ECON1268

Price Theory
Lecture 2 - Utility
 Topics for today's lecture . . .
1. Preferences & consumption

2. Utility functions

3. Indifference curves

4. Special utility functions

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Preferences & consumption

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 Consumption
Understanding consumer behaviour begins with describing
the available alternatives. Each of us consumes many
different goods and services, including:

• Food

• Clothing

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 Consumption 2
• Entertainment

• Utilities

• Housing

• Transport

Different goods and services are not typically alternatives in

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 Consumption 3
and of themselves: For example, eating a meal does not
prevent you from wearing a shirt.

Rather, when considering the goods and services we

consume, an alternative must specify a complete ‘plan’ of
consumption.

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 Definition: Consumption basket
A combination of goods and services that an individual might
consume.

A basket describes both which goods and services an

individual consumes, and the quantities consumed.

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Food & clothing

We will confine our attention to

baskets that contain two goods.
In this example,
• x represents number of meals,
and,
• y represents number of items of
clothing.
Each point on the graph describes a
different basket.
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Food & clothing 2

Basket A contains 10 meals, and 8

items of clothing.

Basket B contains 15 meals, and 6

items of clothing.

Basket C contains 20 meals, and

does not contain any clothing.
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 Definition: More is better
An assumption that having more of a good is always better for
a consumer.

The more is better assumption (also called monotonicity)

provides a great deal of structure to consumer preferences.

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Exercise: More is better

1. Using the more is better

assumption, determine how
basket B is ranked with respect
to the six remaining baskets.
2. Does the assumption allow you
to construct complete
preferences for the seven
baskets illustrated here? Briefly
explain.
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Utility functions

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 The problem with preferences . . .
Describing a consumer's preferences over consumption
baskets can be difficult.

• In lecture 1 we saw that the number of rankings needed to

complete the preferences grows much faster than the
number of alternatives.

To resolve this problem we will represent a consumer's

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 The problem with preferences . . . 2
preferences with a utility function.

Note: Only rational preferences can be represented by a

utility function.

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 Definition: Ordinal ranking
A ranking that indicates whether a consumer prefers one
basket to another, but does not contain quantitative
information about the intensity of that preference.

Rational preferences produce an ordinal ranking of

alternatives.

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 Definition: Cardinal preferences
A quantitative measure of the intensity of a preference for one
basket over another.

A consumer's cardinal ranking of alternatives helps us to

understanding the trade-offs she/he faces.

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 Utility functions
A utility function assigns a number to every possible basket of
goods and services.

• Therefore, a utility function can only represent complete

preferences.

For a basket A, we write U(A) to indicate the utility that a

consumer derives from consuming the basket.
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 Utility functions 2
•Bigger
  is better: A B implies U(A) U(B), while the difference
U(A) - U(B) represents the intensity of the consumer's
preference.

• Therefore, a utility function can only represent transitive

preferences.

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Utility functions with a single good
 Consider a utility function with a single
good x, representing the quantity of
hamburgers consumed.

To evaluate the consumer's utility,

substitute the number of hamburgers
into the function.
• When 1 hamburger is eaten, the
consumer's utility is U(1) = 1.
• When 4 hamburgers are eaten, the
consumer's utility is U(4) = 2. 19
 Definition: Marginal utility
The rate at which total utility changes, as the level of
consumption of a good rises, holding constant the level of
consumption of all other goods.

The marginal utility of a good is the partial derivative (slope)

of the utility function, with respect to the good in question.

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Marginal utility

 For a single good utility

function, the marginal utility
of x is written,

Note: You will always be

provided with marginal
utilities in this course.

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 Marginal utility 2
• When 1 hamburger is eaten, the marginal utility (slope) is
1/2.

• When 4 hamburgers are eaten, the marginal utility (slope)

is 1/4.

