Utility

ECON201- MICROECONOMICS
SPRING 2023
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Consumer Theory
• We consider a rational consumer.
• We address the following two questions:
• Which combinations of goods is the consumer able to buy?
• Among the combinations of goods that the consumer is able to buy, which
combination(s) does the consumer prefers to buy?

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Today’s goal
• Can we generate a utility function from preferences?

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Today’s goal
• Can we generate a utility function from preferences?
• Consider a set of preferences ≿ on a choice set X (i.e., the set of
different bundles of goods)
• Can we build a utility function u that represents (or contains the
same information as) ≿ ?

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Today’s goal
• Can we generate a utility function from preferences?
• Consider a set of preferences ≿ on a choice set X (i.e., the set of
different bundles of goods)
• Can we build a utility function u that represents (or contains the
same information as) ≿ ?
• Find a way of assigning utility numbers to bundles such that, for any
two bundles x and y,

x ≿ y if and only if u(x) ≥ u(y)

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From Preferences to Utility Functions
• Can we build a utility function u that represents (or contains the
same information as) ≿ ?
• Yes, as long as the preference relation is complete, reflexive,
transitive!

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From Preferences to Utility Functions
• Can we build a utility function u that represents (or contains the
same information as) ≿ ?
• Yes, as long as the preference relation is complete, reflexive,
transitive!

• Technical note: If the choice set is an uncountable set, then we also

need continuity of preferences.
Ø Continuity means that small changes to a consumption bundle cause only
small changes to the preference level.

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From Preferences to Utility Functions
• A utility function u(x) represents a preference relation if and only if:

xʹ ≿ xʺ ⇔ u(xʹ) ≥ u(xʺ)

xʹ ≻ xʺ ⇔ u(xʹ) > u(xʺ)

xʹ ~ xʺ ⇔ u(xʹ) = u(xʺ)

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From Preferences to Utility Functions
• Suppose there are three alternative bundles x,y and z, and consider
your preferences ≿ over these bundles
• Say, a utility function u(.) that represents these preferences are the
following:
u(x)= 1, u(y)= 2, u(z)= 3
• Does it mean anything that the utility of z is three times the utility of
x?

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From Preferences to Utility Functions
• Suppose there are three alternative bundles x,y and z, and consider your
preferences ≿ over these bundles
• Say, a utility function u that represents these preferences are the following:
u(x)= 1, u(y)= 2, u(z)= 3
• Does it mean anything that the utility of z is three times the utility of x?
• Consider instead the following utility numbers
u(x)= 1, u(y)= 1.9, u(z)= 2

• These represent the same preferences!

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From Preferences to 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 numbers do not have a cardinal meaning
• The difference between the numbers does not matter
• Therefore, many different utility functions represent the same
preferences!

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From Preferences to 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 numbers do not have a cardinal meaning
• The difference between the numbers does not matter
• Therefore, many different utility functions represent the same
preferences!
• Can we determine the relationship between utility functions that
represent the same preferences?

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From Preferences to Utility Functions
Theorem: Consider two utility functions u and v. They both represent
the same preferences if and only if there is a strictly increasing
function f such that
v(x)=f(u(x)) for all x.

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Utility Functions & Indifference Curves
• An indifference curve contains equally preferred bundles.
• Equal preference Þ same utility level.
• Therefore, all bundles on an indifference curve have the same utility
level.
• We have one utility level for each indifference curve.

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Utility Functions & Indifference Curves
• 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; e.g.,

• Call these numbers utility levels.

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Utility Functions & Indifference Curves

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Utility Functions & Indifference Curves

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Utility Functions & Indifference Curves

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Utility Functions & Indifference Curves
• Comparing more bundles will create a larger collection of all
indifference curves and a better description of the consumer’s
preferences.
• This complete collection of indifference curves completely
represents the consumer’s preferences.

