Preference (economics)

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A simple example of a preference order over three goods, in which an orange is preferred to a banana, but an apple is preferred to an orange Preference example.jpg
A simple example of a preference order over three goods, in which an orange is preferred to a banana, but an apple is preferred to an orange

In economics and other social sciences, preference is the order that a person (an agent) gives to alternatives based on their relative utility, a process which results in an optimal "choice" (whether real or theoretical). Instead of the prices of goods, personal income, or availability of goods, the character of the preferences is determined purely by a person's tastes. However, persons are still expected to act in their best (that is, rational) interest. [1]

Economics Social science that analyzes the production, distribution, and consumption of goods and services

Economics is the social science that studies the production, distribution, and consumption of goods and services.

Social science The academic disciplines concerned with society and the relationships between individuals in society

Social science is a category of academic disciplines, concerned with society and the relationships among individuals within a society. Social science as a whole has many branches. Social science is a branch that studies human beings from various aspects. These social sciences include, but are not limited to: anthropology, archaeology, communication studies, economics, history, musicology, human geography, jurisprudence, linguistics, political science, psychology, public health, and sociology. Sociology is defined as the general science of society. The term is also sometimes used to refer specifically to the field of sociology, the original "science of society", established in the 19th century. For a more detailed list of sub-disciplines within the social sciences see: Outline of social science.

Within economics, the concept of utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or satisfaction within the theory of utilitarianism by moral philosophers such as Jeremy Bentham and John Stuart Mill. The term has been adapted and reapplied within neoclassical economics, which dominates modern economic theory, as a utility function that represents a consumer's preference ordering over a choice set. It is devoid of its original interpretation as a measurement of the pleasure or satisfaction obtained by the consumer from that choice.

Contents

Using the scientific method, social scientists try to model how people make practical decisions in order to test predictions about human behavior. Although economists are usually not interested in what causes a person to have certain preferences, they are interested in the theory of choice because it gives a background to empirical demand analysis. [2]

Scientific method Interplay between observation, experiment and theory in science

The scientific method is an empirical method of acquiring knowledge that has characterized the development of science since at least the 17th century. It involves careful observation, applying rigorous skepticism about what is observed, given that cognitive assumptions can distort how one interprets the observation. It involves formulating hypotheses, via induction, based on such observations; experimental and measurement-based testing of deductions drawn from the hypotheses; and refinement of the hypotheses based on the experimental findings. These are principles of the scientific method, as distinguished from a definitive series of steps applicable to all scientific enterprises.

In economics, demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given period of time. The relationship between price and quantity demanded is also known as the demand curve. Preferences which underlie demand, are influenced by cost, benefit, odds and other variables.

History

In 1926 Ragnar Frisch developed for the first time a mathematical model of preferences in the context of economic demand and utility functions. [3] Up to then, economists had developed an elaborated theory of demand that omitted primitive characteristics of people. This omission ceased when, at the end of the 19th and the beginning of the 20th century, logical positivism predicated the need of theoretical concepts to be related with observables. [4] Whereas economists in the 18th and 19th centuries felt comfortable theorizing about utility, with the advent of logical positivism in the 20th century, they felt that it needed more of an empirical structure. Because binary choices are directly observable, it instantly appealed to economists. The search for observables in microeconomics is taken even further by revealed preference theory.

Ragnar Frisch Norwegian economist

Ragnar Anton Kittil Frisch was a Norwegian economist and the co-recipient of the first Nobel Memorial Prize in Economic Sciences in 1969. He is known for being one of the founders of the discipline of econometrics, and for coining the widely used term pair macroeconomics/microeconomics in 1933.

Logical positivism, later called logical empiricism, and both of which together are also known as neopositivism, was a movement in Western philosophy whose central thesis was the verification principle. Also called verificationism, this would-be theory of knowledge asserted that only statements verifiable through direct observation or logical proof are meaningful. Starting in the late 1920s, groups of philosophers, scientists, and mathematicians formed the Berlin Circle and the Vienna Circle, which, in these two cities, would propound the ideas of logical positivism.

