Intermediate Microeconomics

Lecture 2

Preferences and Utility

 Review
 Consumers are assumed to choose
the best bundle of goods they can
afford.
 In last lecture, we discussed what do
we mean by “can afford.”

2
 Budget Constraints
 The consumer’s budget set is the set
of all affordable bundles;
B(p1, … , pn, m) =
{ (x1, … , xn) | x1  0, … , xn 0 and
p1x1 + … + pnxn  m }

 The
budget constraint (line) is the
upper boundary of the budget set.

3
 Budget Set and Constraint for
x2
Two Commodities
Budget constraint is
m /p2
p1x1 + p2x2 = m.

Budget set is the collection

of all affordable bundles.
Budget
Set
m /p1 x1

4
 Consumer Problem
 Consumers face budget constraints.

 They can only buy things they can

afford.

 Buthow do consumers make

choices between goods that they
can afford?

5
 Discussion
 Howdo you allocate your time
between studying and leisure?

6
 Discussion
 Ifyou want to purchase a laptop, how do
you choose between all the affordable
brands/models?

7
 Rationality in Economics
A decision maker always chooses its
most preferred alternative from its set of
available alternatives.

 Tomodel choice, we must model

decision makers’ preferences.

 How do we model preferences?

 Preference Relations

Which one do you prefer?

What kind of relations can we generalize between two
choices?

9
 Preference Relations
 Comparing two different consumption
bundles, x and y:
– strict preference: x is more preferred
than is y.
– weak preference: x is as at least as
preferred as is y.
– indifference: x is exactly as preferred
as is y.
 Preference Relations
 Strictpreference, weak preference and
indifference are all preference relations.

 They are ordinal relations: they state only

the order in which bundles are preferred.

Note: only the ordering matters.

 Preference Relations
p
 denotes strict preference;
p
x y means that bundle x is preferred
strictly to bundle y.
 Preference Relations
p
 denotes strict preference;
p
x y means bundle x is preferred
strictly to bundle y.
 ~denotes indifference; x ~ y means x
and y are equally preferred.
 Preference Relations
p
 denotes strict preference so
p
x y means that bundle x is preferred
strictly to bundle y.
 ~denotes indifference; x ~ y means x
and y are equally preferred.
 f denotes weak preference;
~
x f y means x is preferred at least as
~
much as is y.
 Preference Relations
x f y and y f x imply x ~ y.
~ ~
 Preference Relations
x f y and y f x imply x ~ y.
~ ~
 x f y and (not y f x) imply x
p y.
~ ~
Assumptions about Preference Relations

 1. Completeness: For any two

bundles x and y, it is always possible
to make the statement that either

x fy
or
~
y f x.
~
Assumptions about Preference Relations

 2. Reflexivity: Any bundle x is

always at least as preferred as itself;
i.e.

x f x.
~
Assumptions about Preference Relations

 3. Transitivity: If
x is at least as preferred as y, and
y is at least as preferred as z, then
x is at least as preferred as z; i.e.

x f y and y f z x f z.
~ ~ ~
 Indifference Curves
 Take a reference bundle x’. The set of
all bundles equally preferred to x’ is the
indifference curve containing x’:
The set of all bundles y ~ x’

 Note:An indifference “curve” is not

always a curve, a better name might be
an indifference “set”.
 Indifference Curves
x’ ~ x” ~ x”’
x2
x’ Bundles on the
same
indifference
x” curve are
indifferent.
x”’
How about
bundles that are
x1 strictly preferred
to X’’?
 Indifference Curves
x2 z
p x
p y
x

x1
 Indifference Curves
I2 I1 All bundles in I1 are
x2 strictly preferred to all
in I2.

