Preferences and the utility

function
In the first part of this lecture you will learn:
 how consumer preferences can be
represented by a utility function.
 assumptions on preferences that give ‘well
behaved indifference curves’.
 to define the marginal rate of substitution.

 some common utility functions.

Where are we going?
 Last week we talked about the budget
constraint of the consumer.
 Today, we first will look at the combinations
of goods that the consumer can afford and
ask which combinations would she prefer.
 We shall then combine budget constraints
and preferences to derive “consumer
equilibrium.”
 Next week, we shall derive the demand
curve.
What are preferences?
 Let A = (x, y) and B = (x’, y’) be two different
consumption bundles. We can ask the consumer what
he would prefer to have.
 A ≽ B means that bundle A is weekly preferred to
bundle B.
 A ~ B means the consumer is indifferent between
bundles A and B.
 A ≻ B means that bundle A is strictly preferred to bundle
B.
 Important: A and B are consumption bundles and (in general)
not goods or quantities of only one good.
Consistent preferences
Three assumptions
Note that ‘2’ and ‘3’ are typically
define made on
a preordering
preferences to give
while ‘1,’ ‘2’ and consistent
‘3’ define preferences:
an ordering
1) Completeness: Any two bundles can be
compared, i.e. either A ≽ B, B ≽ A, or both.
2) Reflexivity: Any bundle is at least as good
as itself, i.e. A ≽ A.
3) Transitivity: If bundle A is as good as B and
bundle B as good as C then A should be as
good as C, i.e. if A ≽ B and B ≽ C then A ≽
C.
 Why require consistency?
 If preferences are not consistent it is difficult for
us to say anything useful about a consumer. For
example, if the consumer does not know whether
he prefers bundle A or B then how can we know
what he will choose to buy.
 If preferences are consistent then we can say a
lot about the consumer, because we can derive a
utility function and draw indifference curves.
 Consistency does not seem so strong a
requirement of preferences. But, some care is
needed because we do observe inconsistent
choices.
 Are you consistent?
Scenario 1

“Imagine that you are about to purchase a

stereo for £125 and a calculator for £15. The
salesman tells you that the calculator is on sale
for £5 less at the other branch of the store,
located 20 mins away. The stereo is the same
price. Would you go to the other store?”
 Are you consistent?
Scenario 2

“Imagine that you are about to purchase a

stereo for £125 and a calculator for £15. The
salesman tells you that the stereo is on sale for
£5 less at the other branch of the store, located
20 mins away. The calculator is the same price.
Would you go to the other store?”
 Consistency or not
 68% of people asked were willing to sacrifice 20 mins of time
and effort in order to save £5, when the saving was on the
calculator.
 29% of people asked were willing to sacrifice 20 mins of time
and effort in order to save £5, when the saving was on the
stereo.
 This suggests inconsistent preferences
Kahneman and Tversky (1984) ‘Choices, values and frames’, American
Psychologist 39: 341-350.

 We now know that you do not have to look hard to find

inconsistent preferences. But, if people have consistent
preferences ‘most of the time’ then we still learn
something useful by assuming consistent preferences.
 Utility function
 A utility function U assigns a number to each
consumption bundle such that
 A ≻ B implies that U(A) > U(B) and

 A ~ B implies that U(A) = U(B).

 A utility function is very useful as it allows us to

summarize a consumers preferences in one simple
function.
 Note that we consider ordinal utility functions and so all
that matters is whether U(A) is bigger than or smaller than
U(B). This means the difference U(A) – U(B) is
meaningless and we cannot make interpersonal
comparisons.
Indifference curve
An indifference curve plots a set of bundles between
which the consumer is indifferent. That is, it plots a set of
bundles that give the consumer the same utility.

y A set of well behaved

indifference curves
Indifference curves are
contours of the utility function

U = 20
U = 15
U = 10
U=5

x
Well-behaved indifference curves
We make a number of simplifying assumptions to
get well-behaved indifference curves.
1) Monotonicity: more is better. For any two
bundles A = (x, y) and B = (x’, y’) where x ≻ x’
and y ≻ y’ it must be A ≻ B.
2) Convexity: averages are preferred to
extremes. Given bundles A = (x, y), B = (x’, y’)
and C = (px + (1 – p)x’, py + (1 – p)y’) it must
be that C ≻ A and C ≻ B.
3) Continuity: A small change in consumption
bundle results in a small change in utility.
What does a well behaved
indifference curve look like?
 Monotonicity means that it must slope down.

