Utility Functions

A preference relation that is

complete, reflexive, transitive and
continuous can be represented by a
continuous utility function.
Continuity means that small changes
to a consumption bundle cause only
small changes to the preference level.
 Utility Functions
A utility function U(x) represents a
preference relation f ~ if and only if:
p
x’ x” U(x’) > U(x”)

x’ p x” U(x’) < U(x”)

x’ ~ x” U(x’) = U(x”).
 Utility Functions
Utility is an ordinal (i.e. ordering)
concept.
E.g. if U(x) = 6 and U(y) = 2 then
bundle x is strictly preferred to
bundle y. But x is not preferred three
times as much as is y.
 Utility Functions & ICs
Consider bundles (4,1), (2,3) and (2,2).
(4,1) ~ (2,2).
Suppose (2,3)
p
Assign to these bundles any
numbers that preserve the
preference ordering;
e.g. U(2,3) = 6 > U(4,1) = U(2,2) = 4.
Call these numbers utility levels.
 Utility Functions & ICs
An indifference curve contains
equally preferred bundles.
Equal preference  same utility level.
Therefore, all bundles in an
indifference curve have the same
utility level.
 Utility Functions & ICs
So the bundles (4,1) and (2,2) are in
the IC with utility level U=4.
But the bundle (2,3) is in the IC with
utility level U=6.
On an IC diagram, this preference
information looks as follows:
Utility Functions & ICs

x2 (2,3)
p (2,2) ~ (4,1)

U6
U4

x1
 Utility Functions & ICs
3D plot of consumption & utility levels

Utility U(2,3) = 6

U(2,2) = 4
U(4,1) = 4

x2

x1
 Utility Functions & ICs
This 3D visualization of preferences
can be made more informative by
adding into it the ICs.
Utility Functions & ICs

Utility
U

U
x2 Higher indifference
curves contain
more preferred
bundles.
x1
 Utility Functions & ICs
Comparing more bundles will create
a larger collection of all ICs and a
better description of the consumer’s
preferences.
Utility Functions & ICs

x2

U6
U4
U2
x1
 Utility Functions & ICs

As before, this can be visualized in

3D by plotting each indifference
curve at the height of its utility index.
Utility Functions & ICs

Utility
U6
U5
U4
x2 U3
U2
U1
x1
 Utility Functions & ICs
Comparing all possible consumption
bundles gives the complete collection
of the consumer’s ICs, each with its
assigned utility level.
This complete collection of ICs
completely represents the consumer’s
preferences.
Utility Functions & ICs

x2

x1
Utility Functions & ICs

x2

x1
Utility Functions & ICs

x2

x1
Utility Functions & ICs

x2

x1
Utility Functions & ICs

x2

x1
Utility Functions & ICs

x2

x1
Utility Functions & ICs

x1
Utility Functions & ICs

x1
Utility Functions & ICs

x1
Utility Functions & ICs

x1
Utility Functions & ICs

x1
Utility Functions & ICs

x1
Utility Functions & ICs

x1
Utility Functions & ICs

x1
Utility Functions & ICs

x1
Utility Functions & ICs

x1
 Utility Functions & ICs
The collection of all ICs for a given
preference relation is an indifference
map.
An indifference map is equivalent to
a utility function.
 Utility Functions
There is no unique utility function
representation of a preference
relation.
Suppose U(x1,x2) = x1x2 represents a
preference relation.
Again consider the bundles (4,1),
(2,3) and (2,2).
 Utility Functions
u U(x1,x2) = x1x2, so

U(2,3) = 6 > U(4,1) = U(2,2) = 4;

(4,1) ~ (2,2).
p
that is, (2,3)
 Utility Functions
(2,3) (4,1) ~ (2,2).
p
u U(x1,x2) = x1x2
u Define V = U2.
u Then V(x1,x2) = x12x22 and
V(2,3) = 36 > V(4,1) = V(2,2) = 16
so again (2,3) (4,1) ~ (2,2).
p
u V preserves the same order as U and
so represents the same preferences.
 Utility Functions
(2,3) (4,1) ~ (2,2).
p
u U(x1,x2) = x1x2
u Define W = 2U + 10.
u Then W(x1,x2) = 2x1x2+10 so
W(2,3) = 22 > W(4,1) = W(2,2) = 18.
Again, (2,3) (4,1) ~ (2,2).
p
u W preserves the same order as U and V
and so represents the same preferences.
 Utility Functions
If:
– U is a utility function that
represents a preference relation f ~
and
– f is a strictly increasing function,
then V = f(U) is also a utility function
representing f .
~
 Goods, Bads and Neutrals
A good is a commodity unit which
increases utility.
A bad is a commodity unit which
decreases utility.
A neutral is a commodity unit which
does not change utility.
 Goods, Bads and Neutrals
Utility
Utility
function
Units of Units of
water are water are
goods bads

Water
x
Around x units, a little extra water is a neutral.
Some Other Utility Functions I
Now consider

V(x1,x2) = x1 + x2.

What do the ICs for this “perfect

substitution” utility function look
like?
 Perfect Substitution ICs
x2
x1 + x2 = 5
13
x1 + x2 = 9
9
x1 + x2 = 13
5

5 9 13
x1

All are linear and parallel.

