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Consumer preferences and consumption bundles

January 18, 2012

This is one of the cornerstones of microeconomics, and is not usually taught (as far as I am aware) on the A level syllabus, so this is one of the biggest things you will need to get used to when starting micro at undergraduate level.

A lot of concepts in microeconomics are about choice, and the simplest way to model them is to consider the choice between two goods. We can call the goods X and Y. You can actually use this model quite creatively by having one of the ‘goods’ representing ‘all other goods’ so the two good model is more useful than you might first think, but for now just think of X and Y.

You can represent on a graph, different ‘bundles’ of X and Y, for instance if X was apples and Y was oranges, then 3X, 4Y is a bundle (3 apples and 4 oranges), 5X, 2Y is a bundle (5 apples, 2 oranges). We can then compare bundles in terms of whether one is preferable to another. It would be fairly logical to say that if you had a choice of two bundles, one being 3 apples and 4 oranges, and the other being 4 apples and 5 oranges, then (assuming you liked both apples and oranges) the second bundle would be preferable to the first as you have more of each. But what about if the choice was 3 apples and 4 oranges, or 5 apples and 2 oranges? Which is better? You have 7 pieces of fruit overall but people would give different answers depending on how much they like apples and how much they like oranges. This is basically the concept of preferences in microeconomics, comparing different bundles of goods to see what is preferred to another, depending on the differing tastes and preferences of an individual.

We usually make a few assumptions about preferences:
– they are complete: you can compare any bundle, ie if bundle A and bundle B are different combinations of good X and good Y, then either A is better than B, or B is better than A, or the consumer is ‘indifferent’ between the two bundles (they are the same)
– they are reflexive: any bundle is at least as good as itself
– they are transitive: if you have bundles A, B and C, and A is better than B while B is better than C, then A is better than C

The key one here is the assumption of transitive preferences, it might not be realistic in every situation, but it is the way preferences are usually modelled in microeconomics.

Indifference curves give us a way of graphically representing preferences. Indifference curves show us the full set of bundles that correspond to one level of utility. Utility is like ‘pleasure’, it describes how much you want something. Eg if you are as happy having 3 apples and 4 oranges, as you are having 5 applies and 2 oranges, then you are indifferent between them, so they would be along the same indifference curve.

This is a typical set of indifference curves:

I have drawn five indifference curves here, but in reality there are an infinite number of the curves, each representing a different total level of utility. Here I have just labelled them U1, U2, U3, U4 and U5, in ascending order of utility so any bundle on a higher indifference curve has more utility and is preferable. Higher means further away from the origin. The further you are from the origin of the graph, the higher the indifference curve and so the more preferable the bundle.

There are three bundles there, A, B and C, each representing a different amount of good X and good Y. So which is preferable?

Bundle A and bundle C are on the same indifference curve, corresponding to the level of utility U3. Although bundle A has more good Y and bundle C has more good X, the overall value of each bundle is the same to this consumer, given the shape of his indifference curves. If for instance he really liked good X and wasn’t bothered about good Y, then the indifference curves would be at a very steep angle, so you wouldn’t have to increase good X by much to go to a higher indifference curve but you would have to increase good Y by a lot to go to a higher indifference curve. But here the shape indicates he likes the two goods roughly the same, but when he has a lot of good X, he gets more value from increasing good Y than he does increasing good X, and the same when he has a lot of good Y, he prefers to get some more good X than good Y. This is fairly realistic to the shapes of most of our indifference curves, because even if you liked both apples and oranges around the same when you didn’t have any, if you had 100 apples, you would probably decide that an orange was preferable to another apple!

Bundle B is on a higher indifference curve, corresponding to the level of utility U4, so in this diagram, B is the preferred bundle.

Utility is difficult to measure, we see it as an ordinal measure rather than cardinal measure. This means that whilst we can say that a certain bundle gives us more utility than another, we can’t say ‘by how much’ it is better than another. It’s like if I ask you would you prefer a free gift of going on holiday to Barcelona or have free tickets to watch a film at the cinema. You would probably regard the holiday as the better gift, but if you were asked the question “by how much do you prefer the holiday to the cinema tickets” then it would be impossible to answer accurately, you couldn’t say “I rate it 17 times higher” or something along those lines. You could say that 17 sets of cinema tickets would give you the same amount of utility as the holiday in Barcelona, but that would be a slightly different concept than saying you regard one holiday 17 times better than one set of tickets. This is because you do not usually get the same amount of utility from each amount of the same good. Think for instance of ice cream, on a hot day when you really felt like an ice cream, you might get a lot of pleasure from having it, but having another one might not necessarily double your pleasure, and having ten in a row definitely wouldn’t increase your pleasure by a factor of ten – you might have had well more than enough after two or three and any further ice creams would actually reduce your level of utility.

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