Rationality and Preferences

Question 1

Examples of theories included in rational choice

Answer 1

• Social choice theory
• Public choice theory
• Expected utility theory
• Game theory
• Smaller theories

Question 2

Social choice theory (examples of theories included in rational choice)

Answer 2

A theoretical framework for analysis of combining individual opinions, preferences, interests, or welfares to reach a collective decision or social welfare

Question 3

Public choice theory (examples of theories included in rational choice)

Answer 3

• The study of political decision making with the help of economic models
• It models individual behavior under a variety of political institutions

Question 4

Expected utility theory (examples of theories included in rational choice)

Answer 4

The account of how to choose rationally when you are not sure which outcome will result from your acts

Question 5

Game theory (examples of theories included in rational choice)

Answer 5

The study of mathematical models of strategic interaction between rational decision makers

Question 6

Smaller theories (examples of theories included in rational choice)

Answer 6

• Median Voter Theorem
• Voting paradox
• Hotelling’s model

Question 7

What are the two important assumptions of rational choice?

Answer 7

• Methodological individualism
• Rational behavior (utility maximization)

Question 8

What is methodological individualism?

Answer 8

What is methodological individualism?
- The unit of analysis is the individual person
- This stands in contrast to theories that take the “group” as the unit of analysis
- The focus of rational choice is on individuals and individual actions

Question 9

How do we understand an organization / society since we have methodological individualism in rational choice?

Answer 9

We understand an organization by explaining the behavior of its leaders, members, consumers, shareholders, etc.
- Society is the sum of individuals
- Society does not shape individuals, individuals are shaped independently of the social structure

Question 10

So how would an analysis work in rational choice? (methodological individualism)

Answer 10

• Every analysis must begin with the individuals, deal with individual choices and experiences, with collectives formed as aggregates
• Bottom-up analysis

Question 11

What does rational choice state about rationality?

Answer 11

• Individuals have goals or desires
• Individuals act in accordance with those goals and desires

Question 12

What do we call individuals’ wants (goals/desires)?

Answer 12

Preferences

Question 13

Does rational choice care about where preferences come from?

Answer 13

Rational choice does not care about where preferences come from and why people want certain things (no judgment; at least not in terms of rationality)

Question 14

Generalizations about preferences

Answer 14

• What individuals want and desire (preferences) are given
• This does not change much (in the short run)
• It does not really matter where these preferences come from
• We do not know the preferences of others; we only know our own preferences
• However, we make assumptions about the preferences of others

Question 15

What is self-interest in rational choice?

Answer 15

If an individual has preferences and acts in accordance to these preferences, we call the individual rational and self-interested
- Rational is directly related to the individual’s action
- People pursue what they find important ie. they pursue their preferences

Question 16

What are the two versions of rationality?

Answer 16

Thin version of rationality
- We do not make any assumptions about an individual’s goals, we only know she has goals
Thick version of rationality
- We make more explicit assumptions about the goals of individuals

Question 17

What do the different notations in rational choice mean?

Answer 17

• i is the term that denotes the individual
• x, y, z denote the preferences of an individual (i)
• x Pi y means i prefers option x to y
  – P means >
• x Ii y means individual i is indifferent between option x and y
  – I means =

Question 18

What makes a choice rational?

Answer 18

• An individual i is rational if she makes a choice between the outcomes in accord to her preferences
• A choice is rational if the object chosen is better than any other available objects according to the chooser’s preferences
  – x Pi y Pi z
• A choice is rational if the object chosen is as good as any other available objects according to the chooser’s preferences
  – x Ii y Ii z

Question 19

What do we really mean when we say an individual has preferences?

Answer 19

We really mean they have a preference ordering
- They can say which outcomes they prefer

Question 20

What two assumptions are important for being able to order your preferences?

Answer 20

• Comparability / Completeness
• Transitivity

Question 21

What is comparability / completeness?

Answer 21

• All alternatives in the choice set must be comparable in terms of preferences
• The outcomes are comparable if, for any pair of them, you can indicate whether you prefer the first to the second, or the second to the first, or if you are indifferent between them
• To be complete, you must be able to tell: x Pi y or y Pi x or x Ii y

Question 22

What is transitivity?

Answer 22

• A strict preference relation is said to be transitive if for any or the three (or more) possibilities:
  – x Pi y, y Pi z, x Pi z
• If you prefer x over y and y over z, then you should (if I am rational) prefer x over z
• An indifferent relationship is transitive if:
  – x Ii y, y Ii z, x Ii z

Question 23

What are problems of completeness (comparability)?

Answer 23

If the comparison does not make sense for the individual
- Do you want this apple or do you want to travel to Greece?

Question 24

What are problems of transitivity?

Answer 24

• It requires consistency
• It gets complicated

Question 25

Example of completeness violation

Answer 25

- Imagine you go to AH XXL to buy some products - You rank all goods that are available - You have all the time in the world, and you will be honest - After the first round, you need to do it again - We will certainly discover some inconsistencies - It might be caused by other factors (you make a mistake, or you changed your preferences), but the simpler explanation is that you simply do not have a complete preference ordering over all products - Completeness requires serious reflection on one's preferences

Question 26

Example of transitivity violation (sugar)

Answer 26

- Imagine you prefer one tablespoon of sugar in your coffee over no sugar in your coffee -- 1000 grains Pi 0 grains - Problem: you cannot distinguish the effect of each additional grain of sugar, ie. the stakes are very low -- 0 grains Ii 1 grain, 1 grain Ii 2 grains, ... 999 grains Ii 1000 grains - You are indifferent between each grain of sugar, which implies you are also indifferent between 0 and 1000 grains of sugar which is not the case

Question 27

Example of transitivity violation (pen and mug)

Answer 27

- A student is shown two object: a pen and a mug - She is asked to say which object she likes better, and she answers "the pen" - She is then asked how much she is willing to spend to buy the pen, and she answers "€1" - During the experiment, the student is given the mug as a present - At the end of the experiment, she is asked if she wants to give back the mug in exchange for €1, and she refuses

Question 28

What are the features that make an individual's decision rational?

Answer 28

- Her preference order is complete and transitive - The individual chooses the most preferred alternative available (ie. the individual maximizes) -- Note that the goals of the individual is not included in the definition of rationality - It is the preference ordering and the action of choosing an alternative that is rational or irrational - not the preferred outcome - Rational decisions often involve cost-benefit calculations - A rational individual would pursue a goal if the benefits gained from that goal outweigh the costs

Question 29

What is irrationality?

Answer 29

- An irrational individual will not choose the instrument/action she believes will lead to the most preferred outcome - An irrational individual will not have a coherent preference ordering and, therefore will not be able to choose their most preferred alternative - An irrational individual may behave recklessly and not calculate the costs and benefits of their actions