Ch7
Transcript of Ch7
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Chapter Seven
Revealed Preference
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Revealed Preference Analysis Suppose we observe the demands
(consumption choices) that a consumer makes for different budgets. This reveals information about the consumer’s preferences. We can use this information to ...
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Revealed Preference Analysis
–Test the behavioral hypothesis that a consumer chooses the most preferred bundle from those available.
–Discover the consumer’s preference relation.
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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.
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Assumptions on Preferencesx2
x1x1*
x2*
If preferences are convex andmonotonic (i.e. well-behaved)then the most preferredaffordable bundle is unique.
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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).
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Direct Preference Revelation
x2
x1
x*
y
The chosen bundle x* isrevealed directly as preferredto the bundles y and z.
z
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Direct Preference Revelation
That x is revealed directly as preferred to y will be written as x y.
D
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Indirect Preference Revelation Suppose x is revealed directly
preferred to y, and y is revealed directly preferred to z. Then, by transitivity, x is revealed indirectly as preferred to z. Write this as x z
so x y and y z x z.D
D
I
I
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Indirect Preference Revelation
x2
x1
x*
z
z is not affordable when x* is chosen.
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Indirect Preference Revelation
x2
x1
x*y*
z
x* is not affordable when y* is chosen.
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Indirect Preference Revelation
x2
x1
x*y*
z
z is not affordable when x* is chosen.x* is not affordable when y* is chosen.
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z is not affordable when x* is chosen.x* is not affordable when y* is chosen. So x* and z cannot be compared directly.
Indirect Preference Revelation
x2
x1
x*y*
z
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But x*x* y*
z is not affordable when x* is chosen.x* is not affordable when y* is chosen. So x* and z cannot be compared directly.
Indirect Preference Revelation
x2
x1
x*y*
zD
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But x*x* y*
and y* z
z is not affordable when x* is chosen.x* is not affordable when y* is chosen. So x* and z cannot be compared directly.
Indirect Preference Revelation
x2
x1
x*y*
zD
D
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z is not affordable when x* is chosen.x* is not affordable when y* is chosen. So x* and z cannot be compared directly.
Indirect Preference Revelation
x2
x1
x*y*
zBut x*x* y*
and y* z
so x* z.
D
D
I
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Two Axioms of Revealed Preference
To apply revealed preference analysis, choices must satisfy two criteria -- the Weak and the Strong Axioms of Revealed Preference.
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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.
x y not (y x).D
D
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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.
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The Weak Axiom of Revealed Preference (WARP)
What choice data violate the WARP?
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The Weak Axiom of Revealed Preference (WARP)
x2
x1
xy
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The Weak Axiom of Revealed Preference (WARP)
x2
x1
xy
x is chosen when y is availableso x y.
D
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The Weak Axiom of Revealed Preference (WARP)
x2
x1
xy
y is chosen when x is availableso y x.
x is chosen when y is availableso x y.
D
D
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The Weak Axiom of Revealed Preference (WARP)
x2
x1
xy These statements are
inconsistent with each other.
x is chosen when y is availableso x y.
y is chosen when x is availableso y x.
D
D
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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?
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Checking if Data Violate the WARP
ChoicesPrices
(10, 1) (5, 5) (5, 4)
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13
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Checking if Data Violate the WARP
ChoicesPrices
(10, 1) (5, 5) (5, 4)
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13
Red numbers are costs of chosen bundles.
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Checking if Data Violate the WARP
ChoicesPrices
(10, 1) (5, 5) (5, 4)
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13
Circles surround affordable bundles thatwere not chosen.
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Checking if Data Violate the WARP
ChoicesPrices
(10, 1) (5, 5) (5, 4)
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13
Circles surround affordable bundles thatwere not chosen.
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Checking if Data Violate the WARP
ChoicesPrices
(10, 1) (5, 5) (5, 4)
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13
Circles surround affordable bundles thatwere not chosen.
