Chapter 3

PREFERENCES AND UTILITY

MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION
WALTER NICHOLSON
Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved.
 Axioms of Rational Choice
• Completeness
– If A and B are any two situations, an
individual can always specify exactly one of
these possibilities:
• A is preferred to B
• B is preferred to A
• A and B are equally attractive
 Axioms of Rational Choice
• Transitivity
– If A is preferred to B, and B is preferred to
C, then A is preferred to C
– Assumes that the individual’s choices are
internally consistent
 Axioms of Rational Choice
• Continuity
– If A is preferred to B, then situations “close
to” A must also be preferred to B
– Used to analyze individuals’ responses to
relatively small changes in income and
prices
 Utility
• Given these assumptions, it is possible to
show that people are able to rank in order
all possible situations from least desirable
to most
• Economists call this ranking utility
– If A is preferred to B, then the utility assigned
to A exceeds the utility assigned to B
U(A) > U(B)
 Utility
• Utility rankings are ordinal in nature
– They record the relative desirability of
commodity bundles
• Because utility measures are nonunique,
it makes no sense to consider how much
more utility is gained from A than from B
• It is also impossible to compare utilities
between people
 Utility
• Utility is affected by the consumption of
physical commodities, psychological
attitudes, peer group pressures, personal
experiences, and the general cultural
environment
• Economists generally devote attention to
quantifiable options while holding
constant the other things that affect utility
– ceteris paribus assumption
 Utility
• Assume that an individual must choose
among consumption goods X1, X2,…, Xn
• The individual’s rankings can be shown
by a utility function of the form:
utility = U(X1, X2,…, Xn)
• Keep in mind that everything is being held
constant except X1, X2,…, Xn
 Economic Goods
• In the utility function, the X’s are assumed
to be “goods”
– more is preferred to less
Quantity of Y
Preferred to X*, Y*

Y*

?
Worse
than
X*, Y* Quantity of X
X*
 Indifference Curves
• An indifference curve shows a set of
consumption bundles among which the
individual is indifferent
Quantity of Y
Combinations (X1, Y1) and (X2, Y2)
provide the same level of utility

Y1

Y2 U1

Quantity of X
X1 X2
 Marginal Rate of Substitution
• The negative of the slope of the
indifference curve at any point is called
the marginal rate of substitution (MRS)
Quantity of Y

dY
MRS  
dX U U1
Y1

Y2 U1

Quantity of X
X1 X2
 Marginal Rate of Substitution
• MRS changes as X and Y change
– reflects the individual’s willingness to trade Y
for X
Quantity of Y At (X1, Y1), the indifference curve is steeper.
The person would be willing to give up more
Y to gain additional units of X

At (X2, Y2), the indifference curve

is flatter. The person would be
Y1 willing to give up less Y to gain
additional units of X
Y2 U1

Quantity of X
X1 X2
 Indifference Curve Map
• Each point must have an indifference
curve through it

Quantity of Y

Increasing utility

U3 U1 < U2 < U3
U2
U1
Quantity of X
 Transitivity
• Can two of an individual’s indifference
curves intersect?
The individual is indifferent between A and C.
Quantity of Y The individual is indifferent between B and C.
Transitivity suggests that the individual
should be indifferent between A and B

But B is preferred to A
C
because B contains more
B X and Y than A
U2
A U1
Quantity of X
 Convexity
• A set of points is convex if any two points
can be joined by a straight line that is
contained completely within the set
Quantity of Y The assumption of a diminishing MRS is
equivalent to the assumption that all
combinations of X and Y which are
preferred to X* and Y* form a convex set

Y*
U1

Quantity of X
X*
 Convexity
• If the indifference curve is convex, then
the combination (X1 + X2)/2, (Y1 + Y2)/2
will be preferred to either (X1,Y1) or (X2,Y2)
Quantity of Y
This implies that “well-balanced” bundles are preferred
to bundles that are heavily weighted toward one
commodity

Y1
(Y1 + Y2)/2
Y2 U1

Quantity of X
X1 (X1 + X2)/2 X2
 Utility and the MRS
• Suppose an individual’s preferences for
hamburgers (Y) and soft drinks (X) can
be represented by
utility  10  X  Y
• Solving for Y, we get
Y = 100/X
• Solving for MRS = -dY/dX:
MRS = -dY/dX = 100/X2
 Utility and the MRS
MRS = -dY/dX = 100/X2
• Note that as X rises, MRS falls
– When X = 5, MRS = 4
– When X = 20, MRS = 0.25
 Marginal Utility
• Suppose that an individual has a utility
function of the form
utility = U(X1, X2,…, Xn)
• We can define the marginal utility of
good X1 by
marginal utility of X1 = MUX1 = U/X1
• The marginal utility is the extra utility
obtained from slightly more X1 (all else
constant)
 Marginal Utility
• The total differential of U is
U U U
dU  dX 1  dX 2  ...  dX n
X1 X 2 X n

dU  MUX dX1  MUX dX 2  ...  MUX dXn

1 2 n

• The extra utility obtainable from slightly

more X1, X2,…, Xn is the sum of the
additional utility provided by each of
these increments
 Deriving the MRS
• Suppose we change X and Y but keep
utility constant (dU = 0)
dU = 0 = MUXdX + MUYdY
• Rearranging, we get:
dY MU X U / X
  
dX U constant MU Y U / Y
• MRS is the ratio of the marginal utility of
X to the marginal utility of Y
Diminishing Marginal Utility
and the MRS
• Intuitively, it seems that the assumption
of decreasing marginal utility is related to
the concept of a diminishing MRS
– Diminishing MRS requires that the utility
function be quasi-concave
• This is independent of how utility is measured
– Diminishing marginal utility depends on how
utility is measured
• Thus, these two concepts are different
 Marginal Utility and the MRS
• Again, we will use the utility function
utility  X  Y  X Y 0.5 0.5

