Takeaways from Session 6

1.So, for any preference relation, we can define a utility function by using the same criteria
that we directly use to rank two bundles.

Example:- When two goods are consumed in fixed proportion and that proportion is 1:1, we
know that preference relation can be expressed as :

XRY (i.e X is at least as good as Y) iff min(𝑥1 , 𝑥2 ). ≥ min(𝑦1 , 𝑦2 ).

A utility function which will support the above preference relation is

U(x1, x2)=min(x1,x2)

The bundle with higher min (x1, x2) will be assigned higher utility values.

2. In consumer theory, the role of the utility function is to preserve the ranking corresponding
to any preference relation by assigning specific utility values. Therefore, utility function is
not unique for a specific preference relation.

3. For any preference relation, suppose U(x1, x2) is a valid utility function to rank the
bundles appropriately. We can find another utility function V(x1, x2) that does exact same
ordering/ranking.

Example:- U(x1,x2)=x1+x2

V(x1, x2)=2(x1+x2) will maintain the same ordering.

4. V(x1, x2) is called a positive monotonic transformation of U(x1,x2). A positive monotonic

transformation is a way of transforming one set of numbers into another set of numbers that
preserves the order of the numbers. Example:- multiplying by a positive number, adding a
number, raising the power by an odd number, exponential and logarithmic transformation.

5.We showed (logically argued) that positive monotonic transformation of a utility function is
also another utility function that represents the same preference.
 6. In mathematics, set of all (x1, x2) i.e. all consumption bundles such that u(x1, x2)
equals a constant is called a level set. Therefore the indifference curves are the level
sets of the utility function.

7. We showed that the positive monotonic transformation changes the labelling of the
indifference curves but the shape of the indifference curves (slope at any point and the
curvature) remain unchanged.

Example:- 𝑢(𝑥1 , 𝑥2 ) = 𝑥1 𝑥2 is a utility function. 𝑣(𝑥1 , 𝑥2 ) = 𝑥12 𝑥22 is a positive

monotonic transformation of 𝑢(𝑥1 , 𝑥2 ). One can check that the same bundle is
assigned different utility values under 𝑢(𝑥1 , 𝑥2 ) and 𝑣 (𝑥1 , 𝑥2 ). But there is no change
in the preference ordering among the bundles. No change in the shape of the
indifference curves.

8. Introduce Cobb-Douglas utility function:

𝑢(𝑥1 , 𝑥2 ) = 𝑥1𝑐 𝑥2𝑑

where c and d are positive preference parameters. Cobb-Douglas functional form is

extensively used in theoretical and practical applications.

9. By raising the power of the above utility function by (1/c+d) which is a positive
monotonic transformation of 𝑢(𝑥1 , 𝑥2 ) = 𝑥1𝑐 𝑥2𝑑 , one can show that this utility
function can be alternatively written as

𝑣 (𝑥1 , 𝑥2 ) = 𝑥1𝑎 𝑥21−𝑎

This alternative form is very useful and we will use it later. The fraction a in the
power is the share of income spent on commodity 1 and 1-a is the share of income
spent on commodity 2. These interpretations are not very clear now but will be clear
soon.

10. Define marginal utility. It measures the rate of the change in utility associated with a
small change in the amount of one commodity holding the amount of the other
commodities fixed. Therefore, in a two commodity framework, marginal utility of
commodity 1 is the rate of the change in utility associated with a small change in the
amount of the commodity 1 holding the amount of commodity 2 fixed. Similar
definition holds for the marginal utility of commodity 2.

11. Marginal utilities are partial derivatives and we show the mathematical expressions
(explained in the class).
 12. We showed that the slope of the indifference curve i.e. MRS can be expressed as ratio
𝑀𝑈
of marginal utilities i.e. 𝑀𝑅𝑆 = − 𝑀𝑈1 . MU1 and MU2 are the marginal utilities of
2
two commodities respectively (derivation explained in the class note).

13. Derivation of MU1, MU2 and MRS for Cobb-Douglas utility function. We can check
that marginal utilities and MRS is diminishing for Cobb-Douglas.

14. If marginal utilities are constant, then MRS is constant. Example:- Perfect substutes.

15. Using the Cobb-Douglas utility function, we showed that MRS is invariant to positive
monotonic transformation. Gave you a hint of the general proof. Please try to work it
out (it is there in problem set 3 as well).

Please read relevant portion from chapter 4 (Hal Varian).