Tastes and Indifference Curves

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1 Chapter 4 Tastes and Indifference Curves Individuals try to do the best they can given their circumstances. 1 This was our starting point when we introduced the topic of microeconomics in Chapter 1, and we have devoted the intervening chapters to the question of how to model individual circumstances what we called choice or budget sets. Choice sets do not tell us what individuals will do only all the possible actions they could take. Put differently, knowing what our choice sets are is a necessary first step to finding what choices are best but it is not sufficient. To determine what an individual will actually do when presented with a given choice set, we need to know more about the individual and about his or her tastes. This is tricky both because tastes differ enormously across people and because they are difficult to observe. I hate peanut butter but my wife loves it, and she hates fish which I cannot get enough of. Clearly we will make very different choices when faced with exactly the same choice set over fish and peanut butter, but it is difficult for an economist to look at us and know how much we like different goods without observing our behavior under different circumstances. 2 The good news is that there are some regularities in tastes that we can reasonably assume are shared across most people, and these regularities will lead us to be able to make predictions about behavior that will be independent of what exact tastes an individual has. Furthermore, economists have developed ways of observing choices that individuals make and then inferring from these choices what kinds of tastes they have. We will therefore be able to say a great deal about behavior and how behavior changes as different aspects of an economy change. First, however, we have to get comfortable with what it is that economists mean when we talk about tastes. 4A The Economic Model of Tastes In the previous two chapters, we described a choice set as a subset of all possible combinations of goods and services the subset that is affordable given an individual s particular circumstances. In our example of me going to Wal-Mart to buy shirts and pants, for instance, we used the information we had on the money I had available and the prices for shirts and pants to delineate the budget line in the larger space of all combinations of shirts and pants. While I was unable to afford bundles of 1 No prior chapter required as background for this chapter. 2 OK maybe I eat so much fish that I smell a lot like fish but we probably don t want to build a model about tastes by smelling people.

2 82 Chapter 4. Tastes and Indifference Curves shirts and pants outside the choice set, I may nevertheless dream about bundles outside that set or put differently, I may nevertheless have tastes for bundles outside the choice set. For instance, I get deeply annoyed at the crammed conditions on commercial airplanes and have long dreamed of getting myself a private plane modeled after Air Force 1. Unless Oprah invites me on her show and then tells everyone to buy this textbook, I doubt I will ever be in a position to really be able to afford such a plane and will thus be confined to commercial airlines for the rest of my life. Still, one can dream. Tastes are therefore defined not only over bundles of goods that fall in our choice sets but also over bundles that we may never be able to attain. 4A.1 Two Fundamental Rationality Assumptions about Tastes While individuals differ widely in how they would rank different bundles of goods, we will argue in this section that there are two basic properties of tastes that must be satisfied in order for us to be able to analyze rational choice behavior. There is some controversy within the broader social sciences regarding these basic properties, but they are nevertheless quite fundamental to much of what we will have to say in the rest of this book. 4A.1.1 Complete Tastes First, economists assume that individuals are able to compare any two bundles to one another and this represents our most fundamental assumption about tastes. Put precisely, we assume that economic agents whether they are workers, consumers or financial planners are able to look at any two choice bundles and tell us which they prefer or whether they are indifferent between them. When an economic agent can do this, we say that she has complete tastes (or preferences) complete in the sense that the agent is always able to make comparisons between bundles. A statement such as one recently uttered by my wife in a clothing store It is impossible for me to compare these two outfits because they are so different moves economists like me to despair because they directly violate this assumption of complete preferences. We suspect that such statements are rarely true human beings indeed do seem to have the ability to make comparisons when confronted with options. 4A.1.2 Transitive Tastes A second fundamental assumption economists make about tastes is that there is an internal consistency to tastes that makes choosing a best bundle possible. Consider, for instance, bundles A, B and C each containing different quantities of pants and shirts. If tastes are complete, I should be able to compare any two of these bundles and tell you which I prefer (or whether I am indifferent). But suppose that I tell you that I like A better than B, that I like B better than C and that I like C better than A. Although my tastes may be complete I could after all compare each set of two bundles and tell you which is better there is no best alternative. You could present me with a sequence of choices, first A and B, then B and C, then C and A, etc., and we could forever cycle between the three alternatives, never finding one that is best of all (or at least not worse than any other bundle.) To rule out this possibility and thus form the foundations of a model of choice, we assume the following: Whenever an individual likes A at least as much as B and B at least as much as C, it must be the case that she also likes A at least as much as C. 3 When this holds for 3 Similarly, when the individual likes A strictly more than B and B strictly more than C, it must be the case that the individual likes A strictly more than C.

3 4A. The Economic Model of Tastes 83 all consumption bundles, we say that a person s tastes are transitive. To be honest, it is not clear that people s tastes are indeed always transitive. A friend of mine told me of his experience at a car dealership where he ordered a new car to be custom made. The sales person started with a stripped down version of the car model he had selected and then offered various special features. For instance, he would offer a choice as to whether to put a CD player into the car for an additional $300, or air conditioning for an additional $1,000, etc. Each time, my friend found himself agreeing to the additional feature. At the end, however, he saw the price tag of the car with all the features and decided he liked the stripped down version better. This certainly seems like a violation of transitivity, although I suspect that my friend in the end had simply not thought carefully along the way whether the various features were really worth the decrease in his other consumption that they implied. After all, in the end he did make a decision. 4 Nevertheless, psychologists have sometimes been critical of the economist s transitivity assumption based on experiments in which people seemed to violate the assumption. Economists, however, continue to find the assumption useful in the sense that it permits us to make predictions about people s choice behavior, predictions that seem consistent with the data most of the time (even if there are instances, such as my friend s initial behavior in the car dealership, when the assumption might appear to be violated, at least briefly.) 4A.1.3 Rational Tastes When an economic agent s tastes satisfy both completeness and transitivity, we will say that the individual has rational tastes or preferences. The term rational here does not imply any grand philosophical value judgements. Individuals might have tastes that most of us would consider entirely self-destructive (and irrational, as the term is commonly used), but such individuals might still be able to compare any pair of alternatives and always choose the best one (or one where none of the other alternatives is worse). In that case, we could refer to such individuals as rational when we speak as economists although we may turn around and call them fools behind their backs when we step outside our role as economists. To the economist, rationality simply means the ability to make choices, and economic agents whose tastes violate the two rationality assumptions are incapable of making choices when faced with some types of choice sets. 4A.2 Three More Assumptions While much of what economists have modeled depends critically only on the validity of the two rationality assumptions discussed above, some additional assumptions about tastes can simplify our models while remaining true to most real world applications. One such additional assumption is that, for most goods, more is better than less (or, in some instances, more is no worse than less ). A second additional assumption is that averages are better than extremes (or, in some instances, averages are no worse than extremes ). Finally, we often assume that there are no sudden jumps in tastes that happiness changes gradually as the basket of goods we consume changes only slightly. Below we will explain in more detail what exactly we mean by each of these, and in Section 4A.3 it will become clear how these assumptions simplify our models of tastes in a way that makes our models workable. 4 All right, I ll confess: The friend at the car dealership was actually me and it took my wife, a non-economist, to point out the apparent evidence of an intransitivity in my tastes!

