Lecture 3: Chapter 3

Key concepts
1. Marginal rate of substitution (MRS)
2. Convexity
3. Common forms of utility functions

Quiz
1) . Write down a monotonic transformation of this utility function.
2) Draw an indifference curve for this utility function

*Ex. U = .
-Write down a monotonic transformation of this utility function. U=X+Y
-Draw an indifference curve for this utility function.

If you wanted to draw an indifference curve for this utility function without doing the
monotonic transformation, then just pick U=4 and some of the combinations that would
work would be: (2,0), (0,2), (1,1), (3,-1)…

[1] Marginal Rate of Substitution

Last class we talked about indifference curves.

*What is an indifference curve?
-graphically it is a curve of bundles which I am equally happy

*What do we know about the slope of an indifference curve?

-The slope of the indifference curve is always negative, showing that if the
individual is forced to give up some Y, he or she will need to be compensated
with some amount of X to remain indifferent between the two bundles.

*Also, in this particular graph, what is happening to the slope of the indifference curve as
I consume more X?

This means that as I get more X, I become less willing to trade away my Y to get more X.

We define the negative of the slope of the indifference curve as the marginal rate of
technical substitution:
The reason we put the negative sign out in front is that indifference curves always slope
downwards and we want higher values of the MRS to represent a larger (or steeper)
slope.

Ex. U =

Let U=10 → 10= → 100= → =

When x=1, MRS=100

x=5, MRS=4
x=10, MRS=1

MRS = the amount of Y that you must give me for 1 X to make me equally happy.

If the MRS is large then the slope is really steep (such as when x is really small) then you
have to give a lot of Y to get an X. When the slope is really flat then you only have to
give a little bit of Y to get an X.

*[i clicker] What does an MRS of 4 mean?

A. If I take away 1 X, I would have to give you 4 Y.*
B. If I take away 1 Y, I would have to give you 4 X.

Alternative Approach to finding the MRS

Let’s use a little bit of math to find an easier way to calculate the MRS.

take a total derivative.

-so I can break my change in happiness into the things that lead to that change.

Along indifference curve dU=0

 =

This was just an application of the implicit function theorem which would allow
you to get it directly. From here on out this will be the approach to getting MRS
that we will mostly use.

Marginal Utility

In this formula the UX and UY represent the marginal utility of X and Y. The marginal
utility of X is how much additional utility I get when I consume 1 more X.

William Jevons (1835- 1887) came up with the idea that value is determined by the
interaction between the person and the object, and that value may change as a person
possessed more of the object
- Principle of Diminishing Marginal Utility

Jevons’ Rule: Condition for Maximum Utility-

MU per dollar of apples= MU per dollar of butter= MU per dollar ……..

[Test question]
*[I Clicker] Suppose that Jenny spends ten times as much money on chick flicks as she
does on football. Which activity gives her greater marginal utility per dollar?
A. Chick Flicks
B. Football
C. Same*

Examples of finding the MRS

*Ex. U = X*Y, Find the MRS, when X=10 and Y=1

MUx = Y
MUy = X
so MRS = Y/X

-suppose X is Oreos and Y is Milk (in teaspoons)

-if you have 10 Oreos and only 1 teaspoon of milk. Then your MRS is 1/10 so
I would only have to give you a little bit of milk for one of your Oreos.

*Ex. U = 2*Soda + 1*hamburger. Find the MRS.

So soda gives 2 utils where 1 extra hamburger gives 1 util so MRS =2

-which is constant, not related to X
*Ex. since utility is ordinal, you can use a monotonic transformation and it
will preserve order.

→ →

Research Break

“Happiness and Economic Performance” (Oswald 1997)

*We’ve been talking about utility, how would you measure utility?
-how happy are you?; life satisfaction; depression
-suicide (in the “Lives of Others” this is the statistic he is trying to report about
East Germany)
*How would you measure how Utah is doing (relative to other states)?

