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Chapter 2Chapter 2

A Theory of PreferencesA Theory of Preferences

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Theory of Theory of PreferencesPreferences is based on is based on three ideas regarding individuals:three ideas regarding individuals:

1.1. They have consistent preferences.They have consistent preferences.

2.2. They seek to maximize preference They seek to maximize preference rankings.rankings.

3.3. They are willing to make tradeoffs They are willing to make tradeoffs between different goods.between different goods.

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CompletenessCompleteness AssumptionAssumption::

Given any two bundles, one of the Given any two bundles, one of the following is true:following is true:

- Bundle 1 is preferred to bundle 2- Bundle 1 is preferred to bundle 2

- Bundle 2 is preferred to bundle 1- Bundle 2 is preferred to bundle 1

- Bundle 1 is indifferent to bundle- Bundle 1 is indifferent to bundle 22

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Figure 2.1 Possible Figure 2.1 Possible consumption bundlesconsumption bundles

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TransitivityTransitivity AssumptionAssumption::

Given any three bundles:Given any three bundles:

- - If bundle 1 is at least as good as If bundle 1 is at least as good as bundle 2, and bundle 2 is at bundle 2, and bundle 2 is at

least as good as bundle 3, then least as good as bundle 3, then bundle 1 is at least as good as bundle 1 is at least as good as bundle 3.bundle 3.

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Nonsatiation AssumptionNonsatiation Assumption::

Given any two bundles, if bundle 1 Given any two bundles, if bundle 1 contains more of one good than contains more of one good than bundle 2, and it does not contain less bundle 2, and it does not contain less of the other good, then bundle 1 is of the other good, then bundle 1 is preferred to bundle 2.preferred to bundle 2.

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Maximization AssumptionMaximization Assumption::

Individuals always make choices that Individuals always make choices that leave them better off.leave them better off.

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Figure 2.2 An indifference curve for EleanorFigure 2.2 An indifference curve for Eleanor

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Continuity AssumptionContinuity Assumption

Through any consumption bundle in Through any consumption bundle in which the quantity of at least one which the quantity of at least one good is positive, there is a good is positive, there is a continuous continuous indifference curveindifference curve..

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Figure 2.3 Clem’s indifference curvesFigure 2.3 Clem’s indifference curves

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Figure 2.4 Slope of an indifference curveFigure 2.4 Slope of an indifference curve

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Figure 2.5 An Figure 2.5 An indifference mapindifference map

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Figure 2.6 Impossible indifference curvesFigure 2.6 Impossible indifference curves

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Marginal Rate of SubstitutionMarginal Rate of Substitution

The The marginal rate of substitutionmarginal rate of substitution (MRS) is the rate at which someone is (MRS) is the rate at which someone is willing to trade-off one good for another willing to trade-off one good for another while maintaining the same level of while maintaining the same level of satisfaction.satisfaction.

More precisely, the marginal rate of More precisely, the marginal rate of substitution of good 2 for good 1 at any substitution of good 2 for good 1 at any point (point (xx11,x,x22), denoted as MRS (), denoted as MRS (xx11,x,x22), is the ), is the absolute value of the slope of the absolute value of the slope of the indifference curve at that point. (See indifference curve at that point. (See Figure 2.7).Figure 2.7).

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Figure 2.7 Marginal rate of substitutionFigure 2.7 Marginal rate of substitution

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Diminishing Marginal Rate Diminishing Marginal Rate of Substitutionof Substitution

Note that in Figure 2.7 the MRS Note that in Figure 2.7 the MRS diminishes in a movement down the diminishes in a movement down the indifference curve.indifference curve.

A person whose preferences are A person whose preferences are shown in Figure 2.7 is less willing to shown in Figure 2.7 is less willing to substitute good 2 for good 1 at point substitute good 2 for good 1 at point B than at point A.B than at point A.

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Figure 2.8 Constructing a Figure 2.8 Constructing a utility functionutility function

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Figure 2.9 Different preferences and Figure 2.9 Different preferences and different indifference curvesdifferent indifference curves

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Figure 2.10 Figure 2.10 Perfect substitutesPerfect substitutes and and perfect complementsperfect complements

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Figure 2.11 Employee preferences for Figure 2.11 Employee preferences for leisure and incomeleisure and income

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Figure 2.12 Preferences for current and Figure 2.12 Preferences for current and future consumptionfuture consumption

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From Figure 2.12 Preferences for From Figure 2.12 Preferences for current and future consumptioncurrent and future consumption

People smooth out their consumption People smooth out their consumption over time in order to raise their level over time in order to raise their level of utility.of utility.

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Figure 2.13 The cost of pollutionFigure 2.13 The cost of pollution

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Figure 2.13 The cost of pollutionFigure 2.13 The cost of pollution

When consumption contains a bad When consumption contains a bad and a good, the indifference curves and a good, the indifference curves are upward sloping.are upward sloping.