CHAPTER 3

PREFERENCES
3.1 Consumer Preferences
Consumer Preference Definition Equation Example of
relationship
Strictly Preferred The consumer prefers (x1,x2) > (y1,y2) ▪If (x1,x2) ≥ (y1,y2) but
one x-bundle over the it is not the case that
y-bundle (x1,x2) ~ (y1,y2), then
(x1,x2) > (y1,y2)
Indifferent The consumer would (x1,x2) ~ (y1,y2)
be just satisfied
consuming any of the ▪ If (x1,x2) ≥ (y1,y2) and
two bundled (y1,y2) ≥ (x1,x2) then
Weakly Prefers The consumer prefers (x1,x2) ≥ (y1,y2) (x1,x2) ~ (y1,y2)
or is indifferent
between the bundles.

X is at least as
preferred as Y.

3.2 Assumption about Preferences

Assumptions on Definition Equation
Preferences
Complete Any two different (x1,x2) ≥ (y1,y2) or
bundles can be (y1,y2) ≥ (x1,x2) or
compared. (x1,x2) ~ (y1,y2)
Reflexive Any bundle is at least (x1,x2) ≥ (x1,x2)
as good/ as preferred
as itself.
Transitive If X bundle is at least If (x1,x2) ≥ (y1,y2)
as good as Y, And (y1,y2) ≥ (z1,z2),
and Y is at least as then (x1,x2) ≥ (z1,z2)
good as Z, then X is at
least as good as Z

3.3 Indifference Curves

The curve in the graph that at any point gives you the same marginal utility.
 Consumers prefer higher indifference curves because that means more of the goods
 Indifference curves are downward sloping
 Indifference curves never cross, if they do, they should be in the same curve
  The indifference curve consists of all the bundles you’d be indifferent to getting
compared to a specific bundle.
 There is one indifference curve through each possible bundle
 Indifference curve is the graphical representation

3.4 Examples of Preferences

Extreme Cases Definition Graph

Perfect Substitute The consumer is willing to The slope (Marginal Indifference

substitute one good for the Curve) is constant.
other at a constant rate.

Commodity 1 and 2 are

equivalent, only the total
amount determines the
preference order

Perfect Complements Goods that are always

consumed together at a
fixed proportion. Getting
one without the other
would not leave you better
off.

Bad Commodity that the 1 bad(anchovies), 1 good

consumer doesn’t want.
 1 bad + 1 good = trade off
2 bads = the nearer to the
origin, the more utility

2 bads

Neutrals The consumer doesn’t care

about it one way or
another

Satiation When there is overall a

best bundle and the
“closer” he is to that, the
better off he is in terms of
his preferences of goods,
the farther away, the
worse of he will be.

This is called the satiation

point/ bliss point
Discrete Good This is bought and sold
only in integer units.

3.5 Well-Behaved Indifference Curves

4 More Assumptions
  Commodities are good (no bad)
 More is better than less (Monotonic Preferences)
 There is no maximum amount of a good that the consumer desires (no satiation)
 Average are preferred to extremes (Convex Preferences)
Term Definition Graph

Monotonicity More of any commodity is

always better (before any
satiation sets in and every
commodity is a good).

Convex Set For any two points in the

set, the weighted average is
also in the set.

Weighted average We assume that an average

bundle is always better than
the two extreme bundles

Non-convex set There is a bend in the

budget line which indicates
that every good after x1*, the
budget line is flatter.

One of the goods or both has

less price after that bend.

Preferences Definition
Monotonic Consumption of more goods
Preferences mean more satisfaction.

Between two bundles, the

consumer will always choose
one where they have more of a
good without having less of the
other.
Implications in For any two points in the set,
the Graph the weighted average is also in
the set.