Findings:
(1) US (General Social Survey): “Taken all together, how would you say things are
today- would you say that you are very happy, pretty happy, or not too happy?”

1972 1980 1990

Very happy 30.3% 33.9% 33.4%
Not too happy 16.5% 13.3% 9.0%

Top three state for very happy: UT 42%, NH 37.5%, WV 37.1%

Bottom three: Maine 27%, MD 24%, DE 24%

Lowest state on not too happy: ND 4%, UT 5.8%, NH 5.9%

(2) Europe (Eurobarameter): “On the whole, are you very satisfied with the life you
lead?”
-fraction very satisfied: 6 countries have risen, 3 have dropped.

(3) reported happiness is high among married, high-income, well-educated, self-

employed, retired, and those who are homemakers. (U-shaped with age, peaks at 30)

(4) unemployed people are very unhappy

[2] Convexity

One other property that we will assume about preferences is

convexity. Convex preferences simply means that we prefer
average bundles to extremes. You can think of this as a taste
for variety.

In this graph, the average bundle ( ) would put

us on a higher indifference then either (x1, y1) or (x2,y2).

There is a distinction between strictly convex (>) and weakly convex (≥) but in this class
when we say convex we will mean weakly convex.

*Draw an example of an indifference curve that isn’t convex.

Convexity is the same as diminishing MRS so one way to check if a utility function

reflects convex preferences is to check if:

*Ex: Find the MRS of the following utility function and check if the indifference curves
are convex.

not convex

Convexity↔MRS is strictly decreasing

*What does the indifference curve for this utility function look like?

-The utility function in your problem set looks nasty, but just follow these steps and
compare your answer with someone because it will be easy to make a mistake.

[3] Utility functions for specific preferences

1) Cobb-Douglas=
2) Perfect Substitutes=

3) Perfect Complements=

*Can you think of some examples of a pair of goods that might fit each of the utility
functions?
CD- Movies and Pizza
PS- Exxon Gas and Shell Gas
PC- peanut butter & jelly; left shoe/right shoe

4) CES Utility = where 1,

and U = α∙ln(x) + β∙ln(y) if δ = 0.

Perfect Substitutes
Cobb-Douglas
Perfect Compliments (based on work using limits)

*At soccer games, the kids all get a drink and a treat. My son Joseph would always trade
his drink for his friend’s treat. Which of the utility functions that we just talked about are
consistent with this type of behavior?
-(only perfect substitutes)

Homothetic preferences

Another property of preferences is whether they are homothetic. Homothetic preferences

are such that the MRS only depends on the ratio of the two goods and not the total
quantities of the goods.

*Ex.

*What is the MRS?

*Are these preferences homothetic? yes
-An easy way to check is to double y and double x and see if the MRS
changes.

The importance of homothetic preferences is that the slope of the indifference curves
only depend on the ratio of y/x and not how far you are from the origin. This allows us to
examine an individual’s behavior using just one or even a few close indifference curves
and not be concerned that our results would change at very different levels of utility.

An easy way to check if preferences are homothetic is to double both the X and Y in the
MRS and see if the MRS changes (i.e. can you cancel out all the 2’s or not).

*Ex. Suppose that an individual obtains utility only from amounts of X and Y that exceed
minimal subsistence levels given by x0 and y0: U =
*Find the MRS
*Check if it is homothetic.

MRS when there are many goods

Total differential-

We will let = 0 since we will stay on the same indifference curve and all the other
dx’s =0 since we wont be changing those quantities.

So the things we are doing in 2-good case generalized to a model with lots of goods.

Let’s finish by going back to Jevon’s rule

If goods have different prices we can normalize this

or MRS= Price Ratio

More Practice plotting and working with indifference curve

X y
1 11
2 5
3 3
 4 2
6 1
12 0

Ex.
*Draw the indifference curve.
let U=12
12

*Find the MRS

*Are these preferences convex?

= →yes this is convex

*Are these preferences homothetic? no