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Preferences and Utility
Simon Board∗
This Version: October 6, 2009
First Version: October, 2008.
These lectures examine the preferences of a single agent. In Section 1 we analyse how the agent chooses among a number of competing alternatives, investigating when preferences can be represented by a utility function. In Section 2 we discuss two attractive properties of preferences: monotonicity and convexity. In Section 3 we analyse the agent’s indifference curves and ask how she makes tradeoffs between different goods. Finally, in Section 4 we look at some examples of preferences, applying the insights of the earlier theory.
1 The Foundation of Utility Functions
1.1 A Basic Representation Theorem
Suppose an agent chooses from a set of goods X = {a, b, c,.. .}. For example, one can think of these goods as different TV sets or cars.
Given two goods, x and y, the agent weakly prefers x over y if x is at least as good as y. To avoid us having to write “weakly prefers” repeatedly, we simply write x < y. We now put some basic structure on the agent’s preferences by adopting two axioms.^1
Completeness Axiom: For every pair x, y ∈ X, either x < y, y < x, or both. ∗Department of Economics, UCLA. http://www.econ.ucla.edu/sboard/. Please email suggestions and typos to sboard@econ.ucla.edu. 1 An axiom is a foundational assumption.
Transitivity Axiom: For every triple x, y, z ∈ X, if x < y and y < z then x < z.
An agent has complete preferences if she can compare any two objects. An agent has transitive preferences if her preferences are internally consistent. Let’s consider some examples.
First, suppose that, given any two cars, the agent prefers the faster one. These preferences are complete: given any two cars x and y, then either x is faster, y is faster or they have the same speed. These preferences are also transitive: if x is faster than y and y is faster than z, then x is faster than z.
Second, suppose that, given any two cars, the agent prefers x to y if it is both faster and bigger. These preferences are transitive: if x is faster and bigger than y and y is faster and bigger than z, then x is faster and bigger than z. However, these preferences are not complete: an SUV is bigger and slower than a BMW, so it is unclear which the agent prefers. The completeness axiom says these preferences are unreasonable: after examining the SUV and BMW, the agent will have a preference between the two.
Third, suppose that the agent prefers a BMW over a Prius because it is faster, an SUV over a BMW because it is bigger, and a Prius over an SUV, because it is more environmentally friendly. In this case, the agent’s preferences cycle and are therefore intransitive. The transitivity axiom says these preferences are unreasonable: if environmental concerns are so important to the agent, then she should also take them into account when choosing between the Prius and BMW, and the BMW and the SUV.
While it is natural to think about preferences, it is often more convenient to associate different numbers to different goods, and have the agent choose the good with the highest number. These numbers are called utilities. In turn, a utility function tells us the utility associated with each good x ∈ X, and is denoted by u(x) ∈ <. We say a utility function u(x) represents an agent’s preferences if
u(x) ≥ u(y) if and only if x < y (1.1)
This means than an agent makes the same choices whether she uses her preference relation, <, or her utility function u(x).
Theorem 1 (Utility Representation Theorem). Suppose the agent’s preferences, <, are com- plete and transitive, and that X is finite. Then there exists a utility function u(x) : X → < which represents <.
N BT (y) ⊆ N BT (x). Completeness means that a good is weakly preferred to itself, so that y ∈ N BT (y). Since N BT (y) ⊆ N BT (x), we conclude y ∈ N BT (x). Using the definition of the “no better than” set, this implies that x < y, as required.
1.3 Increasing Transformations
A number system is ordinal if we only care about the ranking of the numbers. It is cardinal if we also care about the magnitude of the numbers. To illustrate, Usain Bolt and Richard Johnson came 1st and 2nd in the 2008 Olympic final of the 100m sprint. The numbers 1 and 2 are ordinal: they tell us that Bolt beat Johnson, but do not tell us that he was 1% faster or 10% faster. The actual finishing times were 9.69 for Bolt and 9.89 for Johnson. These numbers are cardinal: the ranking tells us who won, and the magnitudes tells us about the margin of the win.
Theorem 1 is ordinal: when comparing two goods, all that matters is the ranking of the utilities; the actual numbers themselves carry no significance. This is obvious from the construction: when there are 10 goods, it is clearly arbitrary that we give utility 9 to the best good, 8 to the second best, and so on. This idea can be formalised by the following result:
Theorem 2. Suppose u(x) represents the agent’s preferences, <, and f : < → < is a strictly increasing function. Then the new utility function v(x) = f (u(x)) also represents the agent’s preferences <.
