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3. Consumer Preferences and the Concept of Utility

3.1. Representations of Preferences

In this chapter we are concerned with the preferences of consumers
Consumer preferences are indications of how a consumer would rank, that is,
compare the desirability, of any two possible baskets of goods and services,
assuming that the baskets were available to the consumer at no cost.
A basket is a combination of goods and services that an individual might
consume.

Assumptions about Consumer Preferences
There are three basic assumptions that underlie the theory of consumer choice.
These assumptions take for granted that consumers behave rationally.
Preferences are complete: This means that a consumer is able to rank any two
baskets A and B, meaning she can determine which of the following is true:
She prefers A to B.
She prefers B to A.
He is indifferent between A and B.
Preferences are Transitive: This means that a consumer makes choices that
are consistent with each other. In particular:
If A is preferred to B and B is preferred to C then it must be that A
is preferred to C.
More is Better: Basically this means that having more of a good is better for a
consumer.
If there are two baskets with the same goods, but basket B has
more of each good, then it must be that B is preferred to A.

Ordinal and Cardinal Ranking
Throughout this course we will be interested in two types of rankings: ordinal and
cardinal.
Ordinal rankings give us information about the order in which a consuer
ranks baskets, they indicate whether a consumer prefers one basket to
another, but do not contain quantitative information about the intensity of
that preference.
Cardinal rankings give us information about the intensity of a consumers
preferences; they are quantitative measures of the intensity of a preference
for one basket over another.

We find that consumers are able to give ordinal rankings in most situations,
however, cardinal rankings are more problematic, and luckily it turns out that
ordinal rankings normally provide enough information to explain a consumers
decisions.

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3.2. Utility Functions
The three assumptions about preferences allow us to represent preferences with a utility
function.
Preferences with a Single Good: The Concept of Marginal Utility
A utility function measures the level of satisfaction that a consumer receives from a
basket of goods and services.


















Example: We are concerned with a single consumer, Sarah. Imagine that Sarah purchases only
one good, hamburgers. Let y denote the number of hamburgers that she consumes each week,
and let U(y) measure the level of satisfaction that Sarah derives from purchasing y hamburgers.
Suppose Sarahs utility function is U(y) =


The graph of Sarahs utility
shows us that Sarahs
preferences satisfy the
three assumptions
mentioned previously.
More is better: The more
hamburgers the higher the
utility
Completeness: Sarah can
always determine which
bundle she prefers; it is
simply the one with more
hamburgers.
Transitivity: Sarahs
preferences are rational.



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We are often concerned with how the level of satisfaction will change in response to a
change in the level of consumption. Economists refer to this as marginal utility.
Marginal Utility is the rate at which total utility changes as the level of consumptions
rises.
MU =

Graphically the marginal utility at a particular point is represented by the
slope of a line tangent to the utility function at that point, in other words the
derivative of the Utility function at that point.
The marginal utility in the above example is

The following points should be kept in mind when drawing total utility and marginal
utility:
Total Utility and Marginal Utility cannot be plotted on the same graph; this is
because the vertical axes in the two graphs are not the same.
The marginal utility is the slope of the total utility function, this should
sound familiar as the same held true for marginal cost and total cost.
The relationship b/w total and marginal functions holds for other measures
in economics (like cost).

The graph in the prior example demonstrates the Principle of diminishing marginal
utility which states that after some point, as consumption of a good increases, the
marginal utility of a good will begin to fall.
This should make intuitive sense, consider your own consumption behavior,
the more of something you consume, for example candy bars or hamburgers,
the less additional satisfaction you get from additional consumption.
It is important to realize that marginal utility may become negative after a
certain point. Imagine that you have eaten 4 candy bars, and the 5
th,
rather
then providing you will a small increase in utility, will actually make you
sick, thus decreasing your overall utility. This is a case where the marginal
utility of the 5
th
candy bar is negative.

Now we will consider a more realistic situation in which utility is based on multiple
goods rather than just one. In this scenario we are able to examine the trade-offs a
consumer must make in choosing his optimal basket.
Let us consider a consumer Brandon who must decide how much food (x) and how
much clothing (y) to purchase in a given month.
Brandons utility for any basket (x, y) is measured by =
The concept of marginal utility carries over to this multiple good situation:

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Learning by doing 3.1 and 3.2
To illustrate the trade-offs involved in consumer choice, we use indifference curves.
You may recall from previous economics courses that each indifference curve connects a
set of consumption baskets that yield the same level of satisfaction (Utility) to the
consumer.

Indifference curves on an indifference map have the following four properties:
When the consumer liked both goods, all indifference curves have a negative
slope.


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Indifference curves cannot intersect. This causes a logical inconsistency, As
U1> U2 in some areas and U2>U1 in others.

Every consumption bundle lies on one and only one indifference curve. This
follows from the property that indifference curves cannot intersect.
Indifference curves are not thick. The picture below helps to demonstrate
this fact. Since B lies to the northeast of A, it must be that B provides higher
utility, thus A and B cannot be on the same IC

The marginal rate of substitution is the rate at which the consumer will give up one
good to get more of another, holding the level of utility constant.
For example a consumers marginal rate of substitution of hamburgers for
lemonade is the rate at which the consumer would be willing to give up
glasses of lemonade to get more hamburgers, while maintaining the same
level of utility.
The marginal rate of substitution is equal to the negative of the slope of the
indifference curve. This makes sense since each IC curve represents all the
bundles that provide the same level of utility and the slope (

) is going to
represent the trade-off b/w the two goods that keeps utility constant.
We can also derive another formula for the MRS.

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Suppose a consumer changes the level of consumption of x and y by and
the corresponding impact on utility is:

We know that MRS implies that there is no change in utility
( = 0.
So we know that :

= 0
This can be rewritten as:

This can be rewritten as:

holding utility constant

So we conclude that
,
=

Preferences often demonstrate a Diminishing Marginal Rate of Substitution meaning
that the marginal rate of substitution of one good for another good diminishes as the
consumption of the first good increases along an indifference curve.
The following curve represents this fact. It also makes sense, as at point A
mostly glasses of lemonade are being consumed, so the consumer would be
willing to give up many glasses to get an additional hamburger. However, at
point D, there are very few glasses of lemonade being consumed, so the
consumer would be willing to give up very little lemonade for an additional
hamburger.

Learning By doing Exercise 3.3 and 3.4