Lecture 10 Axioms & Assumptions of NM

Sairam

[!NOTE] Crux - Basic Axioms (fundamental) vs other Auxiliary assumptions (flexible to vary in different circumstances) - Weakness of NM

  • Axioms relating to consumer preference:
    1. Completeness: Comparison must lead to one of the three possible mutually exclusive outcomes.
      • \((x_{1},x_{2})\succ (y_{1},y_{2})\) Prefers X
      • \((x_{1},x_{2})\prec (y_{1},y_{2})\) Prefers Y
      • \((x_{1},x_{2})\sim(y_{1},y_{2})\) Indifferent
      • Complete because it covers all possible otucomes
    2. Transitivity:
      • \((x_{1},x_{2})\succ (y_{1},y_{2})\) and \((y_{1},y_{2})\succ (z_{1},z_{2})\) then \((x_{1},x_{2})\succ (z_{1},z_{2})\)
      • \((x_{1},x_{2})\sim (y_{1},y_{2})\) and \((y_{1},y_{2})\sim (z_{1},z_{2})\) then \((x_{1},x_{2})\sim (z_{1},z_{2})\)
    3. Reflexibility: A bundle is at least as good as itself. Trivial
      • \((x_{1},x_{2}) \succsim (x_{1},x_{2})\)
    4. Revealed Preference:
      • Weak
      • Strong
    5. Four Additional principles exist, relevant in situations with uncertainty. EUT is relevant
  • Assumptions (increasing importance, acc. to normative appeal) \(4 \gt 3 \gt 2 \gt 1\)
    1. Cancellation: (In statistics: independent events can be ignored) Any state of the world that results in the same outcome regardless of the choice can be cancelled/ignored.
    2. Dominance: \(X \succ Y\) in one state and \(X \succsim Y\) in all other states. Then \(X\) dominates option \(Y\), and should be chosen.
    3. Extensionality: People have same attitude towards a certain object (in terms of value attached to it), regardless of how it is described.
      • e.g. "Packaged Meat is bad." whether it is described as 5% fat or 95% fat-free.
    4. Invariance: (Essential for any normative theory). Ruling out of 'framing effects'. Different representations of the same choice, will lead to the same preferences.
      • Preference doesn't depend on description. Description invariance
      • Doesn't depend on method of elicitation. Procedure invariance
      • e.g. Glass, half-empty/half-full.
    5. Consumers maximize utility: Taken as both a descriptive (people do behave this way) and normative (they ought to behave this way to maximize their welfare).
      • Normative aspect relates to rationality

  • (Can be relaxed) Assumptions

    • Characteristics of IC
      • Transitivity
      • Monotonicity of preferences: curves are downward-sloping (more is preferred than less)
        • not essential, since when people reach satiation, principle no longer applies
      • Assumption of convexity of preferences: curves are convex to the origin
        • meaning: additional units will eventually lead less marginal utility.
        • not essential, since it follows from law of DMU

          Good is a commodity where more is preferred than less. Opposite: 'bads' where less is preferred than more (e.g. Pollution)

  • Important Terms related to NM

    • Definitions are not universally agreed upon but shared (by either economics or psychologists)
    • Attitude: psychological tendency, expressed by evaluation, evaluating a particular entity with some degree of (dis)favor. (can relate to any entity that people like or dislike).
      • Entities = physical objects, living/non-living, abstract/concrete. (Anything that can elicit an affective response)
      • Object is a mental representation (not real objective state of affairs) based on beliefs
      • Help us understand violation of invariance and extension: e.g. 95% and 5% fat-free or fat representation creates different impressions
      • Involve judgement
      • e.g. Duration neglect: we tend to recall past as a prototypical moment (made-up) - coping mechanism
    • Value: Two senses
      1. value determine attitude: tastes or likes/dislikes (including moral values)
      2. attitude determines value: quantitative evaluation due to attitude. (referred to utility by economists either experienced or decision utility)
    • Preference: econ bother about preferences, psychos bother with attitudes
      • NM: "attitude \(\implies\) preferences" (may not be true)
    • Choice: An action involving some kind of decision
      • SM: choice = "revealed preference"
      • Two observations however
        • Preferences \(\neq\) choices
        • Attitude & Judgements \(\nRightarrow\) choices