Intermediate Microeconomics

Lecture 4

Revealed Preference and Intertemporal Choice

 Discussion
 We don’t directly observe utility
functions or indifference curves.
 How do we estimate each one’s
preference?

2
 Revealed Preference Analysis
 Consumers’ consumption choices
can reveal their preferences.

 Suppose we observe the demands

(consumption choices) that a
consumer makes for different
budgets.

 We can use this information to ...

3
Revealed Preference Analysis
– Test the behavioral hypothesis that
a consumer chooses the most
preferred bundle from those
available.

– Discover the consumer’s

preference relation.
 Assumptions on Preferences
 Preferences
– do not change while the choice data are
gathered.
– are strictly convex.
– are monotonic.

 Together,convexity and monotonicity imply

that the most preferred affordable bundle is
unique.
 Assumptions on Preferences
x2
If preferences are convex and
monotonic (i.e. well-behaved)
then the most preferred
x2* affordable bundle is unique.

x1* x1
 Revealed Preference
- If we observe Jeff drives Honda,
can we say that Jeff prefers Honda
to Benz?

7
 Direct Preference Revelation
 Suppose that the bundle x* is chosen
when the bundle y is affordable.
Then x* is revealed directly as
preferred to y.

 Otherwise y would have been chosen.

 Direct Preference Revelation
x2
The chosen bundle x* is
revealed directly as preferred
to the bundle y.
x*

y
x1
 Direct Preference Revelation
 Thatx is revealed directly as
preferred to y will be written as
p
x y.
D
 Indirect Preference Revelation
 Suppose x is revealed directly
preferred to y, and y is revealed
directly preferred to z.
 By transitivity, x is revealed indirectly
as preferred to z. Write this as
p
x I z
p p p
so x D
y and y D
z x I
z.
 Two Axioms of Revealed
Preference
 To apply revealed preference
analysis, choices must satisfy two
criteria:

 The
Weak and the Strong Axioms of
Revealed Preference.
 The Weak Axiom of Revealed
Preference (WARP)
 If the bundle x is revealed directly as preferred
to the bundle y then it is never the case that y
is revealed directly as preferred to x; i.e.
p p
x D
y not (y x).
D
 If the consumers are choosing the best bundle
they can afford,
 then the other bundles that are affordable
but not chosen must be worse than what is
chosen.
 The Weak Axiom of Revealed
Preference (WARP)

 Choice data which violate the WARP are

inconsistent with economic rationality.
 The WARP is a necessary condition for
applying economic rationality to explain
observed choices.

 If rational must satisfy WARP.

 WARP
 What choice data violate the WARP?
 WARP
x2

y
x
x1
 WARP
x2
x is chosen when y is available
so x
p y.
D

y
x
x1
 WARP
x2
x is chosen when y is available
so x
p y.
D
y is chosen when x is available
so y
p x.
D
y
x
x1
 WARP
x2
x is chosen when y is available
so x
p y.
D
y is chosen when x is available
so y
p x.
D These statements are
y
x inconsistent with
each other.
x1
 WARP
• There is no set of indifference
curves that could be drawn that
could make both bundles utility
maximizing bundles.

• If y-bundle is affordable when the

X-bundle is purchased, then when
y-bundle is purchased, the x-
bundle must not be affordable.
20
Checking if Data Violate the WARP
A consumer makes the following
choices:
– At prices (p1,p2)=($2,$2) the choice
was (x1,x2) = (10,1).
– At (p1,p2)=($2,$1) the choice was
(x1,x2) = (5,5).
– At (p1,p2)=($1,$2) the choice was
(x1,x2) = (5,4).
 Is the WARP violated by these data?
 Checking if Data Violate the WARP

Choices
(10, 1) (5, 5) (5, 4)
Prices
($2, $2) $22 $20 $18

($2, $1) $21 $15 $14

($1, $2) $12 $15 $13

Red numbers are costs of chosen bundles.

