Introduction

Preferences

Rational
Preferences
Rational Choice under Certainty
Indifference
and Strict
Preference

Preference
Orderings

Utility Manoogian College of Business and Economics, American University of

Armenia
Set of
Possibilities

Choice under
Certainty

Discussion

1 / 28
 Theory of Rational Choice under Certainty

1 Introduction
Introduction
2 Preferences
Preferences

Rational 3 Rational Preferences

Preferences

Indifference
and Strict
4 Indifference and Strict Preference
Preference

Preference
5 Preference Orderings
Orderings

Utility 6 Utility
Set of
Possibilities 7 Set of Possibilities
Choice under
Certainty 8 Choice under Certainty
Discussion
9 Discussion

2 / 28
 Introduction

• The theory of rational choice specifies what it means to

make rational decisions – in short, what it means to be
Introduction
rational.
Preferences
• The phrase “under certainty” simply means that there is
Rational
Preferences no doubt as to which outcome will result from a given act.
Indifference • Before discussing what it means to make rational choices
and Strict
Preference under conditions of certainty, however, we need to talk
Preference about what preferences are and what it means to have
Orderings
rational preferences.
Utility

Set of
• The theory of rational choice consists of a set of axioms:
Possibilities basic propositions that cannot be proven using the
Choice under
Certainty
resources offered by the theory, and which will simply have
Discussion to be taken for granted (have to be memorized).
• After learning the axioms of rational choice, we will provide
new propositions on the basis of axioms and definitions.
3 / 28
 Preferences = Relations

• Express a relationship between things (entities):

– Alf is older than Betsy ⇒ binary relation.
Introduction – Relationship is called ternary, if it involves three things.
Preferences – We use lower case letters to denote things or entities or
Rational
individuals compared in a relation (Alf = a and Betsy=b)
Preferences – We use capital letters to denote relations (e.g. letter R can
Indifference represent relation ”older than”) ⇒ Alf is older than Betsy ⇔
and Strict
Preference aRb 6= bRa
Preference – The universe, U, is the (possibly infinite) set of things that can
Orderings
be related to one another. E.g., Donald Ducks nephews:
Utility U = {Huey, Dewey, Louie} & the order doesn’t matter.
Set of • Modern economics is based on preference relations:
Possibilities
– Weak preference (<) ”at least as good as.”
Choice under
Certainty – Strong (strict) preference () “is better than.”
Discussion – Indifference (∼) “is as good as.”
– Preference relations for certain individuals are denoted by
subscripts: E.g. for Alf coffee is at least as good as tea
= t <A c 4 / 28
 Consumption Bundles

• In Economics, preferences are usually defined over the

universe of consumption bundles, which are collections
Introduction
of goods.
Preferences
• Thus, when talking about the preference relations, the
Rational
Preferences universe can also be referred to as the set of alternatives.
Indifference
and Strict
Preference

Preference
Orderings

Utility

Set of
Possibilities

Choice under
Certainty

Discussion

5 / 28
 Rationality of Weak Preferences

• Rational (weak) preferences are transitive and complete:

Axiom
Introduction
Transitivity of <: For all x, y, z in the universe, if x < y and y < z
Preferences
then x < z.
Rational
Preferences
• The opposite of transitive is intransitive. Any examples of
Indifference
and Strict intransitive relations?
Preference

Preference
Axiom
Orderings
Completeness of <: For all x, y in the universe, either x < y or
Utility
y < x (or both)
Set of
Possibilities
• The opposite of complete is incomplete. Any examples of
Choice under
Certainty
incomplete relations?
Discussion
• Completeness implies reflexivity: x < x.
• The assumption that the weak preference relation is rational
(transitive and complete) is in effect everything necessary to
build a theory of rational choice under certainty.
6 / 28
 Exercise

Introduction
• Are the following relations complete? Are they transitive?
Preferences
Assume the universe is the set of all people-past, present,
Rational
Preferences
and future.
Indifference – “is the mother of”
and Strict
Preference
– “is an ancestor of”
Preference
– “is the sister of”
Orderings – “detests”
Utility – “weighs more than”
Set of – “weighs at least as much as”
Possibilities
– “has the same first name as”
Choice under
Certainty
– “is taller than”
Discussion

