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Topic 1: Utility Function.: ECON30010 Microeconomics
Topic 1: Utility Function.: ECON30010 Microeconomics
Topic 1: Utility Function.: ECON30010 Microeconomics
ECON30010 Microeconomics
3 March 2016
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Classical Economics
Example
I
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Neoclassical Economics
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Since we are going to use utility function all the time, we need to
have clear understanding what it is and how we could deal with it.
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ECON20002 recap
Suppose an agent consumes food (F ) and junk food (J). Given prices
PF and PJ , what is the optimal consumption bundle of this agent?
If we know the agents utility function (e.g. U = J F ), the optimal
bundle is given by:
MRSJF =
PJ
MUJ
=
MUF
PF
How many of you can write down your own function for F and J?
If not many, what are we talking about if even a group of economics
students cannot do it?
Utility function is not what agents possess. It is a useful model of agents
underlying preferences.
This model will have the underlying assumptions, a proof (that we will
defer until honours year) and a conclusion.
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Plan
I
I
I
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Model: Assumptions
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Model: Assumptions
In math notation, bold letters, such as x and y, will always stand for a vector, as it
is here. Thus, x = (1, 3) should be understood as a bundle that consists of 1 unit of
good 1 and 3 units of good 2.
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Model: Assumptions
One example of transitivity are real numbers and greater than relation
(>). It is transitive: if a > b and b > c then a > c.
What happens if transitivity does not hold? Suppose that
you prefer ECON20001 to ECON30010 (ECON20001 ECON30010),
and you prefer ECON20002 to ECON20001 (ECON20002 ECON20001),
but you prefer ECON30010 to ECON20002 (ECON30010 ECON20002).
These are not great preferences to have as a manipulator would be able to
make you whatever choice he or she likes (including taking ECON30010!).
I would hope that whenever you observe yourself making such choices
(which is, of course, possible), you would regard them as a mistake.
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Model: Assumptions
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Model: Assumptions
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Model: Assumptions
What do we need it for? With these assumptions, we can start to use very
powerful math tools.
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Model: Results
Theorem
If preferences over bundles of goods x satisfy completeness, transitivity,
and continuity, then there exists a continuous utility function u(x) that
represents these preferences.
Why is this theorem important? Because mathematicians are very good at
working with functions, and we can use a lot of their tools.
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Model: Results
Why: The only important thing about a utility function is how two
numbers compare (e.g., u(x) > u(y)). But the very definition of a
positive monotonic transformation is that this inequality is preserved!
Example:
I u 1 (x) = x1 x2
I u 3 (x) =
x1 x2
I
all represent the same preferences (e.g. all four of these utility
functions could be utility functions of the same individual).
How could you check it? Take any two consumption bundles, e.g.
(1, 3) and (2, 1), and calculate u 1 , u 2 , u 3 , u 4 for these two bundles.2
2
Note: this is not a proof. For a proof, you need to show that the same holds for any
two bundles, (x1 , x2 ) and (y1 , y2 ); that is, if for given x, y, u i (x) > u i (y) for one of these
functions, the same holds for all three others.
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Model: Results
Summary
A utility function is a fake. When I say consider an agent with utility
function u = F J, this is short for: consider an agent who, when faced
with the choice between food and junk food, make a choice as if his or her
utility function is u = F J.
If you ever hear someone say:
Economists are silly, they assume people have utility function,
but if I ask them to write their own utility function, they cannot
do even that
then you would need to say that economists do not assume that people
have utility function. Economists assume that peoples preferences are (1)
complete; (2) transitive; (3) monotone. Which one do you have a problem
with?
This is, of course, not to say that utility function cannot be incorrectly
specified. We will look at it next.
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Model: Results
2
x , for x [2, 3].
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Selfish behaviour
Sometimes you can hear that
Economists assume selfish behaviour, which is silly as we see
many instances of altruistic behaviour, such as when people
share their money with others.
This description is a bit too generic, so let us think about a concrete
situation: suppose that agent 1 is given $5 that agent 1 can allocate
between herself and agent 2. Suppose that we observe that agent 1 gives
y > 0 to agent 2. I will call this situation Situation 1.4
Is it a contradiction to anything we have assumed so far?
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A standard model
Choice set is (x, y ), x 0, y , 0. I interpret x as the amount of money
kept to oneself and y as an amount of money given to the other person.
Utility function u(x, y ) defined over this choice set. The utility function
that is consistent with selfish behaviour is u(x, y ) = x.
In Situation 1, there is an additional requirement, x = 5 y .
What standard model predicts? Since agent 1s utility function is
u(x, y ) = x, then her optimal choice is y = 0.
I assumed that agent 1 splits the money so that y > 0. This is
inconsistent with the prediction of the standard model.
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1
5
1
5 2x =
x = +
4
2 8
Note that is not known and may vary among individuals; the only thing
we assume about is that > 0. Thus, the prediction is that agent 1 will
keep more than 1/2 of $5 (nothing more can be said).
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1
x = 5/2 +
2
Recall that is not known; so the prediction here is that agent 1 will keep
more than 1/2 of $5 to herself.
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x = 5/2 +
1
8FS 0
x = 5/2 +
1
2LL
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Situation 2
Now, we change the situation a little: suppose that agent 1 can not only
give some y 5 to agent 2, but also can take up to $1 from agent 2. So,
in Situation 1 0 y 5 and in Situation 2 1 y 5.
What are the predictions for FS 0 and LL?
FS 0 :
For these who gave $0 in Situation 1, they could either give $0 or -$1.
I
Indeed, if is very small, then such an agent would have loved to take
everything for agent 2, but was more constrained in Situation 1 (could
take at most $0) than in Situation 2 (could take at most -$1).
For these who gave more than $0 in Situation 1, their choice should
not change.
I
LL: We can argue that x e changes in LL, so the split may be different not
only for these 29% who gave nothing in Situation 1, but for everyone
else.
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% in S1
0
.29
.17
.15
0
.07
.25
.03
.04
% in S2
.21
.44
.09
.07
.04
.04
.09
.03
0
6
The Econometricians among us may like to see a formal test of this claim, but we
will rely on a visual test (and a claim that it is obvious that LL fits the data better).
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Is LL better than FS 0 ?
7
The theory is falsifiable, or refutable, if it is possible to design a test which proves
the theory false.
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Sources
Textbooks
Varian:
I
Preferences: Ch. 3
Utility: Ch. 4
Serrano-Feldman:
I
Ch. 2
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Sources
Papers
I
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