 Checking if Data Violate the WARP

Choices
(10, 1) (5, 5) (5, 4)
Prices
($2, $2) $22 $20 $18

($2, $1) $21 $15 $14

($1, $2) $12 $15 $13

Circles surround affordable bundles that

were not chosen.
Checking if Data Violate the WARP

(10,1) is directly revealed preferred

to (5,4), but (5,4) is directly revealed
preferred to (10,1), so the WARP is
violated by the data.
 The Strong Axiom of Revealed
Preference (SARP)
 Ifthe bundle x is revealed (directly or
indirectly) as preferred to the bundle
y and x  y, then it is never the case
that the y is revealed (directly or
indirectly) as preferred to x; i.e.
p p
x y or x y
D I
not ( y
p x or y
p x ).
D I
 The Strong Axiom of Revealed
Preference
 What
choice data would satisfy the
WARP but violate the SARP?
 The Strong Axiom of Revealed
Preference
 Consider the following data:

A: (p1,p2,p3) = (1,3,10) & (x1,x2,x3) = (3,1,4)

B: (p1,p2,p3) = (4,3,6) & (x1,x2,x3) = (2,5,3)

C: (p1,p2,p3) = (1,1,5) & (x1,x2,x3) = (4,4,3)

 The Strong Axiom of Revealed
Preference
A: ($1,$3,$10)
Choice
(3,1,4). Prices
A B C

B: ($4,$3,$6) A $46 $47 $46

(2,5,3).
B $39 $41 $46

C: ($1,$1,$5) C $24 $22 $23

(4,4,3).
 The Strong Axiom of Revealed
Preference
Choices In situation A,
A B C
Prices bundle A is
directly revealed
A $46 $47 $46
preferred to
bundle C;
B $39 $41 $46 p
A C.
D
C $24 $22 $23
 The Strong Axiom of Revealed
Preference
Choices In situation B,
A B C
Prices bundle B is
directly revealed
A $46 $47 $46
preferred to
bundle A;
B $39 $41 $46 p
B A.
D
C $24 $22 $23
 The Strong Axiom of Revealed
Preference
Choices In situation C,
A B C
Prices bundle C is
directly revealed
A $46 $47 $46
preferred to
bundle B;
B $39 $41 $46 p
C B.
D
C $24 $22 $23
The data do not
Violate WARP.
 The Strong Axiom of Revealed
Preference
We have that A B C
p p p
A C, B A and C B A I D
D D D

so, by transitivity, B D I
p p p
A B, B C and C A. C I D
I I I
 The Strong Axiom of Revealed
Preference
p
B A is inconsistent A B C
D
p
with A B. A I D
I

B D I

C I D
 The Strong Axiom of Revealed
Preference
p
A C is inconsistent A B C
D
p
with C A. A I D
I

B D I

C I D
 The Strong Axiom of Revealed
Preference
p
C B is inconsistent A B C
D
p
with B C. A I D
I

B D I

C I D
 The Strong Axiom of Revealed
Preference
A B C
The data do not violate
the WARP but there are A I D
3 violations of the SARP.
B D I

C I D
 The Strong Axiom of Revealed
Preference
 That the observed choice data satisfy
the SARP is a condition necessary
and sufficient for there to be a well-
behaved preference relation that
“rationalizes” the data.
 So the 3 choice data cannot be
rationalized by a well-behaved
preference relation.
Intertemporal Choice

38
 Discussion
Remember we discussed the government
could stimulate the post-covid
consumption by dispensing vouchers.

What if the government directly gives out

cash/tax credits?

39
 Discussion
What factors affect your
saving/borrowing decisions?

40
 Intertemporal Choice
 Personsoften receive income in
“lumps”; e.g. monthly salary.

 How is a lump of income spread over the

following month (saving now for
consumption later)?

41
 Intertemporal Choice
 Orhow is consumption financed by
borrowing now against income to be
received in future?

 Think about credit cards.

42
 Present and Future Values
 Begin with some simple example:
 Take just two periods; 1 and 2.
 Let r denote the interest rate per
period.

43
 Future Value
 E.g., if r = 0.1 then $100 saved at the
start of period 1 becomes $110 at the
start of period 2.
 The value next period of $1 saved
now is the future value of that dollar.

44
 Future Value
 Givenan interest rate r the future
value one period from now of $1 is
FV  1  r.
 Givenan interest rate r the future
value one period from now of $m is
F V  m ( 1  r ).

45
 Present Value
 Suppose you can pay now to obtain
$1 at the start of next period.
 What is the most you should pay?
 $1?

46
 Present Value
 Suppose you can pay now to obtain
$1 at the start of next period.
 What is the most you should pay?
 $1?
 No. If you saved your $1 now, you
would have $(1+r) > $1 in next period,
so paying $1 now for $1 next period
is a bad deal.