7 / 28
 Indifference

Introduction
Definition of Indifference
Preferences

Rational
x ∼ y (denotes ”x is as good as y”) if and only if x < y and
Preferences y < x.
Indifference
and Strict
Preference • Some important properties of indifference
Preference The following conditions hold:
Orderings
(i) Reflexivity: x ∼ x (for all x)
Utility
(ii) Symmetry: If x ∼ y then y ∼ x
Set of
Possibilities (ii) Transitivity: If x ∼ y and y ∼ z then x ∼ z.
Choice under
Certainty
• The indifference relation is not complete. Why?
Discussion

8 / 28
 Proofs of the Indifference Properties

Introduction Reflexivity Symmetry Transitivity

Preferences
1. x < x (from the 1. x ∼ y 1. x ∼ y & y ∼ z
Rational
Preferences completeness 2. x < y & y < x 2. x < y & y < x
Indifference axiom)
and Strict 3. y < x & x < y 3. y < z & z < y
Preference
2. x < x & x < x
Preference 4. y ∼ x 4. x < z
Orderings ∴x∼x
Utility
∴x∼y↔y∼x 5. z < x
Set of 6. x ∼ z
Possibilities

Choice under
∴x∼y &y∼z→
Certainty x ∼ z.
Discussion

9 / 28
 Strong (Strict) Preferences

Introduction

Preferences

Rational
Definition of strict preference
Preferences
x  y if and only if x < y and not y < x
Indifference
and Strict
Preference
• Some important properties of strict preferences
Preference
Orderings (i) Transitivity: If x  y and y  z, then x  z
Utility (ii) Anti-symmetry: If x  y, then not y  x.
Set of (iii) Irreflexivity: Not x  x.
Possibilities

Choice under
Certainty

Discussion

10 / 28
 Logical Symbols

Introduction

Preferences
• x & y: x and y
Rational
Preferences
• x ∨ y: x or y
Indifference
and Strict • x → y: if x then y; x only if y; x only if y
Preference

Preference • x ↔ y: x if only if y; x only if y; x just in case y

Orderings

Utility
• ¬p: not p
Set of • ⊥: contradiction, false
Possibilities

Choice under
Certainty

Discussion

11 / 28
 Proofs of Strict Preference Properties

Transitivity Anti-Symmetry Irreflexivity

Have to prove that Have to prove that Have to prove that
Introduction x < z and ¬z < x x  y and ¬y  x ¬x  x
Preferences 1. x < y & ¬y < x 1. x  y 1. Proof by
Rational 2. y < z & ¬z < y 2. Proof by contradiction:
Preferences
contradiction: Suppose x  x
Indifference 3. → x < z
and Strict Suppose y  x 2. x < x & ¬x < x
Preference 4. Proof by
contradiction: 3. From 1. 3. Contradictions
Preference
Orderings
Suppose z < x x < y & ¬y < x within the two
Utility 4. From 2. conditions in 2.
5. From 1. x < y
Set of y < x & ¬x < y ∴ ¬x  x.
Possibilities 6. From 4. and 5.
Choice under →z<y 5. Contradiction in 3.
Certainty & 4.
7. But from 2. ¬z < y
Discussion x < y & ¬x < y
8. ⊥ → ¬z < x
∴ ¬y  x
∴ from 3. & 8.
x < z and ¬z < x 12 / 28
 Summary

Introduction

Preferences
Property Definition < ∼ 
Rational
Preferences
(a) Transitivity xRy & yRz → xRz X X X
Indifference
and Strict (b) Completeness xRy ∨ yRz X
Preference
(c) Reflexivity xRx X X
Preference
Orderings (d) Irreflexivity ¬xRx X
Utility (e) Symmetry xRy → yRx X
Set of
Possibilities
(f) Anti-symmetry xRy → ¬yRx X
Choice under
Certainty

Discussion

13 / 28
 Preference Ordering

• Since we assume preferences are rational (transitive and

complete), a preference ordering can be constructed.
Introduction
• Thus, with a rational preference relation we can order all
Preferences
alternatives in a list, with the best at the top and the
Rational
Preferences worst at the bottom.
Indifference Example Heavenly Bliss
and Strict


Preference

Preference
Orderings
Coke ∼ Pepsi


Utility

Set of
Eternal Suffering
Possibilities • Completeness guarantees that there will be only one
Choice under
Certainty ordering; transitivity that there will be no cycles in strict
Discussion preference.
• Weak preferences can cycle. That is, one can prefer a to b
and b to c and c to a. What would this entail?
14 / 28
 Preference Ordering

