As explained in the previous chapter, there are only two main methods of microeconomic analysis. The first is finding an optimum: what's the best thing to do? The second is finding the equilibrium: when everyone's actions are taken into account, what's the overall result? Here in Part Two of the book, we apply the first of these methods to analyze the optimum of the consumer. Specifically, what is the best bundle of goods for a consumer to purchase?
People in a market economy face two fundamental choices: how to earn an income, and how to spend it. Part Two deals with how income is spent, taking earnings (income) as given. Part Four will analyze the decisions that generate income – for example, whether or not to work overtime.
THE LAWS OF PREFERENCE
The economist thinks of the individual as aiming to maximize utility. The logic of utility analysis is the central topic of this chapter.
Theories or models are pictures that simplify reality. Irrelevant details are stripped away to concentrate on essentials. The economist's picture (theory) of preferences is based on two axioms:
The Axiom of Comparison: A person can compare any two baskets A and B of commodities. Such a comparison must lead to one of the three following results: he or she (i) prefers basket A over B, or (ii) prefers basket B over A, or (iii) is indifferent between A and B.
The Axiom of Transitivity: Consider any three baskets A, B, and C. If a consumer prefers A to B, and also prefers B to C, he or she must prefer A to C. Similarly, a person who is indifferent between A and B, and is also indifferent between B and C, must be indifferent between A and C.