Understanding Rationality in Economics: Preferences and Decision Making

1. L02 Preferences

2. PS1: Due date 09/19/17 before the class Quiz: How much do you like economics A: I love it so much B:I would die for it C: I cannot live without it D: All of the above

3. Rationality in Economics • Behavioral Postulate:A decisionmaker chooses its most preferred alternative from the set of affordable alternatives. • Budget set = affordable alternatives • To model choice we must have decisionmaker’s preferences.

4. Last Week oranges x=(2,3) p1=2 p2=1 M=6 apples

5. Budget Set with • What happens to • Inflation • Ad Valorem Taxes • Budgets with kinks • Gifts • Minimal/Maximal Purchase • Quantity discount

6. f ~ f ~ Today: Preferences • Rational agents: can rank any two consumption bundles • We call such ranking preferences • weak preference: x is at least as good as is y. (x y) • strict preference: x is strictly better than is y. (x y) • indifference: x is exactly as preferred as is y. (x y)

7. Completeness: • either or or both x y y x f ~ II) Transitivity: x y and y z x z. f f f f f f f f f z ~ ~ ~ ~ ~ ~ ~ ~ ~ Rational Decisionmaker • Rationality Axioms (Assumptions) x2 y x x1

8. f ~ Indifference Curves • Convenient representation of Indifference Curve Map • The set of all bundles equally preferred to x is the indifference curve containing x; • The collection of all bundles y ~ x.

9. Representation: Indifference Curves • Indifference curve = a collection of all indifferent bundles. x2 x’ ~ x” ~ x”’ x’ x” x”’ x1

10. Indifference Curve Map x2 zxy p p x z y x1

11. Q:Can Indifference Curves Intersect? x2 x y z x1

12. Q:Indifferent person? x2 x1

13. Example: Perfect Complements • Two goods always consumed in the same proportion • Example: Right and Left Shoes • We like to have more of them but always in pairs

14. Example 1: Perfect complements Left 1:1 Right

15. Example: Perfect substitutes • Two goods that are substituted at the constant rate • Example: French and Dutch Cheese (I like cheese but I cannot distinguish between the two kinds)

16. Example: Perfect substitutes Dutch French

17. Slopes of Indifference Curves (MRS) • The slope of an indifference curve is its marginal rate-of-substitution (MRS). • Why rate-of-substitution? • Why marginal?

18. Slope: Marginal Rate of Substitution x2 MRS(x) is a slope of the indifference curve at x x

19. Slope of Indifference Curves • When more of a commodity is always preferred, the commodity is a good. • Two goods. Sign of MRS? Good 2 Good 1

20. Slope of Indifference Curves • If less of a commodity is prefered the commodity is a bad. (Spinach) • Two goods. Sign of MRS? Bad 2 Good 1

21. Preferences Exhibiting Satiation • Many commodities become bads after some threshold of consumption (salt and pepper) • Bundle consisting of threshold quantities is called a satiation point or a bliss point. • A satiation point is strictly preferred to any other bundle.

22. Preferences Exhibiting Satiation (pepper) x2 Satiation point x*2 x*1 x1 (salt)

23. Well-Behaved Preferences • We will typically assume that preferences are well-behaved: • monotonic (all goods) • weakly convex

24. Convexity. Preferences are convex if mixtures “z” are (weakly) preferred to extremes x and y. x=(1,3) x2 z =(2,2) y=(3,1) y2 x1 y1