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Defining Utility Function

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xA preference relation that is complete, reflexive, transitive and continuous can be represented by a continuous utility function.

xContinuity means that small changes to a consumption bundle cause only small changes to the preference level. xA utility function U(x) represents a preference relation if and only if: x x x x x x U(x) > U(x) U(x) < U(x) U(x) = U(x).

xUtility 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.

xConsider the bundles (4,1), (2,3) and (2,2), suppose (2,3) (4,1) (2,2). xAssign to these bundles any numbers that preserve the preference ordering; e.g. U(2,3) = 6 > U(4,1) = U(2,2) = 4. These numbers are utility levels. xAn indifference curve contains equally preferred bundles. xEqual preference implies same utility level. Therefore, all bundles in an indifference curve have the same utility level.

Defining Utility

xComparing all possible consumption bundles gives the complete collection of the consumers indifference curves, each with its assigned utility level. xThis complete collection of indifference curves completely represents the consumers preferences.

xThe collection of all indifference curves for a given preference relation is an indifference map. xAn indifference map is equivalent to a utility function; each is the other.

Properties: Monotonicity

xThere is no unique utility function representation of a preference relation. xSuppose U(x1,x2) = x1x2 represents a preference relation. xAgain consider the bundles (4,1), (2,3) and (2,2). U(x1,x2) = x1x2, so U(2,3) = 6 > U(4,1) = U(2,2) = 4; that is, (2,3) (4,1) (2,2).

xDefine 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). xV preserves the same order as U and so represents the same preferences. Any positive monotonic transformation of a utility function represent the same preference

Properties: Monotonicity

Any positive monotonic transformation of a utility function represent the same preference A rule: 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

xA good is a commodity unit which increases utility (gives a more preferred bundle). xA bad is a commodity unit which decreases utility (gives a less preferred bundle). xA neutral is a commodity unit which does not change utility (gives an equally preferred bundle).

xconsider V(x1,x2) = x1 + x2. What do the indifference curves for this perfect substitution utility function look like?

xconsider W(x1,x2) = min{x1,x2}. What do the indifference curves for this perfect complementarity utility function look like? xA utility function of the form U(x1,x2) = f(x1) + x2 is linear in just x2 and is called quasi-linear.

E.g.

xAny 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.

Marginal Utility

1. extra utility from some extra consumption of one of the goods, holding the other good fixed 2. this is a derivative, but a special kind of derivative a partial derivative 3. this just means that you look at the derivative of u(x1, x2) keeping x2 fixed treating it like a constant 4. examples a) if u(x1, x2) = x1 + x2, then MU1 = Xx1 = 1 b) if u(x1, x2) = x1^a * x2^b , then MU1 = Xx1 = ax1^a-1 * x2^b 5. note that marginal utility depends on which utility function you choose to represent preferences a) if you multiply utility times 2, you multiply marginal utility times 2 b) thus it is not an operational concept c) however, MU is closely related to M RS, which is an operational concept

relationship between MU and M RS a) u(x1, x2) = k, where k is a constant, describes an indifference curve b) we want to measure slope of indifference curve, the M RS c) so consider a change (dx1, dx2) that keeps utility constant. Then

MU1dx1 + MU2dx2 = 0

d) Hence

Some properties

xA quasi-linear utility function is of the form U(x1,x2) = f(x1) + x2.

U = f ( x1 ) x1

U = 1 x2

so:

d x2 U / x1 = = f ( x 1 ). MRS = d x1 U / x2

xMRS = - 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. What does that make the indifference map for a quasilinear utility function look like?

xApplying a monotonic transformation to a utility function representing a preference relation simply creates another utility function representing the same preference relation. xWhat happens to marginal rates-of substitution when a monotonic transformation is applied? xif 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

=

Some properties

U / x1 . U / x2

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