Advanced Microeconomics

Saba Yifredew
Department of Economics
Addis Ababa University
Email: [email protected]
Consumer theory
Introduction
• Central assumption in the theory of the consumer: optimization
• “Given the feasible set of consumption bundles, the bundle chosen is
the one the consumer prefers”
• A three-steps analysis:
1. How to model the consumer’s preferences?
2. What are the feasible consumption bundles?
3. What is (are) the best consumption bundle(s) among all feasible
consumption bundles?
 Why is the choice essential in the study of
economics?
• How do people make choices?
• Is there a pattern in choice making?
• How do we impact choices? Do we need to ?
How do incentives affect choices?
Most notable incentives prices, tax
Moral incentives: Society, culture, norms, moral appeals
Coercive incentives: Punishment
Remunerative incentives: Material rewards
The traditional approach to consumer behavior is to
assume that

• The consumer has well-defined preferences over all the alternative

bundles, and
• He/she attempts to select the most preferred bundle from those which
are available.
There are 4 building blocks in any model of consumer choice:

1. The consumption set or commodity space:

→the set of all alternatives a consumer can conceive; The choice set
2. The feasible set:
→The set of all alternatives the consumer can actually and realistically
achieve;
3. The preference relation:
→forming about the consumer’s tastes for the different objects of
choice;
4. The behavioral assumption:
→The guiding principle the consumer uses to make final choices:
selecting the most preferred available alternative.
• We assume that there is a finite, fixed, but arbitrary number n of
different goods. Call X the commodity space.
• Let 𝑥 𝑖 ∈ ℝ represent the number of units of good i. Only nonnegative
units of each good are feasible.
• The vector x = (𝑥 1 , 𝑥 2 , … . , 𝑥 𝑛 )is called a consumption bundle or
consumption plan.
• A consumption bundle x is thus represented by a point 𝑥 ∈ 𝑋 ⊂ ℝ𝑛+
Usually, consumption set as the entire non-negative orthant, 𝑋 = ℝ𝑛+
Preference relation (≿)
Rules binary comparisons must conform to.
These axioms ensure consumer can choose and that choices
are consistent
we represent the consumer’s preferences by a binary relation, ≿ ,
defined on the consumption set, X.
We thus require the consumer to only make binary comparisons, i.e.,
to compare two bundles at a time and make a decision about them.
Example: If x1 ≿ x2, we say that x1 is at least as good as x2, for this
consumer. This is also read as x1 is weakly preferred to x2
Axioms of consumer choice

• Consider X- The mother set of alternatives

• A prefernce relation on set X is a binary relation(≿) on X which
satisfies the following properties:
i. Reflexive: x1 ≿ x1
For every altenarnative in the set X,the alternative should be as good as
itself.
"I like one apple and one mango at least as well as one apple
and one mango.
 Axioms of consumer choice
i. Reflexive: x1 ≿ x1
• if the preference relation were not reflexive, there could be contradictions like:
• A≿B (A is at least as good as B)
• B≿A (B is at least as good as A)
• But A≿A does not hold, which could lead to inconsistent conclusions.
• Reflexivity helps avoid these inconsistencies, making sure that every alternative
can always be compared to itself in a way that maintains logical coherence in
the ranking.
Question: Is a strict preference ≻ ordering refleive?
Suppose x≻x. Then, by definition, x⪰x and x⋡x, which is impossible. The ≻ is not
reflexive.
Axioms of consumer choice
2. Completness: For any two bundles x1 and x2, the consumer can
compare the bundles as follows:
• 𝑥 1 ≿ 𝑥 2 stands for the statement that the consumer regards 𝑥 1
as at least as good as 𝑥 2 . 𝑥 1 could either be strictly better than
or indifferent to 𝑥 2 .

