Advanced Microeconomics

Çağatay Kayı

Universidad del Rosario

1/17
Ç. Kayı Advanced Microeconomics
 “... Mere observations, however, are not knowledge. In order to
understand the universe, we need to connect observations into compre-
hensive theories. Earlier traditions usually formulated in terms of stories.
Modern science uses mathematics.”

Sapiens: A Brief History of Mankind, Yuval Noah Hariri, 2015.

“... Economists build models to capture salient aspects of social in-

teractions. ... But what are economic models? The easiest way to un-
derstand them is as simplifications designed to show how specific mech-
anisms work by isolating them from other, confounding effects. A model
focuses on particular causes and seeks to show how they work their effects
through the system. A modeler builds an artificial world that reveals cer-
tain types of connections among the parts of the whole-connections that
might be hard to discern if you were looking at the real world in its welter
of complexity.”

Economics Rules, Dani Rodrik, 2015.

2/17
Ç. Kayı Advanced Microeconomics
 “... The word ’model’ sounds more scientific than ‘fable’ or ‘fairy
tale’ [yet] I do not see much difference between them.”

Economic Fables, Ariel Rubinstein, 2012.

“As technological advances continue to expand our reach to more

complex systems, we need to maintain the humility of Rubinstein’s fablists,
but still be willing to roll up our sleeves and get our hands dirty when it
is needed, [like engineers and plumbers] just as Roth and Duflo suggest.”

The Role of Theory in an Age of Design and Big Data, Matthew Jackson,
2019.

3/17
Ç. Kayı Advanced Microeconomics
How people make decisions
I First, we analyze the theory of individual decision making in a complete
abstract setting.

I Let X be a set of alternatives.

I A preference relation  is a binary relation on X, i.e., ⊆ X × X.

I x  y ⇔ x is at least as good as y.

I From , we define two other relations on X:

I The strict preference relation  where

x  y ⇔ x  y and not y  x.
x  y ⇔ x is preferred to y.
I The indifference preference relation ∼ where

x ∼ y ⇔ x  y and y  x.
x  y ⇔ x is indifferent to y.
4/17
Ç. Kayı Advanced Microeconomics
Example
I Let X = {a, b, c, d, e, f } and
= {(a, a), (a, b), (a, c), (a, d), (a, e), (a, f ),
(b, b), (b, d), (b, e), (b, f ),
(c, a), (c, b), (c, c), (c, d), (c, e), (c, f ),
(d, d), (d, e), (d, f ),
(e, d), (e, e), (e, f ),
(f , f )} ⊆ X × X
f a ∼ a, a  b, a ∼ c, a  d, a  e, a  f

e b ∼ b, b  d, b  e, b  f

d c ∼ a, c ∼ c, c  b, c  d, c  e, c  f

c d ∼ d, d ∼ e, d  f

b e ∼ e, e ∼ d, e  f

a f ∼f

a b c d e f 5/17
Ç. Kayı Advanced Microeconomics
Properties of Preference Relations
I A preference relation  is complete if for each x, y ∈ X, we have x  y or
y  x.

I A preference relation  is transitive if for each x, y, z ∈ X, if x  y and y  z,

then we have x  z.

I A preference relation  is rational if it is complete and transitive.

I Rational preference relation is also known as total preorder or weak order.

I Criticism: Strong assumptions?

I Completeness: Can an individual always have a well–defined preference

between any two possible alternatives?
I Transitivity: 50 shades of grey.