The proof of Theorem 2 is simply a rewriting of definitions. Suppose u(x) represents the agent’s preferences, so that equation (1.1) holds. If x < y then u(x) ≥ u(y) and f (u(x)) ≥ f (u(y)), so that v(x) ≥ v(y). Conversely, if v(x) ≥ v(y) then, since f (·) is strictly increasing, u(x) ≥ u(y) and x < y. Hence v(x) ≥ v(y) if and only if x < y
and v(x) represents <.
Theorem 2 is important when solving problems. Suppose an agent has utility function
u(x) = −
(x^11 / 2 + x^12 / 2 + 10)^3
Solving the agent’s problem with this utility function may be be algebraically messy. Using
Theorem 2, we can rewrite the agent’s utility as
v(x) = x^11 / 2 + x^12 /^2
Since u(x) and v(x) preserve the rankings of the goods, they represent the same preferences. As a result, the agent will make the same choices with utility u(x) and v(x). This is useful since it is much simpler to solve the agent’s choice problem using v(x) than u(x).
Theorem 2 is also useful for cocktail parties. For example, some people dislike the way I rank movies of a 1-10 scale. They claim that a movie is a rich artistic experience, and cannot be summarised by a number. However, Theorem 1 tells us that, if my preferences are complete and transitive, then I can represent my preferences over movies by a number. Moreover, Theorem 2 tells us that I can rescale the numbers to put them on a 1-10 scale.
Choosing from Budget Sets
Theorem 1 assumes that the consumer chooses from a finite number of goods. While this is realistic, it is more mathematically convenient to allow consumers to choose from a continuum of goods. For example, if the agent has $10 and a hamburger costs $2, it is easier to allow the consumer to any number between 0 and 5, rather than forcing her to choose an integer.
Suppose the choice set is given by X ⊆ <n +. A typical element is x = (x 1 ,... , xn), where xi is the number of the ith^ good the agent consumes. In order to prove a representation theorem for this larger set of choices, we need one more (rather technical) axiom.
Continuity Axiom: Suppose x^1 , x^2 , x^3 ,... is a sequence of feasible choices, so that xi^ ∈ X for each i, and suppose the sequence converges to x ∈ X. If xi^ < y for each i, then x < y.
Theorem 3 (Representation Theorem for Budget Sets). Suppose the agent’s preferences, <, are complete, transitive and continuous, and that X ⊆ <n +. Then there exists a continuous utility function u(x) : X → < which represents <.
We will not prove this result. The following example examines a case where the continuity axiom does not hold and no utility representation exists.
Suppose there are two goods and the agent has lexicographic preferences: when faced with two bundles the agent prefers the bundle with the most of x 1 ; if the two bundles have the same
As we will see, the assumption of monotonicity is very useful. It implies that indifference curves are thin and downwards sloping. It implies that an agent will always spend her budget. A slightly stronger version of monotonicity also rules out inflexion points in the agent’s utility function which is useful when we analyse the agent’s utility maximisation problem.
2.2 Convexity
Preferences are convex if whenever x < y then
tx + (1 − t)y < y for all t ∈ [0, 1]
Convexity says that the agent prefers averages to extremes: if the agent is indifferent between x and y then she prefers the average tx + (1 − t)y to either x or y.
We can write this assumption in terms of utilities. Preferences are convex if whenever u(x) ≥ u(y) then
u(tx + (1 − t)y) ≥ u(y) for all t ∈ [0, 1] (2.1)
Slightly confusingly, a utility function that satisfies (2.1) is called quasi–concave.
The assumption of convexity if important when we analyse the consumers utility maximisa- tion problem. Along with monotonicity, it means that any solution to the agent’s first–order conditions solve the agent’s problem.
3 Indifference Curves
An agent’s indifference curve is the set of bundles which yield a constant level of utility. That is, Indifferent Curve = {x ∈ X|u(x) = const.}
An agent has a collection of indifference curves, each one corresponding to a different level of utility. By varying this level, we can trace out the agent’s entire preferences.
To illustrate, suppose an agent has utility
u(x 1 , x 2 ) = x 1 x 2
x 1
0 2 4 6 8 10
x 2
0
2
4
6
8
10
Figure 1: Indifference Curves. This figure shows two indifference curves. Each curve depicts the bundles that yield constant utility.
Then the indifference curve satisfies the equation x 1 x 2 = k. Rearranging, we can solve for x 2 , yielding
x 2 = (^) xk 1
which is the equation of a hyperbola. This function is plotted in figure 1.
