Rational Choice and Utility Theory: Some Beginnings (Early Price Theory …
Rational Choice and Utility Theory: Some Beginnings
Early Price Theory
Costs of Production
the goods are to those who are interested in obtaining them
Actual prices consumers pay
How are these three related?
Why: diamonds (relatively useless) more expensive than water?
Labor Theory of Value
Developed by Ricardo
Good's value derives from:
Number of labor hours it takes to produce
Diamonds: much larger number of hours than water
Rocks cut into shape of clouds: as hard to produce
They have a value of zero
So, no explanation for diamond-water paradox
as the total amount
Water is plentiful now
Its value will increase in times of scarcity
Now it's approaching the margins
2nd liter of Water vs
10001th liter of water
Which one has higher value?
Why is it the case?
Why is it the case?
Happiness maximization :smiley:
Much more happiness :arrow_up: from
of water :water_polo:
First liter of water: priceless
10000th liter of water: few cents
Resolving Water-Diamond Paradox
Pricing is related to scarcity by:
by :arrow_up: their actions
is diminishing :arrow_down: at the margin
Formalizing the theory of Choice
Explain gambling decisions
Rational decision: maximizing expected value
expected value = win * probability
What's more rational:
7000 dollars definitely
Either 20.000 dollars or 0 dollars
According to Pascal:
7.000 < 20.000
7.000 < 10.000
Choosing 7.000 is irrational
But... Is it really IRRATIONAL:!?:
Consider a poorman... Would you call him choosing 7.000 irrational?
So, maximizing expected value is not the best for decision theory :red_cross:
For Bernoulli: logarithmic function
u(7000 + w)
average[ u(10.000 + w) + u(0 + w)]
Utility is a function of...
How much a given dollar
total wealth w
Why do we need w?
Millionaire might take the gamble, since he doesn't loose much anyway
Reflecting on ideas of...
Diminishing marginal utility
How do we measure utility?
How does it depend on:
Costs of production
Economists tried to find a shape of utility function
No independent evidence for utility existence
no way to directly derive a unique utility value from...
are only really good for...
Apples > Grapes > Oranges
u(Apples) > u(Grapes) > u(Oranges)
Still true if it's 3>2>1
1.5 > 1 > 0.5
We know apples are better
We don't know HOW MUCH better
The Ordinal Revolution
:check:utility functions are only about
values described by
abstract mathematical functions.
Pareto: all that is needed for theory of choice