6/17
Ç. Kayı Advanced Microeconomics
Example
I Let X = {a, b, c, d, e, f } and
= {(a, a), (a, b), (a, c), (a, d), (a, e), (a, f ),
(b, b), (b, d), (b, e), (b, f ),
(c, a), (c, b), (c, c), (c, d), (c, e), (c, f ),
(d, d), (d, e), (d, f ),
(e, d), (e, e), (e, f ),
(f , f )} ⊆ X × X
f  is complete and rational.

b
a

a b c d e f 7/17
Ç. Kayı Advanced Microeconomics
Example
I Now consider two more relations:
= {(a, a), (a, b), (a, c), (a, d), (a, e), (a, f ),
(b, b), (b, d), (b, e), (b, f ),
(c, a), (c, b), (c, c), (c, d), (c, e), (c, f ),
(d, d), (d, e), (d, f ),
(e, d), (e, e), (e, f ),
(f , f )} ⊆ X × X

I 0 = \{(a, c).(c, a)}.

I 00 = ∪{(f , a)}.
I 0 is not complete because we have neither a 0 c nor a 0 c.
I 00 is not transitive because we have e 00 f and f 00 a but we do not have
e 00 a.

8/17
Ç. Kayı Advanced Microeconomics
Properties of Preference Relations
I A preference relation  is reflexive if for each x ∈ X, we have x  x.

I A preference relation  is irreflexive if for each x ∈ X, we do not have x  x.

I A preference relation  is symmetric if for each x, y ∈ X, x  y implies y  x.

I A preference relation  is asymmetric if for each x, y ∈ X with x 6= y, x  y

implies not y  x.

Example: , 0 , 00 are reflexive.

I 000 = \{(f , f )} is not reflexive because (f , f ) ∈
/ 000 .
I , 0 , 00 are asymmetric because in each case we have (a, d) but not (d, a).

9/17
Ç. Kayı Advanced Microeconomics
Properties of Preference Relations
Proposition: (i) If  is rational, then  is irreflexive and transitive.
(ii) If  is rational, then ∼ is reflexive, transitive, and symmetric.
(iii) If  is rational, then x  y  z implies x  z.
Proof: (i) Since  is rational, it is complete. Then, for each x ∈ X, x  x.
Hence, there is no x ∈ X such that x  x, i.e., x  x and not x  x. Hence.  is
irreflexive.
Let x, y, and z ∈ X. Suppose that x  y and y  z. Then, we have x  y and
not y  x, and y  z and not z  y. Since  is rational, it is transitive. Then,
we have x  z.
Next, we need to show that we do not have z  x. Assume on the contrary that
we have z  x. We also have x  y. Since  is transitive, we have z  y which
is a contradiction. Hence, we cannot have z  x.
Then, we have x  z. Hence,  is transitive.

10/17
Ç. Kayı Advanced Microeconomics
Issues with transitivity
I Kahneman and Tversky’s (1984) framing problem about transitivity:
I Imagine that you are about to purchase a stereo for 125 dollars and a calculator
for 15 dollars. The salesman tells you that the calculator is on sale for 5 dollars
less at the other branch of the store, located 20 minutes away. The stereo is the
same price there. Would you make the trip?
I It seems that the fraction of respondents saying that they would travel to the
other store for 5 dollars discount is much more higher than the fraction who
say they would travel when the questions is changed so that 5 dollar saving is
on the stereo.
I Now, consider the following situation, because of a stockout, you must travel to
the other store to get the two items and you will receive 5 dollars off on either
item as compensation. Do you care on which item this 5 dollar rebate is given?
I x = Travel to the other store and get 5$ discount on calculator.
y = Travel to the other store and get 5$ discount on stereo.
z = Buy both items in the first store.
I Given the responses from the first two choices, we have x  z and z  y, but
the last choice reveals x ∼ y. This is contrary to the transitivity.
11/17
Ç. Kayı Advanced Microeconomics
Issues with transitivity
I Majority voting: A household formed by Mom, Dad, and Child makes
decisions by majority voting about three alternatives X = {a, b, c}. Each
individual has rational preferences over X.
The preference relations are given below:

Mom Dad Child

a b c
b c a
c a b
I Imagine three majority-rule votes over each pair: a vs b, b vs c, and a vs c.
I a vs b ⇒ a  b.
I b vs c ⇒ b  c.
I a vs c ⇒ c  a.
I The household’s preference relation  is not transitive since a  b  c  a.
I This is known as Condorcet Paradox and we will discuss this in Social Choice.

