VE Praha September 2009 Micro (VE) Consumption theory 09/09 1 / 24 Economics II: Microeconomics Consumers: People. Households. Applications. Firms: Internal Organisation. Industrial Organisation. Equilibrium: Holds. Does not hold. Micro (VE) Consumption theory 09/09 2 / 24 Microeconomics Consumers: People. Now Households. Applications. Firms: Internal Organisation. Industrial Organisation. Equilibrium: Holds. Does not hold. Micro (VE) Consumption theory 09/09 3 / 24 Neoclassical theory of consumption Basics PEOPLE CHOOSE THE BEST THINGS THEY CAN AFFORD. Micro (VE) Consumption theory 09/09 4 / 24 Neoclassical theory of consumption Basics PEOPLE CHOOSE THE BEST THINGS THEY CAN AFFORD. Micro (VE) Consumption theory 09/09 5 / 24 Neoclassical theory of consumption Basics THE BEST THINGS: Denition Consumtion bundle is a complete list of the goods & services that are involved in the choice problem that is investigated. (say, X and ). Fact Notation: Strict preference: X ~ Indierence: X ~ Alternative notation: Weak preference: X _ Micro (VE) Consumption theory 09/09 6 / 24 Neoclassical theory of consumption Basics Relationship between ~, ~,and _ Lemma if X _ and _ X then ? if X _ but not _ X then ? Micro (VE) Consumption theory 09/09 7 / 24 Neoclassical theory of consumption Basics Relationship between ~, ~,and _ Lemma if X _ and _ X then X ~ if X _ but not _ X then X ~ Micro (VE) Consumption theory 09/09 8 / 24 Neoclassical theory of consumption Homo-economicus The economic agent (or economic human) Rational Egoist (or self-interested) Micro (VE) Consumption theory 09/09 9 / 24 Neoclassical theory of consumption Homo-economicus The economic agent (or economic human) Rational Egoist (or self-interested) Micro (VE) Consumption theory 09/09 9 / 24 Neoclassical theory of consumption Homo-economicus The economic agent (or economic human) Rational Egoist (or self-interested) Micro (VE) Consumption theory 09/09 9 / 24 Neoclassical theory of consumption Rationality Axiom 1 st Axiom: Complete preferences Either of X ~ Y Y ~ X X ~ Y [or[ Either of X _ Y Y _ X both Example Buridans ass... 2 nd Axiom: Reexive preferences X ~ X [or[ X _ X Micro (VE) Consumption theory 09/09 10 / 24 Neoclassical theory of consumption Rationality Axiom 3 rd Axiom: Transitive preferences If X ~ Y and Y ~ Z then X ~ Z If X ~ Y and Y ~ Z then X ~ Z or If X _ Y and Y _ Z then X _ Z Example The Dutch-booking... Micro (VE) Consumption theory 09/09 11 / 24 Indierence curves e = (15, 25) d = (10, 15) e ~ c ~ a I 1 ~indierece curve Micro (VE) Consumption theory 09/09 12 / 24 Indierence curves I 0 : a ~ e I 1 : b ~ e Q : Do the axioms hold? Question : (a) I 0 ~ I 1 ~ I 2 ; (b) I 0 ~ I 1 ~ I 2 ; or (c) I 2 ~ I 1 ~ I 0 Micro (VE) Consumption theory 09/09 13 / 24 Indierence curves I 0 : a ~ e I 1 : b ~ e Q : Do the axioms hold? Proposition Indierence curves representing distinct levels of preference cannot cross. Proof. Otherwise the transitivity axiom is violated. Micro (VE) Consumption theory 09/09 14 / 24 Indierence curves I 0 : a ~ e I 1 : b ~ e Q : Do the axioms hold? Question : (a) I 0 ~ I 1 ~ I 2 ; (b) I 0 ~ I 1 ~ I 2 ; or (c) I 2 ~ I 1 ~ I 0 Micro (VE) Consumption theory 09/09 15 / 24 Indierence curves Psych. Assumptions Axiom 4 th Axiom: Insatiable (monotonic) preferences If X Y then X ~ Y If X > Y then X _ Y 5 th Axiom: Convex preferences (w) If X ~ Y then X + (1 ) Y _ X where (0, 1) (s) If X ~ Y then X + (1 ) Y ~ X Question : (a) I 0 ~ I 1 ~ I 2 ; (b) I 0 ~ I 1 ~ I 2 ; or (c) I 2 ~ I 1 ~ I 0 Micro (VE) Consumption theory 09/09 16 / 24 Indierence curves: No-No-No Cases Micro (VE) Consumption theory 09/09 17 / 24 Indierence curves: Special Cases Micro (VE) Consumption theory 09/09 18 / 24 Marginal rate of substitution Denition Marginal rate of substitution (MRS) is the rate at which the consumer is just willing to substitute one good for the other - MRS is the (absolute of the) slope of an indierence curve at a particular point: x 2 x 1 or dx 2 dx 1 Micro (VE) Consumption theory 09/09 19 / 24 Diminishing Marginal Rate of Substitution Micro (VE) Consumption theory 09/09 20 / 24 Next lecture Further studies in Neoclassical Theory! Thank you! Micro (VE) Consumption theory 09/09 21 / 24 Utility measure of happiness cardinal utility ordinal utility Denition Utility function: A way of assigning a number to every possible consumption bundle, such taht more preferred bundles get assigned larger numbers. Micro (VE) Consumption theory 09/09 22 / 24 Utility Theorem of Debreu Theorem Given the assumptions of Rationality and Monotonicity, u () s.t. (x 1 , x 2 ) ~ (y 1 , y 2 ) ==u (x 1 , x 2 ) > u (y 1 , y 2 ) . Proof. Do not need for this course. Micro (VE) Consumption theory 09/09 23 / 24 Utility Monotonic transforations Lemma Any monotonic transformation of the original utility function is a utility function representing the same preferences. Proof. 1. Suppose u () is the utility function representing the preferences ~ P . (x 1 , x 2 ) ~ P (y 1 , y 2 ) ==u (x 1 , x 2 ) > u (y 1 , y 2 ) (1) 2. And suppose that f (u) is a monotonic transformation of u () . u (x 1 , x 2 ) > u (y 1 , y 2 ) ==f (x 1 , x 2 ) > f (y 1 , y 2 ) (2) 3. From (1) and (2) follows: (x 1 , x 2 ) ~ P (y 1 , y 2 ) ==f (x 1 , x 2 ) > f (y 1 , y 2 ) (3) Micro (VE) Consumption theory 09/09 24 / 24