1

Budget Constraint, Preferences

and Utility
 Topics
• Budget constraint. Non-linear budget
constraints. Budget constraint with
endowment.
• Assumptions about preferences. Ordinal
preferences. Utility. Indifference curves and
marginal rate of substitution. MRS and
marginal utility.
• Utility functions for specific preferences:
Cobb-Douglas utility, perfect substitutes,
perfect complements, CES utility, quasilinear
preferences, Stone-Geary utility. Homothetic
preferences.
 Reading
 Вэриан [В], гл 2-4
 Чеканский и Фролова [ЧФ], гл 1, 1.1-
1.4.
 Slopes of Indifference Curves
• The slope of an indifference curve is its
marginal rate-of-substitution (MRS).
• How can a MRS be calculated?
 Marginal Rate of Substitution

𝑥2
𝑀𝑅𝑆 at 𝑥’ is the slope of the
indifference curve at 𝑥’
Δ𝑥2
𝑥’ 𝑀𝑅𝑆 =
Δ𝑥1

𝑥1
 Marginal Rate of Substitution

𝑥2 𝑀𝑅𝑆 at 𝑥’ is
𝑀𝑅𝑆 =
Δ𝑥2 𝑑𝑥2
limΔ𝑥1→0 =
Δ𝑥1 𝑑𝑥1
Δ𝑥2 𝑥’ at 𝑥’

Δ𝑥1

𝑥1
 Marginal Rate of Substitution
𝑑𝑥2 = 𝑀𝑅𝑆 ∙ 𝑑𝑥1 so, at 𝑥’,
𝑥2 𝑀𝑅𝑆 is the rate at which the
consumer is only just willing
to exchange commodity 2 for
a small amount of commodity
𝑑𝑥2 𝑥’ 1.
𝑑𝑥1

𝑥1
Marginal Rate of Substitution
• The negative of the slope of the
indifference curve at any point is called the
marginal rate of substitution (MRS)

𝑥2 𝑑𝑥2
𝑀𝑅𝑆 = −
𝑑𝑥1 𝑈=𝑈1

𝑨
𝑩

𝑈1

𝑥1
Marginal Rate of Substitution
• MRS changes as x and y change
– reflects the individual’s willingness to trade y
for x

𝑥2 At A the indifference curve is steeper.

The person would be willing to give up more
good 2 to gain additional units of good 1

At B the indifference curve

is flatter. The person would be
𝑨 willing to give up less good 2 to gain
𝑩
additional units of good 1
𝑈1

𝑥1
 Indifference Curve Map
• Each point must have an indifference curve
through it

𝑥2

Increasing utility

𝑈3 𝑈1 < 𝑈2 < 𝑈3
𝑈2
𝑈1
𝑥1
 Transitivity
• Can any two of an individual’s indifference
curves intersect?

The individual is indifferent between A and C.

The individual is indifferent between B and C.
𝑥2
Transitivity suggests that the individual
should be indifferent between A and B

But B is preferred to A
𝐶
because B contains more
𝐵 𝑥 and 𝑦 than A
𝑈2
𝐴
𝑈1

𝑥1
 Convexity
• A set of points is convex if any two points
can be joined by a straight line that is
contained completely within the set

𝑥2
The assumption of a diminishing MRS is
equivalent to the assumption that all
combinations of x and y which are
preferred to x* and y* form a convex set
𝐴

𝐵
𝑈1

𝑥1
 Utility and the MRS
• Suppose an individual’s preferences for 𝑦
and 𝑥 can be represented by
𝑈 = 𝑥𝑦 = 10

• Solving for 𝑦, we get

𝑦 = 100/𝑥

• Solving for 𝑀𝑅𝑆 = − 𝑑𝑦 𝑑𝑥:

𝑀𝑅𝑆 = − 𝑑𝑦 𝑑𝑥 = 100/𝑥 2
 Utility and the MRS
𝑀𝑅𝑆 = − 𝑑𝑦 𝑑𝑥 = 100/𝑥 2
• Note that as 𝑥 rises, 𝑀𝑅𝑆 falls
– when 𝑥 = 5, 𝑀𝑅𝑆 = 4
– when 𝑥 = 20, 𝑀𝑅𝑆 = 0,25
 Marginal Utility
• Suppose that an individual has a utility
function of the form 𝑈(𝑥, 𝑦)
• The partial derivatives of 𝑈 with respect
𝜕𝑈 𝜕𝑈
to 𝑥 and 𝑦 are and
𝜕𝑥 𝜕𝑦
• These are marginal utilities of 𝑥 and 𝑦
– the extra utility that a consumer gets from
consuming the last unit of a good
Marginal Utility and the MRS
• Suppose that an individual has a utility
function of the form 𝑈(𝑥, 𝑦)
• The total differential of U is
𝜕𝑈 𝜕𝑈
𝑑𝑈 = 𝑑𝑥 + 𝑑𝑦
𝜕𝑥 𝜕𝑦
• Along any indifference curve, utility is
constant (𝑑𝑈 = 0)
 Deriving the MRS
• Therefore, we get:
𝑑𝑦 𝜕𝑈/𝜕𝑥
𝑀𝑅𝑆 = − =
𝑑𝑥 𝑈=𝑐𝑜𝑛𝑠𝑡 𝜕𝑈/𝜕𝑦

