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Ariel Rubinstein: Lecture Notes in Microeconomic Theory

is published by Princeton University Press and copyrighted, c 2006, by Princeton

September 29, 2005 12:58 master Sheet number 56 Page number 40

LECTURE 4

Consumer Preferences

The Consumers World

Up to this point we have dealt with the basic economic model of

rational choice. In this lecture we will discuss a special case of the

rational man paradigm: the consumer. A consumer is an economic

agent who makes choices between available combinations of com-

modities. As usual, we have a certain image in mind: a person goes

to the marketplace with money in hand and comes back with a

bundle of commodities.

As before, we will begin with a discussion of consumer preferences

and utility, and only then discuss consumer choice. Our rst step is

to move from an abstract treatment of the set X to a more detailed

structure. We take X to be

K

+

= {x = (x

1

, . . . , x

K

)| for all k, x

k

0}.

An element of X is called a bundle. A bundle x is interpreted as a com-

bination of K commodities where x

k

is the quantity of commodity k.

Given this special interpretation of X, we impose some conditions

on the preferences in addition to those assumed for preferences in

general. The additional three conditions use the structure of the

space X: monotonicity uses the orderings on the axis (the ability

to compare bundles by the amount of any particular commodity);

continuity uses the topological structure (the ability to talk about

closeness); convexity uses the algebraic structure (the ability to speak

of the sum of two bundles and the multiplication of a bundle by a

scalar).

Monotonicity

Monotonicity is a property that gives commodities the meaning

of goods. It is the condition that more is better. Increasing the

amount of some commodities cannot hurt, and increasing the

amount of all commodities is strictly desired. Formally,

September 29, 2005 12:58 master Sheet number 57 Page number 41

Consumer Preferences 41

Monotonicity:

The relation satises monotonicity if for all x, y X,

if x

k

y

k

for all k, then x y, and

if x

k

> y

k

for all k, then x y.

In some cases, we will further assume that the consumer is strictly

happier with any additional quantity of any commodity.

Strong Monotonicity:

The relation satises strong monotonicity if for all x, y X

if x

k

y

k

for all k and x = y, then x y.

Of course, in the case that preferences are represented by a util-

ity function, preferences satisfying monotonicity (or strong mono-

tonicity) are represented by monotonic increasing (or strong

monotonic increasing) utility functions.

Examples:

The preference represented by min{x

1

, x

2

} satises monotonicity

but not strong monotonicity.

The preference represented by x

1

+x

2

satises strong mono-

tonicity.

The preference relation |x x

property that is sometimes used in the literature: for every

x X and for any > 0 there is some y X that is less than

away from x so that y x. Every monotonic preference re-

lation satises nonsatiation, but the reverse is, of course, not

true.

Continuity

We will use the topological structure of

K

+

(induced from the stan-

dard distance function d(x, y) =

(x

k

y

k

)

2

) to apply the deni-

tionof continuity discussed inLecture 2. We say that the preferences

September 29, 2005 12:58 master Sheet number 58 Page number 42

42 Lecture Four

Figure 4.1

satisfy continuity if for all a, b X, if a b, then there is an > 0

such that x y for any x and y such that d(x, a) < and d(y, b) < .

Existence of a Utility Representation

Debreus theorem guarantees that any continuous preference rela-

tion is represented by some (continuous) utility function. If we

assume monotonicity as well, we then have a simple and elegant

proof:

Claim:

Any consumer preference relation satisfying monotonicity and con-

tinuity can be represented by a utility function.

Proof:

Let us rst show that for every bundle x, there is a bundle on

the main diagonal (having equal quantities of all commodi-

ties), such that the consumer is indifferent between that bun-

dle and the bundle x. (See g. 4.1.) The bundle x is at least as

good as the bundle 0 = (0, . . . , 0). On the other hand, the bundle

September 29, 2005 12:58 master Sheet number 59 Page number 43

Consumer Preferences 43

M = (max

k

{x

k

}, . . . , max

k

{x

k

}) is at least as good as x. Both0 and M are

on the main diagonal. By continuity, there is a bundle on the main

diagonal that is indifferent to x (see the problem set). By mono-

tonicity this bundle is unique; we will denote it by (t(x), . . . , t(x)).

