Microeconomics: Lecture 3...Lecture 3 2 Roadmap for Part I: Preferences and assumptions Indifference...

Microeconomics: Lecture 3

Consumer Behavior (Part I)

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Consumer Theory: Roadmap Building Blocks:

Part I

• Preferences and Axioms of Rationality

Part II

• Representation of Rational Preferences: Utility

• Affordable Bundles: Budget Set

Part III

• A Model of Consumer Choice: Utility Maximization

• Derivation of Individual Demand

Part IV

• Derivation of Market Demand

Lecture 3 2

Roadmap for Part I:

Preferences and assumptions

Indifference curves Marginal rate of

substitution Examples

Lecture 3 3

A Model of Consumer

Theory

Lecture 3 4

• A model of consumer theory is a

formal description of how consumers

behave

• Goals:

• predict consumers’ choices, in order

to determine demand of goods

• evaluate effects of price increases on well-

being of consumers

Applications of Consumer

Theory

Lecture 3 5

1. To what extent did the food stamp program provide individuals with more food versus merely subsidizing food they bought anyway?

2. How would General Mills determine the price to charge for a new cereal before it went to the market?

3. How will drivers react to lower prices for gasoline, will they buy more cars and move further out to the suburbs?

Building Blocks of

Consumer Theory Preferences

• What people like

Budget Constraints

• What people can afford

How consumers decide how to make choices

• Do they choose randomly or do they behave in way that allows them to achieve the highest possible well-being?

Preference Relations

A preference relation (“) describes an

individual's attitude towards alternatives

It is a binary relation on the set of

possible alternatives

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Basic Assumptions:

Axioms of Rational Choice

Axiom 1: Completeness

If A and B are any two bundles, an individual

can always specify exactly one of these

possibilities:

A is (weakly) preferred to B: A “B

B is (weakly) preferred to A: B “A

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Basic Assumptions:


Axiom 2: Transitivity

If a consumer prefers A to B and B to C,

then the consumer also prefers A to C

In other words, we assume that individuals

choices are internally consistent

Basic Assumptions:


Axiom 3: Continuity

if A is preferred to B, then situations suitably

“close to” A must also be preferred to B

This axiom allows us to analyze an

individual’s response to relatively small

changes in income and prices

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Axiom 4: Strict Monotonicity

More is better: If A, B are real numbers and A>B

then A > B

Axiom 5: Convexity

If A “ B then tA+(1-t)B “ B, where t is a number

in [0,1]

Basic Assumptions:


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Consumer Preferences

Consumer preferences can be represented

graphically using indifference curves

A person will be indifferent to all bundles on a

given indifference curve

This means that a person will be equally satisfied

with the choice of any bundles that lie on the

same indifference curve


Indifference Curves:

An Example

Graph the points with one good on the x-

axis and the other good on the y-axis

Plotting the points, we can make some

immediate observations about preferences

More is better


• The consumer

prefers A to all

combinations in

the yellow box

• All combinations

in the green box

are preferred to A


An Example

Food

10

20

30

40

10 20 30 40

Clothing 50

G

A

E H

B

D



An Example Points such as B and D have more of one good but less of another compared with point A

Need more information about consumer ranking

Consumer may decide that they are indifferent between B, A and D

We can then connect those points with an indifference curve


•Indifferent between

points B, A, & D

•E is preferred to

points on U1

•Points on U1 are

preferred to H & G


An Example

Food

10

20

30

40

10 20 30 40

Clothing 50

U1

G D

A

E H

B


Indifference Curves

A set of indifference curves (indifference

map) describes preferences for all

combinations of goods/services

Each indifference curve in the map shows the

market baskets among which the person is

indifferent

Indifference curves further away from the

origin are ‘better’: they offer higher utility


U3

Indifference Map

Food

Clothing

U2

U1

A B D

Market basket A

is preferred to B

Market basket B

is preferred to D


Indifference Curves

Cannot Cross

Clothing

•B is preferred to D

•A is indifferent to

both B and D

•B must be indifferent

to D

•But that cannot be if

B is preferred to D

U1

U1

Food

U 2

U 2

A

B D


A

B

D

G

-6

1

-4

1 -2

1 -1

E

1

Observation:

The amount

of clothing given up for

1 unit of food decreases

from 6 to 1

Indifference Curves

Food

Clothing

1 2 3 4 5

16

14

12

10

8

6

4

2

22 Microeconomics tutor new York

Indifference Curves

21

The shapes of indifference curves describe

how a consumer is willing to substitute one

good for another

A to B, give up 6 clothing to get 1 food

D to E, give up 2 clothing to get 1 food

The more clothing and less food a person has,

the more clothing they give up to get more food


Marginal Rate of

Substitution

23

We measure how a person trades one good for

another using the marginal rate of substitution

(MRS)

It quantifies the amount of one good a consumer

will give up to obtain more of another good

The negative of the slope of the indifference curve

is the marginal rate of substitution of y for x


Quantity of y

x1

y 1

y2

x2

U1

Quantity of x

At (x1, y1) indifference curve is steeper.

Individual would be willing to give up more

units of y to gain additional units of x

At (x2, y2), the indifference curve

is flatter. Individual would be

willing to give up less y to gain

additional units of x

MRS changes as x and y change

Reflects individual’s willingness to trade y for x

Marginal Rate of Substitution

Lecture 3 24


Marginal Rate of

Substitution

1000 of Square Feet

House Size

Restaurants

Nearby 16

14

12

10

8

6

4

2

A

B

D

E G

-6

1

1

1 2 3 4 5

-4

1 -2

1 -1

MRS = 6

MRS = 2

MRS R SF



Indifference curves are convex

25

As more of one good is consumed, a consumer would

prefer to give up fewer units of a second good to get

additional units of the first one

Along an indifference curve there is a diminishing

marginal rate of substitution

Consumers generally prefer a balanced market basket


Convexity

Quantity of x

Quantity of y

U1

x1 (x1 + x2)/2

This implies that “well-balanced” bundles are

preferred to bundles that are heavily weighted

toward one commodity

If the indifference curve is convex, then the

combination (x1 + x2)/2, (y1 + y2)/2 will be preferred to

either (x1,y1) or (x2,y2)

x2

y1

(y1 +y2)/2

y2



27

Indifference curves with different shapes imply a

different willingness to substitute

Two polar cases are of interest

Perfect substitutes (advil vs. ibuprofen)

Perfect complements (left glove and right glove)


Perfect Substitutes

ibuprofen

28

Advil

2 3 4 1

1

2

3

4

0

Two goods are perfect

substitutes when the marginal

rate of substitution of one

good for the other is constant


Perfect Complements

Right Shoes

29

Left

Shoes

2 3 4 1

1

2

3

4

0

Two goods are perfect

complements when the

indifference curves for

the goods are shaped

as right angles


Microeconomics: Lecture 3...Lecture 3 2 Roadmap for Part I: Preferences and assumptions Indifference...

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