Lecture 1

Utility Theory I
 Consumer Theory

Cardinal Utility :Measurable Utility.

A 1. it was assumed that consumer process a cardinal measure of utility i.e. assigning
to every commodity as combination a number representing the amount of utility
associated with it.

If A 20 units (utils)
B 60 units
=> A is referred 3 times to B.

A.2. Additions to a consumer’s total utility resulting from consuming additional

units of commodity decrease as he consumes more of it.

Assume that the price of the good is $2. The utility of a dollar of the consumer income
is 5 utils

Unit Additional utility

1A 20
2A 9
3A 7
Ordinal Utility (  , )
Property of the consumption Set X:
X is not empty
X  Rn
0 X
X is closed
X is convex
Properties of Preferences:
Description of consumer preference
Consumers have preferences over consumption bundles for all possible pairs
of alternatives
X is preferred to X’ : X  X’

X is indifferent to X’: X~ X’  Not [ X  X’] and not [X’  X]

X is at least as good as X’: X  X’  Not [X’  X]

Consumer is suppose to have preference over the consumption
bundles that satisfy the following set of axioms.

Axiom 1. Completeness
Only one of the three possibilities is true for any pair of alternatives.

The  ordering is complete for any two bundles X, X’ either

X  X’

Or
X’  X
Or both

Remark if X  X’
X’  X

Then X~ X’
The preference relation  is Asymmetric if X  X’ than Not [X’ X].

Axiom 2. Transitivity

The preference relation  and the indifference relation ≈ are transitive.

If X  X’ If X ~ X’
And X’  X’’ And X’ ~ X’’
Then X  X’’ Then X ~ X’’

 Weak preference
X Y X’ Then X  X’
 Strict preference
~ indifference
Axiom 3. Continuity
For all Y in X the sets
{ X: X  Y} and {X: X  Y} are closed sets.

Thus {X: X Y} and {X:X Y} are open sets.

The reason for this assumption to rule out any discontinuous behavior.
In other words, it rules out the sudden reversal in preferences.
Sequence

A sequence (Xn) is determined by a rule which assigns to each natural

number n a unique real number Xn. (Xn) the sequence where with
term is Xn   1=-1,
n
+1, -1, +1.
Convergence

A sequence X n is said to converge to the limit l iff the following criterion is

satisfied

Given  >0 we can find an N such that, for any n>N.

Xn l  
lim  l
n  

l
X1
l



1 2 3 4 5 6 7 8 9 10 11
Observe that the definition of convergence begins given any  > 0. It is clear
that the smaller the value of  > 0 the bigger must be the corresponding N.

If (Xi) is a sequence of consumption bundles that are all at least as good as a

bundle y, If this sequence convergence to some bundle Xt. Then Xt is at least
as good as y.
This property

if Y>Z
if X is close enough to Y
then X>Z
Continuity
Given a condition A1 we can consider the set of all combinations at least as
well liked as A1 . A set of combination not more liked than A1 .
These two sets are closed if you select a infinite sequence of combinations
which converge to some limiting combination A0 . and if each member of
the sequence were at least as will liked as A1 , then A0 is at least as well
liked as A1 . N0 jumps.

Example violating continuity

A1=( q11 q12 ) A2=( q12 q22 )

1 1
A1 is preferred to A2 if q 1 > q 2
1
or q
1 = q1
2
and q12 > q22
Lexicographic ordering A=( q10 q20 ) q1 and q2
1 i
The combination (q10  q1 ,q20 q2 ) Ai  (q  ( )  q1 ,q20 q2 )
0
1
2
Ai  A but lim Ai  (q10 , q20 q2 )  A
i 
 Axiom 4. Strong Monotonocity

At least as much of everything is at least as good

If X  Y then X  Y
And more of some

If X Y then X Y
Axiom 4’. Local nonsatiation
Given any x  X and any  > 0 then there is some bundle y  X with
X Y   such that Y  X

Rules out thick indifference curves X2

One can always do a bit better even

with small change in the
consumption bundle.
Axiom 4 imply 4’ but not the vice versa.
X1
Axiom 5’. Convexity

Given X, Y, and Z  X such that X  Z and Y  Z then

tX + (1-t) Y  Z for all 0  t  1

Axiom 5. Strict Convexity

Given X Y and Z  X if X  Z and Y  Z

Then tX + (1-t) Y Z for all 0 < t < 1

The set of all consumption bundles that are indifferent to each

other is called the indifference curve.
 X  Y Cartesian product
Given any two sets X and Y an ordered (X, Y) where x  X and
y  Y the collection of all these.

