Microeconomics NVM Lec 2 Prefrences

TOPIC

Preferences

- Important Concepts - Fundamental Assumptions of Microeconomics What is microeconomics?

– The study of how people fulfill unlimited wants with limited means.

Fundamental Assumptions– Unlimited Desires/Nonsatiation – Limited Means/Scarcity

Cost/Benefit Approach to Decision Making– Rationality & Rational Self-Interest

Opportunity & Sunk Costs Positive & Normative Economic Analysis/Comparative Static

Analysis

Marginal Analysis– Marginal Benefits– Marginal Costs

Fundamentals of Cost/Benefit Decision Making

Question: How does someone choose which wants to fulfill when they cannot fulfill them all?

Economists Answer: By weighing the cost and benefit of fulfilling a want.

If the benefit outweighs the cost, just do it!

If the cost outweighs the benefit, don’t do it!

Everything in microeconomics boils downto this simple cost benefit comparison!

Rationality Rational Decisions:

– Decisions based on a cost/benefit comparison. Rationally Self-Interested Decisions:

– Decisions based on a cost/benefit comparison where only the costs and benefits to an individual are considered, and not the costs and benefits to other individuals.

Much of economic theory is developed around the assumption of

rational self-interest, but there are economic theories that relax this

assumption.

What makes something so simple, so hard?

Identifying what benefits are relevant to a decision can be difficult.

Identifying what costs are relevant to a decision can be difficult.

Adding up benefits and costs can be difficult.

Opportunity & Sunk Cost

Opportunity Cost: – The cost of engaging in one activity instead of

another.– Understanding and weighing opportunity costs is

paramount for good decision making.– But, opportunity costs are often neglected.

Sunk Cost: – Costs incurred regardless of whether or not you

engage in an activity.– Understanding and ignoring sunk costs is

paramount for good decision making.– But, opportunity cost are not always ignored.

Marginal Analysis

Many decision we make in life are all or nothing propositions.

– Should I buy a house or rent?

– Should I go to college?

– Should I get Married?

– For these types of decisions, the basic cost/benefit comparison is a relatively straightforward yes or no answer.

But, many decisions are not all or nothing propositions.

– How many cans of soup should I buy?

– How much money should I put in a savings account each month?

– How many Prius will Toyota manufacture next year?

– Marginal analysis extends our fundamental cost/benefit decision making framework to decisions where we must choose how much of an activity to engage in.

Marginal Costs & Benefits

Marginal Cost:

– The increase in the total cost that results from carrying out one additional unit of an activity

Marginal Benefit:

– The increase in the total benefit that results from carrying out one additional unit of an activity.

Marginal Analysis says that we should increase our level of

activity as long the marginal benefit exceeds the marginal cost!

Two Approaches to Modeling Individual Choice

Preference Based Approach

Choice Based Approach

Preference Based Approach

- Unobservable preference relation is primitive.

- Specify a preference relation while imposing rationality axioms and then derive the implications of those axioms in terms of individual choice.

Choice Based Approach

-- Observable choice behavior is primitive

-- Specify consistency assumptions regarding observed choice and then derive the implications of these assumptions in terms of observed choices.

Preferences

To explain consumer behavior, economists assume that consumers have a set of tastes or preferences that they use to guide them in choosing between goods. These tastes differ substantially among individuals.

Preferences

Behavioral Postulate:A decisionmaker always chooses its most preferred alternative from its set of available alternatives.

So to model choice we must model decisionmakers’ preferences.

Preference Relations Comparing two different consumption

bundles, x and y:

– strict preference: x is more preferred than is y.

– weak preference: x is as at least as preferred as is y.

– indifference: x is exactly as preferred as is y.

Preference Relations

Strict preference, weak preference and indifference are all preference relations.

Particularly, they are ordinal relations; i.e. they state only the order in which bundles are preferred.


denotes strict preference; x y means that bundle x is preferred strictly to bundle y.


denotes strict preference; x y means bundle x is preferred strictly to bundle y.

denotes indifference; x y means x and y are equally preferred.


denotes strict preference so x y means that bundle x is preferred strictly to bundle y.

denotes indifference; x y means x and y are equally preferred.

denotes weak preference;x y means x is preferred at least as much as is y.

