Preference Relation

Advanced Microeconomics
Ordinal preference theory
Harald Wiese
University of Leipzig
Harald Wiese (University of Leipzig)
1 / 68
Part A. Basic decision and preference theory

1
Decisions in strategic (static) form
Decisions in extensive (dynamic) form
Decisions under risk
2 / 68

Overview
1
The vector space of goods and its topology
Preference relations
Axioms: convexity, monotonicity, and continuity
Utility functions
Quasi-concave utility functions and convex preferences
Marginal rate of substitution
3 / 68
The vector space of goods

Assumptions
households are the only decision makers;

nite number ` of goods dened by
place
time
contingencies
example: an apple of a certain weight and class to be delivered

in Leipzig
on April 1st, 2015,
if it does not rain the day before
4 / 68

Exercise: Linear combination of vectors
Problem
Consider the vectors x = (x1 , x2 ) = (2, 4) and y = (y1 , y2 ) = (8, 12) .
Find x + y , 2x and 41 x + 34 y !
5 / 68

Notation
For ` 2 N:
R` := f(x1 , ..., x` ) : xg 2 R, g = 1, ..., `g .
0 2 R` null vector (0, 0, ..., 0);
vectors are called points (in R` ).
Positive amounts of goods only:

n
R`+ := x 2 R` : x
Vector comparisons:
x y : , xg
yg for all g from f1, 2, ..., `g ;
x > y :, x y and x 6= y ;
x
y :, xg > yg for all g from f1, 2, ..., `g .
6 / 68
Distance between x and y
y
c
x
euclidian
distance: c
city-block
distance: a+b
infinity
distance: max(a, b)
7 / 68
Distance
Denition
In R` :
euclidian (or 2-) norm: kx
innity norm: kx
city-block norm: kx
y k : = kx
y k2 : =
y k := maxg =1,...,` jxg

y k1 : =
`
g =1
jxg
yg j
g` =1 (xg
yg )2
yg j
8 / 68
Distance
Exercise
Problem
What is the distance (in R2 ) between (2, 5) and (7, 1) , measured by the
2-norm k k2 and by the ininity norm k k ?
9 / 68
Distance and balls

Ball
Denition
Let x 2 R` and > 0. )
n
K = x 2 R` : k x
x k<
(open) -ball with center x .
x*
kx x k = holds for all x on the circular line;

K all the points within
Problem
Assuming the goods space R2+ , sketch three 1-balls with centers
(2, 2) , (0, 0) and (2, 0) , respectively.
10 / 68
Distance and balls

Boundedness
Denition
A set M is bounded if there exists an -ball K such that M
Example
The set [0, ) = fx 2 R : x
K.
0g is not bounded.
11 / 68
Sequences and convergence

Sequence
Denition
A sequence x j
j 2N
in R` is a function N ! R` .
Examples
In R: 1, 2, 3, 4, ... or x j := j;
In R2 :
(1, 2) , (2, 3) , (3, 4) , ...
1, 21 , 1, 13 , 1, 14 , 1, 15 , ... .
12 / 68

Convergence
Denition
x j j 2N in R` converges towards x 2 R` if for every > 0 there is an
N 2 N such that
x j x < for all j > N
holds.
Convergent a sequence that converges towards some x 2 R` .
Examples
1, 2, 3, 4, ... is not convergent towards any x 2 R;
1, 1, 1, 1, ... converges towards 1;
1, 12 , 13 , ... converges towards zero.
13 / 68

Lemma 1
Lemma
Let x j
j 2N
If x j
xj
be a sequence in R` .
j 2N
j 2N
converges towards x and y ) x = y .
= x1j , ..., x`j
j 2N
converges towards (x1 , ..., x` ) i xgj
converges towards xg for every g = 1, ..., `.
Problem
Convergent?
(1, 2) , (1, 3) , (1, 4) , ...

or
1,
1
2
, 1,
1
3
, 1,
1
4
, 1,
1
5
, ... .
14 / 68
Boundary point
Denition
A point x 2 R` is a boundary
point of M R` i there is a
sequence of points in M and
another sequence of points in
R` nM so that both converge
towards x .
x*
M
R2 \ M
15 / 68
Interior point
Denition
A point in M that is not a
boundary point is called an
interior point of M.
x*
M
R2 \ M
Note: Instead of R` , we can consider alternative sets, for example R`+ .
16 / 68
Closed set
Denition
A set M R` is closed i every converging sequence in M with
convergence point x 2 R` fullls x 2 M.
Problem
Are the sets
f0g [ (1, 2),

