CHAPTER 3

CONSUMER PREFERENCES &

THE CONCEPT OF UTILITY

Consumer Preferences
Consumer preferences
Indications of how a consumer would rank any
two possible baskets, assuming the baskets were
available to the consumer at no cost

Basket
A combination of goods and services that an
individual might consume
E.g. a pair of jeans, two pairs of shoes, and 5 pounds of
chocolate

Three Assumptions
Preferences are complete
Consumer can rank two baskets
Prefers basket A to basket B (A > B); prefers basket B
to basket A (B > A); indifferent between basket A and B

Preferences are transitive

Consumer makes choices that are consistent with
each other
Prefers basket A to basket B, and basket B to basket C
also prefers basket A to basket C
A > B; B > C; A > C
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Three Assumptions (cont.)

More is better
Having more of a good is better for the consumer
E.g. Individual likes more food better than less food and
prefers to have more clothing than less clothing

Types of Ranking
Ordinal rankings
Indicates whether a consumer prefers one basket to
another
Does not contain quantitative information about the
intensity of that preference
Does not answer how much more he likes A than B

Cardinal rankings
A quantitative measure of the intensity of a
preference for one basket over another
Likes A twice as much as B
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Utility Function
The three assumptions about preferences can
represent preferences with a utility function
A function that measures the level of satisfaction a
consumer receives from any basket of goods and
services
Assigns a number to each basket so that more
preferred baskets get a higher number than less
preferred baskets.
U(y)
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Utility Function (cont.)

An ordinal concept
The precise magnitude of the number that the
function assigns has no significance
E.g. U(y) = y1/2 = 200

Utility is not comparable across individuals

Any transformation of a utility function that
preserves the original ranking of bundles is an
equally good representation of preferences

Marginal Utility
Marginal utility
An additional utility that the consumer gets from
consuming an additional y
Assuming y is a good or service

Rate at which total utility changes as the level of

consumption of good y rises
MUy = U/y
Slope of the utility function with respect to y

Marginal Utility (cont.)

Marginal Utility (cont.)

Diminishing marginal utility
After some point, as consumption of a good
increases, the marginal utility of that good will
begin to fall
The more of something we consume, the less additional
satisfaction we get from additional consumption

More is not always better

Marginal utility can be negative at some point
When this happens, total utility curve is downward
slopping
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Marginal Utility (cont.)

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Marginal Utility (cont.)

Example of U(H) and MUH
U(H) = 10H H2
MUH = 10 2H
H
2
4
6
8
10

H2
4
16
36
64
100

U(H) MUH
16
6
24
2
24
-2
16
-6
0
-10
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Utility Multiple Goods

Utility derived from consumption of two
goods (x, y)
MUx
Marginal utility of x: (U/x)
Total utility changes as consumption of x rises, holding
consumption of y constant (i.e. partial derivative)

MUy
Marginal utility of y: (U/y)
Total utility changes as consumption of y rises, holding
consumption of x constant (i.e. partial derivative)
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Utility Multiple Goods (cont.)

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Utility Multiple Goods (cont.)

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Indifference Curve
Indifference curve
A curve connecting a set of consumption baskets
that yield the same level of satisfaction to the
consumer
Four properties:
All the indifference curves have a negative slope
Indifference curve cannot intersect
Every consumption basket lies on one and only one
indifference curve
Indifference are not thick
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Indifference Curve (cont.)

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Marginal Rate of Substitution

Marginal rate of substitution (MRS)
The maximum rate at which the consumer would
be willing to substitute more of one good for a less
of another good
The increase in one good that the consumer would
require in exchange for a small decrease in another
good
In order to leave the consumer just indifferent between
consuming the old basket or the new basket

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Marginal Rate of Substitution

(cont.)

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Marginal Rate of Substitution

(cont.)
Diminishing marginal rate of substitution
Marginal rate of substitution of one good for
another good diminishes
As the consumption of the first good increases along an
indifference curve

The slope of indifference curve getting flatter as x

increases
Indifference curve with diminishing MRSxy must
be bowed in toward the origin
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Marginal Rate of Substitution (cont.)

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Marginal Rate of Substitution (cont.)

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Marginal Rate of Substitution (cont.)

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Marginal Rate of Substitution (cont.)

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Special Preferences
Perfect substitutes
The MRS of one good for the other is constant
The indifference curve are straight lines
E.g. David likes both butter (B) and margarine
(M), and he is always willing to substitute a pound
of either commodity for a pound of the other
MRSBM = MRSMB = 1

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Special Preferences (cont.)

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Special Preferences (cont.)

Perfect complements
Leontief utility function
Two goods that the consumer always wants to
consume in fixed proportion

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Special Preferences (cont.)

Cobb-Douglas utility function
Function of the form U = Axy
Where U measures the consumers utility from x units
of one good and y units of another good and where A, ,
and are positive constant

Properties
MUx and MUy are positive, thus the more is better
Indifference curves will be downward sloping
Exhibit diminishing marginal rate of substitution

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Special Preferences (cont.)

Quasilinear utility function
A utility function that is linear in at least one of the
goods consumed, but may be a nonlinear function
of the other goods
Linear in y, but not linear in x

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