Let u(x) = t(x). To see that the function u represents the preferences,

note that by transitivity of the preferences x y iff (t(x), . . . , t(x))

(t(y), . . . , t(y)), and by monotonicity this is true iff t(x) t(y).

Convexity

Consider, for example, a scenario in which the alternatives are can-

didates for some position and are ranked in a left-right array as fol-

lows:

abcde.

In normal circumstances, if we know that a voter prefers b to d,

then:

We tend to conclude that c is preferred to d, but not necessarily

that a is preferred to d (the candidate a may be too extreme).

We tend to conclude that d is preferred to e (namely, we do not

nd it plausible that both e and b are preferable to d).

Convexity is meant to capture related intuitions that rely on the

existence of geography in the sense that we can talk about an

alternative being between two other alternatives. The convexity

assumption is appropriate for a situation in which the argument if

a move from d to b is an improvement then so is a move part of the

way to c is legitimate, while the argument if a move from b to d

is harmful then so is a move part of the way to c is not.

Following are two formalizations of these two intuitions (g. 4.2).

We will see that they are equivalent.

Convexity 1:

The preference relation satises convexity 1 if x y and (0, 1)

implies that x +(1 )y y.

This captures the intuition that if x is preferred to y, then going

a part of the way from y to x is also an improvement.

September 29, 2005 12:58 master Sheet number 60 Page number 44

44 Lecture Four

Figure 4.2

Two denitions of convexity.

Convexity 2:

The relation satises convexity 2 if for all y, the set AsGood(y) =

{z X|z y} is convex.

(Recall that a set A is convex if for all a, b A and for all [0, 1],

a +(1 )b A.) This captures the intuition that if both z

1

and z

2

are better than y, then the average of z

1

and z

2

is denitely better

than y.

Claim:

A preference satises convexity 1 if and only if it satises convex-

ity 2.

Proof:

Assume that satises convexity 1 and let a y and b y ; without

loss of generality assume a b. Then by the denition of convex-

ity 1, a +(1 )b b and by the transitivity of , a +(1 )b y

and thus a +(1 )b AsGood(y).

Assume that satises convexity 2. If x y then both x and y are

in AsGood(y) and thus x +(1 )y AsGood(y), which means that

x +(1 )y y.

September 29, 2005 12:58 master Sheet number 61 Page number 45

Consumer Preferences 45

As usual, the above property also has a stronger version:

Strict Convexity:

The preference relation satises strict convexity if for every a y,

b y, a = b and (0, 1) imply that a +(1 )b y.

Example:

The preferences represented by

x

1

+

x

2

satisfy strict convexity.

The preferences represented by min{x

1

, x

2

} and x

1

+x

2

satisfy con-

vexity but not strict convexity. The lexicographic preferences satisfy

strict convexity. The preferences represented by x

2

1

+x

2

2

do not sat-

isfy convexity.

We now look at the properties of the utility representations of

convex preferences.

Quasi-Concavity:

A function u is quasi-concave if for all y the set {x| u(x) u(y)} is

convex.

The terms name derives from the fact that for any concave func-

tion f and for any y the set {x|f (x) f (y)} is convex.

Obviously, if a preference relation is represented by a utility func-

tion, then it is convex iff the utility function is quasi-concave. How-

ever, the convexity of does not imply that a utility function

representing is concave. (Recall that u is concave if for all x, y,

and [0, 1], we have u(x +(1 )y) u(x) +(1 )u(y).)

Special Classes of Preferences

Often in economics, we limit our discussion of consumer prefer-

ences to a class of preferences possessing some additional special

properties. Following are some examples of popular classes of

preference relations discussed in the literature.

