Utility

UTILITY FUNCTIONS
◆ A preference relation that is complete,
reflexive, transitive and continuous can be
represented by a continuous utility
function (as an alternative, or as a
complement, to the indifference “map” of
the previous lecture).
◆ Continuity means that small changes to a
consumption bundle cause only small
changes to the preference (utility) level.
 UTILITY FUNCTIONS
◆ A utility function U(x) represents a
preference relation if and only if:
~
x0 x1 U(x0) > U(x1)

x0 x1 U(x0) < U(x1)

x 0 ∼ x1 U(x0) = U(x1)
 UTILITY FUNCTIONS
◆ Utility is an ordinal (i.e. ordering or
ranking) concept.
◆ For example, if U(x) = 6 and U(y) = 2
then bundle x is strictly preferred to
bundle y. However, x is not
necessarily “three times better” than
y.
 UTILITY FUNCTIONS
and INDIFFERENCE CURVES

◆ Consider the bundles (4,1), (2,3) and

(2,2).
◆ Suppose (2,3) > (4,1) ∼ (2,2).
◆ Assign to these bundles any
numbers that preserve the
preference ordering;
e.g. U(2,3) = 6 > U(4,1) = U(2,2) = 4.
◆ Call these numbers utility levels.
 UTILITY FUNCTIONS
and INDIFFERENCE CURVES
◆ An indifference curve contains
equally preferred bundles.
◆ Equal preference ⇒ same utility
level.
◆ Therefore, all bundles on an
indifference curve have the same
utility level.
 UTILITY FUNCTIONS
and INDIFFERENCE CURVES

◆ So the bundles (4,1) and (2,2) are on

the indifference curve with utility
level U ≡ 4
◆ But the bundle (2,3) is on the
indifference curve with utility level U
≡6
 UTILITY FUNCTIONS
and INDIFFERENCE CURVES

x2 (2,3) > (2,2) = (4,1)

x2

U≡6
U≡4

x1
xx1 1
 UTILITY FUNCTIONS
and INDIFFERENCE CURVES

◆ Comparing more bundles will create

a larger collection of all indifference
curves and a better description of
the consumer’s preferences.
 UTILITY FUNCTIONS
and INDIFFERENCE CURVES

x 2x 2

U≡ 6
U≡4
U≡ 2
x x1
 UTILITY FUNCTIONS
and INDIFFERENCE CURVES

◆ Comparing all possible consumption

bundles gives the complete collection
of the consumer’s indifference curves,
each with its assigned utility level.
◆ This complete collection of
indifference curves completely
represents the consumer’s
preferences.
 UTILITY FUNCTIONS
and INDIFFERENCE CURVES

◆ The collection of all indifference

curves for a given preference
relation is an indifference map.
◆ An indifference map is equivalent to
a utility function; each is the other.
 UTILITY FUNCTIONS
◆ If
(i) U is a utility function that represents a
preference relation; and (ii) f is a strictly
increasing function,
then
V = f(U) is also a utility function
representing the original preference
function.
Example? V = 2.U
 GOODS, BADS and NEUTRALS
◆ A good is a commodity unit which
increases utility (gives a more
preferred bundle).
◆ A bad is a commodity unit which
decreases utility (gives a less
preferred bundle).
◆ A neutral is a commodity unit which
does not change utility (gives an
equally preferred bundle).
 GOODS, BADS and NEUTRALS

Utility
Utility
function
Units of Units of
water are water are
goods bads

x’ Water
Around x’ units, a little extra water is a neutral.
 UTILITY FUNCTIONS
Cobb-Douglas Utility Function

U ( x1 , x2 ) = x x (a > 0, b > 0)
a b
1 2
Perfect Substitutes Utility Function

U ( x1 , x 2 ) = ax1 + bx 2 Note: MRS = (-)a/b

Perfect Complements Utility Function

U ( x1 , x 2 ) = min ( x1, x 2 ) Note: MRS = ?
 UTILITY
Preferences can be represented by a
utility function if the functional form has
certain “nice” properties

Example: Consider U(x1,x2)= x1.x2

◆ δu/δx1>0 and δu/δx2>0

◆ Along a particular indifference curve
x1.x2 = constant ⇒ x2=c/x1
As x1 ↑ ⇒ x2↓
i.e. downward sloping indifference curve
 UTILITY
Example U(x1,x2)= x1.x2 =16
X1 X2 MRS
1 16
2 8 (-) 8
3 5.3 (-) 2.7
4 4 (-) 1.3
5 3.2 (-) 0.8
3. As X1 ↑ MRS ↓ (in absolute terms),
i.e convex preferences
COBB DOUGLAS UTILITY FUNCTION

◆ Any utility function of the form

U(x1,x2) = x1a x2b

with a > 0 and b > 0 is called a Cobb-

Douglas utility function.
◆ Examples

U(x1,x2) = x11/2 x21/2 (a = b = 1/2)

V(x1,x2) = x1 x23 (a = 1, b = 3)
COBB DOUBLAS INDIFFERENCE
CURVES
x2
All curves are “hyperbolic”,
asymptoting to, but never
touching any axis.