Some Other Utility Functions II
Now consider

W(x1,x2) = min{x1,x2}

What do the indifference curves for

this “perfect complementarity” utility
function look like?
Perfect Complementarity ICs
x2
45o

8 min{x1,x2} = 8
5 min{x1,x2} = 5
3 min{x1,x2} = 3
x1
3 5 8
All are right-angled with vertices on a ray
from the origin.
Some Other Utility Functions III
Quasi-linear utility function:

U(x1,x2) = f(x1) + x2

is linear in just x2.

E.g.: U(x1,x2) = 2x11/2 + x2.
 Quasi-linear Indifference Curves
x2 Each curve is a vertically shifted copy of the
others.

x1
Some Other Utility Functions IV
Cobb-Douglas utility function:

U(x1,x2) = x1a x2b

with a > 0 and b > 0.

E.g. U(x1,x2) = x11/2 x21/2 (a = b = 1/2)
V(x1,x2) = x1 x23 (a = 1, b = 3)
 Cobb-Douglas ICs
x2
All curves are hyperbolic,
asymptoting to, but never
touching any axis.

x1
 Marginal Utilities (MU)
Marginal means “incremental”.
The marginal utility of commodity i is
the rate-of-change of total utility as
the quantity of commodity i
consumed changes; i.e.
U
MU i =
 xi
 MU and MRS
The general equation for an IC is

U(x1,x2)  k (k is a constant)

Totally differentiating this identity gives

U U
dx1 + dx 2 = 0
 x1  x2
 MU and MRS
Rearranged, it is:

d x2  U /  x1
=− .
d x1  U /  x2
This is the MRS between 1 and 2.
That is, how many of 2 is 1 worth?
 MU and MRS: An example
Consider C-D U(x1,x2) = x1x2:
U
= (1)( x2 ) = x2
 x1
U
= ( x1 )(1) = x1
 x2
d x2  U /  x1 x2
so MRS = =− =− .
d x1  U /  x2 x1
MU and MRS: An example
x2 x2
U(x1,x2) = x1x2; MRS = −
x1

8 MRS(1,8) = - 8/1 = -8
MRS(6,6) = - 6/6 = -1.
6

U = 36
U=8
1 6 x1
 MRS for Quasi-linear Utility
Functions
A quasi-linear utility function is of
the form U(x1,x2) = f(x1) + x2.
U U
= f ( x1 ) =1
 x1  x2
d x2  U /  x1
so MRS = =− = − f  ( x1 ).
d x1  U /  x2
 MRS for Quasi-linear Utility
MRS = - f  (x1) does not depend upon
x2, so the slope of ICs for a quasi-
linear utility function is constant
along any line for which x1 is fixed.
 MRS for Quasi-linear Utility
x2
Each curve is a vertically shifted
MRS =f(x1’) copy of the others.

MRS = -f(x1”) MRS is a constant

along any line for
which x1 is
constant.

x1’ x1” x1
 Monotonic Transformations
Applying a monotonic transformation
to a utility function representing a
preference relation simply creates
another utility function representing
the same preference relation.
What happens to MRS when a
monotonic transformation is applied?
Monotonic Transformations &
MRS
For U(x1,x2) = x1x2, the MRS = -x2/x1.
Create V = U2; i.e. V(x1,x2) = x12x22.
What is the MRS for V?
 V /  x1 2
2 x1 x 2 x2
MRS = − =− =−
 V /  x2 2
2 x1 x 2 x1
which is the same as the MRS for U.
 Monotonic Transformations &
MRS
More generally, if V = f(U) where f is a
strictly increasing function, then
 V /  x1 f  (U )   U / x1
MRS = − =−
 V /  x2 f '(U )   U / x 2
 U /  x1
=− .
 U /  x2
So MRS is unchanged by a positive
monotonic transformation.
 Excercise
1/ Elmer’s utility function is U(x; y) = min(x,y2)
(a) If Elmer consumes 4 units of x and 3 units of y, his utility is .
(b) If Elmer consumes 4 units of x and 2 units of y, his utility is .
(c) If Elmer consumes 5 units of x and 2 units of y, his utility is .
(d) Draw the indifierence curve for Elmer that contains the bundles that he likes
exactly as well as the bundle (4; 2).
(e) Draw the indifierence curve for Elmer that contains bundles that he likes
exactly as well as the bundle (1; 1) and the indifierence curve that passes
through the point (16; 5).
(f ) On your graph, show the locus of points at which Elmer’s indifierence curves
have kinks. What is the equation for this curve? .
(g) On the same graph, use black ink to draw Elmer’s budget line when
the price of x is 1, the price of y is 2, and his income is 8. What bundle doe Elmer
choose in this situation?

59
 Excercise
2/ Linus has the utility function U(x; y) = x + 3y.

(a) Draw the indifierence curve passing through the point (x; y) = (3; 3). Use black
ink to sketch the indifierence curve connecting bundles that give Linus a utility of 6.
(b) On the same graph, draw Linus’s budget line if the price of x is 1 and the price
of y is 2 and his income is 8. What bundle does Linus choose in this situation? .
(c) What bundle would Linus choose if the price of x is 1, the price of y is 4, and his
income is 8?

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