ECON1268

Price Theory
Lecture 1 – Preferences
 Topics for today’s lecture…
1. Choices in economics

2. Rationality and preferences

3. Social choice

4. The limitations of social choice

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Choices in economics

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How would you spend your Saturday night?

Imagine that you have to choose what to do with your

Saturday night. You have three options, but you can only
choose one:

• Attend a football match.

• Watch a movie at the cinema.

• Review your Price Theory notes at home. 4

 Definition: Preferences
A description of how a decision-maker would rank (compare
the desirability of) any two alternatives, assuming the
alternatives are available to the decision-maker at no cost.

In economics we regard preferences as being innate to each

individual. Everyone is different, and no two people share
identical preferences.
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 Ranking two alternatives
•   are three ways in which you can rank a pair of
There
alternatives. Consider, for example, the alternatives ‘attend a
football match’ and ‘watch a movie at the cinema’:
• It may be that you prefer the ‘football match’ over the
‘cinema’. (Written: football match cinema)

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• Or, it may be that you prefer the ‘cinema’ over the and the
‘football match’. (Written: football match < cinema)
• Finally, you may be indifferent between ‘football match’ and
‘cinema’ (Written: football match ∼ cinema)

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 Definition: Revealed preferences
•The
  preferences a decision-maker reveals through the
choices she/he makes.

If you choose option A when option B is available, you reveal

that your ranking of the two alternatives is either A B or A ∼
B.

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 Definition: Stated preferences
The preference a decision-maker reports when asked about
real situations they might encounter.

Economists tend to regard revealed preferences as being

more reliable than stated preferences because revealed
preferences are derived from actions that affect the welfare of
the decision-maker.
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Your preferences depend on your circumstances

In what way would your answers to the following questions

depend on your circumstances?

• “Would you like an aspirin?”

• “Would you prefer a hot drink or a cold drink?”

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 Your preferences change over time

Have your answers to the following questions changed over time?

• “Would you prefer to play on the swings, or

drink a cup of coffee at a cafe?”

• “Do you prefer to get your news from television, news websites,
or social media?

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Rationality and preferences

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 Definition: Rational preferences
A decision-maker’s preferences are rational if they are
complete and transitive.

If a decision-maker’s preferences are not rational, she/he may

encounter a situation in which she/he cannot make a choice
from amongst the available alternatives.

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 Complete preferences
•A decision-maker’s
  preferences are complete if she/he can
rank every pair of alternatives. That is to say, for any two
alternatives A and B either,

• A B, or,

• B A, or,

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 Complete preferences (cont’d)
• A ∼ B.

Note: The inability to rank two alternatives is not the same as

being indifferent between the two alternatives.

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 Transitive preferences
•A decision-maker’s
  preferences are transitive if the rankings
are consistent in the following sense: For any three
alternatives A, B and C,

• if A B,

• and B C,

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 Transitive preferences (cont’d)
•  then A C.

If a decision-maker’s preferences are not transitive, then

there must exist cycles within the preferences.

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 Cycles
•A cycle
  exists in an individual’s preferences whenever there
are three alternatives A, B and C such that:

• A B,

• B C,

• C A.

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 Cycles (cont’d)
Faced with a choice between A, B and C, the decision-maker
will be unable to settle on an alternative.

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 Money pumps
Suppose this individual starts with alternative A.

The decision-maker would be happy to swap C for A, and

may be willing to pay a small amount to do so.

But the decision-maker is then willing to swap B for C.

And then A for B.

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 Money pumps (cont’d)
Leaving the individual back where she/he started, but with
less money.

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 Quiz 1
•Suppose
  that Harry is deciding what to do on his holiday.
Harry can choose between going skiing, taking a cruise, and
a holiday at the beach. Harry’s preferences over the three
alternatives are:

skiing cruise, and cruise beach.

These preferences are,

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 Quiz 1 (cont’d)
(a) both complete and transitive.

(b) complete but NOT transitive.

(c) transitive but NOT complete.

(d) NEITHER complete nor transitive.

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How many rankings are necessary to complete
preferences?

A
A
4 alternatives B C

A
B C
D E
B C
3 alternatives 5 alternatives

D
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 Quiz 2
•Suppose
  that Harry is deciding what to do on his holiday.
Harry can choose between going skiing, taking a cruise, and
a holiday at the beach. Harry's preferences over the three
alternatives are:

skiing cruise, beach cruise, and beach skiing.

