11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
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Utility Function: Meaning and
Construction | Microeconomics
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Here is an elaborated discussion on the utility function, highlighting:- 1. Meaning of the
Utility Function 2. Constructing a Utility Function 3. Some Very Common Utility
Functions.
Meaning of the Utility Function:
Privacy - Terms
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
A utility function is a way of assigning a number to each possible consumption bundle
such that larger numbers are assigned to more-preferred bundles than less-preferred
ones and the same number is assigned to equally preferred bundles. This simply means
that a bundle (x1, x2) is preferred to a bundle (x’1, x’2) if and only if the utility of (x1, x2)
exceeds that of (x’1, x’2).
(x1, x2) > (x’1, x’2) iff u(x1, x2) > u(x’1, x’2)
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and u(x1, x2) = u(x’1, x’2) iff (x1, x2) ~ (x’1, x’2)
The only restriction on this transformation rule is that when u1 increases u2 must
increase.
Ordering the Bundles of Goods:
The sole important property of utility assignment is related to the ordering the bundles
of goods. The magnitude of the utility function is important only because it ranks the
different consumption bundles; the magnitude of the utility difference between any
two consumption bundles is not a decision variable.
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
Flights from Flights from Flights from Flights from Flights from
Mumbai to Mumbai to Mumbai to New Delhi Hyderabad
Chennai Goa Bangalore to Srinagar to Mumbai
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Due to the emphasis on ordering of goods, rather than measuring the magnitude of
utility, this kind of utility is known as ordinal utility.
In Table 5.1 we illustrate different ways of assigning utilities to three bundles of goods,
all of which order the bundles in the same way. In this case the consumer prefers X to Y
and Y to Z because X is associated with a higher number than Y, which, in its turn, is
associated with a higher number than Z.
So only the ranking of the consumption bundles matters. There is no unique way to
assign utilities to bundles of goods, i.e., the utility function is not unique. One way of
assigning utility numbers to bundles of goods is through a monotonic transformation.
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https://www.microeconomicsnotes.com/utility-function/utility-function-meaning-and-construction-microeconomics/13639 3/18
11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
If, for example, m(x1, x2) represents a way to assign utility numbers to the bundle (x1,
x2), then multiplying u(x1, x2) by 2 (or any positive number) is an example of a monotonic
transformation. A monotonic transformation is a way of transforming one set of
numbers into another in such a way that the order of the numbers is not disturbed.
A monotonic transformation of a function f(u) occurs when each number u is
transformed into some other number f(u) such that u1 > u2 which implies that f(u1) >
f(u2). Mathematically speaking, there is no fundamental difference between a
monotonic transformation and a monotonic function.
The graph of a monotonic function will always have a positive slope, as shown in Fig 5.1
(a). A monotonic function is one that is always increasing. Part (b) illustrates a function
that is not monotonic, since it sometimes increases and sometimes decreases.
In short, a monotonic transformation of a utility function is one that represents the
same preferences as the original utility function. Since utility is a way to label
indifference curves a monotonic transformation is just a relabeling of them.
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
Flights from Flights from Flights from Flights from Flights from
Mumbai to New Delhi to Mumbai to Kolkata to Mumbai to
Goa Srinagar Lucknow Bangalore Ahmedabad
from ₹1,366 from ₹3,137 from ₹2,580 from ₹5,876 from ₹1,735
A related point may also be noted in this context. Since a larger label is put on
indifference curves containing more-preferred bundles than those containing less-
preferred bundles, the labelling does not alter the preferences. In other words, the
labelling will represent the same preferences.
Constructing a Utility Function:
It may be noted at the outset that intransitive preferences cannot be represented by a
utility function. An example of this is X > Y > Z > A.
A utility function, is a way to label the indifference curves such that large numbers are
assigned to higher indifference curves. This point becomes clear from the indifference
map shown in Fig. 5.2. The distance of each indifference curve from the origin is
measured along the diagonal line OR drawn through the origin.
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
The line is a utility function for the simple reason that if preferences are monotonic
then the line through the origin must intersect every indifference curves only once.
Since every bundle is getting a label, and those bundles on higher indifference curves
are getting larger labels, the diagonal line is indeed a utility function, as suggested by
Hal Varian.
By drawing a diagonal line from the origin, it is possible to label indifference curves, i.e.,
to label to each indifference curve to show how far it is from the origin, measured along
the diagonal line, so long as preferences are monotonic. Almost any type ‘reasonable’
preference (consistent choice) can be represented by a utility function.
Some Very Common Utility Functions:
Various types of preference and the associated indifferences curves may be
represented by utility functions.