47
 Present Value
 Q: How much money would have to be
saved now, in the present, to obtain $1
at the start of the next period?

48
 Present Value
 Q: How much money would have to be
saved now, in the present, to obtain $1
at the start of the next period?
 A: $m saved now becomes $m(1+r) at
the start of next period, so we want
the value of m for which
m(1+r) = 1

That is, m = 1/(1+r),

49
 Present Value
 Thepresent value of $1 available at
the start of the next period is
1
PV  .
1r
 And the present value of $m
available at the start of the next
period is
m
PV  .
1r
50
 Present Value
 E.g.,
if r = 0.1 then the most you
should pay now for $1 available next
period is
1
PV   $0  91.
1 01

 And if r = 0.2 then the most you

should pay now for $1 available next
period is
1
PV   $0  83.
1 02
51
 The Intertemporal Choice
Problem
 Let m1 and m2 be incomes received
in periods 1 and 2.
 Let c1 and c2 be consumptions in
periods 1 and 2.
 Let p1 and p2 be the prices of
consumption in periods 1 and 2.

52
The Intertemporal Choice Problem
 Theintertemporal choice problem:
Given incomes m1 and m2, and given
consumption prices p1 and p2, what is
the most preferred intertemporal
consumption bundle (c1, c2)?

 What do we need to know to answer

this question?
 What makes you want to save now for
consumption in future?
53
The Intertemporal Choice Problem

 We need to know:
– the intertemporal budget constraint
– intertemporal consumption
preferences.

54
 The Intertemporal Budget
Constraint
 Tostart, let’s ignore price effects by
supposing that

p1 = p2 = $1.

55
 The Intertemporal Budget
Constraint
 Suppose that the consumer chooses
not to save or to borrow.
 Q: What will be consumed in period 1?

 Q: What will be consumed in period 2?

56
 The Intertemporal Budget
Constraint
 Suppose that the consumer chooses
not to save or to borrow.
 Q: What will be consumed in period 1?
 A: c1 = m1.
 Q: What will be consumed in period 2?
 A: c2 = m2.

57
 The Intertemporal Budget
c2 Constraint

m2

0 m1 c1

58
 The Intertemporal Budget
c2 Constraint
So (c1, c2) = (m1, m2) is the
consumption bundle if the
consumer chooses neither to
save nor to borrow.
m2

0 c1
0 m1

59
 The Intertemporal Budget
Constraint
 Now suppose that the consumer
spends nothing on consumption in
period 1; that is, c1 = 0 and the
consumer saves
s1 = m1.
 The interest rate is r.
 What now will be period 2’s
consumption level?

60
 The Intertemporal Budget
Constraint
 Period 2 income is m2.
 Savings plus interest from period 1
sum to (1 + r )m1.
 So total income available in period 2 is
m2 + (1 + r )m1.
 So period 2 consumption expenditure
is
c 2  m 2  ( 1  r )m 1

61
 The Intertemporal Budget
c2 Constraint
the future-value of the income
m2 
endowment
( 1  r )m1

m2

0 c1
0 m1

62
 The Intertemporal Budget
c2 Constraint
m2  ( c 1 , c 2 )   0 , m 2  ( 1  r )m 1 
( 1  r )m1 is the consumption bundle when all
period 1 income is saved.

m2

0 c1
0 m1

63
 The Intertemporal Budget
Constraint
 Now suppose that the consumer
spends everything possible on
consumption in period 1, so c2 = 0.
 What is the most that the consumer
can borrow in period 1 against her
period 2 income of $m2?
– Let b1 denote the amount borrowed
in period 1.

64
 The Intertemporal Budget
Constraint
 Only $m2 will be available in period 2
to pay back $b1 borrowed in period 1.
 So b1(1 + r ) = m2.
 That is, b1 = m2 / (1 + r ).
 So the largest possible period 1
consumption level is
m2
c 1  m1 
1r
65
 The Intertemporal Budget
c2 Constraint
m2 
( 1  r )m1

m2 the present-value of
the income endowment

0
0 m1 m 2 c1
m1 
1r
66
 The Intertemporal Budget
c2 Constraint
m2 
( 1  r )m1


( c 1 , c 2 )   m1 
m2 
, 0
 1r 
m2 is the consumption bundle
when borrowing period 2
money.
0
0 m1 m 2 c1
m1 
1r
67
 The Intertemporal Budget
Constraint
 Suppose that c1 units are consumed
in period 1. This costs $c1 and
leaves m1- c1 saved. Period 2
consumption will then be

c 2  m 2  ( 1  r )( m 1  c 1 )