K = x 2 R` : k x
K = x 2 R` : k x
x k< ,
x k
closed?
17 / 68
Overview
1
Utility functions
18 / 68
Preference relations and indierence curves

Preference relation
Denition
(weak) preference relation - a relation on R`+ that is
complete (x - y or y - x for all x, y )
transitive (x - y and y - z implies x - z for all x, y , z) and
reexive (x - x for all x);
indierence relation:
y :, x - y and y - x;
x
strict preference relation:
x
y :, x - y and not y - x.
19 / 68
Relations and equivalence classes

Exercise
Problem
For any two inhabitants from Leipzig, we ask whether one is the father of
the other.
This relation fullls the following properties (?). Fill in "yes" or "no":
property is the father of
reexive
transitive
complete
20 / 68

Exercise
Problem
Fill in:
property indierence strict preference
reexive
transitive
complete
21 / 68

transitivity of strict preference
We want to show
x
y ^y
z)x
Proof: x y implies x - y , y z implies y - z.

Therefore, x y ^ y z implies x - z.
Assume z - x. Together with x y , transitivity implies z - y ,
contradicting y z. Therefore, we do not have z - x, but x z.
22 / 68

Better and indierence set
Denition
Let % be a preference relation on R`+ . )
By := x 2 R`+ : x % y
Wy : = x 2
R`+
better set By of y ;
:x -y
Iy := By \ Wy = x 2
worse set Wy of y ;
R`+
:x
y s indierence set;
indierence curve the geometric locus of an indierence set.
23 / 68

Indierence curve
numbers to indicate preferences:

x2
3
x2
x1
x1
24 / 68
Indierence curves must not intersect

Two dierent
indierence curves,
Thus C B
x2
C
But
C
A^A
A
B
B)C
Contradiction!
x1
25 / 68

Exercise
Problem
Sketch indierence curves for a goods space with just 2 goods and,
alternatively,
good 2 is a bad,
good 1 represents red matches and good 2 blue matches,
good 1 stands for right shoes and good 2 for left shoes.
26 / 68

Lexicographic preferences
In two-good case:
x -lex y :, x1 < y1 or (x1 = y1 and x2
y2 ).
Problem
What do the indierence curves for lexicographic preferences look like?
27 / 68

Overview
1
Utility functions
28 / 68
Convex preferences
Convex combination
Denition
Let x and y be elements of R` . )
kx + (1
k ) y , k 2 [0, 1]
the convex combination of x and y .
29 / 68
Convex preferences
Convex and strictly convex sets
y
x
M
M
y
c
x
not convex
interior
point
boundary
point
convex,
but not strictly convex
strictly convex
Denition
A set M R` is convex if for any two points x and y from M, their
convex combination is also contained in M.
A set M is strictly convex if for any two points x and y from M, x 6= y ,
kx + (1
k ) y , k 2 (0, 1)
is an interior point of M for any k 2 (0, 1) .

30 / 68
Convex preferences
Convex and concave preference relation
Denition
A preference relation % is
convex if all its better sets By are convex,
strictly convex if all its better sets By are strictly convex,
concave if all its worse sets Wy are convex,
strictly concave if all its worse sets Wy are strictly convex.
Preferences are dened on R`+ (!):
x2
x2
interior
better set point in R 2
+
worse set
x1
interior
point in R+2
x1
31 / 68
Convex preferences
Exercise
Problem
Are these preferences convex or strictly convex?
x2
x2
better set
better set
(a)
(b)
x1
x1
x2
x2
better set
(c)
better set
x1
(d)
x1
32 / 68
Monotonicity of preferences
Monotonicity
Denition
A preference relation % obeys:
weak monotonicity if x > y implies x % y ;
strict monotonicity if x > y implies x
y;
local non-satiation at y if in every -ball with center y a bundle x

exists with x y .
Problem
Sketch the better set of y = (y1 , y2 ) in case of weak monotonicity!
33 / 68
Exercise: Monotonicity and convexity

Which of the properties
(strict) monotonicity and/or
(strict) convexity
do the preferences depicted by the indierence curves in the graphs below
satisfy?
x2
x2
[1]
[2]
3
x1
x1
x2
x2
[3]
[4]
x1
x1
34 / 68
Monotonicity of preferences
Bliss point
x2
7
6
x1
35 / 68
Continuous preferences
Denition
A preference relation - is continuous if for all y 2 R`+ the sets
n
o
Wy = x 2 R`+ : x - y
and
are closed.
n
o
By = x 2 R`+ : y - x
36 / 68
Lexicographic preferences are not continuous

Consider the sequence
xj
j 2N
1
2+ ,2
j
! (2, 2)
All its members belong to the better set of (2, 4) .

