Neoclassical Micro-Utility Maximising Consumers
Income effect from lower price
Can consume more of all commodities because fall in price of one while income constant means increase in real income
Can overwhelm substitution effect
Buy more of a good as its price rises
Solution: "Hicksian compensated demand curves"
If consumer income was reduced to cancel out income effect then all such demand curves would be downward sloping.
Procedure to derive Hicksian compensated curve:
Consider initial budget line aa
Consumer chooses combination A on indifference curve X
Now consider new relative price ab
Consumer chooses combination B on indifference curve Y
Move new budget line back till tangential to original indifference curve X
Point of tangency is combination C
Substitution effect only: consumer necessarily consumes more Bananas when price of bananas falls.
"Law of Demand" restored.
Next step - aggregate from single consumer to all consumers in a market
This step glossed over in micro textbooks
Check your micro textbook to see if you can find any discussion of this crucial step
Discueed in next lecture
Back to theory of a
How does it stack up in reality?
Samuelson's "Revealed Preference" argues indifference curves can be inferred from behaviour
Sippel (1997) tried to ttestt his
Very careful experimental design
Numerous previous experiments "sloppy" in some way
E.g. Household expenditure surveys [Koo (1963), Mossin (1972) and Mattei (1994)] subject to change in preferences over time.
Study of inmates in a psychitric hospital .. to see if they were rational?? [Battalio (1973)]
Even on rats (to see if they were human??]
In contrast Sippel
Used university students as subjects
Presented them with a budget constant, a set of 8 commodities from which to choose
Good - Video clips (Max amount 30 - 60 mimutes), Computer games (27.5 - 60 minutes), Magazines (30 - 60 minutes), Coca COla (400ml - 2 litres), Orange jucie (400ml - 2 litres), Coffee (600ml - 2 litres), Candy (400gms - 2 kilos), Pretzels, peanuts (600gms - 2 kilos).
Unlimited time to choose preferred bundle
Test repeated ten times with dofferent relative prices, budget constraints
One preferred bundles from each of tests chosen at random for each student to consume in one hour after test.
Clearly were expressing preferences between bundles:
"There can be no doubt that the subjects tried to select a combination of goods that came as close as possible to what they really liked to consume given the repsective budget constraints. They spent a considerable amount of time on their decisions (typically 30 - 40 minutes) and repeatedly corrected entries on some of their order sheets when they reconsidered previous choices."
Key propositions being tested:
"Weak Axiom of Revealed Preference" WARP - If A > B then never B > A. If consumer chooses bundle A once when B also affordable, then consumer will always choose A instead of B, regardless of relative prices.
"Strong Axiom of Revealed Preference" SARP - If A > B & B > C then never C > A. Formal definition of a utility maximiser.
"Genrealised Axiom of Revealed Preference" GARP - If A > B & B > C then pc*A >= pc *C.
If A > B & B > C then A more expensive than set C at prices when C declined in favour of B.
X - Initial budget line
Consumer chooses A when A & B both affordable
Rational consumer "should" always prefer A to B
But in experiments they don't do this!
Sometimes they choose B instead of A.
Results first experiment (12 subjects) - 11 of 12 subjects violated SARP & WARP. out of 12 violated weaker test GARP.
Results second experiment (30 subjects) - 22 of 30 subjects violated SARP and WARP. 19 of 30 violated weaker test GARP.
Sipple's interpretation of results - In general "not too favourable to neocalssical theory of consumer behaviour ..." (p. 1438); but Low numebr of inconsistencies (median 2 ourt of 45 - but average higher). Subjects did try to "select a combination of goods that cameas close as possible to what they really liked to consume given their respective bugdet constriants" (p. 1439)
Use waste of income from inconsistent choice as guide to how significant were deviations from "rationality"; Afriat index: ratio (pb*A/Pb*B) when (from previous experimental round) A > B. Where consumer choose A when B affordable, use formula "A > B if (e*PA*A)>=(PA*B)"
Consumer deeemed to prefer A over B if A (say) 11% more expensive than B & consumer still chooses A (here e=0.9)
Like having "thicker indifference curves".
With thicker indifference curves, more combinations are shown as "indifferent"; e=1: C> B> A
e=.95: C>B & A but B=A
Choosing A or B appears "rational" for e=.95 but not for e=1.
The "good" news: number of apparent violations of GARP dropped significantly for e
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