I3 z
x
All bundles in I2 are
y strictly preferred to
all in I3.
x1
 Indifference Curves
x2
WP(x), the set of Weakly preferred set:
x bundles weakly The shaded area
preferred to x. consists of all
bundles that are at
least as good as
I(x) I(x’) bundle X

x1
 Indifference Curves
x2
WP(x), the set of
x bundles weakly
preferred to x.
WP(x)
includes
I(x) I(x).

x1
 Indifference Curves
x2
SP(x), the set of
x bundles strictly
preferred to x, Strictly preferred set
does not
include
I(x) I(x).

x1
 Indifference Curves

x2 I2
I1
Indifference curves
cannot cross!
Why?
x
y
z

x1
 Indifference Curves Cannot
Intersect
x2 I2 From I1, x ~ y.
I1 From I2, x ~ z.
Therefore y ~ z.
But from I1 and
p
I2 we see y z,
x
y which is a
contradiction.
z

x1
 Indifference Curve
Q:Should indifference curves always be
negatively slopped?

29
 Slopes of Indifference Curves
 When more of a commodity is always
preferred, the commodity is a good.
 If every commodity is a good then
indifference curves are negatively
sloped.
 Slopes of Indifference Curves
Good 2
Two goods
a negatively sloped
indifference curve.

(The more, the

better)
Good 1
 Slopes of Indifference Curves
 Ifless of a commodity is always
preferred then the commodity is a
bad.
 What does the indifference curve
looks like if with one good and one
bad.
 Slopes of Indifference Curves
Good 2
One good and one
bad
a positively sloped
indifference curve.

Bad 1

Good 2: the more, the better

Bad 1: the less, the better
 Extreme Cases of Indifference Curves

 Case1:You have pencils of two

different colors (red and blue) and
you have no specific preference for a
particular color.
 What does the indifference curve
look like?

34
 Perfect Substitutes
If a consumer always regards units of
commodities 1 and 2 as equivalent,

the commodities are perfect

substitutes and only the total amount
of the two commodities in bundles
determines their preference rank-order.
 Perfect Substitutes
x2
Slopes are constant at - 1.
15 I2
Bundles in I2 all have a total
of 15 units and are strictly
8 preferred to all bundles in
I1, which have a total of
I1 only 8 units.

8 15 x1
Only care about the number of pencils, not the color of them.
 Extreme Cases of Indifference Curves

 Case2: You wear both right and left

shoes. You always need to wear
them as a pair.

 Havingonly a right shoe is useless

without the left one and vice versa.

37
 Perfect Complements
If a consumer always consumes commodities 1
and 2 in fixed proportion (e.g. one-to-one),

the commodities are perfect complements and

only the number of pairs determines the
preference rank-order of bundles.

For example, Xbox (hardware)+Games

(Software)
 Perfect Complements
x2
45o Each of (5,5), (5,9)
and (9,5) contains
5 pairs so each is
equally preferred.
9
5 I1

5 9 x1
 Perfect Complements
x2 Since each of (5,5), (5,9)
45o and (9,5) contains 5 pairs
(I1) , each is less preferred
than the bundle (9,9) which
contains 9 pairs (I2)
9 I2
5 I1

5 9 x1
 Extreme Cases of Indifference Curves

 Case 3: Exercise
 You like pizzas but hate vegetables.
You are only willing to eat an extra
unit of vegetable if you get to eat an
extra unit of pizza.

 What does the indifference curve

look like?

41
 Extreme Cases of Indifference Curves

 Case 4: You always want to study for

6 hours and workout for 2 hours. Any
deviation from it gives you a lower
utility level.

42
Preferences Exhibiting Satiation
A bundle strictly preferred to any
other is a satiation point or a bliss
point.

 What do indifference curves look like

for preferences exhibiting satiation?
 Indifference Curves Exhibiting
Satiation
x2
Satiation
(bliss)
point

x1
 Indifference Curves Exhibiting
Satiation
x2
Satiation
(bliss)
Better point

x1
 Indifference Curves Exhibiting
Satiation
x2
Satiation
(bliss)
Better point

x1
The closer to the satiation point, the better.
Not always the more, the better.
 Indifference Curves for Discrete
Commodities
How do we measure the quantity
of each commodity?
e.g. water? And cars?

47
Indifference Curves for Discrete
Commodities
A commodity is infinitely divisible
(continuous) if it can be acquired in
any quantity; e.g. water or cheese.

