THEORY OF UTILITY AND

PREFERENCES
 Why does a person demand a certain commodity?

Satisfaction, happiness, benefit

Definition:
• Utility is the satisfaction that an individual
receives from consuming goods or services.
• To analyze the behavior of consumers we need to make
an important assumption that each consumer has exact
and perfect knowledge.

• Consumers are generally assumed to be rational.

 Hence their objective is to maximize their

satisfaction or utility from the consumption of
goods and services for given money income.

• The complete list of these goods and services is called

consumption bundle.
 Consumer preference
• tells as how a consumer ranks any two basket of goods.

Example:
– Basket 1: (X1, X2) & Basket 2: (Y1, Y2)

• given the above bundles of products a consumer can

rank/prefer the products as:
completeness: the consumer knows which bundle gives
him/her a higher or lower utility or indifferent between the two
goods.

Basket 1 first Basket 2 first

Basket 1 & 2 are equal

Basket 2 second
Basket 1 second
 The concept of utility is characterized by:

• Utility and usefulness are not synonymous.

• Utility is subjective.

• The utility of a good/service can be different at different

places and time.

• The consumer considers the following points to get maximum

level of satisfaction.
• how much satisfaction he/she gets from consuming and purchasing the
extra unit of product.
• the price he/she pay to the good and for alternative goods.
• satisfaction he/she gets from alternative good.
• Their are different views in relation to the
comparison of the utility obtained from different
bundles.

• This are:-
– The Cardinal Approach and
– The Ordinal Approach.
 Cardinal Utility Approach
• This approach took the view that utility is
measurable and additive.
Measure called util

• A consumer will choose the bundle which gives

him the highest possible number of utils.
 Assumptions of Cardinal Utility Theory

1. The TU of a ‘basket of goods’ depends on the

quantities of the individual commodities.
• This assumption implies; U  f ( X1 , X 2 ,..., X n )

2. Rationality: the consumer is rational.

• Consumer aims at the maximization of his utility

subject to the constraint imposed by his given income.
• This brings – prioritizing of consumption bundles.
 Assumptions of Cardinal Utility Theory

3. Utility is cardinal: the utility derived from each

commodity is measurable.
– The most convenient measure is money.

4. Constant marginal utility of money: this assumption

is necessary if monetary units are to be used as the
measure of utility.

• However, if the marginal utility of money changes with the level

of income (wealth) of the consumer, then money cannot be
considered as a measurement of utility.
 Assumptions of Cardinal Utility Theory

5. Limited Money Income: consumer has limited

money income to spend on the goods and services
he/she chooses to consume.

6. Diminishing marginal utility: the extra satisfaction

gained from successive units of a commodity
diminishes.
 Total Utility and Marginal Utility
Total utility
is the total amount of utility that consumers receive
from consumption of commodities.

Marginal utility
 is the amount of satisfaction added by an additional
unit of consumption.
Diminishing Marginal Utility
Change in total utility U n  U n1
MU  
Change in quantity consumed Qn  Qn1
 Utility Schedule for chocolates

Units of chocolates Marginal utility Total utility

consumed ( in units) ( in units)
1 20 20

2 16 36

3 10 46

4 4 50

5 0 50

6 -6 44
 Law of diminishing marginal Utility (LDMU)

 As the quantity consumed of a commodity increases per

unit of time, the utility derived from each successive unit
decreases, consumption of all other commodities
remaining constant.

Assumption of Diminishing Marginal Utility

 Cardinality  Homogeneity
 Reasonability  Rationality
 Continuity
 Utility and Consumer Behavior

• A consumer may not choose the item which has the

greatest utility because price and income are also
important factors.

• In other words, consumers don’t always buy their

first choice.

• This is rational behaviour, and we can see the reason

by looking at price and utility.
 Utility and Consumer Behavior
Hypothetical Utility per ETB Comparisons
Choice Marginal Price MU/ETB
Utility
Coca Cola 30 3.00 10
Pepsi 27 2.25 12
Sprite 20 2.00 10

 Thus, in deciding how to spend your money, you look at

marginal utility per ETB rather than marginal utility alone.
MU X MU X MU X
1
 2
 .........  n
 MU m
PX1 PX 2 PX n
 Equilibrium of the Consumer

• A consumer is said to be at equilibrium

– when he maximizes his utility from the
consumption of commodities for a given price and
income.