September 29, 2005 12:58 master Sheet number 62 Page number 46

46 Lecture Four

Figure 4.3

Homothetic preferences.

Homothetic Preferences:

A preference is homothetic if x y implies x y for all 0.

(See g. 4.3.)

The preferences represented by

k=1,...,K

x

k

k

, where

k

is positive,

are homothetic. In fact, any preference relation represented by a

utility function u that is homogeneous of any degree is homo-

thetic. (x y iff u(x) u(y) iff

u(x)

x y).

Note that lexicographic preferences are also homothetic.

Claim:

Any homothetic, continuous, and increasing preference relation on

the commodity bundle space canbe represented by a utility function

that is homogeneous of degree one.

Proof:

We have already proven that any bundle x has a unique bundle

(t(x), . . . , t(x)) on the main diagonal so that x (t(x), . . . , t(x)), and

that the function u(x) = t(x) represents . By the assumption that

September 29, 2005 12:58 master Sheet number 63 Page number 47

Consumer Preferences 47

Figure 4.4

Quasi-linear (in good 1) preferences.

the preferences are homothetic, x (t(x), . . . , t(x)) and thus

u(x) = t(x) = u(x).

Let us now consider an additional class of consumer preferences.

Quasi-Linear Preferences:

A preference is quasi-linear in commodity 1 (referred to as the nu-

meraire) if x y implies (x +e

1

) (y +e

1

) (where e

1

= (1, 0, . . . ,

0) and > 0). (See g. 4.4.)

The indifference curves of preferences that are quasi-linear incom-

modity 1 are parallel to each other (relative to the rst commodity

axis). That is, if I is an indifference curve, then the set I

= {x| there

exists y I such that x = y +(, 0, . . . , 0)} is an indifference curve.

Any preference relation represented by x

1

+v(x

2

, . . . , x

K

) for some

function v is quasi-linear in commodity 1. Furthermore:

Claim:

Any continuous preference relation satisfying strong monotonicity (at

least in commodity 1) and quasi-linearity in commodity 1 can be

represented by a utility function of the form x

1

+v(x

2

, . . . , x

K

).

September 29, 2005 12:58 master Sheet number 64 Page number 48

48 Lecture Four

Proof:

In the problem set you will prove that every preference relation that

is monotonic, continuous, and quasi-linear in commodity 1 sat-

ises that for every (x

2

, . . . , x

K

) there is some number v(x

2

, . . . , x

K

)

so that (v(x

2

, . . . , x

K

), 0, . . . , 0) (0, x

2

, . . . , x

K

). Then, from quasi-

linearity in commodity 1, for every bundle x, (x

1

+v(x

2

, . . . , x

K

),

0, . . . , 0) (x

1

, x

2

, . . . , x

K

), and thus by strong monotonicity in the

rst commodity, the function x

1

+v(x

2

, . . . , x

K

) represents .

Differentiable Preferences (and the Use of Derivatives in Economic

Theory)

We often assume in microeconomics that utility functions are dif-

ferentiable and thus use standard calculus to analyze the consumer.

In this course I (almost) avoid calculus. This is part of a deliberate

attempt to steer you away from a mechanistic approach to eco-

nomic theory.

Can we give the differentiability of a utility function an eco-

nomic interpretation? We introduce a nonconventional denition

of differentiable preferences. Basically, differentiability of preferences

requires that the directions for improvement can be described using

local prices.

Let us conne ourselves to preferences satisfying monotonicity

and convexity. For any vector x we say that the direction of change

d

K

is an improvement direction at x if there is some > 0 so that

x +d x. In other words, there is some move from x in the di-

rection of d, which is an improvement. Let D(x) be the set of all

improvement directions at x. Given monotonicity, D(x) includes

all positive vectors. We say that a consumers monotonic prefer-

ences are differentiable at the bundle x if there is a vector v(x) of K

numbers so that D(x) contains all vectors d

K

for which dv(x) > 0

(dv(x) is the inner product of d and v(x)). In such a case the vector

of numbers (v

1

(x), . . . , v

K

(x)) is interpreted as the vector of subjec-

tive values of the commodities. Starting from x, any small-enough

move in a direction that is evaluated by this vector as positive is an

improvement. We say that is differentiable if it is differentiable at

any bundle x (see g. 4.5).