From a chosen utility function such as u(x1, x2) it is fairly easy to draw a set of
indifference curves we have just to plot all the points (x1, x2) such that’ u(x1, x2) is a
constant, i.e., all the points on an indifference curve represent the same level of utility.
The set of all (x1, x2) such that u(x1, x2) equals a constant is called a level set. For each
different value of the constant such as u1, u2, u3, etc. we get a different indifference
curve.
Here;
u3(x1,x2) > u2(x1, x2) > u1(x1, x2)
Various types of indifference curves from different types of utility functions:
We can draw different types of indifference curves from different types of utility
functions.
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
Flights from Mumbai to Flights from New Delhi to
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Let us suppose the utility function is of the following form:
u(x1, x2) = x1x2
We have already noted that an indifference curve is just the set of all x1 and x2 such that
u = x1x2 for some constant k. If we solve for x2 as a function of x1, the equation of the
indifference;
x2 = u/x1,
which is the formula for hyperbola.
This curve is shown in Fig. 5.3 for these values of u.
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
Example:
Suppose the utility function is of the following type v(x1, x2) = x12x22. In this case also
we get indifference curves of the type shown in Fig. 5.3.
This point is proved thus:
This utility function may be expressed as v(x1x2) = x12x22 = (x1x2)2 = u(x1, x2)2. In this
case the utility function v(x1, x2) is just a square of the original one m(x1x2). Since u(x1,
x2) is always non-negative, v(x1, x2) is a monotonic transformation of the original
function.
So this utility function v(x1, x2) = x12x22 will have exactly the same shape as those shown
in Fig. 5.3. It is because v(x1, x2) describes exactly the same preferences as u(x1, x2) since
it orders all of the bundles in the same way. Hence all indifference curves look alike.
Only the labeling of the curves will be different.
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New Delhi
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Flights from Bangalore to Flights from New Delhi to
Goa Srinagar
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Flights from New Delhi to Flights from Pune to
Hyderabad Bangalore
from ₹4,344 from ₹2,642
The labels that were 1, 2, 3 will now be 1, 4, 9. But the set of bundles that has v(x1, x2) =
9 is exactly the same as the set having u(x1, x2) = 3. Thus v(x1, x2) describes the same
preferences as u(x1, x2).
Finding Utility Function from Indifference Curves:
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
It is also possible to move in the opposite direction — to find a utility function that
represents some indifference curves. This is done by following a simple intuitive
approach. Given a description of the preferences, we have to think about what the
consumer is trying to maximise, i.e., what combination of the goods describes our
representative consumer’s choice behaviour. A few examples will make the point clear.
Perfect Substitutes:
If apples and oranges are perfect substitutes the combination of the two is not
important. What is important is their total number. Therefore we pick up the utility
function u(x1, x2) = x1 + x2. Alternatively we could take the square of the number of
apples (or, oranges) and use the utility function v(x1, x2) = (x1 + x2)2 = x12 + 2x1x2 + x22
because it is also a monotonic transformation of u(x1, x2).
If 3 units of x1 is as valuable as one unit of x2, the MRS will be —1/3. It is because the
consumer will require three units of x2 to compensate him for giving up one unit of x1.
Since the desired rate of commodity substitution is different from one-to-one, the
utility function takes the form w(x1, x2) = 3x1 + x2. In this case since x2 is thrice as
valuable to the consumer as x1, this utility function yields indifference curves with a
slope of -1/3.
The general form of the utility function representing preferences for perfect
substitutes is;
u(x1, x2) = k1x1 + k2x2
where the two positive numbers (k1, k2 > 0) measure the ‘value’ of x1 and x2 to the
consumer. In this case the slope of a typical indifference curves is – k1/k2.
Perfect Complements:
In case of perfect complements such as left shoe and right shoe, since the consumer
cares about the number of pairs of shoes in his possession, he (she) has to decide how
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
many pairs of shoes to choose. This choice forms his utility function. The number of
complete pairs of shoes possessed by the consumer is the minimum number of right
shoes, x1 and the number of a left shoes x2 in his stock.
Thus the utility function for perfect complements is expressed as u(x1, x2) = min (x1, x2).
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Flights from Kolkata to Flights from Ahmedabad to
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Flights from Kochi to Flights from Bangalore to
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Suppose a consumer is currently choosing a bundle such as (5, 5). If he acquires an extra
unit of x1, he gets (6, 5) which will keep him on the same indifference curve. Since the
6th unit of x1 is useless without the 6th unit of x2, min {5, 5} = min {6, 5} = 5. Any
monotonic transformation would be quiet appropriate in case of this type of utility
function.