• The marginal utility of a soft drink is

marginal utility = MUX = U/X = 0.5X-
0.5Y0.5

• The marginal utility of a hamburger is

marginal utility = MUY = U/Y = 0.5X0.5Y-
0.5
0.5 0.5
dY MU X .5 X Y Y
MRS     0.5  0.5

dX Uconstant MUY .5 X Y X
Examples of Utility Functions
• Cobb-Douglas Utility
utility = U(X,Y) = XY
where  and  are positive constants
– The relative sizes of  and  indicate the
relative importance of the goods
Examples of Utility Functions
• Perfect Substitutes
utility = U(X,Y) = X + Y
Quantity of Y
The indifference curves will be linear.
The MRS will be constant along the
indifference curve.

U3
U2
U1
Quantity of X
Examples of Utility Functions
• Perfect Complements
utility = U(X,Y) = min (X, Y)
Quantity of Y
The indifference curves will be
L-shaped. Only by choosing more
of the two goods together can utility
be increased.

U3
U2
U1
Quantity of X
Examples of Utility Functions
• CES Utility (Constant elasticity of
substitution)
utility = U(X,Y) = X/ + Y/
when   0 and
utility = U(X,Y) = ln X + ln Y
when  = 0
– Perfect substitutes   = 1
– Cobb-Douglas   = 0
– Perfect complements   = -
Examples of Utility Functions
• CES Utility (Constant elasticity of
substitution)
– The elasticity of substitution () is equal to
1/(1 - )
• Perfect substitutes   = 
• Fixed proportions   = 0
 CES Utility Function
One of the assumptions of the Ordinal
Theory is the assumption of continuity or
substitutability. How easy it is to
substitute one good for another has an
impact on the shape of the utility
function, thus, the indifference curve.
 CES Utility Function
Along an indifference curve the MRS
decreases as the Y/X ratio decreases.
we wish to define some parameter that
measures this degree of responsiveness. If
the MRS does not change at all as the ratio
of Y/X changes, we might say that
substitution is easy—perfect substitutes
where MRS = α / β and σ = ∞.
 CES Utility Function
Alternatively, if the MRS changes
rapidly for small changes in Y/X ratio,
we would say the substitution is difficult,
because minor variations in the Y/X
ratio will have a substantial effect on the
good’s relative utility, thus, the shape of
the indifference curve.
 CES Utility Function
A scale-free measure of this responsiveness
is provided by the elasticity of substitution.
Elasticity of substitution (σ) is:
y y
%( ) d( ) MRS
 x  x *
%(MRS ) d( MRS ) y
x
1

1 
 CES Utility Function
For Cobb-Douglass Utility Function:
δ=0σ=1
For Perfect Substitutes:
δ=1σ=∞
For Perfect Complements:
δ = -∞  σ = 0
σ is always positive because Y/X ratio and
MRS change in the same direction.
 Homothetic Preferences
• If the MRS depends only on the ratio of
the amounts of the two goods, not on
the quantities of the goods, the utility
function is homothetic
– Perfect substitutes  MRS is the same at
every point
– Perfect complements  MRS =  if Y/X >
/, undefined if Y/X = /, and MRS = 0 if
Y/X < /
Nonhomothetic Preferences
• Some utility functions do not exhibit
homothetic preferences
utility = U(X,Y) = X + ln Y
MUY = U/Y = 1/Y
MUX = U/X = 1
MRS = MUX / MUY = Y
• Because the MRS depends on the
amount of Y consumed, the utility function
is not homothetic
Monotonic Transformation
A monotonic transformation is a way of
transforming a set of numbers to
another set of numbers in a way that
preserves the order of the numbers.
A monotonic transformation of a utility
function is a utility function that
represents the same preferences as the
original utility function.
 Important Points to Note:
• If individuals obey certain behavioral
postulates, they will be able to rank all
commodity bundles
– The ranking can be represented by a utility
function
– In making choices, individuals will act as if they
were maximizing this function
• Utility functions for two goods can be
illustrated by an indifference curve map
 Important Points to Note:
• The negative of the slope of the
indifference curve measures the marginal
rate of substitution (MRS)
– This shows the rate at which an individual
would trade an amount of one good (Y) for one
more unit of another good (X)
• MRS decreases as X is substituted for Y
– This is consistent with the notion that
individuals prefer some balance in their
consumption choices
 Important Points to Note:
• A few simple functional forms can capture
important differences in individuals’
preferences for two (or more) goods
– Cobb-Douglas function
– linear function (perfect substitutes)
– fixed proportions function (perfect
complements)
– CES function
• includes the other three as special cases