2) Preferences

Economic Rationality
Principal behavioral assumption decision maker chooses its most preferred
alternative from those available
o Model decision-makers preferences
o Available choice constitute the choice set
Theory of Preferences
Self-interest individual maximizes over a set of preferences subject to constraints
o They do their best given the circumstances
Theory based on
1. Individuals have consistent preferences
2. Individuals seek to maximize their preference ranking
3. Individuals are willing to make tradeoffs between different goods
preference statements:
o ability to say you like a bundle better
o ability to say you like both equally (indifferent)
preference ordering:
o using preference statements
o if 2 conditions are satisfied:
1. always able to make preference statements
2. preference statements are consistent
Preference Relations
Comparing 2 consumption bundles
o X (has x1 of good 1 and x2 of good 2)
o Y (has y1 of good 1, y2 of good 2)
Strict preference: x is more preferred than y
o
o x y x preferred strictly to bundle y
Weak preference: x is liked as much as y (at least as
o
o x y x preferred at least as much as y
Indifference: x is exactly liked as much as y
o ~
o x ~ y x & y equally preferred
x y and y x x ~ y
x y and (not y x) x y

preferred)
x

These are all ordinal relations

State only the order in which bundles are preferred
Binary Relationship Properties
preference relation: (ordering)
o Complete
o Reflexive
o Transitive

Complete
Relationship (R) is complete for any pair of elements x,y
o xRy ; yRx
o at least one is true
relationship complete:
o relation is F (fits) example triangle fitting in a circle ; another triangle fitting
in a circle
o not relation when the triangle dont fit into each other
NOT complete
Completeness: any 2 bundle x and y its always possible to make:
o x y (x liked as much as y)
o y x (y liked as much as x)
never unable to rank them (indifferent)
Reflectivity
any bundle x is at least as preferred as itself
o x x
not every relation is reflexive
o A perpendicular to B
o B perpendicular to A
o A is not perpendicular to itself
Transitivity
Is x is at least as preferred as y
& y at least as preferred as z
then x is at least as preferred as z
o x y and y z x z
no every relation is transitive
o A perpendicular to B
o B perpendicular to C
o A is not perpendicular to C = parallel
Non-Transitive Preferences
Alberts preferences
o A B, B C, C A
o Has bundle A offer C in exchange for A and $1
o Then offer B in exchange for C + $1
o Offer A in exchange for B + $1
o In the end has what he started with - $3
Binary Relationship Properties
Preference relation is
o Complete
All bundles of gods ranked
o Reflexive
A is liked as much as itself
o Transitive
x liked at least as much as y & y liked at least as much as z x liked
alam as z)

Indifference Curves
bundle x
shows bundles consumers think are indifferent not ones that are better and worse
indifference curves cannot cross (transivity assumption)
carver farther from the origin are more preferred
set of all bundles equally preferred to x is the indifference curve containing x
o the set of all bundle y ~ x
not always a curve
indifference set

Slopes of Indifference Curves

commodity is good more of a commodity is always preferred
o if every commodity good negatively sloped
commodity is bad less of a commodity is always preferred
Example:
you like chicken (good) ; mom makes you eat brussel sp (bad)
electricity for consumers (good); carbon generated in coal-fired plants (bad)
leisure time (good) ; labour [work] time (bad)

Extreme
Indifference Curves
Perfect
Substitutes
if consumer thinks of the units of commodities 1 & 2 are equivalent
o perfect subs

o only total amount rank-order

willing to sub 1 good for another at constant
o slope of -1
convex not strictly convex
Example
PetroCan & Shell gas; Neilson & Sealtest
milk
Perfect Compliments
Always consumes commodities 1 & 2 in fixed
proportion (1-1)
o Perfect complements
o Number or pairs preference rank-order
Example
Tires and rims; left shoes right shoes

Bads
commodity consumer doesnt like
example likes peperoni doesnt like anchovies (tradeoff)
o give extra peperoni to compensate for the anchovies
o anchovies vertical (bad); pep on horizontal (good)
Neutrals
consumer doesnt care about it one way or the other
o cares about amount of pepperoni he has, nothing about
anchovies
Preferences Exhibiting Station
Bundle strictly preferred is a satiation point (bliss
point)
Overall best bundle
Indifference curves:
Indifference Curves With a Discrete Good
Commodity infinitely divisible if it can be acquired in any quantity
(water/cheese)
Commodity discrete: comes in unit integers (1,2,)
(cars/comps)
Example:
Commodity 2 = infinitely divisible (gas)
Commodity 1 = discrete (cars)

rate

Well-Behaved preference
Well-behaved: if it is monotonic & convex
Monotonicity: more of any good is always preferred
o no satiation, every commodity is a good
o negative slope
o more of both bundles is better
Convexity: mixture of bundles (atleast weakly) preferred to
bundles themselves
Example:
50-50 mixture of x & y z = (0.5)x + (0.5)y z at least as preferred as x or y
Strict Convexity

Convexity, Strict Convexity

convex set: any point on straight line joining 2 elements of the set is also contained
in the set
o ends points (boundary) t = 0/1
o set of bundles weakly preferres convex set
o may have flat spots
Strictly convex any point on a line joining 2 elements, EXCEPT end points of this
line, must like entirely within set (not boundary points)
o Weighted avg of 2 indifferent bundle is strictly preferred to the 2 extreme
bundles
o Curves are round
(Weak) Convexity

Non-Convex Preferences I

Slopes

of Indifference

Non-Convex Preference II

Curves

Marginal Rate of Substitution (MRS) = slope

Marginal value (MV)
Change in x2/ change in x1
usually a negative number

measures rate at which consumer is willing to substitute a good marginal

willingness to pay
diminishing marginal rate of Substitution: amount of good 1 person is willing to
give up for additional amount of good 2 increases the amount of good 1 increases
o for strictly convex MRS decreases as we increase x1

MRS & Indifference Curve Properties