By Bank Ngamarunchot, KMUTT 2013

Draft Foundation Economics

Source: http://recoverycontinuum.wordpress.com/2013/09/20/is-addiction-a-rational-choice/, By Web Servant

Individuals: Homo-economicus and Homo-sentimentalis

1“We have always known that heedless self interest was bad morals, we now know that it is bad economics.”

– Franklin D. Roosevelt

Source: www.performancetrading.it

2.1 Preference and Utility

Tale of Good Life and Preference

Once upon a time, Epicurus (371-240BC.), Greek philosopher, projected his own concept about pleasure. In his view, human was motivated by pleasure and pain. Unfortunately, both of them were not completely separated. For example, you ought to be pleasured when you commit relationship with your girl/boy-friend, at the same time, you also ought to be pained by feeling that fear to loose him/her. To clear-cut, he stated that only pleasure without pain is “real” pleasure; in the other words, pleasure is pain minimization.

Afterwards, Jeremy Bentham (1748-1846) who is friend of Sir John Bowring, es-tablished concept that will be accepted as the foundation of Utilitarianism school. His idea about pleasure was called “greatest happiness principle". Like Epicurus, Ben-tham stated that “Nature has placed man-kind under the governance of two sover-eign masters, pain and pleasure.”; how-ever, his objective was not to minimize pain but to maximize pleasure/happiness.

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Head of Epicurus, Wikipedia

Portrait of Jeremy Bentham, Wikipedia

“It is vain to talk of the interest of the community, with-out understanding what is the interest of the individual.”

– Franklin D. Roosevelt

Bentham wrote that “fundamental axiom, it is the great-est happiness of the greatest number that is the measure of right and wrong" (Bentham, 1776 p.preface). This axiom was used as the core concept of modern economic ration-ality. Rational man should select the choice that gain net individual maximized happiness; moreover, this behavior was justified as the moral principle and social justice. Hence, Utilitarians prefer choice that create net social maxi-mized happiness even though many peoples are harmed from that choice.

By training, modern economists are utilitarianism. Their rationality is called as “Instrumental rationality” be-cause it is automatically anchored by logic of happiness maximization, which will be showed in many sections of this book. Happiness can be revealed by what humans pre-fer; therefore, “preference” is analytical basis of economic behavior. For example, Mr.Bank prefer veal than chicken so he get happiness from consuming veal than chicken.

Rational Preference and Its Characters

Rational preference is important because rational-ity can predictable; on the other hand, irrationality can not. Therefore rationality is necessary condition to understand human’s behavior, especially for period that behavioral eco-nomics was not existed. Rational preference are based on three axioms.

Angle said “if citizens collective decide to bury only one man for sacrifice, all peoples in city will get permanent pleasure by my magic”. Do you prefer to sacrifice only “one” Homo-sacer for all citizens?yes = you are utilitarianism No = you are not

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Firstly, rational humans can completely define their own preference without confusion. e.g. Mr.Bank has two bundles of choice, named A and B. If he is rational man, he could have only three optional patterns of preference. [1] A is preferred to B, [2] B is preferred to A, and [3] Both A and B are equally pre-ferred. This axiom is called “Completeness”. Secondly, rational mans should have internal consistent mind, or “transitivity”. e.g. if A is preferred to B and B is preferred to C; therefore, A is preferred to C. Thirdly, if rational humans declare that A is pre-ferred to B, then situation suitably close to A is preferred to B. Last axiom is called “Continuity”.

Preference and Ordinal Utility

Utility is representative function of individual preference. For example, U(A) is function that refer to the preference from consumption on A. Therefore, “A is preferred to B” can be re-written as U(A) > U(B). Note that, individual utility functions can be ordinal compared together within himself, but cannot be il-lustrated a comparison between people; because they assign numbers to represent utility with different definition which can-not be unified.

For example, Even though Mr.Bank and Mr.Krugman equally assign 10 util to represent their utility from consuming A, they do not mean the same. In contrast, if Mr.Bank reveal his preference that U(A) = 10 util and U(B) = 20 util; and Mr.Krugman reveal his U(A) = 100 and U(B) = 150; they declare the same massage, A is preferred to B.

What if that Homo-sacer is your family member or someone who you love?Your answer is still yes, or no?

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Law of Diminishing and Marginal Utility

This law states that marginal utility will be decreased in every unit of marginal consumption. For instance, although you gain utility by consuming, let’s say, comic, your additional pleasure is decreased when you read it second round and more decreased in third round until you have no pleasure to read it anymore. The point of no attraction to consume more unit of goods is called “saturated point”. To consume over than saturated consumption, consumers will be dissatisfied; in other words, they have negative marginal utility and their cu-mulative utility are decreased.