Convex Two goods where the consumer

Preferences prefers the
combination/average than the
extremes of those two
Strict Convexity The weighted average is strictly
preferred to the two extremes
Implications in All the weighted averages is
the Graph inside the indifference curve

Any point outside the

indifference curve gives us
more utility, any point inside
gives less utility which is why
we always want to consume the
weighted average
Non Convex Preferring to have a little bit
Preferences more of one good than the
other, or vice versa does not
want equal amounts

Implications in We get less utility from the

the Graph balance/combination, we
operate outside the utility curve
Concave Preferring to have an extreme
Preferences of the goods than an average of
combination

Implications in Any two points in the graph will

the Graph always have a weighted average
inside the graph but by
monotonicity – any point in the
graph is less desirable than
operating on the indifference
curve,
So we do not want the weighted
average and we go for the
extremes

3.6 The Marginal Rate of Substitution

MRS – The rate at which you are willing to substitute one good for the other, the slope of the
indifference curve.
As you go along that indifference curve, the MRS is always diminishing because of the
Diminishing Marginal Utility.
−MarginalUtility of x
MRS =
Marginal Utility of y
If the consumer’s preference is monotonic and convex, we can offer him a trade good 1 for good
2 at the “rate of exchange” of E. This exchange line must be tangent to the indifference curve.

3.7 Other interpretations of MRS

The slope of the indifference curve is sometimes also measures the marginal willingness to pay.
This applies specially if good 2 represents “all other goods” and is measured in dollars.
Marginal willingness to give up dollars to consume a little more of good 1 = paying dollars to
consume a little more of good 1.
Note:
Marginal – a little extra consumption
Willingness – determined by your preference
Therefore; how much you are willing to pay is not the same as the amount you are willing to pay
for some extra consumption, and how much you are willing to pay for a large change is different
from that of a marginal change.
3.8 Behaviour of MRS
Preference MRS
Perfect Substitutes Constant at -1
Perfect Complements Either 0 or infinity, nothing in between
Neutrals Everywhere infinite
Monotonicity Indifference curve = negative slope, MRS=

Strictly convex indifference curves
always involves reducing consumption of one
good to get more of the other (negative MRS)
MRS (slope of indifference curve) decreases
in absolute value as we increase x1 thus, it
exhibits the diminishing marginal rate of
substitution

Diminishing marginal rate of substitution – refers to the consumer's willingness to part with
less and less quantity of one good in order to get one more additional unit of another good. MRS
decreases as one moves down the indifference curve.
CHAPTER 4

UTILITY
Utility Function – a way of assigning a number to every possible consumption bundle such that
more-preferred bundles get assigned larger numbers than less-preferred bundles. Its property is
that it ranks the different consumption bundles but the difference in utility between two bundles
doesn’t matter. It is not a cardinal concept, but an ordinal one. (You can’t count it but you can
rank it)
It allows you to weigh the elements of the consumption bundle so you can rank them and choose.
 The marginal utility will feature a diminishing marginal utility. (It falls as you have more
of a good)

Ordinal Utility – We just assign a higher utility to the chosen bundle over the rejected bundle,
we rank them.
Monotonic transformation – a way of transforming one set of numbers into another set of
numbers in a way that preserves the order of the numbers. Always has a positive rate of change,
positive slope.
We can do this by making functions such as multiplication by a positive number, adding any
number, raising to an odd power, and so on.
Examples of the numbers after a monotonic transformation:
Bundl U1 U2 U3
e
A 3 17 -1
B 2 10 -2
C 1 .002 -3

Whatever the function, the fact the A is better than B, and B is better than C remains.
4.1 Cardinal Utility
Cardinal Utility Theories – The size of the utility difference between the two bundles of goods
is supposed to have some sort of significance.
It can be measured if, for instance, you are willing to pay twice for the good or run twice as fast
to get it, or to wait twice as long, or to gamble for it twice. But none of these is really compelling
interpretation to that statement.
This is not really needed or is not that helpful when we are making choices.
4.2 Constructing a Utility Function
We can be able to construct a Utility Function if we have “reasonable” preferences, such that all
choices are transitive (A>B>C so C  ≯ A) and we observe monotonicity (more is always better).

4.3 Some Examples of Utility Functions

 We want a utility function that assigns higher values to higher indifference curves.
 We try to think about what the consumer is trying to maximize.
Plot all the points (x1, x2), such that u(x1, x2) equals a constant called a level set. Each different
value of the constant, you get a level set.
Ex.
x1 k
k= wherein k is the constant so we derive the formula of the indifference curve as x2=
x2 x1

When making a function below, consider the ff:

 Is it constant to the indifference curve?
 Does it assign higher value to more-preferred levels?
Types Maximization Equation

