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:

x
0
x
1
U(x
0
) > U(x
1
)

x
0
x
1
U(x
0
) < U(x
1
)

x
0
~ x
1
U(x
0
) = U(x
1
)
~
f
p
p
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
U 6
U 4
(2,3) > (2,2) = (4,1)
xx1
1
x
2
x
1
x
2
UTILITY FUNCTIONS
and INDIFFERENCE CURVES
Comparing more bundles will create
a larger collection of all indifference
curves and a better description of the
consumers preferences.
UTILITY FUNCTIONS
and INDIFFERENCE CURVES
U 6
U 4
U 2
xx
1
1
x
2
x
2

UTILITY FUNCTIONS
and INDIFFERENCE CURVES
Comparing all possible consumption
bundles gives the complete collection
of the consumers indifference curves,
each with its assigned utility level.
This complete collection of
indifference curves completely
represents the consumers
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
Water
x
Units of
water are
goods
Units of
water are
bads
Around x units, a little extra water is a neutral.
Utility
function
UTILITY FUNCTIONS
( ) 0) b 0, (a ,
2 1 2 1
> > =
b a
x x x x U
bx ,
2 1 2 1
+ = ax x x U
( ) min ,
2 , 1 2 1
x x x x U =
Cobb-Douglas Utility Function
Perfect Substitutes Utility Function
Perfect Complements Utility Function
Note: MRS = (-)a/b
Note: MRS = ?
UTILITY
Preferences can be represented by a
utility function if the functional form has
certain nice properties

Example: Consider U(x
1
,x
2
)= x
1
.x
2


1. ou/ox
1
>0 and ou/ox
2
>0
2. Along a particular indifference curve
x
1
.x
2
= constant x
2
=c/x
1
As x
1
| x
2
+
i.e. downward sloping indifference curve
UTILITY
Example U(x
1
,x
2
)= x
1
.x
2
=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 X
1
| MRS + (in absolute terms),
i.e convex preferences

COBB DOUGLAS UTILITY FUNCTION
Any utility function of the form

U(x
1
,x
2
) = x
1
a

x
2
b

with a > 0 and b > 0 is called a Cobb-
Douglas utility function.
Examples
U(x
1
,x
2
) = x
1
1/2
x
2
1/2
(a = b = 1/2)
V(x
1
,x
2
) = x
1
x
2
3
(a = 1, b = 3)
COBB DOUBLAS INDIFFERENCE CURVES
x
2
x
1
All curves are hyperbolic,
asymptoting to, but never
touching any axis.
PERFECT SUBSITITUTES
Instead of U(x
1
,x
2
) = x
1
x
2
consider

V(x
1
,x
2
) = x
1
+ x
2
.


PERFECT SUBSITITUTES
5
5
9
9
13
13
x
1
x
2
x
1
+ x
2
= 5
x
1
+ x
2
= 9
x
1
+ x
2
= 13
All are linear and parallel.
V(x
1
,x
2
) = x
1
+ x
2

PERFECT COMPLEMENTS
Instead of U(x
1
,x
2
) = x
1
x
2
or
V(x
1
,x
2
) = x
1
+ x
2
, consider

W(x
1
,x
2
) = min{x
1
,x
2
}.


PERFECT COMPLEMENTS
x
2
x
1
45
o
min{x
1
,x
2
} = 8
3 5 8
3
5
8
min{x
1
,x
2
} = 5
min{x
1
,x
2
} = 3
All are right-angled with vertices/corners
on a ray from the origin.
W(x
1
,x
2
) = min{x
1
,x
2
}
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.
MU
U
x
i
i
=
c
c
MARGINAL UTILITY
U=(x
1
,x
2
)
MU
1
=AU/Ax
1
AU=MU
1
.Ax
1

MU
2
=AU/Ax
2
AU=MU
2
.Ax
2

Along a particular indifference curve

AU

= 0 = MU
1
(Ax
1
) + MU
2
(Ax
2
)

Ax
2
/Ax
1
{= MRS} = (-)MU
1
/MU
2
MARGINAL UTILITY
E.g. if U(x
1
,x
2
) = x
1
1/2
x
2
2
then
2
2
2 / 1
1
1
1
2
1
x x
x
U
MU

= =
c
c
MARGINAL UTILITY
E.g. if U(x
1
,x
2
) = x
1
1/2
x
2
2
then
MU
U
x
x x
1
1
1
1 2
2
2
1
2
= =

c
c
/
MARGINAL UTILITY
E.g. if U(x
1
,x
2
) = x
1
1/2
x
2
2
then
MU
U
x
x x
2
2
1
1 2
2
2 = =
c
c
/
MARGINAL UTILITY
E.g. if U(x
1
,x
2
) = x
1
1/2
x
2
2
then
MU
U
x
x x
2
2
1
1 2
2
2 = =
c
c
/
MARGINAL UTILITY
So, if U(x
1
,x
2
) = x
1
1/2
x
2
2
then
2
2 / 1
1
2
2
2
2
2 / 1
1
1
1
2
2
1
x x
x
U
MU
x x
x
U
MU
= =
= =

c
c
c
c
MARGINAL UTLITIES AND MARGINAL
RATE OF SUBISITUTION
The general equation for an
indifference curve is
U(x
1
,x
2
) k, a constant
Totally differentiating this identity gives
c
c
c
c
U
x
dx
U
x
dx
1
1
2
2
0 + =
MARGINAL UTLITIES AND MARGINAL
RATE OF SUBISITUTION
c
c
c
c
U
x
dx
U
x
dx
1
1
2
2
0 + =
c
c
c
c
U
x
dx
U
x
dx
2
2
1
1
=
rearranging
MARGINAL UTLITIES AND MARGINAL
RATE OF SUBISITUTION
c
c
c
c
U
x
dx
U
x
dx
2
2
1
1
=
rearranging
2
1
1
2
/
/
x U
x U
x d
x d
c c
c c
=
This is the MRS.
MUs and MRS: An example
Suppose U(x
1
,x
2
) = x
1
x
2
. Then


c
c
c
c
U
x
x x
U
x
x x
1
2 2
2
1 1
1
1
= =
= =
( )( )
( )( )
1
2
2
1
1
2
/
/
x
x
x U
x U
x d
x d
MRS = = =
c c
c c
so
MUs and MRS: An example
MRS
x
x
=
2
1
MRS(1,8) = - 8/1 = -8
MRS(6,6) = - 6/6 = -1.
x
1
x
2
8
6
1 6
U = 8
U = 36
U(x
1
,x
2
) = x
1
x
2
;
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(x
1
,x
2
) = x
1
x
2
the MRS = (-) x
2
/x
1

Create V = U
2
; i.e. V(x
1
,x
2
) = x
1
2
x
2
2
What is
the MRS for V?





which is the same as the MRS for U.
MRS
V x
V x
x x
x x
x
x
= = =
c c
c c
/
/
1
2
1 2
2
1
2
2
2
1
2
2
MONOTONIC TRANSFORMATIONS AND MRS
More generally, if V = f(U) where f is a
strictly increasing function, then
MRS
V x
V x
f U U x
f U U x
= =
'

c c
c c
c c
c c
/
/
( ) /
'( ) /
1
2
1
2
=
c c
c c
U x
U x
/
/
.
1
2
So MRS is unchanged by a positive
monotonic transformation.