These preferences are,

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 Quiz 2 (cont’d)
a) both complete and transitive.

b) complete but NOT transitive.

c) transitive but NOT complete.

d) NEITHER complete nor transitive.

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 Quiz 3
•Suppose
  that Harry is deciding what to do on his holiday.
Harry can choose between going skiing, taking a cruise, and
a holiday at the beach. Harry's preferences over the three
alternatives are:

skiing cruise; cruise beach and skiing ~ beach.

These preferences are,

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 Quiz 3 (cont’d)
a) both complete and transitive.

b) complete but NOT transitive.

c) transitive but NOT complete.

d) NEITHER complete nor transitive.

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 Using preferences to order alternatives

•If preferences
  are rational, then the alternatives can be
ordered from most-preferred (best), to least-preferred
(worst).

Example 1: Complete and transitive preferences.

B C; B A; and C A

In example 1, B is the most-preferred alternative, and A is the

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 Using preferences to order alternatives (cont’d)

least-preferred.

Example 1 (Transitive)

• B Best

C
•

A
• Worst
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Using preferences to order alternatives (cont’d)

•If preferences
  are not complete and transitive, then it is not
possible to order the alternatives.

Example 2: Complete, non-transitive preferences.

A B, B C and A ~ C.

In example 2, the alternatives cannot be ordered because C

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Using preferences to order alternatives (cont’d)

should both lie below B, and at the same level as A.

Example 2 (Non-Transitive)
A C

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 Exercise: Rational preferences
Using your stated preferences over the alternatives `football
match', `cinema' and `revise', that you provided earlier in this
lecture:
1. Confirm that your preferences are complete.

2. Determine whether your preferences are transitive.

3. What is your most preferred (best) alternative(s)?

4. What is your least preferred (worst) alternative(s)?

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Social choice

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 Equity versus efficiency
One of the fundamental trade-offs facing society, is the trade-
off between equity and efficiency.

• If a society is equitable, then economic wellbeing is evenly

distributed amongst its citizens.

• If a society is efficient, then it is maximising the production

of goods and services given its scarce resources.
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 Equity versus efficiency (cont’d)
Policies that increase equity (reduce inequality) tend to
reduce economic efficiency. By redistributing income (or
wealth) from rich to poor, they typically reduce the incentive
for hard work.

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Visualising the equity-efficiency trade-off

Each point on this line represents

one possible social policy
(equity-efficiency trade-off).

More equitable More efficient

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 Single-peaked preferences
Each individual in society has preferences over the range of
alternative policies. We say that an individual's preferences
are single peaked if:

• The individual's preferences are rational (complete and

transitive).

• The individual has a single, most-preferred policy.

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 Single-peaked preferences (cont’d)
• If two alternative policies lie on the same side of the most-
preferred policy, the individual prefers the policy closest to
the most-preferred policy.

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 Quiz 4
Suppose that Sarah has single-peaked preferences over
alternative policies, and that Sarah's most preferred policy is
policy A. Sarah's preferences over the policies B and C are:

(a) B > C.

(b) C > B.

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 Quiz 4 (cont’d)
(c) B ~ C.

(d) Cannot be determined.

C B A

More equitable More efficient

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 Quiz 5
Suppose that Sarah has single-peaked preferences over
alternative policies, and that Sarah's most preferred policy is
policy A. Sarah's preferences over the policies B and C are:

(a) B > C.

(b) C > B.

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 Quiz 5 (cont’d)
(c) B > C.

(d) Cannot be determined.

C A B

More equitable More efficient

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 Definition: Social preferences
Preferences over policy alternatives that affect society as a
whole; constructed by aggregating the preferences of the
individuals within society.

Social preferences are not an innate characteristic of a

society. Rather, they are a product of the method used to
aggregate individual preferences.
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 Majority voting
Policy A defeats policy B in majority voting if more citizens
prefer A over B, than prefer B over A. (The vote is a tie if
equal number of citizens prefer each policy.)

Majority voting can be used to construct social preferences as

follows:

• Policy A is socially preferred to policy B, if A defeats B in

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 Majority voting (cont’d)
majority voting.

• Policy B is socially preferred to policy A, if B defeats A in

majority voting.

• There is social indifference between policies A and B, if A

and B are tied in majority voting.

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 Majority voting (cont’d)
A policy that defeats every other policy in majority voting is
called the Condorcet winner. A Condorcet winner is the
socially most-preferred policy.

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Majority voting and social preferences

The social preferences derived from majority voting have the

following properties:

• The social preferences are complete.

