Consumer preferences tell us about people's likes and dislikes.
Consumer theory assumes that consumers' preferences are coherent, in the sense that they respect the Ranking Principle. It also assumes that their decisions reflect preferences, in the sense that they respect the Choice Principle.
Consumer preferences
Since many consumer decisions are interdependent, decision makers need to compare consumption bundles.
For the typical decision, it's reasonable to assume that consumers prefer more to less. In summarizing the properties of indifference curves below, we make this assumption.
Indifference curves for goods are thin and never slope upward.
The indifference curve that runs through any consumption bundle, call it X, is the boundary that separates all the better-than-X alternatives from all other options. The better-than-X alternatives lie to the northeast of the indifference curve. The worse-than-X alternatives lie to the southwest.
Indifference curves from the same family never cross.
In comparing any two alternatives, the consumer prefers the one located on the indifference curve furthest from the origin.
One way to describe consumers' preferences mathematically is to write formulas for their indifference curves.
For every bad there is an associated good. We can apply consumer theory to bads by thinking about the associated goods.
Substitution between goods
The marginal rate of substitution varies from one consumer to another according to the relative importance the consumer attaches to the goods in question.
As we move along an indifference curve from the northwest to the southeast, the curve usually becomes flatter. Equivalently, the amount of one good, Y, required to compensate a consumer for a fixed change in another good, X—and hence the MRS for X with Y—declines as X becomes more plentiful and Y becomes more scarce. This feature is known as a declining MRS.
A second way to describe consumers' preferences mathematically is to write formulas for their marginal rates of substitution.
Whether or not two individuals can engage in mutually beneficial trade depends on their marginal rates of substitution.
The indifference curves for perfect substitutes are straight lines.
The indifference curves for perfect complements are L-shaped—vertical above a kink point, and horizontal below it.
Utility
Economists use the concept of utility to summarize everything that is known about a consumer's preferences.
We can create a utility function from a family of indifference curves by assigning the same utility value to all bundles on an indifference curve, with higher values assigned to indifference curves that correspond to higher levels of well-being. We can construct indifference curves from a utility function by setting the function equal to a constant.
In modern microeconomic theory, utility functions are only intended to summarize ordinal information.
By itself, the marginal utility of a good does not measure anything meaningful. However, the ratio of the marginal utilities for two goods is equal to the marginal rate of substitution between them.