A commodity is discrete if it comes

in unit lumps of 1, 2, 3, … and so on;
e.g. aircraft, ships and refrigerators.
Indifference Curves for Discrete
Commodities
 Suppose commodity 2 is an infinitely
divisible good (water) while
commodity 1 is a discrete good
(pens).
 What do indifference “curves” look
like?
 Indifference Curves With a
Discrete Good
Water
Indifference “curves”
are collections of
discrete points.

0 1 2 3 4 Pens
 Indifference Curves
 Do we need to make some
assumptions on the shapes of the
indifference curves?
 We begin with some preferences that
are well-behaved.

51
 Well-Behaved Preferences
A preference relation is “well-behaved”
if it is
– monotonic and convex.
 1. Monotonicity: More of any
commodity is always preferred (i.e. no
satiation and every commodity is a
good).
 Monotonic?
x2
Satiation
(bliss)
Better point

x1

53
 Well-Behaved Preferences
 2. Convexity: Mixtures of bundles are
(at least weakly) preferred to the
bundles themselves.

 E.g., the 50-50 mixture of the bundles

x and y is
z = (0.5)x + (0.5)y.
z is at least as preferred as x or y.
 Convexity

x2 x

x2+y2 x+y is strictly preferred

z=
2 to both x and y.
2
y
y2
x1 x1+y1 y1
2
 Convexity

x2 x
z =(tx1+(1-t)y1, tx2+(1-t)y2)
is preferred to x and y
for all 0 < t < 1.
y
y2
x1 y1
 Convexity
 Geometrically,it means that the set
of bundles weakly preferred to x is a
convex set.

 Ifyou take any two points in the set

and draw the line connecting the two
points, that line segment lies entirely
in the set.

57
 Convexity

x Preferences are
x2 strictly convex when
z all mixtures z are
strictly preferred to
their component
bundles x and y.
y
y2
x1 y1
 Non-Convex Preferences

x2
The mixture z
is less preferred
z than x or y.

y2 These are concave

preferences.
x1 y1
 More Non-Convex Preferences

x2
The mixture z
z is less preferred
than x or y.
y2
x1 y1
 Convexity
 We want monotonicity as we need the
commodity to be good.
 Intuitively, why do we need to assume
convexity preferences?

61
 Convexity

 Forthe most part, goods are consumed

together.

 Consumers would want to trade some of

one good for the other and end up
consuming some of each, rather than
specializing in consuming only one of the
two goods.

62
 Slopes of Indifference Curves
 The slope of an indifference curve (at
a given point) is its marginal rate-of-
substitution (MRS).
 Marginal Rate of Substitution
x2
MRS at x’ is the slope of the
indifference curve at x’ (the line
tangent to the curve)
x’

x1
 Marginal Rate of Substitution
MRS at x’ is
x2 lim {Dx2/Dx1}
Dx1 0
= dx2/dx1 at x’
D x2 x’
MRS measures the
rate at which the
Dx1
consumer is just
willing to substitute
x1 one good for the
other.
 Marginal Rate of Substitution
At x’, dx2=dx1 MRS.
x2 MRS is the rate at which the
consumer is only just willing to
exchange commodity 2 for a
small amount of commodity 1
dx2 x’
(rate of exchange).
dx1

x1
 MRS & Ind. Curve Properties
 Does MRS tell us anything about the
indifference curves?
(signs and magnitude)

67
 MRS & Ind. Curve Properties
Good 2
Two goods
a negatively sloped
indifference curve
MRS < 0.

Good 1
 MRS & Ind. Curve Properties
Good 2
One good and one
bad
a positively sloped
indifference curve
MRS > 0.

Bad 1
 MRS & Ind. Curve Properties
Good 2
MRS = - 5
MRS always increases with x1
(becomes less negative) if and
only if preferences are strictly
convex.

MRS = - 0.5 Good 1

 MRS & Ind. Curve Properties
x2 MRS decreases
MRS = - 0.5
(becomes more negative)
as x1 increases
nonconvex preferences

MRS = - 5
x1
 MRS & Ind. Curve Properties
x2 MRS is not always increasing as
x1 increases nonconvex
preferences.
MRS = - 1
MRS
= - 0.5
MRS = - 2

x1
 Utility Functions
 So far, we see we can use indifference
curves to describe preferences.
 Is there another way to describe
preferences?