68
 The Intertemporal Budget
Constraint
 Suppose that c1 units are consumed in
period 1. This costs $c1 and leaves m1-
c1 saved. Period 2 consumption will
then be
c 2  m 2  ( 1  r )( m 1  c 1 )
which is
c 2   ( 1  r ) c 1  m 2  ( 1  r )m 1 .








slope intercept
69
 The Intertemporal Budget
c2 Constraint
m2 
c 2   ( 1  r ) c 1  m 2  ( 1  r )m 1 .
(1  r)m1
slope = -(1+r)

m2

0
0 m1 m 2 c1
m1 
1r
70
 The Intertemporal Budget
c2 Constraint
c 2   ( 1  r ) c 1  m 2  ( 1  r )m 1 .
m2 
(1  r)m1 slope = -(1+r)
Consume less
than m1 today

m2 Consume more
than m1 today

0
0 m1 m 2 c1
m1 
1r
71
 The Intertemporal Budget Constraint
( 1  r ) c 1  c 2  ( 1  r )m 1  m 2
is the “future-valued” form of the budget
constraint since all terms are in period 2
values. This is equivalent to
c2 m2
c1   m1 
1r 1r
which is the “present-valued” form of the
constraint since all terms are in period 1
values.

72
 The Intertemporal Budget
Constraint
 Now let’s add prices p1 and p2 for
consumption in periods 1 and 2.
 How does this affect the budget
constraint?

73
 Intertemporal Choice
 Given her endowment (m1,m2) and
prices p1, p2， what intertemporal
consumption bundle (c1*,c2*) will be
chosen by the consumer?
 Maximum possible expenditure in
period 2 is m 2  ( 1  r )m 1
so maximum possible consumption in
period 2 is m  ( 1  r )m
c2  2 1.
p2

74
 Intertemporal Choice
 Similarly,
maximum possible
expenditure in period 1 is
m2
m1 
1r
so maximum possible consumption
in period 1 is
m1  m 2 / ( 1  r )
c1  .
p1
75
 Intertemporal Choice
 Finally,if c1 units are consumed in
period 1 then the consumer spends
p1c1 in period 1, leaving m1 - p1c1
saved for period 1. Available income
in period 2 will then be

so m 2  ( 1  r )( m 1  p 1 c 1 )

p 2 c 2  m 2  ( 1  r )( m 1  p 1 c 1 ).

76
 Intertemporal Choice
p 2 c 2  m 2  ( 1  r )( m 1  p 1 c 1 )
rearranged is
( 1  r ) p 1c 1  p 2 c 2  ( 1  r ) m 1  m 2 .
This is the “future-valued” form of the
budget constraint since all terms are
expressed in period 2 values.

77
 Intertemporal Choice
Equivalent
to it is the “present-valued” form

p2 m2
p1c 1  c 2  m1 
1r 1r
where all terms are expressed in period 1
values.

78
The Intertemporal Budget
c2 Constraint

m2/p2

0 c1
0 m1/p1

79
 The Intertemporal Budget
c2 Constraint
( 1  r )m1  m 2
p2

m2/p2

0 c1
0 m1/p1

80
 The Intertemporal Budget
c2 Constraint
( 1  r )m1  m 2
p2

m2/p2

0 c1
0 m1/p1
m1  m 2 / ( 1  r )
p1 81
 The Intertemporal Budget
c2 Constraint
( 1  r )m1  m 2
( 1  r ) p 1c 1  p 2 c 2  ( 1  r ) m 1  m 2
p2 p1
Slope =  ( 1  r )
p2

m2/p2

0 c1
0 m1/p1
m1  m 2 / ( 1  r )
p1 82
 The Intertemporal Budget
c2 Constraint
( 1  r )m1  m 2 ( 1  r ) p 1c 1  p 2 c 2  ( 1  r ) m 1  m 2
p2 p1
Slope =  ( 1  r )
p2

m2/p2

0 c1
0 m1/p1
m1  m 2 / ( 1  r )
p1 83
The Intertemporal Budget
Constraint

What affects the price changes?