x1
 PERFECT SUBSITITUTES
◆ Instead of U(x1,x2) = x1x2 consider

V(x1,x2) = x1 + x2.
 PERFECT SUBSITITUTES
x2
x1 + x 2 = 5
13
x1 + x 2 = 9
9
x1 + x2 = 13
5
V(x1,x2) = x1 + x2

5 9 13 x1
All are linear and parallel.
PERFECT COMPLEMENTS
◆ Instead of U(x1,x2) = x1x2 or
V(x1,x2) = x1 + x2, consider

W(x1,x2) = min{x1,x2}.
 PERFECT COMPLEMENTS
x2
45o
W(x1,x2) = min{x1,x2}

8 min{x1,x2} = 8
5 min{x1,x2} = 5
3 min{x1,x2} = 3

3 5 8 x1
All are right-angled with vertices/corners
on a ray from the origin.
 MARGINAL UTILITY

◆ Marginal means “incremental”.

◆ The marginal utility of product i is
the rate-of-change of total utility as
the quantity of product i consumed
changes by one unit; i.e.
∂U
MU i =
∂ xi
 MARGINAL UTILITY
U=(x1,x2)
MU1=∆U/∆x1 ⇒ ∆U=MU1.∆x1
MU2=∆U/∆x2 ⇒ ∆U=MU2.∆x2

Along a particular indifference curve

∆U = 0 = MU1(∆x1) + MU2(∆x2)

⇒ ∆x2/∆x1 {= MRS} = (-)MU1/MU2

 MARGINAL UTILITY

◆ E.g. if U(x1,x2) = x11/2 x22 then

∂ U 1 −1/ 2 2
MU1 = = x1 x2
∂ x1 2
 MARGINAL UTILITY
◆ E.g. if U(x1,x2) = x11/2 x22 then

∂ U 1 −1/ 2 2
MU1 = = x1 x2
∂ x1 2
 MARGINAL UTILITY
◆ E.g. if U(x1,x2) = x11/2 x22 then

∂U 1/ 2
MU 2 = = 2 x1 x2
∂ x2
 MARGINAL UTILITY
◆ E.g. if U(x1,x2) = x11/2 x22 then

∂U 1/ 2
MU 2 = = 2 x1 x2
∂ x2
 MARGINAL UTILITY
◆ So, if U(x1,x2) = x11/2 x22 then

∂ U 1 −1 / 2 2
MU 1 = = x1 x 2
∂ x1 2
∂ U
MU 2 = = 2 x1 x 2
1/ 2

∂ x2
 MARGINAL UTLITIES AND MARGINAL
RATE OF SUBISITUTION

◆ The general equation for an

indifference curve is
U(x1,x2) ≡ k, a constant
◆ Totally differentiating this identity gives

∂U ∂U
dx1 + dx2 = 0
∂ x1 ∂ x2
MARGINAL UTLITIES AND MARGINAL
RATE OF SUBISITUTION

∂U ∂U
dx1 + dx2 = 0
∂ x1 ∂ x2
rearranging
∂U ∂U
dx2 = − dx1
∂ x2 ∂ x1
MARGINAL UTLITIES AND MARGINAL
RATE OF SUBISITUTION

∂U ∂U
dx2 = − dx1
∂ x2 ∂ x1
rearranging
d x2 ∂ U / ∂ x1
=−
d x1 ∂ U / ∂ x2
This is the MRS.
 MU’s and MRS: An example
Suppose U(x1,x2) = x1x2. Then

∂U
= (1)( x2 ) = x2
∂ x1
∂U
= ( x1 )(1) = x1
∂ x2
d x2 ∂ U / ∂ x1 x2
so MRS = =− =−
d x1 ∂ U / ∂ x2 x1
 MU’s and MRS: An example
x2
x2 U(x1,x2) = x1x2; MRS = −
x1
8 MRS(1,8) = - 8/1 = -8
6 MRS(6,6) = - 6/6 = -1.

U = 36
U=8
1 6 x1
MONOTONIC TRANSFORMATIONS AND MRS

◆ Applying a monotonic
transformation to a utility function
representing a preference relation
simply creates another utility
function representing the same
preference relation.
◆ What happens to marginal rates-of-
substitution when a monotonic
transformation is applied?
(Hopefully, nothing)
MONOTONIC TRANSFORMATIONS AND MRS

◆ For U(x1,x2) = x1x2 the MRS = (-) x2/x1

◆ Create V = U2; i.e. V(x1,x2) = x12x22 What is

the MRS for V?

2
∂ V / ∂ x1 2 x1 x2 x2
MRS = − =− =−
∂ V / ∂ x2 2
2 x1 x2 x1

which is the same as the MRS for U.

MONOTONIC TRANSFORMATIONS AND MRS

◆ More generally, if V = f(U) where f is a

strictly increasing function, then

∂ V / ∂ x1 f ′ (U ) × ∂ U / ∂x1
MRS = − =−
∂ V / ∂ x2 f '(U ) × ∂ U / ∂x2
∂ U / ∂ x1
=− .
∂ U / ∂ x2
So MRS is unchanged by a positive
monotonic transformation.