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Part IIA, Paper 1 Consumer and Producer Theory

Part IIA, Paper 1 Consumer and Producer Theory. Lecture 4 Revealed Preferences and Consumer Welfare Flavio Toxvaerd. Today’s Outline. Leftovers from Lecture 2 Revealed preferences WARP, SARP, GARP Indices . Primal Approach. Dual Approach. Duality. Integrability problem. Solve. Solve.

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Part IIA, Paper 1 Consumer and Producer Theory

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  1. Part IIA, Paper 1Consumer and Producer Theory Lecture 4 Revealed Preferences and Consumer Welfare Flavio Toxvaerd

  2. Today’s Outline • Leftovers from Lecture 2 • Revealed preferences • WARP, SARP, GARP • Indices

  3. Primal Approach Dual Approach Duality Integrability problem Solve Solve Marshallian Demand x1(p,m) and x2(p,m) Hicksian Demand Equivalent if Substitute into cost equation Roy’s Identity Substitute into u(x,y) Shephard’s Lemma Indirect Utility v(p,m) Invert Expenditure Function

  4. Consumer Surplus and Welfare Following a price change,

  5. Consumer Surplus and Welfare p1 a b Marshallian Demand x1

  6. Question • Question: What can we say about consumer preferences from observations of choice decisions? • Recall ‘rationality’ assumption: Consumers select ‘most preferred’ option available • So observed selection has been revealed as ‘preferred’ to all other available options

  7. Revealed Preference If, at prices p1 , p2 and income m, a consumer purchases a consumption bundle a, then this bundle is said to have been Directly Revealed Preferred to all other affordable bundles x2 a x1

  8. Weak Axiom of Revealed Preference (WARP) No two different bundles, a and b, can be directly revealed preferred to each other That is, if at prices (p1,p2) bundle (a1,a2) is chosen, and at prices (q1,q2) bundle (b1,b2) is chosen, then it cannot be the case that , b affordable when a chosen , a affordable when b chosen

  9. Weak Axiom of Revealed Preference (WARP) x2 Graphically, we cannot have a b x1

  10. Indirect Revealed Preference If a bundle a is directly revealed preferred to a different bundle b, and bundle b is directly revealed preferred to an alternative bundle c, then we can say that bundle a is Indirectly Revealed Preferredto bundle c. x2 a b c x1

  11. Strong Axiom of Revealed Preference (SARP) • No two different bundles, a and c, can be either directly or indirectly revealed preferred to each other • Note that both the strong and weak axioms of revealed preference require consumers to select a unique consumption bundle at any budget constraint

  12. Generalised Axiom of Revealed Preference(GARP) • If bundle a is indirectly revealed preferred to bundle c then whenever c is purchased the purchase of awould have been more expensive, that is pca pcc • This is a more general specification, as it allows the consumer to be indifferent between two affordable consumption bundles. Effectively allowing flat spots in the indifference curves

  13. Afriat’s Theorem • For any finite number of price/consumption observations, there exists a continuous utility functions satisfying the condition that more is better, and with convex indifference curves which ‘rationalises’ the data if and only if the observations satisfy GARP • Here is Homo Economicus

  14. Question • Is the utility function obtained by this process unique? NO! • Utility functions are ordinal, so the same set of indifference curves may be generated by many different utility functions • Practically, any finite number of observations may be ‘explained’ by a number of different indifference maps, each generating different ‘out-of-sample’ behaviour

  15. Index Numbers • Consider a consumer who, in some base period, is observed consuming a bundle b when prices are pb and in some subsequent period is observed consuming bundle c when prices are pc • Can anything be said about the welfare of this consumer over the interval? • From revealed preference: If pb.b > pb.c then the consumer is worse off. If pc.c > pc.b then the consumer is better off

  16. Indices Laspeyres Quantity Index Paasche Quantity Index

  17. Indices Laspeyres Quantity Index Paasche Quantity Index

  18. Consumer Price Index The Consumer Price Index (CPI) measures the proportional change in the cost of purchasing a ‘given’ bundle of commodities. Specifically, The CPI is commonly compared with the growth in nominal incomes to assess ‘real’ income changes Is this comparison justifiable?

  19. Consumer Price Index If CPI < M (ratio of incomes) then consumers are better off. But if CPI > M cannot conclude that consumers are worse off. x2 u0 Increasing incomes by CPI will generally improve welfare c b x1

  20. Readings • Varian, Intermediate Microeconomics, chapter 7 • Varian, Microeconomic Analysis, chapter 8 • Samuelson P. (1948) ‘Consumption theory in terms of revealed preference’ Econometrica, vol. 15, pp. 243-253.

  21. Next Time… • Welfare • Consumer surplus • Equivalent variation • Compensating variation • Slutsky vs Hicksian substitution

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