4 84 Chapter 4. Tastes and Indifference Curves 4A.2.1 More is Better, or at least not Worse (Monotonicity) In most economic applications, we are interested in situations where individuals make choices involving aspects of life that involve scarcity whether this involves current consumption, future consumption or leisure. If individuals did not in fact think more is better in such choices, scarcity would not be a problem. Everyone would simply be content with what he or she has, and there would be little need for economics as a discipline. The idea of a world in which individuals are just happy with what they have is appealing to many of us but it is not the world we actually occupy. For better or worse, we always seem to want more, and our choices are often aimed at getting more. The economist s recognition of this is not an endorsement of a philosophy of life focused on materialism or consumerism rather it is a simple starting point for better understanding human behavior in a world characterized by scarcity. If an individual has tastes for goods such that more is better (or at least that more is not worse ), we will sometimes call such tastes monotonic, or we will say that such tastes satisfy the monotonicity assumption. Consider the five bundles of pants and shirts depicted in Graph 4.1. The monotonicity assumption allows us to conclude that E must be better than C because E contains more pants and shirts than C. In cases where we compare two bundles that are the same in terms of one of the goods but differ in terms of the other, we will interpret more is better as meaning more is at least as good. For instance, bundle C contains just as many shirts as D but it also contains more pants. Thus, more is better implies that C is at least as good as D. But the more is better assumption does not make it clear how A and C relate to each other because neither contains clearly more A has more shirts than C but C has more pants than A. Similarly, the assumption does not clarify how the pairs A and B, C and B or B and D are ranked. Graph 4.1: Ranking Consumption Bundles Exercise 4A.1 Do we know from the monotonicity assumption how E relates to D, A and B? Do we know how A relates to D? It is worth noting at this point that monotonicity may hold even in cases where it seems at first glance that it does not hold if we conceptualize the model appropriately. For instance, we might think that we would prefer less work over more and thus cite labor as a good that violates the more is better assumption. But we could equivalently model our choices over how much labor to provide as a choice of how much leisure we choose not to consume (as we did when

5 4A. The Economic Model of Tastes 85 we constructed choice sets for workers in Chapter 3). By re-conceptualizing labor as the amount of leisure we do not consume, we have redefined the choice as one between leisure and consumption rather than between labor and consumption and leisure is certainly a good that we would like to have more of rather than less. Similarly, consider someone who does not like more consumption beyond some basic subsistence level. For such a person, more consumption may not be better than less. At the same time, such an individual might care about the wellbeing of others whose consumption has not reached subsistence levels. The economic scarcity problem faced by such a person then involves choices over what to do with money in excess of his own subsistence needs perhaps what charitable causes to support. Once the problem has been re-conceptualized in this way, more (charity) is once again better than less. Thus, in many cases we can re-conceptualize a choice involving goods we would prefer to have fewer of as a choice involving goods that satisfy the more is better assumption. Exercise 4A.2 What other goods are such that we would prefer to have fewer of them rather than many? How can we re-conceptualize choices over such goods so that it becomes reasonable to assume more is better? 4A.2.2 Averages are better than Extremes, or at least no Worse (Convexity) While it may be obvious that the very nature of economic problems arises from the reality that people believe more is better than less, it is less obvious what we mean by averages are better than extremes or why this should be an assumption that is at all reasonable. Consider, for instance, two baskets of goods: the first contains 9 apples and 1 orange while the second contains 9 oranges and 1 apple. If we mixed the two baskets together and then divided them into two identical average baskets, we would get baskets with 5 apples and 5 oranges. It certainly seems plausible that this average basket might be preferred to the more extreme baskets we started with, but one could imagine someone who really likes apples and only sort of likes oranges preferring the more extreme basket with 9 apples. Thankfully, the economist s assumption that averages are better than extremes when properly defined does not actually rule out this scenario. Rather, it gives expression to a general tendency by human beings to like variety in consumption choices. Let s begin by stating what we mean more precisely. We will say that your tastes satisfy the assumption that averages are better than extremes whenever it is the case that the average between two baskets that you are indifferent between is at least as good as the original two baskets. Thus, if you are indifferent between the 9 apples/1 orange basket and the 9 oranges/1 apple basket, then you would be willing to trade either of these extreme baskets for a basket with 5 apples and 5 oranges. If someone really likes apples and only sort of likes oranges, he would of course not be indifferent between the two extreme baskets. But if you are indifferent between the more extreme baskets, it is reasonable to assume that you would be willing to give up some of the good that you have a lot of for some of the good that you have only a little of and that you would therefore prefer the 5 apples/5 oranges basket or at least not mind taking such a basket instead of one of the extremes. This assumption of averages being better than extremes is often called the convexity assumption, and tastes that satisfy it are referred to as convex tastes. Consider again the five bundles graphed in Graph 4.1. There is nothing immediate the convexity assumption allows us to say in addition to what we could conclude from applying the monotonicity assumption in the previous section. However, suppose we find out that I am indifferent between bundles A and B. Then the convexity assumption lets us know that I would be at least as happy with an average between A and B. Bundle C is just that it contains 5 shirts and 6 pants, which