• The social preferences have the Pareto property: If every

individual in society prefers policy A over policy B, then A is
socially preferred to B.
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Majority voting and social preferences (cont’d)

• The social preferences give equal weight to every

individual in society.

• The method for generating the social preferences is not

biased towards a particular alternative. (e.g. There is no
bias towards the status quo.)

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 Definition: Median voter theorem
A theorem that states: When all individuals in society have
single peaked preferences over policy alternatives, the
Condercet winner will be the most-preferred policy of the
median voter.

The median voter theorem is particularly powerful because it

requires only that we know each individual's most preferred
policy. 50
Finding the Condorcet winner
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7

8 29 34

9 13 25 30 35 39
5 10 14 22 26 31 36 40 43

4 11 15 17 20 23 27 32 37 41 44 46

1 2 3 12 16 18 19 21 24\ 28 33 38 42 45 47

More equitable Median voter More efficient

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 Implications of the median voter theorem

Political parties spend a great deal of effort and resources to

identify the median voter, and determine what policies they
prefer.

The median voter theorem helps explain why competing

political parties, with different ideologies, often propose very
similar policies.
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Implications of the median voter theorem (cont’d)

The median voter theorem can also help explain why people
who have a strong preference for either equity or efficiency,
tend to feel marginalised by political debates.

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The limitations of social choice

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A three-cornered contest
Three political parties compete in an
Election
• The Green party is socially
progressive and prefers equity.
• The Blue party is socially
conservative and prefers
efficiency.
• The Red party is socially
progressive and prefers a
balance between equity and
efficiency. 55
A three-cornered contest (cont’d)
 Three voters have the following
rational preferences over political
parties.
• Tony's preferences are: B G, B
R and R G.
• Tanya's preferences are: R G, R
B and G B.
• Sarah's preferences are: G B, G
R and B R.

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Red versus Blue

The Blue party defeats the Red party.

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Red versus Blue (cont’d)

The Green party defeats the Blue party.

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Red versus Blue (cont’d)

The Red party defeats the Green party.

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 The Condorcet paradox
If we use the results of the majority voting to construct social
preferences, we get,

• Blue is socially preferred to Red,

• Red is socially preferred to Green, and,

• Green is socially preferred to Blue.

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 The Condorcet paradox (cont’d)
Even though each individual's preferences are rational, the
social preferences produced through majority voting are not
transitive (they contain a cycle).

The Condorcet paradox is possible in any situation where

the preferences of individual voters are not single peaked.

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Thinking about social preferences another way . . .

Instead of starting with a method, and investigating what

properties the resulting social preferences possess, we could
start with a list of desirable properties and use these to design
an appropriate method.

Economists tend to agree that the following properties are

desirable:
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Thinking about social preferences another way . . .
(cont’d)

• Rationality.

• The Pareto property.

• Independence from irrelevant alternatives.

Independence from irrelevant alternatives requires that the

social ranking of two alternatives is only affected by the way
in which individuals rank the two alternatives. 63
 Definition: Arrow's impossibility theorem

A theorem that states: In general, the only method for constructing

social preferences that are rational, have the Pareto property, and
are independent of irrelevant alternatives, is dictatorial.

A dictatorial mechanism selects one individual in society, and

dictates that social preferences match her/his preferences.

Any individual selected in this way is called a dictator.

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Implications of Arrow's impossibility theorem

The theorem shows us that any form of collective decision-

making is unlikely to have the coherence of individual
decision-making.

• This is important to keep in mind during your studies: It is

common for us to treat firms, governments and nations, as
individual decision-makers.
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Implications of Arrow's impossibility theorem (cont’d)

The theorem illustrates the importance of institutional

structures: For example, the choice of voting system can,
sometimes, determine the outcome of a vote.

The theorem warns us to be aware of the hidden assumptions

in any empirical research that aggregates the preferences of
many individuals.
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Implications of Arrow's impossibility theorem (cont’d)

A warning: The theorem should not be interpreted as stating

that democracy is impossible, or advocating for dictatorship.

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Questions?

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 Key concepts from today's lecture
You can use these concepts (as search terms) to conduct
further research into the topics covered in today's lecture:

• Preferences

• Rationality

• Completeness

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 Key concepts from today's lecture (cont’d)

• Transitivity

• Cycles

• Ordering alternatives

• Social preferences

• Single peaked preferences

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Key concepts from today's lecture (cont’d)

• Majority voting

• Median voter theorem

• Condorcet paradox

• Arrow's impossibility theorem

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