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Intermediate Microeconomics

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Intermediate Microeconomics Preferences Consumer Behavior Budget Set organizes information about possible choices available to a given consumer. – PowerPoint PPT presentation

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Title: 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?
  • Will slope of indifference curves be positive or
    negative? How do we know?
  • 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 preferences 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 Apple Juice?
  • 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?
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