6 86 Chapter 4. Tastes and Indifference Curves is exactly half of bundles A and B added together. (Note that such an average bundle lies halfway between the more extreme bundles on the line segment connecting those bundles). Thus, convexity implies that C is at least as good as A and B. Exercise 4A.3 Combining the convexity and monotonicity assumptions, can you now conclude something about the relationship between the pairs E and A and E and B if you do not know how A and B are related? What if you know that I am indifferent between A and B? Exercise 4A.4 Knowing that I am indifferent between A and B, can you now conclude something about how B and D are ranked by me? In order to reach this conclusion, do you have to invoke the convexity assumption? In essence, the averages are better than extremes or convexity assumption gives expression to the general human tendency to seek diversity in consumption. No matter how much we like steak, few of us sit down to a meal of only steak or only salad, only potatoes, only coffee, only dessert, or only wine. We might in fact be able to create all sorts of single-item meals that we are indifferent between a certain quantity of steak, a certain quantity of salad, a certain quantity of potatoes, etc.; but most of us would prefer a meal with some of each of these an average of single-item meals. The meal here is of course just an analogy that we don t want to push too far certain sets of single-item meals (perhaps pancakes and caviar) would, after all, not average well into one meal. Over the course of a week, however, even single-item meals that we may not want to mix in one meal might create welcome variety. Similarly, I may be indifferent between a basket containing 10 blue shirts with matched pants and another containing 10 red shirts with matched pants. My wife would not let me leave the house with mismatched clothes so she would never let me mix one of the red shirts with one of the pants that matches only blue shirts. But, unless I like wearing the same outfit every day, I probably would prefer to have 5 of each the average of the more extreme baskets and then alternate which matched pair I wear on any given day. These analogies give a sense of what it is that we mean intuitively when we say that often, averages in life are indeed better than extremes. In more life-changing decisions, the same seems to be true. Suppose I am indifferent between, on the one hand, consuming $100,000 a year before retirement and living in poverty afterwards and, on the other hand living in poverty now and consuming $150,000 a year after retirement. It seems reasonable that most of us would prefer an average between these scenarios one that permits us a comfortable standard of living both before and after retirement. Or suppose that I am equally happy consuming a lot while working almost all the time and consuming very little while working very little. Most of us probably would prefer an average between these two bundles work without becoming a workaholic and consume less than we could if we did work all the time. 4A.2.3 No Sudden Jumps (or Continuity) Finally, we will usually assume that a consumer s happiness does not change dramatically if the basket she consumes changes only slightly. Perhaps you are currently enjoying a nice cup of coffee so that you can stay awake as you read this chapter. If you you like milk in your coffee, our no sudden jumps assumption implies that you will become neither dramatically better off nor dramatically worse off if I add one more drop of milk to the coffee. Starting out with coffee that is black, you may become gradually happier as I add milk and, at some point, gradually worse off as even more milk is added 5 but you will never switch from agony to ecstasy from just one more drop. Tastes 5 Note that in this example, your tastes violate the more is better assumption if it is indeed the case that you become worse off as I add milk at some stage. Of course this is true only when the situation is viewed very narrowly

7 4A. The Economic Model of Tastes 87 that satisfy this assumptions are often called continuous, and the no sudden jumps assumption is referred to as the continuity assumption. The continuity assumption is most appealing for goods that can easily be divided into smaller and smaller units (such as milk) and less appealing for goods that come in very discrete units (such as, perhaps, pants and shirts, or larger goods like cars). For purposes of our models, however, we will treat these other types of goods just as we treat milk we will assume that you can in fact consume fractions of pants and shirts and cars. We do this not because it is realistic but rather because it simplifies our models in ways that ultimately are not all that critical for any of the analysis we will do with our models. If, for instance, we conclude from our analysis that a 10% drop in the price of pants will result in an increase of your consumption of pants by 3.2, we can simply round this off and know that you will probably end up buying three more pants. Furthermore, in cases where the assumption of continuity becomes particularly problematic, there are often other ways of modeling the behavior such that the assumption once again is reasonable. For instance, we might think of cars or houses as very discrete units it is, after all, not easy to consume three quarters of a car or house. At the same time, we could model cars as bundled goods goods that provide you with varying degrees of speed, safety, comfort, etc. What you are really trying to buy is not a car but rather speed, safety and comfort on the road, and your tastes over these attributes are probably quite immune to sudden jumps. Similarly, in the case of housing, we can think of your choice as one involving square footage, the age of the house, the quality of the neighborhood, features of the floorplan, etc. and once again it is likely that your tastes over these attributes of housing are not subject to sudden jumps. (We explore this concept of modeling discrete goods as bundles of attributes further in the end-of-chapter exercises 4.9.) 6 4A.3 Graphing Tastes In Chapters 2 and 3 we found ways of graphically representing the constraints on people s choices or what we called the choice sets from which people can choose given their circumstances. Armed with the assumptions introduced above, we will now do the same for people s tastes before demonstrating in Chapter 6 how tastes and constraints combine to result in human behavior we can then observe. More precisely, we will find that it is impossible to graph fully the tastes of any individual, but we will develop ways of graphing the particular portions of individual tastes that are most relevant for the choices that confront individuals at different times. 4A.3.1 An Indifference Curve The basic building block of our graphs of tastes is what we will call an indifference curve. Suppose, for instance, that we are back to choosing between pants and shirts, and suppose that I currently have 8 shirts and 4 pants in my shopping basket. This is represented as point A in Graph 4.2a. The indifference curve containing point A is defined as the set of all other consumption bundles (i.e. the set of all other pairs of shirts and pants) that would make me exactly as happy as bundle A. While it is difficult to know exactly where such bundles lie, our assumptions about tastes allow us to derive the approximate location of this indifference curve. as one instant in time you would certainly continue to become better off if, instead of adding the additional milk to your coffee, I put it in the refrigerator for later use. 6 The most common example of tastes that violate the continuity assumption is known as lexicographic tastes. An example of such tastes is given in end-of-chapter exercise 4.8.

