Utility as a way to describe

preferences
„ The theory of consumer behavior has been
reformulated in terms of consumer preferences.
The utility function
„ Utility is seen as a way to describe preferences.

All that matters about utility as far as choice behavior is

concerned is whether one bundle has a higher utility than
another -- how much higher doesn't really matter.

zThat is, when we say that bundle A has a higher

utility than bundle B, we really mean to say that Bundle
(x1, y1) is preferred to Bundle (x2, y2).
Thanks to Donald Liu for the permission to use.

A utility function
A utility function is a way of assigning a number to
every possible consumption bundle such that more-
preferred bundles get assigned larger numbers than
What do I have to say to you? less-preferred bundles.

(x1, y1) :>: (x2, y2) if and only if u(x1, y1) > u(x2, y2)
„ Preferences are the
fundamental. „ The only property of a utility assignment that is
important is how it orders the bundles of goods.
„ Utility is viewed as a
z The magnitude of the utility function is important
fictitious device only insofar as it ranks the different consumption
contrived for the bundles.
purpose of describing
the fundamental z The size of the utility difference between any two
consumption bundles doesn't matter.
::the
thepreferences.
preferences.

Ordinal utility
Ordinal utility Since only the ranking of the bundles matters, there can
be no unique way to assign utilities to bundles of goods.
The only property of a utility assignment that is
important is how it orders the bundles of goods.
If we can find one way to assign utility numbers to bundles of goods,
we can find an infinite number of ways to do it.
Because of this emphasis on ordering bundles of goods,
this kind of utility is referred to as ordinal utility. Just multiplying the utility measures by any positive numbers.

U1 U2 U3 U1 U2 U3

Bundle A 3 17 -1 Bundle A 3 17 -1

Bundle B 2 10 -2 Bundle B 2 10 -2

Bundle C 1 0.002 -3 Bundle C 1 0.002 -3

A is preferred to B, and B is preferred to C. A is preferred to B, and B is preferred to C.
 Monotonic transformation
If u(x1, y1) represents a way to assign utility numbers to the
Graph talk
bundles (x1, y1), then multiplying u(x1, y1) by any positive number
is just as good a way to assign utilities. Geometrically, a utility
function is a way to label Y
indifference curves, in such a
In fact, any monotonic transformation of u(x1, y1) is just as good a
way that higher indifference
way to assign utilities as u(x1, y1) itself.
curves get assigned larger
A monotonic transformation is a way of transforming one set of numbers.
numbers into another set of numbers in a way that preserves the Hence, a monotonic
order of the numbers. transformation is just a
relabeling of indifference curves, 300
3
** 2 *3 with the new labeling scheme 200
2
1, 4, 9, 16 1, 2, 3, 4 3, 6, 9, 12 representing the same 100
1 X
preferences.

So? Cardinal utility

A monotonic transformation is a way of transforming
one set of numbers into another set of numbers in a
way that preserves the order of the numbers.
There are some theories of utility that attach a significance to the
magnitude of utility. These are known as cardinal utility.
„ In a theory of cardinal utility, the size of the utility
difference between two bundles of goods is supposed to be
of significance.

A monotonic transformation of a utility function
is itself a utility function that represents the same
preferences as the original utility function.
„ But a cardinal utility is used under restrictive assumptions
about people behavior and their willingness to pay for
certain goods.
„ We will not make such restrictive assumption and thus, we
will stick with the ordinal utility framework!