• MRS is the ratio of the marginal utility of

𝑥 to the marginal utility of 𝑦
Diminishing Marginal Utility
and the MRS
• Intuitively, it seems that the assumption of
decreasing marginal utility is related to the
concept of a diminishing MRS
– diminishing MRS requires that the utility
function be quasi-concave
• this is independent of how utility is measured
– diminishing marginal utility depends on how
utility is measured
• Thus, these two concepts are different
 Examples of Utility Functions
• Cobb-Douglas Utility
𝑈 𝑥, 𝑦 = 𝑥 𝛼 𝑦 𝛽
where  and  are positive constants
– The relative sizes of  and  indicate the
relative importance of the goods
– Since utility is unique only up to a monotonic
transformation, it is often convenient to
normalize these parameters so that  +  = 1.
 Examples of Utility Functions
• Perfect Substitutes
𝑈 𝑥, 𝑦 = 𝛼𝑥 + 𝛽𝑦

𝑦
The indifference curves will be linear.
The MRS will be constant along the
indifference curve.

𝑈3
𝑈2
𝑈1
𝑥
 Examples of Utility Functions
• Perfect Complements
𝑈 𝑥, 𝑦 = min(𝛼𝑥, 𝛽𝑦)

𝑦 The indifference curves will be

L-shaped. Only by choosing more
of the two goods together can utility
be increased.

𝑈3
𝑈2
𝑈1

𝑥
 Examples of Utility Functions
• CES Utility (Constant elasticity of
substitution)
𝑈 𝑥, 𝑦 = (𝑥 𝜌 + 𝑦 𝜌 )1/𝜌
when 0 ≠ 𝜌 ≤ 1
• Elasticity of substitution is
𝑦 𝑦
%∆ ∆ ∆𝑀𝑅𝑆𝑥,𝑦
𝜎𝑥,𝑦 = 𝑥 = 𝑦 : 𝑥
%∆𝑀𝑅𝑆𝑥,𝑦 𝑀𝑅𝑆𝑥,𝑦
𝑥
 Examples of Utility Functions
• Elasticity of substitution is
𝑦 𝑦
%∆ ∆ ∆𝑀𝑅𝑆𝑥,𝑦
𝜎𝑥,𝑦 = 𝑥 = 𝑦 : 𝑥
%∆𝑀𝑅𝑆𝑥,𝑦 𝑀𝑅𝑆𝑥,𝑦
𝑥
𝑑 ln(𝑦/𝑥)
=
𝑑 ln(𝑀𝑈𝑥 /𝑀𝑈𝑦 )
 Examples of Utility Functions
1 1
𝑑 ln(𝑦/𝑥) = 𝑑 ln(𝑦) − 𝑑 ln 𝑥 = 𝑑𝑦 − 𝑑𝑥 =
𝑦 𝑥
1 1
= − 𝑑𝑥 − 𝑑𝑦
𝑥 𝑦
𝑀𝑈𝑥 = 1 𝜌 𝑥 𝜌 + 𝑦 𝜌 1 𝜌−1 𝜌𝑥 𝜌−1
= 𝑥 𝜌 + 𝑦 𝜌 1 𝜌−1 𝑥 𝜌−1
𝑀𝑈𝑦 = 𝑥 𝜌 + 𝑦 𝜌 1 𝜌−1 𝑦 𝜌−1
𝑀𝑅𝑆𝑥,𝑦 = (𝑥 𝑦)𝜌−1
Examples of Utility Functions
ln(𝑀𝑈𝑥 /𝑀𝑈𝑦 ) = ln[(𝑥 𝑦)𝜌−1 ] =
= 𝜌 − 1 [ln(𝑥) − ln 𝑦 ]
1 1
𝑑 ln(𝑀𝑈𝑥 /𝑀𝑈𝑦 ) = 𝜌 − 1 𝑑𝑥 − 𝑑𝑦
𝑥 𝑦
𝑑 ln(𝑦/𝑥)
𝜎𝑥,𝑦 = =
𝑑 ln(𝑀𝑈𝑥 /𝑀𝑈𝑦 )
1 1
− 𝑑𝑥 − 𝑑𝑦
𝑥 𝑦
=
1 1
𝜌−1 𝑑𝑥 − 𝑑𝑦
𝑥 𝑦
 Examples of Utility Functions

