Chapter 3: Preferences
Preferences
Preferences and tastes determine what I want to purchase. A decision maker always chooses his
or her most preferred alternative from his or her set of available alternatives. Vilfredo Pareto gave
contributions to statistics, political and economics by finding two equal ways of representing
individual preferences.
1. indifference curves (I): are more intuitive to understand.
2. utility functions (U)
To explain consumer behavior, economists assume that consumers have a set of
tastes/preferences that they use to guide them in choosing among commodities. Goods are then
ranked according to how much pleasure (utility) a consumer gets from consuming each good.
- ≻ strict preference: saying that the consumer strictly prefers a= (x 1a, x2a) to b= (x1b, x2b)
Preference relations summarize a consumer’s ranking:
- ∼ indifference preference: the consumer is indifferent between bundles a and b.
means that the consumer prefers a to the b.
- ⪰ weak preference: a consumer either prefers a to be or is indifferent between a and b.
It is important to remember that economists take preferences as given and do not discuss,
value or judge an individual’s preferences and observe an individual’s behavior.
We can model mathematically people’s tastes. To build a model that explains and predicts
consumers’ choices, economists assume that individual preferences satisfy a minimum set of
regularity assumptions/axioms. There are 3 axioms:
1. completeness (“always have an answer” and prohibits from say “I don’t know”): it
a ⪰ b, or b ⪰ a or a∼b
guaranties that you always find the optimal bundle since for any bundle a and b, either
2. reflexivity: any bundle a ⪰ a
3. transitivity: it avoids contradictory answers since if b ⪰ a and c ⪰ b, then c ⪰ a.
We say that individual preferences are well-behaved if they also satisfy two more axioms:
x1a and x2b ≥ x2a, then b ≻ a
4. monotonicity. if you have two goods, the one in more quantity is better. In symbols if x 1b ≥
just one good). In symbols If a ∼ b, then for any 0 ≤ t ≤ 1
5. convexity: conveys preferences for mixing. People prefer variety of good to extremes (to
t·a + (1 - t)·b ≿ a
t·a + (1 - t)·b ≿ b
Indifference Curves
Given bundle a = (x1a, x2a) to bundle b = (x1b, x2b), indifferent curves is the set of bundles (x 1, x2)
which the individual considers as good as bundle a. The individual is “indifferent” in the sense that
he or she is willing to exchange them and be equally happy:
- above the I the consumer is happy
- below the I the consumer is not happy
Well-behaved indifference curves: properties
If preferences satisfy the 5 axioms, then indifference curves have six properties:
1. monotonicity axiom: bundles on indifference curves farther from the origin are preferred
to bundles on indifference curves closer to the origin.
Monotonicity implies that I have a negative slope. In fact, looking at the second picture, if
we start at bundle c and move
anywhere up and to the right,
we must be moving to a
worse position. So, if we are
moving to an indifferent
position, we must be moving
either left and up or right and
down. (As we’ll learn later the
slope is the MRS).
2. completeness axiom: every bundle lies on indifference curve
3. I for the same individual cannot cross.
4. When commodities are “goods” (not “bads” indifference curves slope downward. Ex.
bundle (x1, x2) with x1= pepperoni which the consumer likes, and x2= anchovies which the
consumer doesn’t like. The direction of increasing preference is down and to the right, that
is toward the direction of decreased anchovy consumption and increased pepperoni
consumption. If the I doesn’t slope downward
- a should be indifferent to b because they lie on the same indifference curve
- but b should be preferred to a because of monotonicity axiom (b has more x 1 and x2), so
there’s a contradiction.
5. Indifference curves cannot be thick. If they were thick:
- a should be indifferent to b because they lie on the same I
- but b should be preferred to a because of monotonicity axiom, so there’s a contradiction.
6. indifference curves are convex (due to convexity axiom). Individuals prefer to diversify their
consumption (any linear combination of two bundles lying on a IC is preferred to either
bundles, for instance c is preferred to either f or g. (MRS is diminishing)
MRS
Marginal (the changes are really small) rate (it’s a ratio) of
substitution (you are substitute one good for the other to
be equally happy).
The MRS is the ratio at which the individual is willing to
trade exchange one good with the other and remain
equally “happy”. That is, it is the maximum quantity of
good x2 the individual is willing (not must as in the budget
constraint) to give up/trade off in order to get one
addition unit of x1 and remain equally “happy”.
