l02
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L02. Preferences. 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. Last Week. oranges. x=(2,3). - PowerPoint PPT PresentationTRANSCRIPT
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.
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)
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Rational Decisionmaker
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I) Completeness:either or or both
~ ~x y y x
II) Transitivity:x y and y z x z.~ ~ ~yy
~x~
zz~ ~
~
Rationality Axioms (Assumptions)
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.
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Representation: Indifference Curves
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x”x”
x”’x”’
x’ x’ x” x” x”’ x”’x’
Indifference curve = a collection of all indifferent bundles.
Two goods always consumed in the same proportion
Example: Right and Left Shoes
We like to have more of them but always in pairs
Example: Perfect Complements
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)
Example: Perfect substitutes
Slopes of Indifference Curves (MRS)
The slope of an indifference curve is its marginal rate-of-substitution (MRS).
Why rate-of-substitution? Why marginal?
Slope: Marginal Rate of Substitution
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MRS(x) is a slope of the RS(x) is a slope of the indifference indifference
curve at xcurve at xxx
Slope of Indifference Curves
When more of a commodity is always preferred, the commodity is a good.
Two goods. Sign of MRS?
Good 2Good 2
Good 1Good 1
Slope of Indifference Curves
If less of a commodity is prefered the commodity is a bad. (Spinach)
Two goods. Sign of MRS?
Bad 2Bad 2
Good 1Good 1
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.
Preferences Exhibiting Satiation
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xx1 1 (salt)(salt)
SatiationSatiation point point
x*x*11
x*x*22
(pepper)(pepper)
Well-Behaved Preferences
We will typically assume that preferences are well-behaved:
1) monotonic (all goods)
2) weakly convex
Convexity.
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x=(1,3)
y=(3,1)
z =(2,2)
Preferences are convex if mixtures “z”Preferences are convex if mixtures “z”are (weakly) preferred to extremes x and y.are (weakly) preferred to extremes x and y.