Lesson 2. Preferences and Utility Lesson 2 Preferences and Utility c 2010, 2011 Roberto Serrano and Allan M.

Feldman All rights reserved Version C 1. Introduction

Life is like a shopping center. The consumer enters it and sees lots of goods, in various quantities, that she might buy. A consumption bundle, or a bundle for short, is a combination of quantities of the various goods (and services) that are available. For instance, a consumption bundle might be 2 apples, 1 banana, 0 cookies, and 5 diet sodas. We would write this as (2, 1, 0, 5). Of course the consumer prefers some consumption bundles to others; that is, she has tastes or preferences regarding those bundles. In this lesson we will discuss the economic theory of preferences in some detail. We will make various assumptions about a consumers feelings about alternative consumption bundles. We will assume that when given a choice between two alternative bundles, the consumer can make a comparison. (This assumption is called completeness.) We will assume that when looking at three alternatives, the consumer is rational in the sense that, if she says she likes the rst better than the second and the second better than the third, she will also say that she likes the rst better than the third. (This is part of what is called transitivity.) We will examine other basic assumptions that economists usually make about a consumers preferences: one says that the consumer prefers more of each good to less (called monotonicity), and another says that a consumers indierence curves (or sets of equally-desirable consumption bundles) have a certain plausible curvature (called convexity). We will describe and discuss the consumers rate of tradeo of one good against another (called her marginal rate of substitution). After discussing the consumers preferences, we will turn to her utility function. A utility function is a numerical representation of how a consumer feels about alternative consumption bundles: if she likes the rst bundle better than the second, then the utility function assigns a higher number to the rst than to the second, and if she likes them equally well, then the utility

Lesson 2. Preferences and Utility

function assigns the same number to both. We will analyze utility functions and describe marginal utility, which, loosely speaking, is the extra utility provided by one additional unit of a good. We will derive the relationship between the marginal utilities of two goods and the marginal rate of substitution of one of the goods for the other. We will provide various algebraic examples of utility functions, and, in the appendix, we will briey review the calculus of derivatives and partial derivatives. In this lesson and others to follow, we will often assume there are only two goods available, with x1 and x2 representing quantities of goods 1 and 2, respectively. Why only two goods? For two reasons: rst, for simplicity (two goods gives a much simpler model than three goods or ve thousand, often with no loss of generality); and second, because we are often interested in one particular good, and we can easily focus on that good and call the second good all other goods, or everything else, or other stu. When there are two goods any consumption bundle can easily be shown in a standard two-dimensional graph, with the quantity of the rst good on the horizontal axis and the quantity of the second good on the vertical axis. All the gures in this lesson are drawn this way. In this lesson we will focus on the consumers preferences about bundles of goods, or how she feels about various things that she might consume. But in the shopping center of life some bundles are feasible or aordable for the consumer; these are the ones which her budget will allow. Other bundles are non-feasible or unaordable; these are the ones her budget wont allow. We will focus on the consumers budget in Lesson 3. 2. The Consumers Preference Relation The consumer has preferences over consumption bundles. We represent consumption bundles with symbols like X and Y . If there are two goods, X is a vector (x1 , x2 ), where x1 is the quantity of good 1 and x2 is the quantity of good 2. The consumer can compare any pair of bundles and decide which one is better, or decide they are equally good. If she decides one is better than the other, we represent her feelings with what is called a preference relation; we use the symbol to represent the preference relation. That is, X Y means the consumer prefers bundle X over

bundle Y . Presented with the choice between X and Y , she would choose X. We assume that if X Y , then Y X cannot be true; if the consumer likes X better than Y , then she had better

Lesson 2. Preferences and Utility

not like Y better than X! Obviously, a consumers preferences might change over time, and might change as she learns more about the consumption bundles. (The relation is sometimes Y means

called the strict preference relation rather than the preference relation, because X the consumer denitely, unambiguously, prefers X to Y , or strictly prefers X to Y .)