September 29, 2005 12:58 master Sheet number 65 Page number 49

Consumer Preferences 49

Figure 4.5

Differentiable preferences.

Examples:

The preferences represented by 2x

1

+3x

2

are differentiable. At

each point x, v(x) = (2, 3).

The preferences represented by min{x

1

, . . . , x

K

} are differen-

tiable only at points where there is a unique commodity k

for which x

k

< x

l

for all l = k (verify). For example, at x =

(5, 3, 8, 6), v(x) = (0, 1, 0, 0).

Assume u is a differentiable quasi-concave utility function rep-

resenting the consumers preferences. Let du/dx

k

(x) be the partial

derivative of u with respect to the commodity k at point x. If all

vectors (du/dx

k

(x)) of partial derivatives are nonzero, then the in-

duced preference is differentiable with v

k

(x) = du/dx

k

(x) (the partial

derivative of u with respect to the commodity k at the point x).

Bibliographic Notes

Recommended readings: Kreps 1990, 3237; Mas-Colell et al. 1995,

Chapter 3, AC.

The material in this lecture up to the discussion of differentiability

is fairly standard and closely parallels that found in Arrowand Hahn

(1971).

September 29, 2005 12:58 master Sheet number 66 Page number 50

Problem Set 4

Problem 1. (Easy)

Characterize the preference relations on the interval [0, 1] that are contin-

uous and strictly convex.

Problem 2. (Easy)

Show that if the preferences satisfy continuity and x y z, then there

is a bundle m on the interval connecting x and z such that y m.

Problem 3. (Moderate)

Show that if the preferences satisfy continuity and monotonicity, then

the function u(x), dened by x (u(x), . . . , u(x)), is continuous.

Problem 4. (Moderate)

In a world with two commodities, consider the following condition:

The preference relation satises convexity 3 if for all x and

(x

1

, x

2

) (x

1

, x

2

+

1

) (x

1

2, x

2

+

1

+

2

) implies

2

1

.

Interpret convexity 3 and show that for strong monotonic and continu-

ous preferences, it is equivalent to the convexity of the preference relation.

Problem 5. (Moderate)

Formulate and prove a proposition of the following type:

If the preferences are quasi linear in all commodities, continuous, and

strongly monotonic, then there is a utility function of the form (. . . add a

condition here . . .) that represents it.

Problem 6. (Difcult)

Show that for any consumers preference relation satisfying continuity,

monotonicity and quasi-linearity with respect to commodity 1 and for every

vector x, there is a number v(x) so that x (v(x), 0, . . . , 0).

September 29, 2005 12:58 master Sheet number 67 Page number 51

Consumer Preferences 51

Problem 7. (Easy)

We say that a preference relation satises separability if it can be represented

by anadditive utility function, that is, a functionof the type u(x) =

k

v

k

(x

k

).

Showthat such preferences satisfy that for any subset of commodities J, and

for any bundles a, b, c, d, we have

a

J

, c

J

b

J

, c

J

a

J

, d

J

b

J

, d

J

,

where

x

J

, y

J

takes the components of y for any k / J.

Demonstrate this condition geometrically for K = 2.

Problem 8. (Moderate)

Let be monotonic and convex preferences that are represented by a dif-

ferentiable utility function u.

Show that for every x there is a vector v(x) of K nonnegative numbers

so that d is animprovement at x iff dv(x) > 0 (dv(x) is the inner product

of v(x)).

Show that the preferences represented by the function min{x

1

, . . . , x

K

}

cannot be represented by a differentiable utility function.

Check the differentiability of the lexicographic preferences in

2

.

Assume that for any x and for any d D(x), (x +d) x. What can you

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