In mathematics, a binary relation over two sets A and B is a set of ordered pairs consisting of elements a of A and elements b of B. That is, it is a subset of the Cartesian product A × B. It encodes the information of relation: an element a is related to an element b if and only if the pair belongs to the set.

Despite utilitarianism and decision theory, many economists have differing definitions of "rational agents". In the 18th century, utilitarianism gave insight into the utility-maximizing versions of rationality, however, economists still have no single definition or understanding of what preferences and rational actors should be analyzed by. [5]

Since the pioneer efforts of Frisch in the 1920s, one of the major issues which has pervaded the theory of preferences is the representability of a preference structure with a real-valued function. This has been achieved by mapping it to the mathematical index called utility. Von Neumann and Morgenstern 1944 book "Games and Economic Behaviour" treated preferences as a formal relation whose properties can be stated axiomatically. These type of axiomatic handling of preferences soon began to influence other economists: Marschak adopted it by 1950, Houthakker employed it in a 1950 paper, and Kenneth Arrow perfected it in his 1951 book "Social Choice and Individual Values". [6]

John von Neumann mathematician and physicist

John von Neumann was a Hungarian-American mathematician, physicist, computer scientist, and polymath. Von Neumann was generally regarded as the foremost mathematician of his time and said to be "the last representative of the great mathematicians"; a genius who was comfortable integrating both pure and applied sciences.

Gérard Debreu, influenced by the ideas of the Bourbaki group, championed the axiomatization of consumer theory in the 1950s, and the tools he borrowed from the mathematical field of binary relations have become mainstream since then. Even though the economics of choice can be examined either at the level of utility functions or at the level of preferences, to move from one to the other can be useful. For example, shifting the conceptual basis from an abstract preference relation to an abstract utility scale results in a new mathematical framework, allowing new kinds of conditions on the structure of preference to be formulated and investigated.

Gérard Debreu French economist and mathematician

Gérard Debreu was a French-born economist and mathematician. Best known as a professor of economics at the University of California, Berkeley, where he began work in 1962, he won the 1983 Nobel Memorial Prize in Economic Sciences.

Nicolas Bourbaki collective pseudonym for a group of (mainly French) 20th-century mathematician

Nicolas Bourbaki is the collective pseudonym of a group of mathematicians. Their aim is to reformulate mathematics on an extremely abstract and formal but self-contained basis in a series of books beginning in 1935. With the goal of grounding all of mathematics on set theory, the group strives for rigour and generality. Their work led to the discovery of several concepts and terminologies still used, and influenced modern branches of mathematics.

Another historical turnpoint can be traced back to 1895, when Georg Cantor proved in a theorem that if a binary relation is linearly ordered, then it is also isomorphically embeddable in the ordered real numbers. This notion would become very influential for the theory of preferences in economics: by the 1940s prominent authors such as Paul Samuelson, would theorize about people having weakly ordered preferences. [7]

Notation

Suppose the set of all states of the world is and an agent has a preference relation on . It is common to mark the weak preference relation by , so that means "the agent wants y at least as much as x" or "the agent weakly prefers y to x".

The symbol is used as a shorthand to the indifference relation: , which reads "the agent is indifferent between y and x".

The symbol is used as a shorthand to the strong preference relation: , which reads "the agent strictly prefers y to x".

Meaning in decision sciences

In everyday speech, the statement "x is preferred to y" is generally understood to mean that someone chooses x over y. However, decision theory rests on more precise definitions of preferences given that there are many experimental conditions influencing people's choices in many directions.

Suppose a person is confronted with a mental experiment that she must solve with the aid of introspection. She is offered apples (x) and oranges (y), and is asked to verbally choose one of the two. A decision scientist observing this single event would be inclined to say that whichever is chosen is the preferred alternative.

Under several repetitions of this experiment (and assuming laboratory conditions controlling outside factors), if the scientist observes that apples are chosen 51% of the time it would mean that . If half of the time oranges are chosen, then . Finally, if 51% of the time she chooses oranges it means that . Preference is here being identified with a greater frequency of choice.

This experiment implicitly assumes that the trichotomy property holds for the order relation. Otherwise, out of 100 repetitions, some of them will give as a result that neither apples, oranges or ties are chosen. These few cases of uncertainty will ruin any preference information resulting from the frequency attributes of the other valid cases.

