L7 Indifference curves

Page 1

Introduction

• Title: Principles of Microeconomics - Consumer Theory Lecture 7

• Presenter: Tien-Der Jerry Han

• Focus: Indifference Curves

Page 2

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.

Page 3

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.

Page 4

Lecture Outline

1. Preferred Bundles

2. Utility and Indifference Curves

3. Special Indifference Curves

Page 5

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

Page 6

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)

Page 7

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.

Page 8

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.

Page 13

Practical Exercise in Preferences

• Ranking preferences for bundles and understanding Convexity and Monotonicity in practical examples.

Page 14

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.

Page 15

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.

Page 16

Indifference Curve Shape

• Indifference curves are bowed inwards towards the origin due to Axiom 5 (Convexity).

Page 17

Transitivity and Indifference Curves

• Axiom 2: Indifference curves cannot intersect; crossing indicates inconsistency in preferences.

Page 18

Exercise on Indifference Curves

• Practical application exercise to visually represent rankings using indifference curves.

Page 19

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.

Page 21

Indifference Curves for 'Bads'

• ‘Bads’ (e.g., pollution) indicate that increasing quantity results in decreased utility.

Page 22

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.

Page 24

Summary of Rational Preferences

• Preferences can be ranked and display consistency.

• Well-behaved preferences correlate to similar ranks and average preference.

Page 25

Final Learning Outcomes

• Following this lecture, students should be able to:

  1. State the five axioms of consumer theory.

  2. Rank bundles for individuals with well-behaved preferences.

  3. Discuss the implications of the axioms on indifference curves.