PREFERENCES

AND RATIONALITY

MODELING CONSISTENCY IN WHAT WE WANT

INTRODUCTION TO DECISION
MAKING BY CONSUMERS
We want to study how individual agents (consumers and
then firms) make optimal decisions
Two elements of any decision making problem
what is feasible
what is desirable
Last week we studied first element in a market setting
Today we focus on the second one

we are interested in how individuals order the alternatives

that are feasible to them

ROAD MAP
Are you crazy?
rational preference relations and their properties
Whatever
indifference curves
goods and bads, substitutes and complements
A taste for diversity
monotonicity
convexity
Trading off

the marginal rate of substitution

RATIONALITY IN ECONOMICS
Behavioral postulate: a decision maker always chooses her
most preferred alternative from the set of feasible
alternatives
this is clearly an approximation to the real world
in various situations people not only make mistakes but exhibit
systematic biases
To model rational choice we must model the decision
makers preferences

systematic study of ranking of alternatives (ordinal ranking)

construct a ranking of alternatives that makes sense

PREFERENCE RELATIONS
Ordinal comparison between two different consumption
bundles, x and y

(weak) preference: x is as at least as good as y, or equivalently x

is weakly preferred to y
we are establishing a relation between two objects (consumption
bundles x and y) that expresses a preference ranking
the preference relation is denoted by the symbol %
if x is weakly preferred to y, we write x % y

PREFERENCE RELATIONS
Lets assume that bundle x is weakly preferred to y
There are two possibilities
strict preference: x is strictly better than y
indifference: x is exactly as preferred as is y
In the first case, bundle x is weakly preferred to y but bundle y
is not weakly preferred to x
we write x % y and y 6% x --- or equivalently x y
In the second case, bundle x is weakly preferred to y and
bundle y is weakly preferred to x

we write x % y and y % x --- or equivalently x y

RATIONALITY ASSUMPTIONS
Completeness: for any two bundles x and y it is always
possible to make the statement that either x is weakly
preferred to y or y is weakly preferred to x
it is always possible to compare two alternatives
this rules out Sophies Choice situations (clip)
completeness is a convenient but not essential
assumption; most of decision theory survives without it
Remark: reflexivity is a redundant assumption

it is not necessary because it follows from completeness

RATIONALITY ASSUMPTIONS
Transitivity: if x is weakly preferred to y, and y is weakly
preferred to z, then it must be the case that x is weakly
preferred to z

x % y and y % z =) x % z
Transitivity is at the heart of rationality --- without it we dont
have a theory
transitivity rules out starving monkeys and money pumps
A preference relation is said to be rational if it is complete and
transitive

10

Claim: if the preference relation is transitive, then the indifference

and the strict preference relations are both transitive

INDIFFERENCE CURVES
Fix a bundle x
The set of all bundles equally preferred to x is the
indifference curve containing x:
it contains all bundles y such that y is indifferent to x

I(x) =

y 2 X: y x

11

An indifference curve is not always a curve

INDIFFERENCE CURVES
x2
x = (x1 , x2 )

y = (y1 , y2 )
z = (z1 , z2 )
I(x)

12

x1

INDIFFERENCE CURVES
x2
x = (x1 , x2 )

y = (y1 , y2 )

I(x)

x1
13

z = (z1 , z2 )

INDIFFERENCE CURVES
x2
All bundles in I1 are
strictly preferred to all
bundles in I

I1
I
x1
14

I2

INDIFFERENCE CURVES
x2

I(x)

I(x)
x1
15

WP(x) is the set of

bundles weakly
preferred to x

INDIFFERENCE CURVES
x2

I(x)

It does not
include I(x)

x1
16

SP(x) is the set of

bundles strictly
preferred to x

INDIFFERENCE CURVES CANNOT

INTERSECT
I1

I2

y
z
x1
17

x2

INDIFFERENCE CURVES CANNOT

INTERSECT
I1

I2

Suppose otherwise:
From I1 we get x y, and from I2
we get x z
Therefore y z

y
z
x1
18

x2

SLOPES OF INDIFFERENCE
CURVES
Good 2
two goods
a negatively sloped
indifference curve

