Utility

Dr. Leon Vinokur

ECN 111 – Microeconomics 1
Lecture 3

1
 Objectives
• Last week we looked at a person’s preferences
• This week we think about how these
preferences can be represented by a utility
function

2
 Utility Functions
• Utility is an ordinal (i.e. ordering) concept.
• E.g. if U(x) = 6 and U(y) = 2, then bundle x is
strictly preferred to bundle y. But x is not
preferred three times as much as is y.
• Since only the ranking of the bundles matter,
there is no unique way to assign utility
numbers to the various bundles.

3
 Only the ranking matters
Bundle U1 U2 U3
A 3 17 -1
B 2 10 -2
C 1 .002 -3

Each of these are valid utility functions

that describe the same preferences: A is
always strictly preferred to B and B to C.
4
 Monotonic Transformations
• 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.
• A monotonic transformation of a utility function is a
utility function that represents the same preferences as
the original utility function.
• Thus, infinite set of ways to represent a set of
preferences.
• Examples of monotonic transformations?
– Multiplying by a positive number
– Adding any number
– Raising to an odd power 5
 Review Question
Which function is not a monotonic
transformation of the others?

1. U=x+y
2. U = 3(x + y)
3. U = (x + y) + 30
4. U = ln(x + y)
5. U = -(x + y)

6
 Cardinal vs. Ordinal Utility
• Theories of utility that attach significance to magnitude of
utility are cardinal utility theories.
• How much more utility does A give you than B?
• But, how can you tell if you like one bundle twice as much as
another?
– Are you willing to pay twice as much for it?
– Run twice as far or wait twice as long to get it?
• These are feasible, but not particularly compelling
interpretations of “like one bundle twice as much”.
• To know whether one bundle or another is chosen, we only
need to know which is preferred.
– Knowing how much larger utility is does not add to description of
choice. 7
Utility Functions & Indiff. Curves

x2 (2,3)
p
(2,2) ~ (4,1)

U º6
U º4

x1 8
 Utility Functions & Indiff. Curves
3D plot of consumption & utility levels for 3 bundles

Utility Utility U(2,3) = 6

U(2,2) = 4
U(4,1) = 4

x
x2
2

x
x11
9
Utility Functions & Indiff. Curves

Utility
Uº6

Uº4
x2 Higher indifference
curves contain
more preferred
bundles.
x1 10
Utility Functions & Indiff. Curves

Utility
Uº6
Uº5
Uº4
x2 Uº3
Uº2
Uº1
x1 11
 Utility Functions & Indiff. 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.

12
 Utility Functions
• There is no unique utility function
representation of a preference relation.
• Suppose U(x1,x2) = x1x2 represents a preference
relation.
• Again consider the bundles (4,1),
(2,3) and (2,2).

13
 Utility Functions
• U(x1,x2) = x1x2, so

U(2,3) = 6 > U(4,1) = U(2,2) = 4;

p
that is, (2,3) (4,1) ~ (2,2).
• How do you graph the corresponding
indifference curves?
– For each constant k, find the set of bundles
that give utility = k
14
 Utility Functions and Indifference Curves

• U(x1,x2) = x1x2, y
• U(2,3) = 6 (1, 6)

• (3,2), (1,6), (6,1),

(.5, 12)… (2, 3)

• Infinite combination of
(3, 2)
goods (if continuous (6,1)
goods) that yield U = 6 K= 6

15
 Utility Functions
p
• U(x1,x2) = x1x2 (2,3) (4,1) ~ (2,2).

• Define V = U2 (a monotonic transformation).

• Then V(x1,x2) = x12x22 and

V(2,3) = 36 > V(4,1) = V(2,2) = 16
p
so again (2,3) (4,1) ~ (2,2).

• V preserves the same order as U and so represents

the same preferences.
16
 Utility Functions
p
• U(x1,x2) = x1x2 (2,3) (4,1) ~ (2,2).

• Define W = 2U + 10 (monotonic transformation)

• Then W(x1,x2) = 2x1x2+10 so

W(2,3) = 22 > W(4,1) = W(2,2) = 18.
p
Again, (2,3) (4,1) ~ (2,2).

• W preserves the same order as U and V and so

represents the same preferences. 17
 Some Other Utility Functions and Their
Indifference Curves
• Suppose there are green and blue M&Ms.
• You are just as happy with green or blue ones. So,
it is the total number of M&Ms that determines
your utility, not the distribution of colors.
• What would this utility function look like?

V(x1,x2) = x1 + x2.