If the consumer likes X and Y equally well, we say she is indierent between them. We write X Y in this case, and is called the indierence relation. Sometimes we will say that X and Y are indierent bundles for the consumer. In this case, if presented with the choice between them, the consumer might choose X, might choose Y , might ip a coin, or might even ask us to choose for her. We assume that if X Y , then Y X must be true; if the consumer likes X exactly as well as Y , then she had better like Y exactly as well as X! The reader might notice that the symbols for preference and for indierence are a little like the mathematical symbols > and =, for greater than and equal to, respectively. This is no accident. And, just as there is a mathematical relation that combines these two, for greater than or equal to, there is also a preference relation symbol X , for preferred or indierent to. That is, we write

Y to represent the consumers either preferring X to Y , or being indierent between the relation is sometimes called the weak preference relation.)

two. (The

Assumptions on preferences: At this point we make some basic assumptions about the consumers preference and indierence relations. Our intention is to model the behavior of what we would consider a rational consumer. In this section we will assume the two goods are desirable to the consumer; we will touch on other possibilities (such as neutral goods or bads) in the Exercises. Assumption 1. Completeness. For all consumption bundles X and Y , either X Y Y , or

X, or X Y . That is, the consumer must like one better than the other, or like them

equally well. This may seem obvious, but sometimes its not. For example, what if the consumer must choose whats behind the screen on the left, or the screen on the right, and she has no idea what might be hidden behind the screens? That is, what if she doesnt know what X and Y are? We force her to make a choice, or at least to say she is indierent. Having a complete ordering of bundles is very important for our analysis throughout this book. (In Lessons 19 and 20 we will analyze consumer behavior under uncertainty, or incomplete information.)

Lesson 2. Preferences and Utility Assumption 2. Transitivity. This assumption has four parts: First, transitivity of preference: if X Y and Y Z, then X Z.

Second, transitivity of indierence: if X Y and Y Z, then X Z. Third, if X Y and Y Z, then X Z. Z, then X Z.

Fourth and nally, if X Y and Y

The transitivity of preference assumption is meant to rule out irrational preference cycles. You would probably think your friend needs psychiatric help if she says she prefers Econ. 1 (the basic economics course) to Soc. 1 (the basic sociology course), and she prefers Soc. 1 to Psych. 1 (the basic psychology course), and she prefers Psych. 1 to Econ. 1. Cycles in preferences seem irrational. However, do not be too dogmatic about this assumption; there are interesting exceptions in the real world. We will provide one later on in the exercises. The transitivity of indierence assumption (that is, if X Y and Y Z, then X Z) makes indierence curves possible. An indierence curve is a set of consumption bundles (or, when there are two goods, points in a two-dimensional graph) which the consumer thinks are all equally good; she is indierent among them. We will use indierence curves frequently throughout this book, starting in Figure 2.1 below. The gure shows two consumption bundles, X and Y , and an indierence curve. The two bundles are on the same indierence curve, and therefore the consumer likes them equally well.

Lesson 2. Preferences and Utility

y2

x2

X Indifference Curve

y1 Fig. 2.1

x1

Good 1

Caption for Fig. 2.1: At bundle X, the consumer is consuming x1 units of good 1 and x2 units of good 2. Similarly at bundle Y , she is consuming y1 units of good 1 and y2 units of good 2. Since X and Y are on one indierence curve, the consumer is indierent between them. Assumption 3. Monotonicity. We normally assume that goods are desirable, which means the consumer prefers consuming more of a good to consuming less. That is, suppose X and Y are two bundles of goods such that (1) X has more of one good (or both) than Y does and (2) X has at least as much of both goods as Y has. Then X Y . Of course there are times when this

assumption is inappropriate. For instance, suppose a bundle of goods is a quantity of cake and a quantity of ice cream, which you will eat this evening. After 3 slices of cake and 6 scoops of ice cream, more cake and more ice cream may not be welcome. But if the goods are more generally dened (e.g., education, housing), monotonicity is a very reasonable assumption. Some important consequences of monotonicity are the following: indierence curves representing preferences over two desirable goods cannot be thick or upward sloping. Nor can they be vertical or horizontal. This should be apparent from Figure 2.2. below, which shows an upward sloping indierence curve, and a thick indierence curve. On any indierence curve, the consumer is indierent between any pair of consumption bundles. A brief examination of the gure should convince the reader that the monotonicity assumption rules out both types of indierence curves