Mathematically the MRS is the slope of the indifference
curve I. (Remember that the MRS is always a negative
number. You can also take the absolute value of the MRS.)
MRS x 1 x 2=d x 2 /d x1
In the example we can see that, if 1 paper book is taken away but two more e-books are given, the
individual will be equally happy. This means that the MRS between the two point is -2 / 2 in
absolute value (MRS= -2. I am willing to give up 2 e-books to get one more paper book). If move
along the indifference curve we can see that the slope changes. The economic intuition is:
- the steeper the I gets, the more willing to sacrifice good x2 to get an extra good x1 you are
- the flatter the I gets, the less willing to sacrifice good x 2 to get an extra good x1 you are (you
don’t want to give up good x2 to get and extra good x1).
There is also another interpretation of the MRS. In fact, we could also say that the consumer is just
on the margin of being willing to “pay” some of good 1 in order to buy some more of good 2. So
we can say that the indifference curve measures the marginal willingness to pay. If good 2
represent the consumption of “all the other goods” and it is measured in dollars that you can
spend on other goods, then the marginal rate of substitution of good 2 for good 1 is how many
dollars you would just be willing to give up spending on other goods in order to consume a little bit
of good 1. But giving up dollars is just like paying dollars in order to consume little more of good 1.
If an individual’s preferences violate one (or more) of the axioms:
1. Perfect substitutes: strict convexity violated
2. Perfect complements: monotonicity violated
3. Concave IC: convexity violated
4. Neutral goods: monotonicity and convexity violated
5. Bads: monotonicity violated
Perfect Substitutes
If a consumer always regards units of commodities 1 and 2 as
equivalent, then the commodities are perfect substitutes and
only the total amount of the two commodities determines their
preference rank-order. This means that indifference curves are
straight lines with constant slope. Hence the MRS is constant -
1.
Perfect complements
If a consumer always consumes commodities 1 and 2
in fixed proportions, then the commodities are
perfect complements and only the number of pairs
of units of the two commodities determines the
preference rank-order of bundles. ex. of shoes. the
consumer likes shoes but always wears right and left
shoes together, so having only one out of a pair of
shoes doesn’t do the consumer a bit of good. Indifference curves are L-shaped, with slope equal to
zero on the horizontal tract, infinitive on the vertical tract, and undefined at the kink.
Correspondingly, the MRS is zero, infinite or undefined. (Remember that 2 perfect substitutes for
instance sugar and honey are so in my head/according to my preferences).
Concave IC
Individuals prefer NOT to diversify their consumption. IC
curves are concave means that any linear combination of two
bundles lying on IC is less preferred to either bundles, e.g., a or
b are strictly preferred to c. This means that MRS is increasing.
Neutral Goods
A good is a neutral good if the consumer doesn’t care about it one
way or the other
Bads
A bad is a commodity that the consumer doesn’t like. For example, suppose that the commodities
in question are now pepperoni and anchovies—and the consumer loves pepperoni but dislikes
anchovies. But let us suppose there is some possible tradeoff between pepperoni and anchovies.
That is, there would be some amount of pepperoni on a pizza that would compensate the
consumer for having to consume a given amount of anchovies. How could we represent these
preferences using indifference curves? Clearly, we have to give him some extra pepperoni to
compensate him for having to put up with anchovies. Thus, this consumer must have indifference
curves that slope up and to the right.
N.B.
1. Satiation: in a situation involving satiation, there is some
overall best bundle for the consumer and the “closer” he is to
that best bundle, the better off he is in terms of his own
preferences. For example, suppose that the consumer has some
most preferred bundle of goods (x̄1, x̄2), and the farther away
he is from that bundle, the worse off he is. In this case we say
that (x̄ 1, x̄ 2) is a satiation point or a bliss point. In this case the
indifference curves have a negative slope when the consumer
has “too little” or “too much” of both goods, and a positive slope
when ha has “too much” of one of the goods.
- When he has too much of one of the goods, it becomes a bad, thus reducing the
consumption of the bad good moves him closer to his “bliss point”.
- If he has too much of both goods, they both are bads, so reducing the consumption of each
moves him closer to the bliss point.
2. Discrete good
Goods that are available in integer amount (goods that
come in discrete unites).