Chapter 4

Principles and Preferences

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

Rights Reserved.

Main Topics
Principles of decision-making
Consumer preferences
Substitution between goods
Utility
Recommended Reading: Applications
4.1, 4.2; Example 4.3

4-2

Building Blocks of Consumer

Theory
Preferences tell us about a consumers likes
and dislikes
A consumer is indifferent between two
alternatives if she likes (or dislikes) them
equally
The Ranking Principle: A consumer can rank,
in order of preference, all potentially available
alternatives
The Choice Principle: Among available
alternatives, the consumer chooses the one
that he ranks the highest
4-3

The Consumers Problem

Consumers economic problems is to allocate
limited funds to competing needs and desires
over some time period
Chooses a consumption bundle
Should reflect preferences over various
bundles, not just feelings about any one good
in isolation
Decision to consume more of one good is a
decision to consume less of another
4-4

Principles of Consumer DecisionMaking

The Ranking Principle: A consumer can rank,
in order of preference, all potentially available
alternatives
The Choice Principle: Among available
alternatives, the consumer chooses the one
that he ranks the highest
The More-is-better Principle: When one
consumption bundle contains more of every
good than a second bundle, a consumer
prefers the first bundle to the second
4-5

Indifference Curves
Use when goods are (or assumed to be)
available in any fraction of a unit
Represent alternatives graphically or
mathematically rather than in a table
Starting with any alternative, an
indifference curve shows all the other
alternatives a consumer likes equally
well
4-6

Figure 4.1: Identifying Alternatives

and Indifference Curves

4-7

Properties of Indifference Curves

Thin
Do not slope upward
Separates bundles that are better from
bundles that are worse than those that
are on the indifference curve

4-8

Figure 4.2: Indifference Curves Ruled Out by the

More-is-better Principle

4-9

Families of Indifference Curves

Collection of indifference curves that
represent the preferences of an
individual
Do not cross
Comparing two bundles, the consumer
prefers the one on the indifference curve
further from the origin
4-10

Figure 4.3: A Family of

Indifference Curves

4-11

Figure 4.4: Indifference Curves

Do Not Cross

4-12

Formulas for Indifference Curves

More complete and precise to describe
preferences mathematically
For example, we can write a formula for a
consumers indifference curves
Formula describes an entire family of
indifference curves
Each indifference curve represents a particular
level of well-being
Higher levels of well-being are on indifference
curves further from the origin
4-13

Figure 4.6: Plotting Indifference

Curves
Formula for
indifference curves is
B = U/S
U is well-being, or
utility
To find a particular
curve, plug in a
value for U, then
plot the relationship
between B and S
4-14

Substitution Between Goods

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 make
trade-offs between different goods
Indifference curves provide that
information
4-15

Rates of Substitution
Consider moving along an indifference curve,
from one bundle to another
This is the same as subtracting units of one
good and compensating the consumer for the
loss by adding units of another good
Slope of the indifference curve shows how
much of the second good is needed to make
up for the decrease in the first good

4-16

Figure 4.8: Rates of Substitution

Look at movement
from bundle A to C
Consumer loses 1
soup; gains 2 bread
Willing to substitute
for soup with bread
at 2 ounces per pint

4-17

Marginal Rate of Substitution

The marginal rate of substitution for X with Y, MRSXY,
is the rate at which a consumer must adjust Y to
maintain the same level of well-being when X
changes by a tiny amount, from a given starting point

MRS XY Y X
Tells us how much Y a consumer needs to compensate
for losing a little bit of X
Tells us how much Y to take away to compensate for
gaining a little bit of X
4-18

Figure 4.9: Marginal Rate of

Substitution
MRSSB=-B/S=3/2

4-19

What Determines Rates of

Substitution?
Differences in tastes
Preferences for one good over another affect the
slope of an indifference curve
Implications for MRS

Starting point on the indifference curve

People like variety so most indifference curves get
flatter as we move from top left to bottom right
Link between slope and MRS implies that MRS
declines; the amount of Y required to compensate
for a given change in X decreases
4-20

Figure 4.10: Indifference Curves

and Consumer Tastes

4-21

Figure 4.11: MRS along an

Indifference Curve

4-22

Formulas for MRS

MRS formula tells us the rate at which a
consumer will exchange one good for
another, given the amounts consumed
Every indifference curve formula has an
MRS formula that describes the same
preferences
Indifference curves: B=U/S; MRSSB=B/S
4-23

Perfect Substitutes and

Complements
Some special cases of preferences represent
opposites ends of the substitutability spectrum
Two products are perfect substitutes if their
functions are identical; a consumer is willing to
swap one for the other at a fixed rate
Two products are perfect complements if they
are valuable only when used together in fixed
proportions
Note that the goods do not have to be
exchanged one-for-one!
4-24

Figure 4.12: Perfect Substitutes

4-25

Figure 4.13: Perfect Complements

4-26

Utility
Summarizes everything that is known about
a consumers preferences
Utility is a numeric value indicating the
consumers relative well-being
Recall that the consumers goal is to benefit
from the goods and services she uses
Can describe the value a consumer gets
from consumption bundles mathematically
through a utility function

U S , B 2 S 5 S B

4-27

Utility Functions and Indifference

Curves
Utility functions must assign the same value to
all bundles on the same indifference curve
Must also give higher utility values to
indifference curves further from the origin
Can start with information about preferences
and derive a utility function
Or can begin with a utility function and
construct indifference curves
Can also think of indifference curves as
contour lines for different levels of utility
4-28

Figure 4.14: Representing

Preferences with a Utility Function

4-29

Deriving Indifference Curves from

a Utility Function
For each bundle, the
utility correspond to
the height of the
utility hill
The indifference
curve through A
consists of all
bundles for which the
height of the curve is
the same
4-30

Ordinal vs. Cardinal Utility

Information about preferences can be ordinal or
cardinal
Ordinal information allows us to determine only
whether one alternative is better than another
Cardinal information reveals the intensity of
preferences, How much worse or better?
Utility functions are intended to summarize ordinal
information
Scale of utility functions is arbitrary; changing scale
does not change the underlying preferences

4-31

Marginal Utility
To make a link between MRS and utility,
need a new concept
Marginal utility is the change in a
consumers utility resulting from the addition
of a very small amount of some good,
divided by the amount added

MU X U X
4-32

Marginal Utility
Using Calculus, marginal utility of X in
the change in U when X changes by a
very small amount.

U
MU X
X

Utility Functions and MRS

MRS XY

MU
X

MU Y

Small change in X, X, causes utility to

change by MUXX
Small change in Y, Y, causes utility to
change by MUYY
If we stay on same indifference curve,
then Y/X =MUXMUY
4-34