73
 Utility Functions

 We can assign a number to every

possible consumption bundle such
that more-preferred bundles get
assigned larger numbers than less-
preferred bundles.

74
 Utility
 Utility
was thought of as a numeric
measure of a person’s happiness.

 Consumers make choices so as to

maximize their utility to make
themselves as happy as possible.

75
 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.

76
 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”).

77
 Utility Functions
 Utility is an ordinal 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.]
 How much higher doesn’t matter.

78
Utility Functions & Indiff. Curves
 Considerthe 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.

79
Utility Functions & Indiff. Curves
 Anindifference curve contains
equally preferred bundles.
 Equal preference  same utility level.

 Therefore, all bundles on an

indifference curve have the same
utility level.

80
Utility Functions & Indiff. Curves
 Sothe bundles (4,1) and (2,2) are on
the indiff. curve with utility level U 

 Butthe bundle (2,3) is on the indiff.

curve with utility level U  6.

 Whatdoes this preference look like

on an indiff. curve?

81
Utility Functions & Indiff. Curves

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

U6
U4

x1 82
Utility Functions & Indiff. Curves
 Another way to visualize this same
information is to plot the utility level
on a vertical axis.

 Thehigher the value on the y-axis,

the higher utility levels.

 What does the graph look like for the

three bundles?
83
 Utility Functions & Indiff. Curves
3D plot of consumption & utility levels for 3 bundles

Utility U(2,3) = 6

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

x2

x1 84
Utility Functions & Indiff. Curves
Add into it the two indifference curves.

Utility
U 

U 
x2 Higher indifference
curves contain
more preferred
bundles.
x1 85
 Utility Functions
 How do we assign ordinal utilities?

 Isthere a utility function that

describes any reasonable preference
ordering?

86
 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).
 Which bundle is the most preferred?

87
 Utility Functions
 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)

88
 Utility Functions

 Q:
Is this the only function that can
describe this preference ordering?
p

89
 Utility Functions
(4,1) ~ (2,2).
p
 U(x1,x2)= x1x2 (2,3)
 Define V = U2.

90
 Utility Functions
(2,3) (4,1) ~ (2,2).
p
 U(x1,x2) = x1x2
 Define V = U2.
 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
 V preserves the same order as U and
so represents the same preferences.
 Again the values do not matter!
91
 Utility Functions
(4,1) ~ (2,2).
p
 U(x1,x2)
= x1x2 (2,3)
 Define W = 2U + 10.

92
 Utility Functions
(2,3) (4,1) ~ (2,2).
p
 U(x1,x2)= x1x2
 Define W = 2U + 10.
 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
 W preserves the same order as U and V
and so represents the same preferences.

93
 Utility Functions
 Doyou see any similar pattern of W
and V?

 Given a utility function U, what kind

of transformation preserves the
same preferences?

94
 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 .
~

95
 Perfect Substititution
 Instead of U(x1,x2) = x1x2 consider

V(x1,x2) = x1 + x2.

What do the indifference curves for

this “perfect substitution” utility
function look like?
– Substitute good 1 for good 2 at a rate
that is one-to-one. Only the total
numbers matter.
96
Perfect Substitution Indifference
Curves
x2
x1 + x2 = 5
13
x1 + x2 = 9
9
x1 + x2 = 13
5
V(x1,x2) = x1 + x2.

5 9 13 x1

97
 Perfect Substitution
 What about V(x1,x2) = 2x1 + x2?

 What do the Indiff. Curves look like?

98
 Perfect Substitution
 What about V(x1,x2) = 2x1 + x2?

 What do the Indiff. Curves look like?

 The slope of the Indiff. Curves would
be -2.
 For V(x1,x2) = ax1 + bx2, the slope of
an indiff. curve is –a/b.

99
 Utility Functions

 You like pizzas but hate vegetables. You

are only willing to eat an extra unit of
vegetables if you get to eat an extra unit
of pizza.
 What is a possible utility function?

100
 Perfect Complements
 What about the goods that are perfectly
complements?
 Left and right shoes, pencils and erasers,
fries and ketchup, game consoles and
games.
– Only pairs matter. If you have more of
either, it will not increase your utility.

