Preferences & Utility

Dr Seefat-E-Rabbi Khan
Email: seefat-e-rabbi.khan@city.ac.uk

City, University of London: Department of Economics

Rationality in Economics
Behavioral Postulate:
• A decision maker always chooses his or her most preferred alternative
from his or her set of available options. So, to understand model choice,
we must first model decision maker preferences.

Example: Choice of car.

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Preference Relations – 1
Comparing two different consumption bundles x and y:
• Strict preference: x is preferable than y.
• Weak preference: x is at least as preferable as y.
• Indifference: x and y are equally preferable.

Strict preference, weak preference, and indifference are all preference

relations.
Note: They are ordinal relations i.e., they state only the order in which
bundles are preferred.

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Preference Relations – 2
≻ denotes strict preference.
➢ x ≻ y means that bundle x is strictly preferred to bundle y.
~ denotes indifference.
➢ x ~ y means that the individual is indifferent between bundles x and y.
≿ denotes weak preference.
➢ x ≿ y means that bundle x is preferred at least as much as is bundle y.

Remember:
➢ x ≿ y and y ≿ x imply x ~ y.

➢ x ≿ y and (not y ≿ x) imply x ≻ y.

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Assumptions about Preference Relations – 1
Completeness: For any two bundles x and y, it is always possible to make
the statement that either
x≿y
or
y ≿ x.

Example: A consumer chooses between apples (A) and oranges (O). There
only exists 3 possibilities: A preferred to O; O preferred to A; or indifferent
between A and O.

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Assumptions about Preference Relations – 1
Reflexivity: Any bundle x is always at least as preferred as itself i.e.,
x ≿ x.

Example: A consumer likes one apple and one orange a day at least
as well as one orange and one apple.

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Assumptions about Preference Relations – 3
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 ≿ y and y ≿ z ⇒ x ≿ z.

Example: A consumer chooses between apples (A), oranges (O), and bananas
(B). If she prefers A to O, and O to B, then we also know that she prefers A to B.

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Indifference Curves – 1
Consider a particular bundle, xʹ. The set of all bundles equally preferred to xʹ is
the indifference curve containing xʹ.
Since an indifference “curve” is not always a curve a better name might be an
indifference “set.”

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Indifference Curves – 2

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Indifference Curves – 3

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Indifference Curves Cannot Intersect

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Slopes of Indifference Curves – 1
If more of a commodity is always preferred to less, then the commodity is a
“good.”
➢ If every commodity is a good, then indifference curves are negatively
sloped.

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Slopes of Indifference Curves – 2

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Slopes of Indifference Curves – 3
If less of a commodity is always preferred, then the commodity is a “bad.”

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Slopes of Indifference Curves – 4

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Extreme Cases of Indifference Curves: Perfect Substitutes – 1
If a consumer always regards units of commodities 1 and 2 as equivalent,
then the commodities are “perfect substitutes” and only the total amount of
the two commodities in bundles determines their preference rank-order.

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Extreme Cases of Indifference Curves: Perfect Substitutes – 2

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Extreme Cases of Indifference Curves: Perfect Complements – 1
If a consumer always consumes commodities 1 and 2 in fixed proportion (e.g.,
one-to-one), then the commodities are “perfect complements” and only the
number of pairs of units of the two commodities determines the preference
rank-order of bundles.

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Extreme Cases of Indifference Curves: Perfect Complements – 2

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Preferences Exhibiting Satiation
A bundle strictly preferred to any other is a “satiation point” or a “bliss point.”

Example: Making the perfect pepperoni pizza.

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Indifference Curves Exhibiting Satiation – 1

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Indifference Curves Exhibiting Satiation – 2

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Indifference Curves for Discrete Commodities
• A commodity is “infinitely divisible” if it can be acquired in any quantity.
For e.g., water or cheese.
• A commodity is “discrete” if it comes in unit lumps of 1, 2, 3, . . . and so on.
For e.g., aircraft, ships, and refrigerators.

➢ Suppose commodity 2 is an infinitely divisible good (gasoline) while

commodity 1 is a discrete good (aircraft). What do the indifference
“curves” look like?

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Indifference Curves with a Discrete Good

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Well-Behaved Preferences
A preference relation is “well-behaved” if it is both:
• Monotonic
• Convex

Monotonicity: More of any commodity is always preferred (i.e., no

satiation and every commodity is a good).

Convexity: Mixtures of bundles are (at least weakly) preferred to

the bundles themselves. For e.g., the 50-50 mixture of the bundles
x and y is z is at least as preferred as x or y.