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Utility Functions & Indifference Curves

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Utility Functions & Indifference Curves

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Utility Functions & Indifference Curves
• The collection of all indifference curves for a given preference
relation is an “indifference map.”
• An indifference map is equivalent to a utility function.

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Utility Functions
• There is no unique utility function representation of a preference
relation.

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Utility Functions
• There is no unique utility function representation of a preference
relation.
• Suppose u(x1, x2)= x1x2 represents a preference relation.
• Can you use this utility function to rank the bundles (4,1), (2,3), and
(2,2)?

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Utility Functions
• There is no unique utility function representation of a preference
relation.
• Suppose u(x1, x2)= x1x2 represents a preference relation.
• Can you use this utility function to rank the bundles (4,1), (2,3), and
(2,2)?

• u(2,3)=6 > u(4,1)=u(2,2)=4 (2,3) ≻ (4,1) ~ (2,2)

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Utility Functions
• u(x1, x2)= x1x2 Þ (2,3) ≻ (4,1) ~ (2,2)
• Define V=u2. This implies V(x1, x2)= x12 x22 represents the same
preference relation.
• V(2,3)=36 > V(4,1)=V(2,2)=16
• (2,3) ≻ (4,1) ~ (2,2)
• V preserves the same order as u and therefore represents the same
preferences.

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Utility Functions
• u(x1, x2)= x1x2 Þ (2,3) ≻ (4,1) ~ (2,2)
• Define V=u2. This implies V(x1, x2)= x12 x22 represents the same
preference relation.
• V(2,3)=36 > V(4,1)=V(2,2)=16
• (2,3) ≻ (4,1) ~ (2,2)
• V preserves the same order as u and therefore represents the same
preferences.
• Define W=2u+5. Does W preserve the same order as u?

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Utility Functions
• Reformulation of the earlier theorem:
• 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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Utility Functions & Indifference Curves
• u(x1, x2)= x1x2

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Some Other Utility Functions
• Can you draw the indifference curves for the utility function u(x1, x2)=
x1+ x2?

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Perfect Substitution Indifference Curves

All are linear and parallel.

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Some Other Utility Functions
• Can you draw the indifference curves for the utility function u(x1, x2)=
min{x1, x2} ?

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Perfect-Complementarity Indifference Curves

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 Marginal Utilities and Marginal Rates of
Substitution
• Marginal Rate of Substitution (MRS)
• Slope of the indifference curve
• Rate at which you would change one good for another while remaining indifferent
• How can we calculate the MRS from utility functions?

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 Marginal Utilities and Marginal Rates of
Substitution
• Marginal Utility
• The rate at which utility changes with the quantity of one good, keeping the other
constant
• The partial derivative of the utility function
• Recall that 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.

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 Marginal Utilities and Marginal Rates of
Substitution
• The general equation for an indifference curve is u(x1, x2)≡k, where k is a
constant.
• Totally differentiating this identity yields:

• Rearranging the terms:

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MU and MRS: An Example
• Suppose u(x1, x2)= x1x2. Calculate MU for each good and the MRS.

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MU and MRS: An Example

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Monotonic Transformations & MRS
• 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 & MRS
• Recall that for u(x1, x2)= x1x2 , MRS= -x2/x1.
• Define V=u2. What is the MRS for V?

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Monotonic Transformations & MRS
• More generally, if V = f (u) where f is a strictly increasing function,
then the MRS remains unchanged by this positive monotonic
transformation.

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 Remark on MU and MRS
• Marginal Utility – depends on the specific utility function used
• Not very meaningful
• Marginal Rate of Substitution – does not depend on the specific utility
function used
• All utility functions which represent the same preferences yield the same MRS
• Behaviorally meaningful

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Two other utility functions
• A utility function of the form u(x1, x2)= x1a x2b, with a>0 and b>0, is
called a “Cobb-Douglas” utility function.
• A utility function of the form u(x1, x2)=f(x1)+ x2, where f(.) is possibly
a non-linear function is called a “quasi-linear” utility function.
• Can you compute MUs and the MRS for each function?

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