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Checking if Data Violate the WARP
( 1 0 , 1 ) ( 5 , 5 ) ( 5 , 4 )
( 1 0 , 1 ) D D
( 5 , 5 ) D
( 5 , 4 ) D
Ch o i c e sP r i c e s
( 1 0 , 1 ) ( 5 , 5 ) ( 5 , 4 )
( $ 2 , $ 2 ) $ 2 2 $ 2 0 $ 1 8
( $ 2 , $ 1 ) $ 2 1 $ 1 5 $ 1 4
( $ 1 , $ 2 ) $ 1 2 $ 1 5 $ 1 3
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Checking if Data Violate the WARP
( 1 0 , 1 ) ( 5 , 5 ) ( 5 , 4 )
( 1 0 , 1 ) D D
( 5 , 5 ) D
( 5 , 4 ) D
Ch o i c e sP r i c e s
( 1 0 , 1 ) ( 5 , 5 ) ( 5 , 4 )
( $ 2 , $ 2 ) $ 2 2 $ 2 0 $ 1 8
( $ 2 , $ 1 ) $ 2 1 $ 1 5 $ 1 4
( $ 1 , $ 2 ) $ 1 2 $ 1 5 $ 1 3
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Checking if Data Violate the WARP
( 1 0 , 1 ) ( 5 , 5 ) ( 5 , 4 )
( 1 0 , 1 ) D D
( 5 , 5 ) D
( 5 , 4 ) D
(10,1) is directlyrevealed preferredto (5,4), but (5,4) isdirectly revealedpreferred to (10,1),so the WARP isviolated by the data.
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Checking if Data Violate the WARP
(5,4) (10,1)
(10,1) (5,4)
x1
x2
D
D
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The Strong Axiom of Revealed Preference (SARP)
If the 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. x y or x y
not ( y x or y x ).D
D
I
I
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The Strong Axiom of Revealed Preference
What choice data would satisfy the WARP but violate the SARP?
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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)
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The Strong Axiom of Revealed Preference
ChoicePrices
A B C
A $46 $47 $46
B $39 $41 $46
C $24 $22 $23
A: ($1,$3,$10) (3,1,4).
B: ($4,$3,$6) (2,5,3).
C: ($1,$1,$5) (4,4,3).
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The Strong Axiom of Revealed Preference
ChoicesPrices
A B C
A $46 $47 $46
B $39 $41 $46
C $24 $22 $23
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The Strong Axiom of Revealed Preference
ChoicesPrices
A B C
A $46 $47 $46
B $39 $41 $46
C $24 $22 $23
In situation A,bundle A isdirectly revealedpreferred tobundle C; A C.
D
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The Strong Axiom of Revealed Preference
ChoicesPrices
A B C
A $46 $47 $46
B $39 $41 $46
C $24 $22 $23D
In situation B,bundle B isdirectly revealedpreferred tobundle A; B A.
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The Strong Axiom of Revealed Preference
ChoicesPrices
A B C
A $46 $47 $46
B $39 $41 $46
C $24 $22 $23D
In situation C,bundle C isdirectly revealedpreferred tobundle B; C B.
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The Strong Axiom of Revealed Preference
ChoicesPrices
A B C
A $46 $47 $46
B $39 $41 $46
C $24 $22 $23
A B C
A D
B D
C D
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The Strong Axiom of Revealed Preference
ChoicesPrices
A B C
A $46 $47 $46
B $39 $41 $46
C $24 $22 $23
A B C
A D
B D
C D
The data do not violate the WARP.
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The Strong Axiom of Revealed Preference
A B C
A D
B D
C D
The data do not violate the WARP but ...
We have that
A C, B A and C B
so, by transitivity,
A B, B C and C A.
D
D
D
I
I
I
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The Strong Axiom of Revealed Preference
A B C
A D
B D
C D
The data do not violate the WARP but ...
We have that
A C, B A and C B
so, by transitivity,
A B, B C and C A.
D
D
D
I
I
I
I
I
I
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The Strong Axiom of Revealed Preference
A B C
A D
B D
C D
D
I
I
I
I
B A is inconsistent
with A B.