The elasticity of substitution is

1
𝜎𝑥,𝑦 =
1−𝜌
 Examples of Utility Functions
• CES Utility (Constant elasticity of
substitution)
– The elasticity of substitution () is equal to
1/(1 - )
• Perfect substitutes   → 1,  → ∞
• Fixed proportions   → ― ∞ ,  → 0, so
substitution is impossible
• Cobb-Douglas Utility   → 0
Perfect substitutes, fixed proportions, and Cobb-
Douglas functions are special cases of the CES
utility function.
 Examples of Utility Functions
• Stone-Geary utility
– A utility function that incorporates
subsistence levels of consumption below
which utility is not defined
𝑈 𝑥, 𝑦 = (𝑥 − 𝑐)𝛼 (𝑦 − 𝑑)𝛽
where the c and d are interpreted as minimum
subsistence levels of x and y
These preferences are not defined on the whole of
ℝ2+ . They are only defined on consumption
bundles for which 𝑥 ≥ 𝑐 and 𝑦 ≥ 𝑑 .
 MRS for Quasi-linear Utility
Functions
• A quasi-linear utility function is of the
form
𝑈 𝑥, 𝑦 = 𝑓 𝑥 + 𝑦
𝜕𝑈 ′ 𝜕𝑈
= 𝑓 (𝑥) =1
𝜕𝑥 𝜕𝑦
so
𝑑𝑦 𝜕𝑈/𝜕𝑥
𝑀𝑅𝑆 = − = = 𝑓 ′ (𝑥)
𝑑𝑥 𝜕𝑈/𝜕𝑦
 Monotonic Transformations and
the 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 the MRS when a
monotonic transformation is applied?
 Monotonic Transformations and
MRS
• For 𝑈 𝑥, 𝑦 = 𝑥𝑦 the 𝑀𝑅𝑆 = 𝑦/𝑥.
• Create 𝑉 = 𝑈2; i.e. 𝑉 𝑥, 𝑦 = 𝑥2𝑦2. What
is the 𝑀𝑅𝑆 for 𝑉?
𝜕𝑉/𝜕𝑥 2𝑥𝑦2 𝑦
𝑀𝑅𝑆 = = 2 =
𝜕𝑉/𝜕𝑦 2𝑥 𝑦 𝑥

which is the same as the 𝑀𝑅𝑆 for 𝑈.

 Monotonic Transformations and
the MRS

• More generally, if 𝑉 = 𝑓(𝑈) where 𝑓 is a

strictly increasing function, then
𝜕𝑉/𝜕𝑥 𝑓 ′ (𝑈) ∙ 𝜕𝑈/𝜕𝑥 𝜕𝑈/𝜕𝑥
𝑀𝑅𝑆 = = ′ =
𝜕𝑉/𝜕𝑦 𝑓 (𝑈) ∙ 𝜕𝑈/𝜕𝑦 𝜕𝑈/𝜕𝑦

So 𝑀𝑅𝑆 is unchanged by a positive

monotonic transformation
 Homothetic Preferences
• If the MRS depends only on the ratio of
the amounts of the two goods, not on the
quantities of the goods, the utility
function is homothetic
– Perfect substitutes  𝑀𝑅𝑆 is the same at
every point
– Perfect complements  𝑀𝑅𝑆 = ∞ if 𝑦 𝑥 >
/, undefined if 𝑦 𝑥 = /, and 𝑀𝑅𝑆 = 0 if
𝑦 𝑥 < /
 Homothetic Preferences
• For the general Cobb-Douglas function,
𝑈 𝑥, 𝑦 = 𝑥 𝛼 𝑦 𝛽
the MRS can be found as
𝜕𝑈/𝜕𝑥 𝛼𝑥 𝛼−1 𝑦 𝛽 𝛼 𝑦
𝑀𝑅𝑆 = = 𝛼 𝛽−1 =
𝜕𝑈/𝜕𝑦 𝛽𝑥 𝑦 𝛽𝑥
 Homothetic Preferences
• If (𝑥 𝐴 , 𝑦 𝐴 ) is preferred to (𝑥 𝐵 , 𝑦 𝐵 ), then
(𝑡𝑥 𝐴 , 𝑡𝑦 𝐴 ) is preferred to (𝑡𝑥 𝐵 , 𝑡𝑦 𝐵 ) for
any 𝑡 > 0
• Along any ray from the origin 𝑀𝑅𝑆 is
constant
 Nonhomothetic Preferences
• Some utility functions do not exhibit
homothetic preferences
• E.g. 𝑈 𝑥, 𝑦 = 𝑥 + ln 𝑦
𝜕𝑈/𝜕𝑥 1
𝑀𝑅𝑆 = = =𝑦
𝜕𝑈/𝜕𝑦 1
𝑦