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Well-Behaved Preferences: Convexity – 1

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Well-Behaved Preferences: Convexity – 2

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Non-Convex Preferences

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Slopes of Indifference Curves
The slope of an indifference curve is its “marginal rate of substitution” (MRS).
➢ How can a MRS be calculated?

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Marginal Rate of Substitution – 1

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Marginal Rate of Substitution – 2

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MRS and Indifference Curve Properties – 1

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MRS and Indifference Curve Properties – 2

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Utility Functions
A preference relation that is complete, reflexive, transitive, and continuous can
be represented by a utility function.
• Utility is usually an ordinal (i.e., ordering) concept.
➢ For 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.

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Utility Functions & Indifference Curves – 1
Consider the bundles (4, 1), (2, 3), and (2, 2).
• Suppose (2, 3) ≻ (4, 1) ~ (2, 2).
• Assign to these bundles any numbers that preserve the preference
ordering. For e.g.,
• Call these numbers utility levels.

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Utility Functions & Indifference Curves – 2
Recall: An indifference curve contains equally preferred bundles.
• Equal preference  same utility level.
• Therefore, all bundles on an indifference curve have the same utility
level.

➢ So, the bundles (4, 1) and (2, 2) are on the indifference curve with
utility level, u = 4.
➢ But the bundle (2, 3) is on the indifference curve with utility level,
u = 6.
➢ In an indifference curve diagram, this preference information looks
as follows.

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Utility Functions & Indifference Curves – 3

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Utility Functions & Indifference Curves – 4

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Utility Functions & Indifference Curves – 5
Collection of all indifference curves for a given preference relation is called an
“indifference map.”
➢ An indifference map is equivalent to a utility function.

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Utility Functions – 2
There is no unique utility function representation of a preference relation.
➢ Suppose represents a preference relation.
➢ Again, consider the bundles (4, 1), (2, 3), and (2, 2).

➢ Since
➢

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Utility Functions – 3

• Define
➢ Then,
➢ So again,
• V preserves the same order as u and therefore represents the same
preferences.

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Utility Functions – 4

• Define
➢ Then,
➢ So again,
• W preserves the same order as u and therefore represents the same
preferences.

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Utility Functions – 5
If
• u is a utility function that represents a preference relation
and
• f is a strictly increasing function,
then V = f (u) is also a utility function representing the same preference
relation. This is known as a “monotonic transformation.”

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Some Other Utility Functions and Their Indifference Curves – 1
Instead of consider

• This utility function is an example of two goods that are perfect substitutes.
• What do the indifference curves for this “perfect substitution” utility function
look like?

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Perfect Substitution Indifference Curves

All are linear and parallel.

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Some Other Utility Functions and Their Indifference Curves – 2
Instead of consider

• This utility function is an example of two goods that are perfect

complements.
• What do the indifference curves for this “perfect complementarity”
utility function look like?

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Perfect-Complementarity Indifference Curves

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Some Other Utility Functions and Their Indifference Curves – 3
A utility function of the form is linear in just x2
and is called “quasi-linear.”
➢ For e.g.,
• What do the indifference curves for this utility function look like?

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Quasi-linear Indifference Curves

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Some Other Utility Functions and Their Indifference Curves – 4
Any utility function of the form with a > 0 and b > 0
is called a “Cobb-Douglas” utility function.
➢ For e.g.,

• What do the indifference curves for this utility function look like?

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Cobb-Douglas Indifference Curves

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Marginal Utilities
Marginal means “incremental.”
Marginal utility of commodity i is the rate of change of total utility as the
quantity of commodity i consumed changes.
➢ i.e.,

So, if then:

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Marginal Utilities and Marginal Rates of Substitution

Recall: General equation for an indifference curve is

➢ k is a constant.
Totally differentiating this identity gives:

Can be rearranged algebraically to be:

➢ This is the MRS.

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MU and MRS: An Example – 1
Suppose Then:

and

So,

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MU and MRS: An Example – 2

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Monotonic Transformations & Marginal Rates of Substitution – 1
Recall: Applying a monotonic transformation to a utility function representing
a preference relation simply creates another utility function representing the
same preference relation.
➢ What happens to marginal rates of substitution when a monotonic
transformation is applied?

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Monotonic Transformations & Marginal Rates of Substitution – 2

For the
Create What is the MRS for V?

➢ This is the same as the MRS for u.

Note: More generally, if V = f (u) where f is a strictly increasing function, then
the MRS is unchanged by this positive monotonic transformation.

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Things to do
• Read Varian, H.R. 9th Ed
― Chapter 3 & 4
• Try Exercise 1

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