Many of the models used to understand and describe individual human behavior are based on the concept of utility maximization. These models are simply written as:
where the arguments on the right-hand side 'X' & 'Y' represent measurable quantities of goods or services. Unfortunately the term on the left-hand side of the expression, utility 'U', is neither observable nor measurable. Thus we have to resort to the notion of individual preferences for goods and services to indirectly represent the utility (satisfaction) gained from consumption of these items.
We will make several assumptions about these preferences:
The first assumption states that given several goods 'a', 'b', and 'c', a consumer can define his preferences for these goods and put these preferences in some type of order. For example 'b' may be prefered to 'a', and 'a' may be preferred to 'c'. We summarize this assumption by saying that preferences are complete.
The second assumtion states that if 'b' is preferred to 'a' and 'a' is prefered to 'c' then it must be true that 'b' is preferred to 'c'. This is known as the transitivity condition.
The third assumption is straight-forward in that greater quantities provide greater levels of satisfaction to the individual. This is known as non-satiation.
The last assumption states that consumers prefer bundles (or combinations) of goods and services that contain some variety of those goods rather than extreme bundles that contain large amounts of just one particular good. This is the concept of diminishing marginal utility.
If we consider two goods: books and movies, as shown in the left diagram of figure 1 below. Both goods are desired by a given consumer (known as economic goods rather than economic bads). Points a, b, c, d, e each represent different combinations of these two goods.
From assumptions 1 and 2 we find that the consumer will decide on one of the following:
In the case where preferences for the two goods are defined, it must be the case that one good will provide more satisfaction (utility) relative to the other good. When indifference is the case, it must be true that the two bundles provide equal levels of satisfaction.
From our third assumption we can state that:
Finally the fourth assumption allows for comparison between the two extreme bundles 'b' and 'c' and an average bundle 'e'. In this case if bundles b and c provide the same level of satisfaction then bundle e (which represents an arithmetic average of the former, i.e., e = ab + (1-a)c for 0 < a < 1), will be prefered.
Using these notions with respect to preferences, we can define a mapping that includes additional bundles of books and movies. This mapping is shown with the addition of the curves in the diagram on the right of figure 1. These curves, known as indifference curves represent combinations of the two goods that provide equal levels of satisfaction. All points on IC1 represent bundles of books and movies that provide the same level of satisfaction as bundle b (8 movies, 1 book) or bundle c (2 movies, 3 books). All bundles on IC2 provide more satisfaction than bundles included on IC1 which provide more satisfaction than bundles on IC0.
The position and general shape of these curves are defined through assumptions 1 and 2. In addition, assumption 2 prevents these curves from intersecting. For example, suppose that IC1 and IC2 intersected at point b. This would imply that:
but e is contains more books and movies than certain points on IC1 (points to the interior of e) such that e must be preferred to these points as well as point c. Behavior in the case of intersecting indifference curves would be inconsistent and irrational.
These curves are downward sloping consistent with assumption 3 (if they were upward sloping, horizontal, or strictly vertical they would violate the condition of more is preferred to less). Finally assumption 4 (averages are preferred to extremes) leads to the convexity of the curves-- given e > c ~b implies that IC1 must contain points to the interior of e.
In different models these indifference curves can be used to identify preferences for combinations of: different products, consumption spending in the present and in the future, work-time and leisure time, or financial risk and return.
In the first two cases, we are talking about two goods where the indifference curves are downward sloping and movement to the north-east in the diagram indicates the individual is better off.. In the latter two cases we are talking about one good (something preferred) and one bad (something to avoid) where the indifference curves would be upward sloping and movement to the north-west or south-east (towards the good and away from the bad) indicates the individual is better off.
Concepts for Review: