Chapter 4: Utility - Study Notes

📖 What is Utility?
Old Idea (Victorian Era): Utility = happiness meter

Economists thought they could measure how "happy" goods made people

Tried to say things like "this apple gives me 10 utils of happiness"

Modern Idea: Utility = ranking system

Just a way to put numbers on bundles so we know which ones are preferred
Like ranking movies: 1st, 2nd, 3rd place - the actual scores don't matter

🎯 Key Point: ORDINAL vs CARDINAL

Ordinal Utility: Only ranking matters (what we use)

Bundle A gets higher number than Bundle B if A is preferred to B

Like Olympic medals: Gold > Silver > Bronze

Cardinal Utility: Actual numbers matter (what we DON'T use)

Would mean "Bundle A is exactly twice as good as Bundle B"

Can't really measure this in real life

🔢 Utility Functions
Definition: u(x₁, x₂) = a number assigned to bundle (x₁, x₂)

Rule: If you prefer Bundle A to Bundle B, then u(A) > u(B)

Example: Ranking Food Bundles

Bundle Pizzas Burgers Utility Option 1 Utility Option 2 Utility Option 3

A 3 2 100 10 3

B 2 3 80 8 2

C 1 1 50 5 1

All three utility assignments are equally valid because they all show A > B > C
🔄 Monotonic Transformations
Big Idea: You can transform utility numbers in any way that keeps the same order

Valid Transformations:
Multiply by positive number: u → 2u

Add any number: u → u + 10

Take square root: u → √u

Take natural log: u → ln(u)

Example:
Original utilities: A=100, B=80, C=50
After multiplying by 2: A=200, B=160, C=100
Still shows A > B > C, so it's the same preferences!

Invalid Transformation:
Square everything: u → u² (when u can be negative)

This can flip the order, so it changes preferences

📊 Types of Utility Functions

1. Perfect Substitutes
Formula: u(x₁, x₂) = ax₁ + bx₂

Example: Red pencils and blue pencils

u(x₁, x₂) = x₁ + x₂ (if they're equally good)

u(x₁, x₂) = 2x₁ + x₂ (if red pencils are twice as valuable)

What it means: You only care about the total amount, can substitute one for the other at a constant rate

Indifference curves: Straight lines

x₂
|
| \ u=4
| \
| \u=3
| \
| \u=2
|____________\______ x₁
2. Perfect Complements
Formula: u(x₁, x₂) = min{ax₁, bx₂}

Example: Left shoes and right shoes

u(x₁, x₂) = min{x₁, x₂}

Having 10 left shoes and 1 right shoe = having 1 complete pair

What it means: You need both goods together - extra of one good alone is useless

Indifference curves: L-shaped (right angles)

x₂
|
| ┌───── u = 3
| │
| │ ┌── u = 2
| ││
| ││┌u=1
|__|_│_│_______ x₁

3. Cobb-Douglas
Formula: u(x₁, x₂) = x₁ᶜ × x₂ᵈ

Example: u(x₁, x₂) = √(x₁ × x₂) = x₁^(1/2) × x₂^(1/2)

Alternative forms:

u(x₁, x₂) = c·ln(x₁) + d·ln(x₂)

u(x₁, x₂) = x₁ᵃ × x₂^(1-a)

What it means: "Normal" preferences - smooth tradeoffs between goods

Indifference curves: Smooth, curved lines (hyperbolas)

x₂
|
| ╲ u=3
| ╲╲
| ╲╲ u = 2
| ╲╲
| ╲╲ u = 1
|_______╲╲_____ x₁
4. Quasilinear

Formula: u(x₁, x₂) = v(x₁) + x₂

Example: u(x₁, x₂) = √x₁ + x₂

What it means: Linear in one good, curved in the other

Indifference curves: Same shape, just shifted up/down

x₂
|
| ⌒⌒⌒⌒ u = 3
| ⌒⌒⌒⌒ u = 2
| ⌒⌒⌒⌒ u = 1
|_____________ x₁

📈 Marginal Utility (MU)

Definition: How much utility increases when you get one more unit of a good

Formula: MU₁ = Δu/Δx₁

Example:

You have 2 apples, utility = 10

You get 1 more apple, utility = 13

MU of apples = (13-10)/(3-2) = 3

⚠️ IMPORTANT WARNING:
Marginal utility by itself is MEANINGLESS! It depends on how you measure utility.

If you double all utility numbers, marginal utility also doubles, but preferences stay the same.

🔄 Marginal Rate of Substitution (MRS)

Formula: MRS = -MU₁/MU₂

What it means: How much of good 2 you're willing to give up to get one more unit of good 1

Why MRS Matters:

1. Observable: Can be measured from real choices

2. Meaningful: Doesn't depend on how you measure utility

 3. Behavioral: Shows actual tradeoffs people make

Example Calculation:
For u(x₁, x₂) = √(x₁ × x₂):

MU₁ = x₂/(2√(x₁ × x₂))

MU₂ = x₁/(2√(x₁ × x₂))

MRS = -MU₁/MU₂ = -(x₂/x₁)

Interpretation: If you have 4 units of good 2 and 2 units of good 1, MRS = -4/2 = -2 This means you'd
give up 2 units of good 2 to get 1 more unit of good 1.

🏗️ How to Build Utility Functions

Method 1: Intuitive Approach
Ask: "What is the consumer trying to maximize?"

Examples:

Perfect substitutes → total quantity

Perfect complements → number of complete pairs

General case → some combination

Method 2: Geometric Method

1. Draw indifference curves
2. Draw a diagonal line from the origin

3. Measure distance along this line to each curve

4. Use these distances as utility values

Method 3: Mathematical Method

Find a function that:

Stays constant along each indifference curve

Gives higher numbers to better curves

🚗 Real-World Example: Transportation Economics

Study Question: Should I drive or take the bus to work?

Estimated Utility Function: U = -0.147×(Walking Time) - 0.041×(Travel Time) - 2.24×(Cost)

What this tells us:

Walking time is about 3.6 times worse than travel time (0.147/0.041 ≈ 3.6)

People valued time at $1.10 per hour in 1967

The model correctly predicted 93% of people's actual choices

Policy Use: This helps city planners decide if adding more buses is worth the cost

✅ Key Takeaways
1. Utility ≠ Happiness - It's just a tool for ranking preferences

2. Only Order Matters - The actual numbers don't matter, just which is bigger
3. Many Representations - Infinite ways to represent the same preferences

4. MRS is Key - This connects utility theory to real observable behavior

5. Different Types - Each utility function captures different preference patterns

❌ Common Mistakes
✗ Thinking utility measures happiness in absolute terms

✗ Comparing utility numbers across different people

✗ Believing marginal utility alone has meaning

✗ Forgetting the negative sign: MRS = **-**MU₁/MU₂

✗ Thinking one utility function is "more correct" than its transformations

🧠 Practice Problems
Problem 1: Are these the same preferences?

u(x₁, x₂) = x₁ × x₂
v(x₁, x₂) = ln(x₁) + ln(x₂)

Answer: Yes! Since ln(x₁ × x₂) = ln(x₁) + ln(x₂), v is just ln(u)

Problem 2: For u(x₁, x₂) = 2x₁ + 3x₂, what is the MRS?

Answer: MU₁ = 2, MU₂ = 3, so MRS = -2/3

Problem 3: What type of preferences does u(x₁, x₂) = min{3x₁, x₂} represent?

Answer: Perfect complements where you need 3 units of good 1 for every 1 unit of good 2