Perfect Substitute – We use the monotonic We can use the following monotonic
In here, what matters transformation/function transformations:
is the total number of that will prioritize the We can simply add them: u(x1, x2) = x1+ x2
the product. total number of the Square them: u(x1, x2) = (x1+ x2)2 = x21 + 2 x1 x2 +
product. x22
Or substitute at 2:1 u(x1, x2) = 2 x1+ x2

Generally, u(x1, x2) = ax1+ bx2, a and b = positive

−a
numbers, “value” of goods, slope =
b
Perfect Complement We get the minimum u(x1, x2) = min{x1, x2}
– the consumer only number of the pairs we
cares about the pairs want to have. If 2:1 (two teaspoons of sugar, 1 coffee)
of the good he has. 1
min{x1, x2}, multiply by 2 to rid of the fraction
Ex. 2
(10,10) = 10 pairs, if so: u(x1, x2) = min{2x1, x2}
(11,10) = minimum is
still 10 pairs Generally: u(x1, x2) = min{ax1, bx2}
a & b = positive numbers, proportions of the goods
Quasilinear The utility function is The height of the indifference curve along the
Preferences – linear one good, but vertical axis = k, so we equate it to the utility.
This means that all of (possibly) nonlinear in u(x1, x2) = k = u(x1, x2).
the indifference the other; hence the e.g. u(x1, x2)= √ x1 + x2, or u(x1, x2) = ln x1 + x2
curves are name Quasilinear
just vertically utility, meaning “partly
“shifted” versions of linear”.
one indifference curve
Cobb-Douglas We can always take a u(x1, x2)= x1c, x2d where c, d = consumer’s
Preferences – monotonic preference
indifference curves transformation of the
that look well- Cobb-Douglas utility natural log of utility: v (x1, x2)= ln (x1cx2d) =
behaved, generates function that make the c ln x1 + d ln x2
well-behaved exponents sum to 1.
preferences raising it to 1/(c + d): x1c/c+d x2d/c+d so we have
c
a= the function is v (x1, x2)=x a1 x 1−a
2
c+ d
4.4 Marginal Utility
It is a derivative of the utility function with respect to one of the elements. (e.g. The marginal
utility of a cookie is the utility of the next cookie, given how many cookies you’ve had)
It answers whether you like the next unit. It is always positive because you always get some
benefit from the next unit.
The marginal utility of commodity is the rate-of-change of total utility as the quantity of
commodity consumed changes.
ΔU u(x 1+ Δx1 , x 2)−u(x 1 , x 2)
MU1 = =
Δx 1 Δx 1
MU – Marginal Utility measures the rate of change in utility (ΔU) associated with a small
change in the amount of good 1 (Δx1). Note that the amount of good 2 is held fixed in this
calculation.
4.5 Marginal Utility and MRS
A utility function u(x1, x2) can be used to measure the marginal rate of substitution (MRS).
Since MRS- slope of the indifference curve, or rate at which a consumer is just willing to
substitute a small amount of good 2 for good 1.
Solving for the slope of the indifference curve.
Δx 2 ΔMU 1
MRS = ¿−
Δx 1 ΔMU 2
Consider a change in the consumption of each good, (Δx1, Δx2), that keeps utility constant—that
is, a change in consumption that moves us along the indifference curve. Then we must have
MU1Δx1 + MU2Δx2 = ΔU = 0.
The Marginal Utility of good 1 and the change in good 1, plus the marginal utility plus the
change in good two is equal to the change in Utility which is 0 because they remain in the same
indifference curve.
4.6 Utility for Commuting
Utility function basically tells us about the preferences of the consumer. This is applied in
transportation economics too.
Usually, consumers have the choice of using public transportation or driving to work. With this,
they need to consider factors such as: x1 –travel time, x2 – waiting time, x3 –out-of-pocket costs,
x4 –comfort, x5 – convenience, and so on.
One study reports a utility function that had the form4
U(TW, T T, C) = −0.147TW − 0.0411T T − 2.24C
Where
TW = total walking time to and from bus or car
TT = total time of trip in minutes
C = total cost of trip in dollars
Given a utility function and a sample of consumers we can forecast which consumers will drive
and which consumers will choose to take the bus. This will give us some idea as to whether the
revenue will be sufficient to cover the extra cost.
Furthermore, we can use the marginal rate of substitution to estimate the value that each
consumer places on the reduced travel time.