Lecture 9 The Standard Model in Neoclassical Economics
- Intro to Standard Economic Models (SEM)
- To build on top of SEM
- Talk about its violations
- SEM
- Key Assumptions
- Rationality (logical and consistent evaluation)
- Self-interest (maximize personal gain or utility)
- Utility maximization (get the highest possible level of satisfaction from choices)
- Complete info (access to ALL relevant info: prices, products & potential outcomes)
- Consistent Preferences (logical & predictable preferences)
- Perfect Foresight (accurately predict future outcomes)
- Most accepted mathematical model: Augmented Neoclassical Model.
- NM in mathematical terms helps for three objective:
- Concise description
- Illustration of various components
- General consideration => how they relate to various components
- The Systematization (expression through mathematics) is very attractive.
- Key Assumptions
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Augmented Neoclassical Model
- (1)The \(i\) Individual at time \(t = 0\) maximizes expected utility
- (2) \(\delta\) is the discount rate.
- (3)S.T. probability distribution \(p(s)\) of the states of the world \(s \in S\). (Different states have different probabilities)
- (4) Payoff \(x_{i}^t\)
- Assumptions:
- Rational (1), (2), (3) & (4)
- Economic agents are motivated by expected utility maximization: (1), (3) & (4)
- Agent's utility is governed by purely selfish concerns. Doesn't consider others' utlity: (4)
- Agents are Bayesian Probability operators: (3) #explore
- Agents have consistent time preferences according to the discounted utility model: (2)
- All income and assets are completely fungible: (4)
\(\(max \sum_{t=0}^\infty \delta^t\sum_{s_{t}\in S_{t}} p(s_{t})U(x_{i}^t|s_{t})\)\) - Example of neoclassical model: Expected utility. Optimal decision is dictated by - Probability estimates of the state of the world. Expected Utility of drinking coffee = 8.4 vs beer (5.6). Thus Coffee is preferred. - Estimation of Bayesian Priors have a significant impact on decision-making - Rational person will update the priors in the light of new information. - Discovered Preference Hypothesis of Plott (1996) - SEM is a good predictor - if... people have ample opportunity to learn from experience
| Decision | State of the world (S) | Probability (Bayesian Priors) | Payoff |
|---|---|---|---|
| Coffee | Interesting | 0.8 | 10 |
| Boring | 0.2 | 2 | |
| Beer | Interesting | 0.8 | 6 |
| Boring | 0.2 | 4 |
- NM - The Decision-making process
- We act on instinct, without conscious thought (not decisions)
- Reason:
- No time to use the cold analytical cognitive system
- Use hot affective system
- Dependent on instantaneous emotional or visceral responses (e.g. Duck an object flying, lash out anger, gaali etc)
- Sometimes even when the "hot" system is working, there are situations where some stimulus results in an action. Here, a decision-making process is involved #doubt (what did she mean by this?)
- Need a general model for DM process that explains
- Why we reach for the Oreo cookies in the market
- Where we buy lottery ticket
- Why we choose a particular medical treatment
- In all these situations, form's different but certain aspects are common: Three fundamental characteristics.
- Components of Neoclassical DM process (PBR)
- Preferences: Rankings over a set of options/gambles... based on attitudes and values related to their outcomes
- Belief: \(P(\text{Outcome}| \text{Available Information})\)
- Rationality: involves all four components. Refers to way in which people
- Determine preferences
- appropriately modify their beliefs wrt new information
- discount values for future outcomes
- succeed in choosing optimal outcomes
- Note:
- Notable interdependence and overlap exists. \(\text{Belief}\to \text{Preferences}\)
- this classification (PBR), factors within each category are involved in DM
- Deviations from the Standard NM
- DellaVigna (2009) examines deviations in PBR, referring to these as non-standard preferences, beliefs and DM.
Important Approaches & Tools in NM¶
- Consumer Behavior in SNM
- Objects of consumer choice: consumption bundle is a complete list of goods and services being considered.
- More generally, context also matters (e.g. future available of goods and services) (water in a dessert rather than Antartic)
- Bundle, \(X = (X_{1}, X_{2})\). Two goods can be graphically represented
- NM: consumers rank bundle based on desirability
>or< - Indifferent between two bundles
~ - Preference symbol
- Revealed Preference
- Preference relations are operational notions
- NM assumes choice is determined by preference. Important because choice can be observed, preference cannot
- If consumer chooses a bundle, it is assumed to be preferred to another - if... the other bundle was both available and affordable.
- Indifference Curves
- Indifference map (away from the origin: preferred to those on lower IC, \(I_{1}\)). \(I_{2} \succ I_{1}\)
- Usually convex
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IC - Equilibrium
- Can be used to illustrate notion of consumer equilibrium
- Budget constraint: money available: \(p_{x}X + p_{y}Y \leq m\)
- \(m\) is the available budget
- Optimal point of consumption will occur at the point of tangency between the IC and the budget constraint line.
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Or... "Slopes should be equal", the condition: > Marginal Utility of the last dollar spent on each good is the SAME.
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Consumer equilibrium is defined by using 'marginal utility' (not necessary). We can also use MRS of one good for another (which is the slope of the indifference curve).
- \(MRS_{xy}\) = amount of \(y\) that a consumer is prepared to give up for one more unit of \(x\).
- Thus, equilibrium condition: \(MRS_{xy} = \dfrac{p_{x}}{p_{y}}\)
- This form of exposition, avoids the thorny concept of utility.
- Can be used to illustrate notion of consumer equilibrium