Lesson 2

Utility
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).
p
• Suppose (2,3) (4,1) ~ (2,2).
• Assign to these bundles any numbers that
preserve the preference ordering;
e.g. U(2,3) = 6 > U(4,1) = U(2,2) = 4.
• Call these numbers utility levels.
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
• 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).
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).
Utility Functions
p
• U(x1,x2) = x1x2 (2,3) (4,1) ~ (2,2).
• Define V = U2.
• Then V(x1,x2) = x12x22 and
V(2,3) = 36 > V(4,1) = V(2,2) = 16
so again
p
(2,3) (4,1) ~ (2,2).
• V preserves the same order as U and so represents
the same preferences.
Utility Functions
p
• U(x1,x2) = x1x2 (2,3) (4,1) ~ (2,2).
• Define W = 2U + 10.
• Then W(x1,x2) = 2x1x2+10 so
W(2,3) = 22 > W(4,1) = W(2,2) = 18. Again,
p
(2,3) (4,1) ~ (2,2).
• W preserves the same order as U and V and so
represents the same preferences.
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 .
~
Goods, Bads and Neutrals
• A good is a commodity unit which increases utility
(gives a more preferred bundle).
• A bad is a commodity unit which decreases utility
(gives a less preferred bundle).
• A neutral is a commodity unit which does not
change utility (gives an equally preferred bundle).
Goods, Bads and Neutrals
Utility
Utility
function
Units of Units of
water are water are
goods bads
x’ Water
Around x’ units, a little extra water is a neutral.

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)
Cobb-Douglas Indifference Curves
x2
All curves are hyperbolic,

asymptoting to, but never
touching any axis.
x1
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
• So, if U(x1,x2) = x11/2 x22 then
 U 1  1/ 2 2
MU1   x1 x2
 x1 2
U
MU 2   2 x11/ 2 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  dx2  0
 x1  x2
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
MRS(6,6) = - 6/6 = -1.
6
U = 36
U=8
1 6 x1
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
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
All are linear and parallel.

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
All are right-angled with vertices on a ray
from the origin.
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.
Quasi-linear Indifference Curves
x2 Each curve is a vertically shifted copy of the others.
x1
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?
Utility
2x Functions
MRS = Each curve is a vertically shifted copy of the others.
- f(x1’)
MRS = -f(x1”) MRS is a constant

along any line for which x1 is
constant.
x 1’ x 1” x1
OPTIMAL CHOICE
1. Choice
- Optimal choice
- Consumer demand
- Implication of MRS conditions
29
Economic Rationality
• The principal behavioral postulate is that a decisionmaker
chooses its most preferred alternative from those available
to it.
• The available choices constitute the choice set.
• How is the most preferred bundle in the choice set located?
Rational Constrained Choice
x2
x1
Utility x2
x1
Utility x2
x1
Utility
x2
x1
Utility
x2
x1
Utility
x2
x1
Utility
x2
x1
Utility
Affordable, but not

the most preferred
affordable bundle.
x2
x1
Utility The most preferred

of the affordable
bundles.
Affordable, but not
the most preferred
affordable bundle.
x2
x1
Utility
x2
x1
Utility
x2
x1
x2
Utility
x1
x2
Utility
x1
x2
Affordable
bundles
x1
x2
More preferred
bundles
Affordable
bundles
x1
x2
More preferred
bundles
Affordable
bundles
x1
x2
x2*
x1* x1
x2 (x1*,x2*) is the most
preferred affordable
bundle.
x2*
x1* x1
• The most preferred affordable bundle is called the
consumer’s ORDINARY DEMAND at the given prices and
budget.
• Ordinary demands will be denoted by
x1*(p1,p2,m) and x2*(p1,p2,m).
• When x1* > 0 and x2* > 0 the demanded bundle is INTERIOR.
• If buying (x1*,x2*) costs $m then the budget is exhausted.

