Chapter 3

PREFERENCES AND UTILITY

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 •
  Rat
al Ch
e
G Completeness
± if A and B are any two situations, an
individual can always specify exactly one of
these possibilities:
G A is preferred to B
G B is preferred to A
G A and B are equally attractive

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 •
  Rat
al Ch
e
G 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

m
 •
  Rat
al Ch
e
G Continuity
± if A is preferred to B, then situations suitably
³close to´ A must also be preferred to B
± used to analyze individuals¶ responses to
relatively small changes in income and
prices

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 Ãt
l
ty
G iven these assumptions, it is possible to
show that people are able to rank in order
all possible situations from least desirable
to most
G Economists call this ranking utility
± if A is preferred to B, then the utility assigned
to A exceeds the utility assigned to B
Ã(A) > Ã(B)

×
 Ãt
l
ty
G Utility rankings are ordinal in nature
± they record the relative desirability of
commodity bundles
G Because utility measures are not unique,
it makes no sense to consider how much
more utility is gained from A than from B
G It is also impossible to compare utilities
between people

A
 Ãt
l
ty
G Utility is affected by the consumption of
physical commodities, psychological
attitudes, peer group pressures, personal
experiences, and the general cultural
environment
G Economists generally devote attention to
quantifiable options while holding
constant the other things that affect utility
± 0
  assumption
X
 Ãt
l
ty
G Assume that an individual must choose
among consumption goods 1, 2,«, n
G The individual¶s rankings can be shown
by a utility function of the form:
utility = Ã(1, 2,«, n; other things)
± this function is unique up to an order-
preserving transformation

o
 9
 G
G In the utility function, the ¶s are assumed
to be ³goods´
± more is preferred to less
Quantity of y
Preferred to x*, y*

Worse
than
x*, y* Quantity of x
]
 ñ
eree Curve
G 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

y2 U1

Quantity of x
c
 2
Úarg
al Rate  Subt
tut

G The negative of the slope of the
indifference curve at any point is called
the marginal rate of substitution (Ú
)
Quantity of y


 ‘

à ‘Ãc
y

y2 Ã

Quantity of x
cc
 2
Úarg
al Rate  Subt
tut

G
RS changes as  and  change
± reflects the individual¶s willingness to trade 
for 
Quantity of y At (1, 1), the indifference curve is steeper.
The person would be willing to give up more
 to gain additional units of 

At (2, 2), the indifference curve

is flatter. The person would be
y willing to give up less  to gain
additional units of 
y2 U1

Quantity of x
c©
 2
 ñ
eree Curve Úap
G Each point must have an indifference
curve through it

Quantity of y

Increasing utility

U3 Ã1 < Ã2 < Ã3
U2

U1
Quantity of x
cm
 ra
t
v
ty
G Can any 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  and  than A
U2

A U1

Quantity of x
cè
 Cve
ty
G 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
RS is
equivalent to the assumption that all
combinations of  and  which are
preferred to * and * form a convex set

y
U1

Quantity of x
c×
 Cve
ty
G If the indifference curve is convex, then
the combination (1 + 2)/2, (1 + 2)/2 will
be preferred to either (1,1) or (2,2)
Quantity of y
This implies that ³well-balanced´ bundles are preferred
to bundles that are heavily weighted toward one
commodity

y
y y2)/2

y2 U1

Quantity of x
   2)/2
cA
2
 Ãt
l
ty a the ÚRS
G Suppose an individual¶s preferences for
hamburgers () and soft drinks () can
be represented by
V V
V V  ù 
G SovngVforV, we get
 = 100/

G Solving for
RS = -/:

Ú
= -/ = 100/2
cX
 Ãt
l
ty a the ÚRS
Ú
= -/ = 100/2
G Note that as  rises, Ú
falls
± when  = 5, Ú
= 4
± when  = 20, Ú
= 0.25

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 Úarg
al Ãt
l
ty
G Suppose that an individual has a utility
function of the form
utility = Ã(
G The total differential of à is
à Ã

Ã



 

G Along any indifference curve, utility is

constant (Ã = 0)
c]
 ¬er
v
g the Ú

G Therefore, we get:

M 




 0



M
G Ú
iheri  fhemrgi
luiliy f
  hemrgi
luiliy f

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¬


h
g Úarg
al Ãt
l
ty
a the Ú

G Intuitively, it seems that the assumption
of decreasing marginal utility is related to
the concept of a diminishing Ú

