Introduction

Commodities
Preference relations
The budget

Advanced Microeconomics

Consumer theory: preferences, utility, budgets

Jan Hagemejer

September 30, 2014

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Introduction
Preference relations
The budget

Introduction

The plan:

1 Some (very basic) denitions

2 Preference relations (most general)
3 Utility function
4 The budget

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Commodities
Preference relations The choice set
The budget

Commodities

The decision problem faced by the consumer in a market economy is to

choose consumption levels of various goods and services that are
available for purchase in the market

commodities - goods and services.

physical characteristics:

homogeneous/dierentiated
divisible/indivisible
durable/storable/perishable

BUT: location, time, state of the world contingency!

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Commodities
Preference relations The choice set
The budget

The choice set

A set of mutually exclusive alternatives that the decision maker can

choose from.

We will usually denote such set in capital letters: eg. X

The choices made by the decision maker we will denote by lower case
letters: eg. x, y ∈ X
We will refer to the consumption set
X as
n
We will usually assume X ⊂ R is nonempty, closed, convex, bounded
n
below (∃z ∈ R such that ∀x ∈ X , xi ≥ zi , i = 1, 2, ..., n) and has a
nonempty interior (but there may be exceptions from that rule)
X = Rn+ (example: economic
Usually we will restrict attention to
`bads')

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Commodities
Preference relations The choice set
The budget

Commodities

we will refer to goods as nite if we can talk about the total

number of commodities

usually refer to a vector x ∈ Rn

general assumptions:

commodities are divisible

there is a price on each commodity set by a market

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Commodities
Preference relations The choice set
The budget

Bounded consumption set

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Commodities
Preference relations The choice set
The budget

Indivisible commodities

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Commodities
Preference relations The choice set
The budget

Location

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Commodities
Preference relations The choice set
The budget

Survival needs

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Preference relations

We will be talking about the consumer/decision maker choices based

on his preferences

In the most general setting, we will talk about preference relation .

Our decision maker will be comparing dierent alternatives

eg.A  B will mean that A is at least as good as B (just preferred)

A  B will mean that A is strictly preferred to B
A ∼ B will mean that the decision maker is indierent between A
and B.

The easiest example: R, ≥, >, =

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Rational preference relation

rational preference relation satises:

completeness: for all x, y ∈ X we have that x y or y x or both

(we can always compare two choices)
transitivity: for all x, y , z ∈ X , if x y and y  z, then x  z.
Both are, in fact, fairly restrictive.

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Rational preference relation

If  is rational:

1  is irreexive (∀x ∈ X , not x  x) and transitive

2 ∼ is reexive (∀x ∈ X , x ∼ x) and transitive and symmetric
(∀x, y ∈ X , x ∼ y ⇒ y ∼ x)
3 x y z ⇒x z

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Some more properties

Monotonicity:

Preference relation is monotone if (x, y ∈X and y  x) implies

y  x.
Preference relations is strongly monotone if (y ≥x and y 6= x )
implies y  x.
Goods are desirable if we prefer more to less.

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Properties of preferences

Indierence set - set of

all bundles that are
indieren to a given x:
{x ∈ X : y ∼ x}
Upper contour set - set of
all bundles that are at
least as good as x:
{x ∈ X : y  x)
Lower contour set - set of
all bundles that x is at
least as good as:
{x ∈ X : x  y )

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Local nonsatiation

Preferences are locally In other words: for each x

nonsatiated on X if for every there exists y that is
x ∈ X and every ε > 0, there arbitrarily close to x and
isy ∈ X such that y  x.
k y − x k≤ ε and y  x.
ky −x k is the Euclidean
distance
 1 /2
2
P
L
= l=1 (yl − xl )

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Local non-satiation violated

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Exercise 3.B.1 MWG

Show the following:

1 If  is strongly monotone, then it is monotone.

2 If  is monotone, then it is locally nonsatiated.

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Convexity

A preference relation is convex if for every x ∈X its upper contour set

{y ∈ X : y  x} is convex

dene convexity: for all α ∈ [0, 1] y  x and z x implies that

αy + (1 − α)z  x
so every linear combination of y and z preferred to x is also
preferred to x
Strict convexity:

for all α ∈ (0, 1) y  x and z x with y 6= z implies that

αy + (1 − α)z  x

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Convexity and non-convexity

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Convexity and strict convexity

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Homothecity

A preference relation is homothethic if all indierence sets are related by

proportional expansion along rays from origin; that is if x ∼ y, then
αx ∼ αy for any α > 0.

