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Microeconomics
University of Melbourne
Third year

Mar 06, 2016

© © All Rights Reserved

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Giorgi
Microeconomics
University of Melbourne
Third year

© All Rights Reserved

25 views

Giorgi
Microeconomics
University of Melbourne
Third year

© All Rights Reserved

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ECON30010 Microeconomics

3 March 2016

ECON30010

3 March 2016

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Classical Economics

to be similar to the laws of physics (e.g. Newtons laws).

Example

I

income per capita and inequality;

These ideas are derived from observing aggregate variables, not

individual behaviour.

I

ECON30010

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Neoclassical Economics

aggregate variables, are concerned with microfoundations: is my

macroeconomic model consistent with the behaviour of the

individuals?

ECON30010

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individuals.

utility function, which summarizes what individuals like and dislike.

Since we are going to use utility function all the time, we need to

have clear understanding what it is and how we could deal with it.

ECON30010

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ECON20002 recap

Suppose an agent consumes food (F ) and junk food (J). Given prices

PF and PJ , what is the optimal consumption bundle of this agent?

If we know the agents utility function (e.g. U = J F ), the optimal

bundle is given by:

MRSJF =

PJ

MUJ

=

MUF

PF

How many of you can write down your own function for F and J?

If not many, what are we talking about if even a group of economics

students cannot do it?

Utility function is not what agents possess. It is a useful model of agents

underlying preferences.

This model will have the underlying assumptions, a proof (that we will

defer until honours year) and a conclusion.

ECON30010

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Plan

I

I

I

setup and assumptions.

We start by looking at the assumptions we want to impose on

individual preferences. This is a bit of ECON20002 recap, but we will

be more careful.

As any model, it makes predictions. I will argue that these predictions

are very weak.

However, in practice we use these weak predictions to make further

strong assumptions (not implied by our original assumptions) and use

a specific form of a utility function.

This specific form is another instance of a model, which does not

always conform to the reality (and, in fact, any model should not

always conform to reality)

We then talk about testing different models.

We finish by throwing in few more assumptions on preferences.

ECON30010

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Model: Assumptions

they would choose two very dry commodities: good 1 (the quantity of

good 1 consumed will be denoted by a letter with subindex 1, such as q1 ,

x1 , or y1 ) and good 2 (quantities q2 , x2 , or y2 ). As often as life allows us

we will deal with only two goods, for simplicity.

When we model individuals, we need to be very precise and careful about

the choice set. In many models the choice set is introduced in a single

sentence, but we will see today that this choice is important.

ECON30010

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Model: Assumptions

Note: this mostly reviews the concepts you have learned in ECON20002 last year.

assumptions on how agents choose from this choice set.

In most economic problems, the following assumptions seem reasonable:

I

compared.1

compare these two objects what do you like better,

singing or a cylinder hat? but if you cannot compare,

do you really ever need to choose between the two?

In math notation, bold letters, such as x and y, will always stand for a vector, as it

is here. Thus, x = (1, 3) should be understood as a bundle that consists of 1 unit of

good 1 and 3 units of good 2.

ECON30010

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Model: Assumptions

In most economic problems, the following assumptions seem reasonable:

I

good as bundle z, then x is at least as good as z.

One example of transitivity are real numbers and greater than relation

(>). It is transitive: if a > b and b > c then a > c.

What happens if transitivity does not hold? Suppose that

you prefer ECON20001 to ECON30010 (ECON20001 ECON30010),

and you prefer ECON20002 to ECON20001 (ECON20002 ECON20001),

but you prefer ECON30010 to ECON20002 (ECON30010 ECON20002).

These are not great preferences to have as a manipulator would be able to

make you whatever choice he or she likes (including taking ECON30010!).

I would hope that whenever you observe yourself making such choices

(which is, of course, possible), you would regard them as a mistake.

ECON30010

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Model: Assumptions

Consider a dinner where you are to choose the wine (red or white) and the

main dish (fish or beef).

Suppose: red wine white wine fish beef.