101
 Perfect Complementarity
Indifference Curves
x2
45o
W(x1,x2) = min{x1,x2}

8 min{x1,x2} = 8
5 min{x1,x2} = 5
3 min{x1,x2} = 3

3 5 8 x1

102
 Some Other Utility Functions
A utility function of the form

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

is linear in just x2 and is called quasi-

linear.
 E.g. U(x1,x2) = 2x11/2 + x2.

103
 Quasi-linear Indifference Curves
x2 Each curve is a vertically shifted
copy of the others.

x1
104
 Some Other Utility Functions
 Any utility function of the form

U(x1,x2) = x1a x2b

with a > 0 and b > 0 is called a Cobb-

Douglas utility function.
 E.g. U(x1,x2) = x11/2 x21/2 (a = b = 1/2)
V(x1,x2) = x1 x23 (a = 1, b = 3)

105
 Cobb-Douglas Indifference
x2 Curves
All curves are hyperbolic,
asymptoting to, but never
touching any axis.

x1

106
 Cobb-Douglas Utility Functions
 Cobb-Douglas indiff. Curves look just like
the convex monotonic indiff. Curves
(“well-behaved indiff. Curves”)

 Cobb-Douglas preferences are quite

useful to present algebraic examples of
the economic ideas we’ll study later.

107
 Marginal Utilities
if U(x1,x2) = x11/2 x22 , what is the
 E.g.
marginal utility of X1?
 Marginal Utilities
 E.g. if U(x1,x2) = x11/2 x22 then

 U 1 1/ 2 2
MU 1   x1 x2
 x1 2

U
MU 2   2 x11/ 2 x2
 x2
 Marginal Utilities and Marginal
Rates-of-Substitution
 The general equation for an
indifference curve is
U(x1,x2)  k, a constant.

Totally differentiating this identity gives

U U
dx1  dx 2  0
 x1  x2

110
Marginal Utilities and Marginal
Rates-of-Substitution
U U
dx1  dx 2  0
 x1  x2
rearranged is
U U
dx 2   dx1
 x2  x1

111
Marginal Rates-of-Substitution

And U U
dx 2   dx1
 x2  x1
rearranged is
d x2  U /  x1
 .
d x1  U /  x2
This is the MRS.

112
 Marg. Rates-of-Substitution; An
example
 Suppose U(x1,x2) = x1x2. Then
U
 ( 1)( x 2 )  x 2
 x1
U
 ( x1 )( 1)  x1
 x2
d x2  U /  x1 x2
so M RS    .
d x1  U /  x2 x1
113
Marg. Utilities & Marg. Rates-of-
Substitution;
x2
x2 U(x1,x2) = x1x2; MRS  
x1
8 MRS(1,8) = - 8/1 = -8
6 MRS(6,6) = - 6/6 = -1.

U = 36
U=8
1 6 x1
114
 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 M RS     f  ( x 1 ).
d x1  U /  x2
What does this mean?
115
 MRS for Quasi-linear Utility
Functions
 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 x1 is
constant.

 Whatdoes the indifference curve for

a quasi-linear utility function look like?
116
 MRS for Quasi-linear Utility
x2
Functions
MRS = Each curve is a vertically
- f(x1’) shifted copy of the others.
MRS = -f(x1”) MRS is a
constant
along any line
for which x1 is
constant.

x1’ x1” x1
117
 Monotonic Transformations &
MRS
 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?
118
 Monotonic Transformations &
MRS
 For U(x1,x2) = x1x2 the MRS = - x2/x1.
 Create V = U2; (Monotonic
Transformation)
 V(x1,x2) = x12x22. The MRS for V is?

 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.

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 Monotonic Transformations &
Marginal Rates-of-Substitution
 More generally, if V = f(U) where f is
a strictly increasing function, then
 V /  x1 f  (U )   U /  x1
M RS   
 V /  x2 f ' (U )   U /  x 2
 U /  x1
 .
 U /  x2
So MRS is unchanged by a positive
monotonic transformation. 120
 Exercise
 Linda’spreferences over magazines
(M) and books (B) are given by:

 AreLinda’s preferences convex or

not?

121