8 88 Chapter 4. Tastes and Indifference Curves Graph 4.2: Tastes & Indifference Curves We can begin by noting some places that could not possibly contain bundles that lie on the indifference curve which contains bundle A. Consider, for instance, the shaded magenta area to the northeast of A. All bundles in this area contain more pants and more shirts. If more is better, then bundles which contain more pants and shirts must be better than A and thus could not be indifferent to A. Similarly, consider bundles to the southwest of bundle A. All bundles represented by this shaded blue area contain fewer pants and shirts than bundle A and must therefore be worse. Thus, the monotonicity assumption allows us to rule out the shaded areas in Graph 4.2a as bundles that could lie on the indifference curve containing bundle A. Bundles that lie in non-shaded areas, on the other hand, are not ruled out by the monotonicity assumption. Those to the northwest of A, for instance, all have fewer pants but more shirts, while those to the southeast have more pants and fewer shirts than bundle A. You therefore know from the monotonicity assumption that my indifference curve containing bundle A must be downward sloping through bundle A, but you can glean nothing further without knowing more about me. Now suppose that I tell you I am indifferent between the bundles represented by points A (4 pants, 8 shirts) and B (2 shirts, 8 pants) in Graph 4.2b. This means that you of course immediately know that bundle B lies on the indifference curve that contains bundle A. You can also now draw some additional shaded areas (to the northeast and southwest of point B) that you know could not possibly include further indifferent bundles based on the more is better or monotonicity assumption. More importantly, however, you can now employ the averages are better than extremes or convexity assumption to come to some additional conclusions about the shape of the indifference curve that contains bundles A and B. The convexity assumption simply states that, whenever someone is indifferent between two bundles of goods and services, the average bundle (that is created by mixing the two original bundles and dividing them into two equal ones) is judged to be at least as good as the extreme bundles. In our case, the average bundle would be 5 shirts and 6 pants. Graphically, this average bundle is simply the midpoint of the line segment connecting points A and B, labeled C in Graph 4.2b. Now notice that any bundle to the southwest of C has fewer pants and fewer shirts and is thus worse than C. Suppose we start at C and move a little to the southwest by taking just a tiny bit of each good away (assuming for the moment that it is possible to take away bits of shirts and pants).

9 4A. The Economic Model of Tastes 89 Then, given our no sudden jumps or continuity assumption, the new bundle is just a little worse than C. Suppose we keep doing this, each time creating yet another bundle that s just a little worse and moving a little further southwest. If C is strictly better than A (and B), it should be the case that, as we inch our way southwest from C, we at some point hit a bundle F that is indifferent to A and B. Without knowing more about me, you can t tell exactly how far southwest of C the new indifferent point F will lie all we know is that it lies to the southwest. Exercise 4A.5 Illustrate the area in Graph 4.2b in which F must lie keeping in mind the monotonicity assumption. Exercise 4A.6 Suppose our tastes satisfy weak convexity in the sense that averages are just as good (rather than strictly better than) extremes. Where does F lie in relation to C in that case? We now have three bundles between which I am indifferent A, B and F. We could repeat what we just did for the average between A and F and the average between B and F. The intuition that should be emerging already, however, is that the indifference curve containing bundles A and B must not only be downward sloping (because more is better ) but must be continuous (because of no sudden jumps ) and bend toward the origin (because averages are better than extremes ). For someone with tastes like this, all bundles that lie above the indifference curve (in the shaded region) must be better than any of the bundles on the indifference curve because these contain more of everything relative to some bundle that lies on the indifference curve. Similarly, all bundles that lie below this indifference curve (in the non-shaded region) are worse because they contain less of everything compared to some bundle that lies on the indifference curve. 4A.3.2 Marginal Rates of Substitution We have just demonstrated how our five assumptions about tastes result in a particular shape of indifference curves. One way of describing this shape is to say that the slope of indifference curves is negative and becomes smaller in absolute value as one moves to the right in the graph. The slope of the indifference curve at any given point is, however, more than a mere description of what the indifference curve looks like it has real economic content and is called the marginal rate of substitution. Consider, for instance, the slope of 3 at point A in Graph 4.3. This slope tells us that we could go down by 3 shirts and over to the right by 1 pair of pants and end up roughly on the same indifference curve as the one that contains bundle A. 7 Put differently, when I am consuming bundle A, I would be willing to trade in three of my shirts to get one more pair of pants because that would leave me roughly as well off as I currently am. Thus, the slope of the indifference curve at point A gives us an indication of how much I value one more pair of pants in terms of shirts. This marginal rate of substitution is therefore my willingness to trade shirts for one more additional (or marginal) pair of pants given what I am currently consuming. Since the slope of the indifference curve typically changes as one moves along the indifference curve, the marginal rate of substitution or how much value we place on an additional good on the horizontal axis in terms of the good on the vertical axis also changes. Consider, for example, the shallower slope of 1/2 at point B (in Graph 4.3). This slope tells us that I would be willing to give up only half a shirt for one more pair of pants (or 1 shirt for two additional pants) when I am already consuming bundle B. This makes sense given our discussion about the averages are units. 7 We would in fact end up slightly below the indifference curve unless we measured shirts and pants in very small

