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Introduction Principles Consumer Preferences Substitution Utility Exercices

EC2101 - Lecture 1

Younghwan In

National University of Singapore

14 August 2008

I. IntroductionII.1. Consumption Decisions: Principles and Preferences

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Introduction Principles Consumer Preferences Substitution Utility Exercices

Microeconomics Microeconomics concerns individual decision making and its

collective effect on allocation of a societys resources Individuals: typically consumers and the managers of firms. Institutions for allocating resources: centralized or

decentralized? markets (buyers, sellers, prices). We assume people are motivated only by material self-interest

(unless stated otherwise). Positive versus normative analysis.

The scientific method: Initial observation (data) Theorizing (models) Identification of additional implications Further observation (data) and testing Refinement of the theory

Uses of microeconomics Helps make important personal and business decisions. Provides tools for understanding and evaluating the effect of

public policies.

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Introduction Principles Consumer Preferences Substitution Utility Exercices

Supply and Demand - Market Equilibrium

Bernheim and Whinston p.36.

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Supply and Demand - Elasticities

Suppose that a change in X causes a change in Y.

Then the elasticity of Y with respect to X is the percentagechange in Y divided by the percentage change in X:

EYX

=% change in Y

% change in X

.

For example, the price elasticity of demand

Ed =% change in amount demanded(Q)

% change in price(P)=

100 (Q/Q)

100 (P/P)

=(Q/Q)

(P/P)

= (Q

P)(

P

Q).

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Balancing Benefits and Costs

Bernheim and Whinston p.79.

C f S

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Introduction Principles Consumer Preferences Substitution Utility Exercices

Principles of Decision Making

We assume the following two principles on consumer preferences:

1. The Ranking Principle: A consumer can rank, in order ofpreference (though possibly with ties), all potentially availablealternatives.

2. The Choice Principle: Among available alternatives, the

consumer chooses the one that he ranks the highest.

Bernheim and Whinston p.94.

Application 4.1 (Bernheim and Whinston p.94) Netflix.

I d i P i i l C P f S b i i U ili E i

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Introduction Principles Consumer Preferences Substitution Utility Exercices

How Do People Rank Consumption Bundles?

A consumption bundle is the collection of goods that anindividual consumes over a given period.Now an additional assumption on consumer preferences:

3. The More-is-better Principle: When one consumptionbundle contains more of every good than a second bundle, a

consumer prefers the first bundle to the second.

Bernheim and Whinston p.96.

I t d ti P i i l C P f S b tit ti Utilit E i

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Indifference Curves

Indifference curves are used when goods are (or assumed tobe) available in any fraction of a unit.

Starting with any alternative, an indifference curve shows allthe other alternatives a consumer likes equally well.

Bernheim and Whinston p.98.

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Properties of Indifference Curves

1. Indifference curves are thin.2. Indifference curves do not slope upward.

Bernheim and Whinston p.100.

3. An indifference curve separates bundles that are better frombundles that are worse than those that are on the indifferencecurve.

Introduction Principles Consumer Preferences Substitution Utility Exercices

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Properties of Families of Indifference Curves

4. Indifference curves from the same family do not cross.5. Comparing two bundles, the consumer prefers the one on the

indifference curve further from the origin.

Bernheim and Whinston p.101.

Application 4.2 (Bernheim and Whinston p.102-103) Preferences

for Automobile Characteristics.

Introduction Principles Consumer Preferences Substitution Utility Exercices

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Plotting Indifference Curves from a Formula

Bernheim and Whinston p.104.

Introduction Principles Consumer Preferences Substitution Utility Exercices

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Goods versus Bads

Bernheim and Whinston p.105.

Introduction Principles Consumer Preferences Substitution Utility Exercices

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p y

Rate of Substitution

Economic decisions involve trade-offs. To determine whether a consumer has made the best choice,

we need to know the rate at which she is willing to maketrade-offs between different goods.

Bernheim and Whinston p.106.

Introduction Principles Consumer Preferences Substitution Utility Exercices

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Marginal Rate of Substitution

The marginal rate of substitution for X with Y,

MRSXY(= Y

X ), is the rate at which a consumer mustadjust Y to maintain the same level of well-being when Xchanges by a tiny amount, from a given starting point.

Tells us how much Y a consumer needs to compensate forlosing a little bit of X.

Tells us how much Y to take away to compensate for gaininga little bit of X.

Bernheim and Whinston p.107.

Introduction Principles Consumer Preferences Substitution Utility Exercices

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What Determines Rates of Substitution?

1. Differences in tastes across consumers Preferences for one good over another affect the slope of an

indifference curve.

Bernheim and Whinston p.109.

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What Determines Rates of Substitution?

2. As we move along an indifference curve ... People like variety so most indifference curves get flatter as we

move from top left to bottom right. MRS declines; the amount of Y required to compensate for a

given change in X decreases.

Bernheim and Whinston p.109.

Introduction Principles Consumer Preferences Substitution Utility Exercices

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Why Are Rates of Substitution Important?

If two people have different MRS ... Is mutually beneficial and voluntary trade possible? Example 4.3 (Bernheim and Whinston p.111).

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Special Case (1): Perfect Substitutes

Two products are perfect substitutes if their functions areidentical; a consumer is willing to swap one for the other at afixed rate.

Bernheim and Whinston p.113.

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Special Case (2): Perfect Complements

Two products are perfect complements if they are valuableonly when used together in fixed proportions.

Bernheim and Whinston p.114.

Introduction Principles Consumer Preferences Substitution Utility Exercices

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Utility, Utility Function

Utility is a numeric value indicating the consumers relativewell-being.

We can describe the value a consumer gets from consumptionbundles mathematically through a utility function. Forexample,

U(S, B) = 2S + 5(S B).

Introduction Principles Consumer Preferences Substitution Utility Exercices

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From Preferences (Indiff Curves) to a Utility Function

Bernheim and Whinston p.116.

Introduction Principles Consumer Preferences Substitution Utility Exercices

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From a Utility Function to Preferences (Indiff Curves)

Bernheim and Whinston p.117.

Lecture1a.mws.

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Ordinal versus Cardinal Utility

Information about preferences can be ordinal or cardinal.

Ordinal information allows us to determine only whether onealternative is better than another.

Cardinal information reveals the intensity of preferences,How much worse or better?

In modern microeconomic theory, utility functions are onlyintended to summarize ordinal information.

Another utility function obtained by an order-preserving

transformation of an original utility function represents thesame preferences.

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Utility Functions and MRS

Marginal utility is the change in a consumers utilityresulting from the addition of a very small amount of somegood, divided by the amount added.

MUX =

U

X.

By itself, the marginal utility of a good does not measureanything meaningful. However, the ratio of the marginalutilities for two goods is equal to MRS between them:

MRSXY =MUX

MUY.

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Exercises for Tutorial 1

In-Text Exercise 4.3 (Bernheim and Whinston p.111-112).

In-Text Exercise 4.5 (Bernheim and Whinston p.115, 120).

Exercise 4.2 (Bernheim and Whinston p.121-122).

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