SM 300

Engineering Economics
 Consumer Preferences (contd.)
Marginal Rate of Substitution (MRS)
= Maximum amount of a good that a consumer is willing to give up in
order to obtain one additional unit of another good.
The magnitude of the slope of an
indifference curve measures the
consumer’s marginal rate of substitution
(MRS) between two goods.

Here, the MRS between clothing (C) and

food (F) falls from 6 (between A and B)
to 4 (between B and D) to 2 (between D
and E) to 1 (between E and G).

When the MRS diminishes along an

indifference curve, the curve is convex.
 Consumer Preferences (contd.)
• The shape of an indifference curve describes the willingness of a
consumer to substitute one good for another.
• An indifference curve with a different shape implies a different
willingness to substitute.
Perfect Substitutes:
Two goods for which the marginal rate of substitution of one for the
other is a constant… Eg.
Blue ink pen and Dark-blue ink pen for writing notes in class
Perfect Complements:
Two goods for which the Marginal Rate of Substitution is zero or
infinite. Eg.
Left shoe and Right shoe
How will the Indifference Curves be in above two cases?
 Consumer Preferences (contd.)

Note: The slope of the indifference curves need not be 1 for perfect
substitutes. Eg. If one believes that one 16-megabyte memory chip is
equivalent to two 8-megabyte chips because both combinations have
the same memory capacity
 the slope of the indifference curve will be 2 (16-Mbyte chip is on y-axis)
 Consumer Preferences Eg.- Designing a New Automobile
Suppose you work for a leading car company and have to help them plan
new models to introduce.
To find out how much people are willing to pay for various attributes, the
company undertakes a survey… The following are the preference curves
for two different market segments (i.e. groups of consumers), say A & B.

Which attribute will you focus on for designing the new car models for
each of the Market Segments?
 Consumer Preferences Eg.- Designing a New Automobile
Ans:

For market segment A, as compared to market segment B, attribute

“Acceleration” is more important since the market segment is
willing to give up more of space to get little more of acceleration.
Note: The scale and units of the two attributes are the same for the
indifference maps of Market Segments A & B.
 Utility Functions and Indifference Curves
• Consumer theory relies on the assumption that consumers can
provide only relative rankings of market baskets.
• Yet, it is often useful to assign numerical values to individual
baskets.
• In the language of economics, the concept of utility refers to the
numerical score representing the satisfaction that a consumer
gets from a market basket…. i.e., utility is a device used to simplify
the ranking of market baskets.
Utility Function
A utility function = a formula that assigns a level of utility to each
market basket. Eg.
If the utility function for food (F) and clothing (C) is U(F,C) = F + 2C,
calculate utility for market basket (i) 8 units of food, 3 units of
clothing and (ii) 6 units of food and 4 units of clothing and (iii) 4
units of food and 4 units of clothing. Also comment on the
findings.
 Utility Functions and Indifference Curves (Contd.)
Ans.
(i) U(8,3) = 8 + 2*3 = 14
(ii) U(6,4) = 6 + 2*4 = 14
(iii) U(4,4) = 4 + 2*4 = 12
Baskets (i) and (ii) are on same utility curve and they are preferred
over (iii)

Let another utility function be U(F,C) = FC… then all the isoutility
curves would be such that their product would be equal to the
value of FC…
Suppose U(F,C) = 25… then some of the market baskets on this
indifference curve would be (5,5), (10,2.5), (2.5,10) and so on…
Another indifference curve could be at U(F,C) = 50 or U(F,C) =100.
How will the indifference map look like?
 Utility Functions and Indifference Curves (Contd.)
Ans.

Cardinal Utility Function =

Utility function describing by how much one market basket is
preferred to another.
 Utility Functions and Indifference Curves (Contd.)
However, in real world we have no way of telling whether a person
gets twice as much satisfaction from one market basket as from
another….
Nor do we know whether one person gets twice as much satisfaction
as another from consuming the same basket.

Hence, for understanding consumer behavior Ordinal rather than

Cardinal Utility Function is considered.

Ordinal Utility Function = Utility function that generates a ranking of

market baskets in order of most to least preferred.
It does not indicate by how much one is preferred to another.