utility theory slides-1

# utility theory slides-1 - Utility Theory Preferences and...

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Utility Theory

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Preferences and Utility Bundles of goods (“market baskets”): A={x 1 ,x 2 ,…,x n }, B={x ̃ 1 ,x ̃ 2 ,…,x ̃ n }, etc. Utility Function: U(x 1 ,x 2 ,…,x n ) Order-preserving function that is strictly increasing Preference assumptions: Completeness: either A B or B A or A~B Consumers can compare and rank all bundles Transitivity: if A B and B C, then A C “rationality property” More is Better Continuity Strict Convexity
Indifference Curves X 1 X 2 5 5 A 15 15 B 20 8 C 12 12 D 8 18 E A B D C E What if this consumer is indifferent between C,D, and E ? … U 1 •Downward-sloping (otherwise violates “more is better”) -Willing to give up some of Good2 in order to get one more unit of Good1 -Marginal Rate of Substitution = slope of IC (negative) = Δ X 2 / Δ X 1 = dx 2 /dx 1 •Invoke “strict convexity”: diminishing MRS -Willing to give up less and less of Good2 in order to obtain one more unit of Good1 -IC convex to origin •Exceptions ( don’t

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