1. Preferences

Using assumptions, we can make predictions about consumer preferences.  Preferences can be considered as allocating your money to buy a particular bundle of goods and services.  We can represent these preferences with a function, which allows values to be assigned to different bundles, which in turn allows higher numbers to be assigned to better[1] bundles.  The five assumptions we must make about preferences are:

1. Completeness - any two bundles of goods can be compared (and a preference for one or the other stated).
2. Transitivity - if bundle A is at least as good as Bundle B, and B is at least as good as C, then A is at least as good as C.
3. More is better (also called nonsatiation) – if all other things are equal, more of a commodity is better than less of it.
4. Continuity - if bundle A is better than B and bundle C is sufficiently close to B, then A is better than C.
5. Strict convexity – bundles that are mixtures are better than bundles that comprise mostly one good or the other.   If preferences are strictly convex, the best bundle (which is where the indifference curve meets the budget line) is unique.  If preferences are just convex (as opposed to strictly convex, there are multiple optimal bundles.  Convex preferences can be considered preference for diversity.

Note that some preferences can not be described by a utility function.  If preferences are represented by a utility function , this utility function is not unique – any positive monotonic transformation of the utility function will represent the same preferences.  For example, each of these functions:

• U(q₁, q₂)=q₁q₂
• U(q₁, q₂)=lnq₁+lnq₂
• U(q₁, q₂)=Aq₁Aq₂
• U(q₁, q₂)=q₁²q₂²

represent the same preferences (although each dot point represents a different person – they all have different utility functions, but the same preferences).  Different preferences represent different choices, even though the utility functions are different.

FOOTNOTES
1. Better, in this context, is purely a decision of the individual consumer – what’s better for you does not have to be better for me, and vice versa.↑