Metric Space: Given an arbitrary set X if a function d from X  X into

R is defined and if d satisfies

d(X, Y)=0 iff X=Y

d(X,Y)+d(Y,Z)  d(Z,X)

Then X is metric space. (X,d)

n
Ex R with Euclidian distance

n
d ( X ,Y )   i i
( X 
i 1
Y ) 2
Consider a point X 0 in a metric space (X, d) say, R n , and define a set
Br ( X 0 )  {x : x X , d ( X , X 0 )  r}
Where r is some positive real number.

The set Br ( X 0 ) is called the open ball about X0 with radius r.

X2

X0

X1
 n
Given an open ball Br ( X 0 ) in R quick any point X in Br ( X 0 ) . Then
we can always find another open ball about this point X.

Which is contained in Br ( X 0 ) open set . Let S be a subset in a metric

space (X,d), This set S is called an open set if for any X in S there exists a
positive real number r such that Br ( X )  S

Closed set
is the complement
of an open set
X0 S C or X \ S
X0
Given a metric space (X,d), a point X 0 in X, and a
q
subset S of X, a sequence { X } in S is said to converge
to X 0 if for any real number  >0 , there exists a
 
positive integer such that q  q implies
q
d(Xo, X q)  
. X0 Is called the limit of { X q
} , and
such a sequence { X q } is called a convergent
sequence in S if X 0  S.
Euclidian Distance
n
d ( X ,Y )   i i
( X
i 1
 Y ) 2

X(X1, X2)

d ( X , Y )  ( X 1  Y1 ) 2  ( X 2  Y2 ) 2

Y (Y1, Y2)

d(X,Y)=0 iff X=Y

Triangular inequality d(X,Y)+d(Y,Z)>d(Z,X)

d(X,Y)  0 for all X and Y

Symmetry d(X,Y)=d(Y,X)
 Existence of a utility function
Suppose preferences are complete, reflexive, transitive,
continuous and strongly monotonic. Then there exists a
continuous utility function u : Rk  R which represents
those preferences.

Proof: Let e be vector of ones. Then given any vector

X, let u(X) be that number such that X~ u(X)e. Show
that number exists and unique.
B  {t  R : te  X } and W  {t  R : X  te }
The sets are closed by continuity.

Since R is connected, there is some tx such that txe~X let

 Let

U(X)= t x where t x e~ X

U(X)= ty where t y e~ Y

Then if t x t y then t x e  t y e and transitivity

imply X~ t x e  ty e ~ y

Reflexive for all x  X x X

Utility function: u : X R
Such that X Y if and only if U(X) > U(Y)
If preference ordering is complete, reflexive, transitive and continuous
then it can be represented by a continuous utility function.

If u(X) represents some preferences  f : R  R is a monotonic

function. Then f(u(X)) represent the preferences.

f is strictly increasing on the set S

x  S and y  S
x < y f(x) < f(y)
or f(x) > f(Y) if x>y

Properties of the utility function:

1. u(X)is strictly increasing if and only if  is strictly monotonic.
2. u(X) is quasi concave if and only if  is convex.
3. u(X) is strictly quasi concave if and only if  is strictly convex.
Let X be the consumption set, the satisfaction from consumption
can be expressed by an index which is a real number. This u
utility index which is a function from X into R. This function
denoted by u(X)

Preference is represent able by natural order of real number

X  Y iff u(X)  u(Y)

X  Y iff u(X)  u(Y)

X ~ Y iff u(X) = u(Y)

Any monotone increasing function can replace it.