WELL-BEHAVED PREFERENCES

• Monotonicity
• We will typically assume that more goods are better
• If (x1, x2) is a bundle of goods and (y1, y2) is another
bundle of goods with at least as much of one good
and more of the other, then (y1, y2)  (x1, x2)
• The assumption of monotonicity implies
• non-satiation (more is always preferred)
• and that indifference curves have a negative slope.
• Convexity
• Mixtures of bundles are (at least weakly)preferred
to the bundles themselves
• e.g., the 50-50 mixture of the bundles x and y is
z = (0.5)x + (0.5)y.
z is at least as preferred as x or y
WELL-BEHAVED PREFERENCES
 WELL-BEHAVED PREFERENCES
• Various kinds of preferences.
• Panel A depicts convex preferences
• panel B depicts nonconvex preferences, and
• panel C depicts concave preferences.

x2 x2 x 2 (y , y )
1 2
(y1, y 2) Averaged
(y1, y 2)
bundle
Averaged
bundle

Averaged
(x1, x2) bundle (x1, x 2) (x1, x 2)
x1 x1 x1
A Convex B Nonconvex C Concave
preferences preferences preferences
 WELL-BEHAVED PREFERENCES
• Non-convex preferences: Example
• Think of ice cream and tomato ketchup
• I like ice cream and I like ketchup but I don’t like to have them
together
• In considering my consumption in the next hour, I might be
indifferent between consuming 10 ounces of ice cream or 10
ounces of ketchup
• Either one of these bundles would be better than consuming 5
ounces of each (the average bundle)
• We assume that well-behaved preferences are convex because
mostly goods are consumed together
• Non-convex preferences imply that the consumer would
prefer to specialize, at least to some degree, and to consume
only one of the goods.
• However, the normal case is where the consumer would want
to trade some of one good for the other and end up
consuming some of each, rather than specializing in
consuming only one of the two goods.
 MARGINAL RATE OF SUBSTITUTION
• The slope of an indifference curve is known as the
marginal rate of substitution (MRS).
• MRS measures the rate at which the consumer is just
willing to substitute one good for the other.
• Suppose that we take a little of good 1, Δx1, away from
the consumer.
• Then we give him Δx2, an amount that is just sufficient to
put him back on his indifference curve, so that he is just as
well off after this substitution of x2 for x1 as he was before.
• We think of the ratio Δx2/Δx1 as being the rate at which the
consumer is willing to substitute good 2 for good 1.
• When we write the ratio Δx2/Δx1, we will always think of
both the numerator and the denominator as being small
numbers
• describing marginal changes from the original
consumption bundle
• Since the MRS is the numerical measure of the slope of an
indifference curve, it will be a negative number
 MARGINAL RATE OF SUBSTITUTION
• MRS is the rate at which the consumer is just willing to
exchange commodity 2 for a small amount of commodity 1
• If good 2 represents the consumption of “all other goods,”
measured in dollars that you can spend on these goods, then MRS
measures the marginal willingness to pay (give up dollars) in order
to consume a small amount more of good 1

x2

Indifference curve

Δx2 Slope = Δx2/Δx1

Δx1 = Marginal rate of substitution

x1
 MARGINAL RATE OF SUBSTITUTION
• How much you actually end up buying of a good
will depend on
• your preferences for that good and
• the prices that you face

• How much you would be willing to pay for a small

amount extra of the good is a feature only of your
preferences.
 MARGINAL RATE OF SUBSTITUTION
• MRS is useful in describing the shapes of indifference
curves
• Perfect substitutes indifference curves are
characterized by the fact that the MRS is constant
• The indifference curves for perfect complements are
characterized by the fact that the MRS is either zero or
infinity, and nothing in between.
• The assumption of monotonicity implies that
indifference curves must have a negative slope
• For strictly convex indifference curves, the MRS
decreases (in absolute value) as we increase x1.
• Thus the indifference curves exhibit a diminishing marginal
rate of substitution.
MARGINAL RATE OF SUBSTITUTION
• This means that the amount of good 1 that the
person is willing to give up for an additional
amount of good 2 increases as the amount of
good 1 increases.
• In other words, the more you have of one good,
the more willing you are to give some of it up in
exchange for the other good.
x2

Slope = Δx2/Δx1 = MRS = -4

Δx2
Indifference curve
Δx1
Slope = Δx2/Δx1 = MRS = -0.25

x1
 UTILITY
• Due to conceptual problems associated with utility
measurement, economists have abandoned the
old-fashioned view of utility as being a measure of
happiness.

• Instead, the theory of consumer behavior has been

reformulated entirely in terms of consumer
preferences, and utility is seen only as a way to
describe preferences.