However, this example was used for only illustrative purposes, and it should not be interpreted as an indication that the economic theory of preferences starts with experiments and moves on to theorems. On the contrary, the method used in the theory preferences is essentially an armchair method. Economists make assumptions, and from these assumptions they deduce theorems which presumably can be tested, even though the test is not indispensable.

Consumers are by definition demanders of goods and services. Standard economic theory states that their demand behaviour can be thought of maximizing a utility index, or its parallel: the ranking of the set of possible consumption bundles by means of either the binary relation "at least as good as" or the relation "strictly preferred as".

Of all the available bundles of goods and services, only one is ultimately chosen. The theory of preferences examines the problem of getting to this optimal choice using a system of preferences within a budgetary limitation.

In reality, people do not necessarily rank or order their preferences in a consistent way. In preference theory, some idealized conditions are regularly imposed on the preferences of economic actors. One of the most important of these idealized conditions is the axiom of transitivity : [2]

Axiom of transitivity: If alternative is weakly preferred to alternative , and to , then is weakly preferred to .

Symbolically, this can be stated as

If and then

Sometimes a weaker axiom (that is, it is implied by transitivity, but not vice versa), called "quasi-transitivity" is used, which only requires the above for strict preferences:

If and then

The language of binary relations allow one to write down exactly what is meant by "ranked set of preferences", and thus gives an unambiguous definition of order. A preference relation should not be confused with the order relation used to indicate which of two real numbers is greater. [8] Order relations over the real number line satisfy an extra condition:

and implies

But in preference relations, two things can be equally liked without being in some sense numerically equal. Hence, an indifference relation is used instead of an equality relation (the symbol denotes this kind of relation). Thus we have

and implies

A system of preferences or preference structure refers to the set of qualitative relations between different alternatives of consumption. For example, if the alternatives are:

In this example, a preference structure would be:

"The apple is at least as preferred as the orange", and "The orange is as least as preferred as the Banana". One can use to symbolize that some alternative is "at least as preferred as" another one, which is just a binary relation on the set of alternatives. Therefore:

The former qualitative relation can be preserved when mapped into a numerical structure, if we impose certain desirable properties over the binary relation: these are the axioms of preference order. For instance: Let us take the apple and assign it the arbitrary number 5. Then take the orange and let us assign it a value lower than 5, since the orange is less preferred than the apple. If this procedure is extended to the banana, one may prove by induction that if is defined on {apple, orange} and it represents a well-defined binary relation called "at least as preferred as" on this set, then it can be extended to a function defined on {apple, orange, banana} and it will represent "at least as preferred as" on this larger set.

Example:

5 > 3 > 2 = u(apple) > u(orange) > u(banana)

and this is consistent with Apple Orange, and with Orange Banana.

Axiom of order (Completeness): For all and we have or or both.

In order for preference theory to be useful mathematically, we need to assume the axiom of continuity. Continuity simply means that there are no ‘jumps’ in people's preferences. In mathematical terms, if we prefer point A along a preference curve to point B, points very close to A will also be preferred to B. This allows preference curves to be differentiated. The continuity assumption is "stronger than needed" in the sense that it indeed guarantees the existence of a continuous utility function representation. Continuity is, therefore, a sufficient condition, but not a necessary one, for a system of preferences. [9]

Although commodity bundles come in discrete packages, economists treat their units as a continuum, because very little is gained from recognizing their discrete nature. According to Silberberg,[ citation needed ] the two approaches are reconcilable by this rhetorical device: When a consumer makes repeated purchases of a product, the commodity spaces can get converted from the discrete items to the time rates of consumption. Instead of, say, noting that a consumer purchased one loaf of bread on Monday, another on Friday and another the following Tuesday, we can speak of an average rate of consumption of bread equal to 7/4 loaves per week. There is no reason why the average consumption per week cannot be any real number, thus allowing differentiability of the consumer's utility function. We can speak of continuous services of goods, even if the goods themselves are purchased in discrete units.

