and y’ are weakly
x’
preferred to
everything along
the indifference
curve.
The blue line
y’ consists entirely
of bundles weakly
preferred to x’.
Well-Behaved Preferences –
Convexity
x’ The blue lines
consist entirely of
bundles weakly
preferred to x’.
x”
y”
y’
Preferences that are weakly convex can
have indifference curves with flat spots.
Well-Behaved Preferences –
Strict Convexity
Preferences are strictly convex if for
any indifference curve, the line
segment connecting any two weakly
preferred consumption bundles
consists entirely of strictly preferred
consumption bundles.
Well-Behaved Preferences –
Strict Convexity.
x The blue line
x2 consists of
bundles strictly
preferred to x.
y
y2
x1 y1
Preferences that are strictly convex cannot
have indifference curves with flat spots.
Non-Convex Preferences
x2 The blue line
does not consist
entirely of
bundles weakly
preferred to x.
y2
x1 y1
More Non-Convex Preferences
x2 The blue line
does not consist
entirely of
bundles weakly
preferred to x.
y2
x1 y1
Agenda – Preferences
The Preference Relation – what the
consumer prefers
Basic Consistency Assumptions About
Preferences
Completeness, Reflexivity, Transitivity
How to Represent Preferences with
Indifference Curves
Assumptions about Well-Behaved
Preferences
Monotonicity and Convexity
Marginal Rate of Substitution (MRS)
Marginal Rate of Substitution
x2 Through any point, we can
draw an indifference curve.
The Marginal Rate of
Substitution (MRS) at x’ is
x’ the slope of the
indifference curve at x’
MRS =
x1
MRS & Ind. Curve Properties
Good 2
Two goods yield
negatively sloped
indifference curves,
so the MRS < 0.
Good 1
MRS & Ind. Curve Properties
Good 2
One good and one
bad yield a positively
sloped indifference
curve, so MRS > 0.
Bad 1
MRS & Ind. Curve Properties
Good 2
For two goods, MRS
MRS = - 5 always increases as x1
increases (becomes less
negative) if and only if
preferences are strictly
convex.
MRS = - 0.5 Good 1
Diminishing Marginal Rates of Substitution
Economics 401 Intermediate Micro
Instructor: Chris Proulx
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