• For example a consumer purchasing decision of a

product depends on two choices
 either spending his income on the purchase of
good X
 or retaining his/her income.
 Equilibrium of the Consumer

• The equilibrium quantity of the commodity is,

then, defined at the equality of
– the additional utility (marginal utility) of the
commodity and the marginal utility of money.

• Mathematically, the equilibrium condition of a

firm that consumes a single good X occurs when

MUx = Px
 Utility schedule for a single commodity

Quantity of TU MU MU per ETB MU of

Orange (price=2 ETB) money

0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.5 1
5 13 0 0 1
6 11 -2 -1 1
 Weaknesses of Cardinal Utility Approach:

• The assumption of cardinal (measurable) utility is

doubtful.

Satisfaction cannot be objectively measured.

 The assumption of constant utility of

money is also unrealistic.
• The utility derived from a unit of money varies
with the level of income of the consumer.
 Ordinal Utility Approach

 Utility cannot be measured absolutely but different

consumption bundles are ranked according to preferences.
 Assumptions of Ordinal Utility Theory

1. The consumers are assumed to be rational.

2. Utility is ordinal- it is assumed that consumers can

rank their preferences.

3. The total utility of the consumer depends on the

quantities of the commodities consumed.
 Assumptions of Ordinal Utility Theory
4. For any two consumption bundles A and B, the
consumers are able to determine the bundle that
provides the most satisfaction.

5. Preferences are transitive.

– if A is preferred to B and B is preferred to C, then A is
preferred to C.
consistent
means that If market basket X is greater than market
basket Y (X>Y) then Y not greater than X (Y not >X).
 Assumptions of Ordinal Utility Theory
6. Diminishing Marginal Rate of Substitution (MRS)
• is the rate at which a consumer is willing to substitute
one commodity (x) for another commodity (y) so that
his total satisfaction remains the same.

As a result, Indifference curves are convex to the origin.

 Preference Ranking
Bundle Amount of X Amount of Y Rank order

A 6
B 3
C 4
D 5
E 3
F 1
G 2
H 3
6 4
5 3
3 3
2 3
4 2
4 1
2 1
1 1

Indifference Set/ Schedule

 It is a combination of goods for which the consumer is indifferent,

preferring none of any others.
 the consumer derives the same level of utility.
 Indifference curve
• Is a locus of points–particular combinations or
bundles of goods–in a commodity space, which yield
the same utility to the consumer, so that he is
indifferent between the different consumption
bundles.

• Each point on an indifference curve yields the same

total utility as any other point on that same
indifference curve.
 Indifference Curve
• Consumers’ preferences are such that they choose the
best things they can afford.
• These consumption bundles are represented by (X, Y),
where X represents the good of our particular interest and
Y all other goods.
• In a consumer choice problem involving two
consumption bundles (X1, Y1) and (X2, Y2):

• (X1, Y1) is preferred to (X2, Y2).

• indifferent between the two bundles.
 Indifference Curve

• If the utility function is given by U(X1, X2,…, Xn), where

X1 is the amount of good 1 consumed, X2 the amount of
good 2 consumed, and so on.

• Then an indifference curve is defined as the set of all

consumption bundles (X1, …, Xn) that satisfy the
equation U(X1, X2, …, Xn) = C

• A set of indifference curves is called indifference map

– Indifference map provides different level of satisfaction for the
consumers.
 Example

• Assume that a consumer’s utility function is given as.

– A consumption bundle with 6 units of X and 10 units of Y

and a bundle with 12 units of X and 5 units of Y yield the
same level of satisfaction (60) to the consumer, therefore,
lie on the same indifference curve. A bundle with 8 units of
X and 8 units of Y, however, is preferred to both bundles
because it yields a higher level of satisfaction, therefore lies
on a higher indifference curve.
 Characteristics of Indifference Curves

1. An indifference curve has negative slope.

– which denotes that if the quantity of one commodity (Y)
decreases, the quantity of the other (X) must increase, if
the consumer is to stay on the same level of satisfaction.
– Indifference curves are convex to the origin.

2. Consumers can compare any two bundles in the

commodity space and decide that he prefers one of
them or is indifferent between them.
 Characteristics of Indifference Curves

3. The farther from the origin an indifference curve lies,

the higher the level of utility it denotes.

4. Indifference curves do not intersect each other. If they

did, the point of their intersection would imply two
different level of satisfaction.
 Marginal Rate of Substitution/MRS
• The slope of an indifference curve: marginal rate of
substitution.
• Marginal rate of substitution is a measure of substitution
of two commodities in consumption.
– MRS of X for Y (MRS x,y) is defined as the number of units
of commodity Y that must be given up in exchange for an extra
unit of commodity of X so that the consumer maintains the
same level of satisfaction.

