6 Utility

• Recall (subsection 3.4) that a utility function is a way of assigning

numbers to every possible consumption bundle such that x < y if and
only if u (x) ≥ u(y). In words, more-preferred bundles get assigned
larger numbers than less preferred bundles.

6.1 Monotonic transformation

• It is important to note that the only property of utility function that is
important is how it orders the bundles. The size of the utility difference
between any two bundles does not matter.

Definition 11 A monotonic transformation is a way of transforming a set

of numbers into another set of numbers in an order preserving way. A
monotonic function and a monotonic transformation are essentially the same.

• Thus, any monotonic transformation of a utility function also represent

the preferences. Because, (i) if u represent some particular preferences
relation, <, then u (x) ≥ u(y) if and only if x < y. So, (ii) if f(u)
is a monotonic transformation of u, then u(x) ≥ u(y) if and only if
f(u(x)) ≥ f(u(y)). Thus, (iii) f (u(x)) ≥ f (u(y)) if and only if x < y,
so the function f (u) represents the preferences in the same way as the
function u.

6.2 The Marginal Rate of Substituting (M RS)

• The slope of the indifference curve is known as the marginal rate of
substitution ( MRS). That is, the rate in which the consumer is just
willing to substitute one good for the other. Thus, the MRS measures
the rate at which the consumer is just on the margin of trading or not
trading.

• On the other hand, recall (subsection 4.1) that the slope of the budget
line measures the rate at which the market is willing to exchange good
1 for good 2. That is, the opportunity cost of consuming good 1.

• Therefore, at any market rate of exchange (as given by the slope of the
budget line) other than the M RS, the consumer would want to trade

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 one good for the other. But, if the market rate of exchange equals the
MRS the consumer wants to stay put.

Figure 1

• The typical convex indifference curves exhibits an interesting behavior

for the M RS. For strictly convex indifference curves, the M RS de-
creases (in absolute value) as x1 increases. Thus, the rate in which the
consumer is just willing to trade x1 for x2 decreases as we increase the
amount of x1 .

• Hence, we can see that convexity is very natural: the more we have of
one good, the more we are willing to give some of it up in exchange for
the other good.

• The marginal utility of good 1, written as Mu1 , measures the change in

the consumer’s utility as x1 increases and x2 is left unchanged. Thus,
it measures the rate of change in utility, 4u, associated with a small
change in the amount of good 1, 4x1 when the amount of good 2 is
fixed. Precisely, as elsewhere in economics, marginal simply means a
derivative.

4u u (x1 + 4x1 , x2 ) − u (x1 , x2 ) ∂u (x1 , x2 )

M u1 = = lim =
4x1 4x1 →0 4x1 ∂x1

• The utility function, u(x1 , x2 ), can be used to measure the M RS, which
is the rate in which the consumer is willing to substitute small amount
of good 2 for good 1. Using calculus, the derivation of the M RS is
done by using differentials. That is, consider a change (dx1 , dx2 ) that
keeps the level of utility constant:

∂u (x1 , x2 ) ∂u (x1 , x2 )
du = dx1 + dx2 = 0
∂x1 ∂x2
• The first term measures the change in utility from the small change
dx1 and the second term measures the change in utility from the small
change dx2 . That is,

du = M u1 dx1 + M u2 dx2 = 0

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 Rearranging,
dx1 M u1
=−
dx2 M u2
That is,

∂u(x1 ,x2 )
dx1 ∂x1
M RS ≡ = − ∂u(x1 ,x2 )
dx2
∂x2

6.3 Cobb-Douglas
• The most commonly used utility function in economics is the Cobb-
Douglas (Paul Douglas was an economist at the University of Chicago
and later became a U.S. senator. See www.igpa.uillinois.edu/ethics/htm/about_phdouglas.ht
utility function:
u (x1 , x2 ) = xα1 xβ2
where α, β > 0 and describe the preferences of the consumer

• The Cobb-Douglas indifference curves looks just like the well-behaved

indifference curves that we previously referred to. Note that at this
stage you should be able to point by using algebra why it is so.

M RS = − Mu
Mu2
1

= − ∂u(x 1 ,x2 )/∂x1

∂u(x1 ,x2 )/∂x2
αxα−1 xβ
= − βxα1 xβ−12
1 2
= − αx2
βx1

• In fact, the formula of the Cobb-Douglas utility function is about the

simplest algebraic expression that generates well-behaved preferences.

• Clearly, any monotonic transformation of a Cobb-Douglas utility func-

tion represent the same preferences. Moreover, you may find some
monotonic transformation very useful. For example,

u (x1 , x2 ) = xα1 xβ2

and

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 v(x1 , x2 ) = ln u (x1 , x2 ) = ln(xα1 xβ2 ) = α ln x1 + β ln x2

represent the same preferences.

• The indifference curves for this utility function looks just like the ones
for the original Cobb-Douglas utility function (you should verify it).

6.3.1 Optimal choice

• A consumption bundle (x∗1 , x∗2 ) is an optimal choice for the consumer
if the set of bundles that the consumer prefers to (x∗1 , x∗2 ) - the set of
bundles above the indifference curve through (x∗1 , x∗2 ) - has an empty
intersection with the bundles she can afford - the bundles beneath her
budget line.

• It follows that at (x∗1 , x∗2 ) the indifference curve is tangent to the budget
line. Note that, clearly, the above holds for an interior optimum and not
for a boundary optimum. Can you see why a Cobb-Douglas preferences
induce an interior solution?

Figure 2

6.3.2 Consumer’s demand

• Demanded bundle - the optimal bundle at some set of prices and income.