Do you think this law can be applied for all cases? How about services of your boy/girl-friend such as care and hug. These also diminished your marginal utility, or not?

Indifference curve: If you plot three dimensional diagram of utility from consuming goods A and B, by positioning unit of goods as horizontal axis and utility from consumption as vertical axis. The illustration look like conic snack at right hand side. Then you horizontally section the conic from base to the top. Each slice will create the circle which represent the same level of utility so it is called “Indifference Curve”. The circles are orderly existed from the biggest size (base-slice) to the smaller, and finally, spot (top-slice). Smaller circle means higher level of utility; therefore, spot is saturated point. Generally, indifference circle of normal goods is presented only the third quadrant which is convex and negative slope.

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Sconic section picture from: www.EvilMadScientist.comReferred by The Guardian

Normal Indifference Curve and Its properties

The first property is negative slope: Indifference curve is line which represents the same level of utility from consuming 2 goods, e.g. pornography and adult movie. Both of them are satisfy yours; therefore, you have to decrease adult movie when you increase consuming pornography to maintain constant level of utility (pleasure). Under this nega-tive relationship, trading off between the goods can be measured by indifference curve’s slope which called “marginal rate of substitution (MRS)”.

MRS = - dY/dX (alongU) = - dU/dY / dU/dX

= - dU/d(chips) / dU/d(cola)

The second property is “more is better”: Nor-mally, indifference curve is placed in unsaturated utility area; therefore, “more is better”. An expan-sion of consumption either pornography or adult movie causes higher level of utility then moves in-difference curve forward to north-east region of the graph. To watch lowest graph at right hand side, indifference curve that is positioned nearest origin point means lowest utility; in contrast, the farthest one means highest utility.

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The Indifference Curve, Wikimedia

More is better

The Third property is convexity: Convexity of indifference curve can be explained by three lines of logic. Firstly, concave curve will lead to illogical explanation of consumption (e.g. Cola and Chips case). Secondly, convexity reflects to an imper-fect trading off between two goods. For instance, If you drink only cola without any chips, you may prefer to give large unit of cola for trading-off with a little chips; but unit of cola that you prefer to exchange would be decreased by any additional unit of chips; thereupon, slope of indifference curve should be

flattered (MRS should be lowered); hence the curve is convex. Thirdly, balance consump-tion is preferred to extreme choices. For example, you willing to have salads so you go to market and choose vegetables. Today, greengrocer has only two kinds of goods: broccoli and cucumber. Under this property, you should prefer combination between broccoli and cucumber than only one of them. To see annual ring picture, choice A creates utility level, let’s say, U(cucumber , 0); in contrast, choice B creates U(0 , broccoli). Both choices A and B are standing on lower indifference curve than choice C, U(cucumber/2 , broccoli/2).

Above black arrows show flattered slope along the indifference curve.

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Whole Indifference Circle is like annual ring of tree, Each ring represents each indifference curve (the same level of utility/pleasure). convex curve exists only in the third quadrant.annual ring picture from: www.baannatura.com

Quantity of goods (Cola or Broccoli)

Quantity of goods (Chips or Cucumber)

A

B

C

The forth property is “do not intersect”: To under stand this property, we must look back to the deriving of indifference curve. As you know that indifference curve is created from horizontal slice on the three dimensional graph of utility which associated to 2 goods. Under the law of diminishing; in other words, the graph looks like conic form, each horizontal slice should cause only one utility curve and every higher slice cause smaller curve without interception between them. In fact, it is possible to happen interception between indifference curve; however, the situation is implied to either inconsistence preference or overrule property of “more is better”.

Class-room Experiment: Do we are rational human?

Experimental design: This experiment used paper base to collect data. Students were requested to reveal their ordinal preference on three choices. The experiment was ran two round, and each round can be separated to two sections. The first round, section1, asked about ordinal preference on three objects; however, section2 asked the same question on three baskets of objects. By revealing preferences, we can learn their rationality on either single-consumption or bundle con-sumption. The second round of experiment was ran after stu-dents were instructed about rational choice theory. Experimen-tal design was similar with the first round; therefore, we can learn about effect of learning rational theory to the subjects’ behavior.

“The first lesson of economics is scarcity: there is never enough

of anything to fully satisfy all those who

want it. The first lesson of politics is to

disregard the first lesson of economics.”

– Thomas Sowell

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