Chapter 3

Consumer Preferences and the Concept of Utility

1

Chapter Three Overview

1. Motivation 2. Consumer Preferences and the Concept of Utility 3. The Utility Function Marginal Utility and Diminishing Marginal Utility 4. Indifference Curves 5. The Marginal Rate of Substitution 6. Some Special Functional Forms

Chapter Three

Motivation
Why study consumer choice? Study of how consumers with limited resources choose goods and services Helps derive the demand curve for any good or service Businesses care about consumer demand curves Government can use this to determine how to help and whom to help buy certain goods and services
Chapter Three 3

Consumer Preferences
Consumer Preferences tell us how the consumer would rank (that is, compare the desirability of) any two combinations or allotments of goods, assuming these allotments were available to the consumer at no cost.

These allotments of goods are referred to as baskets or bundles. These baskets are assumed to be available for consumption at a particular time, place and under particular physical circumstances.

Chapter Three

Consumer Preferences

Preferences are complete if the consumer can rank any two baskets of goods (A preferred to B; B preferred to A; or indifferent between A and B) Preferences are transitive if a consumer who prefers basket A to basket B, and basket B to basket C also prefers basket A to basket C
A B; B C == > A C
Chapter Three 5

Consumer Preferences

Preferences are monotonic if a basket with more of at least one good and no less of any good is preferred to the original basket.

Chapter Three

Types of Ranking

Students take an exam. After the exam, the students are ranked according to their performance. An ordinal ranking lists the students in order of their performance (i.e., Harry did best, Joe did second best, Betty did third best, and so on). A cardinal ranking gives the mark of the exam, based on an absolute marking standard (i.e., Harry got 80, Joe got 75, Betty got 74 and so on). Alternatively, if the exam were graded on a curve, the marks would be an ordinal ranking.

Chapter Three

The Utility Function

The three assumptions about preferences allow us to represent preferences with a utility function. Utility function

a function that measures the level of satisfaction a consumer receives from any basket of goods and services.
assigns a number to each basket so that more preferred baskets get a higher number than less preferred baskets. U = u(y)
Chapter Three 8

The Utility Function

An ordinal concept: the precise magnitude of the number that the function assigns has no significance.
Utility not comparable across individuals. Any transformation of a utility function that preserves the original ranking of bundles is an equally good representation of preferences. e.g. U = y vs. U = y + 2 represent the same preferences.

Chapter Three

Marginal Utility
Marginal Utility of a good y additional utility that the consumer gets from consuming a little more of y i.e. the rate at which total utility changes as the level of consumption of good y rises

MUy = U/y
slope of the utility function with respect to y
Chapter Three 10

Diminishing Marginal Utility

The principle of diminishing marginal utility states that the marginal utility falls as the consumer consumes more of a good.

Chapter Three

11

Diminishing Marginal Utility

Chapter Three

12

Marginal Utility
The marginal utility of a good, x, is the additional utility that the consumer gets from consuming a little more of x when the consumption of all the other goods in the consumers basket remain constant. U(x, y) = x + y U/x (y held constant) = MUx U/y (x held constant) = MUy

Chapter Three

13

Marginal Utility
Example of U(H) and MUH

U(H) = 10H H2 MUH = 10 2H

H 2 4 6 8 10 H2 4 16 36 64 100 U(H) 16 24 24 16 0
Chapter Three

MUH 6 2 -2 -6 -10
14

Marginal Utility
U(H) = 10H H2

MUH = 10 2H
15

Chapter Three

Marginal Utility
Example of U(H) and MUH
The point at which he should stop consuming hotdogs is the point at which MUH = 0 This gives H = 5. That is the point where Total Utility is flat. You can see that the utility is diminishing.
Chapter Three 16

Marginal Utility multiple goods

U = xy2 MUx = y2 MUy = 2xy
More is better? More y more and more x indicates more U so yes it is monotonic Diminishing marginal utility? MU of x is not dependent of x. So the marginal utility of x (movies) does not decrease as the number of movies increases. MU of y increases with increase in number of operas (y) so neither exhibits diminishing returns.
Chapter Three 17

Indifference Curves
An Indifference Curve or Indifference Set: is the set of all baskets for which the consumer is indifferent

An Indifference Map : Illustrates a set of indifference curves for a consumer

Chapter Three

18

Indifference Curves

1) Monotonicity => indifference curves have negative slope and indifference curves are not thick

2)

Transitivity => indifference curves do not cross

3) Completeness => each basket lies on only one indifference curve

Chapter Three 19

Indifference Curves

Chapter Three

20

Indifference Curves

Suppose that B preferred to A. but..by definition of IC, B indifferent to C A indifferent to C => B indifferent to C by transitivity. And thus a contradiction.