Lesson 2. Preferences and Utility shown, and similar arguments rule out vertical and horizontal indierence curves.
Good 2 Upward Sloping

Th

ick

Good 1 Fig. 2.2

Caption for Fig. 2.2: Each indierence curve shown is a set of equally-desirable consumption bundles. For example, for any pair of bundles X and Y on the upward sloping curve, X Y . Can you see why the monotonicity assumption makes the upward sloping indierence curve impossible? How about the thick indierence curve? In Figure 2.3 below we show a downward sloping thin indierence curve, which is what the monotonicity assumption requires. The gure also shows the set of bundles which by the monotonicity assumption must be preferred to all the bundles on the indierence curve (the more preferred set), and the set of bundles which by the monotonicity assumption must be liked less than all the bundles on the indierence curve (the less preferred set).

Lesson 2. Preferences and Utility

More Preferred Set Less Preferred Set

Indifference Curve Good 1

Fig. 2.3

Caption for Fig. 2.3: The only graph compatible with monotonic preferences is a downward sloping thin indierence curve. Another implication of the assumptions of transitivity (of indierence) and monotonicity is that two distinct indierence curves cannot cross. This is shown in the Figure 2.4.
Good 2

X Y Z Good 1 Fig. 2.4

Caption for Fig. 2.4: Two distinct indierence curves cannot cross. Here is why. Suppose the curves did cross at the point X. Since Y and X are on the same indierence curve, Y X.

Lesson 2. Preferences and Utility

Since X and Z are on the same indierence curve, X Z. Then by transitivity of indierence, Y Z. But by monotonicity, Y contradiction. Assumption 4. Convexity for indierence curves. This assumption means that averages of consumption bundles are preferred to extremes. Consider two distinct points on one indierence curve. The (arithmetic) average of the two points would be found by connecting them with a straight line segment, and then taking the midpoint of that segment. This is the standard average, which gives equal weight to the two extreme points. A weighted average gives possibly unequal weights to the two points; geometrically a weighted average would be any point on the line segment connecting the two original points, not just the midpoint. The assumption of convexity for indierence curves means this: for any two distinct points on the same indierence curve, the line segment connecting them (excepting its end points) lies above the indierence curve. In other words, if we take a weighted average of two distinct points, between which the consumer is indierent, she prefers the weighted average to the original points. We show this in Figure 2.5 below. We call preferences well behaved when indierence curves are downward sloping and convex.
Good 2

Z. Therefore having the indierence curves cross leads to a

Y Good 1 Fig. 2.5

Caption for Fig. 2.5: Convexity of preferences means that indierence curves are convex, as

Lesson 2. Preferences and Utility

in the gure, rather than concave. This means that the consumer prefers averaged bundles over extreme bundles. For example, the bundle made up of 1/2 times X plus 1/2 times Y , that is X/2 + Y /2, is preferred to either X or Y . This is what we normally assume to be the case. In reality, of course, indierence curves are sometimes concave. There are many examples we can think of in which a consumer might like two goods, but not in combination. You may like sushi and chocolate ice cream, but not together in the same dish; you may like classical music and hip-hop, but not in the same evening; you may like pink clothing and orange clothing, but not in the same outt. Again, if the goods are dened generally enough, like classical music consumption per year, hip-hop consumption per year, pink and orange clothing worn this year, the assumption of convexity of indierence becomes very reasonable. We show a concave indierence curve in Figure 2.6 below.
Good 2

Good 1 Fig. 2.6

Caption for Fig. 2.6: A concave indierence curve. This consumer prefers the extreme points X and Y to the average X/2 + Y /2. 3. The Marginal Rate of Substitution The marginal rate of substitution is an important and useful concept because it describes the consumers willingness to trade consumption of one good for consumption of the other. Consider this thought experiment. The consumer gives up a unit of good 1 in exchange for getting some