Although some authors include reflexivity as one of the axioms required to obtain representability (this axiom states that ), it is redundant inasmuch as the completeness axiom implies it already. [10]

Most commonly used axioms

Normative interpretations of the axioms

Everyday experience suggests that people at least talk about their preferences as if they had personal "standards of judgment" capable of being applied to the particular domain of alternatives that present themselves from time to time. [11] Thus, the axioms are an attempt to model the decision maker's preferences, not over the actual choice, but over the type of desirable procedure (a procedure that any human being would like to follow). Behavioral economics investigates inconsistent behavior (i.e. behavior that violates the axioms) of people. Believing in axioms in a normative way does not imply that everyone is asserted to behave according to them. Instead, they are a basis for suggesting a mode of behavior, one that people would like to see themselves or others following. [4]

Here is an illustrative example of the normative implications of the theory of preferences: [4] Consider a decision maker who needs to make a choice. Assume that this is a choice of where to live or whom to marry and that the decision maker has asked an economist for advice. The economist, who wants to engage in normative science, attempts to tell the decision maker how she should make decisions.

Economist: I suggest that you attach a utility index to each alternative, and choose the alternative with the highest utility.

Decision Maker: You've been brainwashed. You think only in terms of functions. But this is an important decision, there are people involved, emotions, these are not functions!

Economist: Would you feel comfortable with cycling among three possible options? Preferring x to y, and then y to z, but then again z to x?

Decision Maker: No, this is very silly and counterproductive. I told you that there are people involved, and I do not want to play with their feelings.

Economist: Good. So now let me tell you a secret: if you follow these two conditions making decision, and avoid cycling, then you can be described as if you are maximizing a utility function.

Consumers whose preference structures violate transitivity would get exposed to being exploited by some unscrupulous person. For instance, Maria prefers apples to oranges, oranges to bananas, and bananas to apples. Let her be endowed with an apple, which she can trade in a market. Because she prefers bananas to apples, she is willing to pay, say, one cent to trade her apple for a banana. Afterwards, Maria is willing to pay another cent to trade her banana for an orange, and again the orange for an apple, and so on. There are other examples of this kind of irrational behaviour.

Completeness implies that some choice will be made, an assertion that is more philosophically questionable. In most applications, the set of consumption alternatives is infinite and the consumer is not conscious of all preferences. For example, one does not have to choose over going on holiday by plane or by train: if one does not have enough money to go on holiday anyway then it is not necessary to attach a preference order to those alternatives (although it can be nice to dream about what one would do if one would win the lottery). However, preference can be interpreted as a hypothetical choice that could be made rather than a conscious state of mind. In this case, completeness amounts to an assumption that the consumers can always make up their mind whether they are indifferent or prefer one option when presented with any pair of options.

Under some extreme circumstances there is no "rational" choice available. For instance, if asked to choose which one of one's children will be killed, as in Sophie's Choice, there is no rational way out of it. In that case preferences would be incomplete, since "not being able to choose" is not the same as "being indifferent".

The indifference relation ~ is an equivalence relation. Thus we have a quotient set S/~ of equivalence classes of S, which forms a partition of S. Each equivalence class is a set of packages that is equally preferred. If there are only two commodities, the equivalence classes can be graphically represented as indifference curves. Based on the preference relation on S we have a preference relation on S/~. As opposed to the former, the latter is antisymmetric and a total order.

Applications to theories of utility

In economics, a utility function is often used to represent a preference structure such that if and only if . The idea is to associate each class of indifference with a real number such that, if one class is preferred to the other, then the number of the first one is greater than that of the second one. When a preference order is both transitive and complete, then it is standard practice to call it a rational preference relation, and the people who comply with it are rational agents . A transitive and complete relation is called a weak order (or total preorder). The literature on preferences is far from being standardized regarding terms such as complete, partial, strong, and weak. Together with the terms "total", "linear", "strong complete", "quasi-orders", "pre-orders" and "sub-orders", which also have a different meaning depending on the author's taste, there has been an abuse of semantics in the literature. [11]

According to Simon Board, a continuous utility function always exists if is a continuous rational preference relation on . [12] For any such preference relation, there are many continuous utility functions that represent it. Conversely, every utility function can be used to construct a unique preference relation.

