Part 2

PREFERENCES AND UTILITY

Objectives of the chapter

Study a way to represent consumers

preferences about bundles of goods
What are bundles of goods? =combinations
of goods. For instance:

X=slices of pizza
Y=glasses of juice

Bundles:

P: X=1, Y=1
Q: X=3, Y=0
R: Y=3, X=0
S: X=2, Y=1

Objectives of the chapter

Johns preferences are such that:

P is preferred to both Q and R

S is preferred to P

This way of representing preferences would

be very messy if we have many bundles
In this chapter we study a simple way of
representing preferences over bundles of
goods
This is useful because in reality there are
many bundles of goods
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Axioms of rational choice

Before describing this simple method to

represent preferences over bundles, we
will study what requirements must the
preferences satisfy in order for the method
to work
These requirements are the axioms of
rational choice
Without these requirements, it would be
very difficult to come up with a simple
method to represent preferences over
many bundles of goods

It is easy to read a tube map, but not so much

to read a tube-bus-and rail map !!!!

Axioms of Rational Choice

Completeness

if A and B are any two bundles, an

individual can always specify exactly
one of these possibilities:

A is preferred to B
B is preferred to A
A and B are equally attractive

In other words, preferences must exist

in order to be able to describe them
through a simple method
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Axioms of Rational Choice

Transitivity

if A is preferred to B, and B is preferred

to C, then A is preferred to C
assumes that the individuals choices
are internally consistent
If transitivity does not hold, we would
need a very complicated method to
describe preferences over many
bundles of goods
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Axioms of Rational Choice

Continuity

if A is preferred to B, then bundles

suitably close to A must also be
preferred to B
If this does not hold, we would need a
very complicated method to describe
individuals preferences

Utility

Given these assumptions, it is

possible to show that people are
able to rank all possible bundles
from least desirable to most
Economists call this ranking utility

if A is preferred to B, then the utility

assigned to A exceeds the utility
assigned to B
U(A) > U(B)
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Utility

Game

Someone state the preferences using

numbers from 1 to 10
Can someone use different numbers
from 1 to 10 but state the same
ordering?
Can someone use numbers 1 to 100
and state the same preferences?

Utility

Game

Clearly, the numbers are arbitrary

The only consistent thing is the ranking
that we obtain

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Utility

Utility could be represented by a

Bundles
Example Utility
Table
P

Q
R
S

0
0
2

U(P)=1>U(Q)=0 because we said that P was preferred to Q

U(B)=U(C) because Q and R are equally preferred

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Utility

Notice that several tables of utility can represent

the same ranking
Bundles Another
Example
Utility
example
P

We can think that the rankings are real. They are in anyones
mind. However, utility numbers are an economists invention
The difference (2-1, 4-1) in the utility numbers is
meaningless. The only important thing about the numbers is
that they can be used to represent rankings (orderings)
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Utility

Utility rankings are ordinal in nature

they record the relative desirability of

commodity bundles

Because utility measures are not unique,

it makes no sense to consider how much
more utility is gained from A than from B.
This gain in utility will depend on the
scale which is arbitrary
It is also impossible to compare utilities
between people. They might be using
different scales.
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Utility

If we have many bundles of goods, a Table is not a

convenient way to represent an ordering. The
table would have to be too long.
Economist prefer to use a mathematical function
to assign numbers to consumption bundles
This is called a utility function
utility = U(X,Y)

Check that the previous example of the three columns

table is obtained with the following utility functions:

U=X*Y,
and U=(X*Y)2

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Utility

Clearly, for an economist it is the same to

use U=X*Y than to use U=(X*Y)2 because both

represent the same ranking (see the table), so both

functions will give us the same answer in terms of
which bundles of good are preferred to others
Any transformation that preserves the ordering
(multiply by a positive number, take it at a power
of a positive number, take ln) will give us the
same ordering and hence the same answer
We can use this property to simplify some
mathematical computations that we will see in the
future

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Economic Goods

In the utility function, the x and y

are assumed to be goods

more is preferred to less

Quantity of y
Preferred to x*, y*

?
y*

Worse
than
x*, y*

?
Quantity of x
x*

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Indifference Curves

An indifference curve shows a set of

consumption bundles among which
the individual is indifferent

Quantity of y

Combinations (x1, y1) and (x2, y2)

provide the same level of utility
y1
y2

U1

Quantity of x
x1

x2

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Indifference Curve Map

Each point must have an indifference curve through it

Quantity of y

Increasing utility
U3
U2
U1

U1 < U2 < U3

Quantity of x

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Transitivity

Can any two of an individuals indifference curves intersect?

Quantity of y

The individual is indifferent between A and C.

The individual is indifferent between B and C.
Transitivity suggests that the individual
should be indifferent between A and B

B
A

U2

But B is preferred to A
because B contains more
x and y than A

U1

Quantity of x

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Convexity

Economist believe that:

Balanced bundles of goods are

preferred to extreme bundles
This assumption is formally known as
the assumption of convexity of
preferences
Using a graph, shows that if this
assumption holds, then the indifference
curves cannot be strictly concave, they
must be strictly convex
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Convexity

Formally, If the indifference curve is convex, then the combination

(x1 + x2)/2, (y1 + y2)/2 will be preferred to either (x1,y1) or (x2,y2)

This means that well-balanced bundles are preferred

to bundles that are heavily weighted toward one
Commodity (extreme bundles).
The middle points are better than the
Extremes, so the middle is at a higher indifference
Curve.