Shall we conclude from this that you would choose red wine and fish for

your dinner? If not, whats wrong?

The choice set is incorrectly defined. If you want to choose a drink and a

main dish, then the choice set should be: (red wine, beef), (white wine,

fish), (red wine, fish), (white wine, beef).

The choice of the choice set should be appropriate for the question you

want to ask.

ECON30010

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Model: Assumptions

In most economic problems, the following assumptions seem reasonable:

I

y and bundle z is sufficiently close to y, then x is better than z.

wine and 1 kg of fish, then you would prefer x to 1.01y (that is, to 1.01`

of white wine and 1.01 kg of fish).

ECON30010

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Model: Assumptions

In most economic problems, the following assumptions seem reasonable:

I

compared.

good as bundle z, then x is at least as good as z.

y and bundle z is sufficiently close to y, then x is better than z.

What do we need it for? With these assumptions, we can start to use very

powerful math tools.

ECON30010

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Model: Results

Even though people simply make a choice from the choice set, we can

pretend that they have a utility function.

Specifically, we will assign to each bundle (such as 1` of red wine and 1 kg

of beef) a (real) number and then compare numbers instead of bundles.

Formally: We say that a utility function u(x) represents the preferences if,

whenever x better than y, we have u(x) > u(y).

This leads to a very important theorem:

Theorem

If preferences over bundles of goods x satisfy completeness, transitivity,

and continuity, then there exists a continuous utility function u(x) that

represents these preferences.

Why is this theorem important? Because mathematicians are very good at

working with functions, and we can use a lot of their tools.

ECON30010

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Model: Results

I

function (but they would not satisfy our assumptions).

If preferences are represented by a utility function, this utility function

is not unique. Any positive monotonic transformation of the utility

function will represent the same preferences.

I

Why: The only important thing about a utility function is how two

numbers compare (e.g., u(x) > u(y)). But the very definition of a

positive monotonic transformation is that this inequality is preserved!

Example:

I u 1 (x) = x1 x2

I u 3 (x) =

x1 x2

I

all represent the same preferences (e.g. all four of these utility

functions could be utility functions of the same individual).

How could you check it? Take any two consumption bundles, e.g.

(1, 3) and (2, 1), and calculate u 1 , u 2 , u 3 , u 4 for these two bundles.2

2

Note: this is not a proof. For a proof, you need to show that the same holds for any

two bundles, (x1 , x2 ) and (y1 , y2 ); that is, if for given x, y, u i (x) > u i (y) for one of these

functions, the same holds for all three others.

ECON30010

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Model: Results

Summary

A utility function is a fake. When I say consider an agent with utility

function u = F J, this is short for: consider an agent who, when faced

with the choice between food and junk food, make a choice as if his or her

utility function is u = F J.

If you ever hear someone say:

Economists are silly, they assume people have utility function,

but if I ask them to write their own utility function, they cannot

do even that

then you would need to say that economists do not assume that people

have utility function. Economists assume that peoples preferences are (1)

complete; (2) transitive; (3) monotone. Which one do you have a problem

with?

This is, of course, not to say that utility function cannot be incorrectly

specified. We will look at it next.

ECON30010

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Model: Results

Do the preferences described by the following utility functions3 satisfy

(1) completeness;

(3) continuity;

(2) transitivity?

1. u(x) = x for x [0, 1]

2. u(x) = 1 for x [0, 1), u(x) = 2 for x [1, 2].

3. u(x) = 1/x for x (0, 1], u(x) = 0 for x = 0.

4. u(x) = 10, for x (1, 2),

2

x , for x [2, 3].

ECON30010

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Next we will talk about selfish behaviour (or the lack of thereof). Why do

we want to talk about it?

Specific knowledge:

1. We have made assumptions on preferences; I want to show you that

these assumptions still allow for a variety of different utility functions.

Generic skills:

2. I want a simple environment that I can use to talk about different

models.

3. I want to drive home a point that models are not fixed, received

knowledge. They are subject to testing and modifications and may be

suitable in some cases and unsuitable in some other cases.

