Intermediate Microeconomics

1
Intermediate Microeconomics

• Preferences

2
Consumer Behavior

• Budget Set organizes information about possible
  choices available to a given consumer.
• Next step is to determine how a consumer will
  choose among the bundles available in his or her
  budget set.
• To do so, we make the seemingly obvious
  assumption that individuals are rational
• Each individual chooses the bundle he or she most
  prefers among all bundles available in his or her
  budget set.
• Therefore, we need to develop a theory of
  preferences, that is both flexible and yet
  restrictive enough to be useful for understanding
  how choices will change as the economic
  environment changes.

3
Theory of Preferences

• Consider again a bundle of goods denoted A-q1A,
  q2A, , qnA
• For any given individual and any given bundle A,
  we want to be able to describe the following
  sets
• Strictly preferred set all bundles the
  individual strictly prefers to A.
• Weakly preferred set all bundles the individual
  weakly prefers to A (i.e. likes at least as much
  as A)
• Any bundle not in weakly preferred set, the
  individual must like strictly less than A.

4
Preferences

• 3 axioms in our theory of consumer preferences
• Completeness An individual can weakly rank any
  two possible bundles.
• Reflexivity A bundle is at least as good as
  itself.
• Transitivity If a bundle C is strictly
  preferred to a bundle A, and an individual is
  indifferent between a bundle A and another bundle
  D, then the individual must also strictly prefer
  bundle C to bundle D.

5
Preferences

• Final common assumption - preferences exhibit
  non-satiation or monotonicity.
• Weaker version more cant be worse.
• Essentially assumes free-disposal
• Stronger version more is always better
• Certainly not true at levels (100 donuts does me
  no better than 99)
• For practical purposes though, not bad, as we
  want to model situations where individuals have
  to make choices between things they value.

6
Preferences

• Key issue we want to understand and analyze in
  economics is trade-offs.
• e.g. how much of one good is an individual
  willing to trade-off to consume more of another
  good?
• Our preference axioms allow us to consider such
  trade-offs via indifference curves.
• For any given bundle A, there is an indifference
  curve that connects A to each bundle B where a
  given consumer is indifferent between A and B.

7
Indifference Curves

• Characteristics of Indifference Curves
• Consider one of your indifference curves between
  number of chips and ounces of Coke.
• Is every possible bundle on an indifference
  curve? Why or why not?
• How many indifference curves are there?
• Why are indifference curves drawn with a negative
  slope?
• Can indifference curves cross? Why or why not?
• If A is on a higher indifference curve than B,
  what does this mean? How do we know this?

8
Interpreting Indifference Curves
q2 q2

• Indifference curve indicates that at bundle
  q1,q2, an individual will be willing to give
  up ?q2 units of good 2 to increase consumption of
  good 1 by ?q1.
• What happens as ?q1 goes to zero?

?q1
-?q2
q1
q1
9
Interpreting Indifference Curves

• Marginal Rate of Substitution (MRS) the slope
  of indifference curve at a given point.
• MRS indicates an individuals willingness-to-pay
  for a marginal increase of one good in terms of
  the other, at a given bundle.
• So how do you interpret an indifference curve
  when it is very steep at a given bundle (i.e.
  slope large in magnitude)?
• How about when it is relatively flat?

10
Well-behaved preferences

• In addition to our three Axioms and monotonicity,
  we will also often assume that weakly preferred
  sets are convex.
• Convex preferences - If bundles
• B-q1B, q2B and C-q1C , q2C
• are in weakly preferred set to A, then so will
• (q1B q1C)/2 , (q2B q2C)/2 .
• Intuition averages are at least as good as
  extremes, or that individuals prefer to have a
  combination of goods at moderate levels to lots
  of one and little of the other (consider chips
  and coke)
• Monotonic and Convex preferences are called
  well-behaved preferences.

11
Interpreting Indifference Curves

• Consider an indifference curve of following form.
  
• Does it represent convex preferences?
• What does this shape reveal about MRS as q1
  increases and q2 decreases?
• What is intuition?

q2
q1
12
Interpreting Indifference Curves

• Diminishing MRS
• Implies an individuals willingness to trade one
  good for another diminishes the less he has of
  that good.
• Slope of Indifference Curve decreases as q1
  increases and q2 falls.
• Examples
• Chips and Coke?
• Coke and a composite good?
• Coke and Pepsi?
• What is intuition behind different shapes of
  indifference curves?

13
Interpreting Indifference Curves

• Perfect substitutes - constant MRS
• Examples?
• What will indifference curves look like?
• Perfect Complements must consume in fixed
  proportions, or individual not willing to trade
  off some of one for more of another, therefore
  MRS is undefined.
• Examples?
• What will indifference curves look like?
• Are such preferences well-behaved?
• Examples of when preferences might not be
  well-behaved?

14
Modeling Preferences over Other Types of Goods

• Suppose again you work for Doctors Without
  Borders.
• What will your indifference curves look like
  between people cured of Tuberculosis vs.
  people cured of AIDS?