84
 Price Inflation

 Define the inflation rate by p where

p1 (1  p )  p 2 .
 For
example,
p = 0.2 means 20% inflation, and
p = 1.0 means 100% inflation.

85
 Price Inflation

 We set p1=1 so that p2 = 1+ p .

 Then we can rewrite the budget
constraint
p2 m2
p1c 1  c 2  m1 
1r 1r
as
1 p m2
c1  c 2  m1 
1r 1r

86
 Price Inflation
1 p m2
c1  c 2  m1 
1r 1r
rearranges to
1r （1  r)m 1 m2 
c2   c1    
1p  1p 1p
so the slope of the intertemporal budget
constraint is 1 r
 .
1 p

87
 Price Inflation
 When there was no price inflation
(p1=p2=1) the slope of the budget
constraint was -(1+r).
 Now, with price inflation, the slope of
the budget constraint is -(1+r)/(1+ p).
This can be written as
1r
 (1  r )  
1 p
r is known as the real interest rate.
88
 Real Interest Rate
1r
 (1  r )  
1 p
gives
rp
r .
1 p
For low inflation rates (p  0), r  r - p .
For higher inflation rates this
approximation becomes poor.

89
Real Interest Rate

90
 Comparative Statics
 The slope of the budget constraint is
1 r
 (1  r )   .
1 p
 How does an increase in interest rate
or inflation rate affect consumer’s
borrowing and saving behaviors?

91
 Comparative Statics
 The slope of the budget constraint is
1 r
 (1  r )   .
1 p
 The constraint becomes flatter if the
interest rate r falls or the inflation
rate p rises (both decrease the real
rate of interest).

92
 Comparative Statics
c2 1r
slope =  ( 1  r )  
1 p

m2/p2

0 c1
0 m1/p1

93
 Saving
c2 1r
slope =  ( 1  r )  
1 p
The consumer saves.

m2/p2

0 c1
0 m1/p1

94
 Comparative Statics
c2 1r
slope =  ( 1  r )  
1 p
An increase in the
inflation rate or a
decrease in the
interest rate
m2/p2 “flattens” the
budget constraint.

0 c1
0 m1/p1

95
 Comparative Statics
c2 1r
slope =  ( 1  r )  
1 p
If the consumer saves then
saving is reduced by a lower
interest rate or a
higher inflation
m2/p2 rate.

0 c1
0 m1/p1

96
 Borrowing
c2 1r
slope =  ( 1  r )  
1 p
The consumer borrows.

m2/p2

0 c1
0 m1/p1

97
 Comparative Statics
c2 1r
slope =  ( 1  r )  
1 p
An increase in the
inflation rate or a
decrease in the interest
rate “flattens” the
m2/p2 budget constraint.

0 c1
0 m1/p1

98
 Comparative Statics
c2 1r
slope =  ( 1  r )  
1 p
If the consumer borrows then
borrowing is increased by a
lower interest rate or a
higher inflation
m2/p2 rate.

0 c1
0 m1/p1

99
Exercise

100
Exercise

101
 Valuing Securities
A financial security is a financial
instrument that promises to deliver
an income stream.
 E.g.; a security that pays
$m1 at the end of year 1,
$m2 at the end of year 2, and
$m3 at the end of year 3.
 What is the most that should be paid
now for this security?

102
 Valuing Securities
 The PV of $m1 paid 1 year from now is
m1 / (1  r )
 The PV of $m2 paid 2 years from now is
2
m 2 / (1  r )
 The PV of $m3 paid 3 years from now is
m 3 / (1  r ) 3
 The PV of the security is therefore
m1 / (1  r )  m 2 / (1  r ) 2  m 3 / (1  r ) 3 .

103
 Valuing Bonds
A bond is a special type of security
that pays a fixed amount $x for T
years (its maturity date) and then
pays its face value $F.
 What is the most that should now be
paid for such a bond?

104
 Valuing Bonds

x x x F
PV     .
1  r (1  r ) 2 (1  r )T  1 (1  r )T
105
 Lottery
 Suppose you win a lottery. The prize
is $1,000,000 but it is paid over 10
years in equal installments of
$100,000 each. What is the prize
actually worth?

106
 Lottery
$100,000 $100,000 $100,000
PV   
1  0  1 ( 1  0  1) 2 ( 1  0  1) 10

 $614,457

is the actual (present) value of the prize.

107