lecturenotes_test2 - ECON 2106 1Lecture Notes for Exam 2...

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ECON 2106 1Lecture Notes for Exam 2 Consumer Theory, Preferences, and Utility; Indifference and Budget Curves Axioms of Rational Choice : 1. Completeness : if A and B are any two situations, the individual must be able to specific one of the following three possibilities, that: a. “A is preferred to B” b. “B is preferred to A”, or c. “A and B are equally attractive” 2. Transitivity : If “A is preferred to B” and “B is preferred to C”, then “A must be preferred to C” 3. Continuity : If “A is preferred to B”, then situations suitably “close to” A must also be preferred to B. It rules out bimodal utility distributions. Utility is the ability of rational consumers to ordinally rank in order all possible situations from the least desirable to the most desirable. Utility rankings, which represent individuals’ preferences, may have numbers attached to these situations. The fact that utility rankings are ordinal, not cardinal, suggests that they hold up to monotonic (order- preserving) transformations of the utility function. Individual’s rankings of bundles and the utility functions implied by these rankings are unobservable to the policy researcher. We learn things about an individual’s utility based on their responses to prices, income, and other factors. Interpersonal comparisons of utility are not possible (ex. Person A rates a steak dinner a “5” whereas Person B rates the same dinner a “100” – but the scales may be different) unless, according to Sen, the utility scales are the same. Arguments of the Utility Function are varied depending on the behavior modeled. In some cases, arguments include aggregate variables like real wealth (W), consumable goods (C), and leisure time (L), or disaggregate variables like milk and bread (x and y). Indifference Curves illustrate a set of consumption bundles among which the individual is indifferent (all bundles provide the same level of utility – “iso-utility”). The northeast corner emanating from a given point on a graph shows the preferred points that increase utility. The slope of the indifference curve is negative, reflecting the fact that if the individual is forced to give up some y, he/she must be compensated by an additional amount of x to remain indifferent between the two bundles of goods. Indifference curves are bowed to reflect the fact that consumers are progressively less willing to trade away y to get more x (i.e. the slope diminishes as x increases, suggesting that we know something about the second partial derivative. Marginal Rate of Substitution is the slope of the indifference curve. Pg. 76 shows how 1) intersecting indifference curves imply inconsistent preferences. The logic is that two indifferent points on the same indifference curve are inconsistent with the preferences of another individual. 2) Nonsatiation suggests that “A is preferred to B” and “C is preferred to D”. But the axiom of transitivity implies that A must be preferred to D. This
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lecturenotes_test2 - ECON 2106 1Lecture Notes for Exam 2...

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