10 90 Chapter 4. Tastes and Indifference Curves Graph 4.3: Diminishing Marginal Rate of Substitution better than extremes assumption. At bundle A, I had relatively few pants and relatively many shirts and I thus placed a high value on additional pants because that would get me to a less extreme bundle (and keep me from having to wash pants all the time or else run around without pants). At bundle B, on the other hand, I have relatively many pants and few shirts, and thus I would not be willing to give up more shirts very easily given that this would get me to even more extreme bundles (causing me to have to wash shirts all the time or else run around shirtless). In fact, we concluded in the previous section that the shape of the indifference curve pictured in Graph 4.3 is due to the averages are better than extremes assumption. This shape implies that marginal rates of substitution begin as large numbers in absolute value and decline (in absolute value) as we move down an indifference curve. This is known as the concept of diminishing marginal rates of substitution and it arises only when averages are indeed better than extremes. Exercise 4A.7 Suppose extremes are better than averages. What would an indifference curve look like? Would it still imply diminishing marginal rates of substitution? Exercise 4A.8 Suppose averages are just as good as extremes? Would it still imply diminishing marginal rates of substitution? 4A.3.3 Maps of Indifference Curves In deriving our first indifference curve, we defined it with respect to one bundle. Put differently, we mapped out the indifference curve that contains one arbitrarily selected bundle bundle A in Graph 4.2b. But of course we could have begun with some other arbitrary bundle for instance bundle E in Graph 4.4a. Just as there is an indifference curve that runs through bundle A, there is an indifference curve that runs through bundle E. Notice that E lies to the northeast of the highlighted segment of the indifference curve that contains A in Graph 4.4a. This means that E contains more shirts and pants than any of the highlighted bundles, which means that it must be the case that E is better than those bundles (because of our more is better assumption). But this also means that E is better than all bundles on the indifference curve that contains bundle A.

11 4A. The Economic Model of Tastes 91 Graph 4.4: Parallel & Converging Indifference Curves Exercise 4A.9 Show how you can prove the last sentence in the previous paragraph by appealing to the transitivity of tastes. An important logical consequence of this is that the indifference curve that goes through point A can never cross the indifference curve that goes through point E. If the two indifference curves did cross, they would share one point in common. This intersection point would be indifferent to A (because it lies on the indifference curve that contains A), and it would also be indifferent to E (since it lies on the indifference curve that contains E). Since E is preferred to A, transitivity implies that the intersection point cannot be indifferent to both E and A simultaneously. Thus, as long as tastes are rational (i.e. they satisfy completeness and transitivity), indifference curves cannot cross. They can be parallel like those in Graph 4.4a, or they can converge like those in Graph 4.4b, or they can relate to each other in any number of other ways, but they can never touch. Furthermore, if tastes are complete, then some indifference curve runs through every bundle. As we showed earlier, the monotonicity assumption implies that indifference curves will be downward sloping; the convexity and continuity assumptions imply that they will bend toward the origin; and the transitivity assumption implies that no two indifference curves can ever cross. Graph 4.5 then illustrates an example of a whole map of indifference curves that represent the tastes over pants and shirts for one individual whose tastes satisfy the rationality assumptions as well as the three additional assumptions outlined in Section 4A.2. This is, of course, only one possible configuration of an indifference map that satisfies all these assumptions. While the assumptions we have made about tastes result in particular general shapes for indifference curves, we will see in Chapter 5 that there exist many different types of indifference maps (and thus many different tastes) that can be modeled using these assumptions. Finally, in order to indicate that indifference curves to the northeast of Graph 4.5 represent bundles that yield greater happiness than indifference curves to the southwest of the graph, each indifference curve is accompanied by a number which indicates how bundles on that particular curve compare to bundles on other curves. For instance, when we compare bundle A to bundle E, we can read off the number 2 on the indifference curve containing point A and the number 4 on the indifference curve containing point E, and we can infer from this that bundle E is preferred to

12 92 Chapter 4. Tastes and Indifference Curves Graph 4.5: Map of Indifference Curves bundle A. If less is better than more, then the ordering of indifference curves would be reversed. Exercise 4A.10 Suppose less is better than more and averages are better than extremes. Draw three indifference curves (with numerical labels) that would be consistent with this. We cannot, however, infer from these two numbers that bundles on one indifference curve yield twice as much happiness as bundles on the other indifference curve. Happiness is simply not something that is objectively quantifiable. While economists in the past had indeed hoped to measure happiness or utility in units they called utils, modern economists have abandoned any such attempts as misguided. To see just how silly the notion of objectively measuring happiness is, try asking one of your friends the following when you see him or her for the first time after he or she went on a date: So, how many utils did you get out of that date? We can say that all bundles on a particular indifference curve yield the same level of utility (and thus must have the same numerical label), and that different utility numbers associated with different indifference curves tell us which are more preferred and which less. But we could change all the numbers in Graph 4.5 by multiplying them by 2 or dividing them by 5 or adding 13 to them because in each case, the ordering of indifference curves would remain unchanged. Thus, so long as the shape of indifference curves and the ordering of the numbers that accompany the curves are unchanged between two graphs, we will say that the maps of indifference curves in the two graphs represent the same tastes. By changing the numerical labels on indifference curves without changing their order, all we are in effect doing is changing the ruler we use to measure happiness and since there isn t an agreed upon ruler, any ruler that preserves the ordering of indifference curves will do. This becomes somewhat clearer if you think of the following analogy (which we expand on in more detail in part B). Consider a 2-dimensional map of a mountain (such as that depicted in Graph 4.10) a map in which different heights of the mountain are represented by outlines of the shape of the mountain at that height accompanied by a number that indicates the elevation of that outline. In essence, such maps are depictions of horizontal slices of the mountain at different heights drawn on a single 2-dimensional surface. Indifference curves are very much like this. Longitude and