Quantity of y

y1
(y1 + y2)/2
y2

U1

x1

(x1 + x2)/2

Quantity of x
x2

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Marginal Rate of
Substitution

Important concept !!
MRSYX is the number of units of good Y
that a consumer is willing to give up in
return for getting one more unit of X in
order to keep her utility unchanged
Lets do a graph in the whiteboard !!!
MRSYX is the negative of the slope of
the indiference curve (where Y is in the
ordinates axis)
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Marginal Rate of
Substitution

The negative of the slope of the

indifference curve at any point is called
the marginal rate of substitution (MRS)

Quantity of y

dy
MRS yx
dx U U1
y1
y2

U1

Quantity of x
x1

x2

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Marginal Rate of Substitution

Notice that if indifference curves are strictly convex, then the MRS is decreasing (as x increases, the MRSyx decreases)
See it in a graph: As x increases, the amount of y that the consumer is gives up to stay in the same indifference curve (that is MRS yx) decreases
If the assumption that balanced bundles are preferred to extreme bundles (convexity of preferences assumption holds then the MRSyx is
decreasing!!

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Marginal Rate of Substitution

MRS changes as x and y change

and it is decreasing

Quantity of y

y1
y2

At (x1, y1), the indifference curve is steeper.

At this point, the person has a lot of y,
So, he would be willing to give up more y
to gain additional units of x
At (x2, y2), the indifference curve
is flatter. At this point, the person
does not have so much y,
so he would be willing to give up
less y to gain
U1
additional units of x
Quantity of x
x1

x2

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Utility and the MRS

Suppose an individuals preferences

for hamburgers (y) and soft drinks
(x) can be represented by
utility 10 x y

Solving for y, we get the indifference curve for level 10:

y = 100/x

Taking derivatives, we get the MRS =

-dy/dx:
MRS = -dy/dx = 100/x2

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Utility and the MRS

MRSyx = -dy/dx = 100/x2

Note that as x rises, MRS falls

when x = 5, MRSyx = 4
when x = 20, MRSyx = 0.25

When x=20, then the individual does

not value much an additional unit of x.
He is only willing to give 0.25 units of y
to get an additional unit of x.

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Another way of computing the

MRS

Suppose that an individual has a

utility function of the form
utility = U(x,y)

The total differential of U is

U
U
dU
dx
dy
x
y

Along any indifference curve, utility is constant (dU = 0)

dU/dy and dU/dx are the marginal utility of y and x
respectively

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Another way of computing the

MRS

Therefore, we get:
dy
MRS yx
dx

U constant

U
x
U
y

MRS is the ratio of the marginal utility of x to the marginal

utility of y
Marginal utilities are generally positive (goods)
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Example of MRS

Suppose that the utility function is

utility x y

We can simplify the algebra by taking the logarithm of this

function (we have explained before that taking the logarithm
does not change the result because it preserves the ordering,
though it can make algebra easier)

U*(x,y) = ln[U(x,y)] = 0.5 ln x + 0.5 ln y

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Deriving the MRS

Thus,
U * 0.5
y

x
x
MRS yx

U * 0.5 x
y
y

Notice that the MRS is decreasing in x: The

MRS falls when x increases
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Examples of Utility Functions

Cobb-Douglas Utility
utility = U(x,y) = xy

where and are positive constants

The relative sizes of and indicate the

relative importance of the goods
The algebra can usually be simplified by
taking ln(). Lets do it in the blackboard.

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Examples of Utility Functions

Perfect Substitutes
U(x,y) =U= x + y
Y= -(/ )x + (1/ )U ,

Quantity of y

indifference curve for level U

The indifference curves will be linear.

The MRS =(/
indifference curve.

is constant along the

U3
U1

U2

Quantity of x

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Examples of Utility Functions

Perfect Substitutes
U(x,y) =U= x + y
dU= dx + dy

Notice that the change in utility will be the same if (dx= and dy= 0) or if (dx= 0 and dy= ). So x and y are exchanged at a fixed rate
independently of how much x and y the consumer is consumed
It is as if x and y were substitutes. That is why we call them like that

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Examples of Utility Functions

Perfect Complements
utility = U(x,y) = min (x, y)

The indifference curves will be

L-shaped. It is called complements
because if we
Are in the kink then utility does not
increase by we increase the quantity
of only one good. The quantity of both
Goods must increase in order to increase
utility

Quantity of y

U3
U2

U1

Quantity of x

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Examples of Utility Functions

CES Utility (Constant elasticity of

substitution)
utility = U(x,y) = x/ + y/

when 0 and
utility = U(x,y) = ln x + ln y

when = 0

Perfect substitutes = 1
Cobb-Douglas = 0
Perfect complements = -
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Examples of Utility Functions

CES Utility (Constant elasticity of

substitution)

The elasticity of substitution () is

equal to 1/(1 - )

Perfect substitutes =
Fixed proportions = 0

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