19

Good 1

SLOPES OF INDIFFERENCE
CURVES
Good 2
one good and one
bad a positively
sloped indifference
curve

20

Good 1

PERFECT SUBSTITUTES
x2

I2

Bundles in I2 all have a total

of 15 units and are strictly
preferred to all bundles in
I1, which have a total of
only 8 units in them

I1
8

15

x1
21

15

Slopes are constant at - 1

PERFECT COMPLEMENTS
x2

45o
Each of (5,5), (5,9) and
(9,5) bundles contains
5 pairs so each is
equally preferred

9
5

I1
9

x1
22

PERFECT COMPLEMENTS
x2

45o

I2

Each of (5,5), (5,9) and

(9,5) bundles contains
5 pairs so each is
equally preferred

I1
9

x1
23

INDIFFERENCE CURVES
EXHIBITING SATIATION
x2
Satiation
(bliss)
point

24

x1

INDIFFERENCE CURVES
EXHIBITING SATIATION
x2

Better

Satiation
(bliss)
point

25

x1

INDIFFERENCE CURVES
EXHIBITING SATIATION
x2

Better

Satiation
(bliss)
point

26

x1

WELL-BEHAVED PREFERENCES
A rational preference relation is well-behaved if it is
monotone and convex
Monotonicity: more of any commodity is always preferred
(i.e. no satiation and every commodity is a good)
Convexity: convex combinations (mixtures) of bundles are
at least weakly preferred to the bundles themselves

27

example: the 50-50 mixture of the bundles x and y is

z = .5 x + .5 y

CONVEX PREFERENCES
x

x2

x + y is strictly preferred to
z=
both x and y
2

y
x1

y1
28

y2

CONVEX PREFERENCES
x

x2

y
x1

y1
29

y2

CONVEX PREFERENCES
x

x2

Preferences are strictly convex

when all mixtures z
are strictly
preferred to their
component
bundles x and y

y
x1

y1
30

y2

NON-CONVEX
PREFERENCES
x2
The convex
combination z is
less preferred
than x or y

z
y2
y1

31

x1

NON-CONVEX
PREFERENCES
x2
The convex
combination z is
less preferred
than x or y

Why is convexity
important?

y2
y1

32

x1

SLOPE OF INDIFFERENCE
CURVES
The slope of an indifference curve at a given consumption
bundle x is its marginal rate of substitution (MRS) at x
It tells us the trade off in terms of preferences between
consumption of good 2 and consumption of good 1 to
while keeping consumption at the indifference curve

33

how much of good 2 are we willing to forsake to increase

consumption of good 1 (marginally)
equivalently, how much extra of good 2 do we need to
consume if we decrease our consumption of good 1
(marginally)
How can a MRS be calculated?

MARGINAL RATE OF
SUBSTITUTION
x2

x2

x1

34

x1

MARGINAL RATE OF
SUBSTITUTION
x2

MRS(
x)
x2

lim

x1 !0

dx2
=
dx1

x2
x1

x1

35

x1

THE MRS AND THE

INDIFFERENCE CURVES
Good 2
two goods
a negatively sloped
indifference curve
MRS < 0

36

Good 1

THE MRS AND THE

INDIFFERENCE CURVES
Good
one good, one bad
a positively sloped
indifference curve
MRS > 0

37

Bad

THE MRS AND THE

INDIFFERENCE CURVES
MRS = - 5
MRS always increases with x1
(becomes less negative) if and only if
preferences are strictly convex
Equivalently, the absolute value
of the MRS is decreasing in x1
That is, convexity of preferences
associated to diminishing
marginal rate of substitution

MRS = - 0.5

x1
38

x2

THE MRS AND THE

INDIFFERENCE CURVES
MRS = - 0.5

MRS decreases with x1 (becomes

more negative)
non-convex preferences

MRS = - 5

x1
39

x2