Ordinal utility Constructing a utility function

Given a preference ordering can we always find a
Notice that the ordinal framework doesn't have utility function that will order bundles of goods in
the measurement problems associated with the the same way as those preferences?
cardinal framework.
„ Not all kinds of preferences can be represented by a
utility function.
„ We know how to tell whether a given person prefers
one bundle of goods to another:
z For example, suppose that someone had intransitive
preferences so that:
z Simply offer him a choice between the two bundles
and see which one is chosen. A :>: B :>: C :>: A
z Then a utility function for these preferences would
„ We then simply assign a higher utility to the chosen have to consist of numbers u(A), u(B), and u(C) such
bundle than to the rejected bundle. that:
u(A) > u(B) > u(C) > u(A)
z Any assignment that does this will be a utility This is mathematically impossible!
function.
 Derive indifference curves
from the utility function
A utility function is a way of assigning a number to
every possible consumption bundle such that more-
more- If you are given a utility function, u(x, y), it is
preferred bundles get assigned larger numbers than less-
less- relatively easy to draw the indifference curves.
preferred bundles.
bundles.

A reminder: What is the indifference curve?

If we rule out perverse cases like intransitive preferences,
we will typically be able to find a utility function to
represent preferences.
preferences We will see some examples.

However, this utility function will not be unique:

unique A
monotonic transformation of a utility function is itself a
utility function representing the same underlying
preferences.

Derive indifference curves

Indifference Curve from the utility function
If you are given a utility function, u(x, y), it is relatively
Definition easy to draw the indifference curves.
Indifference Curve: A set of bundles among which the
consumer is indifferent or equally satisfied. An indifference curve tells us all bundles that are equally satisfying
That is, give the same utility level
„ So, we want to plot many pairs of (x, y) such that u(x, y)
An indifference equals a constant.
curve tells us all
bundles that are z e.g., Find 20 pairs of (x, y) that satisfy u(x, y) = 10.
equally satisfying Then, use those 20 pairs to plot an indifference curve.

„ For each different value of the constant, you get a

different indifferent curve.

Suppose that the utility function is given

by: u(x, y) = x y
u( x, y ) = xy =k y=
k
x
We know that a typical indifference curve is just the set
of all x and y such that k = x y for some constant k. Y

Solving for y as a function of x

we see that a typical k
indifference curve has the y=
formula: x k=3
Set k = 1, and identify many pairs of (x, y) satisfying the
formula. Then, plot the indifference curve for k = 1. k=2

X
Follow the same procedure for k = 2, 3, 4,…
 u(x , y ) = x y v ( x , y )= x 2 y 2
Our utility function was specified as: u( x , y ) = x y
A MONOTONIC
Now, suppose we were given v ( x , y )= x 2 y 2 Y TRANSFORMATION IS
another utility function: JUST A RELABELING
OF THE INDIFFERENCE
How do the indifference curves of v(x, y) look like?
CURVES
By the standard rules of algebra we know that:

v ( x , y )= x 2 y 2 =( x y ) 2 =u ( x , y ) 2
k=3 k=9
Thus the utility function v(x, y) is just the square of the utility
k=2 k=4
function u(x, y).
k =1 k =1
v(x, y) is a monotonic transformation of X
u(x, y).

WE HAVE LEARNED
Perfect substitutes
HOW TO DRAW Remember the red pencil and blue
INDIFFERENCE CURVES, pencil example? All that mattered to
the consumer was the total number X
GIVEN THE UTILITY FUNCTION of pencils.

„ Thus it is natural to measure utility by the total number

of pencils:
NOW, LET'S HAVE SOME EXAMPLES ON u(x, y) = x + y
HOW TO FIND A UTILITY FUNCTION, „ Of course, this isn't the only utility function that we could
GIVEN THE INDIFFERENCE CURVES use. Perfect substitution can be between one red pencil
and three blue ones. That depends on the underline
preferences. We assume one red pencil is a perfect
substitute to one blue pencil.

