Choice Based Analysis

Introduction
• How can we describe rational choices with
minimal structure?
• Problem with preference based approach is
the use of utility (unobservable)
• Samuelson: How can we say that observed
choices are consistent with utility
maximization framework?
 Introduction
• We now focus on the actual choice behavior
rather than individual preferences.
– From the alternatives in set !, which one would
you choose?
• A choice structure (B, "(·)) contains two
elements:
1) B is a family of nonempty subsets of #, so that
every element of B is a set $ ⊂ #.
2) "(·) is a choice rule that selects, for each budget set
$, a subset of elements in $, with the interpretation
that "($) are the chosen elements from $.
 Three ingredients of
minimum structure
• We need to impose a consistency
requirement on the choice-based
approach, similar to rationality
assumption on the preference-based
approach. These would be:
– Consumer always spends her entire budget
(Walra’s Law)
– Only real opportunities matter
(homogeneity of demand)
– Choice reveal information about stable
preferences (Weak Axiom of Revealed
Preference)
 Requirement 1: Walra’s Law
• p*x(p,w)ºw or Σipi*xi(p,w)ºw
• Implication 1:
– Any change in wealth is accompanied by an equal
change in expenditure. Proof [totally
differentiate Bpw wrt w]
• Implication 2:
– There should always be at least 1 normal good
Empirical Implications from
Implication # 1
• Observe expenditure before and
after wealth change
• Econometric Test: Coefficients
attached to income for each demand
equation should sum to one [illustrate
a system of demand equations]
Empirical Implications from
Implication # 1
• Often imposed rather than tested
• What if not observed?
– Possibility that one good was left out
– Satiated preferences
– Wrong theory
– Wrong data set
 Implication # 2: Choice responses to
change in price
• Totally differentiate with respect to
one price pj
• xi + Σjpj*δxj(p,w)/δpi=0
– Total expenditure will not change
• Change in pi:
– Spending on good i increases
– Rearrange consumption of other goods
Alternative Formulation:
Budget Shares and Elasticities
• Use previous equation
• Do the following trick:
– Multiply by xj/xj inside summation sign
– Multiply pi/w both sides of equation
• bi + Σjbjeji=0
• Why reformulate? Sometimes easier
to get data on shares and elasticities
 Homogeneity of Demand
Revisited
• x(ap,aw)ºx(p,w)
• Bp,w ={x: px≤w}=Bap,aw ={x: apx≤aw}
• Implication:
– Changes in behavior should come from changes
in the set of available alternatives
– Nominal prices are meaningless. Only relative
prices matter. Thus we can always arbitrarily
normalize prices (set one price equal to one)
 Third Requirement: WARP
• Weak Axiom of Revealed Preference
(WARP): The choice structure (B, !(·))
satisfies the WARP if:
• 1) for some budget set " ∈ B with $, % ∈ ",
we have that element $ is chosen, $ ∈ !("),
then
• 2) for any other budget set "′ ∈ B where
alternatives $ and % are also available,
$, % ∈ "′, and where alternative % is chosen,
% ∈ !("′), then we must have that alternative
$ is chosen as well, $ ∈ !("′).
The 3rd Requirement: WARP
• Suppose you’re a chocoholic
• So, suppose I offer you a choice
between a chocolate and an ice
cream, and you choose the chocolate.
• If tomorrow I see you eating an ice
cream, I can infer that you weren’t
offered a chocolate
 Weak Axiom of Revealed Preference
(WARP) and Walrasian Demand
• Consider any two distinct price-
wealth vectors (p, w) and (p’, w’)≠(p,
w). Let z = z(p, w) and y = y(p’, w’).
