Walter

Nicholson | Christopher Snyder 12th edition

CHAPTER Preferences
3 and Utility
PowerPoint Slides prepared by:
V. Andreea CHIRITESCU
Eastern Illinois University
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 Utility
• Assuming: completeness, transitivity, and
continuity
– People are able to rank all possible situations
from the least desirable to the 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)

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 Utility
• Utility
– Individuals’ preferences are assumed to be
represented by a utility function of the form
U(x1, x2, . . . , xn)
• Where x1, x2,…, xn are the quantities of each of n
goods that might be consumed in a period
• This function is unique only up to an order-
preserving transformation

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3.1 More of a Good Is Preferred to Less

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 Trades and Substitution
• Indifference curve
– Shows a set of consumption bundles about
which the individual is indifferent
– All consumption bundles that the individual
ranks equally
– The bundles all provide the same level of
utility

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 Properties of Indifference Curve

• Cannot cross
y

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 Properties of Indifference Curve

• Downward sloping
y

7
 Properties of Indifference Curve

• Cannot touch axis depending on the goods

y

8
 Properties of Indifference Curve

• Bowed in
y

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 Trades and Substitution
• Marginal rate of substitution, MRS
– The negative of the slope of an indifference
curve (U1) at some point
• Marginal rate of substitution at that point
– MRS changes as x and y change
• Reflects the individual’s willingness to trade y for
x
dy
MRS = -
dx U =U1
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 3.2 A Single Indifference Curve

Quantity of y

y1

y2 U1

Quantity of x
x1 x2
The curve U1 represents those combinations of x and y from which the individual derives the
same utility. The slope of this curve represents the rate at which the individual is willing to
trade x for y while remaining equally well off. This slope (or, more properly, the negative of
the slope) is termed the marginal rate of substitution. In the figure, the indifference curve is
drawn on the assumption of a diminishing marginal rate of substitution.

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 Convexity of Indifference curves
• Convexity of indifference curves
– Indifference curves are convex
– Diminishing MRS

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 3.5 The Notion of Convexity as an Alternative
Definition of a Diminishing MRS

In (a) the indifference curve is convex (any line joining two points above U1 is also above U1).
In (b) this is not the case, and the curve shown here does not everywhere have a
diminishing MRS.
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 3.6 Balanced Bundles of Goods Are Preferred to
Extreme Bundles

If indifference curves are convex (if they obey the assumption of a diminishing MRS), then
the line joining any two points that are indifferent will contain points preferred to either of
the initial combinations. Intuitively, balanced bundles are preferred to unbalanced ones.
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Example: Utility and the MRS
• A person’s ranking of hamburgers (y) and soft
drinks (x), utility = 𝑥 · 𝑦
• An indifference curve for this function (Let U1
=10)

• MRS = -dy/dx(along U1)=100/x2

– As x rises, MRS falls
• When x = 5, MRS =
• When x = 20, MRS =
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 3.7 Indifference Curve for Utility= 𝑥·𝑦

This indifference curve illustrates the

function 10 = U = 𝑥·𝑦.
At point A (5, 20), the MRS is 4,
implying that this person is willing to
trade 4y for an additional x.
At point B (20, 5), however, the MRS
is 0.25, implying a greatly reduced
willingness to trade.

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The Mathematics of Indifference Curves
• Trade-offs: the rate at which x can be traded
for y is given by the negative of the ratio of
the ‘‘marginal utility’’ of good x to that of
good y
dy Ux
MRS = - =
dx U ( x , y )=k U y

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 Utility Functions for Specific Preferences
• Cobb-Douglas Utility, U(x,y) = xayb
– a and b are positive constants, each <1
– The relative sizes of a and b indicate the
relative importance of the goods
– Normalize so that a + b = 1
U(x,y) = xdy1-d
• Where d=a/(a+b) and 1-d=b/(a+b)

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 Utility Functions for Specific Preferences
• Perfect substitutes
– Linear indifference curves
U(x,y) = ax + by
– Where a and b are positive constants
– The MRS will be constant along the
indifference curves
• MRS = a/b along the entire indifference curve

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 Utility Functions for Specific Preferences
• Perfect complements
– L-shaped indifference curves
U(x,y) = min (ax, by)
– Where a and b are positive parameters

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 Utility Functions for Specific Preferences
• CES Utility (constant elasticity of substitution)
U(x,y) = [xd + yd]1/d , where d £ 1, d ¹ 0
– For d = 1: U(x,y) corresponds to perfect
substitutes case
– For d approaching 0: U(x,y) approaches Cobb-
Douglas
– For d approaching -¥: U(x,y) approaches the case
of perfect complements
– Monotonic transformation U* = Uδ/δ, so
U(x,y) = xd/δ+ yd/d
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 Utility Functions for Specific Preferences
• The elasticity of substitution, σ
– CES utility Þ σ = 1/(1 - d)
– Perfect substitutes Þ σ = ¥
– Perfect complements Þ σ = 0

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 3.3 Homothetic Preferences
• Utility function is homothetic
– If the MRS depends only on the ratio of the
amounts of the two goods
• Not on the total quantities of the good
• Perfect substitutes
– MRS is the same at every point
• Perfect complements
– MRS is ¥ if y/x > a/b
– MRS is undefined if y/x = a/b
– MRS is 0 if y/x < a/b

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 3.3 Homothetic Preferences
• General Cobb-Douglas function
– The MRS depends only on the ratio y/x

a -1 b
¶U ¶x a x y a y
MRS = = a b -1 = ×
¶U ¶y b x y b x

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 3.4 Nonhomothetic Preferences
• Some utility functions do not exhibit
homothetic preferences
utility = U(x,y) = x + ln y
– Good y exhibits diminishing marginal utility, but
good x does not
– The MRS diminishes as the chosen quantity of y
decreases, but it is independent of the quantity of x
consumed

¶U ¶x 1
MRS = = =y
¶U ¶y 1 y
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Practice Questions
• Consider the following Utility functions
a. U(x,y) = xy
b. U(x,y) =x ' y '
c. U(x,y) = ln x + ln y
Show that each of the these has a diminishing MRS but
they exhibit constant, increasing, and decreasing
marginal utility respectively.

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Practice Questions
• Let ≽ be a preference relation over a finite set X.
a. Show that a is minimal with respect to ≽ in X if and
only if there is no x ∈ X such that a ≻ x.
b. Give an example to show that if X is not finite then a
preference relation may have no minimal and
maximal elements in X.

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