Y left shoes
What if the consumer is willing
to substitute good X for good Y
at a rate that is different from Perfect complements
one-to-one? RED 2
The consumer only cares
about the number of pairs 1
X of shoes he has.
Suppose that the consumer would BLUE 1 2 right shoes
require two red pencils to compensate
him for giving up one blue pencil. „ So, it is natural to choose the number of pairs of shoes as
the utility function.
This means a blue pencil is twice as
„ But, the number of complete pairs of shoes that the
valuable to the consumer as a red pencil. consumer has is the minimum of the number of right shoes
he has (x), and the number of left shoes he has (y).
Thus, the utility function takes the form u(x, y) = 2x + 1y „ Thus, the utility function for perfect complements takes
the form: u(x, y) = min{x, y}
 left shoes
u(x, y) = min{x, y}
Y

We said that the utility function for „ Thus, we have seen that
the perfect complements takes the 2
this utility function works!
form: u(x, y) = min{x, y} 1

„ As a reminder, any
1 2 right shoes
X monotonic transformation
would be suitable as well.
„ Suppose you have 10 pairs of shoes: (x, y) = (10, 10). For example,

v(x, y) = 100 min{x, y}

z So, your utility is 10. That is, min{10, 10} = 10
„ What about the case
„ Now, I give you one extra right shoe: (x, y) = (11, 10) where the consumer wants 4 olives for every one shot
to consume the goods in
some proportion other
z What is your new level of utility? min{11, 10} = 10
than one-to-one?

Let x be the number of shots of martini.

Let y be the number of olives available. Marginal utility

u(x, y) = min{x, 4y} ??? Consider a consumer who is consuming some bundle
of goods, (x, y). How does this consumer's utility
i.e., one olive contributes to only 0.25 glass of the drink change as we give him a little more of good X?

No! The number of correctly concocted glasses of drink is: This rate of change is called the marginal utility with
min{x, 0.25y} [ or its monotonic transformation: min{4x, y} ] respect to good X.
If x = 1 and y = 4: Concoct 1 glass of the drink
∆U Eat two ∆ U 10
MU X ≡ more MU ≡ = =5
∆x ∆x
Utility is u(x, y) = min{1, 0.25*4} = 1 X
apples 2
If x = 1 and y = 3: Concoct only 75% of a glass of the drink

Utility is u(x, y) = min{1, 0.25*3} = 0.75
If x = 0.5 and y = 4: Concoct only 50% of a glass of the drink
Utility is u(x, y) = min{0.5, 0.25*4} = 0.50
MUX measures the rate of change in utility (∆U ) associated
with a small change in the amount of good X (∆x. )
Holding constant y in this calculation!!!

Marginal utility and MRS The MRS

It turns out that marginal utilities can be used to Say, we take a little of good X, ∆x , away from the
measure the marginal rate of substitution (MRS). consumer.
Say, we then give her a little of good Y, ∆y , an amount that is
just sufficient to put her back on her previous indifference curve.
Recall that the MRS measures the slope of the indifference
curve at a given bundle of goods and it can be interpreted as
the rate at which a consumer is just willing to substitute a Y
Then: ∆y/∆x along the
small amount of good Y for good X. same IC
Back to
where I was

∆y is the rate at which the before!

MRS ≡ consumer is willing to

∆x ∆y
stay on the same IC
substitute good Y for
good X.
∆x
= slope of the IC ∆ is very small
X
 Thus, the MRS can be interpreted as the rate at which a
consumer is just willing to substitute a small amount of good Y ∆y MU X
for good X. He will do that only if his utility does not decrease! So:? MRS ≡ =−
∆x MU Y
Now:
Consider a change in the consumption of each
good, (∆x,∆y) that keeps utility constant: u(x, y) = „ Taking a monotonic transformation of an utility
constant function is just a re labeling the indifference curves.
MU X ∆x + MUY ∆y =∆U =0
„ The calculation for the MRS described above is
∆y MU concerned with moving along a given indifference
=− X Thus, marginal utilities can be curve.
∆x MUY used to measure the marginal
rate of substitution. „ Even though the marginal utilities are changed by
monotonic transformations, the ratio of marginal
MRS utilities (i.e., the MRS) is independent of the particular
And MRS can be used to measure the rate of marginal utilities way chosen to represent the preferences.