Chapter:4

Utility Functions

Consumers make choices so as to maximize their utility. The theory of consumer behaviour has
been entirely reformulated in terms of consumer preferences. Utility is seen only as a way to
describe preferences. All that mattered about utility as far as choice behaviour was concerned
was whether one bundle had a higher utility than another. The preferences of the consumer are
the fundamental description useful for analyzing choice, and utility is Simply a Way or
describing preferences.

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. That is, a
bundle (𝑥1 , 𝑥2 )is preferred to a bundle(𝑦1 , 𝑦2 ) if and only if the utility of(𝑥1 , 𝑥2 ) is larger than
the utility of (𝑦1 , 𝑦2 ) in symbols (𝑥1 , 𝑥2 ) > (𝑦1 , 𝑦2 ) if and only if 𝑢(𝑥1 , 𝑥2 ) > 𝑢(𝑦1 , 𝑦2 ).

 Ordinal utility: a kind of utility with the emphasis on ordering bundles of goods.
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.
They are represented by a function 𝑓(𝑢) . This means that if 𝑢1 > 𝑢2 then 𝑓(𝑢1 ) >
𝑓(𝑢2 )
The rate of change of 𝑓(𝑢). as 𝑢 changes can be measured by looking at the change in f
between two values of 𝑢, divided by the change in 𝑢 .
∆𝑓 𝑓(𝑢2 ) − 𝑓(𝑢1 )
=
∆𝑢 𝑢2 − 𝑢1
For a monotonic transformation 𝑓(𝑢2 ) − 𝑓(𝑢1 ) always has the same sign as 𝑢2 −
𝑢1 .Thus, a monotonic function always has a positive rate of change.

In monotonic transformation three statements are worthwhile.

1) 𝑢(𝑥1 , 𝑥2 ) > 𝑢(𝑦1 , 𝑦2 ) ↔ (𝑥1 , 𝑥2 ) > (𝑦1 , 𝑦2 )

2) If 𝑓(𝑢) is a monotonic transformation then (𝑥1 , 𝑥2 ) > 𝑢(𝑦1 , 𝑦2 ) ↔ 𝑓(𝑢(𝑥1 , 𝑥2 )) >
𝑓(𝑢(𝑦1 , 𝑦2 )) .
3) The function 𝑓(𝑢) represents the preferences in the same way as the original utility
function .A monotonic transformation of a utility function is a utility function that
represents the same preferences as the original utility function.

Since every bundle on an indifference curve must have the same utility, a utility function
is a way of assigning numbers to the different indifference curves in a way that higher
indifference curves get assigned larger numbers
4.1 Cardinal Utility
Cardinal utility theories are utility theories that emphasize the magnitude of utility. The
magnitude of the utility difference between two bundles of goods is meant to be
significant.
Knowing how much larger (the utility is) adds nothing to our choice description. We'll
remain with a solely ordinal utility framework because cardinal utility isn't required to
model decision behavior, and there's no compelling way to assign cardinal utilities either.

4.2 Constructing a Utility Function

A utility function cannot represent all types of preferences (e.g. intransitive Preferences).
We should be able to find a utility function to represent preferences in most cases. Using
indifference curves to create a utility function: Draw a diagonal line and mark each
indifference curve with its distance from the origin along the line. If preferences are
monotonic, the line across the origin must intersect every indifference curve precisely
once.
Thus every bundle is getting a label and those bundles on higher indifference curve
getting larger labels and that’s all it takes to be a utility function.

Monotonic is a condition to be met in order to use this kind of construction of a utility

function.
4.3 Some Examples of Utility Functions
Level set: the set of all (𝑥1 , 𝑥2 ) such that 𝑢(𝑥1 , 𝑥2 ) equals a constant (a plot of the level
set is the indifference curve).
Let suppose: 𝑢(𝑥1 , 𝑥2 ) = 𝑘
𝑘
Solving for 𝑥2 we get 𝑥2 = 𝑥 where k is a certain constant for which we would like to
1
draw the indifference curve. If we look at this expression closely it’s depicting a shape of
hyperbola. Plugging the value of 𝑘 = 1.2.3. … ..

