Chapter 3

Preferences and Utility

Dealing with an individuals
behavior when confronted with
choices to maximize satisfaction
Axioms of Rational Choice Choice is
assumed to be rational. Preference
system is assumed to have three basic
properties:
Completeness Individual can always specify
one of the following (no indecision):
A is preferred to B
B is preferred to A
A and B are equally attractive
) B A ( =
) B A (
) A B (
Preferred means more satisfaction (utility).
Transitivity If A is preferred to B and B is
preferred to C, then A is preferred to C.
Internally consistent.
- Continuity If A is preferred to B, then
situations close to A (eg., C) are also preferred
to B.

U
x
B
C
A

A
Continuous function
Not a continuous function
B
C
Utility Overall satisfaction
Normally can only rank different situations
ordinarily. Cannot quantify differences. Cannot
measure cardinally (number required for this).
Can say A is preferred to B, but cant say by
how much more A is preferred to B.
As we examine choices, we will limit ourselves
to a small number of alternatives and ceteris
paribus everything else affecting utility.
Usually also assume nonsatiation. More is
always preferred to less (within reason).
Utility function expressed as U = U(x
1
,x
2
,,x
n
).
Indifference Curves - An approach to showing
that is diminishing (SOC for U Max).
Considering two goods, ceteris paribus, an
indifference curve shows various combinations of
the two goods among which the individual is
indifferent. U is constant along curve.
Curves to Northeast represent
higher U. Slope is negative. As
consumer gives up y, he/she must
have more x to remain at fixed U.
is the slope of indifference
curve. is the marginal rate of
substitution of x for y.
dx
dy
x
U
1
= 100 =xy
y
U
2
y) f(x, U =
Along an indifference curve, utility is fixed and x and y vary; e.g.
U
1
= 100 = xy y = 100/x
MRSxy
dx
dy
=
2
100/x dx dy =
dx
dy

MRSxy
. 100/x MRSxy
2
=
, so
U
3
Also, the slope of the curve increases (becomes
less negative) as he/she gives up y for more x
(trades y for x). He/she is willing to trade less and
less y for an additional unit of x. Means the MRS
diminishes as he/she moves down along the curve
(less y more x).
y
MRS large; slope
very negative;
large y
MRS small; slope
closer to 0;
small y
x
=
2
1
x
U
dx
dy
and
x
After 3 days
lost in the
desert, given
hotdogs that can
be eaten or
traded for
water. How
many hotdogs
for 1
st
liter
water? How
many for 2
nd
,
3
rd
, 4
th
?
1
U U
xy
dx
dy
MRS
=
=
MRS = negative of the
change in y over change in
x along a given
indifference curve.
Example: If U
1
=xy then
x
U
y
1
=
The x, y space is dense with many
curves. Every point is on a curve.
No cardinal numbers can be
assigned to curves.
x
y
y
xy
2
1
MRS
x
U
dx
dy
= =
U
1
Convexity of the Indifference Curves and
Diminishing MRS Diminishing MRS is
equivalent to the assumption that all
combinations of x and y that are equivalent
to or preferred to x
*
and y
*
form a strictly
convex set.
A set is strictly convex if any straight line
joining two points in the set is completely (not
on the boundary) within the set. A convex set
(not strictly) can have linear segments in the
boundary.
See next slide.
y
U
*

Strictly Convex Set
y
*
x x
*
Assures that the indifference curves slope is increasing
toward 0. MRS is diminishing as y is given up and x is
acquired. The indifference curve is not linear or concave
over any portion. This means the utility function is strictly
quasi-concave. The indifference curve is strictly convex and
forms a strictly convex set for U = f(x,y) U
*
= f(x
*
,y
*
).
y
x
U
2
U
1
x
1
x
2
y
2
y
1
x
3
y
3
0.5(x
1
+ x
2
)
0.5(y
2
+ y
1
) =
Strictly convex indifference curves result from a utility
function, U = f(x,y), that is strictly quasi-concave, which
means it forms a strictly convex set for U = f(x,y) U* =
f(x*,y*); no linear segments and diminishing MRSxy.
Diminishing MRS implies that Balanced bundles
of goods are preferred to bundles weighted toward
one good or the other.
Superscripts indicate
different levels of
consumption of the goods.
Marginal Utility Approach (Marshall) This is a
mathematical approach to defining MRS
xy
and
showing that it diminishes (SOC). It requires
specification of a cardinal utility function.
Marginal U of
Assumes y is constant.
y) U(x, U =
x
MU
x
U
is x =

MU
x
is the addition to U resulting from a small
addition to x, ceteris paribus.
The total differential of U for many
good case is:
U
x
x
U
MU
x
U
x