In Section 3.1 we derive five important properties of indifference curves. In Section 3.2 we introduce the idea of the marginal rate of substitution. For simplicity, we assume there are only two goods.
3.1 Properties of Indifference Curves
We now describe five important properties of indifference curves. Throughout, we assume that preferences satisfy completeness, transitivity and continuity, so a utility function exists. We also assume monotonicity.
- Indifference curves are thin. We say an indifference curve is thick if it contains two points x and y such that xi > yi for all i. This is illustrated in figure 2. Monotonicity says that y must
Figure 3: Indifference Curves that Cross.
Figure 4: An Upward Sloping Indifference Curve.
Figure 5: An Indifference Curve with a Gap.
- If preferences are convex then indifference curves are convex to the origin. Suppose x and y lie on an indifference curve. By convexity, tx + (1 − t)y lies on a higher indifference curve, for t ∈ [0, 1]. By monotonicity, this higher indifference curve lies to the northeast of the original indifference curve. Hence the indifference curve is convex, as shown in figure 6.
3.2 Marginal Rate of Substitution
The slope of the indifference curve measures the rate at which the agent is willing to substitute one good for another. This slope is called the marginal rate of substitution or MRS. Mathematically,
M RS = − dx^2 dx 1
∣u(x 1 ,x 2 )=const.^
We can rephrase this definition in words: the MRS equals the number of x 2 the agent is willing to give up in order to obtain one more x 1. This is shown in figure 7.
The MRS can be related to the agent’s utility function. First, we need to introduce the idea of marginal utility
M Ui(x 1 , x 2 ) = ∂u( ∂xx^1 , x^2 ) i which equals the gain in utility from one extra unit of good i.
Let us consider the effect of a small change in the agent’s bundle. Totally differentiating the utility u(x 1 , x 2 ) we obtain
du = ∂u(x^1 , x^2 ) ∂x 1 dx 1 + ∂u(x^1 , x^2 ) ∂x 2 dx 2 (3.3)
Equation (3.3) says that the agent’s utility increases by her marginal utility from good 1 times the increase in good 1 plus the marginal utility from good 1 times the increase in good 2. Along an indifference curve du = 0, so equation (3.3) becomes
∂u(x 1 , x 2 ) ∂x 1 dx 1 + ∂u(x^1 , x^2 ) ∂x 2 dx 2 = 0
Rearranging,
− dx dx^2 1
= ∂u ∂u((xx^1 , x^2 )/∂x^1 1 , x 2 )/∂x 2
Equation (3.2) therefore implies that
M RS = M U^1 M U 2
The intuition behind equation (3.4) is as follows. Using the definition of MRS, one unit of x 1 is worth MRS units of x 2. That is, M U 1 = M RS × M U 2. Rewriting this equation we obtain (3.4).
We can relate MRS to our earlier concepts of monotonicity and convexity. Monotonicity says that the indifference curve is downward sloping. Using equation (3.2), this means that MRS is positive.
Under the assumption of monotonicity, convexity says that the indifference curve is convex. This means that the MRS decreasing in x 1 along the indifference curve. Formally, an indifference curve defines an implicit relationship between x 1 and x 2 ,
u(x 1 , x 2 (x 1 )) = k
Convexity then implies that M RS(x 1 , x 2 (x 1 )) is decreasing in x 1. This is illustrated in the next section.
Finally, we can relate the MRS to the ordinal nature of the utility representation. In Theorem 2 we showed that the choices made under u(x) and v(x) = f (u(x)) are the same, where f : < → < is strictly increasing. One way to understand this result is through the MRS. Under utility function u(x) the MRS is given by equation (3.4). Under utility function v(x), the MRS is
given by
M RSv^ = ∂v/∂x^1 ∂v/∂x 2 = f^
′(u)∂u/∂x 1 f ′(u)∂u/∂x 2 = ∂u/∂x^1 ∂u/∂x 2 = M RSu
where the second equality uses the chain rule. This means that the agent faces the same tradeoffs under the two utility functions, has identical indifference curves, and therefore makes the same decisions.
3.3 Example: Symmetric Cobb Douglas
Suppose u(x 1 , x 2 ) = x 1 x 2. We calculate the marginal rate of substitution two ways.