The data do not violate the WARP but ...
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The Strong Axiom of Revealed Preference
A B C
A D
B D
C D
D
I
I
I
I
A C is inconsistent
with C A.
The data do not violate the WARP but ...
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The Strong Axiom of Revealed Preference
A B C
A D
B D
C D
D
I
I
I
I
C B is inconsistent
with B C.
The data do not violate the WARP but ...
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The Strong Axiom of Revealed Preference
A B C
A D
B D
C D
I
I
I
The data do not violatethe WARP but there are3 violations of the SARP.
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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 our 3 data cannot be rationalized by a well-behaved preference relation.
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Recovering Indifference Curves
Suppose we have the choice data satisfy the SARP.
Then we can discover approximately where are the consumer’s indifference curves.
How?
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Recovering Indifference Curves
Suppose we observe:A: (p1,p2) = ($1,$1) & (x1,x2) = (15,15)B: (p1,p2) = ($2,$1) & (x1,x2) = (10,20)C: (p1,p2) = ($1,$2) & (x1,x2) = (20,10)D: (p1,p2) = ($2,$5) & (x1,x2) = (30,12)E: (p1,p2) = ($5,$2) & (x1,x2) = (12,30).
Where lies the indifference curve containing the bundle A = (15,15)?
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Recovering Indifference Curves
The table showing direct preference revelations is:
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Recovering Indifference Curves
Direct revelations only; the WARPis not violated by the data.
A B C D E
A D D
B
C
D D D D
E D D D
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Recovering Indifference Curves
Indirect preference revelations add no extra information, so the table showing both direct and indirect preference revelations is the same as the table showing only the direct preference revelations:
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Recovering Indifference Curves
A B C D E
A D D
B
C
D D D D
E D D D
Both direct and indirect revelations; neitherWARP nor SARP are violated by the data.
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Recovering Indifference Curves
Since the choices satisfy the SARP, there is a well-behaved preference relation that “rationalizes” the choices.
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Recovering Indifference Curvesx2
x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20)C: (p1,p2)=(1,2); (x1,x2)=(20,10)D: (p1,p2)=(2,5); (x1,x2)=(30,12)E: (p1,p2)=(5,2); (x1,x2)=(12,30).
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Recovering Indifference Curvesx2
x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20)C: (p1,p2)=(1,2); (x1,x2)=(20,10)D: (p1,p2)=(2,5); (x1,x2)=(30,12)E: (p1,p2)=(5,2); (x1,x2)=(12,30).
Begin with bundles revealedto be less preferred than bundle A.
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Recovering Indifference Curvesx2
x1
A
A: (p1,p2)=(1,1); (x1,x2)=(15,15).
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Recovering Indifference Curvesx2
x1
A
A: (p1,p2)=(1,1); (x1,x2)=(15,15).
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Recovering Indifference Curvesx2
x1
A
A: (p1,p2)=(1,1); (x1,x2)=(15,15).
A is directly revealed preferredto any bundle in
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Recovering Indifference Curvesx2
x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20).
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Recovering Indifference Curvesx2
x1
A
B
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20).
![Page 66: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/66.jpg)
Recovering Indifference Curvesx2
x1
A
B
A is directly revealed preferredto B and …
![Page 67: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/67.jpg)
Recovering Indifference Curvesx2
x1
B
B is directly revealed preferredto all bundles in
![Page 68: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/68.jpg)
Recovering Indifference Curvesx2
x1
B
so, by transitivity, A is indirectlyrevealed preferred to all bundles in
![Page 69: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/69.jpg)
Recovering Indifference Curvesx2
x1
B
so A is now revealed preferredto all bundles in the union.
A
![Page 70: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/70.jpg)
Recovering Indifference Curvesx2
x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)
C: (p1,p2)=(1,2); (x1,x2)=(20,10).
![Page 71: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/71.jpg)
Recovering Indifference Curvesx2
x1
A C
A: (p1,p2)=(1,1); (x1,x2)=(15,15)
C: (p1,p2)=(1,2); (x1,x2)=(20,10).