• In Economics, preference orderings are often represented

using indifference curves, also called indifference maps.
Introduction

Preferences

Rational
Preferences

Indifference
and Strict
Preference

Preference
Orderings

Utility

Set of
Possibilities

Choice under
Certainty

Discussion

15 / 28
 Preference Ordering

Introduction
• Each bundle on one of these indifference curves is as good
Preferences

Rational
as every other bundle on the same curve.
Preferences
• When two bundles are on different curves, one of the two
Indifference
and Strict bundles is strictly preferred to the other.
Preference

Preference
• Insofar as people prefer more of each good to less, bundles
Orderings on curves to the top right will be strictly preferred to
Utility
bundles on curves to the bottom left.
Set of
Possibilities • What does relative flattening or steepening in the tails of
Choice under
Certainty
indifference curves mean?
Discussion

16 / 28
 Utility

• Economists use numbers to represent strength of preference.

This is done through utility functions.
Introduction • A utility function associates a number with each member of the
Preferences universe (assuming completeness):
Rational Example Heavenly Bliss (HB) ⇒ u(HB) = 3
Preferences


Indifference
and Strict
Coke ∼ Pepsi (C or P) ⇒ u(C) = u(P ) = 2


Preference

Preference Eternal Suffering (ES) ⇒ u(ES) = 1

Orderings
• Because higher utilities correspond to more preferred items, we
Utility
say that the utility function u(·) represents the preference
Set of
Possibilities
relation <.
Choice under
• This does not mean that “Heavenly Bliss” is 3 times better than
Certainty “Eternal Suffering.”
Discussion • For any given preference relation there are many utility functions
that could represent them. This is related to the ordinal
property of utility, all utility does is allow you to order things.
17 / 28
 Utility Functions

Introduction

Preferences Definition of a Utility Function

Rational
Preferences A function u(·) from the set of alternatives into the set of real
Indifference numbers is a utility function representing the preference
and Strict
Preference relation < just in case x < y ⇔ u(x) ≥ u(y) (for al x and y).
Preference
Orderings
• Important Properties of u(·):
Utility

Set of
(i) x  y ⇔ u(x) > u(y)
Possibilities (ii) x ∼ y ⇔ u(x) = u(y)
Choice under
Certainty

Discussion

18 / 28
 Proofs of the Properties of a Utility Function

Property (i) Property (ii)

Introduction 1. x  y → x < y and 1. x ∼ y → x < y and y < x
Preferences ¬y < x 2. From the definition of
Rational
Preferences 2. From the definition of utility function
Indifference utility function u(x) ≥ u(y) and u(y) ≥
and Strict
Preference u(x) ≥ u(y) and ¬u(y) ≥ u(x) ⇒ u(x) = u(y)
Preference u(x) ⇒ u(x) > u(y) 3. Working backward from 2.
Orderings

Utility 3. Working backward from 2. and again invoking the

Set of and again using the definition of utility, it can
Possibilities
definition of utility, it can be shown that
Choice under
Certainty be shown that u(x) = u(y) ⇒ x ∼ y
Discussion u(x) > u(y) ⇒ x  y ∴ x ∼ y ⇔ u(x) = u(y)
∴ x  y ⇔ u(x) > u(y)
19 / 28
 Utility Functions

• A function u(·) that satisfies the definition above can be

Introduction
said to be an index or measure of preference relation <.
Preferences • A utility function does not refer to pleasure, happiness,
Rational
Preferences
and satisfaction of receiving, owning, or consuming
Indifference
something.
and Strict
Preference • Note also that utility functions are not unique, any utility
Preference function (indexing) that represents preferences will do as
Orderings
long as it associate higher numbers with more preferred
Utility
options.
Set of
Possibilities • Thus, it is important not to ascribe any significance to
Choice under
Certainty absolute utility numbers or ratios.
Discussion • Utility in economics is often called ordinal utility, because
all it does is allow you to order preferences.

20 / 28
 How Do Utilities Relate to Indifference Curves?

