Theory of Preferences

The theory of preferences belongs to the most difficult parts of basic microeconomics. It is very important to both understand and be able to use preference-theory in the rest of the material.

We have probably heard the expression that “one should not compare apples and oranges,” or something similar. The point here is precisely that one should do that, and even to compare anything with anything else. This is done through a preference order. We will assume that an individual always knows what she prefers: she prefers basket A to basket B, she prefers B to A, or she is indifferent between them. If all baskets are ordered accordingly, we have a preference order and such an order is valid for a certain individual.

Usually, the following four assumptions are made about preference orders:

1- Complete. The individual can order all conceivable baskets of goods.

2- Transitive. If the individual prefers A to B, and B to C, she also prefers A to C. In other words, there are no “circles” in preferences.

3- Non-satiation. An individual always prefers more of a good to less. This assumption is a bit tricky. Suppose we think of pollution as a good. Is more pollution usually preferred to less pollution? No, obviously not. To get around this type of problem, we have to define the good in the opposite way: Instead of pollution, we define clean air to be the good. More clean air is better than less.

4- Convexity. Suppose we have two baskets that an individual is indifferent between, A and B. She will then always prefer (or at least be indifferent between) baskets that lie between these two baskets. Say that she is indifferent between a basket consisting of (2 apples, 4 bananas) and (4 apples, 2 bananas). She will then, according to the assumption, prefer a basket of (3 apples, 3 bananas) to the other two (or, at least, be indifferent between all of them).

Are these assumptions true? Many people have debated the reasonableness of them. Are you, for instance, non-satiable? Which do you prefer: 2 liters of milk or 10,000 liters? Probably 2 liters. The rest will not fit into the refrigerator and will soon start to smell. It will also require a lot of work to get rid of them.

In many models, however, it is also assumed that there are no transaction costs. This means that, there are no costs to trading, except for the price of the goods. Examples of transaction costs are the cost of a stamp if you mail in an order, the effort it takes to go to the market where you can buy things, or the cost to hire a lawyer to go through a contract before you sign it. Models that include transaction costs become much more complicated, but, on the other hand, they also become more realistic. In the example, you would probably prefer 10,000 liters of milk if it would not cost you anything to sell them and immediately get rid of them. In a worst-case scenario, you would sell then at a price of 0, which should make you indifferent between 2 and 10,000 liters of milk.