![Page 72: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/72.jpg)
Recovering Indifference Curvesx2
x1
A C
A is directly revealedpreferred to C and ...
![Page 73: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/73.jpg)
Recovering Indifference Curvesx2
x1
C
C is directly revealed preferredto all bundles in
![Page 74: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/74.jpg)
Recovering Indifference Curvesx2
x1
C
so, by transitivity, A isindirectly revealed preferredto all bundles in
![Page 75: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/75.jpg)
Recovering Indifference Curvesx2
x1
C
so A is now revealed preferredto all bundles in the union.
B
A
![Page 76: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/76.jpg)
Recovering Indifference Curvesx2
x1
C
so A is now revealed preferredto all bundles in the union.
B
A
Therefore the indifferencecurve containing A must lie everywhere else above this shaded set.
![Page 77: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/77.jpg)
Recovering Indifference Curves
Now, what about the bundles revealed as more preferred than A?
![Page 78: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/78.jpg)
Recovering Indifference Curvesx2
x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20)C: (p1,p2)=(1,2); (x1,x2)=(20,10)D: (p1,p2)=(2,5); (x1,x2)=(30,12)E: (p1,p2)=(5,2); (x1,x2)=(12,30).A
![Page 79: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/79.jpg)
Recovering Indifference Curvesx2
x1
D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)
D: (p1,p2)=(2,5); (x1,x2)=(30,12).
A
![Page 80: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/80.jpg)
Recovering Indifference Curvesx2
x1
D
D is directly revealed preferredto A.
A
![Page 81: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/81.jpg)
Recovering Indifference Curvesx2
x1
D
D is directly revealed preferredto A.Well-behaved preferences areconvex
A
![Page 82: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/82.jpg)
Recovering Indifference Curvesx2
x1
D
D is directly revealed preferredto A.Well-behaved preferences areconvex so all bundles on the line between A and D are preferred to A also.A
![Page 83: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/83.jpg)
Recovering Indifference Curvesx2
x1
D
D is directly revealed preferredto A.Well-behaved preferences areconvex so all bundles on the line between A and D are preferred to A also.A
As well, ...
![Page 84: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/84.jpg)
Recovering Indifference Curvesx2
x1
D
all bundles containing thesame amount of commodity 2and more of commodity 1 thanD are preferred to D and therefore are preferred to A also.A
![Page 85: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/85.jpg)
Recovering Indifference Curvesx2
x1
DA
bundles revealed to be strictly preferred to A
![Page 86: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/86.jpg)
Recovering Indifference Curvesx2
x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20)C: (p1,p2)=(1,2); (x1,x2)=(20,10)D: (p1,p2)=(2,5); (x1,x2)=(30,12)E: (p1,p2)=(5,2); (x1,x2)=(12,30).A
![Page 87: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/87.jpg)
Recovering Indifference Curvesx2
x1
A
E
A: (p1,p2)=(1,1); (x1,x2)=(15,15)
E: (p1,p2)=(5,2); (x1,x2)=(12,30).
![Page 88: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/88.jpg)
Recovering Indifference Curvesx2
x1
A
E
E is directly revealed preferredto A.
![Page 89: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/89.jpg)
Recovering Indifference Curvesx2
x1
A
E
E is directly revealed preferredto A.Well-behaved preferences areconvex
![Page 90: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/90.jpg)
Recovering Indifference Curvesx2
x1
A
E
E is directly revealed preferredto A.Well-behaved preferences areconvex so all bundles on the line between A and E are preferred to A also.
![Page 91: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/91.jpg)
Recovering Indifference Curvesx2
x1
A
E
E is directly revealed preferredto A.Well-behaved preferences areconvex so all bundles on the line between A and E are preferred to A also.
As well, ...
![Page 92: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/92.jpg)
Recovering Indifference Curvesx2
x1
A
E
all bundles containing thesame amount of commodity 1and more of commodity 2 thanE are preferred to E and therefore are preferred to A also.