± diminishing Ú
requires that the utility
function be quasi-concave
G this is independent of how utility is measured
± diminishing marginal utility depends on how
utility is measured
G Thus, these two concepts are different
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 Cve
ty  ñ
eree
Curve
G Suppose that the utility function is


V V ùM
G WeVcanVsmpfV
heVagebraVbV
akngV
heV
ogar
hmVofV
hsVf nc
on
Ã(,) = ln[Ã(,)] = 0.5 ln  + 0.5 ln 

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 Cve
ty  ñ
eree
Curve
G Thus,

 
×


M

 
×

M M

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 Cve
ty  ñ
eree
Curve
G If the utility function is
Ã(,) = 
G There is no advantage to transforming
this utility function, so

Ã

 c 


à c 


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 Cve
ty  ñ
eree
Curve
G Suppose that the utility function is
utility ùM

G For this example, it is easier to use the

transformation
Ã(,) = [Ã(,)]2 = 2 + 2

©×
 Cve
ty  ñ
eree
Curve
G Thus,

 

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  ©M M
M

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9 aple  Ãt
l
ty Fut

G Cobb-Douglas Utility
utility = Ã() = 9
where 9 and are positive constants
± The relative sizes of 9 and indicate the
relative importance of the goods

©X
9 aple  Ãt
l
ty Fut

G Perfect Substitutes
utility = Ã(,) = 9 + 
Quantity of y
The indifference curves will be linear.
The
RS will be constant along the
indifference curve.

U3

U2
U1
Quantity of x
©o
9 aple  Ãt
l
ty Fut

G Perfect Complements
utility = Ã(,) = min (9, )
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
©]
9 aple  Ãt
l
ty Fut

G CES Utility (Constant elasticity of
substitution)
utility = Ã(,) = H/H + H/H
when H { 0 and
utility = Ã(,) = ln  + ln 
when H = 0
± Perfect substitutes   H = 1
± Cobb-Douglas   H = 0
± Perfect complements   H = -g
m
9 aple  Ãt
l
ty Fut

G CES Utility (Constant elasticity of
substitution)
± The elasticity of substitution (3) is equal to
1/(1 - H)
G Perfect substitutes   3 = g
G Fixed proportions   3 = 0

mc
 thet
 Preeree
G If the Ú
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   Ú
is the same at
every point
± Perfect complements   Ú
= g if / >
9/ , undefined if / = 9/ , and Ú
= 0 if
/ < 9/
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 thet
 Preeree
G For the general Cobb-Douglas function,
the Ú
can be found as






cM
M
Ú
ù


M
c

M

mm
ghthet
 Preeree
G Some utility functions do not exhibit
homothetic preferences
utility = Ã(,) =  + ln 

Ã
 c
 ‘ ‘ ‘
à c
 

mè
 he Úay-G Cae
G Suppose utility is a function of a goods
given by
utility = Ã(1, 2,«, n)
G The total differential of à is

à à Ã

Ã


 ëëë
 a
   a

m×
 he Úay-G Cae
G We can find the Ú
between any two
goods by setting à = 0
 


À


 å
  å

G Rearranging, we get
Ã
  
Ú
 
   
 Ã
  mA
 Úult
g ñ
eree
Surae
G We will define an indifference surface
as being the set of points in a
dimensions that satisfy the equation
Ã(1,2,«a) = 
where  is any preassigned constant

mX
 Úult
g ñ
eree
Surae
G If the utility function is quasi-concave,
the set of points for which à u  will be
convex
± all of the points on a line joining any two
points on the à indifference surface will
also have à u 

mo
 ñprtat P
t t gte:
G 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
G Utility functions for two goods can be
illustrated by an indifference curve map
m]
 ñprtat P
t t gte:
G The negative of the slope of the
indifference curve measures the marginal
rate of substitution (Ú
)
± the rate at which an individual would trade
an amount of one good () for one more unit
of another good ()
G Ú
decreases as  is substituted for 
± individuals prefer some balance in their
consumption choices
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 ñprtat P
t t gte:
G 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
G includes the other three as special cases
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 ñprtat P
t t gte:
G It is a simple matter to generalize from
two-good examples to many goods
± studying peoples¶ choices among many
goods can yield many insights
± the mathematics of many goods is not
especially intuitive, so we will rely on two-
good cases to build intuition

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