12/17
Ç. Kayı Advanced Microeconomics
Utility
I A utility function is a mathematical representation of a preference relation.
I A function u : X → R is a utility function representing the preference relation
 if for each x, y ∈ X,
x  y ⇔ u(x) ≥ u(y).
I Note that the utility function representing the preference relation  is not
unique.
I Let f be a strictly increasing function such that f : R → R.
Consider for each x ∈ X, v(x) = f (u(x)). For each x, y ∈ X, u(x) ≥ u(y) ⇔
v(x) ≥ v(y) ⇔ x  y. Hence, v also represents .

13/17
Ç. Kayı Advanced Microeconomics
Utility
I Preference relations are ordinal, i.e., only the ranking matters since preference
relations are invariant for any monotonic transformation.
I Cardinal properties are not preserved under such transformation.
Proposition: A preference relation  is represented by a utility function only
if it is rational.
[If  is represented by a utility function, then it is rational.]
Proof: Let  is represented by u. We want to show that  is complete and
transitive. Let x and y ∈ X. Consider u(x) and u(y) ∈ R. Since ≥ is a complete
relation over R. Then, we have u(x) ≥ u(y) or u(y) ≥ u(x). Since u
representes , we have x  y or y  x. Hence,  is complete.
Let x, y, and z ∈ X such that x  y and y  z. Since  is represented by u, we
have u(x) ≥ u(y) and u(y) ≥ u(z). Since ≥ is a transitive relation over R, we
have u(x) ≥ u(z). Then, x  z. Hence,  is transitive. Therefore,  is
rational.

14/17
Ç. Kayı Advanced Microeconomics
Utility
I Can any rational preference relation be represented by some utility function?
I The answer is NO! To see an example, wait until lexicographic preference
relations.
Proposition: If X is finite and  is rational, then  can be represented by a
utility function.
Lemma: Let X be non-empty and finite and  be a rational preference
relation over X. Then,  has a minimum element, i.e., there is x ∈ X such that
for each y ∈ X, x  y.
Proof:
The proof is by induction on the number of the elements of X.
Basis step: |X| = 1. Since  is complete, x  x. Then, x is the minimum.
Induction step: Suppose that the statement is true for |X| = k.
Suppose |X| = k + 1. Let x ∈ X. Since |X\{x}| = k, there is a minimum y in
X\{x}. Since  is complete, x  y or y  x. If x  y, then y is a minimum of
X.If y  x, then by transitivity, for each z ∈ X\{x}, z  y and y  x, we have
z  x.By completeness, x  x. Then, x is a minimum.
15/17
Ç. Kayı Advanced Microeconomics
Utility
Proposition: If X is finite and  is rational, then  can be represented by a
utility function.
Proof: Let M1 be non-empty set of minimums of X. For each x ∈ M1 , let
u(x) = 1. If M1 = X, then we are done.
If not, then let M2 be the non-empty set of minimums of X\M1 . For each
x ∈ M2 , let u(x) = 2. If M1 ∪ M2 = X, then we are done. If not, we continue in
the same way.
In general, for each integer k, define Mk+1 as the non-empty set of minimums
of X\(M1 ∪ M2 ∪ ... ∪ Mk ). For each x ∈ Mk+1 , let u(x) = k + 1.
Finally, we need show that u represents . Let x, y ∈ X such that x  y.
If x  y, then x ∈ X\(M1 ∪ M2 ∪ ... ∪ Mu(y) ). Then, u(x) > u(y).
If x ∼ y, then there is k ∈ N such that {x, y} ⊆ Mk . Then, u(x) = u(y) = k.
Hence, u(x) ≥ u(y). Therefore, u represents .

16/17
Ç. Kayı Advanced Microeconomics
Properties of Preference Relations
I

17/17
Ç. Kayı Advanced Microeconomics