Chapter 3

PREFERENCES AND UTILITY

MANAGERIL ECONOMICS

Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved.

 Axioms of Rational Choice
• Completeness
– If A and B are any two situations, 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
 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 individual’s choices are
internally consistent
 Axioms of Rational Choice
• Continuity
– If A is preferred to B, then situations “close
to” A must also be preferred to B
– Used to analyze individuals’ responses to
relatively small changes in income and
prices
 Utility
• Given these assumptions, it is possible to
show that people are able to rank in order
all possible situations 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)
 Utility
• Utility rankings are ordinal in nature
– They record the relative desirability of
commodity bundles
• Because utility measures are nonunique,
it makes no sense to consider how much
more utility is gained from A than from B
• It is also impossible to compare utilities
between people
 Utility
• Utility is affected by the consumption of
physical commodities, psychological
attitudes, peer group pressures, personal
experiences, and the general cultural
environment
• Economists generally devote attention to
quantifiable options while holding
constant the other things that affect utility
– ceteris paribus assumption
 Utility
• Assume that an individual must choose
among consumption goods X1, X2,…, Xn
• The individual’s rankings can be shown
by a utility function of the form:
utility = U(X1, X2,…, Xn)
• Keep in mind that everything is being held
constant except X1, X2,…, Xn
 Economic Goods
• In the utility function, the X’s 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*
 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
 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 = −
dX U = U1
Y1

Y2 U1

Quantity of X
X1 X2
 Marginal Rate of Substitution
• MRS changes as X and Y change
– reflects the individual’s willingness to trade Y
for X
Quantity of Y At (X1, Y1), the indifference curve is steeper.
The person would be willing to give up more
Y to gain additional units of X

At (X2, Y2), the indifference curve

is flatter. The person would be
Y1 willing to give up less Y to gain
additional units of X
Y2 U1

Quantity of X
X1 X2
 Indifference Curve Map
• Each point must have an indifference
curve through it

Quantity of Y

Increasing utility

U3 U1 < U2 < U3
U2
U1
Quantity of X
 Transitivity
• Can two of an individual’s indifference
curves intersect?
The individual is indifferent between A and C.
Quantity of Y The individual is indifferent between B and C.
Transitivity suggests that the individual
should be indifferent between A and B

But B is preferred to A
C
because B contains more
B X and Y than A
U2
A U1
Quantity of X
 Convexity
• A set of points is convex if any two points
can be joined by a straight line that is
contained completely within the set
Quantity of Y The assumption of a diminishing MRS is
equivalent to the assumption that all
combinations of X and Y which are
preferred to X* and Y* form a convex set

Y*
U1

Quantity of X
X*
 Convexity
• 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)
Quantity of Y
This implies that “well-balanced” bundles are preferred
to bundles that are heavily weighted toward one
commodity

Y1
(Y1 + Y2)/2
Y2 U1

Quantity of X
X1 (X1 + X2)/2 X2
 Utility and the MRS
• Suppose an individual’s preferences for
hamburgers (Y) and soft drinks (X) can
be represented by
utility = 10 = X  Y
• Solving for Y, we get
Y = 100/X
• Solving for MRS = -dY/dX:
MRS = -dY/dX = 100/X2
 Utility and the MRS
MRS = -dY/dX = 100/X2
• Note that as X rises, MRS falls
– When X = 5, MRS = 4
– When X = 20, MRS = 0.25
 Marginal Utility
• Suppose that an individual has a utility
function of the form
utility = U(X1, X2,…, Xn)
• We can define the marginal utility of
good X1 by
marginal utility of X1 = MUX1 = U/X1
• The marginal utility is the extra utility
obtained from slightly more X1 (all else
constant)
 Marginal Utility
• The total differential of U is
U U U
dU = dX 1 + dX 2 + ... + dX n
X 1 X 2 X n

dU = M UX dX1 + M UX dX 2 + ... + M UX dX n
1 2 n

• The extra utility obtainable from slightly

more X1, X2,…, Xn is the sum of the
additional utility provided by each of
these increments
 Deriving the MRS
• Suppose we change X and Y but keep
utility constant (dU = 0)
dU = 0 = MUXdX + MUYdY
• Rearranging, we get:
dY MU X U / X
− = =
dX U = constant MU Y U / Y
• MRS is the ratio of the marginal utility of
X to the marginal utility of Y
Diminishing Marginal Utility
and the MRS
• Intuitively, it seems that the assumption
of decreasing marginal utility is related to
the concept of a diminishing MRS
– Diminishing MRS requires that the utility
function be quasi-concave
• This is independent of how utility is measured
– Diminishing marginal utility depends on how
utility is measured
• Thus, these two concepts are different
 Marginal Utility and the MRS
• Again, we will use the utility function
utility = X  Y = X Y 0.5 0.5

• The marginal utility of a soft drink is

marginal utility = MUX = U/X = 0.5X-0.5Y0.5
• The marginal utility of a hamburger is
marginal utility = MUY = U/Y = 0.5X0.5Y-0.5

dY MU X .5 X −0.5Y 0.5 Y
MRS = − = = 0. 5 − 0. 5
=
dX U= constant MUY .5 X Y X
Examples of Utility Functions
• Cobb-Douglas Utility
utility = U(X,Y) = XY
where  and  are positive constants
– The relative sizes of  and  indicate the
relative importance of the goods
Examples of Utility Functions
• Perfect Substitutes
utility = U(X,Y) = X + Y
Quantity of Y
The indifference curves will be linear.
The MRS will be constant along the
indifference curve.

U3
U2
U1
Quantity of X
Examples of Utility Functions
• Perfect Complements
utility = U(X,Y) = min (X, Y)
Quantity of Y
The indifference curves will be
L-shaped. Only by choosing more
of the two goods together can utility
be increased.

U3
U2
U1
Quantity of X
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   = -
Examples of Utility Functions
• CES Utility (Constant elasticity of
substitution)
– The elasticity of substitution () is equal to
1/(1 - )
• Perfect substitutes   = 
• Fixed proportions   = 0
 Homothetic Preferences
• If the MRS depends only on the ratio of
the amounts of the two goods, not on
the quantities of the goods, the utility
function is homothetic
– Perfect substitutes  MRS is the same at
every point
– Perfect complements  MRS =  if Y/X >
/, undefined if Y/X = /, and MRS = 0 if
Y/X < /
Nonhomothetic Preferences
• Some utility functions do not exhibit
homothetic preferences
utility = U(X,Y) = X + ln Y
MUY = U/Y = 1/Y
MUX = U/X = 1
MRS = MUX / MUY = Y
• Because the MRS depends on the
amount of Y consumed, the utility function
is not homothetic
 Important Points to Note:
• If individuals obey certain behavioral
postulates, they will be able to rank all
commodity bundles
– The ranking can be represented by a utility
function
– In making choices, individuals will act as if they
were maximizing this function
• Utility functions for two goods can be
illustrated by an indifference curve map
 Important Points to Note:
• The negative of the slope of the
indifference curve measures the marginal
rate of substitution (MRS)
– This shows the rate at which an individual
would trade an amount of one good (Y) for one
more unit of another good (X)
• MRS decreases as X is substituted for Y
– This is consistent with the notion that
individuals prefer some balance in their
consumption choices
 Important Points to Note:
• A few simple functional forms can capture
important differences in individuals’
preferences for two (or more) goods
– Cobb-Douglas function
– linear function (perfect substitutes)
– fixed proportions function (perfect
complements)
– CES function
• includes the other three as special cases