• 𝑥 1 ≻ 𝑥 2 (bundle 𝑥 1 is strictly preferred to bundle 𝑥 2 )

• 𝑥 1 ∼ 𝑥 2 (bundle 𝒙𝟏 indifferent to bundle 𝑥 2 ). The statement
implies that the consumer is indifferent between bundles
𝑥 1 𝑎𝑛𝑑 𝑥 2 .
The indifference relation is important in economics since frequently
we will be concerned with indifference sets.
Axioms of consumer choice
• Note that: 𝑥 1 ≻ 𝑥 2 if and only if 𝑥 1 ≿ 𝑥 2 and not 𝑥 2 ≿ 𝑥 1 → 𝑥 1 ≻ 𝑥 2

• 𝑥 1 ∼ 𝑥 2 if and only if 𝑥 1 ≿ 𝑥 2 and 𝑥 2 ≿ 𝑥 1 . The statement implies that

the consumer is indifferent between bundles 𝑥 1 𝑎𝑛𝑑 𝑥 2 .

Thus, we can have on the consumption se X

• 𝑥1 ≿ 𝑥 2 (bundle 𝑥 1 is at least as good as bundle 𝑥 2 )

• 𝑥1 ≼ 𝑥 2 (bundle 𝑥 1 is not better than bundle 𝑥 2 )
• 𝑥1 ≻ 𝑥 2 (bundle 𝑥 1 is strictly preferred to bundle 𝑥 2 )
• 𝑥1 ≺ 𝑥 2 (bundle 𝑥 1 is worse than bundle 𝑥 2 )
• 𝑥1 ∼ 𝑥 2 (bundle 𝑥 1 indifferent to bundle 𝑥 2 )
 Axioms of consumer choice
3. Transitivity
For any three elements in the set X s.t 𝑥 1 , 𝑥 2 and 𝑥 3 ∈ 𝑋 ⊂ ℝ𝑛+
Transitivity implies that if 𝑥 1 ≿ 𝑥 2 and 𝑥 2 ≿ 𝑥 3 then, 𝑥 1 ≿ 𝑥 3
The consumer’s choices be consistent.

Definition: Rational preference relation

A preference relation is called rational if it is complete and transitive.
Hypothetical preferences satisfying
completness and transitivity
The consumer place every point of the consumption set into
three mutually exclusive categories relative to a reference
bundle (𝑥 0 ).
𝑥 0 =(𝑥10 , 𝑥20 )
Thus, the consumer can compare using ≻ 𝑥 0 , ≺ 𝑥 0 and ∼
𝑥0.
Hypothetical preferences satisfying completness
and transitivity:Rational Preferences

These are consistent

But irregular?
The gaps?
The thick zones of indifference?

Need for additional requirements

on preferences
Axioms of consumer choice: Continuity
4. Continuity.
For all x ∈ ℝ𝑛+ , the ‘at least as good as’ set- ≿(x), and the ‘no better than’ set- ≼
(x), are closed in ℝ𝑛+ .
• Continuity rules out the open area in the indifference curve above.
• Preferences should not jump.
• Note that a bundle in the boundary of ∼ (x) does not belong to any set(The
preferences did not satisfy continuity)
• The preference relation ≿ on X is continuous if it is preserved under limits.
if a bundle 𝑥 1 is preferred to bundle 𝑥 2 , then a bundle close to 𝑥 1 are preferred
to bundles close to 𝑥 2 .
if 𝑥 1 ≿ 𝑥 2 and if bundle 𝑥 0 lies with a small distance (ε) between 𝑥 2 𝑎𝑛𝑑 𝑥 1 ,
then 𝑥 1 ≿ 𝑥 0
The continuity axiom guarantees that sudden preference reversals do not occur.
Axioms of consumer choice: Continuity
• If a is preferred to b, then “small” deviations from a or b will
not reverse the ordering.

• Preferences should not jump. No reversals

• A preference relation ≿ on X is continuous if whenever

a ≻ b (and not b ≿ a), there are neighbourhood balls Ba and Bb
around a and b respectively, such that for all x ∈ Baand y ∈ Bb,
then x ≻ y.

• Mathematically, the graph of a continous ≿ is the graph of

is continuous (closed set) i.e., contains all its limit points and
is under the limit operation.

• If ( 𝑎𝑛, 𝑏𝑛, ) is a sequence of pairs of elements in X

satisfying 𝑎𝑛 ≿ 𝑏𝑛 for all n and 𝑎𝑛 → 𝑎 and 𝑏𝑛 → 𝑏 then
𝑎 ≿𝑏
Hypothetical preferences satisfying
completeness, transitivity and continuity
The indifference set ∼ (x) is also a closed set.
 Axioms of consumer choice: Local non-satiation
5. Local non-satiation: Within a vicinity of a given point 𝑥 0 , no mater how small that
vicinity is (𝜀 ), there will always be at least one point x that the consumer prefers to 𝑥 0 .
In other words: for every 𝑥 0 there is a point “nearby” that the consumer prefers to 𝑥 0 .