~~


x y and y x imply x y.~ ~


x y and y x imply x y.

x y and (not y x) imply x y.

~ ~

~ ~

Properties of Consumer Preferences

Economists make five critical assumptions about the properties of consumers’ preferences. For brevity, these properties are referred to as completeness, transitivity, more is better, continuity, and strict convexity.

Assumptions about Preference Relations

Completeness: For any two bundles x and y it is always possible to make the statement that either x y or y x.

~

~


Reflexivity: Any bundle x is always at least as preferred as itself; i.e.

x x.~


Transitivity: Ifx is at least as preferred as y, andy is at least as preferred as z, thenx is at least as preferred as z; i.e.

x y and y z x z.~ ~ ~

Indifference Curves

Take a reference bundle x’. The set of all bundles equally preferred to x’ is the indifference curve 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

xx22

xx11

x”x”

x”’x”’

x’ x’ x” x” x”’ x”’x’

Indifference Curves

xx22

xx11

zz xx yy

x

y

z

Indifference Curves

x2

x1

x

All bundles in I1 arestrictly preferred to all in I2.

y

z

All bundles in I2 are strictly preferred to all in I3.

I1

I2

I3

Indifference Curves

x2

x1

I(x’)

x

I(x)

WP(x), the set of bundles weakly preferred to x.

Indifference Curves

x2

x1

WP(x), the set of bundles weakly preferred to x.

WP(x) includes I(x).

x

I(x)

Indifference Curves

x2

x1

SP(x), the set of bundles strictly preferred to x, does not include I(x).

x

I(x)

Indifference Curves Cannot Intersect

xx22

xx11

xxyy

zz

II11

I2 From IFrom I11, x , x y. From I y. From I22, x , x z. z.

Therefore y Therefore y z. z.

Indifference Curves

All indifference curve maps must have four important properties:– Bundles on indifference curves farther from

the origin are preferred to those on indifference curves closer to the origin.

– There is an indifference curve through every possible bundle.

– Indifference curve cannot cross.– Indifference curves slope downward.

Indifference Curves Cannot Intersect

xx22

xx11

xxyy

zz

II11

I2 From IFrom I11, x , x y. From I y. From I22, x , x z. z.

Therefore y Therefore y z. But from I z. But from I11

and Iand I22 we see y z, a we see y z, a

contradiction. contradiction.

Slopes of Indifference Curves

When more of a commodity is always preferred, the commodity is a good.

If every commodity is a good then indifference curves are negatively sloped.


Better

Better

Worse

Worse

Good 2Good 2

Good 1Good 1

Two goodsTwo goodsa negatively sloped a negatively sloped indifference curve.indifference curve.


If less of a commodity is always preferred then the commodity is a bad.


Better

Better

Wors

e

Wors

e

Good 2Good 2

Bad 1Bad 1

One good and oneOne good and onebad a bad a positively sloped positively sloped indifference curve.indifference curve.

Extreme Cases of Indifference Curves; 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 in bundles determines their preference rank-order.

Extreme Cases of Indifference Curves; Perfect Substitutes

xx22

xx1188

88

1515

1515Slopes are constant at - 1.Slopes are constant at - 1.

I2

I1

Bundles in IBundles in I22 all have a total all have a total

of 15 units and are strictlyof 15 units and are strictlypreferred to all bundles inpreferred to all bundles in I I11, which have a total of, which have a total of

only 8 units in them. only 8 units in them.

Extreme Cases of Indifference Curves; Perfect Complements

If a consumer always consumes commodities 1 and 2 in fixed proportion (e.g. one-to-one), 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.


xx22

xx11

I1

4545oo

55

99

55 99

Each of (5,5), (5,9) and (9,5) contains5 pairs so each is equally preferred.


xx22

xx11

I2

I1

4545oo

55

99

55 99

Since each of (5,5), (5,9) and (9,5) contains 5 pairs, each is less preferred than the bundle (9,9) which contains 9 pairs.

Preferences Exhibiting Satiation

A bundle strictly preferred to any other is a satiation point or a bliss point.

What do indifference curves look like for preferences exhibiting satiation?

