CHAPTER 4

Utility

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Preferences: A Reminder
x ≻ y: x is preferred strictly to y.
x ~ y: x and y are equally preferred.
x ≿ y: x is preferred at least as much as y.

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Utility Functions – 1
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.

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Utility Functions – 2
A utility function u(x) represents a preference relation if and
only if:

xʹ ≿ xʺ ⇔ u(xʹ) ≥ u(xʺ)

xʹ ≻ xʺ ⇔ u(xʹ) > u(xʺ)

xʹ ~ xʺ ⇔ u(xʹ) = u(xʺ)

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Utility Functions – 3
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.

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Utility Functions & Indifference Curves – 1
• Consider the bundles (4, 1), (2, 3), and (2, 2).
• Suppose (2, 3) ≻ (4, 1) ~ (2, 2).
• Assign to these bundles any numbers that preserve the preference
ordering; e.g.,
• Call these numbers utility levels.

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Utility Functions & Indifference Curves – 2
• An indifference curve contains equally preferred bundles.
• Equal preference  same utility level.
• Therefore, all bundles on an indifference curve have the same utility level.

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Utility Functions & Indifference Curves – 3
• So the bundles (4, 1) and (2, 2) are on the indifference curve with utility
level u = 4.
• But the bundle (2, 3) is on the indifference curve with utility level u = 6.
• In an indifference curve diagram, this preference information looks as
follows:

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Utility Functions & Indifference Curves – 4

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Utility Functions & Indifference Curves – 5
Another way to visualize this same information is to plot the utility level on a
vertical axis.

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Utility Functions & Indifference Curves – 6

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Utility Functions & Indifference Curves – 7
This 3D visualization of preferences can be made more informative by adding
into it the two indifference curves.

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Utility Functions & Indifference Curves – 8

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Utility Functions & Indifference Curves – 9
Comparing more bundles will create a larger collection of all indifference
curves and a better description of the consumer’s preferences.

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Utility Functions & Indifference Curves – 10

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Utility Functions & Indifference Curves – 11
As before, this can be visualized in 3D by plotting each indifference curve at
the height of its utility index.

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Utility Functions & Indifference Curves – 12

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Utility Functions & Indifference Curves – 13
• Comparing all possible consumption bundles gives the complete collection
of the consumer’s indifference curves, each with its assigned utility level.
• This complete collection of indifference curves completely represents the
consumer’s preferences.

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Utility Functions & Indifference Curves – 14
The following eight diagrams illustrate the connection between the two-
dimensional look at utility functions and indifference curves to the three-
dimensional look.

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Utility Functions & Indifference Curves – 15

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Utility Functions & Indifference Curves – 16

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Utility Functions & Indifference Curves – 17

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Utility Functions & Indifference Curves – 18

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Utility Functions & Indifference Curves – 19

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Utility Functions & Indifference Curves – 20

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Utility Functions & Indifference Curves – 21

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Utility Functions & Indifference Curves – 22

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Utility Functions & Indifference Curves – 23
The collection of all indifference curves for a given preference relation is an
“indifference map.”
 An indifference map is equivalent to a utility function.

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Utility Functions – 4
There is no unique utility function representation of a preference relation.
 Suppose represents a preference relation.
 Again consider the bundles (4, 1), (2, 3), and (2, 2).

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Utility Functions – 5

 Since


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Utility Functions – 6

• Define
 Then,
 So again,
• V preserves the same order as u and therefore represents the same
preferences.

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Utility Functions – 7

• Define
 Then,
 So again,
W preserves the same order as u and therefore represents the same
preferences.

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Utility Functions – 8
If
• u is a utility function that represents a preference relation
and
• f is a strictly increasing function,
then V = f (u) is also a utility function representing the same preference
relation. This is known as a “monotonic transformation.”

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Goods, Bads, and Neutrals – 1
• A good is a commodity which increases utility with additional consumption.
• A bad is a commodity which decreases utility with additional consumption.
• A neutral is a commodity which does not change utility with additional
consumption.

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Goods, Bads, and Neutrals – 2

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Some Other Utility Functions and Their Indifference Curves – 1
Instead of consider

This utility function is an example of two goods that are perfect substitutes.
What do the indifference curves for this “perfect substitution” utility
function look like?

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Perfect Substitution Indifference Curves

All are linear and parallel.

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Some Other Utility Functions and Their Indifference Curves – 2
Instead of consider

This utility function is an example of two goods that are perfect complements.
What do the indifference curves for this “perfect complementarity” utility
function look like?

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Perfect-Complementarity Indifference Curves

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Some Other Utility Functions and Their Indifference Curves – 3
A utility function of the form is linear in just x2
and is called “quasi-linear.”
E.g.,

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Quasi-linear Indifference Curves

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Some Other Utility Functions and Their Indifference Curves – 4
Any utility function of the form with a > 0 and b > 0
is called a “Cobb-Douglas” utility function.
• E.g.,

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Cobb-Douglas Indifference Curves

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Marginal Utilities – 1
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.,

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Marginal Utilities – 2
E.g., if then

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Marginal Utilities and Marginal Rates of Substitution – 1
• The general equation for an indifference curve is
k is a constant.
• Totally differentiating this identity gives

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Marginal Utilities and Marginal Rates of Substitution – 2

can be rearranged algebraically to be:

 This is the MRS.

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MU and MRS: An Example – 1
Suppose Then

and

So,

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MU and MRS: An Example – 2

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MRS for Quasi-linear Utility Functions – 1
A quasi-linear utility function is of the form
and

So,

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MRS for Quasi-linear Utility Functions – 2
MRS = −f’ (x1) does not depend upon x2 so the slope of indifference curves for
a quasi-linear utility function is constant along any line for which x 1 is
constant. What does that make the indifference map for a quasi-linear utility
function look like?

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MRS for Quasi-linear Utility Functions – 3

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Monotonic Transformations & Marginal Rates of Substitution – 1

As previously discussed, 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 marginal rates of substitution when a monotonic
transformation is applied?

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Monotonic Transformations & Marginal Rates of Substitution – 2

For the
Create What is the MRS for V?

 Which is the same as the MRS for u.

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Monotonic Transformations & Marginal Rates of Substitution – 3

More generally, if V = f (u) where f is a strictly increasing function, then the

MRS is unchanged by this positive monotonic transformation.

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Review Questions: Chapter 4
Q1: The text said that raising a number to an odd power was a monotonic
transformation. What about raising a number to an even power? Is this a
monotonic transformation? (Hint: consider the case f(u) = u^2 .)

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Review Questions: Chapter 4

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Review Questions: Chapter 4
3. We claimed in the text that if preferences were monotonic, then a diagonal
line through the origin would intersect each indifference curve exactly once.

Can you prove this rigorously?

(Hint: what would happen if it intersected some indifference curve twice?)

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Review Questions: Chapter 4

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Review Questions: Chapter 4

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Review Questions: Chapter 4

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Review Questions: Chapter 4

Q7: Can you explain why taking a monotonic transformation of a utility function
doesn’t change the marginal rate of substitution?

Hint: Remember as we move up to the better zones, indifference curves have

higher utility, but MRS is just multiplying.

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Question: Chapter 5

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 Question related to Chapter 5
In the case of convex preferences, any point that satisfies the tangency condition
must be an optimal point.

This is clear geometrically: since convex indifference curves must curve away
from the budget line, they can’t bend back to touch it again.

Hint: Read chapter 5: Choice, page number 77.

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