MGM

Advanced Microeconomics
Econ 611

CHOICE THEORY
CHAPTER ONE
 1. CHOICE THEORY
 CHOICE THEORY, also known as theory of rational choice, or rational
action theory, is a framework for understanding and often formally
modeling social & economic behavior.
 The theory of choice, individual and social, was mainly developed by
economists, with crucial contributions from psychologists, political
scientists, sociologists, mathematicians, and philosophers.
 The basic premise of choice theory is that aggregate social behavior results
from the behavior of individual actors, each of whom is making their
individual decisions.
 Here, an overview of the BUILDING BLOCKS of a choice theory is provided
while focusing primarily on the model of consumer choice and the key
concepts involved.
 More specifically, the chapter will:
identify the BASIC elements in any model of consumer choice; and
specify the FORM each of these building blocks takes in a given choice problem.
The chapter will also review some relevant concepts from SET THEORY to
facilitate the discussion.
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Consumer Choice: An Overview

 Any model of consumer choice has 4 BUILDING BLOCKS:

A. The CONSUMPTION SET (or more broadly, the CHOICE SET)
B. The BUDGET SET (or more broadly, the FEASIBLE SET)
C. The PREFERENCE RELATION and
D. The BEHAVIORAL ASSUMPTION guiding the decision making process.
 Choice theory specifies the FORM each of these components takes
in order to formally describe and analyze different situations that
involve decision making (i.e., CHOICE).
Before going any further, let’s first introduce some useful
concepts from Set Theory to facilitate the discussion:
I. CONVEX SET: is a set containing all linear combinations of every
pair of points in it.
 More formally, if, for any elements (or points) x1 & x2 in set A, tx1 + (1 – t)x2
is also in set A for all t ∈ [0, 1], then A is said to be a CONVEX SET.
Examples??
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Consumer Choice intro Cont’d

II. OPEN SET and CLOSED SET

A set is open if it DOES NOT CONTAIN any of the points on its boundary.
A set is closed if it CONTAINS all of the points in its boundary.
Example: A = {x ∈ ℝ : 4 < x < 10} = (4, 10), set A is open in ℝ.
 How about set C defined as C = {x ∈ ℝ : x ≥ 0} = [0, ∞)?
III. BOUNDED SET: a set is bounded if it is within
ENTIRELY CONTAINED
some open or closed ε - ball; i.e., if we can always draw some ε - ball
entirely around it.
 More formally, a set S ∈ ℝ n is BOUNDED if, for every X0 ∈ ℝn, there exists
an ε > 0 such that S is a PROPER SUBSET of the set of points lying within
a distance ε of X0 ; i.e., if it can be ENCLOSED in a (sufficiently large) ε -
neighborhood of any of its points.
In terms of an interval set, this means that a given interval set is
bounded if it is impossible to go off to infinity while remaining inside it,
and it is unbounded otherwise.
 Thus, a BOUNDED SET can either be OPEN or CLOSED.
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Consumer Choice intro Cont’d

IV.COMPACT SET: a set is compact in ℝn if it is BOTH closed & bounded.

Note here that all of ℝn IS NOT compact because, although it may
be closed, it is not bounded.
Example: A = [0, ∞) is closed in ℝ but not bounded, hence it is not
compact in ℝ. How about set C = {x ∈ ℝ+ : 0 < x < 10} = (0, 10)?
BUILDING BLOCKS OF THE CONSUMER CHOICE MODEL
1. THE NOTION OF A CONSUMPTION SET: denoted by X ∈ ℝn, represents
the set of ALL alternatives (i.e., complete consumption plans) that the
consumer can conceive of, given the physical constraints imposed
by his/her environment.
Example: Let X be the possible consumption levels of bread and
leisure in a day. The physical constraints would then be:
that both levels of consumption must be non-negative, and that
the consumption of more than 24 hours of leisure in a day is impossible.
Note here that the consumption set DOES NOT take into account the
ECONOMIC CONSTRAINTS imposed on the consumer.
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Building Blocks Cont’d