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Marginal utility & more is better
The following statements
are equivalent:
• The utility function is
upward sloping (in the
direction of an increase in
x).
• The marginal utility of
good x is positive.
• The more is better
assumption is satisfied
for good x. 23
Definition: Principle of diminishing marginal utility

The principle that as consumption of a good increases, the

marginal utility of that good will begin to fall.

The principle of diminishing marginal utility states that each

unit of a good consumed, creates less additional benefit for
the consumer than the previous unit.

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The principle of diminishing marginal utility

The following statements

are equivalent:
• The utility function gets
flatter as x increases.
• The marginal utility of x
is downward sloping
(diminishing).
• The principal of
diminishing marginal
utility is satisfied for
good x. 25
Diminishing total utility
For many goods more is not always
better:
• Food.
• Alcohol.
• Pharmaceuticals.

Past a certain point, increased

consumption reduces welfare.

Does this matter?

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Diminishing total utility 2

Probably not: An optimising

consumer will choose to consume a
quantity with a non-negative
marginal utility.

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Indifference curves

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Utility functions with two goods
This graph illustrates a
total utility function with
two goods:
• Food (good x).
• Clothing (good y ).

Each point on the

horizontal plane
corresponds to a
consumption basket.
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Utility functions with two goods 2

The utility created by this

consumption basket is
represented by the height
of the function.

For this consumer U(12, 3)

= 6.

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The marginal utility of x

Treat the quantity of good

y as fixed.

The marginal utility of x is

the slope of the utility
function in the direction of
an increase in x.

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The marginal utility of x 2

 Thisis the partial

derivative of the utility
function with respect to x,

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The marginal utility of y

Treat the quantity of good

x as fixed.

The marginal utility of y is

the slope of the utility
function in the direction of
an increase in y .

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The marginal utility of y 2

 Thisis the partial

derivative of the utility
function with respect to y,

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 Quiz 1
•  Suppose that a consumer's preferences over food (good x)
and clothing (good y ) are represented by the utility function
. The associated marginal utilities are,

The more is better assumption is satisfied for,

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 Quiz 1 2
(a) both food and clothing.

(b) food, but not clothing.

(c) clothing, but not food.

(d) neither food nor clothing.

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 Quiz 2
•  Suppose that a consumer's preferences over food (good x)
and clothing (good y ) are represented by the utility function
. The associated marginal utilities are,

The principle of diminishing marginal utility is satisfied for,

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 Quiz 2 2
(a) both food and clothing.

(b) food, but not clothing.

(c) clothing, but not food.

(d) neither food nor clothing.

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 Definition: Indifference curves
A curve connecting a set of consumption baskets that yield
the same level of utility to the consumer.

Each level of utility has a corresponding indifference curve.

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Indifference curves

An indifference curve is a
line indicating all points on
the utility function at the
same level.

Higher indifference curves

correspond to higher
levels of utility.
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Indifference curves 2

We can only illustrate a

few indifference curves at
a time.

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 Flattening the utility function
Consider the indifference
curve corresponding to
utility U = 4.

The indifference curves for

lower levels of utility lie
below and to the left.

The indifference curves for

higher levels of utility lie
above and to the right. 42
 Exercise: Indifference curves
•Suppose
  that a consumer's preferences over food (good x)
and clothing (good y ) are represented by the utility function .
The associated marginal utilities are,

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 Exercise: Indifference curves 2
1. Will the indifference curves for this utility function intersect
the x-axis? Briefly explain. (Hint: Consider the indifference
curve corresponding to a utility of 12.)

2. Will the indifference curves for this utility function intersect

the y -axis? Briefly explain.

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1. Indifference curves slope down

 The more is better

assumption allows us to
derive three properties of
indifference curve.

Pick any basket A that

lies on the indifference
curve
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1. Indifference curves slope down 2

The consumer prefers A

over any basket that is
below and to the left.

The consumer prefers

any basket that is above
and to the right, over A.

