Econ 410: Micro TheoryPreferences and UtilityFriday, August 31st, 2007The Plan for Today Review Indifference curves and the marginal rate of substitution Consumer Behavior How can we use the MRS to understand preferences in more detail? What are some additional attributes of indifference curves? Utility What is utility anyway? How can we relate it to consumer behavior?Recall from last time… An indifference curve is a graphical representation of all combinations of market baskets that provide a consumer with the same level of satisfaction. The marginal rate of substitution(MRS) isthe amount of a good that a consumer is willing to give up in order to obtain one more unit of another goodThe MRS in Detail The MRS measures the value that an individual places on one extra unit of a good in terms of another Relationship to the indifference curveThe Convexity of Preferences Convexity and the MRS Definition of Convexity Diminishing marginal rates of substitution Relationship to economic assumptions Recall the 3 important economic assumptions we’ve made so far Adding a fourth – is this reasonable?Sample Exam Question Refer to the table above. If preferences satisfy all four of the usual assumptions, then:a) A is on the same indifference curve as Bb) B is on the same indifference curve as Cc) A is preferred to Cd) B is preferred to Ae) Both (a) and (b) are correct85C58B36APizzaBeerPerfect Substitutes Intuitive Definition Technical Definition Two goods are perfect substitutes when the MRS between the goods is constant Graphical IllustrationPerfect Complements Intuitive Definition Technical Definition Two goods are perfect complements when the indifference curves for both are shaped as right angles Graphical Illustration Other “weird” preferencesSample Exam Question Envision a graph with meat on the horizontal axis and vegetables on the vertical axis. A strict vegetarian would have indifference curves that are:a. Verticalb. Horizontal c. Diagonal straight linesd. Right anglese. Upward slopingUtility We have already learned how to compare market baskets relative to one another using graphs But, how do we quantify these preferences? The concept of utility allows us to assign numerical values to different market baskets Technically, utility is the numerical scorerepresenting the satisfaction a consumer obtains from a bundle of goodsUtility Functions A utility function is a formula that assigns a particular level of utility to each market basket Example Suppose Bart’s utility function for burritos and pizza is given by: U(B,Z) = Z + 3B What does this imply? GraphicallyOrdinal vs. Cardinal Utility A utility function that generates a ranking of market baskets is called an ordinal function. A cardinal utility function allows us to find out the magnitude of preferences, or by how much one bundle of goods is preferred to another. What’s the problem with measuring cardinal utility?For next time… Monday’s Agenda We’ll begin looking at the ways in which consumer preferences are limited, using budget constraints.We’ll combine everything we’ve learned about utility so far to see how people make choices Readsections 3.3 and 3.4 in your text over the weekend Come prepared with questions if you have them Quiz - Next Friday over Chapter 3 Make sure you read