Hi again. It’s time now for the third installment of our Econ101 series. After introducing some key concepts needed to speak the 'baby' language of economics, let’s now turn to a more structured and systematic approach. That is, we’re going to follow a text book structure, without having to religiously adopt its verbal and mathematical presentation.1 Yes, we’re going to do it the Cafe-way (and that may as well mean irregular schedule!). Lean back and enjoy your coffee.
When we analyze an individual behavior (in making decision, or more accurately in choosing between available options, given his constraints), we need to make some assumptions with regards to his preference. The most important assumption is that the guy is rational.
What do we mean by rational in this context? We mean his preference relation is complete and transitive. Complete means you can describe the relation between any two goods that he is considering. So, if the guy is considering apple, orange, and banana, you have to be able to say whether he prefers apple to orange. Also, you have to be able to tell his preference over apple and banana, as well as banana and orange. The good thing is, telling that he likes banana as much as apple is a valid statement – we say he is indifferent between banana and apple.2
Transitive means consistent in choice ordering. If our guy prefers apple to orange and orange to banana, he should prefer apple to banana. Yes, this assumption is strong: I know a friend who likes Manchester United more than Liverpool and prefers
How do we conveniently talk about preference? By assigning numbers to the preference order. In our example, the preference order of the guy is: apple-orange-banana (in decreasing order of importance). Now let’s assign some numbers. Yes, we’re assuming that we somehow can measure satisfaction. Suppose the satisfaction experienced by the guy if he consumes an apple is 10. Then, the corresponding number of an orange should be less than 10. Say 7. How about a banana? Yes, it should be less than 7. Say 5. We say, for the guy, the utility of apple, orange, and banana are 10, 7, and 5, respectively. Can we change the numbers? Yes, we can. But mind the order! So, if you like you can use 1,000-700-5, or 356,464-100-0.3. But combination like 3-5-1 or 7-4-10 is not allowed, given the guy’s preference. You see, utility function is an ordinal concept, not cardinal. That is, all that matters is the order, not the number itself. So, if we can use simple numbers as long as we keep the order, why make it complicated?
1 The text I’m referring to is Mas-Colell, Winston and Green. This book is one of the most elaborate modern microeconomics text. However, it is designed for graduate course. In one of its strongest part i.e. general equilibrium analysis, it uses differential topology, so you might want to consult some graduate math texts. Many times, students find it useful to combine this text with the more compact, Varian. If you want a good text for undergraduate level, we recommend Mankiw.
2 Seriously, guys, this is just an illustration. I really don't care if you happen to like orange more than apple :-)