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Quasi-linearity

1
A preference relation  on X = (−∞, ∞) × RL−
+ is quasi-linear with
respect to commodity 1 (the numeraire commodity) if:

1 All the indierence sets are parallel displacements of each other

along the axis of commodity 1. That is, if x ∼ y , then
(x + αe1 ) ∼ (y + αe1 ) for e1 = (1, 0, . . . , 0) and any α > 0.
2 Good 1 is desirable; that is, x + αe1  x for all x and α > 0.

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Utility function

To make our life easier (and the problem tractable and implementable in
a computable way), we will usually assume that preferences can be
described by a utility function.

A function u: X →R is a utility function representing relation  if

for all x, y ∈ X :

x  y ⇔ u(x) ≥ u(y ).

Utility functions are ordinal. Monotonic transformations do not alter

the order. Worn example: Cobb-Douglas utility

Proposition: A preference relation  can be represented by a utility

function only if it is rational (proof: MWG).

Can any rational preference relation be represented by a utility function?

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

The lexicographic preference

Lets limit our attention to R2 . Let x y if either x1 > y1 or  x1 = y1

and x2 ≥ y2 . Dictionary sort order.

Indierence sets are singletons.

Problem with continuity. Continuity means that that preference

relations are preserved under limits.

Lexicographic preferences are not continuous: sequence of

x n = (1/n, 0), y n = (0, 1). For every n we have x n  y n. What
about limits with n → ∞?

Rational preference relation can be represented by a utility function

if it is continuous. Continuity assures that we can nd a bundle that
is indierent to a given bundle arbitrarily close. Also it assures that
for every bundle x we can nd an indierence curve. u in this case
will also be continuous.

Therefore we can map from Rn to R to provide ordering.

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Usual assumptions

The utility function is continuous (preference relations are

continuous).

The utility function is dierentiable (twice continuously).

A widely used exception: Leontief preferences:

x 00  x 0 i Min{x100 , x200 } ≥ Min{x 0 1 , x 0 2 }

u(x) = Min{x1, x2 }

The utility function is increasing.

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Convexity

We will usually assume that the functions are either

quasiconcave (upper contour sets are convex) or
strictly quasiconcave (upper contour sets are strictly convex).

A useful math result (see MWG appendix):

a function is quasiconcave if its Hessian matrix is negative

semidenite
a function is strictly quasiconcave if its Hessian matrix is negative
denite

See: http://en.wikipedia.org/wiki/Quasiconvex_function

and even more basic:

http://en.wikipedia.org/wiki/Positive-denite_matrix

Jan Hagemejer Advanced Microeconomics

 Introduction Standard properties
Commodities Local non-satiation
Preference relations Utility function representation
The budget

Other assumptions

A homothetic preference relation can be represented by a

homogeneous of degree one utility function, such that:
u(αx) = αu(x)
Quasilinear utility - quasilinear preferences:

u(x) = x1 + φ(x2 , . . . , xL )

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Deniton
Preference relations Budget set properties
The budget

The budget

We described the problem, what the consumer can consume and what his
preferences are.

Now lets turn to the remaining part of the consumer problem: what
he can aord.
 
p1
.
The consumer is facing a set of prices: p= .  ∈ RL
 
.
pL
The consumer has a wealth w
Consumer can aord bundles such that:

p · x = p1 x1 + . . . + pL xL ≤ w

We will usually allow only prices >0 (otherwise free goods).

We will also assume price taking.

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Deniton
Preference relations Budget set properties
The budget

Walrasian/competitive budget

The Walrasian or competitive budget set Bp,w = {x ∈ RL+ : p · x ≤ w } is

a set of all feasible consumption bundles for the consumer who faces
market prices p and has wealth w .'
When all goods are desirable we will mostly talk about cases where the
consumer budget constraint is binding (the consumer will be on the
upper boundary of the budget set).

when L = 2, we talk about the budget line p·x =w

when L>2 we talk about the budget hyperplane p·x =w

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Deniton
Preference relations Budget set properties
The budget

Budget set properties

The budget set is convex (usually)

The slope shows the market rate of exchange of goods

Eects of a price change

Jan Hagemejer Advanced Microeconomics

 Introduction
Commodities Deniton
Preference relations Budget set properties
The budget

A real budget set...

Jan Hagemejer Advanced Microeconomics