Chapter 3

Consumer
Preferences and the
Concept of Utility
Chapter Three Overview
• Representations of Preferences
• Utility Functions
• Special Preferences
• Behavioral Aspects of Choice

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Why Study Consumer Choice?
• Study of how consumers with limited resources choose
goods and services
• Helps derive the demand curve for any good or service
• Businesses care about consumer demand curves
• Government can use this to determine how to help and

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whom to help buy certain goods and services

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Consumer Preferences
• Consumer Preferences tell us how the consumer would rank
(that is, compare the desirability of) any two combinations or
allotments of goods
–Assuming these allotments were available to the consumer at no cost
• These allotments of goods are referred to as baskets or
bundles

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• These baskets are assumed to be available for consumption
at a time, place and under particular physical circumstances

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Consumer Preferences Continued

• Preferences are complete if the consumer can rank any two

baskets of goods
–A preferred to B; B preferred to A; or indifferent between A and B
• Preferences are transitive if a consumer who prefers basket A
to basket B, and basket B to basket C also prefers basket A to
basket C
–A } B; B } C  A } C

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• Preferences are monotonic if a basket with more of at least
one good and no less of any good is preferred to the original
basket

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Types of Ranking
• Students take an exam
• After the exam, the students are ranked according to their
performance
• An ordinal ranking lists the students in order of their performance
– Harry did best, Joe did second best, Betty did third best, and so on
• A cardinal ranking gives the mark of the exam, based on an absolute
marking standard

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• Harry got 80, Joe got 75, Betty got 74 and so on
– Alternatively, if the exam were graded on a curve, the marks would be an
ordinal ranking

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The Utility Function
• These three assumptions about preferences allow us to
represent preferences with a utility function
• A utility function is…
–A function that measures the level of satisfaction a consumer
receives from any basket of goods and services.
–Assigns a number to each basket so that more preferred baskets

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get a higher number than less preferred baskets.
–Written as U = u(y)

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Utility Function Implications
• It is an ordinal concept
–The precise magnitude of the number that the function assigns
has no significance
• Utility not comparable across individuals
• Any transformation of a utility function that preserves the
original ranking of bundles is an equally good

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representation of preferences
–For example, 𝑈 = 𝑦 and 𝑈 = 𝑦 + 2 represent the same
function

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Marginal Utility
• Marginal Utility of a good y is the additional utility that the
consumer gets from consuming a little more of y
–In other words, the rate at which total utility changes as the level
of consumption of good y rises
∆𝑈
• 𝑀𝑈𝑦 =
∆𝑦

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• It is the slope of the utility function with respect to y

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 Marginal Utility Example

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Marginal Utility Example Continued

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U(H) = 10H – H2 MUH = 10 – 2H

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Example of U(H) and MUH
• The point at which he should stop consuming hotdogs is
the point at which MUH = 0
• This gives H = 5
• That is the point where total utility is flat
• You can see that the utility is diminishing

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Principle of Diminishing Marginal Utility
• The principle of diminishing marginal utility states that the
marginal utility falls as the consumer consumes more of a
good
• Total utility and marginal utility cannot be plotted on the
same graph
• The marginal utility is the slope of the (total) utility function

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• The relationship between total and marginal functions
holds for other measures in economics
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 Diminishing Marginal Utility

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Marginal Utility – Multiple Goods
• U = xy2 • Are there diminishing marginal
utility?
• MUx = y2
• MU of x is not dependent of x
• MUy = 2xy • So the marginal utility of x does
not decrease as the number of
x’s increases.
• Is more better?
• MU of y increases with increase
• More y nd more x indicates

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in number of y’s
more U so yes • So neither exhibits diminishing
–It is monotonic returns

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Indifference Curves
• An indifference curve or indifference set: The set of all
baskets for which the consumer is indifferent
• An indifference map : Illustrates a set of indifference
curves for a consumer

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Indifference Curves: Key Properties
1. Monotonicity
–Indifference curves have negative slope
2. Transitivity
–Indifference curves do not intersect
3. Completeness

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–Each basket lies on only one indifference curve
4. Indifference curves are not “thick”

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 Indifference Curves have Monotonicity

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 Indifference Curves Cannot Intersect

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 Indifference Curves are not “Thick”

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Indifference Curve Example
• U = xy2
• 𝑀𝑈𝑥   =   𝑦 2
• 𝑀𝑈𝑥   =   𝑦 2
• For U=144

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Example: Utility and the single indifference
curve

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Marginal Rate of Substitution
• The marginal rate of substitution: The maximum rate at which the
consumer would be willing to substitute a little more of good x for a
little less of good y
• It is the increase in good x that the consumer would require in
exchange for a small decrease in good y in order to leave the
consumer just indifferent between consuming the old basket or the
new basket
• It is the rate of exchange between goods x and y that does not affect
the consumer’s welfare

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• It is the negative of the slope of the indifference curve
• 𝑀𝑅𝑆𝑥,𝑦 = −∆𝑦 ∆𝑥 for a constant level of preference

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Marginal Rate of Substitution Continued
• Positive marginal utility
implies the indifference curve
has a negative slope
–Implies monotonicity
• Diminishing marginal utility
implies the indifference
curves are convex to the

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origin
–Implies averages preferred to
extremes

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Indifference Curve Key Properties
• Indifference curves are negatively-
sloped, bowed out from the origin,
preference direction is up and right
• Indifference curves do not intersect
the axes
• Averages preferred to extremes
– Indifference curves are bowed
toward the origin
– Convex to the origin

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• A value of x or y = 0 is inconsistent
with any positive level of utility

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Special Functional Forms
• Perfect substitutes
• Perfect complements
• The Cobb-Douglas utility function
• Quasilinear utility functions

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Perfect Substitutes
• Two goods such that the
marginal rate of
substitution of one good for
the other is constant
• The indifference curves are
straight line
• Marginal rate of

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substitution is constant
–Not necessarily equal to one

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Perfect Complements
• Two goods that the
consumer always wants to
consume in fixed
proportion to each other
–Left and right shoes
• Unwilling to substitute one

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for another

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Cobb-Douglas Utility Function
• A function of the form
𝑈 = 𝐴𝑥 𝛼 𝑦 𝛽
• Where U measures the
consumer’s utility from x
units of one good and y
units of another good and

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where A, α, and β are
positive constants

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Quasilinear Utility Function
• A utility function that is linear
in at least one of the goods
consumed, but may be a
nonlinear function of the
other good(s)
• The only thing that
determines your personal

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trade-off between x and y is
how much x you already
have

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