Lesson 2. Preferences and Utility

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amount of good 2. How much good 2 does she need to get in order to end up on the same indierence curve? This is the quantity of good 2 that she needs to replace one unit of good 1. Or, consider a slightly dierent thought experiment. The consumer gets a unit of good 1 in exchange for giving up some amount of good 2. How much good 2 can she give up and end up on the same indierence curve? This is the quantity of good 2 that she is willing to give up in exchange for a unit of good 1. The answer to either of these questions is a measure of her valuation of a unit of good 1, in terms of units of good 2. This is the intuitive idea of the marginal rate of substitution of good 2 for good 1. It is her rate of tradeo between the two goods, the rate at which she can substitute good 2 for good 1 and remain as well o as she was before the substitution. Now let x1 represent a change in her consumption of good 1, and x2 represent a change in her consumption of good 2, and suppose the two changes move her from a point on an indierence curve to another point on the same indierence curve. Remember that for well behaved preferences, indierence curves are downward sloping, and therefore one of the s will be positive and the other negative. If xi > 0, shes getting some good i; if xi < 0, shes giving up some good i. In the rst thought experiment above, we let x1 = 1; in the second, we let x1 = +1. In both, we were really interested in the magnitude of the resulting x2 . This is the amount of good 2 needed to replace a unit of good 1, or the amount of good 2 that she would be willing to give up to get another unit of good 1. At this point, rather than thinking about the consumer swapping a unit of good 1 in exchange for some amount of good 2, we consider the ratio x2 /x1 . This ratio is the rate at which the consumer has to get good 2 in exchange for giving up good 1 (if x1 < 0 and x2 > 0), or the rate at which she has to give up good 2 in exchange for getting good 1 (if x1 > 0 and x2 < 0). Also, we assume that the s are very small, or innitesimal. More formally, we take the limit as x1 and x2 approach 0. Because we are assuming that x1 and x2 are small moves from a point on an indierence curve that leave the consumer on the same indierence curve, the ratio x2 /x1 represents the slope of that indierence curve at that point. Since the indierence curves are downward sloping, x2 /x1 = Indierence Curve Slope < 0.

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The denition of the marginal rate of substitution of good 2 for good 1, which we will write M RSx1 ,x2 , or just M RS for short, is M RSx1 ,x2 = M RS = x2 /x1 = Indierence Curve Slope. More formally, M RS = lim x2 /x1 = Indierence Curve Slope.

x1 ,x2 0

In Figure 2.7 below, we show a downward sloping indierence curve, and a tangent line at a point X on the indierence curve. We show two increments from X, x1 and x2 , that get the consumer back to the same indierence curve. Note that x1 > 0 and x2 < 0 in the gure. If the consumer gets x1 units of good 1, she is willing to give up x2 units of good 2. Her marginal rate of substitution is the limit of x2 /x1 , as x1 and x2 approach zero. That is, her marginal rate of substitution is -1 times the slope of the indierence curve at X, or -1 times the slope of the tangent line at X.
Good 2

x1 x2

Tangent Line Good 1 Fig. 2.7

Caption for Fig. 2.7: Intuitively, the marginal rate of substitution is an answer to one of these questions: If I take away x1 units of good 1, how much good 2 do I need to give you for you to remain indierent?, or If I give you x1 of units of good 1, how much good 2 can I take away from you and have you remain indierent? The second question is illustrated here.

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For well behaved preferences, the M RS decreases as you move down and to the right along an indierence curve. This makes good sense. It means that if a consumer consumes more and more of a good, while staying on the same indierence curve, she values an additional unit of that good less and less. To convince yourself that this is plausible, consider the following story. A well-o woman (Ms. Well-O) is lost in the middle of a desert. She is so thirsty, almost dying of thirst. She has no water (good 1), but she does have $100 (good 2) in her pocket. A prot-seeking local trader (Mr. Rip-O), carrying water, oers her a drink, and asks her: How much are you willing to pay me for your rst glass of water? (That is, What is your M RS of money for water when you have no water, but $100?) Honest to a fault, she answers $25. Mr. Rip-O immediately proposes this trade, and the rst glass of water is sold for $25. At this point, Mr. Rip-O asks again: You are probably still thirsty, arent you? How much are you willing to pay for a second glass of water? (That is, What is your M RS of money for water when you already have had a glass of water, and you have $75 left?) She now answers: Yes, I am still thirsty. I would pay you $10 for a second glass. They make this trade also. Her valuation of the second glass of water, her M RS of money for water, has dropped by more than half. This process continues for a while. By the time Ms. Well-O has had nine or ten glasses of water, her M RS has dropped to zero, because at this point her need for water is much less pressing than her need for a bathroom.
Money

