Chapter 3: Consumer Preferences and the Concept of UtilityOutlineIntroductionSlide 4Description of Consumer PreferencesProperties of Consumer PreferencesSlide 7Preferences ExamplesIntransitivity and AgeOrdinal vs Cardinal RankingsOrdinal vs Cardinal ExampleUtility FunctionImplicationsUtility Function (one good example) Are the assumptions on preferences meet?Marginal UtilitySlide 16Slide 17Utility function (2 good example)Indifference Curve (IC)Indifference Map:Indifference Curves and MapProperties of Indifference MapsProperties of Indifferences MapsMonotonicity: Consumers like both goods.Monotonicity:Indifference Curves Cannot CrossAverages Preferred to ExtremesSlide 28Slide 29Marginal Rate of SubstitutionSlide 31Slide 32Slide 33Graphing an Indifference CurveSlide 35Slide 36Slide 37Marginal Utility and Marginal Rate of SubstitutionSlide 39Slide 40Slide 41Slide 42Slide 43Slide 44Slide 45Slide 46Special Functional FormsSlide 48Slide 49Slide 50Slide 51Slide 52Quasi-Linear PreferencesSlide 54Slide 55SummaryChapter 3: Consumer Preferences and the Concept of Utility2OutlineIntroductionDescription of consumer preferencesThe Utility functionsMarginal utility and diminishing marginal utilityIndifference CurvesMarginal rate of substitutionSpecial functional forms3Supply and Demand Models (Ch. 2) are useful for analyzing economic questions concerning markets.How will increasing the real wage affect output?In these models we summed each individuals demand to obtain the market demand curve.But, how do individuals decide what to consume and how much to consume. Introduction4We need to develop a model about individual or consumer behaviorModel is based on:1. Individual tastes or preferences determine the amount of pleasure people derive from goods and services. (Chapter 3)2. Consumers face constraints (budget) that limit their choices3. Consumers maximize their well-being or pleasure from consumption, subject to the constraints they face.We want our model to be realistic so we can predict consumer behavior. But, still as simple as possible.Introduction5Description of Consumer PreferencesConsumer Preferences tell us how the consumer would rank any two basket of goods, assuming these allotments were available to the consumer at no cost.baskets or bundles is a collection of goods or services that an individual might consume.61. Complete: Preferences are complete if the consumer can rank any two baskets of goods A strictly preferred to B (A  B )B strictly preferred to A (B  A )indifferent between A and B (A ≈ B) Preferences are transitive if a consumer who prefers basket A to basket B, and basket B to basket C also prefers basket A to basket C2. Transitive: A  B and B  C → A  C NOT C  A The Assumptions of Consumer BehaviorNo illogical behaviorProperties of Consumer Preferences7Properties of Consumer Preferences3. Monotonic (more is better) Preferences: are monotonic if a basket with more of at least one good and no less of any good is preferred to the original basket. – free disposal can’t be worse of with moreThe more is better assumption is also known as the property of non-satiation.It assumes are looking at what economists call a ‘good’. Something we want more ofWe are not looking at a ‘bad’ i.e. pollutionWe can relax this assumption it is the first two that are crucial for the analysis8Preferences Examples9AgeNumberofSubjectsIntransitiveChoices(%)439835338262382735788406895257104552116537128123138141Adults9913Source:SeeHirshleifer,JackandD.Hirshleifer,Price Theory and Applications.SixthEdition.PrenticeHall:UpperSaddleRiver,NewJersey.1998.Intransitivity and Age10Ordinal vs Cardinal RankingsOrdinal Ranking: gives us information on how a consumer ranks different baskets of goods. But it does not say by how much (i.e. 2 times as much)This is how we view preferences.Cardinal Rankings: Give us information on the intensity of the consumer preferences (i.e. they like basket A 10 times more than basket B).Would be hard to say I like eating pizza out 10.5 times more than eating bad Chinese. Putting an exact number to our preferences is hard! – this is why we use ordinal rankings for consumer preferences11Ordinal vs Cardinal ExampleStudents take an exam. After the exam, the students are ranked according to their performance. An ordinal ranking lists the students in order of their performance (i.e., Harry did best, Joe did second best, Betty did third best, and so on). A cardinal ranking gives the grade of the exam, based on an absolute grading standard (i.e., Harry got 50, Joe got 100, so Joe did 2 times better than Harry).12Utility is an ordinal concept: the precise magnitude of the number that the function assigns has no significance. U=F(x1,x2,x3, ….., xn), where the x’s are quantities of n goods that might be consumed in a periodUtility FunctionUtility Function: