Consumer Theory

• Main goal: to understand the connection between the

concepts of choice rules, preference relations and utility
functions.
– Choice rules – almost observable
– Preferences and utility functions – not observable
• These theoretical concepts helps us build models
on how people make decisions.
• Understanding the connection between these three
concepts is essential in order to build up a testable
theory of consumer choice.
• Finally, we will also try to define a good notion of
rationality.
1
 Binary Relations
Microeconomic Theory
Definition: R ⊆ X ×Y is a binary relation from set X to set Y.
Econ 711-UW-Madison By: Lones Smith
That is, 3 a- Consumer
CHAPTER set of Theory
ordered pairs (x,y) consisting of O
Updated:
elements x in X and y in Y.

We write xRy if (x,y) ∈ R.

3. Consumer Theory - I1
We write not xRy, or ¬[xRy], if (x,y) ∉ R.
• Unlike producer theory, consumer theory is an ordinal theory. E
comparing
When R ⊆ X ×alternatives.
X we simply say that R is a binary relation on
X•(not
Whenon comparing
X × X ). alternatives, constraints will matter and thus t

• To model individual decision making there are two main approa

•For most of the course, we will work with binary relations on
X (i.e.,- RThe
⊆X ); a preference-based approach, assumes that c
× Xone,
first
– Preference relation % (i.e
preferencerelations are the
an example
primitive)ofover
that.a given2 set o
preference relation % has to satisfy some axioms of rationa
 (not on X ⇥ X).
Binary Relations
of this section (and most of the course) we will work with binary rela
X ⇥ X); preference relations are an example for that. Moreover, if
• A binary relation on a finite set X is a subset of a two-
ural to you, don’t worry;
dimensional space. soon we are going to be less general and spe
y relation, which we will denote by more familiar symbols like ⌫, %, >
• Possible to picture it in a table that clarifies which
binaryelements
relation on area infinite
R. set X is a subset of a two-dimensional sp
cture it –in i.e.,
a table that
which rows clarifies whichtoelements
are related are in R (or in othe
which columns.
re related
Exampleto which columns).
1: The followingLet’s consider
table a concrete
defines a binaryexample:
relation
2. Theover the set table
following X = {1, 2, 3, 4,
defines 5}.
a binary relation over the set X = {1, 2
5 • •
4 • •
3 • • •
2 •
1 • • •
R 1 2 3 4 5 3
 R 1 R
2 31 42 53 4 5
Binary
Here Relations
is a simple exercise to play with the definition of binary relatio
Here is a simple exercise to play with the definition of binary
Exercise 1.3. Suppose R, Q are two binary relations on X. Prove th
Exercise 1: Suppose R, Q are two binary relations on X.
Exerciseare1.3.
the following Suppose R, Q are two binary relations on X. P
equivalent:
Prove that, given our notation, the following are equivalent:
1. the
R ✓following
Q are equivalent:
2. For all x, y 2 X, xRy =) xQy
1. R ✓ Q
Definition 1.4. The dual R0 of a binary relation R is defined by xR
2. For all x, y 2 X, xRy =) xQy
Definition: The dual R’ of a binary relation R is defined by
ForxR’y
example, on R,
iff (if and
Definition theif)
only
1.4. dual
TheyRx.
dual R0binary
of the relation
of a binary is ,Rand
relation the d
is define
Exercise 1.5. Draw the dual of the relation defined in Example 1.2
•For
Forexample,
example, on on R,, the
the dual
dual of
of5 the
the binary
binary relation
relation≥ isis≤,, an
and the dual of > is <. 4
Exercise 1.5. Draw the dual of the relation defined in Exam
3
Exercise 2. Draw the dual of2 the 5relation defined in
Example 1. 1 4
0
4
Here is a simple exercise to play with the definition of binary r
Binary Relations
Exercise 1.3. Suppose R, Q are two binary relations on X. Pr
the following are equivalent:
Definition: The asymmetric component P of a binary
relation
1. R R✓ isQdefined by xPy iff xRy and ¬[yRx].
2. For all x, y 2 X, xRy =) xQy
Definition: The symmetric component I of a binary relation
Definition
R is defined 1.4.
by xIyThe R0 yRx.
dualand
iff xRy of a binary relation R is defined

Example
For example, on R,, the
2: on thedual
asymmetric component
of the binary of ≥ is ,
relation >, and
since x > y iff x ≥ y and not y ≥ x. Also, it is easy to see that
Exercise 1.5.component
the symmetric Draw the dual
of ≥ isof=.the relation defined in Examp
5
4
3 5
Binary Relations

Exercise 3. Draw the asymmetric and the symmetric

component of the relation defined in Example 1.

•Every binary relation R can be decomposed into its

asymmetric and symmetric components. That is:
– R is the disjoint union of P and I

•Formally, for every R ∈ X × Y , we have R = P ∪ I and I ∩

P = ∅.

6
 Binary Relations
Definition: A binary relation R on X is:
• complete if, for all x,y ∈ X, xRy or yRx.

• symmetric if, for all x, y ∈ X, xRy implies yRx.

• antisymmetric if, for all x, y ∈ X, xRy and yRx imply x = y.
• asymmetric if, for all x, y ∈ X, xRy implies ¬(yRx).
• transitive if, for all x, y, z ∈ X xRy and yRz imply xRz.
• quasi-transitive if, for all x,y,z ∈ X, xPy and yPz imply xPz.
1. Complete (x, y \in X) (xRy) (yRx) (X) (R)
2. Symmetric (x, y \in X) (xRy) (yRx) (x) (y) (R) (y) (x)

3. Antisymmetric (x, y \in X) (xRy) (yRx) (x = y) (x) (y)

(R) (x) (y)
4. Asymmetric (x, y \in X) (xRy) (\neg(yRx)) (x) (y) (R) (y)
(x)
5. Transitive (x, y, z \in X) (xRy) (yRz) (xRz) (x) (y) (R) (y)
(z) (R) (x) (z) (R)
6. Quasi-transitive (x, y, z \in X) (xPy) (yPz) (xPz) (P) (R)
(xRy) (\neg(yRx)) (x) (y) (P) (y) (z) (P) (x) (z) 7
(P)
Binary Relations
Definition: A binary relation R on X is:
• acyclic if, for all x1,x2,...,xn ∈ X, x1Px2, x2Px3, ..., xn−1Pxn
imply x1Rxn.

• reflexive if, for all x ∈ X, xRx.

• irreflexive if, for all x ∈ X, ¬[xRx].
• negatively transitive if, for all x, y, z ∈ X, ¬[xRy] and
1. Acyclic (x_1, x_2, \ldots, x_n \in X) (x_1 P x_2) (x_2 P

¬[yRz] imply ¬[xRz]. x_3) … (x_{n-1} P x_n)

2. Reflexive
(x_1 R x_n)
(x \in X) (xRx)
(P)
(R)
3. Irreflexive (x \in X) (\neg[xRx])
(R)
4. Negatively transitive (x, y, z \in X) (\neg[xRy])
(\neg[yRz]) (\neg[xRz]) (x) (y) (R) (y) (z)
(R) (x) (z) (R)

•Note that completeness implies reflexivity.

8
Binary Relations

Exercise 4. Consider an arbitrary binary relation R. Prove

the following:
1. If R is transitive, then R is quasi-transitive.
2. If R is quasi-transitive, then R is acyclic.

• The converse of 1 in the Exercise 4 is not true.

Example 3:
Let X = {x,y,z}, and R = {(x,y),(y,z),(z,y),(x,z),(z,x)}.
Then we can see that R is quasi-transitive (vacuously), but
it is not transitive since yRz and zRx, but ¬[yRx].

9
Binary Relations
Claim: All swans are white.
• Showing one black swan is sufficient to falsify the claim.
• If there are no swans, then the claim is vacuously true.

• The converse of 2 in the Exercise 4 is not true.

Example:
Let X = {x, y, z}, and R = {(x, y), (y, z), (x, z), (z, x)}.
Here we can see that R is acyclic, but it fails to be quasi-
transitive.
To see this notice that xPy, and yPz and xRz, but we don’t
have xPz (since xIz – recall that I and P are disjoint).

10
Binary Relations
Definition: A binary relation R on X is an equivalence
relation if R is reflexive, symmetric and transitive.
• The equivalence class of x ∈ X is {y ∈ X : xRy}.
• We denote X\R the collection of all equivalence classes
of X given the binary relation R.

Example:
• If X is the set of all cars, and R is the equivalence
relation "has the same color as", then one particular
equivalence class consists of all green cars.
• X/R could be naturally identified with the set of all car
colors.

11
Binary Relations

Exercise 5. Let X be the set of all living people. Verify if the

following relations on X are reflexive, symmetric, transitive,
and/or complete.
•“is married to” (assuming monogamy)
•“is the son or daughter of ”
•“is the ancestor or descendant of”
•“is taller than”

12
Binary Relations

Definition: A binary relation R is a preorder if it is reflexive

and transitive.

Definition: A binary relation R is a weak order if it is

complete and transitive.

•A weak order is also called a preference relation.

Definition: A binary relation R on X is a linear order if R is

complete, transitive, and antisymmetric.

13
Binary Relations
Definition: Given a binary relation R on X,
• The upper contour set of x ∈ X is {y ∈ X : yRx},
• The lower contour set of x ∈ X is {y ∈ X : xRy}.

• The upper (lower) contour set is the set of elements that

x is related to through R.

• The definition is quite intuitive when applied to a

preference relation.
– the upper contour set of x gives you all those
elements in X that are preferred to x,
– the lower contour set gives you the set of all elements
to which x is preferred.
14
 Here is a simple exercise t
⇤how that z⇤2 {z 2 X : xRz}. By ⇤
2 {z 2
Let z 2 {z X
⇤ 2X : yRz}
: yRz}be be given. Wewant
given. We want
to to showshow z ⇤ 2 z{z 2 X
thatthat {z:
nthe
Binary
We also
lower
of the
know xRy;
lower
Relations
contour
by transitivity,
contoursetsetofof y, we have
y, we haveyRz
Exercise
yRz⇤ ⇤
. We. We
1.3. Suppose R
alsoalso
knowknow
xRy; xRy
by t
2 XExercise
z⇤xRz ⇤ .: yRz} ✓ ⇤ {z 2 X : xRz}, as the onfollowing
z . Thus z 26.{zSuppose
Thus⇤ z 2 {z 2 X : R is aTherefore
xRz}.
2 X : xRz}. preorder
Therefore {z 2X.
{z X2Prove
:X
yRz}:are✓equivale
that
yRz} {zif✓
2X{z
xRy, then the lower contour set of y is a subset of the lower
contour set of x. i.e. {z∈X: yRz} ⊆ {z∈X: xRz}. 1. R ✓ Q
e 1.20 (1.20). Construct a linear order Here onisRa2 .2.simple
For all x, y 2 to
exercise X,play
xR
order on R ..
20 (1.20). 2
ExerciseConstruct
7. Construct a alinear
linearorder
Solution: The lexicographic ordering Exercise≥Definition
L is 1.3.
1.4.
orderThe
Suppose
a linear on Qdua
R, are
.r on
TheR2lexicographic ordering † is a linear order on R2 . For any x = (x
hey2 ), .. For any x ordering
lexicographic = (x1 , x2 ), and †† is a the
linearfollowing
order are
on equivalent:
R 2 . For any
where
For anyx1x, x=2 ,(x R, y =is (y
y1 ,, yx2 ),2 and defined
, y ), as follows:
where x1,x2,y1,y2on ∈ R,, the du
lows:
where x1 , x2 , y1 , y2 2 R,1 2 † 1 2 For
is defined as follows:
example,
≥L is defined as follows: 1. R ✓ Q
xx ≥L†yy () (x1 > y1 ) or (x1 =
Exercise 1.5. Draw the
2. yFor
1 and allx2x, yy22 )X, xRy =)
nd x2 yx
2 ) † y () (x1 > y1 ) or (x1 = y1 and x2 y2 )
ns to verify that † is indeed complete, transitive, and antisymmetric0 o
Now, we need to 2verify thatDefinition 1.4. The
≥L is indeed dual R o
complete,
ove,verify
and antisymmetric
transitive,
that and on R . complete, transitive, and antisymme
† is indeed
antisymmetric.
Completeness:
ompleteness: immediate
This follows from For
immediatelythe example,
relation
from ≥ on R,. theofdual
the completeness the
15
of
rel
Binary Relations
Transitivity:
Let x = (x1, x2) ≥L y = (y1, y2) and y ≥L z = (z1,z2).
We need to show that either (x1 > z1) or (x1 = z1 and x2 ≥ z2).
Note that x1 ≥ y1 and y1 ≥ z1 by definition of ≥L.
Hence, if either x1 > y1 or y1 > z1, then x1 > z1, so we are
done.
Let’s assume x1 = y1 = z1. In that case, it must hold by
assumption that x2 ≥ y2 ≥ z2.

Antisymmetry:
If x = (x1, x2) ≥L y = (y1, y2) and y ≥L x, then x1 ≥ y1 and y1 ≥
x1, i.e. x1 =y1.
Hence, it must also hold that x2 ≥ y2 and y2 ≥ x2, i.e. x2 =y2.
16
Binary Relations
Exercise 8. Let R1,..,Rn be binary relations on X.
Define the binary relation R by xRy iff x Ri y,∀i = 1,2,...,n.

Prove or provide counterexamples of the following

statements:
• If each Ri is a preorder, then R is a preorder.
• If each Ri is a weak order, then R is a weak order.

Exercises 5, 6, and 8 are part of your homework

assignment 1.

17
 Model of Consumer’s Choice
• In order to have a good model of how consumers behave
we need to define:
– The set of options that are possible objects of choice
– Among those, a subset that describes what are the
feasible objects of choice.
– A theory that gives us the way a consumer chooses
among the feasible items.

• We start by trying to build the latter starting from a

description of how a consumer would rank any two elements
that belong to the set of possible objects of choice. These
are hypothetical rankings.
18
 Model of Consumer’s Choice
• We then try to see what these hypothetical rankings imply
about actual choices:
– Are choices rational in the sense of being consistent with
those rankings?

• Finally, we ask whether rationality can be tested by an

outside observer (the economist) who does not know what
is inside the consumer’s head:
– Can we say whether a consumer is rational without
knowing her hypothetical rankings?

19
 tional choice imposed on preferences, as we will show further in the lectu
• When comparing alternatives, constraints will matter and thus trade-o↵s
notes.
Preference Relations
• To model individual decision making there are two main approaches:

- The first one, a preference-based approach, assumes that consumer

eferences
Definition: A preference relation % (i.e
binary relation on the
X isprimitive)
a preference relation
over a given set of if it
choices
preference relation % has to satisfy some axioms of rational choice.
is a weak
nsumer order, Theory
Preference i.e. complete
(First and transitive.Here preferences, %, are th
Approach):
- The second one, a choice-based approach, focuses on the consume
•Consider
mitives. a aset
Consider set XX of
behavior consumption
ofand
consumption bundles,
bundles,
takes observables andasand
choices take takex,any
any
the primitives. x,yThe
y 2When
X. th
X. Then, we have
have: satisfy some consistency restrictions, they are equivalent to the axio
tional choice imposed on preferences, as we will show further in th
x % y , x is weakly preferred to y
notes.

, x % y and y 6% x : say x is strictly preferred to y

x3.1 yPreferences
y , x %Preference
x• ⇠Consumer y and y %Theory
x : say (First
x is indi↵erent
Approach):to Here
y preferences, %
primitives. Consider a set X of consumption bundles, and take any x, y 2
•Kreps:
other words x“A preference
%weyhave: relation
is equivalent to x y orexpresses
x ⇠ y. the consumer’s
feelings between pair of objects x % yin
,X”.
x is weakly preferred to y
•A preference
reference relation
relation gives y gives
anx order
, on yan
x %the order
y 6% x :on
elements
and of
sayXxthebasedelementstastes.ofNext
on preferred
is strictly toXy w
based
have someon tastes.
axioms on preferences
x⇠y, that
x %would
y and allow
y % x :us
saytoxextrapolate
is indi↵erent this
to y bina
20
mparisons. In other words x % y is equivalent to x y or x ⇠ y.
A binary relation % on X is a preference relation if it is a weak order, i.e. complete
and transitive.

Preference Relations
x % y reads: the decision maker (DM) weakly prefers x to y ; we also say x is
at least as good as y .
• Preference relations
Kreps: “A preference areexpresses
relation not choices!
the consumer’s feelings between pair
• Later, wein will
of objects X ”. talk about choices the consumer would make
These are not choices. Later, we will talk about choices the consumer would
given some set of options to choose from, and how these
make given some set of options to choose from, and how these choices are
choices
related to are related to
her preference her preference relation.
relation.

Definitions
The upper contour set of x (denoted % (x)) consists of the elements of X that are
weakly preferred to x according to %:
% (x) = {y 2 X : y % x}
The lower contour set of x (denoted - (x)) consists of the elements of X that x is
weakly preferred to according to %:
- (x) = {y 2 X : x % y }

21
 Preference Relations
Preference Relations
Preference Relations
Definitions
Definitions
For any preference relation % on X ,
For any preference relation % on X ,
- denotes the dual of %, defined by
- denotes the dual of %, defined by
x - y , y % x;
x - y , y % x;
≻ denote the asymmetric component of %, defined by
≻ denote the asymmetric component of %, defined by
x ≻ y , [x % y and not y % x];
x ≻ y , [x % y and not y % x];
∼ denote the symmetric component of %, defined by
∼ denote the symmetric component of %, defined by
x ∼ y , [x % y and y % x].
x ∼ y , [x % y and y % x].

xx≻≻yy reads:
reads:DM
DMstrictly
strictlyprefers
prefersx xtotoy ;y ;
xx∼∼yy reads:
reads:DM
DMisisindi§erent
indi§erentbetween
between x and
x and y.y.

22
 Preference Relations: Exercises
Exercise
Preference
PreferenceRelations: Exercises
Relations: Exercises
Exercise
Let X = {a, b, c}. Determine if the following binary relations are complete and/or
Let X = {a, b, c}. Determine if the following binary relations are complete and/or
transitive:
transitive:
1 %= X × X ;
1 %= X × X ;
2 %= ;;
2 %= ;;
3 %= {(a, a), (b, b), (c, c), (a, b), (b, a), (a, c), (b, c)};
3 %= {(a, a), (b, b), (c, c), (a, b), (b, a), (a, c), (b, c)};
4
4 %= {(a,
%= a),(b,
{(a,a), (b,b),
b),(c,
(c,c),
c),(a,(a,
b),b),
(b,(b,
c),c),
(c,(c, a)};
a)};
5
5 %= {(a,
%= b),(b,
{(a,b), (b,c),
c),(a,
(a,c)}.
c)}.

HW1 Question:
Question
Question 3, Problem
3, ProblemSet Set1.1.
Prove that ifif %%isisaapreference
Prove that preferencerelation
relation(i.e.
(i.e.it is
it complete
is complete
andand transitive),
transitive), then:then:
11 - isis aa preference
- preferencerelation;
relation;
22 ≻ isis asymmetric
≻ asymmetricand andtransitive;
transitive;
33 ∼∼ isis an
an equivalence
equivalencerelation.
relation.
44 xx %
% yy and implyx x%%z;z;
andyy∼∼zzimply
23
55 xx %
% yy and
andyy≻≻zzimply
implyx x≻≻z.z.