![Page 93: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/93.jpg)
Recovering Indifference Curvesx2
x1
A
E
More bundles revealed to be strictly preferred to A
![Page 94: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/94.jpg)
Recovering Indifference Curvesx2
x1
A
B
C
E
D
Bundles revealedearlier as preferredto A
![Page 95: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/95.jpg)
Recovering Indifference Curvesx2
x1
B
C
E
D
All bundles revealedto be preferred to A
A
![Page 96: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/96.jpg)
Recovering Indifference Curves
Now we have upper and lower bounds on where the indifference curve containing bundle A may lie.
![Page 97: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/97.jpg)
Recovering Indifference Curvesx2
x1
All bundles revealedto be preferred to A
A
All bundles revealed to be less preferred to A
![Page 98: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/98.jpg)
Recovering Indifference Curvesx2
x1
All bundles revealedto be preferred to A
A
All bundles revealed to be less preferred to A
![Page 99: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/99.jpg)
Recovering Indifference Curvesx2
x1
The region in which the indifference curve containing bundle A must lie.
A
![Page 100: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/100.jpg)
Index Numbers
Over time, many prices change. Are consumers better or worse off “overall” as a consequence?
Index numbers give approximate answers to such questions.
![Page 101: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/101.jpg)
Index Numbers
Two basic types of indices
–price indices, and
–quantity indices Each index compares expenditures
in a base period and in a current period by taking the ratio of expenditures.
![Page 102: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/102.jpg)
Quantity Index Numbers
A quantity index is a price-weighted average of quantities demanded; i.e.
(p1,p2) can be base period prices (p1b,p2
b) or current period prices (p1
t,p2t).
Ip x p x
p x p xq
t t
b b
1 1 2 2
1 1 2 2
![Page 103: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/103.jpg)
Quantity Index Numbers
If (p1,p2) = (p1b,p2
b) then we have the Laspeyres quantity index;
Lp x p x
p x p xq
b t b t
b b b b
1 1 2 2
1 1 2 2
![Page 104: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/104.jpg)
Quantity Index Numbers
If (p1,p2) = (p1t,p2
t) then we have the Paasche quantity index;
Pp x p x
p x p xq
t t t t
t b t b
1 1 2 2
1 1 2 2
![Page 105: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/105.jpg)
Quantity Index Numbers
How can quantity indices be used to make statements about changes in welfare?
![Page 106: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/106.jpg)
Quantity Index Numbers
If then
so consumers overall were better off in the base period than they are now in the current period.
Lp x p x
p x p xq
b t b t
b b b b
1 1 2 2
1 1 2 2
1
p x p x p x p xb t b t b b b b1 1 2 2 1 1 2 2
![Page 107: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/107.jpg)
Quantity Index Numbers
If then
so consumers overall are better off in the current period than in the base period.
Pp x p x
p x p xq
t t t t
t b t b
1 1 2 2
1 1 2 2
1
p x p x p x p xt t t t t b t b1 1 2 2 1 1 2 2
![Page 108: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/108.jpg)
Price Index Numbers
A price index is a quantity-weighted average of prices; i.e.
(x1,x2) can be the base period bundle (x1
b,x2b) or else the current period
bundle (x1t,x2
t).
Ip x p x
p x p xp
t t
b b
1 1 2 2
1 1 2 2
![Page 109: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/109.jpg)
Price Index Numbers
If (x1,x2) = (x1b,x2
b) then we have the Laspeyres price index;
Lp x p x
p x p xp
t b t b
b b b b
1 1 2 2
1 1 2 2
![Page 110: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/110.jpg)
Price Index Numbers
If (x1,x2) = (x1t,x2
t) then we have the Paasche price index;
Pp x p x
p x p xp
t t t t
b t b t
1 1 2 2
1 1 2 2
![Page 111: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/111.jpg)
Price Index Numbers
How can price indices be used to make statements about changes in welfare?
Define the expenditure ratio
Mp x p x
p x p x
t t t t
b b b b
1 1 2 2
1 1 2 2
![Page 112: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/112.jpg)
Price Index Numbers If
then
so consumers overall are better off in the current period.
