L7 Indifference curves
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Introduction
Title: Principles of Microeconomics - Consumer Theory Lecture 7
Presenter: Tien-Der Jerry Han
Focus: Indifference Curves
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Aims of Topic 2
Review of Topic 1: Basics of market operations.
Topic 2: Explore depth in individual decision-making.
Key Assumption: Traditional relationships (lower price = higher demand; higher wage = higher supply) are not universally true.
Goal: Develop a theory of decision-making to understand choices, demand, supply, and government policy effects.
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Lecture Objectives
Introduction to the concept of preferences in consumer theory.
Focus on making rational decisions in a context of scarcity.
Steps in decision-making:
STEP 1: Assess desires → focus here in L7
STEP 2: Consider constraints.
STEP 3: Make a decision.
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Lecture Outline
Preferred Bundles
Utility and Indifference Curves
Special Indifference Curves
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Reading List
Lipsey and Chrystal (14th ed), ch. 4, p.73-84;
Sloman, Wride, and Garratt (11th ed), ch. 4, p.104-117;
Perloff, J. (2018), Microeconomics, 8th edition;
Varian, H. R., Intermediate Microeconomics: A Modern Approach (8th ed), ch.3 p.33-48
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Representing Bundles of Goods
bundles = what consumers are buying
Consumer preference representation limited to two goods.
Examined bundles of beer and pizza:
A = (3, 3)
B = (4, 1)
C = (1, 4)
D = (3, 2)
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Preferences for Bundles
Five axioms (assumptions) of consumer theory representing expected preferences:
Goals: Simplicity, transparency of assumptions, and testable predictions.
Rational buyer expectations (set 1)
Axioms of bundle comparison and consistent ranking.
Preferences influence their ranking.
What do we expect of MOST people MOST of the time (set 2)
a) similar bundles should have similar rankings
b) more is better
c) averages preferred to extreme
assumptions in set 1 must always hold, but ones in set 2 do not.
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Rational Consumer Axioms
Axiom 1: Completeness
Every bundle can be compared; one is preferred to the other.
Axiom 2: Transitivity
If A is preferred to B and B to C, then A is preferred to C.
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Well-Behaved Preferences
Axiom 3: Continuity
Similar bundles lead to similar rankings.
if A is better than B, and B is close to C, then A is stated to be weakly preferred to C
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Well-Behaved Preferences Continued
Axiom 4: Monotonicity
More of both goods is preferred.
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Well-Behaved Preferences Continued
Axiom 5: Convexity
Averages are preferred to extremes.
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Practical Exercise in Preferences
Ranking preferences for bundles and understanding Convexity and Monotonicity in practical examples.
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Utility and Indifference Curves
Total utility: Offer a summarization of preference rankings without specifying satisfaction levels.
Utility is ranked ordinally, not cardinally.
Indifference Curves: Join bundles yielding equal utility.
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Implications of the Axioms on Indifference Curves
Indifference curves represent preferences adhering to Axioms 1, 2, and 3.
Monotonicity Implication: These curves slope downward, indicating trade-offs.
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Indifference Curve Shape
Indifference curves are bowed inwards towards the origin due to Axiom 5 (Convexity).
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Transitivity and Indifference Curves
Axiom 2: Indifference curves cannot intersect; crossing indicates inconsistency in preferences.
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Exercise on Indifference Curves
Practical application exercise to visually represent rankings using indifference curves.
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Special Indifference Curves: Perfect Substitutes
Perfect substitutes create straight line indifference curves due to identical utility from different goods.
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Special Indifference Curves: Perfect Complements
Perfect complements form L-shaped curves, requiring quantities to be used together for increased utility.
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Indifference Curves for 'Bads'
‘Bads’ (e.g., pollution) indicate that increasing quantity results in decreased utility.
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Bliss Point and Utility
A bliss point defines maximum utility; beyond this, increasing consumption may lead to decreased satisfaction.
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Properties of Indifference Curves
Indifference curves connect bundles of equivalent total utility; cannot cross; curves further from the origin represent higher utility.
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Summary of Rational Preferences
Preferences can be ranked and display consistency.
Well-behaved preferences correlate to similar ranks and average preference.
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Final Learning Outcomes
Following this lecture, students should be able to:
State the five axioms of consumer theory.
Rank bundles for individuals with well-behaved preferences.
Discuss the implications of the axioms on indifference curves.