Even if the consumer consumes the two goods in different proportions, not necessarily
one-to-one, the utility function will be the same. Let us suppose 2 biscuits (x1) are
consumed with every cup of tea (x2). Then the optimal (correct) consumption bundle
will be min {x1, 1/2x2}.
Since any monotonic transformation of this utility function will describe the same
preferences, we can express the utility function as u(x1, x2) = min{2x1, x2) by multiplying
x1 and x2 by 2 to be able to express this as integer numbers rather than as fractions.
The general form of the utility function in case of perfect complements is:
u(x1, x2) = min {k1x1, k2x2}
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
where k1 and k2 are positive numbers indicating the proportions in which x1 and x2 are
consumed, i.e., k1 = p1x1/m, k2 = p2x2/m and k1 + k2= 1.
Quasi-Linear Preferences:
In case of quasi-linear preference a consumers indifference curves are vertically shifted
replica of one another, as shown in Fig. 5.4. In this case all the indifference curves are
just vertically shifted versions of the origin indifference curve (the first one). The
equation of an indifference curve in this case is x2 = a – v (x1) where a is a constant.
The value of a is different for different indifference curves. The height of each indiffer‐
ence curve is some function of x1 – v(x1) plus a constant a. Here, a3 > a2 > a1 implying
that higher values of a give higher indifference curves. The utility function representing
such preferences is u(x1, x2) = a = v(x1) + x2.
This is obtained by solving the original equation for a and setting it equal to u.
In this case since the utility function is linear in x2, but (possibly) non-linear in x1 it is
known as quasi-linear (partly linear) utility.
It is very easy to work with quasi-linear utility function. But these are very abstract, not
at all a reflection of reality.
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
Cobb-Douglas Preferences:
A commonly used utility function is the Cobb-Douglas utility function.
u(x1, x2) = x1b1x2b2
where b1 and b2 are positive numbers describing the preferences of the consumer.
Different values of the parameters b1 and b2 lead to different shapes of the indifference
curves. Two examples of such indifference curves are given in Fig. 5.5.
Part (a) shows the case where b1 = 1/2 and b2 = 1/2 and part (b) shows the case where
b1 = 1/5 and b2 = 4/5.
Cobb-Douglas preferences are of interest to us because they generate well-behaved
preferences (indifferent curves). These are examples of nice convex monotonic
indifference curves.
Monotonic Transformation:
Cobb-Douglas preferences are treated as standard examples of well-behaved
indifference curves because a monotonic transformation of the Cobb-Douglas utility
function will represent exactly the same preferences.
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
1. Since logarithm is a monotonic transformation we have, by taking the natural log of
utilities,
v(x1, x2) = 1n (x1b1x2b2) = b11nx1 + b21nx2.
2. If we raise utility to the 1/(b1 + b2) power,
we have b1/x1b1+b2/b2/x2b1+b2
Let us now define a new number α = b1/b1 + b2
We can now express the utility function as v(x1, x2) – x1α x2β
This simply means that we can always take a monotonic transformation of the Cobb-
Douglas utility function that makes the sum of the exponents exactly add up to 1.
Two Predictions of the Cobb-Douglas Utility Function:
1. In case of Cobb-Douglas utility function the expenditure on each commodity is a
constant fraction of wealth irrespective of prices. The Cobb-Douglas utility function in
case of two commodities is given by u(x1, x2) = Ax1αx2β for 0 < α, β < 1 and A > 0. It is
increasing for all (x1, x2) > 0 and this is homogeneous of degree one because it is a
logical deduction of the Cobb-Douglas production function. Here we use the increasing
transformation of a log x1 + β log x2, a strictly concave function, as our utility function.
With this specification the constrained utility maximisation problem can be
expressed as:
Max. U = α log x1 + β log x2 ……..(1)
subject to p1x1 + p2x2 = m
Here U is increasing. So the budget constraint will hold with strict equality at any
solution.
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
Since, log 0 = – α, the optimal choice of x1 and x2 is strictly positive and must satisfy the
first order conditions. Writing the consumption levels simply as x1 and x2, we get
Thus with the Cobb-Douglas utility function, the expenditure on each commodity is a
constant fraction of wealth for all prices. A share a goes to x1 and a share β goes to x2.
2. For Cobb-Douglas utility function budget shares of all goods are independent of
prices and income.
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11/08/2023, 15:48 Utility Function: Meaning and Construction | Microeconomics
To prove the given statement we shall first derive the optimum quantity of two goods x1
and x2 in terms of p1, p2 and m. Then we shall put the value of x and y in the expression
for budget share.
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Home ›› Microeconomics
›› Consumer Behaviour ››
Utility Function
Releted Articles:
Marginal Utility
and MRS (With
Equation) |
Microeconomics
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