But (2, 2) does not.
x2
4
2
x1
37 / 68
Utility functions
Overview
1
Utility functions
38 / 68
Utility functions
Denition
Denition
For an agent i 2 N with preference relation %i ,
U i : R`+ 7! R
utility function if
U i (x )
U i (y ) , x %i y , x, y 2 R`+
holds.
U i represents the preferences %i ;
ordinal utility theory.
39 / 68
Utility functions
Examples of utility functions
Examples
Cobb-Douglas utility functions (weakly monotonic):
U (x1 , x2 ) = x1a x21
with 0 < a < 1;
perfect substitutes:
U (x1 , x2 ) = ax1 + bx2 with a > 0 and b > 0;
perfect complements:
U (x1 , x2 ) = min (ax1 , bx2 ) with a > 0 and b > 0.
40 / 68
Utility functions
Dixit-Stiglitz preferences for love of variety
xj
U (x1 , ..., x` ) =
j =1
where X :=
j =1 xj
X
X
, ...,
`
`
j =1
U
`
with > 1
implies
=
and hence, by
! 1
X
`
1
`X
1
`
! 1
1 ! 1
j =1
1
`
1
= ` 1 X = ` 1
`
! 1
1
1
X = ` 1 X
> 0, a love of variety.
41 / 68
Utility functions
Exercises
Problem
Draw the indierence curve for perfect substitutes with a = 1, b = 4 and
the utility level 5!
Problem
Draw the indierence curve for perfect complements with a = 1, b = 4 (a
car with four wheels and one engine) and the utility level for 5 cars! Does
x1 denote the number of wheels or the number of engines?
42 / 68
Equivalent utility functions

Denition (equivalent utility functions)
Two utility functions U and V are called equivalent if they represent the
same preferences.
Lemma (equivalent utility functions)

Two utility functions U and V are equivalent i there is a strictly
increasing function : R ! R such that V = U.
Problem
Which of the following utility functions represent the same preferences?
a) U1 (x1 , x2 , x3 ) = (x1 + 1) (x2 + 1) (x3 + 1)
b) U2 (x1 , x2 , x3 ) = ln (x1 + 1) + ln (x2 + 1) + ln (x3 + 1)
c) U3 (x1 , x2 , x3 ) = (x1 + 1) (x2 + 1) (x3 + 1)
d) U4 (x1 , x2 , x3 ) = [(x1 + 1) (x2 + 1) (x3 + 1)] 1
e) U5 (x1 , x2 , x3 ) = x1 x2 x3
43 / 68
Existence
Existence is not guaranteed
Assume a utility function U for

lexicographic preferences:
U (A0 ) < U (B 0 ) < U (A00 ) <
U (B 00 ) < U (A000 ) < U (B 000 ) ;
x2
within (U (A0 ) , U (B 0 )) at least

one rational number (q 0 ) etc.
q 0 < q 00 < q 000 ;
injective function
f : [r 0 , r 000 ] ! Q;
not enough rational numbers;
r'
B'
B''
B' ' '
A'
A' '
A' ' '
r' '
r' ' '
x1
contradiction > no utility

function for lexicographic
preferences
44 / 68
Existence
Existence of a utility function for continuous preferences
Theorem
If the preference relation -i of an agent i
is continuous, there is a continuous utility
function U i that represents -i .
Wait a second for the

denition of a continuous
function, please!
x2
(x, x)
(x1 , x 2 )
45
U (x ):= x
x1
45 / 68
Existence
Exercise
Problem
Assume a utility function U that represents the preference relation - .
Can you express weak monotonicity, strict monotonicity and local
non-satiation of - through U rather than -?
46 / 68
Continuous functions
Denition
Denition
f : R` ! R is
continuous at x 2 R` i
for every x j j 2N in R`
that converges towards
x, f x j j 2N
converges towards f (x ).
f (x )
f (x)
Fix x 2 R` .
Consider sequences in the domain x j j 2N that converge towards x.
Convergence of sequences in the range f x j j 2N towards f (x ) > f
continuous at x
No convergence or convergence towards y 6= f (x ) > no continuity
47 / 68
Continuous functions
Counterexample
f (x)
f (x)
excluded
Specic sequence in the domain x j j 2N that converges towards x

but sequence in the range f x j j 2N does not converge towards f (x )
48 / 68

Overview
1
Utility functions
49 / 68
Quasi-concavity
Denition
f : R` ! R is quasi-concave if
f (kx + (1
k) y)
min (f (x ) , f (y ))
holds for all x, y 2 R` and all k 2 [0, 1] .

