Utility

1. Utility

2. UTILITY FUNCTIONS A preference relation that is complete, reflexive, transitive and continuous can be represented by a continuous utility function (as an alternative, or as a complement, to the indifference �map� of the previous lecture). Continuity means that small changes to a consumption bundle cause only small changes to the preference (utility) level.

3. UTILITY FUNCTIONS A utility function U(x) represents a preference relation if and only if: x0 x1 U(x0) > U(x1) x0 x1 U(x0) < U(x1)  x0 ~ x1 U(x0) = U(x1)

4. UTILITY FUNCTIONS Utility is an ordinal (i.e. ordering or ranking) concept. For example, if U(x) = 6 and U(y) = 2 then bundle x is strictly preferred to bundle y. However, x is not necessarily �three times better� than y.

5. UTILITY FUNCTIONSand INDIFFERENCE CURVES 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. U(2,3) = 6 > U(4,1) = U(2,2) = 4. Call these numbers utility levels.

6. UTILITY FUNCTIONSand INDIFFERENCE CURVES An indifference curve contains equally preferred bundles. Equal preference ? same utility level. Therefore, all bundles on an indifference curve have the same utility level.

7. UTILITY FUNCTIONSand INDIFFERENCE CURVES 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

8. UTILITY FUNCTIONSand INDIFFERENCE CURVES

9. UTILITY FUNCTIONSand INDIFFERENCE CURVES Comparing more bundles will create a larger collection of all indifference curves and a better description of the consumer�s preferences.

10. UTILITY FUNCTIONSand INDIFFERENCE CURVES

11. UTILITY FUNCTIONSand INDIFFERENCE CURVES 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.

12. UTILITY FUNCTIONSand INDIFFERENCE CURVES The collection of all indifference curves for a given preference relation is an indifference map. An indifference map is equivalent to a utility function; each is the other.

13. UTILITY FUNCTIONS If (i) U is a utility function that represents a preference relation; and (ii) f is a strictly increasing function, then V = f(U) is also a utility functionrepresenting the original preference function. Example? V = 2.U

14. GOODS, BADS and NEUTRALS A good is a commodity unit which increases utility (gives a more preferred bundle). A bad is a commodity unit which decreases utility (gives a less preferred bundle). A neutral is a commodity unit which does not change utility (gives an equally preferred bundle).

15. GOODS, BADS and NEUTRALS

16. UTILITY FUNCTIONS Perfect Substitutes: Example X1 = pints; X2 = half-pints; and U(X1, X2) = 2X1 + 1X2. U(4,0) = U(0,8) = 8. MRS = -(2/1), i.e. individual willing to give up two units of X2 (half-pints) in order to receive one more unit of X1 (pint).Perfect Substitutes: Example X1 = pints; X2 = half-pints; and U(X1, X2) = 2X1 + 1X2. U(4,0) = U(0,8) = 8. MRS = -(2/1), i.e. individual willing to give up two units of X2 (half-pints) in order to receive one more unit of X1 (pint).

17. UTILITY Preferences can be represented by a utility function if the functional form has certain �nice� properties Example: Consider U(x1,x2)= x1.x2 ?u/?x1>0 and ?u/?x2>0 Along a particular indifference curve x1.x2 = constant ? x2=c/x1 As x1 ? ? x2? i.e. downward sloping indifference curve

18. UTILITY Example U(x1,x2)= x1.x2 =16 X1 X2 MRS 1 16 2 8 (-) 8 3 5.3 (-) 2.7 4 4 (-) 1.3 5 3.2 (-) 0.8 3. As X1 ? MRS ? (in absolute terms), i.e convex preferences

19. COBB DOUGLAS UTILITY FUNCTION Any utility function of the form U(x1,x2) = x1a x2bwith a > 0 and b > 0 is called a Cobb-Douglas utility function. Examples U(x1,x2) = x11/2 x21/2 (a = b = 1/2)V(x1,x2) = x1 x23 (a = 1, b = 3)

20. COBB DOUBLAS INDIFFERENCE CURVES

21. PERFECT SUBSITITUTES Instead of U(x1,x2) = x1x2 consider V(x1,x2) = x1 + x2.

22. PERFECT SUBSITITUTES

23. PERFECT COMPLEMENTS Instead of U(x1,x2) = x1x2 or V(x1,x2) = x1 + x2, consider W(x1,x2) = min{x1,x2}.

24. PERFECT COMPLEMENTS

25. MARGINAL UTILITY Marginal means �incremental�. The marginal utility of product i is the rate-of-change of total utility as the quantity of product i consumed changes by one unit; i.e.

26. MARGINAL UTILITY U=(x1,x2) MU1=?U/?x1 ? ?U=MU1.?x1 MU2=?U/?x2 ? ?U=MU2.?x2 Along a particular indifference curve ?U = 0 = MU1(?x1) + MU2(?x2) ? ?x2/?x1 {= MRS} = (-)MU1/MU2

27. MARGINAL UTILITY E.g. if U(x1,x2) = x11/2 x22 then

28. MARGINAL UTILITY E.g. if U(x1,x2) = x11/2 x22 then

29. MARGINAL UTILITY E.g. if U(x1,x2) = x11/2 x22 then

30. MARGINAL UTILITY E.g. if U(x1,x2) = x11/2 x22 then

31. MARGINAL UTILITY So, if U(x1,x2) = x11/2 x22 then

32. MARGINAL UTLITIES AND MARGINAL RATE OF SUBISITUTION The general equation for an indifference curve is U(x1,x2) � k, a constant Totally differentiating this identity gives

33. MARGINAL UTLITIES AND MARGINAL RATE OF SUBISITUTION

34. MARGINAL UTLITIES AND MARGINAL RATE OF SUBISITUTION

35. MU�s and MRS: An example Suppose U(x1,x2) = x1x2. Then

36. MU�s and MRS: An example

37. MONOTONIC TRANSFORMATIONS AND 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? (Hopefully, nothing)

38. MONOTONIC TRANSFORMATIONS AND 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? which is the same as the MRS for U.

39. MONOTONIC TRANSFORMATIONS AND MRS More generally, if V = f(U) where f is a strictly increasing function, then