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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.
UTILITY FUNCTIONS
◆ A utility function U(x) represents a
preference relation if and only if:
~
x0 x1 U(x0) > U(x1)
x 0 ∼ x1 U(x0) = U(x1)
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.
UTILITY FUNCTIONS
and INDIFFERENCE CURVES
U≡6
U≡4
x1
xx1 1
UTILITY FUNCTIONS
and INDIFFERENCE CURVES
x 2x 2
U≡ 6
U≡4
U≡ 2
x x1
UTILITY FUNCTIONS
and INDIFFERENCE CURVES
Utility
Utility
function
Units of Units of
water are water are
goods bads
x’ Water
Around x’ units, a little extra water is a neutral.
UTILITY FUNCTIONS
Cobb-Douglas Utility Function
U ( x1 , x2 ) = x x (a > 0, b > 0)
a b
1 2
Perfect Substitutes Utility Function
x1
PERFECT SUBSITITUTES
◆ Instead of U(x1,x2) = x1x2 consider
V(x1,x2) = x1 + x2.
PERFECT SUBSITITUTES
x2
x1 + x 2 = 5
13
x1 + x 2 = 9
9
x1 + x2 = 13
5
V(x1,x2) = x1 + x2
5 9 13 x1
All are linear and parallel.
PERFECT COMPLEMENTS
◆ Instead of U(x1,x2) = x1x2 or
V(x1,x2) = x1 + x2, consider
W(x1,x2) = min{x1,x2}.
PERFECT COMPLEMENTS
x2
45o
W(x1,x2) = min{x1,x2}
8 min{x1,x2} = 8
5 min{x1,x2} = 5
3 min{x1,x2} = 3
3 5 8 x1
All are right-angled with vertices/corners
on a ray from the origin.
MARGINAL UTILITY
∆U = 0 = MU1(∆x1) + MU2(∆x2)
∂ U 1 −1/ 2 2
MU1 = = x1 x2
∂ x1 2
MARGINAL UTILITY
◆ E.g. if U(x1,x2) = x11/2 x22 then
∂ U 1 −1/ 2 2
MU1 = = x1 x2
∂ x1 2
MARGINAL UTILITY
◆ E.g. if U(x1,x2) = x11/2 x22 then
∂U 1/ 2
MU 2 = = 2 x1 x2
∂ x2
MARGINAL UTILITY
◆ E.g. if U(x1,x2) = x11/2 x22 then
∂U 1/ 2
MU 2 = = 2 x1 x2
∂ x2
MARGINAL UTILITY
◆ So, if U(x1,x2) = x11/2 x22 then
∂ U 1 −1 / 2 2
MU 1 = = x1 x 2
∂ x1 2
∂ U
MU 2 = = 2 x1 x 2
1/ 2
∂ x2
MARGINAL UTLITIES AND MARGINAL
RATE OF SUBISITUTION
∂U ∂U
dx1 + dx2 = 0
∂ x1 ∂ x2
MARGINAL UTLITIES AND MARGINAL
RATE OF SUBISITUTION
∂U ∂U
dx1 + dx2 = 0
∂ x1 ∂ x2
rearranging
∂U ∂U
dx2 = − dx1
∂ x2 ∂ x1
MARGINAL UTLITIES AND MARGINAL
RATE OF SUBISITUTION
∂U ∂U
dx2 = − dx1
∂ x2 ∂ x1
rearranging
d x2 ∂ U / ∂ x1
=−
d x1 ∂ U / ∂ x2
This is the MRS.
MU’s and MRS: An example
Suppose U(x1,x2) = x1x2. Then
∂U
= (1)( x2 ) = x2
∂ x1
∂U
= ( x1 )(1) = x1
∂ x2
d x2 ∂ U / ∂ x1 x2
so MRS = =− =−
d x1 ∂ U / ∂ x2 x1
MU’s and MRS: An example
x2
x2 U(x1,x2) = x1x2; MRS = −
x1
8 MRS(1,8) = - 8/1 = -8
6 MRS(6,6) = - 6/6 = -1.
U = 36
U=8
1 6 x1
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)
MONOTONIC TRANSFORMATIONS AND MRS
2
∂ V / ∂ x1 2 x1 x2 x2
MRS = − =− =−
∂ V / ∂ x2 2
2 x1 x2 x1
∂ V / ∂ x1 f ′ (U ) × ∂ U / ∂x1
MRS = − =−
∂ V / ∂ x2 f '(U ) × ∂ U / ∂x2
∂ U / ∂ x1
=− .
∂ U / ∂ x2
So MRS is unchanged by a positive
monotonic transformation.