ECON30010

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Selfish behaviour

Sometimes you can hear that

Economists assume selfish behaviour, which is silly as we see

many instances of altruistic behaviour, such as when people

share their money with others.

This description is a bit too generic, so let us think about a concrete

situation: suppose that agent 1 is given $5 that agent 1 can allocate

between herself and agent 2. Suppose that we observe that agent 1 gives

y > 0 to agent 2. I will call this situation Situation 1.4

Is it a contradiction to anything we have assumed so far?

may sometimes be confusing, but in many cases we will indeed look at experiments from

Experimental Economics literature.

ECON30010

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A standard model

Choice set is (x, y ), x 0, y , 0. I interpret x as the amount of money

kept to oneself and y as an amount of money given to the other person.

Utility function u(x, y ) defined over this choice set. The utility function

that is consistent with selfish behaviour is u(x, y ) = x.

In Situation 1, there is an additional requirement, x = 5 y .

What standard model predicts? Since agent 1s utility function is

u(x, y ) = x, then her optimal choice is y = 0.

I assumed that agent 1 splits the money so that y > 0. This is

inconsistent with the prediction of the standard model.

ECON30010

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There is a number of theories that can rationalise giving. Let us look at

few of these theories (which, in this instance, take a form of an

assumption on utility function but they do not have to!).

1. u FS (x, y ) = x |x y |, 0 < < 1: a person cares about own

payoff, but also cares about the difference in payoffs (Fehr and

Schmidt, 1999);

0

but also cares about the difference in payoffs (inspired by FS);

2

x

12 , > 0: a person cares about own

3. u BO (x, y ) = x x+y

payoff and about her share of the payoff (inspired by Bolton and

Ockenfels, 2000);

4. u LL (x) = x (x x e )2 , > 0: x e is an expected decision (e.g.

dictated by social norms) and (x x e )2 is the moral cost of deviating

from an expected decision (inspired by Levitt and List, 2007).

ECON30010

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0

Situation 1?

0

0

What choice does it predict in our environment?

d FS 0

U (x, 5 x) = 1 + 4(5 2x) = 0

dx

1

5

1

5 2x =

x = +

4

2 8

Note that is not known and may vary among individuals; the only thing

we assume about is that > 0. Thus, the prediction is that agent 1 will

keep more than 1/2 of $5 (nothing more can be said).

ECON30010

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Given our situation, we conjecture that x e = 5/2 (wait to ask me why),

hence we can re-write u LL as

u LL (x) = x (x 5/2)2

What choice does it predict in our environment?

d LL

u (x) = 1 2(x 5/2) = 0

dx

1

x = 5/2 +

2

Recall that is not known; so the prediction here is that agent 1 will keep

more than 1/2 of $5 to herself.

ECON30010

3 March 2016

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0

LL .

x = 5/2 +

1

8FS 0

x = 5/2 +

1

2LL

prediction in our Situation 1: we cannot distinguish between two models.

ECON30010

3 March 2016

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This lack of different predictions is bad news for us: if we want to test

0

whether u FS or u LL better describe giving, we could not say. We may,

however, try to make a less precise statement whether they seem to fit

well the reality or not. Let us look at the data:

$

% The right column is a % of people who give the $ amount in

0

.29 the left column. For example, $0 is given by 29% of the

0.5 .17 subjects and $2.5 is given by 25% of the subjects.

1

.15 Recall (previous slide) that if an agent has FS 0 and LL

2

.07 preferences, she would always give less then 2.5 to agent 2.5

2.5 .25 Hence, because we observe so much of $2.5 choices, we may

3

.03 conclude that neither model does a good job explaining all the

5

.04 data; yet we may still want to know which one does better.

Situation 1 does not allow us to distinguish two models, we move to

Situation 2.

5

A bit of a problem for my interpretation is that subjects could give in $.5

increments; we will discuss this separately.

ECON30010

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Situation 2

Now, we change the situation a little: suppose that agent 1 can not only

give some y 5 to agent 2, but also can take up to $1 from agent 2. So,

in Situation 1 0 y 5 and in Situation 2 1 y 5.