Number of units of Y given up

MRS X ,Y 
Number of units of X gained
 Marginal Rate of Substitution/MRS
• As we move from left to right on an indifference
curve, the marginal rate of substitution decreases in
absolute value; this is referred to as the decreasing
marginal rate of substitution

• This implies that the number of units of commodity Y

that the consumer is willing to sacrifice for additional
unit of commodity X declines as the quantity of X
increases.
slope of indifference curve= -dy/dx = MRSxy
 Marginal Rate of Substitution/MRS

• It is important to note that MRSx,y is different from

MRSy,x:

– The former measures the quantity of Y that must be

sacrificed for a unit of X so as to keep the consumer at
the same level of satisfaction.

– The later measures the quantity of X that must be given

up for a unit of Y in consumption such that the
consumer will remain at the same level of utility.
 Marginal Rate of Substitution/MRS

• Marginal rate of substitution is defined by the ratio of

marginal utilities of the commodities involved.
MU X MU Y
MRS X ,Y 
MU Y
Or MRS Y , X 
MU X

• The utility function involving two commodities X and

Y is defined as
U = f (X, Y).
 Marginal Rate of Substitution/MRS

• Along an indifference curve utility is constant,

therefore
U = f (X, Y) = C
• The total differential of the utility function is
U U
dU  dX  dY  0
X Y
MU X  dX  MU Y  dY  0
MU X dY
  MRS X ,Y
MU Y dX
 Example

Level of consumption of good X and Y

Bundle A B C D
(Combination)
Orange(X) 1 2 4 7
Banana (Y) 10 6 3 1

Y 4
MRS X ,Y ( between po int s A and B   4
X 1
 Budget Constraint/line

• As we know, utility of a consumer depends on the

quantities of the commodities consumed.

• A rational consumer must wish to acquire as much

quantities of the commodities as possible. with the
limitation of income.

• So the affordable consumption bundle of the consumer

depend on his income.
 Assumptions for the use of the budget line

In order to draw the budget line facing the consumer, we

consider the following assumptions:

1. there are only two goods, X and Y, bought in quantities X and Y;

2. each consumer is confronted with market determined prices, Px

and Py, of good X and good Y respectively; and
3. the consumer has a known and fixed money income (M).
 Budget Constraint/line
Suppose the consumer consumes two goods:
P1 X 1  P2 X 2  M

• Total expenditure of the consumer cannot exceed his total

income.

• The set of all affordable consumption bundles at a given

income M and prices P1 and P2 is referred to as the budged
set of the consumer.

• The boundary of this set is called the consumer’s budget

constraint.
 Budget Constraint/line

• The set of consumption bundles that can be purchased if

the entire money income is spent, for a given commodity
prices.

• It is shown by the equality of expenditure with income.

P1 X1  P2 X 2  M

• The equation of the budget constraint: Solving for X2

 Budget Constraint

The budget line has the following characteristics.

– Points on the budget line, indicate consumption bundles

that use up the household’s entire income.

– Points below the budget line, indicate combinations of

commodities that cost less than the household’s income.

– Points above the budget line, indicate combinations of

commodities that cost more than the household’s income
 Shifts in the Budget Line
• The budget constraint sets upper limit to the quantities
that a consumer wishes to buy.

• What are the factors that are responsible for the shift in
the budget line?

• Shifts may result from two sources:

Changes in the consumer’s income.

Changes in the prices of the commodities.
 Equilibrium of the Consumer
• The consumer is in equilibrium when he maximizes his
utility, given his income and the commodity prices.
• The maximization of utility can now be shown by
combining a set of indifference curves with the budget
line.
• For the consumer to maximize his utility two conditions
must be satisfied.
 The MRS x,y must be equal to the ratio of commodity
prices.
 The indifference curve must be convex to the origin.
 Optimal choice when the MRS is strictly decreasing

• We can add the individual’s utility map to show the

utility-maximization process

Quantity of y The individual can do better than point A

by reallocating his budget
A
C The individual cannot have point C
B because income is not large enough
U3
Point B is the point of utility
U2
U1
maximization
Quantity of x
 Optimal choice when the MRS is decreasing

• Utility is maximized where the indifference curve is

tangent to the budget constraint
px
slope of budget constraint  
py

Quantity of y dy
slope of indifferen ce curve 
dx U  constant

px dy
-  MRS
py dx U  constant

This last one is usually called the

tangency condition

Quantity of x