Lp x p x
p x p xp
t b t b
b b b b
1 1 2 2
1 1 2 2
p x p x
p x p xM
t t t t
b b b b1 1 2 2
1 1 2 2
p x p x p x p xt b t b t t t t1 1 2 2 1 1 2 2
![Page 113: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/113.jpg)
Price Index Numbers But, if
then
so consumers overall were better off in the base period.
Pp x p x
p x p xp
t t t t
b t b t
1 1 2 2
1 1 2 2
p x p x
p x p xM
t t t t
b b b b1 1 2 2
1 1 2 2
p x p x p x p xb t b t b b b b1 1 2 2 1 1 2 2
![Page 114: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/114.jpg)
Full Indexation? Changes in price indices are sometimes
used to adjust wage rates or transfer payments. This is called “indexation”.
“Full indexation” occurs when the wages or payments are increased at the same rate as the price index being used to measure the aggregate inflation rate.
![Page 115: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/115.jpg)
Full Indexation?
Since prices do not all increase at the same rate, relative prices change along with the “general price level”.
A common proposal is to index fully Social Security payments, with the intention of preserving for the elderly the “purchasing power” of these payments.
![Page 116: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/116.jpg)
Full Indexation?
The usual price index proposed for indexation is the Paasche quantity index (the Consumers’ Price Index).
What will be the consequence?
![Page 117: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/117.jpg)
Full Indexation?
Notice that this index uses currentperiod prices to weight both base andcurrent period consumptions.
Pp x p x
p x p xq
t t t t
t b t b
1 1 2 2
1 1 2 2
![Page 118: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/118.jpg)
Full Indexation?x2
x1
x2b
x1b
Base period budget constraint
Base period choice
![Page 119: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/119.jpg)
Full Indexation?x2
x1
x2b
x1b
Base period budget constraint
Base period choice
Current period budgetconstraint before indexation
![Page 120: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/120.jpg)
Full Indexation?x2
x1
x2b
x1b
Base period budget constraint
Base period choice
Current period budgetconstraint after full indexation
![Page 121: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/121.jpg)
Full Indexation?x2
x1
x2b
x1b
Base period budget constraint
Base period choice
Current period choiceafter indexation
Current period budgetconstraint after indexation
![Page 122: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/122.jpg)
Full Indexation?x2
x1
x2b
x1b
Base period budget constraint
Base period choice
Current period choiceafter indexation
Current period budgetconstraint after indexation
x2t
x1t
![Page 123: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/123.jpg)
Full Indexation?x2
x1
x2b
x1b
x2t
x1t
(x1t,x2
t) is revealed preferred to(x1
b,x2b) so full indexation makes
the recipient strictly better off ifrelative prices change betweenthe base and current periods.
![Page 124: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/124.jpg)
Full Indexation?
So how large is this “bias” in the US CPI?
A table of recent estimates of the bias is given in the Journal of Economic Perspectives, Volume 10, No. 4, p. 160 (1996). Some of this list of point and interval estimates are as follows:
![Page 125: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/125.jpg)
Full Indexation?Author Point Est. Int. Est.
Adv. Commission toStudy the CPI (1995)
1.0% 0.7 - 2.0%
CongressionalBudget Office (1995)
0.2 - 0.8%
Alan Greenspan(1995)
0.5 - 1.5%
Shapiro & Wilcox(1996)
1.0% 0.6 - 1.5%
![Page 126: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/126.jpg)
Full Indexation?
So suppose a social security recipient gained by 1% per year for 20 years.
Q: How large would the bias have become at the end of the period?
![Page 127: Ch7](https://reader033.fdocuments.us/reader033/viewer/2022060117/5583a9aed8b42af5058b48da/html5/thumbnails/127.jpg)
Full Indexation?
So suppose a social security recipient gained by 1% per year for 20 years.
Q: How large would the bias have become at the end of the period?
A: so after 20 years social security payments would be about 22% “too large”.
( )1 0 01 1 01 1 2220 20