13 4B. Tastes and Utility Functions 93 latitude are replaced by pants and shirts, and the height of the mountain is replaced by the level of happiness. While real-world mountains have peaks, our happiness mountains generally do not have peaks because of our more is better assumption. Indifference curves are then simply horizontal slices of our happiness mountain (such as the one depicted in Graph 4.8), with numbers indicating the height of happiness attained at that slice. And just as the outlines of the different elevations of a real world mountain don t change whether we measure the height of the elevation in feet or meters, the outlines of the slices of our happiness mountain i.e. the indifference curves do not change shapes if we use a different ruler to measure happiness. We will have much more to say in Chapter 5 about how to interpret different types of indifference maps what they imply about whether goods are relatively more complementary or substitutable, how to think of relationship of indifference curves to one another, etc. But first, we develop some of the underlying mathematics of the utility mountains through the concept of utility functions. 4B Tastes and Utility Functions We have shown in Section 4A how certain basic assumptions about our tastes can enable us to generate graphical ways of representing tastes with the tool of indifference curves. As was true for choice sets in Chapters 2 and 3, these graphical tools are mere representations of more general mathematical formulations of the same economic concepts. And the assumptions we introduced in Section 4A.1 and 4A.2 will translate directly into mathematical properties of functions that we can use to represent tastes. 4B.1 Two Fundamental Rationality Assumptions When we speak of bundles or baskets of two goods, we have already defined these as points with two components each representing the quantity of one of the goods in the basket. The point labeled A in Graph 4.1, for instance, can be expressed as (x A 1, xa 2 ) = (4, 8), representing a basket with 4 units of good 1 (pants) and 8 units of good 2 (shirts). In general, we can then express a basket that contains two goods as (x 1, x 2 ) R 2 +, (4.1) where is read as is an element of and R 2 + denotes the set of all points with two non-negative (real number) components. Almost all of our graphs of choice sets consist of some subset of points in R 2 +, as do our graphs of indifference curves in Section 4A. When a larger number of different types of goods is included in a basket shirts, pants and socks, for instance we can further generalize this by simply denoting a basket with n different goods by (x 1, x 2,...,x n ) R n +, (4.2) where R n + now represents the set of all points with n non-negative components. In the case of shirts, pants and socks, n = 3. 8 Tastes, or preferences, involve subjective comparisons of different baskets or different points as denoted in (4.1) and (4.2) above. We will use the following shorthand notation (x A 1, x A 2,...,x A n ) (x B 1, x B 2,..., x B n ) (4.3) 8 You may recall from your math classes that points with such multiple components are referred to as vectors.

14 94 Chapter 4. Tastes and Indifference Curves whenever we want to say that the basket (x A 1, xa 2,..., xa n ) is at least as good as the basket (x B 1, x B 2,..., x B n ). Similarly, we read (x A 1, xa 2,...,xA n ) (xb 1, xb 2,..., xb n ) (4.4) as basket (x A 1, xa 2,..., xa n) is strictly better than basket (x B 1, xb 2,..., xb n ), and we will read (x A 1, x A 2,...,x A n ) (x B 1, x B 2,..., x B n ) (4.5) as a person being indifferent between these two baskets. The objects, and are called binary relations because they relate two points to one another. 4B.1.1 Complete Tastes In Section 4A, we defined tastes as complete whenever a person with those tastes can unequivocally compare any two baskets indicating whether one basket is better than the other or whether she is indifferent between the two baskets. We can now write this definition formally as follows: A person has complete tastes over all baskets with n goods if and only if it is true that for all (x A 1, xa 2,..., xa n ) Rn + and for all (xb 1, xb 2,...,xB n ) Rn +, (x A 1, xa 2,...,xA n ) (xb 1, xb 2,..., xb n ) or (x B 1, xb 2,...,xB n ) (xa 1, xa 2,..., xa n ) or both. (4.6) All that we are saying is that a person can compare any two bundles in R n +. Note that logically it has to be the case that if both of the statements in (4.6) are true for a given set of two bundles, then (x A 1, x A 2,..., x A n) (x B 1, x B 2,...,x B n ). (4.7) Exercise 4B.1 True or False: If only one of the statements in (4.6) is true for a given set of bundles, then that statement s can be replaced by. 4B.1.2 Transitive Tastes While we certainly need tastes in our models to be complete in order for individuals within the models to be able to make choices, we argued in Section 4A that this is not enough: in order for an individual to be able to settle on a best choice, there needs to be a certain internal consistency to the tastes that guide the person s choices. We called this internal consistency transitivity and said that a person s tastes are transitive if, whenever the person likes a bundle A at least as much as a bundle B and she likes B at least as much as C, it must be the case that the person likes A at least as much as C. We can now define this more formally using the notation we just developed. In particular, we will say that a person s tastes are transitive if and only if it is true that whenever three bundles are evaluated by the person such that (x A 1, x A 2,..., x A n) (x B 1, x B 2,...,x B n ) and (x B 1, x B 2,..., x B n ) (x C 1, x C 2,..., x C n ) (4.8) we can conclude that (x A 1, x A 2,..., x A n) (x C 1, x C 2,..., x C n ). (4.9) Exercise 4B.2 Does transitivity also imply that 4.8 above implies 4.9 when is replaced by?

15 4B. Tastes and Utility Functions 95 4B.1.3 Rational Tastes The assumptions of completeness and transitivity of tastes are, as already noted in Section 4A, so fundamental to the economist s modeling of tastes that together they define what we mean by rational tastes. An individual s tastes over a particular set of bundles are then said to be rational if they are both complete and transitive. 4B.2 Three More Assumptions While the two rationality assumptions are quite fundamental for the construction of a model of tastes that can result in individuals choosing best alternatives given their circumstances, they do not by themselves tell us very much about what kinds of choices individuals are likely to make. For this reason, we introduced in Section 4A.2 three additional assumptions which we informally called more is better, averages are better than extremes, and no sudden jumps. In more formal language, these same assumptions were referred to as monotonicity, convexity and continuity. 4B.2.1 Monotonicity (or More is Better or at least not Worse ) We argued at length in Section 4A.2.1 that the fundamental scarcity that underlies economic decision making implies that more is indeed considered better by most individuals in most economic contexts. Given that bundles of goods and services by definition contain many different types of goods, we have to be clear about what we mean by more. In Graph 4.1, for instance, bundle E clearly has more of everything than bundle C, but it has more of some and less of other goods when compared to bundles A and B. By more we can mean either more of all goods or more of at least some goods and no less of any of the other goods. When a bundle contains more of all goods than a second bundle, we will generally assume that a consumer strictly prefers that bundle. When a bundle contains more of at least some goods and no less of any of the other goods than a second bundle, on the other hand, we will typically assume that a consumer thinks of this bundle as at least as good as the second bundle thus leaving open the possibility that the consumer might be indifferent between the two bundles. Formally we can then define more is better or what we will call monotonic tastes as follows: A consumer s tastes are monotonic if and only if (x A 1, x A 2,..., x A n) (x B 1, x B 2,..., x B n ) whenever x A i x B i for all i = 1, 2,..., n; and (x A 1, x A 2,..., x A n) (x B 1, x B 2,..., x B n ) whenever x A i > x B i for all i = 1, 2,..., n. (4.10) The first line of this definition allows for the possibility that some of the goods in the A and B bundles are the same while others are larger for the A bundle than for the B bundle, while the second line applies only to pairs of bundles where one contains more of every good than the other. In Graph 4.1, for instance, bundle A contains more shirts but the same number of pants as bundle D, and our definition of monotonic tastes therefore implies that A D or A is at least as good as D. Bundle E, on the other hand, contains more of all goods than bundle D, implying that E D or E is strictly better than D. 9 9 Monotonicity assumptions are sometimes divided into weak and strong monotonicity, where weak monotonicity requires that each element of a bundle A must be larger than each corresponding element of B in order for A to be strictly preferred to B, while a stronger form of monotonicity would require only some elements of A to be larger than the corresponding elements in B (with all remaining elements the same). Our definition corresponds to the weaker