• A utility function in effect assigns one number to each

indifference curve. Thus, two bundles that fall on the same
Introduction curve will be associated with the same utility.
Preferences
• Two bundles that fall on different curves will be associated with
Rational different utilities.
Preferences • Higher numbers will correspond to curves that are more strongly
Indifference preferred.
and Strict
Preference • E.g. in the graph below, for a person who likes apples and
Preference bananas, u1 < u2 < u3 .
Orderings

Utility

Set of
Possibilities

Choice under
Certainty

Discussion

21 / 28
 Utility Functions: Some Important Details

• Is it always possible to find a utility function that represents a

rational preference relation?
Introduction
• When the set of alternatives is finite, then the answer is yes.
Preferences The following representation theorem makes the point.
Rational
Preferences
Representation Theorem
Indifference If the set of alternatives is finite then a preference relation < can be
and Strict
Preference
represented by a utility function only if is rational, that is only if it is
Preference
transitive and complete.
Orderings

Utility
• When the set of alternatives is infinite, representing preference
Set of
relations gets more complicated.
Possibilities • If a utility function represents a preference relation then the
Choice under preference relation is rational.
Certainty
• However, even if a preference relation is rational, it is not always
Discussion
possible to find a utility function representing it.
• One chooses rationally insofar as she maximizes utility ⇒ to
maximize utility is to choose rationally.
22 / 28
 Set of Possibilities or Budget Set

• To make a choice under certainty means you are facing a

Introduction
set of options (or a menu) and you have to chose exactly
Preferences
one option from the set.
Rational
Preferences • The menu has two properties:
Indifference
and Strict
1. mutually exclusive: you can choose at most one of them
Preference at any given time.
Preference 2. exhaustive: you have to choose at least one of them.
Orderings

Utility
• There is no assumption that a menu is small, or even
Set of finite, though we frequently assume that it is.
Possibilities
• In economics, the menu is often referred to as the budget
Choice under
Certainty set, the set of alternatives that you can afford given your
Discussion budget

23 / 28
 Set of Possibilities or Budget Set

• The line separating the bundles that you can afford given
Introduction your budget (the budget set) from the bundles that you
Preferences can’t afford with your budget is called the budget line.
Rational
Preferences

Indifference
and Strict
Preference

Preference
Orderings

Utility

Set of
Possibilities

Choice under
Certainty

Discussion

24 / 28
 What Does It Mean To Make a Rational Choice?

Introduction

Preferences

Rational • To make a rational choice means

Preferences
(i) that you have a rational preference ordering, and
Indifference
and Strict (ii) that whenever you are faced with a menu, you choose the
Preference
most preferred item, or (in the case of ties) one of the
Preference
Orderings most preferred items.
Utility • This is all we mean when we say that somebody is rational.
Set of
Possibilities

Choice under
Certainty

Discussion

25 / 28
 Choice Under Certainty

• The Rational choice can be described graphically if we

Introduction
know the agent’s indifference map and budget set.
Preferences

Rational
Preferences

Indifference
and Strict
Preference

Preference
Orderings

Utility

Set of
Possibilities

Choice under
Certainty • The consumer will choose the bundle marked X, because it
Discussion is the most highly preferred bundle in the budget set.

26 / 28
 Discussion

• One thing to notice about the theory of rational choice is

Introduction what the theory does not say.
Preferences • The theory does not say that
Rational – people are selfish, materialistic, or greedy;
Preferences

Indifference
– it says nothing about why people prefer one thing over
and Strict another;
Preference
– it does not presuppose that people solve mathematical
Preference
Orderings maximization problems in their heads;
Utility
– and it makes no reference to things like pleasure,
Set of
satisfaction, and happiness.
Possibilities
• The fact that the theory is relatively non-committal helps
Choice under
Certainty explain why so many economists are comfortable using it:
Discussion after all, the theory is compatible with a great deal of
behavior.

27 / 28
 Discussion

• Is the theory of rational choice a plausible theory of

human behavior under conditions of certainty?.
Introduction
• This question can be broken down into two:
Preferences
1. Is the theory descriptively adequate? Do people’s choices
Rational
Preferences do as a matter of fact reflect a rational preference ordering.
Indifference 2. Is the theory normatively adequate? Should people’s
and Strict
Preference
choices reflect a rational preference ordering?
Preference
• The answers to these questions are as follows:
Orderings
1. Though both transitivity and completeness may seem
Utility
obviously true of people’s preferences, there are many
Set of
Possibilities
cases in which they do not seem to hold. Thus the answer
to the first question is ”not necessarily.”
Choice under
Certainty 2. Though transitivity and completeness may seem rationally
Discussion required, it can be argued that they are neither necessary
nor sufficient for being rational. Thus, the answer to the
second question is also ”not necessarily.”
28 / 28