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1. Indifference curves slope down (another way)

 The more is better

assumption implies
that both goods have
positive marginal
utilities ( and )

Consuming more of good

y makes the consumer
better o, raising the

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1. Indifference curves slope down (another way) 2

consumer to a higher
level of utility.

To return to the original

indifference curve, the
increase must be offset
by a decrease in the
consumption of good x.

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2. Indifference curves do not intersect

 More is better tells us

that B A.

Therefore, the utility of

every basket on , must
be higher than the utility
of every basket on .

But C lies on both

indifference curves,
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2. Indifference curves do not intersect 2

 implying that .

It is not possible to have

both and , therefore we
can conclude that
indifference curve cannot
intersect.

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3. Indifference are not thick
 If
an indifference curve is
thick then we can pick a
basket A at the bottom
edge of the curve.

We can also pick a

basket B that is above
and to the right of A, but
still on .

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3. Indifference are not thick 2
 More is better implies B
A, therefore A
and B cannot lie on the
same indifference
curve.

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Quiz 3
Suppose E and F lie on
the same indifference
curve, and that the more
is better assumption is
satisfied.

Which basket(s)
CANNOT lie on the
same indifference curve
as E and F?
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Quiz 3 2
(a) B only.
(b) B and C.
(c) C and D.
(d) B, C and D.

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Definition: Marginal rate of substitution

•The
  rate at which units of x are exchanged for units of y along
the indifference curve.

The marginal rate of substitution of good x for good y

(represented by ), is the negative of the slope of the
indifference curve.

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Advanced: Deriving the marginal rate of substitution

•The
  rate at which total utility changes with consumption of
goods x and y is given by the total differential,

Along an indifference curve utility is constant, and therefore .

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Advanced: Deriving the marginal rate of substitution 2

•Substituting
  for and rearranging, gives us,

Note: You will not be assessed on the derivation of this result.

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Definition: Diminishing marginal rate of substitution

A feature of consumer preferences for which the marginal rate

of substitution of one good for another good diminishes as the
consumption of the first good increases along an indifference
curve.

Diminishing marginal rate of substitution of x for y implies that

indifference curves get flatter as we move down along the
curve 58
Diminishing marginal rate of substitution

This indifference curve

displays a diminishing
marginal rate of
substitution.
• Basket A contains a lot
of clothing (good y ),
but little food (good x).
• Basket B contains a lot
of food, but little
clothing.
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Diminishing marginal rate of substitution 2

 The diminishing
assumption
implies a consumer
would prefer a more
even mix of food and
clothing, over either
extreme.

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 Exercise: Sketching indifference curves

•Suppose
  that a consumer's preferences over food (good x)
and clothing (good y ) are represented by the utility function .
The associated marginal utilities are,

and

1. Derive an expression for the marginal rate of substitution.

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Exercise: Sketching indifference curves 2

2. Is the marginal rate of substitution diminishing? Briefly

explain.

3. On a graph, draw two typical indifference curves. The

graph should illustrate all of the features that you have
derived in previous questions and exercises.

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Special utility functions

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Perfect substitutes
 Two goods are perfect
substitutes if the marginal
rate of substitution is
constant.

The utility function for

perfect substitutes takes the
form,

where and are positive

constants. 64
Perfect substitutes 2
 The corresponding marginal
utilities are and , thus the
slope of the indifference
curves is .

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Perfect complements
 Twogoods are perfect
complements when a
consumer wants to
consume them in fixed
proportions.

The utility function for

perfect complements takes
the form,
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Perfect complements 2
For example, if x is left
shoes and y is right shoes,
A and B produce the same
utility because they both
contain two complete pairs.

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Exercise: Interpreting indifference curves

Suppose that Graham's

preferences over baskets
containing tea (good x), and
coffee (good y ), are
illustrated by the
indifference curves in the
figure.

1. If U1 < U2 < U3, how

would you explain the
shape of these 68
Exercise: Interpreting indifference curves 2

indifference curves?
2. Which of our
assumptions concerning
consumer preferences
have been violated
here?

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Questions?

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