Definition: Local non satiation

A preference relation is locally nonsatiated if for every 𝑥 1 and every 𝜀 > 0,
there is a such that∥ 𝑥 2 − 𝑥 1 ∥≤ 𝜀 and 𝑥 2 ≻ 𝑥 1 .

Rules out thickness of indifference curve : We preclude the possibility that the
consumer can even imagine having all his wants and whims for commodities completely
satisfied.)
It rules out the possibility of having ‘zones of indifference’, such as that surrounding 𝑥 1
(See previous fig)
Axioms of consumer choice: Local non-satiation
• If the indifference curves were thick, as in above figure, then there
would be points such as x, where in its neighborhood (the dotted circle)
all points are indifferent to x
• Local non-satiation does not rule out the possibility that the preferred
alternative may involve less of some or even all commodities.

• It does not imply that giving the consumer more of everything

necessarily makes that consumer better off.
• It allows for the possibility that some commodities are “bads”.

• However, it is not possible for all commodities to always be bads if

preferences are non-satiated. Why?
• →֒Because in this case no consumption at all (the point x = 0) would be
a satiation point.
Hypothetical preferences satisfying completeness,
transitivity, continuity and local non-satiation
Complete
Transitive
Continous
Local non-satiation
Axioms of consumer choice:
• Axiom 5. Strict Monotonicity
• When representing preferences over ordinary consumption goods, we
want to express the view that “wants” are unlimited, i.e.: “more is
better”.
• Strict Monotonicity. For all 𝑥 0 , 𝑥 1 ∈ ℝ𝑛+ , if 𝑥 0 ≥ 𝑥 1 then 𝑥 0 ≿ 𝑥 1 , while if
𝑥 0 ≫ 𝑥 1 , then 𝑥 0 ≻ 𝑥 1 .
• if one bundle contains at least as much of every commodity as another
bundle, then the one is at least as good as the other.
• Moreover, it is strictly better if it contains strictly more of every good.
Axioms of consumer choice:Monotonicity
Example: Monotonicity vs. strong monotonicity

• If ≿ is strongly monotone , bundles like y which contain as much of

a commodity (e.g., x1) as x are strictly preferred to x.
• No points northeast or southwest of x (boundaries included) may lie
in the same indifference set as x.
• If is monotone but not strongly (figure b), it need not be the case
that bundles like y are strictly preferred to x.
• No points northeast or southwest of x (boundaries excluded) may
lie in the same indifference set as x.
• If preferences are monotone or strongly monotone ⇒ a consumer
will choose a bundle on the boundary of the (Walrasian) budget
set.
• Actually, consumers would spend all their wealth even if
preferences satisfied the weaker condition of local non/satiation.
 Axioms of consumer choice:Monotonicity
• Any point north-east, such as 𝑥 1 ,
involves more of both goods than does
𝑥0 .
• All such points in the north-east
quadrant must therefore be strictly
preferred to 𝑥 0 .,
• Similarly, any point in the south-west
quadrant, such as 𝑥 2 , involves less of
both goods.
• It eliminates the possibility that the
indifference sets in ‘bend upward’, or
contain positively sloped segments
Axioms of consumer choice:Monotonicity
• Local non-satiation is implied by monotonicity of preferences.
However, as the converse is not true, local non-satiation is a weaker
condition.
• Monotonicity implies local non-satiation
• The preferences shown in this fig are:
✓Complete
✓Transitive
✓Continuous
✓Monotonic
 Axioms of consumer choice: Convexity
• A final significant assumption on preferences concerns the trade-offs
that the consumer is willing to make among different goods.
• Consumer prefers 'taste for diversification’ i.e balanced bundle
• Which actually means that “averages are at least as good as extremes.”
• Preferences are said to be convex if, for any reference bundle x ∈ X, the
at least as good as set ≿ (x) is a convex set.
• Weak and Strict convexity versions
Convexity:
Weak Convexity. If 𝑥 1 ≿ 𝑥 0 , then t 𝑥 1 + (1 − t) 𝑥 0 ≿ 𝑥 0 for all t ∈ [0, 1].
 Convex sets: Intiution
• weighted average = convex combination.
• We say that z is a convex combination of 𝑥 1
and 𝑥 2 , if z = t 𝑥 1 + (1 − t) for some number
t between zero and 1.