• What do the indifference curves for this “perfect

substitution” utility function look like?
18
Perfect Substitution Indifference Curves
x2
x1 + x2 = 5
13
x1 + x 2 = 9
9
x1 + x2 = 13
5
V(x1,x2) = x1 + x2.

5 9 13 x1
All are linear and parallel.
19
 Perfect Substitutes (cont’d)
• What if for every blue M&M you gave, you required two
green M&Ms to be just as satisfied?
– Blue M&Ms are twice as valuable as green ones.

• What would this utility function look like?

V(xG,xB) = xG + 2xB.

• Perfect substitutes can generally be represented as

V(x1,x2) = ax1 + bx2.

20
 Some Other Utility Functions and Their
Indifference Curves
• Instead of U(x1,x2) = x1x2 or
V(x1,x2) = x1 + x2, consider

W(x1,x2) = min{x1,x2}.

What do the indifference curves for this “perfect

complementarity” utility function look like?
• Your utility is determined by the number of
complete pairs that you have.
21
Perfect Complementarity Indifference Curves
x2
45o
W(x1,x2) = min{x1,x2}

8 min{x1,x2} = 8
5 min{x1,x2} = 5
3 min{x1,x2} = 3

3 5 8 x1
All are right-angled with vertices on a ray
from the origin. 22
 Perfect Complements Generalized
• u(x1,x2) = min{ax1, bx2}
• a and b indicate the proportions in which the goods
must be consumed.
• Suppose you need 2 units of x1 and 1 unit of x2 to
have a complete ‘pair’.
• Then, the utility function would be:
u(x1,x2) = min{.5x1, x2}
• Or multiplying by 2 (monotonic transformation),
u(x1,x2) = min{x1, 2x2}
23
 Review Question
• Sophie consumes ham and eggs.
• Given the following descriptions,
– What kind of preferences does she have?
– What utility function can describe these
preferences?

24
 Sophie is just as happy with 3 slices of ham
as she is with 2 eggs.

1. Perfect substitutes: U = 3H + 2E
2. Perfect substitutes: U = 2H + 3E
3. Perfect complements: U = min{3H, 2E}
4. Perfect complements: U = min{2H, 3E}

25
Sophie will only eat 3 slices of ham if can also
have 2 eggs to go with it.

1. Perfect substitutes: U = 3H + 2E
2. Perfect substitutes: U = 2H + 3E
3. Perfect complements: U = min{3H, 2E}
4. Perfect complements: U = min{2H, 3E}

26
 Some Other Utility Functions and Their
Indifference Curves
• A utility function of the form

U(x1,x2) = f(x1) + x2

is linear in just x2 and is called quasi-linear.

• E.g. U(x1,x2) = 2x11/2 + x2.

27
 Quasi-linear Indifference Curves
x2 Each curve is a vertically shifted
copy of the others.

x1
28
 Some Other Utility Functions and Their
Indifference Curves
• Any utility function of the form

U(x1,x2) = x1a x2b

with a > 0 and b > 0 is called a Cobb-Douglas

utility function.
• E.g. U(x1,x2) = x11/2 x21/2 (a = b = 1/2)
V(x1,x2) = x1 x23 (a = 1, b = 3)
29
Cobb-Douglas Indifference Curves
x2

All curves are hyperbolic,

asymptoting to, but never
touching any axis.

x1
30
 Cobb-Douglas Indifference Curves
• Look like the nice convex monotonic
indifference curves that we called “well
behaved indifference curves”
• Will generally use Cobb-Douglas preferences a
fair bit.

31
 Marginal Utility
• Marginal Utility tells us how a consumer’s utility changes
as we give him a little more of one good.
• The marginal utility with respect to good 1 is the rate of
change in utility (U) associated with a small change in
the amount of good 1 (x1), holding the amount of good 2
fixed.
U u  x1  x1 , x2   u  x1 , x2 
MU1  
x1 x1

• The change in utility associated with a small change in x1

is thus: U = MU1x1
• Marginal utility depends on the specific utility function
and the magnitudes do not tell us anything. 32
 Typical Assumptions about Utility Functions
(Consistent with Assumptions on Preferences)
1. As long as x and y are “goods”, utility
increases as x and/or y increases.
 x is hamburgers and y is “all other goods”
 Assumption is that holding y fixed, an increase in
hamburgers results in an increase in utility level.
 In other words, marginal utility of x is positive
• Marginal utility is the change in utility associated with
increasing consumption of x, holding y constant.
• MUx > 0
• For a utility function U(x,y): MU  U  x, y 
x
x
33
Extra Assumptions about Utility Functions
2. Diminishing Marginal Utility
– As consumption of a good increases, utility
increases but at a slower and slower rate; i.e. at a
decreasing rate.
– First hamburger may be great, second hamburger
satisfying, third hamburger okay,…