16 96 Chapter 4. Tastes and Indifference Curves 4B.2.2 Convexity ( Averages are Better than (or at least as good as) Extremes ) Next we argued in Section 4A.2.2 that it is often reasonable for us to assume that averages are better than extremes whenever an individual is indifferent between extreme bundles. By an average bundle we simply meant the bundle that emerges if we mix two more extreme bundles (like bundles A and B in Graph 4.2) and divide them into two identical bundles. 10 We could translate this into a more formal statement by saying that (x A 1, xa 2,...,xA n ) (xb 1, xb 2,..., xb n ( ) ( ) ) implies 1 1 (x A 1, x A 2,..., x A 2 n) + (x B 1, x B 2,...,x B n ) (x A 1, x A 2,..., x A 2 n) and ( ) ( ) 1 1 (x A 1 2, xa 2,..., xa n ) + (x B 1 2, xb 2,...,xB n ) (xb 1, xb 2,..., xb n ). (4.11) Exercise 4B.3 True or False: Assuming tastes are transitive, the third line in expression (4.11) is logically implied by the first and second lines. More generally, if the literal average (as opposed to a weighted average with weights different from 0.5) of two more extreme bundles is better than the extremes, the same logic would suggest that any weighted average that emerges from mixing two extremes is preferable to the extremes so long as it is not even more extreme. For instance, suppose again that I am indifferent between bundle A and B in Graph 4.2 where bundle A contains 4 pants and 8 shirts while bundle B contains 8 pairs of pants and 2 shirts. But now, instead of strictly averaging the two bundles to yield a bundle with 6 pants and 5 shirts, suppose that we create one bundle that consists of 1/4 of bundle A and 3/4 of bundle B, and a second bundle that consists of 3/4 of A and 1/4 of B. An individual who likes averages better than extremes will then also prefer these two bundles to the more extreme original ones and these bundles would also lie on the line segment connecting A and B. Bundles that are created as a weighted average of extremes are called convex combinations of the extreme bundles. Put more precisely, any bundle that is created by weighting bundle A by α and bundle B by (1 α) is a convex combination of A and B so long as α lies between 0 and 1. Our averages are better than extremes or convexity assumption from Section 4A can then be restated in the following way: Tastes are convex if and only if convex combinations of indifferent bundles are at least as good as the bundles used to create the convex combination. Or, in terms of the notation we have developed, tastes over bundles of n goods are convex if and only if, for any α such that 0 α 1, (x A 1, x A 2,..., x A n) (x B 1, x B 2,..., x B n ) implies α(x A 1, x A 2,..., x A n) + (1 α)(x B 1, x B 2,...,x B n ) (x A 1, x A 2,...,x A n ). (4.12) of these definitions of monotonicity. Finally, although we will generally maintain our assumption of monotonicity throughout the text, many of the results that we derive actually hold for a much weaker assumption called local non-satiation. This assumption simply requires that there exists no bundle of goods for which there isn t another bundle close by that is strictly better. These concepts are clarified further in the end-of-chapter exercise As in the case of monotonicity, there exist several stronger and weaker versions of the convexity assumption. Strict convexity is usually defined as averages are strictly preferred to extremes while weak convexity is defined as averages are at least as good as extremens. Note that we will define our convexity notion in line with the latter although you will see in the coming chapters that most of the tastes we work with actually satisfy the stronger definition of convexity.

17 4B. Tastes and Utility Functions 97 4B.2.3 Continuity ( No Sudden Jumps ) Finally, we introduced the assumption that tastes generally do not have sudden jumps in Section 4A.2.3. We can now formalize this assumption by introducing a mathematical concept called a converging sequence of points. This concept is quite intuitive but it consists of several parts. First, a sequence of points in R n + is simply a list of points, each with n different non-negative components. This sequence is infinite if and only if the list has an infinite number of points in it. An infinite sequence of points then is said to converge to a single point in R n + if and only if the distance between the points in the sequence and that single point becomes smaller and smaller (beginning at some point in the sequence). Suppose for instance that we start in Graph 4.6 at a point B in R 2 +. Then suppose that point B is the first point in an infinite sequence that continues with B 1 lying halfway between point B and some other point A, with B 2 lying halfway between point B 1 and A, with B 3 lying halfway between B 2 and A and so forth. An example of the first 4 points of such a sequence is graphed in Graph 4.6. If we now imagine this sequence of points continuing forever, no point in the sequence will ever quite reach point A but it will get ever closer. In the language of calculus, the limit of the sequence is point A and the sequence itself converges to point A. Graph 4.6: Continuity - Converging Sequence of Points Now suppose we have two infinite sequences of points one denoted {B 1, B 2, B 3,...} and the other denoted {C 1, C 2, C 3,...}, with the first sequence converging to point A and the second sequence converging to point D. If it is the case that B i C i for all i s, then the continuity assumption requires that A D. Thus, if the B bundles are always preferred to the C bundles as we move along the two sequences and if this continues to hold as we get closer and closer to the bundles A and D to which the two sequences converge, we can t suddenly have a jump at the end of the sequences that reverses the preference relation and causes D to be preferred to A. 4B.3 Representing Tastes with Utility Functions In Section 4A.3, we demonstrated how the assumptions we have made about people s tastes allow us to graph different types of tastes using indifference curves. We will now see that these indifference