• A convex combination z is thus a point that,

in some sense, lies between the two points
𝑥 1 and 𝑥 2 .
Convex sets

• A convex set is defined as a set of

points in which the line AB
connecting any two points A, B in the
set lies completely within that set.
• A set C is convex if the line segment
between any two points in C lies in C,
i.e. for all 𝑥 1 , 𝑥 2 ∈ C, ∀ 𝜆 ∈ [0, 1]
𝜆𝑥 1 + (1 −𝜆) 𝑥 2 ∈ C.
• Convex sets are all “nicely behaved”.
• They have no holes, no breaks, and
no awkward curvatures on their
boundaries.
Axioms of consumer choice: Convexity

• Strict Convexity. If 𝑥 1 ≿ 𝑥 0 , then t 𝑥 1 + (1 − t) 𝑥 0 ≻ 𝑥 0 for all t ∈ [0, 1].

• Hence, we rule out concave-to-the-origin segments in the indifference sets.

Consider the figure:

• 𝑥 1 ∼ 𝑥 2 On the same IC
• But both contain relatively extreme bundles of goods(e.g., 𝑥 2 contains
too much of good 1, 𝑥1 .
• Now consider a convex combination of 𝑥 1 and 𝑥 2 such as 𝑥 𝑡
• Suppose t=0.2 and (1-t) =0.8
• 𝑥 𝑡 will be a bundle containing a more ‘balanced’ combination of 𝑥1 and
𝑥2 than does either ‘extreme’ bundle 𝑥1 and 𝑥2
• The consumer prefers averages to extremes
Axioms of consumer choice: Convexity

• Implications of convexity for consumers’ tastes focuses attention on

the ‘curvature’ of the indifference sets
• The (absolute value of the) slope of an indifference curve is called the
Marginal rate of Substitution of good two for good one.
• This slope measures, at any point, the rate at which the consumer is
just willing to give up good two per unit of good one received.
• Thus, the consumer is indifferent after the exchange.
• The rate at which the consumer would trade 𝑥2 for 𝑥1 and remain
indifferent to be either constant or decreasing (strictly convex) as we
move from north-west to south-east along an indifference curve
Principle of diminishing marginal rate of
substitution
Slope of the indifference curve is diminishing.
Preferences are convex
 Summary on Axioms
• Indifference sets must be non intersecting(consistent),continuous,thin,
downward sloping, and“bowed upward.”
• A preference relation is “well behaved” if it is if it is –monotonic and convex
• There is nothing in the definition of convexity that prevents flat regions from
appearing on indifference curves.
Question:Can you provide an example of “flat” convex indifference curves?
Three related sets of consumption bundles can be defined w.r.t a given bundle 𝑥.
Indifference set y ∈ ℝ𝒏+ : y ∼ x
Upper contour set: y ∈ ℝ𝒏+ : y ≿ x
Lower contour set: y ∈ ℝ𝒏+ : y ≼ x

Note: The indifference set is the intersection of the upper and lower contour
sets.
 Question on preference relation
Q. Prove that if ≿ is rational, then ∼ is transitive, that is, x ∼ y and y ∼ z
implies x ∼ z.
Solution
For x ∼ z, we must show x ≿ z and z ≿ x
We need to prove that x ∼ y and y ∼ z implies x ∼ z if ≿ is rational.
• We know that x ∼ y is equivalent to x ≿ y and y ≿ x.
• Similarly, y ∼ z is equivalent to y ≿ z and z ≿ y.
• Hence, know x ≿ y and y ≿ z. Using the transitivity of ≿ , it implies that x
≿ z. But we have z ≿ y and y ≿ x.
• The transitivity of ≿ therefore implies that, z ≿ x.
• But x ≿ z and z ≿ x is exactly x ∼ z, hence proved
The Utility Function