Rice University ECO 501: Microeconomic Theory I - Lecture 1: Preference

Rice University
ECO 501: Microeconomic Theory I

———————————————–
Lecture 1: Preference
———————————————–
Christian Roessler
October 1, 2008
1 Consumption Set
In the …rst part of these lectures, we consider the consumer decision
problem in a market economy, where goods are o¤ered at posted prices.
Most of our attention will be on the primitive approach that starts with
"rational" individual preferences and derives optimal choices for given
prices and endowments. We will also look at connections with the
"revealed preference" approach that makes assumptions directly about
choices.
Let there be L di¤erent commodities. A consumption bundle is a list
x1 ; x2 ; : : : ; xL of quantities of each commodity, represented by a vector
2 3
x1
6 7
x = 4 ... 5
xL
in the commodity space RL .
Note that RL includes consumption bundles that list negative quantities
of some goods. These can be interpreted as debts or giving some of one’s
endowment to others.
1
Any two items that could sell at di¤erent prices should be modeled as
distinct commodities. Strictly speaking, the description of a commodity
may have to include detailed context information, such as "a diet coke
can from a vending machine at Grand Central Station in the summer
of 2008."
The de…nition of the commodity space tells us what kind of object a
consumption bundle is. It may be the case that not all such objects
(i.e. not all vectors) can be feasibly consumed, or we may wish to
impose restrictions in a particular model. Physical constraints include:
we need time to consume, and time is limited; we cannot consume in
two places simultaneously; we have to consume enough of certain things
(food, shelter) to survive.
A restriction we will impose for modeling purposes is that the set of
feasible consumption bundles, or the consumption set, is convex. That
is, if x and y are feasible, then any mixture z = x + (1 ) y with
2 (0; 1) is also feasible. This assumption rules out indivisible com-
modities.
Example. Suppose the commodities are time (in minutes) spent watch-
ing television, and time (in minutes) spent in a rollercoaster car on "The
Beast" (Kings Island near Cincinnati), a ride which takes approximately …ve
minutes. It is possible to watch no television and ride "The Beast" once (call
this bundle x), and it is also possible to watch television for one hour and
not ride "The Beast" (call this bundle y). But one cannot watch television
for half an hour and ride "The Beast" for two-and-a-half minutes (unless it
is a one-period model ....). Since this bundle (call it z) is a mixture of x and
y, the consumption set for these two commodities is not convex.
Any economic model is an idealized representation of reality. We will

make many assumptions that are in some sense too strong to ever hold
exactly. In some cases, they preserve the spirit of the problem, and
propositions for the idealized world are also informative about reality.
In others, the assumptions limit the applicability of the model to a more
speci…c problem. Convexity of the consumption set is a convenience
restriction that should not alter the thrust of our results, even though
many commodities are actually indivisible.
2
Most of the time, we will assume that the consumption set X contains
all bundles with only non-negative quantities:
X = RL+ x 2 RL s.t. x` 0 for ` = 1; : : : ; L ,
which is convex.
2 Rational Preference
The …rst step in analyzing individual choices from the consumption
set is to de…ne preference over its elements. For the moment, we can
think of X more generally as a choice set, where the elements may in
particular be consumption bundles. Or they may be something else
one can express a preference about, for example sports teams.
A preference % is a binary relation on X: a subset of X X. We

interpret (x; y) 2%, which is commonly denoted x % y, as "x is at least
as good as y."
The preference % associates with every x 2 X its better-than (or upper

contour) set and worse-than (or lower contour) set:
% (x) fa 2 X s.t. a % xg
- (x) fb 2 X s.t. x % bg :
The intersection of the upper and lower contour sets is the indi¤erence
set at x:
(x) fb 2 X s.t. x bg :
From % derive the strict preference and indi¤erence relations and :
x y i¤ x % y and not y % x
x y i¤ x % y and also y % x:
In almost all economic theory, preferences are assumed to be rational

in the following sense.
3
De…nition. Preference % is rational i¤
(i) % is complete: 8x; y 2 X, x % y or y % x (or both).
(ii) % is transitive: 8x; y; z 2 X, x % y % z =) x % z.
Completeness says that any two elements of X can be compared: one

is always preferred, or else they are indi¤erent. But it is never the case
that the agent could not say whether he prefers x or y (or …nds them
indi¤erent), for example because he is seeking more information. This
scenario could be accommodated by state-dependent preference, where
the state is de…ned by what the agent learns.
Transitivity is most closely related to the usual notion of rationality: it

requires the agent to rank alternatives consistently and predictably. In
practice, people often violate transitivity unwittingly, especially when
the choice objects are complex and unfamiliar. However, most would
revise a stated preference when one points out to them that it is in-
transitive.
Moreover, a transitivity violator is exposed to "Dutch book" trades.

Suppose the agent initially has x. Since the preference is cyclical, e.g.
x y % z % x, and the agent should be willing to pay some non-zero
amount to exchange y for x, one could o¤er z for x, then y for z, then
x for y (at a price). Which leaves the agent with the initial bundle x,
but he has made a payment. If these trades are repeated often enough,
they will bankrupt the agent.
Exercise 1 (MWG 1.B.1, 1.B.2). Show: if % is rational, then 8x; y; z 2 X

(i) x x, (ii) relations and are transitive, (iii) x y % z =) x z.
3 Utility Functions
To apply tools from calculus in analyzing choices, it is useful to repre-
sent the preference relation by a function.
4
De…nition. The function u : X ! R is a utility function that represents
preference relation % if 8x; y 2 X,
x % y () u (x) u (y) :
If u represents %, then any strictly increasing function f : R ! R can

be composed with u to give a new function v : X ! R (where v (x) =
f (u (x)) for all x 2 X), with the property that v (x) v (x0 ) ()
u (x) u (x ). Thus v also represents %. Clearly, utility functions are
0
non-unique.
On the other hand, a utility function may fail to exist. It never exists
for a preference that is not rational.
Proposition. Only a rational preference relation can be represented by a

utility function.
Proof. Suppose a utility function u : X ! R represents preference %
on X. Then % is complete: for any x; y 2 X, we have u (x) u (y) or
u (y) u (x), so x % y or y % x. And % is transitive: when x % y % z, we
have u (x) u (y) u (z), hence u (x) u (z) and then x % z. So existence
of a utility function implies that % is rational. The contrapositive, "if % is
not rational, then there does not exist a utility function," follows.
Exercise 2 (MWG 1.B.5). Show: if X is …nite and % is a rational pref-

erence relation on X, then there exists a utility function u : X ! R that
represents %.

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Rice University

ECO 501: Microeconomic Theory I

Any economic model is an idealized representation of reality. We will

X = RL+ x 2 RL s.t. x` 0 for ` = 1; : : : ; L ,

A preference % is a binary relation on X: a subset of X X. We

The preference % associates with every x 2 X its better-than (or upper

From % derive the strict preference and indi¤erence relations and :

In almost all economic theory, preferences are assumed to be rational

Completeness says that any two elements of X can be compared: one

Transitivity is most closely related to the usual notion of rationality: it

Moreover, a transitivity violator is exposed to "Dutch book" trades.

Exercise 1 (MWG 1.B.1, 1.B.2). Show: if % is rational, then 8x; y; z 2 X

If u represents %, then any strictly increasing function f : R ! R can

Proposition. Only a rational preference relation can be represented by a

Exercise 2 (MWG 1.B.5). Show: if X is …nite and % is a rational pref-

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