When specifying the formal properties of the consumption set, the

following ASSUMPTIONS are often made:
Each good in the consumption set X is measured in some INFINITELY
DIVISIBLE UNITS, so that xi ∈ X represents the number of units of
commodity i.
Only NON-NEGATIVE UNITS of each good are MEANINGFUL, i.e. xi ≥ 0.
It is always possible to conceive of having NO UNITS of any particular
commodity.
There is a FINITE but ARBITRARY NUMBER, ‘n’, of different goods.
Then, a vector X = (x1, x2, …, xn) containing different quantities of each of
the n - commodities is called a CONSUMPTION BUNDLE or CONSUMPTION
PLAN.
 Thus, a consumption bundle X ∈ X is represented by a point X ∈ ℝn+; i.e.,
the consumption set X here is the entire non-negative orthant.
In this case, the consumption set then satisfies some basic properties,
which are specified below.
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Building Blocks Cont’d

 The MINIMAL REQUIREMENTS on the consumption set are:

The consumption set X is NON - EMPTY SET: ≠ X ∈ ℝn+ .
X is CLOSED: the consumption set contains all of its boundaries.
X is CONVEX: each pair of points in it can be joined by a straight line that
lies entirely within the consumption set.
 X ∈ ℝn+ : for any I & II ∈ X, t I +(1 - t) II ∈ X, ∀ t ∈ [0, 1].
0 ∈ X : a set containing no units of any particular commodity is also in
the consumption set; i.e., 0 = (0, 0, 0, … , 0) ∈ X.
Apart from the physical constraints indicated in the consumption set,
the consumer also faces economic constraints – which are far more
importantly governing the consumer’s choice decision.
2. THE NOTION OF A FEASIBLE SET: represents all alternative consumption
bundles that are CONCEIVABLE & REALISTICALLY OBTAINABLE, given the
consumer’s economic circumstances.
 i.e., it is the set of all feasible consumption bundles for a consumer facing
MARKET PRICES and is endowed with a given level of WEALTH or INCOME.
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Building Blocks Cont’d

 Clearly, the feasible set (B) is a PROPER SUBSET of the consumption set.
Formally, B ⊂ X if & only if B ⊆ X but X ≠ B, where B is the feasible set.
 The properties of the feasible set (B) are: CLOSED, BOUNDED, CONVEX,
and NON-EMPTY SET. Clearly, unlike X, B is a COMPACT SET.
3. The PREFERENCE RELATION typically specifies the following regarding
the decision maker, such as the consumer :
The LIMITS (if any) on the CONSUMER’S ABILITY TO PERCEIVE in situations
involving choice; and
The form of CONSISTENCY or INCONSISTENCY in the consumer’s choice;
Info on the CONSUMER’S TASTES for the different objects of choice.
A preference relation plays an important role in any theory of choice,
and is often presented in a set of AXIOMS, using the following SYMBOLS:
 The symbol "≿" represents preference relation on a set of alternatives X; and
we read XI ≿ XII as " XI is preferred or indifferent to XII ", or " XI is at least as
good as XII ", or " XI is no worse than XII ", or " XI is weakly preferred to XII ".

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Building Blocks Cont’d

From " ≿ ", two other preference relations are derived: " ~ " & " ≻".
The INDIFFERENCE symbol " ~ " reads as " is indifferent to".
The STRICT PREFERENCE symbol " ≻ " reads as " is strictly preferred to".
 i.e., I ~ II reads " the consumer is indifferent between I & II " ;
while I ≻ II reads " I is strictly preferred to II "
4. BEHAVIORAL ASSUMPTION: expresses the guiding principle the decision
maker uses to make final choices, and so it specifies the ultimate
OBJECTIVE in choice.

As applied to the theory of consumer behavior, this means that the
consumer always seeks to identify and choose from the available
alternatives that bundle which is the MOST PREFERRED in light of his/her
PERSONAL TASTES; more precisely, the commodity bundle that MAXIMIZES
(gives him/her the highest) SATISFACTION or UTILITY.
How about when this is applied to the theory of the firm?, and when
applied to Consumer/ producer choice under uncertainty?

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