First, we can use equation (3.2) to derive MRS. As in equation (3.1), the equation of an indifference curve is
x 2 = k x 1
Differentiating,
M RS = − dx 2 dx 1 =^
k x^21 (3.6)
We can now verify preferences are convex. Differentiating (3.6) with respect to x 1 ,
d dx 1 M RS^ =^ −^2
k x^31
which is negative, as required.
Alternatively, we can use equation (3.4) to derive MRS. Differentiating the utility function
M RS = M U^1 M U 2 = x^2 x 1
We now want to express MRS purely in terms of x 1. Using (3.5) to substitute for x 2 , equation (3.7) becomes (3.6).
Figure 8: Perfect Complements. These indifference curves are L–shaped with the kink where αx 1 = βx 2.
In general, preferences are perfect complements when they can be represented by a utility function of the form u(x 1 , x 2 ) = min{αx 1 , βx 2 }
The resulting indifference curves are L–shaped, as shown in figure 8, with the kink along the line αx 1 = βx 2. Note that the indifference curve is not strictly decreasing along the bottom of the L. This is because these preferences do not quite obey the monotonicity condition: when the agent has 7 patties and 10 slices of bread, an extra patty does not strictly increase her utility.
The MRS in this example is a little odd. When αx 1 > βx 2 ,
M RS = M U M U^1 2
= β^0 = 0
When αx 1 < βx 2 ,
M RS = M U^1 M U 2 = α 0
At the kink, when αx 1 = βx 2 , then MRS is not defined because the indifference curve is not differentiable.
Figure 9: Perfect Substitutes. These indifference curves are linear with slope −α/β.
4.3 Perfect Substitutes
Suppose an agent is buying food for a party. She wants enough food for her guests and considers 3 hamburgers to be equivalent to one pizza. Since each pizza is three times as valuable as a hamburger, her preferences can be represented by the utility function
u(xh, xp) = x 1 + 3x 2
where x 1 are hamburgers and x 2 are pizzas.
In general, preferences are perfect substitutes when they can be represented by a utility function of the form u(x 1 , x 2 ) = αx 1 + βx 2
The resulting indifference curves are straight lines, as shown in figure 10. As a result, preferences are only weakly convex. The marginal rate of substitution is
M RS =
M U 1
M U 2 =^
α β
That is, the MRS is independent of the number of goods consumed.
4.5 Additive Preferences
Additive preferences are represented by a utility function of the form
u(x 1 , x 2 ) = v 1 (x 1 ) + v 2 (x 2 )
The key property of additive preferences is that the marginal utility of xi only depends on the amount of xi consumed. As a result, the marginal rate of substitution is
M RS = M U^1 M U 2 = v
′ 1 (x 1 ) v′ 2 (x 2 )
For example, suppose we have u(x 1 , x 2 ) = x^21 + x^21
Differentiating, M Ui = 2xi, so the marginal utility of each good is increasing in the amount of the good consumed. For example, one could imagine the agent becomes addicted to either good.
As shown in Figure 11, these preferences are concave. One can see this formally by showing the MRS is increasing in x 1 along an indifference curve. Differentiating,
M RS = M U^1 M U 2 =^2 x^1 2 x 2 = x^1 x 2
The equation of an indifference curve is x^21 +x^22 = k. Rearranging, x 2 = (k−x^21 )^1 /^2. Substituting into (4.1), M RS = x 1 (k − x^21 )^1 /^2
which is increasing in x 1.
4.6 Bliss Points
Suppose preferences are represented by the utility function
u(x 1 , x 2 ) = −
2 (x^1 −^ 10)
2 (x^2 −^ 10)
2
Figure 12 plots the resulting indifference curves which are concentric circles around the bliss point of (x 1 , x 2 ) = (10, 10). These preferences violate monotonicity; as a result the indifference
Figure 11: Addiction Preferences. These indifference curves are concave.
curves are sometimes upward sloping.
The marginal rate of substitution is
M RS = M U M U^1 2
=^1010 −−^ xx^1 2
Hence the MRS is positive in the northeast and southwest quadrants, and is negative in the northwest and southeast quadrants. From figure 12 one can also see that preferences are convex. This is also possible to see from the MRS, but is a little tricky since monotonicity does not hold.
4.7 Quasilinear Preferences
An agent has quasilinear preferences if they can be represented by a utility function of the form
u(x 1 , x 2 ) = v(x 1 ) + x 2
Quasilinear preferences are linear in x 2 , so the marginal utility is constant. These preferences are often used to analyse goods which constitute a small part of an agent’s income; good x 2 can then be thought of as “general consumption”.
