Term 1 Week 2: Preferences

Question 1

What is the difference between ordinal and cardinal relations (1,1)

Answer 1

-Ordinal means what you like more, cardinal means by how much more you like it
-For consumer theory, we only care about ordinal, not cardinal

Question 2

What are the assumptions on preferences + well behaved preferences (3,2)

Answer 2

-Completeness (the consumer can always compare bundles)
-Transitivity (If X > Y, Y > Z, X > Z)
-Continuous (tiny changes in bundles doesn’t change preference ordering)

-Monotonicity (more is better no matter what)
-Convexity (averages > extremes)

Question 3

What do indifference curves look like (4)

Answer 3

-Indifference curves are continuous
-Most peoples indifference curves are convex to the origin
-Indifference curves can’t cross
-Indifference curves are downward sloping

Question 4

How might indifference curves and their utility functions change depending on the type of good (2,2,2)

Answer 4

-For perfect substitutes, an indifference curve will be a straight diagonal downwards sloping line
-U(x, y) = ax + by

-For perfect complements, an indifference curve will be an L shape, as you need both goods to increase utility
-U(x, y) = min { ax, by}

-For a Cobb-Douglas (indifference between the 2 extremes), it will be a downwards sloping curve
-U(x, y) = (x^a)(y^1-a)

Question 5

What is a monotonic transformation (3)

Answer 5

-Applying monotonic transformations to a utility function creates a new function but with the same preferences
-This works as we’re only interested in the ranking (ordinal), not the actual level itself (cardinal)
-Could include log(U(x, y)), e^(U(x, y)) etc

Question 6

Why are consumers not truly rational (4)

Answer 6

-Too many choices
-Loss aversion (giving up > getting something)
-How choices are framed (prospect theory)
-Bounded rationality (behaviour influenced by the environment)

Question 7

What are WARP and SARP (3)

Answer 7

-WARP = Weak Axiom of Revealed Preferences, SARP = Strong Axiom of Revealed Preferences
-WARP refers to directly revealed preferences (choosing one bundle over another when both can be afforded), SARP refers to directly and indirectly revealed
-SARP accounts for transitivity, WARP doesn’t

Question 8

How can we work out WARP and SARP ()

Answer 8

-If we set out our expenditure table, the consumed goods are the ones in the diagonal
-If any bundles are cheaper than the consumed one, we know that the consumed bundle is preferred to that one, so we asterisk it
-If a households preferences are asymmetric, we can determine whether WARP is satisfied