(0, 100) (1, 75)

(5, 25)

Water Fig. 2.8

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Caption of Fig. 2.8: The M RS is decreasing because the consumer gets satiated with water as she consumes more of it. She is willing to pay less and less for the incremental drink. 4. The Consumers Utility Function Mathematically, it is much easier to work with functions than with relations, such as the preference relation and the indierence relation. Our goal now is to construct a function that will represent the preferences of a consumer. Such a function is called a utility function. Imagine that we assign a number to each bundle. For example, we assign the number u(X) = u(x1 , x2 ) = 5, to the bundle X = (x1 , x2 ); we assign the number u(Y ) = u(y1 , y2 ) = 4, to Y = (y1 , y2 ); and so on. We say that such an assignment of numbers to bundles is a consumers utility function if: First, u(X) > u(Y ) whenever X Y.

And second, u(X) = u(Y ) whenever X Y . Note how this assignment of numbers to bundles is a faithful translation of the consumers preferences. It gives a higher utility number to the preferred bundle, and it gives the same number to two bundles that the consumer likes equally well. This is the sense in which this function accurately represents the preferences of the consumer. Our consumers utility function is said to be an ordinal utility function rather than a cardinal utility function. An ordinal statement only gives information about relative magnitudes; for instance, I like Tiany more than Jennifer. A cardinal statement provides information about magnitudes that can be added, subtracted, and so on. For instance, Billy weighs 160 lbs. and Johnny weighs 120 lbs. We can conclude from the latter statement that Billy weighs 40 lbs. more than Johnny, that the ratio of their weights is exactly 4/3, and that the sum of their weights is 280 lbs. Is utility an ordinal or a cardinal concept? The utilitarians, led by the English philosopher Jeremy Bentham (1748-1832), believed that utility is a cardinal magnitude, perhaps as measurable as length, weight, and so on. For them, statements like these would make sense: I get three times as much utility from my consumption bundle as you get from your consumption bundle or I like a vacation cruise in the West Indies twice as much as you do. Today, for the most part, we treat

Lesson 2. Preferences and Utility

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utility simply as an ordinal magnitude. All we care about is whether an individuals utility number from one consumption bundle is larger than, equal to, or smaller than the same individuals utility number from another bundle. For one individual, dierences or ratios of utility numbers from dierent bundles generally do not matter, and comparisons of utilities across dierent individuals have no meaning. Under the ordinal interpretation of utility numbers, if we start with any utility function representing my preferences, and we transform it by adding a constant, it still represents my preferences perfectly well. Or, if we multiply it by a positive number, it still works perfectly well. Or, assuming all my utility numbers are positive, if we square all of them, or raise them all to a positive power, we are left with a modied utility function that still represents my preferences perfectly well. In short, if we start with a utility function representing my preferences, and modify it with whats called an order-preserving transformation, then it still represents my preferences. All this is summed up in the following statement: If u(X) = u(x1 , x2 ) is a utility function that represents the preferences of a consumer, and f is any order-preserving transformation of u, the transformed function f (u(X)) = f (u(x1 , x2 )) is another utility function that also represents those preferences. What is the connection between indierence curves and utility functions? The answer is that we use indierence curves to represent constant levels of utility. Remember that we are assuming the consumers utility level depends on her consumption of two goods, measured as variables x1 and x2 . We need one axis to represent the amount of x1 , and a second axis to represent the amount of x2 . If we were to show utility in the same picture as quantities of the two goods, we would need a third axis to represent the utility level u that corresponds to the consumption bundle (x1 , x2 ). A utility function in such a three-dimensional picture looks like a hillside. But three-dimensional pictures are hard to draw. It is much easier to draw two-dimensional graphs with level curves. A level curve for a function is a set of points in the functions domain, over which the function takes a constant value. If youve hiked or climbed mountains with the help of a topographical map, you have used a picture with level curves; an elevation contour on the map is a level curve. Similarly, a weather map has level curves; the isobar lines represent sets of points with the same

Lesson 2. Preferences and Utility barometric pressure. (Isobar means: the same barometric pressure.)