All the above is independent of the prices of the goods and services and of the budget constraints faced by consumers. These determine the feasible bundles (which they can afford). According to the standard theory, consumers chooses a bundle within their budget such that no other feasible bundle is preferred over it; therefore their utility is maximized.

Primitive equivalents of some known properties of utility functions

Lexicographic preferences

Lexicographic preferences are a special case of preferences that assign an infinite value to a good, when compared with the other goods of a bundle.

Strict versus weak

The possibility of defining a strict preference relation as distinguished from the weaker one , and vice versa, suggests in principle an alternative approach of starting with the strict relation as the primitive concept and deriving the weaker one and the indifference relation. However, an indifference relation derived this way will generally not be transitive. [3] According to Kreps "beginning with strict preference makes it easier to discuss noncomparability possibilities". [13]

Aggregation

Under certain assumptions, individual preferences can be aggregated onto the preferences of a group of people. However, Arrow's impossibility theorem states that voting systems sometimes cannot convert individual preferences into desirable community-wide acts of choice.

Expected utility theory

Preference relations were initially applied only to alternatives that involve no risk and uncertainties because this is an assumption of the homo economicus model of behaviour. Nonetheless, a very similar theory of preferences has also been applied to the space of simple lotteries, as in expected utility theory. In this case a preference structure over lotteries can also be represented by a utility function.

Criticism

Some critics say that rational theories of choice and preference theories rely too heavily on the assumption of invariance, which states that the relation of preference should not depend on the description of the options or on the method of elicitation. But without this assumption, one's preferences cannot be represented as maximization of utility. [14]

Milton Friedman said that segregating taste factors from objective factors (i.e. prices, income, availability of goods) is conflicting because both are "inextricably interwoven".

See also

Related Research Articles

Indifference curve microeconomic graph; connects points representing different quantities of 2 goods, points between which a consumer is indifferent: i.e. the consumer doesnt prefer one combination or bundle of goods over another combination on the same curve

In economics, an indifference curve connects points on a graph representing different quantities of two goods, points between which a consumer is indifferent. That is, any combinations of two products indicated by the curve will provide the consumer with equal levels of utility, and the consumer has no preference for one combination or bundle of goods over a different combination on the same curve. One can also refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. In other words, an indifference curve is the locus of various points showing different combinations of two goods providing equal utility to the consumer. Utility is then a device to represent preferences rather than something from which preferences come. The main use of indifference curves is in the representation of potentially observable demand patterns for individual consumers over commodity bundles.

In social choice theory, Arrow's impossibility theorem, the general possibility theorem or Arrow's paradox is an impossibility theorem stating that when voters have three or more distinct alternatives (options), no ranked voting electoral system can convert the ranked preferences of individuals into a community-wide ranking while also meeting a specified set of criteria: unrestricted domain, non-dictatorship, Pareto efficiency, and independence of irrelevant alternatives. The theorem is often cited in discussions of voting theory as it is further interpreted by the Gibbard–Satterthwaite theorem. The theorem is named after economist and Nobel laureate Kenneth Arrow, who demonstrated the theorem in his doctoral thesis and popularized it in his 1951 book Social Choice and Individual Values. The original paper was titled "A Difficulty in the Concept of Social Welfare".

In welfare economics, a social welfare function is a function that ranks social states as less desirable, more desirable, or indifferent for every possible pair of social states. Inputs of the function include any variables considered to affect the economic welfare of a society. In using welfare measures of persons in the society as inputs, the social welfare function is individualistic in form. One use of a social welfare function is to represent prospective patterns of collective choice as to alternative social states. The social welfare function provides the government with a simple guideline for achieving the optimal distribution of income.

The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption as measured by their preferences subject to limitations on their expenditures, by maximizing utility subject to a consumer budget constraint.

In mathematics, especially in order theory, a maximal element of a subset S of some partially ordered set (poset) is an element of S that is not smaller than any other element in S. A minimal element of a subset S of some partially ordered set is defined dually as an element of S that is not greater than any other element in S.

In mathematics, intransitivity is a property of binary relations that are not transitive relations. This may include any relation that is not transitive, or the stronger property of antitransitivity, which describes a relation that is never transitive.