3. Utility functions are continuous and smooth.

34
 What does utility curve look like?
• Why does the curve slope up?
– Assumption 1 – positive
marginal utility
utility u  x, y 
• Why is the curve bowed?
– Assumption 2 – diminishing
marginal utility
B
– MU at A > MU at B, i.e. as x
increases
A
• At A, MU is high – small
change in x yields big
x change in U.
• At B, MU is low.

35
 MRS Relationship to MU
 MU1
MRS21 
MU 2

• Where does this come from?

• Recall that MU2 is the change in utility associated
with the consumption of an additional unit of
good 2, holding good 1 constant.
– Thus, note that MU is a partial derivative.

36
MRS Relationship to MU (cont’d)
• Take away enough x2
• so that you move from f to g
– How does utility change?
x2 – Change is Δx2*MU2
• Give you enough x1 to bring you
f from g to h.
Δx2 – How does utility change?
h – Change is Δx1*MU1
g Δx U1 • What happens to total utility?
1
x1 – ΔU=0 (f and h on same curve)
• ΔU = 0 = Δx2*MU2 + Δx1*MU1

37
 MRS Relationship to MU (cont’d)
• ΔU = 0 = Δx2*MU2 + Δx1*MU1
• Rearrange terms:

x2  MU1
MRS21  
x1 MU 2

• The negative of the slope of the indifference

curve equals ratio of marginal utilities.
38
Determining Relationship Between MU and
MRS Using Calculus
• The general equation for an indifference curve
is
U(x1,x2) º k, a constant.
Totally differentiating this identity gives
U U
dx1  dx2  0
 x1  x2

39
Marginal Utilities and Marginal Rates-of-
Substitution

U U
dx1  dx2  0
 x1  x2
rearranged is
U U
dx2   dx1
 x2  x1

40
Marginal Utilities and Marginal Rates-of-
Substitution

And U U
dx2   dx1
 x2  x1
rearranged is
d x2  U /  x1
 .
d x1  U /  x2
This is the MRS.

41
 MU and MRS – An example
• Suppose U(x1,x2) = x1x2. Then
U
 (1)( x2 )  x2
 x1
U
 ( x1 )(1)  x1
 x2
d x2  U /  x1 x2
so MRS    .
d x1  U /  x2 x1
42
 MRS for Quasi-linear Utility Functions

• A quasi-linear utility function is of the form

U(x1,x2) = f(x1) + x2.
U U
 f ( x1 ) 1
 x1  x2
d x2  U /  x1
so MRS     f  ( x1 ).
d x1  U /  x2

43
 MRS for Quasi-linear Utility Functions

• MRS = - f’(x1) does not depend upon x2

• So the slope of indifference curves for a quasi-
linear utility function is constant along any line
for which x1 is constant.
• What does that make the indifference map for
a quasi-linear utility function look like?

44
 Marg. Rates-of-Substitution for Quasi-linear
Utility Functions
x2
MRS = Each curve is a vertically
- f(x1’) shifted copy of the others.
MRS = -f(x1”) MRS is a
constant
along any line
for which x1 is
constant.

x1’ x1” x1
45
 In – class exercises
• Calculate MRS for the following utility
functions.
U = ln(x) + ln(y)
U = xy
U = 3x¼y¾

46
Monotonic Transformations & MRS
• Recall that 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?

47
Monotonic Transformations & MRS
• For U(x1,x2) = x1x2 the MRS = - x2/x1.
• Create V = U2; i.e. V(x1,x2) = x12x22. What is the MRS for
V? (Note that for this to be monotonic transformation,
x1 and x2 must be positive.)
2
 V /  x1 2 x1 x2 x2
MRS    
 V /  x2 2
2 x1 x2 x1

• This is the same as the MRS for U.

• Even though the marginal utilities change in
magnitude, the ratio of marginal utilities does not
change.
48
 To keep in mind from this lecture
1. Ordinal Utility
2. Relationship between utility functions and
indifference curves
3. Monotonic transformations
4. Types of preferences: perfect substitutes,
complements, quasi-linear, cobb-douglas
5. Marginal Utility (MU)
6. Relationship between MU and MRS
49