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An indierence curve is a set of points in the consumption bundle picture, among which the consumer is indierent. Since she is indierent among these points, they all give her the same utility. Hence, the indierence curve is a level curve for her utility function. Therefore, in order to represent a consumers utility function, we will simply draw its level curves, its indierence curves, in the (x1 , x2 ) quadrant. This is like transforming a three-dimensional picture of a mountain into a two-dimensional topographical map, with elevation contours. Figure 2.9: Draw two pictures. One is a three-dimensional picture of a mountain-like shape with no peak. In it, label two contours as u = 1 and u = 2. The axes are labeled x1 , x2 and u. The second picture is the usual quadrant with axes x1 and x2 . In it, draw two well behaved indierence curves, and label them u = 1 and u = 2. (Note: Not drawn yet.) Caption of Fig. 2.9: The indierence curves are the level curves of the utility function. 5. Utility Functions and the Marginal Rate of Substitution Next we explain the connection between the marginal rate of substitution, and the utility function that represents the consumers preferences. Figure 2.10 below is similar to Figure 2.7. The marginal rate of substitution of good 2 for good 1, at the point X, is x1 /x2 , roughly speaking. (And precisely speaking, in the limit.) How does this relate to a utility function for this consumer?

Lesson 2. Preferences and Utility

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x2

x1 X x2

x1 Fig. 2.10
Caption for Fig. 2.10: Marginal utility and the marginal rate of substitution. The marginal utility of good 1 is the rate at which the consumers utility increases as good 1 increases, while we hold the quantity of good 2 constant. Loosely speaking, it is the extra utility from an extra unit of good 1. More formally, let x1 represent an increment of good 1. The marginal utility of good 1, which we write M U1 , is dened as: M U1 = lim
x1 0

u(x1 + x1 , x2 ) u(x1 , x2 ) . x1

If it werent for the presence of the variable x2 , students would recognize this as the derivative of the function u(x1 ). And this is almost exactly what it is, except the function u(x1 , x2) is really a function of two variables, the second of which, x2 , is being held constant. The derivative of a function of two variables, with respect to x1 while x2 is being held constant, is called the partial derivative of the function u(x1 , x2 ) with respect to x1 . A derivative is commonly shown with a d symbol, as in df (x)/dx. A partial derivative is commonly shown with a symbol instead of a d, and so the marginal utility of good 1 can be written as M U1 = u(x1 , x2 ) u = . x1 x1

Lesson 2. Preferences and Utility The marginal utility of good 2, which we write M U2 is dened as: M U2 = lim u(x1 , x2 + x2 ) u(x1 , x2 ) u = . x2 0 x2 x2

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Since marginal utility is derived from the utility function, which is ordinal, it shouldnt be interpreted as a cardinal measure. That is, we dont attach any meaning to a statement like My marginal utility from an additional apple is 3. We do attach meaning to a statement like My marginal utility from an additional apple is 3, and my marginal utility from an additional banana is 2. This simply means I prefer an additional apple. Our main use of the marginal utility concept at this point is to calculate the consumers M RS. Consider Figure 2.10 again. From the bundle X = (x1 , x2 ), we increase good 1 by x1 , and simultaneously decrease good 2 by x2 , to get back to the original indierence curve. If we evaluate the change in utility along the way (keeping in mind that we are really thinking of very small moves), we have the following: utility increases because of the increase in good 1, by an amount equal to the marginal utility of good 1 times x1 . At the same time, utility decreases because of the decrease in good 2, by an amount equal to the marginal utility of good 2 times x2 . The sum of the increase and the decrease is zero, since the consumer ends up on the original indierence curve. This gives the following equation (note that x1 is positive and x2 is negative): M U1 x1 + M U2 x2 = 0. From this we easily get M U1 x2 = . x1 M U2

But M RS = x2 /x1 . We conclude that M RS = M U1 . M U2

This gives us a convenient tool for calculating the consumers marginal rate of substitution, either as a function of (x1 , x2 ), or as a numerical value at a given point. 6. A Solved Problem The Problem