=
y is constant.
. dx
x
U
... dx
x
U
dx
x
U
dU
n
n
2
2
1
1

+ +

=
y) x U( U =
Assume that the
marginal utility
of x declines as
x increases (eg.,
hotdogs).
The total change in utility is the sum of
the MUs of the x
i
times the changes
in the x
i
s
If we want to look at tradeoffs between two
goods (MRS), can hold U constant (dU = 0)
and show for two goods:
Solve for
dy
y
U
dx
x
U
0 dU

= =
y
x
MU
MU
dx
dy
=
Could use the implicit function rule:
y
x
MU
MU
y
U
x
U
dx
dy
=

=
) dU (
) x U (
i

). dx (
i
y
x
xy
MU
MU
MRS
dx
dy
= =
or
Why would MRS
xy
diminish as x is substituted for y?
This makes sense because if MU of y is twice that of
x, then it should require unit of y to trade for one
unit of x for U to remain constant. The MRS
xy
is .
y
x
xy
y
x
MRS
MU
MU
dx
dy
2
1
x
y
= = =

2 1 y =
1 x =
Examples of Utility Functions
) y x (U

=
0 x
y
y
0
y
1
y
2
x
0
x
1
x
2
2
2
1
1
0
0
x
y
x
y
x
y
= =
is constant along a radial and and are
constants, so the slope of the indifference curves
is the same where they cross the radial.
x y

y x U =
0
0
>
>
MRS
xy
|
.
|

\
|
= = =

x
y

y x
y x
MU
MU
1
1
y
x
Use the Implicit
Function rule.
MRS is not related to total amounts of goods but ratio of the amounts
of the goods. It is homothetic because MRS
xy
= f(y/x) only.
xy
y
x
MRS
MU
MU
dx
dy
= =
U
3
U
2
U
1
Cobb-Douglas where and > 0. U is homothetic. Homothetic
indifference curves are radial extensions of each other. If preferences are
homothetic, one indifference curve is like another. Indifference curves for
higher utility are simple copies of those for lower utility. Hence, we can study
the behavior of an individual who has homothetic preferences by looking at only
one indifference curve or at a few nearby curves without fearing that our results
would change dramatically at very different levels of utility.
Perfect Substitutes
x
y
Homothetic

>
>
+ =
0
0
y x U
MRS
xy
constant along curve. This is not a strictly quasi-
concave utility function (indifference curves are not strictly
convex). MRS is constant; it is not diminishing.
y
x
xy
xy
y
x
MU
MU

dx
dy
MRS
MRS
MU
MU
dx
dy
= = =
= =
U
1
U
2
U
3
Perfect Complements Goods must be used
together in same proportion to yield utility.
y
x
) y , x min( U =
U is controlled by the
smaller of x or y!
y
*
x
*
x
Adds nothing to utility because y
*
doesnt change.
Homothetic
Constant Elasticity of Substitution (CES) Utility Cobb-
Douglas, Perfect Substitutes, and Perfect Complements are
special cases of this utility function, which takes the form:
Utility = U(x,y) = x

/ + y

/, where 1, 0, and
Utility = U(x,y) = ln x + ln y, where = 0.
The elasticity of substitution is = 1/(1- ). Measures curvature
of the indifference curve. Discussed more in Chapter 7.
Perfect substitutes corresponds to the case where approaches 1;
U(x,y) = x + y and approaches .
Fixed Proportions corresponds to the limit of U(x,y) = x

/ + y

/
as approaches - and = 0.
Cobb-Douglas corresponds to the = 0 case where U(x,y) =xy,
which is the antilog of U(x,y) = ln x + ln y and = 1.
For U(x,y) = x
-1
y
-1
, = 1/(1 ) = , because = -1. This
falls somewhere between fixed proportions and Cobb-Douglas.
Bads
y
x
U
1
U
2
U
3
x is a good.
y is a bad disutility
The indifference
curves in the graph
mean if utility is to
remain constant, a
decrease in y (the bad)
must be accompanied
by a decrease in x
(rather than an
increase).

<
>
+ =
0
0
where y, x U
Most of us would think a week on a sunny beach was a
good and that constant rain on the beach would be a
bad. Not all people feel this way!
Homothetic
Not all utility functions are homothetic. In
fact, hometheticity is a special case. Utility
functions can be written in functional form
for many goods. U = f(x
1
, x
2
, x
3
, , x
n
).
See extensions to Chapter 3.
Not Homothetic!
y
U
1
x
U
0
Slope of U
1
slope of U
0
where radial crosses them;
therefore, not homothetic.
Slope of indifference curves
along the radial changes
because MRS
xy
changes.