3.

Utility
Algebraic Rep of Preference
Utility Function
Assigns a number to every consumption bundle in a persons preference ordering in accordance with
2 rules:
o If someone is indifferent between the bundles assigns number to both bundles
o Has preference of one over the other assigns larger number to the preferred bundle
Continuous utility function: preference relation that is complete, reflexive, transitive and
continuous
Continuity small changes to consumption bundle creates small changes to preference level

U(x) preference relation

An ordinal (ordering) concept

only if:

Example:
U(x) = 6 ; U(y) = 2 bundle x is strictly preferred to bundle y
X is NOT preferred 3 times as much as y
Example: ordinal ranking
MacLeans publishes uni rankings
McGill better that UOttawa, Uottawa better than Brock
Dont have to say Ottawa 5 units better than Brock or McGill twice as good as Brock
Indifference Curves
Example:
Bundles (4,1)(2,3)(2,2)
Suppose (2,3) (4,1) ~ (2,2)
Assign bundle numbers that preserve preference ordering
o U(2,3)=6 > U(4,1)= U(2,2) = 4
o Utility Levels

Indifference curves contains equally preferred bundles

Equal preference same utility level
o all bundles in an indifference curve have same utility level

(4,1) (2,2) in indifference curve with utility level U = 4

(2,3) in indiff.curve with U = 6
graph
3D plot utility from vertical axis & can add indiff. Curve

can compare more bundle better description of consumers

preferences
o can be in 3D plot indifference curve at height of Utility Index

comparing all possible consumption bundles gives complete collection of the consumers
indiff. Curves each with assigned utility level

complete collection of indiff. Curves reps consumers preferences

collection of all indiff.curves for a given preference relation
o indifference map
equivalent to utility function

Utility Functions
no unique Utility function rep of preference relation
suppose U(x1,x2) = x1x2 reps a preference relation
Example:
bundles (4,1)(2,3)(2,2)
U(x1,x2) = x1x2 so
o U(2,3) = 6 > U(4,1) = U(2,2) = 4;
o (2,3) (4,1) ~ (2,2)
U(x1,x2) = x1x2 (2,3) (4,1) ~ (2,2)

Define V = U^2
o V(x1,x2) = x1^2*x2^2
o V(2,3) = 36 > V(4,1) = V(2,2) = 16
(2,3) (4,1) ~ (2,2)
V preserves same order as U same preferences

Define W = 2U + 10
W(x1,x2) = 2x1x2 + 10
o W(2,3) = 22 > W94,1) = W(2,2) = 18
(2,3) (4,1) ~ (2,2)
W preserves same order as U & V

o
o

U = utility function that reps preference relation

F is a strictly increasing function

If
&

then V = f(U) is also a utility function representing

Goods, Bads and Neutrals
good: commodity unit that increases utility (gives more a preferred
bundle)
bad: commodity unit that decreases utility (gives less preferred bundle)
neutral: commodity unit which doesnt change utility (equally preferred
bundle)
consumption bundle has a bad & good indifference curve is
upward sloping
Other Utility Functions and Their Indifference Curves
instead of U(x1,x2) = x1x2

V(x1,x2) = x1 + x2
ex. Sunoco gas, petrocan gas; maple leaf bacon, Schneiders bacon
o
perfect substitutes utility function Indifference curve
All lines are linear and parallel
U(x1,x2) = ax1 + bx2 slope = -a/b

W(x1,x2)
= min{x1,x2} ex. comps & operating systems, stereo receivers &
speakers
o perfect compliments utility function indifference curve
all right angled with vertices on a ray from origin
u(x1,x2) = min {ax1,bx2}

Quasi-linear Indifference Curve

utility function:
o U(x1,x2) = f(x1) + x2 linear in just x2
o x2 = k v(x1) [height of each indifference curve, higher ks =
higher indiff. Curves]
o u (x1x2) = k = f(x1) + x2
Example:
U(x1,x2) = 2x1^(1/2) + x2
Cobb-Douglas Indifference Curves
U(x1,x2) = x1^a * x2^b a > 0 ; b > 0
c = a/(a + b)
u(x1,x2) = x1^ c * x2 ^(1 c)
Example:
U(x1,x2) = x1^(1/2) * x2^(1/2) ( a = b = )
V(x1,x2) = x1* x2^3
( a = 1, b = 3)
Slope of Indifference Curve: Marginal Utilities
Marginal = incremental
marginal utility of commodity i: rate-of-change of total utility as quantity of commodity i
consumed changes

derivative

o
Example:

Marginal Utilities & MRS

general equation of indifference curve
o U(x1,x2) = k
Differentiate:

rearranged:

rearranged:

MRS
Example:
U(x1,x2) = x1x2 differentiate each
x1 differentiated = (1)* x2
x2 diff = x1* (1)
MRS = dx2/dx1 = -x2/x1
MRS for Quasi-linear Utility Functions
U(x1,x2) = f(x1) + x2
o Differentiation of f(x1) = f(x1)
o Differentiation of x2 = 1
MRS = dx2/dx1 = -f(x1)
MRS = - F(x1) doesnt depend on x2
o Slope = constant along any line for which x1 = constant
Indifference map:
Monotonic Transformations & MRS
Apply monotonic to utility function creates another utility function representing same preference
relation
Transforming one set of number into another set preserving order
f(u)
rate of change of f(u) as u changes
o { f(u2) f(u1) }/ u2 u1
MRS when monotonic transformation applied
o U(x1,x2) = x1x2 MRS = -x2/x1
o V = U^2
V(x1,x2) = x1^2 * x2^2
MRS = - (2x1x2^2)/ (2x1^2*x2) = -x2/x1
Same as U
o V = f(U)
MRS = - [f(U) x derive.(U/x1)]/ f(U) x derive.(U/x2)] - d(U/x1) /d(U/x2)
Unchanged
MRS is unchanged by a positive monotonic transformation