x2 (x1*,x2*) is interior.
(x1*,x2*) exhausts the

budget.
x2*
x1* x1
x2 (x1*,x2*) is interior.
(a) (x1*,x2*) exhausts the
budget; p1x1* + p2x2* = m.
x2*
x1* x1
x2 (x1*,x2*) is interior .
(b) The slope of the indiff.
curve at (x1*,x2*) equals
the slope of the budget
constraint.
x2*
x1* x1
• (x1*,x2*) satisfies two conditions:
• (a) the budget is exhausted;
p1x1* + p2x2* = m
• (b) the slope of the budget constraint, -p1/p2,
and the slope of the indifference curve
containing (x1*,x2*) are equal at (x1*,x2*).
Computing Ordinary Demands - a Cobb-
Douglas Example.
• Suppose that the consumer has Cobb-Douglas preferences.
U( x1 , x 2 )  x1a xb2
• Then
U
MU1   ax1a  1xb2
 x1
U
MU2   bx1axb2  1
 x2
Douglas Example.
• So the MRS is
dx 2  U/ x1 ax1a  1xb2 ax 2

MRS     .
dx1  U/ x 2 a b  1 bx1
bx1 x 2
Douglas Example.
• So the MRS is
dx 2  U/ x1 ax1a  1xb2 ax 2

MRS     .
dx1  U/ x 2 a b  1 bx1
bx1 x 2
• At (x1*,x2*), MRS = -p1/p2 so
Douglas Example.
• So the MRS is
dx 2  U/ x1 ax1a  1xb2 ax 2

MRS     .
dx1  U/ x 2 a b  1 bx1
bx1 x 2
• At (x1*,x2*), MRS = -p1/p2 so
ax*2 p1 * bp1 *
   x2  x1 . (A)
bx*1 p2 ap 2
Douglas Example.
• (x1*,x2*) also exhausts the budget so
p1x*1  p 2x*2  m. (B)

Douglas Example.
• So now we know that
* bp1 *
x2  x1 (A)
ap 2
p1x*1  p 2x*2  m. (B)
Douglas Example.
* bp1 *
x2  x1 (A)
ap 2
Substitute
p1x*1  p 2x*2  m. (B)
Douglas Example.
* bp1 *
x2  x1 (A)
ap 2
Substitute
p1x*1  p 2x*2  m. (B)
and get
* bp1 *
p1x1  p2 x1  m.
ap2
This simplifies to ….
Douglas Example.
am
x*1  .
( a  b )p1
Douglas Example.
am
x*1  .
( a  b )p1
Substituting for x1* in

p1x*1  p 2x*2  m
then gives
bm
x*2  .
( a  b)p 2
Douglas Example.
So we have discovered that the most
preferred affordable bundle for a consumer
with Cobb-Douglas preferences
U( x1 , x 2 )  x1a xb2
is
( x*1 , x*2 )  ( am
,
bm
)
( a  b )p1 ( a  b )p2
.
• When x1* > 0 and x2* > 0

and (x1*,x2*) exhausts the budget,
and indifference curves have no
‘kinks’, the ordinary demands are obtained by solving:
• (a) p1x1* + p2x2* = y
• (b) the slopes of the budget constraint, -p1/p2, and of the
indifference curve containing (x1*,x2*) are equal at (x1*,x2*).
• But what if x1* = 0?
• Or if x2* = 0?
• If either x1* = 0 or x2* = 0 then the ordinary demand (x1*,x2*)
is at a corner solution to the problem of maximizing utility
subject to a budget constraint.

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Lesson 2

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Utility

x’ p x” U(x’) < U(x”)

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

Around x’ units, a little extra water is a neutral.

U(x1,x2) = x1a x2b

with a > 0 and b > 0 is called a Cobb-Douglas utility function.

All curves are hyperbolic,

What do the indifference curves for this “perfect substitution” utility

All are linear and parallel.

What do the indifference curves for this “perfect complementarity”

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

MRS = -f(x1”) MRS is a constant

Affordable, but not

Utility The most preferred

• If buying (x1,x2) costs $m then the budget is exhausted.

(x1,x2) exhausts the

dx 2  U/ x1 ax1a  1xb2 ax 2

dx 2  U/ x1 ax1a  1xb2 ax 2

dx 2  U/ x1 ax1a  1xb2 ax 2

p1x1  p 2x2  m. (B)

Substituting for x1* in

• When x1* > 0 and x2* > 0

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