L7 - Indifference Curves

Question 1

What are axioms and why do we habve them?

Answer 1

There are 5 axioms of consumer theory (properties we expect preferences to have)

Why have axioms?

1. Have simplest possible theory
2. Make clear hidden assumptions
3. Develop testable predictions

e.g. you are less likely to give up a product if you have a small amount of it e.g. giving away 1 chocolate out of 5 seems alot more than 1 out of 1000

Question 2

What do we expect of a rational buyer?

Answer 2

What do we expect of a RATIONAL buyer?

a) All bundles can be compared
b) All bundles can be ranked consistently

Question 3

What do we expect of a Most people most of the time?

Answer 3

a) Similar bundles should have similar rankings
b) More is better
c) Averages preferred to extremes

Question 4

What is Axiom 1?

Answer 4

Axiom 1: COMPLETENESS (all bundles can be compared)

For bundles A and B: either A is (weakly) preferred to B or vice versa
• Weak preference versus strict preference

Question 5

What is Axiom 2?

Answer 5

Axiom 2: TRANSITIVITY (all bundles can be ranked consistently

Question 6

What is Axiom 3?

Answer 6

Axiom 3: CONTINUITY (similar bundles have similar rankings)

Question 7

What is Axiom 4?

Answer 7

Axiom 4: MONOTONICITY (more is preferred to less)

Question 8

What is Axiom 5?

Answer 8

Axiom 5: CONVEXITY (averages preferred to extremes)

Question 9

What is Utility?

Answer 9

Utility is the amount of satisfaction an individual get from a bundle

• The number given to a bundle is called total utility.
• Often the units for the score of a bundle is called: utils.

Utility is only an ordinal concept (only ranking matters).
EXAMPLE: if A yields 80 utils and B yields 800 utils
INCORRECT: B is ten times better than A
CORRECT: B is strictly preferred at A
Indifference curves join bundles for which a person receives the same total utility

Question 10

How do the Axioms apply to indifference curves?

Answer 10

• AXIOM 1, 2 & 3: indifference curves can be used to represent preferences
• AXIOM 4: indifference curves are downward sloping–> An upward sloping Indifference curve suggest indifference when somebody’s got more of both goods –> downwards sloping suggest a tradeoff between the two goods
• AXIOM 5: indifference curves have familiar shape –> Indifference curves are bowed towards the origin: they are convex to the origin
• AXIOM 2 SPECIFIC: indifference curves cannot cross

Question 11

What does the special indifference curve look like with perfect substitutes?

Answer 11

Perfect substitutes provide exactly the same utility as each other
The indifference curves are straight lines for perfect substitutes

Question 12

What does the special indifference curve look like with perfect complements?

Answer 12

Perfect complements only provide more utility if used together
-The indifference curves are L-shaped for perfect complements

Question 13

What is a bliss point indifference curve?

Answer 13

• A bliss point is a bundle with the maximum possible utility When little consumed, preferences are well behaved But consuming more than this point lowers utility
• Too much of one product can actually reduce your utility so you are aiming for an optimum amount
• Looks like a circle?

Question 14

What is a bads indifference curve?

Answer 14

‘Bads’ are the opposite of goods: increasing the quantity actually lowers utility

e.g. less pollution is preferred to more