CONSUMER PREFERENCES AND THE CONCEPT OF UTILITY

3.1 REPRESENTATIONS OF PREFERENCES

In a modern economy, consumers can purchase a vast array of goods and services. We begin by
considering a market basket (sometimes called a bundle), defined as a collection of goods and
services that an individual might consume.
Consumer preferences Indications of how a consumer would rank (compare the desirability of)
any two possible baskets, assuming the baskets were available to the consumer at no cost.

ASSUMPTIONS ABOUT CONSUMER PREFERENCES

Our study of consumer preferences begins with three basic assumptions:
1. Preferences are complete. That is, the consumer is able to rank any two baskets. For
baskets A and B, for example, the consumer can state her preferences according to one of
the following possibilities:
a) She prefers basket A to basket B (written A > B).
b) She prefers basket B to basket A (written B > A).
2. Preferences are transitive. By this, we mean that the consumer makes choices that are
consistent with each other. r. Suppose that a consumer tells us that she prefers basket A to
basket B, and basket B to basket E. We can then expect her to prefer basket A to basket
E. (A>B, B>E, A>E)
3. More is better. In other words, having more of a good is better for the consumer.
ORDINAL AND CARDINAL RANKING
We will refer to two types of rankings: ordinal and cardinal.
1. Ordinal rankings give us information about the order in which a consumer ranks
baskets. However, an ordinal ranking would not tell us how much more she likes A than
D.
2. Cardinal rankings give us information about the intensity of a consumer’s preferences.
We can also measure the strength of her preference for A over D.
It is usually easy for consumers to answer a question about an ordinal ranking.

The three assumptions allow us to represent preferences with a utility function. A utility function
measures the level of satisfaction that a consumer receives from any basket of goods.
3.2 UTILITY FUNCTIONS
The three assumptions allow us to represent preferences with a utility function. A utility function
measures the level of satisfaction that a consumer receives from any basket of goods.
PREFERENCES WITH A SINGLE GOOD: THE CONCEPT OF MARGINAL UTILITY
To illustrate the concept of a utility function, let’s begin with a simple scenario in which a
consumer, Sarah, purchases only one good, hamburgers. Let y denote the number of hamburgers
she purchases each week, and let U(y) measure the level of satisfaction (or utility) that Sarah
derives from purchasing y hamburgers.
Figure 3.2(a) depicts Sarah’s utility function for hamburgers. The equation of the utility function
that gives rise to this graph is U(y) =√ y . We observe that Sarah’s preferences satisfy the three
assumptions just described. They are complete because she can assign a level of satisfaction to
each value of y. The assumption that more is better is also satisfied because the more hamburgers
consumed, the higher her utility. For example, suppose the number of hamburgers in basket A is
1, the number in basket B is 4, and the number in basket C is 5. Then Sarah ranks the baskets as
follows: C > B and B > A, which we can see from the fact that Sarah’s utility at point C is higher
than it is at point B, and her utility at point B is higher than her utility at point A. Finally, Sarah’s
preferences are transitive: Since she prefers basket C to basket B and basket B to basket A, she
also prefers basket C to basket A.
Marginal Utility
We will often want to know how the level of satisfaction will change (∆U) in response to a
change in the level of consumption, (∆ is read as “the change in”). Economists refer to the rate at
which total utility changes as the level of consumption rises as the marginal utility (MU).
Marginal utility the rate at which total utility changes as the level of consumption rises. The
∆U
marginal utility of good y (MUy) is thus: MUy =
∆y

Principle of Diminishing Marginal Utility

When drawing total utility and marginal utility curves, you should keep the following points in mind:

1. Total utility and marginal utility cannot be plotted on the same graph
2. The marginal utility is the slope of the (total) utility function
3. The relationship between total and marginal functions holds for other measures in economics
Sarah’s marginal utility declines as she eats more hamburgers. This trend illustrates the principle
of diminishing marginal utility: After some point, as consumption of a good increase, the
marginal utility of that goodwill begins to fall. Diminishing marginal utility reflects a common
human trait. The more of something we consume, the less additional satisfaction we get from
additional consumption. The marginal utility may not decline after the first unit, the second unit,
or even the third unit. But it will normally fall after some level of consumption.

Is More Always Better?

