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2) Preferences

Economic Rationality

Principal behavioral assumption decision maker chooses its most preferred

alternative from those availableo Model decision-makerspreferences

o Availablechoice constitute the choice set

Theory of Preferences Self-interest individual maximizes over a set of preferences subject to constraints

o They do their best iven the circumstances

Theory based on

!" #ndividuals have consistent preferences$" #ndividuals seek to maximize their preference rankin%" #ndividuals are &illin to make tradeo's bet&een di'erent oods

preference statements(

o ability to say you like a bundle better

o ability to say you like both e)ually *indi'erent+

preference orderin(

o usin preference statements

o if $ conditions are satis,ed(

1. al&ays able to make preference statements2. preference statements are consistent

Preference Relations

omparin $ consumption bundles

o X*has x! of ood ! and x$ of ood $+

o Y *has y! of ood !. y$ of ood $+

Strict preference: x is more preferred than y

o o x y xpreferredstrictlyto bundle y

Wea preference:x is liked as much as y *at least as preferred+

o

o x y x preferred at least as muchas y

!n"i#erence: x is exactly liked as much as y

o /

o x / y x 0 y equally preferred

x y and y x x / y

x y and *not y x+

x y

These are all ordinalrelationsState only the order in &hich bundles are preferred

$inary Relationship Properties

preference relation( *orderin+

o omplete

o 1e2exive

o Transitive

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%omplete

1elationship *1+ is complete for any pair of elements x.y

o x1y 3 y1x

o at least one is true

relationship complete(

o relation is 4 *,ts+ example trianle ,ttin in a circle 3 another trianle ,ttin

in a circleo not relation &hen the trianle dont ,t into each other

56T complete %ompleteness:any $ bundle x and y its al&ays 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 *indi'erent+

Re&ectivity

any bundle x is at least as preferred as itself

o x x

not every relation is re2exive

o A perpendicular to 7o 7 perpendicular to A

o A is not perpendicular to itself

Transitivity

#s 'is at least as preferredas y

0 yat least as preferredas (

then ' is at least as preferredas (

o x y and y z x z

no every relation is transitive

o A perpendicular to 7o 7 perpendicular to

o A is not perpendicular to 8 parallel

5on-Transitive Preferences

Alberts preferences

o A 7. 7 . A

o 9as bundle A o'er in exchane for A and :!

o Then o'er 7 in exchane for ; :!

o 6'er A in exchane for 7 ; :!

o #n the end has &hat he started &ith - :%

$inary Relationship Properties

Preference relation is

o omplete

All bundles of ods ranked

o 1e2exive

A is liked as much as itself

o Transitive

x liked at least as much as y 0 y liked at least as much as z x liked

alam as z+

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!n"i#erence %rves

bundle x

sho&s bundles consumers think are indi'erent not ones that are better and &orse

indi'erence curves cannot cross *transivity assumption+

carver farther from the oriin are more preferred

set of all bundles equally preferredto x is the in"i#erence crve containin* 'o the set of all bundle y / x

not al&ays a curve

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o only total amountrank-order

&illin to sub ! ood for another at constant rate

o slope of -1

convex not strictly convex

Example

Petroan 0 Shell as3 5eilson 0 Sealtestmilk

Perfect ompliments

Al&ays consumes commodities ! 0 $ in xed

proportion *!-!+o Perfect complements

o Number or pairspreference rank-order

Example

Tires and rims3 left shoes riht shoes

7ads

commodity consumer doesnt like

example likes peperoni doesnt like anchovies *tradeo'+

o ive extra peperoni to compensate for the anchovies

o anchovies vertical *bad+3 pep on horizontal *ood+

5eutrals consumer doesnt care about it one &ay or the other

o cares about amount of pepperoni he has. nothin about

anchovies

Preferences >xhibitin Station

7undle strictly preferred is a satiation point ,bliss

point)

6verall best bundle

#ndi'erence curves(

#ndi'erence

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Well$ehave" preference

?ell-behaved( if it is monotonic conve'

3onotonicity:more of any ood is al&ays preferred

o no satiation. every commodity is a ood

o neative slope

o more of both bundles is better

%onve'ity:mixture of bundles *atleast &eakly+ preferred to

bundles themselves

Example:

DE-DE mixture of x 0 y z 8 *E"D+x ; *E"D+yz at least as preferred as x or

Strict %onve'ity

%onve'ity4 Strict %onve'ity

conve' set:any point on straiht line joinin $ elements of the set is also containein the set

o

ends points *boundary+ t 8 EB!o set of bundles &eakly preferres convex set

o may have 2at spots

Strictly conve'any point on a line joinin $ elements. >F>PT end points of thiline. must like entirely &ithin set *not boundary points+

o ?eihted av of $ indi'erent bundle is strictly preferred to the $ extreme

bundleso urves are round

,Wea) %onve'ity

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5on%onve' Preferences ! 5on%onve' Preference !!

Slopes of !n"i#erence %rves

3ar*inal Rate of Sbstittion ,3RS) 8 slope

Marinal value *MG+

hane in x$B chane in x!

usually a neative number

measures rate at &hich consumer is &illin to substitute a ood mar*inal

/illin*ness to pay

"iminishin* mar*inal rate of Sbstittion( amount of ood ! person is &illin tive up for additional amount of ood $ increases the amount of ood ! increases

o for strictly convex M1S decreases as &e increase x!

3RS !n"i#erence %rve Properties

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