Week Four: Preferences

Question 1

Motivation for understanding consumer preferences:

Answer 1

Motivation: (1) options and (2) objectives consumers persue

“Objective” Preferences:

1. Preferences Relation: How consumers rank options
2. Axioms: Allows construct, compelte, and consistently rank all potential consumption bundles

Question 2

Define consumer behavior:

Answer 2

Consumer Behavior: people choose the best they can afford → objects of choice are consumer bundles

Question 3

What are the three preference relations?

Suppose two consumer bundles (x_1, x_2) and (y_1, y_2)

Answer 3

Ranked in order of desirability → (x_1, x_2) succ (y_1, y_2) (consumer (1) strictly prefers the second option)

• Idea that one would be chosen over the other (given the opportunity) is based on consumer behavior

Alternatively they can be (2) indifferent between the two: (x_1, x_2) ~ (y_1, y_2)

• Equally satisfied with both options

Finally, consumer (3) weakly prefers a good when the consumer prefers or is indifferent between two bundles: (x_1, x_2) ⪯ (y_1, y_2)

Above relationships related to each other

Question 4

Axioms about preferences:

Answer 4

Complete, Reflexive, Transitive

Indifference curves cannot cross because it would violate the idea of transitivity

Question 5

What is an indifference curve (set)?

Answer 5

For bundle x’, then the set of all bundles equally preferred ⇒ indifference curve (set)

Set of bundles y ~ x’

Shape depends on preferences and infinite amount of indifference curves

• Weakly Preferred Set Shade in all the consuption bundles that are weakly preferred
• Bundles on boundary of this set → just indifferent to (x_1, x_2) ⇒ Indifference Curve

Question 6

Assumptions for Well-Bahaved indifference curves:

Answer 6

Assumptions:

1. Monotonicity Preference: Assumption that more is better
2. Convex: Prefer C over A/b

(Averages are preferred to extremes)

Question 7

What is the marginal rate of substitution and its relation to the slope?

Answer 7

Slope of an indifference Curve: marginal rate of subsitution

Marginal Rate of Subsitution (differential of indifference curve): dx\dy

How many units of one good must be given up to get the other, while maintaing indifference

• Going to be higher at extremes (steeper curve)
• Negative differential: “give up good”

Question 8

Types of Indifference curves

Answer 8

1. Perfect substitutes
2. Perfect Complements
3. Bads
4. Neutrals

Assume that the curves are well-behaving (monotonicity and convex)

Question 9

Types of Indifference Curves

Perfect Subsitutes:

Answer 9

Perfect Substitutes: consumer willing substitute one good for another at a constant rate

• Indifference curves all straight parallel lines (m=-1) -> slope ⇒ constant

Question 10

Types of Indifference Curves

Perfect Complements:

Answer 10

Perfect Complements: goods always consumed together in fixed proportions.

• Fixed proportion (not necessarily one-to-one)
• MRS: 0 (no amount good two want to give up → too much of the othe rgood)

Question 11

Types of Indifference Curves

Bads:

Answer 11

Bad → commodity consumer does not like

Direction of increasing preferences is down and to the right → towards direction of decreasing “bad”

• Positive slope: have to be compensated more of the good to take on more of the bad

Question 12

Types of Indifference Curves

Neutrals:

Answer 12

Neutrals - indifferent towards any option