Utility is increasing in this

y
direction. So, the
indifference curve cannot
slope up.

y’

U=5
x’ x
What does a well behaved
indifference curve look like?
 Convexity means that the preferred set is convex.

y
Bundles on the this line
are preferred to (x, y) and
(x’, y’)
y Any point on this line is given
by:
(αx + (1-α)x’, αy + (1- α)y’), 0< α
Y’ <1
U=5
x x’ x
Are indifference curves well
behaved in reality?
 The assumption of well behaved indifference curves is
much stronger than that of consistency. For example, if
goods only come in whole units there cannot be continuity.

 In the tutorials you will think about examples

where indifference curves are not well behaved.
 If preferences are well behaved then it is much
easier to find the consumer’s optimal bundle. We
can, and will, however consider non-well
behaved indifference curves.
Marginal rate of substitution
 A final concept we need to know is that of the
marginal rate of substitution.
 The MRS of good Y for good X (MRSYX) is
the rate at which the consumer is willing to
trade or exchange good Y for good X.
 (Informally) If you take away one unit of good
X you need to give the consumer MRSYX
units of good Y to leave her indifferent.
A simple example
 Suppose that good Y is £10 notes and good
X is £20 notes. What is your MRSYX?
 If you take away one unit of good X you
need to give the consumer MRSYX units of
good Y to leave her indifferent.
 I would expect that your MRSYX is 2. [If
not, tell me and I can make some money.]
Why is the MRS useful?
 The MRSYX is the slope of the indifference
curve.
The MRSYX given
y bundle (x’, y’) is
the slope of the Note:
indifference Monotoncity implies the
curve at this MRSYX is negative.
point.
Convexity implies the size
y’ of MRSYX is decreasing in x.

U=5
x’ x
A useful fact about the MRS
 The marginal utility of good X is equal to
U
MU X 
x
 The marginal utility of good Y is equal to
U
MU Y 
y
 The MRSYX is equal to
MU X
MRSYX 
MU Y
A quick derivation
 The total differential of the utility function is
U U
dU  dx  dy
x y
 Along an indifference curve dU = 0. Rearranging
gives the slope of an indifference curve
U
dy
  x  MRSYX
dx U
y
Examples of utility functions
 During the next few weeks we will see lots of
examples of utility functions that you need to
become familiar with. The main ones are:
 Perfect substitutes
 Perfect complments
 Quasilinear
 Cobb-Douglas
Source: Lecture Notes for Varian.
Source: Lecture Notes for Varian.
Source: Instructor Manual for Hirschleifer et al.
Source: Instructor Manual for Hirschleifer et al.
Source: Lecture Notes for Varian.
Culturally Different Preference Maps for Shirts and Shoes (Instructor Manual for
Hirschleifer et al)
Part 2: Optimisation
 The lectures on optimisation will begin in this
class and end in the next (hopefully!)
Consumer Optimisation
We will cover:
 how to find the consumers optimum
consumption bundle using diagrams.
 the distinction between tangency solutions,
boundary solutions and corner solutions.
 how to find the consumers optimum
consumption bundle mathematically.
 the Lagrange multiplier method of
constrained optimisation.
Where we are?
 We have now learnt how to describe the
consumers budget set and his preferences.
 Now we shall put this together to solve for the
optimal consumption bundle that the
consumer will choose.
 The next step (next week) will be to look at
comparative statics and derive a demand
function.
The consumers choice problem
The consumer wishes to

Max U ( x, y )
subject to p x x  p y y  m; x  0; y  0
 When we ‘solve’ this we should find an
optimal amount x* and y* that the consumer
should consume.
 If we change prices or income we should find
a new optimum.
Rational Constrained Choice

x2

x1
Rational Constrained Choice

Utility x2

x1
Rational Constrained Choice

Utility x2

x1
Rational Constrained Choice

Utility

x2

x1
Rational Constrained Choice

Utility

x2

x1
Rational Constrained Choice

Utility

x2

x1
Rational Constrained Choice

Utility

x2

x1
Rational Constrained Choice

Utility

x2
x1
Rational Constrained Choice

Utility

Affordable, but not

the most preferred
affordable bundle.

x2
x1
Rational Constrained Choice

Utility The most preferred

of the affordable
bundles.
Affordable, but not
the most preferred
affordable bundle.

x2
x1
Rational Constrained Choice

Utility

x2
x1
Rational Constrained Choice

Utility

x2

x1
Rational Constrained Choice

x2

Utility

x1
Rational Constrained Choice

x2

Utility
x1
Rational Constrained Choice

x2

x1
Rational Constrained Choice

x2

Affordable
bundles

x1
Rational Constrained Choice

x2

Affordable
bundles

x1
Rational Constrained Choice

x2

More preferred
bundles

Affordable
bundles

x1
Rational
x
2
Constrained Choice

More preferred
bundles

Affordable
bundles

x1
Rational
x
2
Constrained Choice

x2*

x1* x1
Rational
x
2
Constrained Choice
(x1*,x2*) is the most
preferred affordable
bundle.

