Ch4 Utility

Chapter Four
Utility
Objective of this Chapter
 Convert preferences into utility
functions.
 Calculate MRS
Preferences - A Reminder
x
p y: x is preferred strictly to y.
 x ~ y: x and y are equally preferred.
 x f y: x is preferred at least as
~
much as is y.
 Completeness: For any two bundles
x and y it is always possible to state
either that
x f y
or that
~
y f x.
~
 Reflexivity:Any bundle x is always
at least as preferred as itself; i.e.
x f x.
~
 Transitivity: If
x is at least as preferred as y, and
y is at least as preferred as z, then
x is at least as preferred as z; i.e.
x f y and y f
~ z x f z.
~
~
Utility Functions
A preference relation that is
complete, reflexive, transitive and
continuous can be represented by a
continuous utility function.
 Continuity means that small changes
to a consumption bundle cause only
small changes to the preference
level.
Utility Functions
A utility function U(x) represents a
preference relation f ~ if and only if:
p
x’ x” U(x’) > U(x”)
x’ p x” U(x’) < U(x”)
x’ ~ x” U(x’) = U(x”).
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.
Utility Functions & Indiff. Curves
 Consider the bundles (4,1), (2,3) and
(2,2).
(4,1) ~ (2,2).
p
 Suppose (2,3)
 Assign to these bundles any
numbers that preserve the
preference ordering;
e.g. U(2,3) = 6 > U(4,1) = U(2,2) = 4.
 Or U(2,3)=1023, U(4,1)=U(2,2) = 39.
 Call these numbers utility levels.
 Anindifference curve contains
equally preferred bundles.
 Equal preference  same utility level.
 Therefore, all bundles in an
indifference curve have the same
utility level.
 So the bundles (4,1) and (2,2) are in
the indiff. curve with utility level U 
 But the bundle (2,3) is in the indiff.
curve with utility level U  6.
 On an indifference curve diagram,
this preference information looks as
follows:
x2 (2,3)
p (2,2) ~ (4,1)
U6
U4
x1
 Another way to visualize this same
information is to plot the utility level
on a vertical axis.
x2
x1
x2
x1
x2
x1
x2
x1
x2
x1
x2
x1
x1
x1
x1
x1
x1
x1
x1
x1
x1
x1
 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
 There is no unique utility function
representation of a preference
relation.
 Suppose U(x1,x2) = x1x2 represents a
preference relation.
 Draw IC with U(x1,x2) =10.
Utility Functions
 Now consider a new utility function.
 V(x1,x2) = U2(x1,x2) = x12x22
 Draw IC with V(x1,x2) =100.
 It generates the same IC as the
previous slide (see next slide).
 Only the utility value changes. That
is not important. Like measuring
temperature in Celsius or Fahrenheit
Utility Functions
 Underlying preferences unchanged
by monotonically increasing
transformation of utility function (eg.
V = U2, V = 2U, V = 10U3 etc.
 Generates same ICs (preference
ordering). If two bundles equally
liked under U, also equally liked
under V.
 This is another sense in which utility
is an ordinal concept, not cardinal.
Utility Functions
 If
– U is a utility function that
represents a preference relation f ~
and
– f is a strictly increasing function,
 then V = f(U) is also a utility function
representing f .
~
Some Other Utility Functions and
Their Indifference Curves
 Instead of U(x1,x2) = x1x2 consider
V(x1,x2) = x1 + x2.
What do the indifference curves for

this “perfect substitution” utility
function look like?
Perfect Substitution Indifference
Curves
x2
x1 + x2 = 5
13
x1 + x2 = 9
9
x1 + x2 = 13
5
V(x1,x2) = x1 + x2.
5 9 13 x1
Perfect Substitution Indifference
Curves
x2
x1 + x2 = 5
13
x1 + x2 = 9
9
x1 + x2 = 13
5
V(x1,x2) = x1 + x2.
5 9 13 x1
All are linear and parallel.
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?
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
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.
Generalization of Three
Important Utility Functions
 We now generalize the three
examples of utility functions we have
seen.
– Cobb-Douglas utility function
– Perfect Substitutes
– Perfect Complements
Cobb-Douglas Indifference
x2 Curves
x1
Calculating MRS
 MRS: Slope of Indifference Curves
 Calculate MRS using utility functions
 Introduce Marginal Utilities (MU)
Marginal Utilities
 Marginal means “incremental”.
 The marginal utility of commodity i is
the rate-of-change of total utility as
the quantity of commodity i
consumed changes; i.e.
U
MU i 
 xi
Marginal Utilities
 E.g. if U(x1,x2) = x11/2 x22 then
 U 1  1/ 2 2
MU1   x1 x 2
 x1 2
Marginal Utilities
 E.g. if U(x1,x2) = x11/2 x22 then
 U 1  1/ 2 2
MU1   x1 x 2
 x1 2
Marginal Utilities
 E.g. if U(x1,x2) = x11/2 x22 then
U 1/ 2
MU 2   2 x1 x2
 x2
Marginal Utilities
 E.g. if U(x1,x2) = x11/2 x22 then
U 1/ 2
MU 2   2 x1 x2
 x2
Marginal Utilities
 So, if U(x1,x2) = x11/2 x22 then
 U 1  1/ 2 2
MU1   x1 x2
 x1 2
U 1/ 2
MU 2   2 x1 x2
 x2
Marginal Utilities and Marginal
Rates-of-Substitution
 The general equation for an
indifference curve is
U(x1,x2)  k, a constant.
Totally differentiating this identity gives
U U
dx1  dx 2  0
 x1  x2
U U
dx1  dx 2  0
 x1  x2
rearranged is
U U
dx 2   dx1
 x2  x1
And U U
dx 2   dx1
 x2  x1
rearranged is
d x2  U /  x1
 .
d x1  U /  x2
Thus,
Marg. Utilities & Marg. Rates-of-
Substitution; 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
Marg. Utilities & Marg. Rates-of-
Substitution; An example
x2
x2 U(x1,x2) = x1x2; MRS  
x1
8 MRS(1,8) = - 8/1 = -8
6 MRS(6,6) = - 6/6 = -1.
U = 36
U=8
1 6 x1
A Fourth Important Utility
Function: Quasi-Linear Utility
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.
Marg. Rates-of-Substitution 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
 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?
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

Ch4 Utility

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Ch4 Utility

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Chapter Four

x’ p x” U(x’) < U(x”)

What do the indifference curves for

What do the indifference curves for

is linear in just x2 and is called quasi-

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