In economics, game theory, and decision theory, the expected utility hypothesis—concerning people's preferences with regard to choices that have uncertain outcomes (gambles)⁠—states that the subjective value associated with an individual's gamble is the statistical expectation of that individual's valuations of the outcomes of that gamble, where these valuations may differ from the dollar value of those outcomes. The introduction of St. Petersburg Paradox by Daniel Bernoulli in 1738 is considered the beginnings of the hypothesis. This hypothesis has proven useful to explain some popular choices that seem to contradict the expected value criterion, such as occur in the contexts of gambling and insurance.

In economics, an ordinal utility function is a function representing the preferences of an agent on an ordinal scale. Ordinal utility theory claims that it is only meaningful to ask which option is better than the other, but it is meaningless to ask how much better it is or how good it is. All of the theory of consumer decision-making under conditions of certainty can be, and typically is, expressed in terms of ordinal utility.

Revealed preference theory, pioneered by economist Paul Samuelson, is a method of analyzing choices made by individuals, mostly used for comparing the influence of policies on consumer behavior. Revealed preference models assume that the preferences of consumers can be revealed by their purchasing habits.

In economics, an agent's preferences are said to be weakly monotonic if, given a consumption bundle , the agent prefers all consumption bundles that have more of all goods. That is, implies . An agent's preferences are said to be strongly monotonic if, given a consumption bundle , the agent prefers all consumption bundles that have more of at least one good, and not less in any other good. That is, and imply .

Pairwise comparison generally is any process of comparing entities in pairs to judge which of each entity is preferred, or has a greater amount of some quantitative property, or whether or not the two entities are identical. The method of pairwise comparison is used in the scientific study of preferences, attitudes, voting systems, social choice, public choice, requirements engineering and multiagent AI systems. In psychology literature, it is often referred to as paired comparison.

In decision theory, the von Neumann-Morgenstern utility theorem shows that, under certain axioms of rational behavior, a decision-maker faced with risky (probabilistic) outcomes of different choices will behave as if he or she is maximizing the expected value of some function defined over the potential outcomes at some specified point in the future. This function is known as the von Neumann-Morgenstern utility function. The theorem is the basis for expected utility theory.

Semiorder

In order theory, a branch of mathematics, a semiorder is a type of ordering that may be determined for a set of items with numerical scores by declaring two items to be incomparable when their scores are within a given margin of error of each other, and by using the numerical comparison of their scores when those scores are sufficiently far apart. Semiorders were introduced and applied in mathematical psychology by Luce (1956) as a model of human preference without the assumption that indifference is transitive. They generalize strict weak orderings, form a special case of partial orders and interval orders, and can be characterized among the partial orders by two forbidden four-item suborders.

In cooperative game theory and social choice theory, the Nakamura number measures the degree of rationality of preference aggregation rules, such as voting rules. It is an indicator of the extent to which an aggregation rule can yield well-defined choices.

In expected utility theory, a lottery is a discrete distribution of probability on a set of states of nature. The elements of a lottery correspond to the probabilities that each of the states of nature will occur. Much of the theoretical analysis of choice under uncertainty involves characterizing the available choices in terms of lotteries.

Some branches of economics and game theory deal with indivisible goods, discrete items that can be traded only as a whole. For example, in combinatorial auctions there is a finite set of items, and every agent can buy a subset of the items, but an item cannot be divided among two or more agents.

Maximal lotteries refers to a probabilistic voting system first considered by the french mathematician and social scientists Germain Kreweras in 1965. The method uses preferential ballots and returns so-called maximal lotteries, i.e., probability distributions over the alternatives that are weakly preferred to any other probability distribution. Maximal lotteries satisfy the Condorcet criterion, the Smith criterion, reversal symmetry, polynomial runtime, and probabilistic versions of reinforcement, participation, and independence of clones.

In economics, the Debreu theorems are several statements about the representation of a preference ordering by a real-valued function. The theorems were proved by Gerard Debreu during the 1950s.

In utility theory, the responsive set (RS) extension is an extension of a preference-relation on individual items, to a partial preference-relation of item-bundles.

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