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Understanding Consumer Preferences: Assumptions and Utility in Consumption Bundles

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This chapter explores consumer preferences through the lens of consumption bundles, highlighting key concepts such as the consumption possibility set, budget constraints, and the psychological makeup of agents. We discuss essential assumptions, including divisibility, additivity, and convexity, which shape how consumers evaluate and rank their options. Additionally, the chapter introduces utility functions, demonstrating how agents derive satisfaction from their consumption choices. By understanding these principles, we gain insight into rational decision-making in economics.

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Understanding Consumer Preferences: Assumptions and Utility in Consumption Bundles

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  1. Chapter 2 Consumers and Their Preferences

  2. Unit of Analysis: Consumption Bundles Good 2 (x 2) b 50 25 a 12 Good 1 (x 1) 0 20 25 50

  3. The consumption possibility set • Assumptions on consumption possibility sets • Divisibility • Goods are infinitely divisible • Additivity • It is possible to add consumption bundles • Convexity • It is possible to combine two bundles to produce a third by consuming fractions of them: c=λa+(1-λ)b

  4. A convex set Oranges A (2,4) B (14,2) Apples If A and B are in the budget set, then any combination budget C, where c=λa+(1-λ)b is also in the budget set.

  5. The Budget Line • Income or budget line • Income • Prices for goods

  6. Income constraints b Good 2 (x 2) c d e 6 6=2x1+1x2 a 2 Good 1 (x 1) 0 2 3

  7. Psychological Makeup of Agents • Agents have preferences that satisfy the following rationality assumptions • R = “at-least-as-good-as” • For any three bundles a, b and c • Rationality Assumptions: • Complete Binary Ordering • aRbor bRa or Indifferent between a and • Reflexivity • aRa • Transitivity • If aRb and bRc, then aRc

  8. Utility Functions • Utility: Level of satisfaction from consumption of a bundles • Based on the three rationality assumptions an agent can rank any group of bundles • A Utility function assigns a number to each bundle such that bundles with a higher number are preferred bundles

  9. Examples of Utility Functions • Additive utility function: U=x+y • Multiplicative utility function: U=xy

  10. Psychological Assumptions • Selfishness • Agents care about their consumption • Nonsatiation • More of anything is always better • Convexity of preferences • Indifferent: bundle a and bundle b • Prefer (or indifferent): a combination, c • Bundle c: at least as good as a or b

  11. Nonsatiated preferences b Good 2 (x 2) Ub a Good 1 (x 1) Giving an agent more of any good must raise his utility. All other bundles in area Ub are strictly better than bundle b.

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