Microeconomics – BS1551 – Rational Consumer Choice Part
2 - Preferences and Indifference Curves
Introduction
Previously we looked at budget constraints and looked at what a customer can afford.
Originally, there were an infinite number of possibilities of what the customer would end up
choosing, and by implementing a budget constraint and thinking about what they could
afford we narrowed it down to consumption bundles that were either on the budget
constraint or below it.
However, this is still a lot of choices. In order to narrow it down and make an exact
prediction about what a consumer will choose. We need to know something about what
they like.
Thinking about preferences
We know what options are feasible for our customers, due to the budget constraint – they
can consume any bundle on, or below, their budget constraint.
What we’d like to be able to do is say which bundle they will choose from the ones
available. To do this, we need to know their preferences.
What are preferences?
In economics, we say a consumer gains utility (satisfaction) from consuming bundles of
goods.
Consider two bundles, A and B. Suppose that A contains 12 square metres/week of shelter
and 8kg/week of food, while B has 10 square metres/week of shelter and 10 kg/week of
food. Knowing nothing about a consumer's preferences, we can say nothing about which of
the bundles they would prefer.
The preference ordering enables the consumers to rank pairs of bundles but not to make
more precise statements about their relative desirability.
- Definition: A preference ordering is a ranking of all possible consumption bundles
in order of the amount of utility they give the customer.
Consider two consumption bundles, X and Y. – we say that if the consumer prefers X to Y
then bundle X gives them more utility than Y.
Economists assume five properties of preference orderings:
You will need to know this, and it is referred to all the time (not just in first year)
- Completeness
- Transitivity
- More-is-better.
- Continuity
- Convexity
, Indifference
What happens if X and Y yield exactly the same utility?
In this case, the consumer would be equally happy with either bundle. We say that the
consumer is indifferent between bundles X and Y.
Preference properties
We now have a way to rank consumption bundles – on their level of utility.
What properties would we like preferences to have?
- We want to rule out any crazy decisions.
- We want to include some obvious characteristics.
Property 1 of preferences: Completeness
A preference ordering is complete if it enables the consumer to rank all possible
combinations of goods and services.
This means that they can always work out exactly how much utility each bundle gives them
and whether it gives them more or less utility than another bundle.
This is realistic in simple cases but in more complex cases, things get more complicated, and
consumers may not be able to know exactly how much utility they get from something.
Completeness means that you would be able to rank choices. For example, you would be
able to rank the following options: going shopping for clothes, going to a football match, or
studying microeconomics.
Being able to rank these is completeness.
Property 2 of preferences: transitivity
To say that a consumer's preference ordering is transitive means that, for any three bundles,
A, B, and C, if he prefers A to B and prefers B to C, then he always prefers A to C.
Let’s suppose the following:
- You prefer books to flags and would give up £20 and a flag for a book.
- You prefer chewing gum to books and would give up £20 and a book for chewing
gum.
- You prefer flags to chewing gum and would give up £20 and a chewing gum for a
flag.
You have £60 and a flag.
I have a book and chewing gum.
Can I hustle you, so that I take all your money and you just end up with a flag?
- You’ve got a flag, but I know you prefer books to flags. So, I say to you, I will give you
this book if you give me your flag and £20, which she would be willing to do, shown
by her preferences.
- Now, she has a book and £40 and I have a flag, £20, and chewing gum.
- Now I go back to her and say I’ve got chewing gum, would you be willing to give me
the book and £20 in order to get the chewing gum. Shown by her preferences, she
would be willing to do this.
- Now, she has £20 and chewing gum and I have a flag, a book, and £40.