• Demand function - a function that relates the optimal bundle - the

quantities demanded - to the different levels of prices and income. That
is, x1 (p1 , p2 , m) and x2 (p1 , p2 , m). Clearly, for each different set of prices
and income, there will be a different bundle which is the optimal choice
for the consumer.

• Let’s find the demand functions for x1 and x2 for the Cobb-Douglas
utility function. The problem that we want to solve is
choose x1 , x2
to max u (x1 , x2 ) = xα1 xβ2
subject to p1 x1 + p2 x2 = m
or,

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 choose x1 , x2
to max v (x1 , x2 ) = α ln x1 + β ln x2
subject to p1 x1 + p2 x2 = m

• There are several ways to solve this problem. The first way is to sub-
stitute the budget constraint in to the objective function,
m p1
max α ln x1 + β ln( − )x1
p2 p2
The f oc for this problem is
∂ α p2 p1
= −β =0
∂x1 x1 m − p1 x1 p2

By a (very) little algebra,

α m
x1 =
α + β p1
This is the demand function for good 1. Similarly, the demand function
for good 2:

β m
x2 =
α + β p2

Figure 3

• The second,
αx2 p1
M RS = − =−
βx1 p2
and,
p1 x1 + p2 x2 = m
which are two equations with two unknowns that can be solved for the
optimal bundle. Thus, substituting:

βp1 x1
p1 x1 + p2 =m
αp2

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 βp1
p1 x1 + x1 = m
α

αp1 x1 + βp1 x1 = αm

α m
x1 =
α + β p1

• This is the demand function for good 1. Similarly, the demand function
for good 2:

β m
x2 =
α + β p2

• The third way is by using the Lagrangeian:

L = α ln x1 + β ln x2 − λ(p1 x1 + p2 x2 − m)

Differentiating to get the three f oc:

∂L α
= − λp1 = 0
∂x1 x1
∂L β
= − λp2 = 0
∂x2 x2
∂L
= m − p1 x1 − p2 x2 = 0
∂λ
These are three equations with three unknowns. The best way for you
to proceed (which you should do!) is to first solve for λ.

6.3.3 Comparative statics

• As we saw the demand functions give the optimal bundle (amounts of
each of the goods) as a function of the prices and income faced by the
consumer. Now, we wish to investigate how the demand changes when
prices or income change. We start by considering a change in income.

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 • Normal good - a good for which the quantity demanded always changes
in the same way as income changes. Put precisely,

∂x(p, m)
>0
∂m
• Inferior good - Clearly,
∂x(p, m)
<0
∂m
Note that nearly any kind low-quality is an inferior good.

Figure 4

• Now we can construct the income offer curve and the Engel curve.
The income offer curve (or income expansion path) depicts the optimal
choice at different level of income holding prices constant. The Engel
curve is just plotting the optimal choice of a single good against income.
That is,

Figure 5
Figure 6

• Now, let us consider price changes while income is fixed and construct
the price offer curve Consider a decrease in p1 while p2 and m are fixed.

Figure 7

• What will happen to the quantity demanded from good 1 if it is a

normal good? inferior good?

Figure 8

6.4 Perfect substitutes

• Two goods are perfect substitutes if the consumer is always willing
to substitute one good for the other at a constant rate. The indiffer-
ence curves of perfect substitutes preferences are illustrated in the next
figure.

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 Figure 9
• Note that when the consumer is willing to substitute the goods on a one-
to-one basis all that mattered to her is the total number of units from
both goods. Clearly, a utility function that represents this preferences
must be constant along the indifference curves and must assign a higher
value to more preferred bundles.
• The simplest utility function that represents one-to-one perfect substi-
tutes preferences is clearly
u (x1 , x2 ) = x1 + x2
However, any other monotonic transformation of u (x1 , x2 ) such as
v (x1 , x2 ) = v(u (x1 , x2 ))2 = (x1 + x2 )2
also represents the same preferences. Note that both yield indifference
curves with a slope of −1.
• Note that when p2 > p1 (p2 < p1 ) then the slope of the budget line
is flatter (steeper) than of the indifference curve. Thus, the demand
function for good 1 is

 m/p1 if p2 > p1
x1 = [0, m/p1 ] if p2 = p1

0 if p2 < p1
Figure 10
• When the consumer is willing to substitute good 1 for good 2 at a
constant rate different from one-to-one, say, for example, that she would
ask for two units of good 2 to compensate her for giving up one unit of
good 1, a utility function that represents the preferences is
u (x1 , x2 ) = 2x1 + x2
which yields indifference curves with a slope of −2.
• In general, the form of a utility function representing perfect substitutes
preferences is
u (x1 , x2 ) = αx1 + βx2
where α, β > 0 and measure the value of goods 1 and 2 to the con-
sumer respectively. Note that the slope of a typical indifference curve
is constant and given by −α/β.

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6.5 Perfect complements
• Perfect complements are goods that are always consumed together in
fixed proportions (the left shoe - right shoe case). So, in some sense the
goods just complement each other. The case of perfect complements is
illustrated in the next figure.

Figure 11

• In the case of left shoe - right shoe all that mattered to the consumer
is the total number of pairs of shoes. Thus, her utility function takes
the form
u (x1 , x2 ) = min{x1 , x2 }
or any monotonic transformation.

• In case the consumer wish to consume good 1 and good 2 at a fixed

proportion different from one-to-one, say, for example, two units of
good 1 for every unit of good 2, her utility function takes the form
1
u (x1 , x2 ) = min{ x1 , x2 }
2

• The general form of a perfect complements utility function is given by

u (x1 , x2 ) = min{αx1 , βx2 }

where α, β > 0 and α/β is the ratio in which the goods are optimally
consumed

6.6 References
• H. Varian, Intermediate Microeconmics - A Modern Approach, fifth
edition, Norton. (3.6-3.8, 4.1-4.5).

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