Problem Set I: Preferences, W.A.R.P.

, consumer choice
Paolo Crosetto
[email protected]
Exercises solved in class on 18th January 2010
Recap: , ~,
Denition
The strict preference relation ~ is
x ~ y x y but not y x
Denition
The indierence relation is
x y x y and y x
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Recap: rationality assumptions
is rational if it is

Complete: x, y X, we have x y or y x or both;

Transitive: x, y, z X, if x y and y z, then x z.

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Recap: and utility function u()
Denition
A function u : X R is a utility function representing if
x, y X : x y u(x) u(y)
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1. MWG, Exercise 1.B.1 + 1.B.2: properties of
Prove that if is rational (complete and transitive), then
1. ~ is both irreexive (x ~ x never holds) and transitive (if x ~ y and y ~ z,
then x ~ z);
2. is reexive (x x, x), transitive (if x y and y z, then x z) and
symmetric (if x y then y x);
3. if x ~ y z then x ~ z.
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Solution: property 3 rst
Proof.
Property 3: if x ~ y z then x ~ z
1. By denition, x ~ y means that x y but not y x;
2. then, x ~ y z means x y z;
3. for transitivity (assumed), this means that x z.
4. Now, lets suppose that z x. Since y z, by transitivity wed have y x
5. but this is a contradiction, since we had in the beginning that x ~ y.
6. So, we have x z but we cannot have z x: this means that x ~ z
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Solution: property 1
Proof.
Property 1: ~ is irreexive and transitive
1. Irreexivity. Use completeness: x y, x, y X:
2. hence, it must hold also for x x, x X;
3. this means that in no case there can be x ~ x.
4. Transitivity. Suppose x ~ y and y ~ z:
5. this means that at least x ~ y z.
6. But we have proved before that this means x ~ z.
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Solution: property 2
Proof.
Property 2: is reexive, transitive and symmetric
1. Reexivity. By completeness, x x, x X:
2. this implies also that x x, x X, by denition of .
3. Transitivity. Suppose x y and y z:
4. by the denition of , this means that all of these hold:
5. x y, y x, y z, z y.
6. By transitivity of , this implies both x z and z x: hence x z.
7. Symmetry. Suppose x y: by denition, then x y and y x.
8. But the latter is also the denition of y x, if you look it the other way
around.
9. hence, x y implies y x.
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2. MWG 1.B.3 + 1.B.4.: and u()

Show that if f : R R is a strictly increasing function and u : X R is a

utility function representing the preference relation , then the function
v : X R dened by v(x) = f (u(x)) is also a utility function representing ;

Consider a preference relation and a function u : X R. Show that if

u(x) = u(y) implies x y and if u(x) > u(y) implies x ~ y then u() is a
utility function representing .
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Solution: strictly increasing function, intuition

We will prove that a utility function associated with is ordinal and not
cardinal in nature.

This is important: among other things, it implies that it is impossible to make

interpersonal utility comparisons directly.

Note the denition of strictly increasing function:

Denition
A function f (x) is said to be strictly increasing over an interval I if f (b) > f (a)
for all b > a, when a, b I .
Example
Functions that are strictly increasing over their whole domain are among others all
positive straight lines (y = ax, a > 0) and positive exponentials (y = a
x
, a > 0);
other functions can be increasing over a part of their domain, as parabola (y = x
2
,
for x > 0).

Tip: a strictly increasing function on interval I has its derivative positive on I .

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Solution: strictly increasing functions, plots
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Solution: strictly increasing function, proof
Proof.
A strictly increasing transformation of a utility function is still a utility function
1. Lets take x, y X. Since u() represents , by denition:
2. if x y then u(x) u(y).
3. since f () is strictly increasing, applying f () to u() does not change order,
but only magnitude;
4. hence, f (u(x)) f (u(y)), i.e. v(x) v(y) when x y:
5. hence, v() is a utility function representing .
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Solution: u(), ~ and .
Proof.
if x y, then u(x) u(y)
1. Suppose x y.
2. if at this we add y x, then x y and u(x) = u(y).
3. if instead we dont have y x, then x ~ y and u(x) > u(y).
4. hence, if x y, then u(x) u(y)
Proof.
if u(x) u(y), then x y
1. Suppose u(x) u(y).
2. if at this we add u(x) = u(y), then x y.
3. if instead we add u(x) > u(y), then x ~ y.
4. hence, if u(x) u(y), then x y.
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3. MWG 1.B.5: and u(), II
Show that if X is nite and is a rational preference relation on X, then there is
a utility function u : X R that represents .
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Solution: intuition

Since X is nite, the set of pairwise combination of elements of X is nite too;

Since is rational (hence complete and transitive):

it denes a preference over all of the nite set of pairs;

it excludes contradictory cycles of preferences.

Hence, intuitively it is possible to rank all x, y X according to ;

it must then be possible to build a utility function with such a complete

ranking using .
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Solution: proving by induction

A proof by induction is done by showing that something is true for n = 1 and

then for n + 1;

it then follows that it must be true for all n up to N.

Proof by induction is used in the set of natural numbers N.

More formally, for any proposition P(n) about positive integers:

Prove that P(1) is true (base case);

Prove that for each k 1, if P(k) is true, then P(k + 1) is true (inductive
step).
Example
Consider a set of domino tiles. If domino tile n falls, tile n + 1 will fall. If we prove
that tile 1 has fallen, then we can conclude that all tiles will fall.
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Solution: proof, x y
Proof.
if X is nite, then there exists a u() representing : no indierence
1. Start considering that no two items are indierent, i.e. x y, x, y X;
2. Lets prove by induction that in such a setting there exists a u() representing
.
3. Base case: if N = 1 there is nothing to prove.
4. Inductive step: Lets suppose the claim is true for N 1, and lets prove it is
still ture for N.
1. Lets take X = x
1
, x
2
, . . . , x
N1
, x
N
.
2. By hypothesis, there exists a u() on dened up to x
N1
.
3. Lets order the x: lets assume u(x
1
) > u(x
2
) > > u(x
N1
).
4. Since we have assumed no indierence, the above ranking means exclusively:

i < N, x
N
~ x
i
i < N, x
i
~ x
N
i < N and j < N s.t. x
i
~ x
N
~ x
j
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Solution: proof, x y continued
Proof.
...continued
In all the three cases above we can nd a value of u() that is consistent:
1. In Case 1, we can take u(N) > u(x
1
);
2. In Case 2, we can take u(N) < u(x
N
1);
3. in Case 3:

Dene two intervals I = i (1 . . . N) : x

i
~ x
N
and J = j (1 . . . N) : x
N
~ x
j
;

I and J are disjoint intervals on N by our hypotheses;

then if i

= max I , i

+1 = min J.

We can then take u(x

N
) to lie in the interval (u(i

), u(i

+1)).
Hence, in all of three cases an utility function can be built.
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Recap: W.A.R.P.,

Denition (WARP)
A choice structure (B, C()) satises the weak axiom if for some B B with
x, y B we have x C(B), then for any B
/
B with x, y B
/
, if we have
y C(B
/
) we must also have x C(B
/
)

Which is indeed a minimal consistency requirement. Note that completeness

and transitivity are not required.
Denition (Revealed preference relation

)
Given a choice structure (B, C()), the revealed preference relation

is dened
as:
x

y there is some B B such that x, y B and x C(B).

Which is just attaching a preference relationship to choices

Note again that nor completeness nor transitivity are implied. It is just
descriptive.
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Recap: Rationalizability
Rational preferences W.A.R.P. satised always
W.A.R.P. satised Rational preferences not always
Denition (Rationalizability)
Given a choice structure (B, C()), the rational preference relation rationalizes
C() relative to B if C(B) = C

(B, ) for all B B. In other words, generates

the choice structure (B, C()).

the W.A.R.P. is a necessary but not sucient condition for rationalizability.

if B includes all subsets of X of up to three elements, then it is also sucient:

intuitively, the three-members property implies transitivity...

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4. Exercise on W.A.R.P.
Consider a choice problem with choice set X = x, y, z. Consider the following
choice structures:

(B
/
, C()), in which B
/
= x, y, y, z, x, z, x, y, z and
C(x, y) = x, C(y, z) = y, C(x, z) = z, C(x) =
x, C(y) = y, C(z) = z.

(B
//
, C()), in which B
//
= x, y, z, x, y, y, z, x, z, x, y, z and
C(x, y, z) = x,
C(x, y) = x, C(y, z) = z, C(x, z) = z, C(x) =
x, C(y) = y, C(z) = z.

(B
///
, C()), in which B
///
= x, y, z, x, y, y, z, x, z, x, y, z
and C(x, y, z) = x,
C(x, y) = x, C(y, z) = y, C(x, z) = x, C(x) =
x, C(y) = y, C(z) = z.
For every choice structure say if the WARP is satised and if it exists a rational
preference relation that rationalizes C() relative to its B. If such a
rationalization is possible, write it down. Comment on your results.
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Solution: (B
/
, C())
The choice structure can be summarised in these three relations:

C(x, y) = x reveals x

y;

C(y, z) = y reveals y

C(x, z) = z reveals z

x
1. W.A.R.P. is trivially satised

the same couple never appears more than once in dierent budgets;

moreover, B
/
does not include all budgets up to three elements.

revealed preference relation is not necessarily transitive

2. B
/
is NOT rationalizable:

C(x, y) = x is rationalised by x ~ y;

C(y, z) = y is rationalised by y ~ z;

C(x, z) = z is rationalised by z ~ x.

It is not transitive, hence (B

/
, C()) is not rationalisable.
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Solution: (B
//
, C())
The choice structure can be summarised in these relations:

C(x, y, z) = x reveals x

y and x

C(x, y) = x reveals x

y;

C(y, z) = y reveals y

z;

C(x, z) = z reveals z

x.
1. W.A.R.P. is NOT satised

z and z

x hold at the same time;

in this case it exists x, z B : C(B) = x, but there is also...

...a x, z B
/
: z C(B
/
) but not x C(B
/
)
2. B
//
is NOT rationalisable:

since in general if is rational

satises W.A.R.P.;

then, by using the contrapositive, if A B, it must be true that B A

Hence (B
//
, C()) is not rationalisable
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Solution: (B
///
, C())
The choice structure can be summarised in these relations:

C(x, y, z) = x reveals x

y and x

C(x, y) = x reveals x

y;

C(y, z) = y reveals y

z;

C(x, z) = x reveals x

z.
1. W.A.R.P. is satised

there are no violations of the type x

y and y

x;

moreover, B
///
includes all budgets up to three elements.
2. B
///
is rationalizable:

C(x, y, z) = x reveals x ~ y and x ~ z

C(x, y) = x reveals x ~ y;

C(y, z) = y reveals y ~ z;

C(x, z) = x reveals x ~ z.

Hence x ~ y ~ z is complete and transitive and rationalises (B

///
, C())
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5. MWG 1.D.2: and W.A.R.P.
Show that if X is nite, then any rational preference relation generates a nonempty
choice rule; that is, C(B) ,= for any B X with B ,= .
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Solution
Proof.
X nite C(B) ,=
1. We proved earlier that if X is nite, then u() is a utility function representing
a rational . (by induction. Remember??)
2. Since X is nite, for any B X with B ,= there exists x C(B) such that
u(x) u(y) for all y B...
3. ...remember that niteness implied that we could order all alternatives in X,
and assign a value.
4. Then, it means that x C

(B, ), i.e. x is chosen according to preference

relation in B.
5. Hence, C

(B, ) cannot be empty: C

(B, ) ,=
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