4 Utility

CHAPTER 4
Utility
Utility function
Develop our study of consumer preferences a step further.
For analytical tractability we need a simple mathematical representation (function)
... that assigns a single number to each preference,
...such that higher numbers represent better bundles (higher indifference curves).
We call this representation of preferences a utility function.
• It is possible to avoid the notion of a utility representation and to our

analysis solely based on the notion of preferences.
• Nevertheless, we often use utility functions rather than preferences
as a means of describing an economic agent’s attitude toward
alternatives.
• Because we find it analytically more convenient to talk about the
maximization of a numerical function than of a preference relation.
Origins of utility theory
The concept of utility was originally conceived by the English philosopher Jeremy Bentham in
the early 1800s as a way of evaluating how well a society was governed.
His vision of society was that it should produce «the greatest happiness for the greatest
number».
His concept of utility gave importance to the magnitude of utility, because his goal was to make
interpersonal comparisons of utility.
Why might interpersonal utility comparisons (aka cardinal utility) be problematic?
Intrapersonal comparisons are easy: just offer a person two bundles of goods and see which
one she chooses. That must be the more preferred bundle, and we can assign that bundle a
higher utility number.
But how do we know if person A likes ice cream twice as much as person B?
More importantly, how can you be sure that you like any bundle twice as much as any other?
Cardinal vs ordinal utility
The cardinal utility states that the level of satisfaction can be measurable and expressed in
quantitative numbers (called util).
Example: Pizza gives me 60 utils of satisfaction, whereas burger gives me only 40 utils.
The ordinal utility states that utility is a psychological phenomenon like happiness (highly
subjective and differs across individuals).
It cannot be quantified, but can be arranged in the order of preference.
Utility is ranked based on satisfaction (in terms of more than or less than).
Example: I get more satisfaction from a pizza as compared to a burger.
Cardinal vs ordinal utility
Developed by Alfred Developed by John

Marshall Utility is Hicks Utility is ranked
measured based on satisfaction
quantitatively (like (in terms of more than
lengthi height, or or less than). It is more
weight) based on utils. practical and sensible.
It is less practical.
From preferences to utility function
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)
Notes:
 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.
 Every preference relation on a finite set can be represented by a utility function.
 Many preference relations on infinite sets can also be represented by utility functions. However,
not all preference relations on infinite sets can be represented by utility functions (example:
lexicographic preference relation)
Utility function
Utility functions and indifference curves
• Consider three bundles such that (2, 3) ≻ (4, 1)  (2, 2)
• Assign to these bundles any numbers that preserve the preference ordering; e.g.,
U(2,3)=6 U(4,1)=4 U(2,2)=4
• Call these numbers utility levels. So the bundles (4, 1) and (2, 2) are on the indifference curve
with utility level u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:
• An indifference curve contains equally

preferred bundles.
• Equal preference  same utility level.
• Therefore, all bundles on an indifference curve
have the same utility level.
Utility functions and indifference curves
What is the relationship between a utility function
and indifference curves?
• A utility function will assign the same number
to all bundles that lie on a indifference curve!
Higher indifference curves will be assigned a
larger number.
Only one indifference curve may pass through a
consumption bundle!
The collection of all indifference curves for a given
preference relation is an “indifference map.”
An indifference map is equivalent to a utility
function.
Non-uniqueness of utility functions
There is no unique utility function representation of a preference relation.
Suppose (2, 3) ≻ (4, 1)  (2, 2).
• Does represent the preference relation?
• Does preserve the same order as u and therefore represent the same preferences?
• Does preserve the same order as u and therefore represent the same
preferences?
Monotonic transformation
Since only the ranking of the bundles matters, if we can find one function to represent a
particular set of preferences, we can find an infinite number of other functions that do the same
thing.
Any transformation of a set of numbers that preserves the order of the numbers is called a
monotonic transformation.
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.”
The transformation is monothonic if implies

Ex. , ,
Utility theory
Note: Continuity means that small changes to a consumption bundle cause only small changes to the preference level
(if a is preferred to b, then “small” deviations from a or from b will not change the ordering)
For any set of preferences that satisfy A1-A6, there exists a continuous utility function that
represents those preferences (Debreu’s Theorem).
Goods, bads, and neutrals
• 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.
Drawing indifference curves
Perfect substitutes
Consider
This utility function is an example of two goods that are perfect substitutes (e.g. The total
number of sodas – cola and pepsi).
All are linear and parallel.

Perfect substitutes
Perfect complements
Consider
This utility function is an example of two goods that are perfect complements (e.g. Left shoe
and right show. In this case, all you care is how many pairs you have.)
Quasi-linear utility functions
is linear in x2  “quasi-linear” function
• E.g.,
Quasi-linear utility functions
Cobb-Douglas preferences
with a > 0 and b > 0  “Cobb-Douglas” utility function
• E.g.,
These are basically the simplest of the «well-

behaved» preferences. For that reason, we're
going to be using this kind of utility function a lot.
Cobb-Douglas preferences
Marginal utility
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.,
E.g., if Taking monotonic transformations will change the

magnitude of the marginal utility, which means that we
can't calculate marginal utilities by looking at choice.
But remember, all we care about is the ordering of bundles

implied by any utility function!
Marginal utility and MRS
• The general equation for an indifference curve is
 k is a constant.
• Totally differentiating this identity gives
Remember, the MRS (marginal rate of

substitution) measures the slope of an
can be rearranged algebraically to be: indifference curve at any particular bundle of
goods.
It tells you the rate at which a consumer will

trade off good 1 and good 2 at current
consumption levels.
 This is the MRS.
An Example
Suppose Then and
So,
Monotonic transformations
Applying a monotonic
transformation to a utility function
representing a preference relation
simply creates another utility
function representing the same
preference relation.
Estimating utility functions
Estimating utility functions

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CHAPTER 4

• It is possible to avoid the notion of a utility representation and to our

Developed by Alfred Developed by John

xʹ ≻ xʺ ⇔ u(xʹ) > u(xʺ)

• An indifference curve contains equally

Suppose (2, 3) ≻ (4, 1)  (2, 2).

• Does represent the preference relation?

The transformation is monothonic if implies

All are linear and parallel.

These are basically the simplest of the «well-

E.g., if Taking monotonic transformations will change the

But remember, all we care about is the ordering of bundles

• Totally differentiating this identity gives

Remember, the MRS (marginal rate of

It tells you the rate at which a consumer will

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