Check for monotonic transformations: Finding a utility function that represents some
indifference curve.
Mathematically, we want to find a function that gives higher values to higher indifference
curves and is constant along each indifference curve.
Intuitive: given a set of preferences, we try to figure out what the customer is aiming to
achieve - what combination of items best characterizes the consumer's choice behavior.
Perfect Substitutes
What matters is the total amount of goods 𝑢(𝑥1 , 𝑥2 ) = 𝑥1 + 𝑥2
1) The function is constant along the indifference curves.
2) The function assigns higher values to more preferred bundles.
Of course, this isn’t the only utility function that we could use. We could also use the
square of the number of pencils. Thus the utility function 𝑢(𝑥1 , 𝑥2 ) = (𝑥1 + 𝑥2 )2 =
𝑥1 2 + 2𝑥1 𝑥2 + 𝑥2 2 ) will also represent the perfectsubstitutes preferences, as would any
other monotonic transformation of 𝑢(𝑥1 , 𝑥2 ).
Substitution at a rate different from one-to-one
In general preferences for perfect substitutes can be represented by a utility function of
the form = 𝛼𝑥1 + 𝑏𝑥2 . 𝛼 𝑎𝑛𝑑 𝑏 are some positive numbers the measure the value of
good 1 and 2 to the consumers. The slope for this particular utility function could be find
𝛼
by − 𝑏 .
Perfect Complements
This is the left shoe–right shoe case. In these preferences the consumer only cares about
the number of pairs of shoes he has, so it is natural to choose the number of pairs of shoes
as the utility function. The number of complete pairs of shoes that you have is the
minimum of the number of right shoes you have,𝑥1 , and the number of left shoes you
have, 𝑥2 .
Thus the utility function: 𝑢 = 𝑚𝑖𝑛{𝑥1 𝑥2 }
In general, a utility function that describes perfect-complement preferences is given by
𝑢 = 𝑚𝑖𝑛{𝛼𝑥1 𝑏𝑥2 }
Where a and b are some positive numbers that indicate the proportions in which the
goods are consumed.
Quasilinear Preferences:
Each indifference curve is a vertically shifted version of a single indifference curve.
Indifference curves that are vertical translates of one another . The equation for an
indifference curve takes the form 𝑥2 = 𝑘 − 𝑣(𝑥1 )
Where 𝑘 is a different constant on each indifference curve: This equation says that the
height of each indifference curve is some function of 𝑥1 − 𝑣(𝑥1 )plus a constant 𝑘. Higher values
of 𝑘 give higher indifference curves. (The minus sign is only a convention; we’ll see why it is
convenient below.)

Quasilinear utility functions: are partly linear utility functions 𝑢 = √𝑥1 + 𝑥2 . Linear in 𝑥2
these are not realistic but easy to work.
MRS is level dependent in case of quasilinear preferences.
Cobb-Douglas: utility function which is given in the form of 𝑢 = 𝑥1 𝑐 𝑥2 𝑑 where c and d
are positive numbers that describe the preferences of the consumer. Cobb-Douglas
indifference curves: different values of the parameters c and d lead to different shapes of
the indifference curves.
Some monotonic transformations:
 Someone can take a natural log : 𝑢 = ln(𝑥1 𝑐 𝑥2 𝑑 ) = 𝑐𝑙𝑛(𝑥1 ) + 𝑑𝑙𝑛(𝑥2 ) raising utility to
1 𝑐 𝑑
𝑐 𝑑
the power 𝑢𝑐+𝑑 = 𝑥1 𝑐+𝑑 𝑥2 𝑐+𝑑 we can use different notions 𝑐+𝑑 = 𝛼 and 𝑐+𝑑 = 𝑏
So 𝑢 = 𝑥1 𝛼 𝑥2 𝑏
In this way the exponent always sum to one 𝛼 + 𝑏 = 1
We define a new number
4.4 Marginal Utility
Marginal utility: the rate at which consumers utility changes when we give him or her a
little more of one good.
∆𝑈 𝑢(𝑥1 + ∆𝑥1 , 𝑥2 ) − 𝑢(𝑥1 𝑥2 )
𝑀𝑈1 = =
∆𝑥1 ∆𝑥1
𝑀𝑈1 as being a ratio that measure the rate of change in utility (∆𝑢) associated with a
small change in the amount of good 1 ∆𝑥1 . Note that the amount of good 2 is held fixed
in this calculation.
∆𝑢 = 𝑀𝑈𝑥1 ∗ ∆𝑥1 𝑜𝑟 ∆𝑢 = 𝑀𝑈𝑥2 ∗ ∆𝑥2

The magnitude of marginal utility depends on the magnitude of utility

4.5 Marginal Utility and the MRS
0 = 𝑀𝑈𝑥1 ∗ ∆𝑥1 + 𝑀𝑈𝑥2 ∗ ∆𝑥2

Solving for the slope of the indifference curve we have:

∆𝑥2 𝑀𝑈𝑥1
𝑀𝑅𝑆 = =−
∆𝑥1 𝑀𝑈𝑥2

The algebraic sign of the MRS is negative: if you get more of good 1 you have to get less of
good 2 in order to keep the same level of utility. The MRS can be measured by observing a
person’s actual behavior.

∆𝑥2 𝑀𝑈𝑥2
𝑀𝑅𝑆 = = −
∆𝑥1 𝑀𝑈𝑥1

MRS remains the same when monotonic transformations occur. Even though the marginal are
utilities are changed by monotonic transformations, the ratio of marginal utilities is independent
of the particular way chosen to represent the preferences.