PREFERENCES WITH MULTIPLE GOODS: MARGINAL UTILITY, INDIFFERENCE

CURVES, AND THE MARGINAL RATE OF SUBSTITUTION
In real life, consumers can choose among myriad goods and services. To study the trade-offs a consumer
must make in choosing his optimal basket, we must examine the nature of consumer utility with multiple
products.
The concept of marginal utility is easily extended to the case of multiple goods. The marginal utility of
any one good is the rate at which total utility changes as the level of consumption of that good rises,
holding constant the levels of consumption of all other goods. For example, in the case in which only two
goods are consumed and the utility function is U(x, y), the marginal utility of food (MUx) measures how
the level of satisfaction will change ( ∆ U) in response to a change in the consumption of food ( ∆ x),
holding the level of y constant:
∆U
MUx = ∆ X │y is held constant

Similarly, the marginal utility of clothing (MUy) measures how the level of satisfaction will change ( ∆ U)
in response to a small change in the consumption of clothing (∆ y), holding constant the level of food (x):

∆U
MUy = ∆ y │x is held constant

The utility function U=√ xy satisfies the assumptions that more is better and that marginal utilities are
diminishing. Because these are widely regarded as reasonable characteristics of consumer preferences, we
will often use this utility function to illustrate concepts in the theory of consumer choice.

Indifference Curves
Indifference curve a curve connecting a set of consumption baskets that yield the same level of
satisfaction to the consumer.
Indifference curves on an indifference map have the following four properties.
1. When the consumer likes both goods (i.e., when MUx and MUy are both positive), all the indifference
curves have a negative slope.
2. Indifference curves cannot intersect
3. Every consumption basket lies on one and only one indifference curve
4. Indifference curves are not “thick.’’

The Marginal Rate of Substitution

A consumer’s willingness to substitute one good for another while maintaining the same level of
satisfaction is called the marginal rate of substitution
When two goods have positive marginal utilities, the trade-off that the consumer is willing to make
between the two goods is illustrated by the slope of the indifference curve.

We can also express the marginal rate of substitution for any basket as a ratio of the marginal
utilities of the goods in that basket. To see how consider any specific basket on the indifference
curve U0. Suppose the consumer changes the level of consumption of x and y by ∆x and ∆y,
respectively. The corresponding impact on utility U will be:

∆U = MUx(∆x) + MUy(∆y)

But it must be that ∆ U = 0, because changes in x and y that move us along the indifference curve U0 must
keep utility unchanged. So 0 = MUx(∆ x) + MUy (∆ y), which can be rewritten as MUy (∆ y) - MUx(∆ x).
We can now solve for the slope of the indifference curve:

∆y MUx
∆x
│holding utility constant = -
MUy
Finally, since MRSx, y is the negative of the slope of the indifference curve, we observe that
 −∆ y MUx
∆x
│holding utility constant =
MUy
= MRXs,y

Diminishing Marginal Rate of Substitution

A feature of consumer preferences for which the marginal rate of substitution of one good for another
good diminishes as the consumption of the first good increases along an indifference curve.

3.3 SPECIAL PREFERENCES

A consumer’s willingness to substitute one good for another will depend on the commodities in
question.

PERFECT SUBSTITUTES

In some cases, a consumer might view two commodities as perfect substitutes for one another. Two
goods are perfect substitutes when the marginal rate of substitution of one for the other is a constant.

PERFECT COMPLEMENTS

In some cases, consumers might be completely unwilling to substitute one good for another. Consider a
typical consumer’s preferences for left shoes and right shoes, depicted in Figure 3.14. The consumer
wants shoes to come in pairs, with exactly one left shoe for every right shoe. The consumer derives
satisfaction from complete pairs of shoes, but gets no added utility from extra right shoes or extra left
shoes. The indifference curves in this case comprise straight-line segments at right angles, as shown
Figure 3.14

The consumer with the preferences illustrated in Figure 3.14 regards left shoes and right shoes as
perfect complements in consumption. Perfect complements are goods the consumer always wants in
fixed proportion to each other.
THE COBB–DOUGLAS UTILITY FUNCTION

The utility functions U =√ xy and U = xy are examples of the Cobb–Douglas utility function. For two
goods, the Cobb–Douglas utility function is more generally represented as U = Ax∝ y β, where A, ∝, and
β are positive constants.
The Cobb–Douglas utility function has three properties that make it of interest in the study of consumer
choice.

 The marginal utilities are positive for both goods. The marginal utilities are MUx = ∝ Ax ∝−1
y β and MUy = β Ax ∝ y β−1; thus, both MUx and MUy are positive when A, ∝, and β are
positive constants. This means that “the more is better” assumption is satisfied.
 Since the marginal utilities are both positive, the indifference curves will be downward
sloping.
 The Cobb–Douglas utility function also exhibits a diminishing marginal rate of substitution.
The indifference curves will therefore be bowed in toward the origin.

QUASILINEAR UTILITY FUNCTIONS

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). A quasilinear utility function can describe preferences for a
consumer who purchases the same amount of a commodity regardless of his income.

The distinguishing characteristic of a quasilinear utility function is that, as we move due north on the
indifference map, the marginal rate of substitution of x for y remains the same. That is, at any value of x,
the slopes of all of the indifference curves will be the same, so the indifference curves are parallel to
each other.