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For each of the following utility functions, nd the marginal rate of substitution function, or M RS. (a) u(x1 , x2 ) = x1 x2 ; (b) u(x1 , x2 ) = 2x2 ; (c) u(x1 , x2 ) = x1 + x2 ; (d) u(x1 , x2 ) = min{x1 , 2x2 }; (e) u(x1 , x2 ) = x2 x2 . 1 The Solution We use the fact that the M RS equals the ratio of the marginal utilities, or M RS = each case, we rst calculate the marginal utilities, and then we nd their ratio. (a) Assume u(x1 , x2 ) = x1 x2 . M U1 = Therefore M RS = (b) Assume u(x1 , x2 ) = 2x2 . M U1 = Therefore M RS = (c) Assume u(x1 , x2 ) = x1 + x2 . M U1 = Therefore M RS = 1 M U1 = = 1. M U2 1 (x1 + x2 ) (x1 + x2 ) = 1 and M U2 = = 1. x1 x2 0 M U1 = = 0. M U2 2 (2x2) (2x2 ) = 0 and M U2 = = 2. x1 x2 x2 M U1 = . M U2 x1 (x1 x2 ) (x1 x2 ) = x2 and M U2 = = x1 . x1 x2
M U1 M U2 .

In

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(d) Assume u(x1 , x2 ) = min{x1 , 2x2}. The marginal utilities depend on whether x1 < 2x2 , or x1 > 2x2 . If x1 < 2x2 , then M U1 = Therefore M RS = If x1 > 2x2 , then M U1 = Therefore M RS = 0 M U1 = = 0. M U2 2 (min{x1 , 2x2 }) (min{x1 , 2x2 }) = 0 and M U2 = = 2. x1 x2 1 M U1 = = . M U2 0 (min{x1 , 2x2 }) (min{x1 , 2x2 }) = 1 and M U2 = = 0. x1 x2

Finally, if x1 = 2x2 , then M RS is undened. (e) Assume u(x1 , x2 ) = x2 x2 . 1 M U1 = Therefore M RS = 2x1 M U1 = 2x1 . = M U2 1 (x2 x2 ) (x2 x2 ) 1 1 = 2x1 and M U2 = = 1. x1 x2

Lesson 2. Preferences and Utility Exercises

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1. We assumed at the beginning of the chapter that a consumers preferences must be transitive, but we hinted that there might be interesting exceptions. Here are two: (a) A consumer likes sugar in her coee, but she simply cannot taste the dierence between a cup of coee with n grams of sugar in it and a cup of coee with n+1 grams. Suppose a teaspoon of sugar is 10 grams, and suppose she takes her coee with one teaspoon of sugar. Why does this violate transitivity? (b) Lets call a committee of three people a consumer. (Groups of people often act together as consumers.) Our committee makes decisions using majority voting. When they compare two alternatives x and y they simply take a vote, and the winner is said to be preferred by the committee to the loser. Suppose that the preferences of the individuals are as follows: Person 1 likes x best, y second best, and z third best. We write this in the following way: Person 1 : x, y, z. Assume the preferences of the other two people are: Person 2 : y, z, x; and Person 3 : z, x, y. Show that in this example the committee preferences produced by majority voting violate transitivity. (This is the famous voting paradox rst described by the French philosopher and mathematician Marquis de Condorcet (1743-1794).)

2. Consider the utility function u(x1 , x2 ) = x1 x2 . (a) Graph the indierence curves for utility levels 1 and 2. (They are symmetric hyperbolas asymptotic to both axes). (b) Graph the locus of points for which the M RS of good 2 for good 1 is equal to 1, and the locus of points for which the M RS is equal to 2.

3. Dierent Harvard students have dierent preferences about economics. Draw the indierence curves associated with each of the following statements. Measure economics books along the horizontal axis and books about other subjects along the vertical. Draw arrows indicating the direction in which utility is increasing.

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(a) I care only about the total amount of knowledge I acquire. It is the same whether that is economic knowledge or of any other kind. That is, all books on all subjects are perfect substitutes for me. (b) I hate the Serrano/Feldman textbook and all other economics books. On the other hand, I love everything else in the Harvard curriculum. (c) I really like books about economics because I want to understand the economic world. Books about other subjects make no dierence to me. (d) I like all my courses and the liberal education that Harvard oers. That is, I prefer to read books on a variety of dierent subjects, rather than to read lots on one subject and little on the others.