Indifference Curves Exhibiting Satiation

xx22

xx11

SatiationSatiation(bliss)(bliss)pointpoint


xx22

xx11

BetteBette

rr

BetteBetterr

Bet

teB

ette

rr



xx22

xx11

BetteBette

rr

BetteBetterr

Bet

teB

ette

rr


Indifference Curves for Discrete Commodities

A commodity is infinitely divisible if it can be acquired in any quantity; e.g. water or cheese.

A commodity is discrete if it comes in unit lumps of 1, 2, 3, … and so on; e.g. aircraft, ships and refrigerators.

Indifference Curves for Discrete Commodities

Suppose commodity 2 is an infinitely divisible good (gasoline) while commodity 1 is a discrete good (aircraft). What do indifference “curves” look like?

Indifference Curves With a Discrete Good

Gas-Gas-olineoline

AircraftAircraft00 11 22 3 44

Indifference “curves”Indifference “curves”are collections ofare collections ofdiscrete points.discrete points.

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

Convexity: Mixtures of bundles are (at least weakly) preferred to the bundles themselves.

E.g., the 50-50 mixture of the bundles x and y is z = (0.5)x + (0.5)y.z is at least as preferred as x or y.

Well-Behaved Preferences -- Convexity.

xx22

yy22

xx22+y+y22

22

xx11 yy11xx11+y+y11

22

x

y

z = x+y

2is strictly preferred is strictly preferred to both x and y.to both x and y.


xx22

yy22

xx11 yy11

x

y

z =(tx1+(1-t)y1, tx2+(1-t)y2)is preferred to x and y for all 0 < t < 1.


xx22

yy22

xx11 yy11

x

y

Preferences are strictly convex when all mixtures z

are strictly preferred to their component bundles x and y.

z

Well-Behaved Preferences -- Weak Convexity.

x’

y’

z’

Preferences are weakly convex if at least one mixture z is equally preferred to a component bundle.

xz

y

Non-Convex Preferences

xx22

yy22

xx11 yy11

zz

Better The mixture zThe mixture zis less preferredis less preferredthan x or y.than x or y.

More Non-Convex Preferences

xx22

yy22

xx11 yy11

zz

BetterThe mixture zThe mixture zis less preferredis less preferredthan x or y.than x or y.


The slope of an indifference curve is its marginal rate-of-substitution (MRS).

How can a MRS be calculated?

Marginal Rate of Substitution

xx22

xx11

x’x’

MRS at x’ is the slope of theMRS at x’ is the slope of theindifference curve at x’indifference curve at x’


xx22

xx11

MRS at x’ isMRS at x’ is lim { lim {xx22//xx11}}

xx11 0 0

= dx= dx22/dx/dx11 at x’ at x’xx22

xx11

x’x’


xx22

x1

dxdx22

dxdx11

dxdx22 = MRS = MRS dx dx11 so, at x’, so, at x’,

MRS is the rate at which MRS is the rate at which the consumer is only just the consumer is only just willing to exchange willing to exchange commodity 2 for a small commodity 2 for a small amount of commodity 1.amount of commodity 1.x’x’

MRS & Ind. Curve Properties

Better

Better

Worse

Worse

Good 2Good 2

Good 1Good 1

Two goodsTwo goodsa negatively sloped a negatively sloped indifference curveindifference curve

MRS < 0.MRS < 0.


Better

Better

Wors

e

Wors

e

Good 2Good 2

Bad 1Bad 1

One good and oneOne good and onebad a bad a positively sloped positively sloped indifference curveindifference curve

MRS > 0.MRS > 0.

MRS & Ind. Curve PropertiesGood 2Good 2

Good 1Good 1

MRS = - 5MRS = - 5

MRS = - 0.5MRS = - 0.5

MRS always increases with xMRS always increases with x11

(becomes less negative) if and (becomes less negative) if and only if preferences are strictlyonly if preferences are strictly convex. convex.


xx11

xx22 MRS = - 0.5

MRS = - 5

MRS decreasesMRS decreases(becomes more negative)(becomes more negative)as xas x11 increases increases

nonconvex preferencesnonconvex preferences


xx22

xx11

MRS= - 0.5

MRS = - 1

MRS = - 2

MRS is not always increasing as MRS is not always increasing as xx11 increases nonconvex increases nonconvex

preferences. preferences.

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Microeconomics NVM Lec 2 Prefrences