Stokey and Zeckhauser reading

This article introduces the Basic Model of Choice, which is a general framework that looks at how people make decisions. And it is basic!

  1. Identify available choices
  2. Identify consumer preferences
  3. Find the optimal choice

Possibilities Frontier: compares two goods/choices/etc and illustrates all potential possibilities available to the decision-maker. There are some important things to remember:

  • You always want to choose a point on the curve (frontier)
  • The slope of this line represent the Marginal Rate of Transformation (MRT), which is just the rate at which it is possible to trade one good for another.
  • Shape of the Frontier Curve
    • Straight: Can substitute any amount at fixed price (this happens when there is a budget constraint).
    • Convex: Have more (of one thing) → harder to get more.
    • Concave: Have more → cheaper/easier to get more.

Indifference Curves: represent the level of utility that can be found for certain combinations of goods.

  • Each line represents the same amount of utility
  • You always prefer an indifference curve that is up and to the right of another one, as that represents more utility.

When you combine possibility frontiers and indifference curves, the best decision is highlighted by the intersection of the frontier curve and the optimal indifference curve, which is up and right. (see slide)