x2*

x1* x1
Rational Constrained Choice
 The most preferred affordable bundle is
called the consumer’s ORDINARY DEMAND
at the given prices and budget.
 Ordinary demands will be denoted by
x1*(p1,p2,m) and x2*(p1,p2,m).
Rational Constrained Choice
 When x1* > 0 and x2* > 0 the demanded
bundle is INTERIOR.
 If buying (x1*,x2*) costs $m then the budget is
exhausted.
Rational
x
2
Constrained Choice
(x1*,x2*) is interior.

(x1*,x2*) exhausts the

budget.

x2*

x1* x1
How do we find the optimum?
 Option 1: We can draw the consumers budget
constraint and indifference curves and see which
consumption bundle would maximise utility.
 Option 2: We can solve this constrained
optimisation problem using standard mathematical
techniques such as the Lagrangian.
 The best thing to do: Use a combination of
options 1 and 2.
Possible types of solution
 Interior solution: if x* > 0 and y* > 0 then
there is an interior optima.
 Boundary solution: if x* = 0 or y* = 0 then
there is a boundary solution.
 Tangency solution: if the optimum is at a
point where the indifference curve is tangent
to the budget constraint.
 Non-tangency solution.
 Interior, tangency solution
This is the ‘textbook’ case (but by no
means the only possible one).
Bundle (x’, y’) is affordable but the consumer
y
could get more utility.
Bundle (x’’, y’’) gives high utility
but is not affordable.
y’’
Bundle (x*, y*) is the consumer’s
y*
optimal consumption bundle.
y’ U = 20
B.C. U = 10
U=5
x’ x* x’’ x
Interior, tangency solution
 IF we know that there is an interior
tangency solution then we can find the
optimum using mathematical techniques.
We can either,
 Use the tangency condition, or

 Use the Lagrange multiplier method

 The tangency condition
At the optima:
slope of B.C.  slope of I.C.
PX MU X
y   MRSYX  
PY MU Y

Slope of I.C. is MU X
y*
MRSYX 
MU Y

B.C. U = 10 Slope of B.C. is PX


PY
x* x
Using the tangency condition
To use the tangency condition,

U ( x, y ) U ( x, y )
1) Find MU X  ; MU Y 
x y
PX MU X
2) Solve 
PY MU Y
 Remember, you need to find x* and y* as a
function of pX, pY and m.
Lagrange multiplier method
The lagrangean is given by

L  U ( x, y )   ( p x x  p y y  m)
Find the optimum by solving

L L L
 0;  0; 0
x y m
Lagrangean and tangency
method compared
Note that
L L
 MU x  p x and  MU x  p y
x y
L L
So, setting  0 and  0 gives
x y
Tangency condition PX MU X

PY MU Y
A word of warning
Remember the tangency condition and
Lagrangean method only work if there is an
interior tangency solution.
 A boundary solution
There are lots of goods you choose to
consume 0 of. This is a boundary solution.

U = 5 U = 10
y There is no tangency solution in this
example.

The consumer optimises his

utility by only buying good X.
B.C.

U = 20
y*
x* x
 What happens at a boundary
solution?
There simply is PX MU X
no point where 
PY MU Y
U = 5 U = 10
y
At the optima PX MU X

PY MU Y
The consumer would like
B.C.
to buy even more X but
cannot given his B.C.
U = 20
y*
x* x
 Finding the optimum
PX means the consumer would
 MRSYX increase his utility by consuming
PY more X.

PX means the consumer

y  MRSYX would increase his utility
PY
by consuming more Y.

y
U = 10

U = 10
B.C. B.C.

x x
 An interior, non tangency solution
PX means the consumer would
 MRSYX increase his utility by consuming
PY more X.

The consumers optimum

y

PX means the consumer

 MRSYX would increase his utility
PY by consuming more Y.

U = 20
U = 10
B.C. U=5
x
Where is the consumer’s optimum?
PX The consumer wants to consume
 MRSYX more Y but cannot. Still not the
PY optimum though.

A point of tangency but not the optima.

y

PX This is where the

 MRSYX consumer maximises his
PY utility.

U=5 B.C. U = 20

U = 10 x
Where to next
 Next week, in the first lecture, we shall look at
some specific utility functions.
 On Thursday in the two-hour session, we
shall consider the derivation of the demand
curve for an individual and extend the
discussion to the market demand curve.