• All that matters about utility as far as choice

behavior is concerned is whether one bundle has a
higher utility than another
• how much higher didn’t really matter.
UTILITY
 UTILITY
• Since only the ranking of the bundles matters, there
can be no unique way to assign utilities to bundles of
goods.
• If we can find one way to assign utility numbers to
bundles of goods, we can find an infinite number of
ways to do it.
• If u(x1, x2) represents a way to assign utility numbers to the
bundles (x1, x2), then multiplying u(x1, x2) by 2 (or any other
positive number) is just as good a way to assign utilities.
• A monotonic transformation is a way of transforming
one set of numbers into another set of numbers in a
way that preserves the order of the numbers.
• Multiplication by 2 is an example of a monotonic
transformation.
 UTILITY
• We typically represent a monotonic transformation by a
function f(u) that transforms each number u into some other
number, in a way that preserves the order of the numbers
• u1 > u2 implies f (u1) > f (u2).

• Examples of monotonic transformations are multiplication by a

positive number (e.g., f (u) = 3u), adding any number (e.g., f (u)
= u + 17), raising u to an odd power (e.g., f (u) = u3), and so on

• In other words, a monotonic transformation of a utility function

is a utility function that represents the same preferences as the
original utility function.
• As long as indifference curves containing more-preferred bundles
get a larger label than indifference curves containing less-
preferred bundles, the labeling will represent the same
preferences.
UTILITY FUNCTIONS: EXAMPLES
 UTILITY FUNCTIONS: EXAMPLES
• The indifference curves k = x1x2 for different values of k
are as follows

x2

Indifference curves

k=3
k=2
k=1
x1
 UTILITY FUNCTIONS: EXAMPLES
• Now consider a utility function v(x1, x2) = x12x22
• By the standard rules of algebra we know that
v(x1, x2) = x12x22 = (x1x2)2 = u(x1, x2)2

• Thus the utility function v(x1, x2) is just the square of the utility
function u(x1, x2).

• v(x1, x2) is a monotonic transformation of the previous utility

function, u(x1, x2).

• This means that the utility function v(x1, x2) = x12x22 has to have
exactly the same shaped indifference curves as those of u(x1,
x 2) = x 1x 2
• The labeling of the indifference curves will be different—the
labels that were (k=) 1, 2, 3, will now be (k=) 1, 4, 9.
 UTILITY FUNCTIONS: EXAMPLES
• In general, preferences for perfect substitutes can be represented
by a utility function of the form
u(x1, x2) = ax1 + bx2
• Here a and b are some positive numbers that measure the value of
goods 1 and 2 to the consumer.

• In general, a utility function that describes perfect-complement

preferences is given by
u(x1, x2) = min{ax1, bx2},
• where a and b are positive numbers that indicate the proportions in
which the goods are consumed.

• When the utility function is linear in one good but (possibly) non-
linear in the other good it is quasilinear (partly linear).
u(x1, x2) = f(x1) + x2 = ln(x1) + x2
u(x1, x2) = f(x1) + x2 = √x1 + x2
 UTILITY FUNCTIONS: EXAMPLES
• In case of Quasilinear utility functions the indifference
curves are just vertically “shifted” versions of one
indifference curve.

x2

Indifference curves

x1
 UTILITY FUNCTIONS: EXAMPLES
• Another commonly used utility function is the Cobb-Douglas utility function
u(x1, x2) = x1ax2b
• where a and b are positive numbers that describe the preferences of
the consumer
• The preferences represented by the Cobb-Douglas utility function have
the general shape depicted in the following figure.
• In panel A, we have indifference curves for a = 1/2, b = 1/2.
• In panel B, we have indifference curves for a = 1/5, b = 4/5.
• Note how different values of the parameters a and b lead to different
shapes of the indifference curves.

x2 x2

x1 x1

A: a = 1/2 b =1/2 B: a = 1/5 b =4/5

 UTILITY FUNCTIONS: EXAMPLES
• Cobb-Douglas preferences are the standard example of
indifference curves that look well-behaved
• In fact the formula describing them is about the simplest
algebraic expression that generates well-behaved preferences.

• Of course monotonic transformations of the Cobb-Douglas

utility function will represent exactly the same preferences,
e.g.,
v(x1, x2) = ln(x1ax2b) = a ln(x1) + b ln(x2)

v(x1, x2) = (x1ax2b)1/(a+b) = x1a/(a+b)x2b/(a+b)

= x1a/(a+b)x2b/(a+b) + a/(a+b) - a/(a+b)
= x1a/(a+b)x2(a+b)/(a+b) - a/(a+b)
= x1a/(a+b)x21 - a/(a+b)
= x1αx21 - α