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98 CHAPTER 3 CONSUMER PREFERENCES AND THE CONCEPT OF UTILITY

on the individual’s absolute consumption of goods and suffer from such handicaps adapt and tend to find life
services but on the consumption of goods and services satisfying (or, at least, less miserable than those who
relative to some sort of reference level. In Koszegi and were merely projecting themselves into that situation
Rabin’s theory, reference levels represent a consumer’s would predict). It would also explain why people who
expectation (prior to making consumption decisions) marry tend to experience a large positive deviation in
about how much of each good the consumer is likely to happiness in the short to medium term but eventually
end up consuming. If the consumer ends up consuming experience a significant drop in this happiness, In ad-
less than the expected amount, the consumer experi- dition, people who divorce tend eventually to be no
ences a loss; if the consumer ends up consuming more happier than before (in part because they tend to
than the expected amount, the consumer experiences also overlook the additional problems that the di-
a gain (which typically would be expected to be smaller vorce will create).
than the loss). These assumptions imply that it could Behavioral economics is an important field of
easily be the case that an increase in consumption economics because it highlights, through empirical
could leave a consumer no happier than he or she and experimental analysis, anomalies in behavior
was before. This would be the case if the consumer that cannot be explained using the tools of tradi-
ends up consuming exactly what he or she expected to tional microeconomic theory. In addition, it points
consume. out how traditional theory tools need to be modified
Utility functions that include reference levels of in order for predicted decisions to be consistent with
consumption are a special case of a broader phenom- real-world evidence. For example, behavioral econo-
enon in which individuals tend to adapt to the situa- mists have formulated theories that explain procras-
tions in which they find themselves. Psychologists tination, lack of self-control, and a willingness to go
define hedonic adaptation as the tendency of our against self-interest (e.g., the willingness of a house-
moods to settle back to some set range after a tempo- hold to heed the call for voluntary reductions in the
rary burst of emotion in response to certain events. use of water during a drought). These contributions
This would explain why individuals predict that they enhance the richness of economic theory and (to par-
would be miserable if they were to suffer a physical aphrase one account in the business press), “put a
handicap, while at the same time, people who do human face on economics.” 17

CHAPTER SUMMAR Y

• Consumer preferences tell us how a consumer ranks • A utility function measures the level of satisfaction
(compares the desirability of ) any two baskets, assuming that a consumer receives from any basket of goods.
the baskets are available at no cost. In most situations, it The assumptions that preferences are complete, that
is reasonable to make three assumptions about consumer preferences are transitive, and that more is better
preferences: imply that preferences can be represented by a utility
1. They are complete, so that the consumer is able to function.
rank all baskets. • The marginal utility of good x (MU x ) is the rate at
2. They are transitive, meaning that if the consumer which total utility changes as the consumption of x rises.
prefers basket A to basket B and he prefers basket B to (LBD Exercises 3.1 and 3.2)
basket E, then he prefers basket A to basket E. • An indifference curve shows a set of consumption
3. They satisfy the property that more is better, so that baskets that yield the same level of satisfaction to the
having more of either good increases the consumer’s consumer. Indifference curves cannot intersect. If the
satisfaction. consumer likes both goods x and y (i.e., if MU x and MU y

17 “Putting a Human Face on Economics,” Business Week ( July 31, 2000), pp. 76–77.