Chapter 3

Preferences and Utility

Nicholson and Snyder, Copyright 2008 by Thomson South-Western. 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 individuals choices are
internally consistent
 Axioms of Rational Choice
Continuity
if A is preferred to B, then situations suitably
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 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
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
the general cultural environment
 Utility
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
We can show his rankings using a utility
function of the form:
utility = U(x1, x2,, xn; other things)

Often other things are held constant

utility = U(x1, x2,, xn)
 Utility
We can assume the individual is
considering two goods, x and y
utility = U(x,y)
 Economic Goods
In the utility function, the xs 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 individuals 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 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

C
But B is preferred to A
B because B contains more
U2
A
x and y than 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

Well-balanced bundles are preferred to those

that are heavily weighted toward one good

y1
(y1 + y2)/2

y2
U1

Quantity of x
x1 (x1 + x2)/2 x2
 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
y = 100/x

Solving for MRS = -dy/dx (along U1):

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(x,y)
The total differential of U is
U U
dU dx dy
x y

Along any indifference curve, utility is

constant (dU = 0)
 Deriving the MRS
Therefore, we get:

dy U x
MR S
dx Uconstant U y

MRS is the ratio of the marginal utility of

x to the marginal utility of y
Diminishing Marginal Utility
and the 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

 Convexity of Indifference
Curves
Suppose that the utility function is
utility x y

We can simplify the algebra by taking the

logarithm of this function
U*(x,y) = ln[U(x,y)] = 0.5 ln x + 0.5 ln y
 Convexity of Indifference
Curves
Thus,

U * x 0. 5 x y
MR S
U * y 0. 5 y x
 Convexity of Indifference
Curves
If the utility function is
U(x,y) = x + xy + y
There is no advantage to transforming
this utility function, so

U x 1 y
MR S
U y 1 x
 Convexity of Indifference
Curves
Suppose that the utility function is

utility x 2 y 2

For this example, it is easier to use the

transformation
U*(x,y) = [U(x,y)]2 = x2 + y2
 Convexity of Indifference
Curves
Thus,

U * x 2 x x
MR S
U * y 2 y y
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
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 1, 0 and
utility = U(x,y) = ln x + ln y
when = 0
Perfect substitutes = 1
Cobb-Douglas = 0
Perfect complements = -
Examples of Utility Functions
For the CES utility function, the
elasticity of substitution () is equal to
1/(1 - )
Perfect substitutes =
Fixed proportions (perfect complements)
=0
 Homothetic Preferences
If the MRS depends only on the ratio of
the amounts of the two goods, the utility
function is homothetic
Perfect substitutes
MRS is the same at every point
Perfect complements
MRS = if y/x > /
MRS is undefined if y/x = /
MRS = 0 if y/x < /
 Homothetic Preferences
For the general Cobb-Douglas function,
the MRS can be found as

1
U x x y y
MR S
U y x y
1
x
Nonhomothetic Preferences
Some utility functions do not exhibit
homothetic preferences
utility = U(x,y) = x + ln y

U x 1
MR S y
U y 1 y
 The Many-Good Case
Suppose utility is a function of n goods
given by
utility = U(x1, x2,, xn)
The total differential of U is

U U U
dU dx1 dx 2 ... dx n
x1 x 2 x n
 The Many-Good Case
We can find the MRS between any two
goods by setting dU = 0
U U
dU 0 dxi dx j
xi x j

Rearranging, we get

dx j U x i
MR S( x i for x j )
dx i U x j
 Multigood Indifference
Surfaces
We will define an indifference surface
as being the set of points in n
dimensions that satisfy the equation
U(x1,x2,xn) = k
where k is any preassigned constant
 Multigood Indifference
Surfaces
If the utility function is quasi-concave,
the set of points for which U k will be
convex
all of the points on a line joining any two
points on the U = k indifference surface will
also have U k
 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)
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
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
 Important Points to Note:
It is a simple matter to generalize from
two-good examples to many goods
studying peoples choices among many
goods can yield many insights
the mathematics of many goods is not
especially intuitive, so we will rely on two-
good cases to build intuition