Chapter Three

21

Indifference Curves
U = xy2
Check that underlying preferences are complete, transitive, and monotonic.

MU x y

for U 144
x 8 4 3 1

MU y 2 xy

y xy^2 4.24 143.8 6 144 6.93 144.07 12 144

22

Chapter Three

Indifference Curves
Indifference Curve for U =
14 12 10 8 y 6 4 2 0 0 1 2 3 4 X 5 6 7 8 9

xy2

Example: Utility and the single indifference curve.

U = 144

Chapter Three

23

Marginal Rate of Substitution

The marginal rate of substitution: is the maximum rate at which the consumer would be willing to substitute a little more of good x for a little less of good y; It is the increase in good x that the consumer would require in exchange for a small decrease in good y in order to leave the consumer just indifferent between consuming the old basket or the new basket; It is the rate of exchange between goods x and y that does not affect the consumers welfare;

It is the negative of the slope of the indifference curve:

MRSx,y = -y/x
(for a constant level of preference)
Chapter Three 24

Marginal Rate of Substitution

If the more of good x you have, the more you are willing to give up to get a little of good y or the indifference curves get flatter as we move out along the horizontal axis and steeper as we move up along the vertical axis

Chapter Three

25

Marginal Rate of Substitution

MUx(x) + MUy(y) = 0 along an IC
MUx/MUy = -y/x = MRSx,y

Positive marginal utility implies the indifference curve has a negative slope (implies monotonicity)
Diminishing marginal utility implies the indifference curves are convex to the origin (implies averages preferred to extremes)
26

Chapter Three

Marginal Rate of Substitution

Implications of this substitution: Indifference curves are negatively-sloped, bowed out from the origin, preference direction is up and right Indifference curves do not intersect the axes

Chapter Three

27

Indifference Curves

Averages preferred to extremes => indifference curves are bowed toward the origin (convex to the origin).

Chapter Three

28

Indifference Curves
Do the indifference intersect the axes? curves

A value of x = 0 or y = 0 is inconsistent with any positive level of utility.

Chapter Three

29

Marginal Rate of Substitution

Example: U = Ax2+By2; MUx=2Ax; MUy=2By (where: A and B positive) MRSx,y = MUx/MUy = 2Ax/2By = Ax/By

Marginal utilities are positive (for positive x and y) Marginal utility of x increases in x;
Marginal utility of y increases in y
Chapter Three 30

Indifference Curves
Example: U= (xy).5;MUx=y.5/2x.5; MUy=x.5/2y.5

A. Is more better for both goods? Yes, since marginal utilities are positive for both. B. Are the marginal utility for x and y diminishing? Yes. (For example, as x increases, for y constant, MUx falls.) C. What is the marginal rate of substitution of x for y? MRSx,y = MUx/MUy = y/x
Chapter Three 31

Indifference Curves
y
Example: Graphing Indifference Curves

Preference direction

IC2

IC1
x
Chapter Three 32

Special Functional Forms

Cobb-Douglas: U = Axy
where: + = 1; A, , positive constants

MUX = Ax-1y
y-1 Ax MUY =

MRSx,y =

(y)/(x)

Standard case
Chapter Three 33

Special Functional Forms

y
Example: Cobb-Douglas (speed vs. maneuverability)

Preference Direction

IC2

IC1
x
Chapter Three 34

Special Functional Forms

Perfect Substitutes: U = Ax + By
Where: A, B positive constants MUx = A MUy = B

MRSx,y = A/B so that 1 unit of x is equal to B/A units of y everywhere (constant MRS).
35

Chapter Three

Special Functional Forms

y
Example: Perfect Substitutes (Tylenol, Extra-Strength Tylenol)

Slope = -A/B

IC1

IC2
Chapter Three

IC3 x
36

Special Functional Forms

Perfect Complements: U = Amin(x,y) where: A is a positive constant. MUx = 0 or A MUy = 0 or A MRSx,y is 0 or infinite or undefined (corner)

Chapter Three

37

Special Functional Forms

y

Example: Perfect Complements (nuts and bolts)

IC2 IC1

0
Chapter Three

x
38

Special Functional Forms

U = v(x) + Ay Where: A is a positive constant.

MUx = v(x) = V(x)/x, where small MUy = A

"The only thing that determines your personal trade-off between x and y is how much x you already have."
*can be used to "add up" utilities across individuals*
39

Chapter Three

Special Functional Forms

y
Example: Quasi-linear Preferences (consumption of beverages)

IC2 IC1 ICs have same slopes on any vertical line

0
Chapter Three

x
40