4. Sketch indierence curves for utility levels 1 and 2 for each of the following utility functions. Describe in a sentence or two the consumers preferences for the two goods. (a) u(x1 , x2 ) = 2x2 ; (b) u(x1 , x2) = x1 + x2 ; (c) u(x1 , x2 ) = min{x1 , 2x2}; (d) u(x1 , x2) = x2 x2 . 1

5. Donald likes shing (x1 ) and hanging out in his hammock (x2 ). His utility function for these two activities is u(x1 , x2 ) = 3x2 x4 . 1 2 (a) Calculate M U1 , the marginal utility of shing. (b) Calculate M U2 , the marginal utility of hanging out in his hammock. (c) Calculate M RS, the rate at which he is willing to substitute hanging out in his hammock for shing. (d) Last week, Donald shed 2 hours a day, and hung out in his hammock 4 hours a day. Using your formula for M RS from (c) above, nd his M RS last week.

Lesson 2. Preferences and Utility

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(e) This week, Donald is shing 8 hours a day, and hanging out in his hammock 2 hours a day. Calculate his M RS this week. Has his M RS increased or decreased? Explain why. (f) Is Donald happier or sadder this week compared to last week? Explain.

6. Suppose you are choosing between hours of work (a bad measured on the horizontal axis) and money (a good measured on the vertical axis). (a) Explain the meaning of M RS in words. (b) Should your M RS be positive or negative in this case? (c) Is your M RS increasing, constant or decreasing as you increase the hours of work along an indierence curve? Explain and draw some indierence curves for this example.

Lesson 2. Preferences and Utility Appendix: Dierentiation of Functions

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This short appendix is not meant to be a substitute for a calculus course. However, it may serve as a helpful review. Lets begin with functions of one variable. Consider a function y = f (x). Its derivative is y = f (x) = dy f (x + x) f (x) = lim . dx x0 x

The derivative of the function f is the rate at which f increases as we increase x, the innitesimal increment in f divided by the innitesimal increment in x. Some examples of dierentiation of functions of one variable are: (1) y = 4x, (2) y = 7x2 , (3) y = ln x; y = 4; y = 14x; y = 1/x.

What about functions of several variables? Consider a function u(x1 , x2 ), like our utility function. We dene two partial derivatives of u, with respect to x1 and with respect to x2 : u(x1 + x1 , x2 ) u(x1 , x2 ) u = lim x1 0 x1 x1 and u(x1 , x2 + x2 ) u(x1 , x2 ) u = lim . x2 x2 0 x2 The rst is the rate at which u increases as we increase x1 , while holding x2 constant. The second is the rate at which u increases as we increase x2 , while holding x1 constant. How do we partially dierentiate a function of several variables? Almost exactly the same way we dierentiate a function of one variable, except that we must remember that if we are dientiating with respect to variable xi , we treat any other variable xj as a constant. Some examples are: (1) u(x1 , x2 ) = x1 x2 ; (2) u(x1 , x2 ) = x2 x3 , 1 2 u/x1 = x2 , u/x2 = x1 ; u/x2 = 3x2 x2 ; 1 2 u/x2 = 2/x2 .

u/x1 = 2x1 x3 , 2

(3) u(x1 , x2 ) = ln x1 + 2 ln x2 ,

u/x1 = 1/x1 ,

Index
bundle, 1 completeness, 1, 3 consumption bundle, 1 convexity, 1, 8 feasible, 2 indierence, 3 indierence curve, 1, 4, 15 indierence relation, 3 marginal rate of substitution, 1, 9, 11, 15, 17 marginal utility, 2, 16, 17 monotonicity, 1, 5 partial derivative, 16 preference relation, 2 strict preference relation, 3 weak preference relation, 3 preferences, 1 well behaved preferences, 8 set less preferred set, 6 more preferred set, 6 transitivity, 1, 4 utility cardinal utility, 13 ordinal utility, 13, 14 utility function, 1, 13 24