18 98 Chapter 4. Tastes and Indifference Curves curves can be interpreted as parts of mathematical functions that summarize tastes more fully. These functions are called utility functions, and utility functions are simply mathematical rules that assign numbers to bundles of goods in such a way that more preferred bundles are assigned higher numbers. Recall from your math classes that a mathematical function is just a formula that assigns numbers to points. For instance, the function f(x) = x 2 is simply a way of assigning numbers to different points in the space R 1 (the real line), the space consisting of points with only a single component. To the point x = 1/2, the function assigns a value of 1/4; to the point x = 1, the function assigns a value of 1; and to the point x = 2, the function assigns the value 4. The full function is depicted in Graph 4.7. Graph 4.7: An Example of a function f : R 1 R 1 In mathematical notation, we would indicate by f : R 1 R 1 that such a function f is a formula that assigns a real number to each point on the real line. We would then read this notation as the function f takes points on the real line R 1 and assigns to them a value from the real line R 1. Such functions are not, however, of particular use to us as we think about representing tastes because we are generally considering bundles that consist of more than one good bundles such as those consisting of combinations of shirts and pants. Thus, we might be more interested in a function f : R 2 + R1 that assigns to each point made up of two real numbers (i.e. points that lie in R 2 + ) a single real number (i.e. a number in R1 ). One example of such a function would be f(x 1, x 2 ) = x 1 x 2, a function that assigns the value 1 to the bundle (1, 1), the value 4 to the bundle (2, 2) and the value 2 to the bundle (2, 1). Suppose, for instance, that we are back to choosing between bundles composed of shirts and pants. If I have rational tastes, I can compare any two bundles and tell you which of the two I prefer or whether I am indifferent between the two. If I can find a function f : R 2 + R 1 that assigns to each bundle of shirts and pants (represented by points in R 2 + ) a value in such a way that more preferred bundles are assigned higher numbers (and indifferent bundles are assigned the same

19 4B. Tastes and Utility Functions 99 number), we will say that I have found a utility function that represents my tastes. More formally, a function f : R 2 + R 1 represents my tastes over pants (x 1 ) and shirts (x 2 ) if and only if, (x A 1, x A 2 ) (x B 1, x B 2 ) implies f(x A 1, x A 2 ) > f(x B 1, x B 2 ) and (x A 1, xa 2 ) (xb 1, xb 2 ) implies f(xa 1, xa 2 ) = f(xb 1, xb 2 ). (4.13) We will typically use u instead of f to denote such utility functions. For the more general case of tastes over bundles with n different goods, we can now define a utility functions as follows: u: R n + R1 represents tastes over bundles of n goods if and only if, for any (x A 1, x A 2,..., x A n) and (x B 1, x B 2,...,x B n ) in R n + (x A 1, xa 2,..., xa n ) (xb 1, xb 2,...,xB n ) implies u(xa 1, xa 2,..., xa n ) > u(xb 1, xb 2,..., xb n ) and (x A 1, xa 2,..., xa n ) (xb 1, xb 2,...,xB n ) implies u(xa 1, xa 2,..., xa n ) = u(xb 1, xb 2,..., xb n ). (4.14) You might notice right away how important our rationality assumptions about tastes are in insuring that we can indeed represent tastes with utility functions. Functions assign values to all points in the space over which they are defined. Thus, we could not use functions to represent tastes unless we indeed were able to evaluate each bundle in relation to others i.e. unless our tastes were complete. Similarly, mathematical functions have to be logically consistent in the sense that, whenever point A is greater than point B and point B is greater than point C, point A must be greater than point C. Thus, if tastes were not also logically consistent as required by our transitivity assumption, we could not use mathematical functions to represent them. 11 4B.3.1 Utility Functions and Indifference Curves Let s return to my tastes over bundles of pants and shirts, with pants represented by x 1 and shirts represented by x 2, and suppose that my tastes can be captured fully by the function u(x 1, x 2 ) = x 1/2 1 x 1/2 2. Graph 4.8a illustrates this function graphically, with shirts and pants measured on the lower axes and the values u(x 1, x 2 ) plotted on the vertical axis. Now suppose that I wanted to plot only those bundles that are assigned a value of precisely 4. I would then focus on one horizontal (magenta) slice of this function that occurs at a height of 4 and could plot that slice in a 2- dimensional picture with just pants and shirts on the axes, as in panels (b) and (c) of Graph 4.8. Since bundles that are assigned the same number are, by the definition of a utility function, valued exactly the same by me, these bundles represent one indifference curve all those bundles of goods that give me utility of exactly 4 as measured by the utility function u. Similarly, I could focus on all bundles that are assigned a value of 2 by the utility function thus creating a second indifference curve. And of course I could do this for all possible values on the vertical axis in Graph 4.8a thus creating an entire map of indifference curves that is represented by this particular utility function. As already suggested in part A of the chapter, this relationship between utility functions and indifference curves becomes more intuitive when we relate it to something that most of us have no trouble with the reading of maps of the geography of a particular region of a country. Graph 4.9 is an example of the kind of map I have in mind. The map itself is two-dimensional it fits nicely on a single page of this book. But the map actually represents three-dimensional mountains. 11 One can formally prove that any tastes that satisfy the rationality and continuity assumptions can be represented by utility functions see Mas-Colell, A., M. Whinston and J. Greene (2002), Microeconomic Theory, New York, Oxford University Press. You can also construct a simplified version of this proof in end-of-chapter exercise 4.14.

20 100 Chapter 4. Tastes and Indifference Curves Graph 4.8: Indifference Curves & Utility Functions

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