f is strictly quasi-concave if
f (kx + (1
k ) y ) > min (f (x ) , f (y ))
holds for all x, y 2 R` with x 6= y and all k 2 (0, 1) .

Note: quasi-concave functions need not be concave (to be introduced
later).
50 / 68
Quasi-concavity
Examples
Also
quasi-concave:
f (x )
f (kx + (1 k )y )
f (y )
kx + (1 k )y
Example
Every monotonically increasing or decreasing function f : R ! R is
quasi-concave.
51 / 68
Quasi-concavity
A counter example
f (x )
f (y )
f (kx + (1 k )y )
x
kx + (1 k )y
52 / 68
Better and worse sets, indierence sets

Denition
Let U be a utility function on R`+ .
BU (y ) := By = x 2 R`+ : U (x )
W U ( y ) : = Wy = x 2
R`+
: U (x )
U (y ) the better set By of y ;

U (y ) the worse set Wy of y ;
IU (y ) := Iy = By \ Wy = x 2 R`+ : U (x ) = U (y ) y s
indierence set (indierence curve) Iy .
53 / 68
Concave indierence curve

Denition
Let U be a utility function on R`+ .
Iy is concave if U (x ) = U (y ) implies
U (kx + (1
k) y)
U (x )
for all x, y 2 R`+ and all k 2 [0, 1] .
Iy is strictly concave if U (x ) = U (y ) implies

U (kx + (1
k ) y ) > U (x )
for all x, y 2 R`+ with x 6= y and all k 2 (0, 1) .
54 / 68
Concave indierence curve

Examples and counter examples
kx + (1 k )y
(b)
(a)
x
x
y
(d)
(c)
55 / 68
Lemma
Lemma
Let U be a continuous utility function on R`+ . A preference relation % is
convex i:
all the indierence curves are concave, or
U is quasi-concave.
U s better
sets strictly
convex
U strictly
quasi-concave
U s better
sets convex
U s better U s indifference
sets strictly
curves strictly
convex and
concave
local
nonsatiation
U quasiconcave
U s indifference
curves concave
56 / 68

Overview
1
Utility functions
57 / 68

Mathematics: Dierentiable functions
Denition
Let f : M ! R be a real-valued function with open domain M
R` .
f is dierentiable if all the partial derivatives

fi ( x ) : =
f
(i = 1, ..., `)
xi
exist and are continuous.

0
f s derivative at x.
1
f1 ( x )
B f2 ( x ) C
C
f 0 (x ) : = B
@ ...
A
f` (x )
58 / 68

Mathematics: Adding rule
Theorem
Let f : R` ! R be a dierentiable function and let g1 , ..., g` be
dierentiable functions R ! R. Let F : R ! R be dened by
F (x ) = f (g1 (x ) , ..., g` (x )) .
`
dF
f dgi
=
.
dx
i =1 gi dx
59 / 68

Economics
x2
x2
(y1 , y 2 )
y2
x1
y1
x1
Iy = (x1 , x2 ) 2 R2+ : (x1 , x2 )
(y1 , y2 ) .
Iy : x1 7! x2 .
60 / 68

Denition and exercises
Denition
If the function Iy is dierentiable and if preferences are monotonic,
dIy (x1 )
dx1
the MRS between good 1 and good 2 (or of good 2 for good 1).
Problem
What happens if good 2 is a bad?
61 / 68

Perfect substitutes
Problem
Calculate the MRS for perfect substitutes (U (x1 , x2 ) = ax1 + bx2 with
a > 0 and b > 0.)!
Solve ax1 + bx2 = k for x2 !
Form the derivative of x2 with respect to x1 !
Take the absolute value!
62 / 68

Lemma 1
Lemma
Let % be a preference relation on R`+ and let U be the corresponding
utility function.
If U is dierentiable, the MRS is dened by:
MRS (x1 ) =
U U
x1 , x2
dIy (x1 )
=
dx1
U
x1
U
x2
marginal utility.
63 / 68