The consumer’s demand function
satisfies WARP if whenever p·y ≤w,
p’·z >w’
• Furthermore z RP y
 Weak Axiom of Revealed Preference
(WARP) in words
• says that if a consumer chooses z when y was also
affordable, this choice reveals that the consumer
prefers z to y. Since we assume that consumer
preferences are constant and we have modeled all
of the relevant constraints on consumer behavior
and preferences, if we ever observe the consumer
choose y, it must be that z was not available (since
if it were, the consumer would have chosen z over
y since she had previously revealed her preference
for z)
 Weak Axiom of Revealed Preference
(WARP) in words
• It is a condition that imposes
stability on choices
• Changes in consumption bundles
brought about by changes in the
constraint
Example: Checking WARP in
choice structures
• Take budget set ! = {", #} with the
choice rule of $({", #}) = ".
• Then, for budget set !′ = {", #, %}, the
“legal” choice rules are either:
• $({",#,%}) ={"},or $({",#,%}) ={%},or
$({",#,%})={",%}
– This implies, individual decision-maker
cannot select
• $({",#,%})≠{#}, or $({",#,%})≠{#,%}, or $({",#,%})
≠{",#}
 Checking if Walrasian
Demands satisfy WARP
Step 1. Check if bundles x(p,w) and
x(p’,w’) are affordable under Bp,w.
– Graphically, x(p,w) and x(p’,w’) should lie
on or below budget line Bp,w
– If this is satisfied then go to step 2
– Otherwise, the premise of WARP does
not hold, which does not allow us to
continue checking if WARP is violated or
not, In this case, we can only say that
“WARP is not violated”
 Checking if Walrasian
Demands satisfy WARP
Step 2. Check if bundle x(p,w) is
affordable under Bp’,w’.
– Graphically, x(p,w) should lie on or below
budget line Bp’,w’
– If this is satisfied then Walrasian
demand violates WARP
– Otherwise, the Walrasian demand
satisfies WARP
 Example: Checking for
WARP
• First x(p,w) and
x(p’,w’) are both
affordable under
Bp,w and x(p,w) was
chosen
• Second x(p,w) is
not affordable
under Bp’,w’. Hence
x(p’,w’) was chosen
• Hence WARP is
satisfied
 Example: Checking for
WARP
• Is WARP
satisfied by the
following
Walrasian
Demands?
 Example: Checking for
WARP
• The demand for
x(p’w’) under final
prcies and wealth is
not affordable under
initial prices and
wealth, i.e. px(p’,w’)>w.
• The premise of
WARP does not hold
• Thus, violates step 1
• All we can say is that
WARP is not violated
 WARP: Notes on Walrasian
Demand Illustrations
• All choices satisfy Walra’s Law and
therefore on budget frontier [Note:
condition p·y ≤w implies that y may
not be on the border/frontier of
budget line]
• No reference to utility functions (no
indifference curves)
 Slutsky Wealth Compensation
• Suppose prices changes from p to p’
• I am going to also change your wealth from w to
w’, where w’ is chosen so that you can still just
afford bundle x at the new prices and wealth (p’,
w’). Thus w’ = p’·x(p,w).
• This is a compensated change in price, since I
changed your wealth to compensate you for the
effects of the price change
• But this is a Slutsky Wealth Compensation: the
increase (decrease) in wealth, measured by ∆!,
that we must provide to the consumer so that he
can afford the same consumption bundle as before
the price increase (decrease), "(#,!)
 Illustration of Slutsky
Wealth Compensation
• Suppose prices of x 1
decreases
• Rotation of budget
line to B p’,w
represents an
uncompensated
price change
• Slutsky
compensation:
change w to w’ such
that x(p,w) is still
affordable
 Slutsky Wealth Compensation
Formally, Slutsky Wealth Compensation or
Adjustment means:

!="·#(",!) under (",!)

!′="′·#(",!) under ("′,!′)

Then,

∆! = ∆" #(",!)

where ∆! = !′ − ! and ∆" = "′ − ".

 Implications of WARP:
Compensated Law of Demand
• Consider two different price-wealth vectors, (p, w)
and (p’, w’), such that bundle z = z(p, w) lies on the
frontier of both B p,w and B p’,w’
• Prices increase from p to p’
• But also change wealth to w’, where w’ is chosen so
that you can still just afford bundle z at the new
prices and wealth (p’, w’). Thus w’ = p’·z
– Implies: w’ = p’·z and w = p·z
• Thus, a compensated change.
• Now consider bundle y=y(p’,w’)≠z
– Also affordable at (p’,w’)
• Thus, w’-w’=p’y-p’z
• So, 0 = p’(y - z)
 Implications of WARP:
Compensated Law of Demand
• Since z is affordable at (p’,w’) by
WARP y was not affordable at (p,w)
• Thus
p.y > w
py – pz > w – w
p(y-z)>0
 Implications of WARP:
Compensated Law of Demand
• Subtracting p(y-z)>0 from p’(y - z)=0
• (p’-p)(y-z)<0
• What does this mean?
– Following a compensated price change, prices
and demand move in opposite directions
• If prices increase, compensated demand
decreases
• Δp.Δxc ≤ 0
• In Calculus terms, dp.dxc ≤ 0
 WARP and Law of Demand
• Does WARP restrict behavior when
we apply Slutsky wealth
compensations?
– Yes
• What if we were not applying the
Slutsky wealth compensation, would
WARP impose any restriction on
allowable locations for !("′,#′) ?
– No!
• Can x(p’,w’) lie on segment A?
– x(p,w) and x(p’,w’) are both
affordable under B p,w
– x(p,w) is affordable under
B p’,w’
– Therefore WARP is violated
if x(p’,w’) lies on segment A
• Can x(p’,w’) lie on segment B?
– x(p,w) is affordable under B p,w
but x(p’,w’) is not
– The premise of WARP does
not hold
– WARP is not violated if x(p,w)
lies on segment B
• Is WARP satisfied under the
uncompensated law of demand
(ULD)?
– !(",#) is affordable under
budget line $p,w but !("′,#) is
not.
– Hence, the premise of WARP is
not satisfied. As a result,
WARP is not violated.
• But, is this result implying
something about whether ULD must
hold?
– No!
– Although WARP is not violated,
ULD is: a decrease in the price
of good 1 yields a decrease in
the quantity demanded
 WARP and Law of Demand
• Distinction between the uncompensated
and the compensated law of demand:
• quantity demanded and price can move
in the same direction, when wealth is
left uncompensated, i.e.,
– ∆!·∆"1>0 as ∆! ⇒∆"1
• Hence, WARP is not sufficient to yield
law of demand for price changes that
are uncompensated, i.e.,
– WARP ⇎ ULD, but WARP ⇔ CLD
 The Compensated Demand
xc(p,w)
• What does it mean to give a consumer a
compensated price change?
• Suppose x’=x’(p,w) is the initial consumption
bundle
• Compensation means that x’ will be
affordable for every possible price
• Hence xic =x(p,p*x’(p,w)) is the
compensated demand for good i
 Slutsky Equation
• Consider previous equation and a
change in the price of good j
• Taking derivatives:
 Slutsky Equation
• Writing previous equation in
derivative form:

• Where

• L in k b a c k
 Slutsky Equation
• If several price changes then:

• Where and
• With several goods (stack equations):
 Slutsky Equation
• Since Δp.Δxc ≤ 0
• We have:

• S is an L x L matrix of substitution
terms
 Notes on result
• implies that matrix S, which we will
call the substitution matrix, is
negative semi-definite.
– means is that if you pre- and post-
multiply S by the same vector, the
result is always a non-positive number.
 Notes on result
• The principal-minor determinants of S
follow a known pattern. (follows from def’n
of semidefiniteness)
• The diagonal elements sii are non-positive.
– Restatement of Compensated Law of Demand
– Giffen good with choice based approach
• WARP does not imply that S is symmetric
– difference between the choice-based approach
and the preference-based approach
 Notes on result
• p.S(p,w)=0
– Follows from comparative statics for
price and wealth changes for
uncompensated demand (illustrate for
two goods)
– A possible test of theory: compute S
from demand function and see if results
hold
– What if it does not: data problems?
 Why reanlayze
• All analysis were made on demand
functions – observables
• Main result of consumer theory on negative
semdefiniteness of Substitution matrix
obtained from:
– Walra’s Law, Homogeneity of demand, and
WARP
• Very minimal structure
– Preference based: monotonicity etc.
 Some other things to Note
• Nice and good, but remember that
the main results of preference based
theory is that we a substitution
matrix that is negative semidefinite
and symmetric.
• We have shown negative
semidefiniteness but not symmetry

4
2
 Some other things to note
• Symmetry comes from the second
partials of the expenditure function
and Young’s Theorem
• We don’t have this in choice based
analysis
• Implies imposing WARP may not lead
to rational preferences