What are the predictions for FS 0 and LL?

FS 0 :

For these who gave $0 in Situation 1, they could either give $0 or -$1.

I

Indeed, if is very small, then such an agent would have loved to take

everything for agent 2, but was more constrained in Situation 1 (could

take at most $0) than in Situation 2 (could take at most -$1).

For these who gave more than $0 in Situation 1, their choice should

not change.

I

get $6 does not change this optimal choice.

LL: We can argue that x e changes in LL, so the split may be different not

only for these 29% who gave nothing in Situation 1, but for everyone

else.

ECON30010

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$

-1

0

0.5

1

1.5

2

2.5

3

5

% in S1

0

.29

.17

.15

0

.07

.25

.03

.04

% in S2

.21

.44

.09

.07

.04

.04

.09

.03

0

situations and has the same structure as the

previous table. We see that in Situation 2

44% give $0 to the other agent.

This is inconsistent with FS 0 prediction (for

these who gave more than $0 in Situation 1, their

choice should not change), but consistent

with LL prediction (which allows for change).6

6

The Econometricians among us may like to see a formal test of this claim, but we

will rely on a visual test (and a claim that it is obvious that LL fits the data better).

ECON30010

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Is LL better than FS 0 ?

theory?

Note x e : there is an extra parameter in this model and there is no

expectation that this parameter should stay the same in different

situations. So, without a theory how x e is formed, LL has very low

predictive power: by suitably choosing parameter x e it is possible to explain

almost any data. In the form I presented this theory, it is not falsifiable.7

7

The theory is falsifiable, or refutable, if it is possible to design a test which proves

the theory false.

ECON30010

3 March 2016

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FS 0 may not explain the data very well, but selfish model (with u(x) = x)

clearly explain it even worse. Why would we routinely assume selfish

behaviour?

It appears that in many situations of our interest that is, in a natural

environment they are OK. They also give extremely sharp (no and x e )

and simple predictions.

John List run the following experiment. Let us consider a slightly more

complex game, called gift exchange game, in which agent 1 first pays

agent 2 some amount of money and then agent 2 return some money back

to agent 1. Note that the second part is similar to our Situation 1 (called

dictator game).

ECON30010

3 March 2016

28 / 31

For added realism, in Lists experiment, agent 2 does not return money.

Agent 2 return baseball cards of different quality. An altruistic agent 2

would return a high-quality, valuable baseball card after receiving high

payment and a low-quality, not valuable card after low payment. Selfish

agent 2 would return a low-quality card no matter what.

As an interesting twist, List uses actual baseball card dealers.

He first puts them in the lab. The results are in line with other lab

experiments: baseball card dealers are altruistic.

He then run field experiment (that is, the same rules of trade but in real

life; dealers are unaware of the experiment). The dealers are much less

altruistic than in the lab experiment.

As a side note, LL model explain that as well, because x e could change.

ECON30010

3 March 2016

29 / 31

Sources

Textbooks

Varian:

I

Preferences: Ch. 3

Utility: Ch. 4

Serrano-Feldman:

I

Ch. 2

ECON30010

3 March 2016

30 / 31

Sources

Papers

I

theory of fairness, competition and cooperation. Quarterly Journal of

Economics, 114, 81768.

BO preferences: Bolton, Gary E., and Axel Ockenfels. 2000. ERC: A

Theory of Equity, Reciprocity, and Competition. American Economic

Review, 90 (3): 16693.

LL preferences: Levitt, Steven and John List. 2007. What Do

Laboratory Experiments Measuring Social Preferences Reveal About

the Real World? Journal of Economic Perspectives, 21(2), 15374.

Lists experiment with -$1: List, John A. 2007. On the interpretation

of giving in dictator games. Journal of Political Economy, 115,

482493.

Lists experiment with baseball card dealers: List, John A. 2006. The

Behavioralist Meets the Market: Measuring Social Preferences and

Reputation Effects in Actual Transactions. Journal of Political

Economy, 114, 137.

ECON30010

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