Lemma: proof
Proof.
U (x1 , Iy (x1 )) constant along indierence curve;
dierentiating U (x1 , Iy (x1 )) with respect to x1 (adding rule):
0=
U dIy (x1 )
U
+
.
x1
x2 dx1
dIy (x1 )
dx1
can be found even if Iy were not given explicitly

(implicit-function theorem).
Problem
Again: What is the MRS in case of perfect substitutes?
64 / 68

Lemma 2
Lemma
Let U be a dierentiable utility function and Iy an indierence curve of U.
Iy is concave i the MRS is a decreasing function in x1 .
x1 < y1 ;
x2
MRS (x1 ) > MRS (y1 ).
x1
y1
x1
65 / 68

Cobb-Douglas utility function
U (x1 , x2 ) = x1a x21

MRS =
U
x1
U
x2
,0 < a < 1
ax1a 1 x21 a
(1 a) x1a x2
a
1
x2
.
a x1
Cobb-Douglas preferences are monotonic so that an increase of x1 is

associated with a decrease of x2 along an indierence curve.
Therefore, Cobb-Douglas preferences are convex (Cobb-Douglas
utility functions are quasi-concave).
66 / 68
Further exercises
Problem 1
Dene strict anti-monotonicity. Sketch indierence curves for each of the
four cases:
strict monotonicity
strict anti-monotonicity
strict convexity
strict concavity
Problem 2
(Strictly) monotonic, (strictly) convex or continuous?
(a) U (x1 , x2 ) = x1 x2 ,
(b) U (x1 , x2 ) = min fa x1 , b x2 g where a, b > 0 holds,
(c) U (x1 , x2 ) = a x1 + b x2 where a, b > 0 holds,
(d) lexicographic preferences

67 / 68
Further exercises
Problem 3 (di cult)
Let U be a continuous utility function representing the preference relation
- on Rl+ . Show that - is continuous as well. Also, give an example for a
continuous preference relation that is represented by a discontinuous utility
function. Hint: Dene a function U 0 that diers from U for x = 0, only
68 / 68

Preference Relation

Uploaded by

Copyright:

Available Formats

You might also like

Preference Relation

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Preference Relation

Uploaded by

Copyright:

Available Formats

Advanced Microeconomics

Ordinal preference theory

Harald Wiese (University of Leipzig)

Part A. Basic decision and preference theory

Decisions in strategic (static) form

Decisions in extensive (dynamic) form

Ordinal preference theory

Decisions under risk

Harald Wiese (University of Leipzig)

Ordinal preference theory

The vector space of goods and its topology

Axioms: convexity, monotonicity, and continuity

Quasi-concave utility functions and convex preferences

Marginal rate of substitution

Harald Wiese (University of Leipzig)

The vector space of goods

households are the only decision makers;

example: an apple of a certain weight and class to be delivered

Harald Wiese (University of Leipzig)

The vector space of goods

Harald Wiese (University of Leipzig)

The vector space of goods

Positive amounts of goods only:

Distance between x and y

Harald Wiese (University of Leipzig)

Harald Wiese (University of Leipzig)

y k := maxg =1,...,` jxg

Harald Wiese (University of Leipzig)

Distance and balls

(open) -ball with center x .

kx x k = holds for all x on the circular line;

Distance and balls

Harald Wiese (University of Leipzig)

Sequences and convergence

Harald Wiese (University of Leipzig)

Sequences and convergence

1, 12 , 13 , ... converges towards zero.

Harald Wiese (University of Leipzig)

Sequences and convergence

converges towards x and y ) x = y .

= x1j , ..., x`j

converges towards (x1 , ..., x` ) i xgj

converges towards xg for every g = 1, ..., `.

(1, 2) , (1, 3) , (1, 4) , ...

Harald Wiese (University of Leipzig)

Note: Instead of R` , we can consider alternative sets, for example R`+ .

Harald Wiese (University of Leipzig)

f0g [ (1, 2),

Harald Wiese (University of Leipzig)

The vector space of goods and its topology

Axioms: convexity, monotonicity, and continuity

Quasi-concave utility functions and convex preferences

Marginal rate of substitution

Harald Wiese (University of Leipzig)

Preference relations and indierence curves

Harald Wiese (University of Leipzig)

Relations and equivalence classes

Harald Wiese (University of Leipzig)