102 Part 2 Choice and Demand

of the Exxon and Shell advertising departments to convince me otherwise. Given this fact, I
am always willing to give up 10 gallons of Exxon in exchange for 10 gallons of Shell because
it does not matter to me which I use or where I got my last tankful. Indeed, as we will see in
the next chapter, one implication of such a relationship is that I will buy all my gas from the
least expensive seller. Because I do not experience a diminishing MRS of Exxon for Shell, I
have no reason to seek a balance among the gasoline types I use.

Perfect complements
A situation directly opposite to the case of perfect substitutes is illustrated by the L-shaped
indifference curves in Figure 3.8c. These preferences would apply to goods that “go to-
gether”—coffee and cream, peanut butter and jelly, and cream cheese and lox are familiar
examples. The indifference curves shown in Figure 3.8c imply that these pairs of goods will be
used in the fixed proportional relationship represented by the vertices of the curves. A person
who prefers 1 ounce of cream with 8 ounces of coffee will want 2 ounces of cream with
16 ounces of coffee. Extra coffee without cream is of no value to this person, just as extra cream
would be of no value without coffee. Only by choosing the goods together can utility be
increased.
These concepts can be formalized by examining the mathematical form of the utility
function that generates these L-shaped indifference curves:
utility ¼ U ðx, yÞ ¼ minðαx, βyÞ. (3.25)
Here α and β are positive parameters, and the operator “min” means that utility is given
by the smaller of the two terms in the parentheses. In the coffee-cream example, if we let
ounces of coffee be represented by x and ounces of cream by y, utility would be given by
utility ¼ U ðx, yÞ ¼ minðx, 8yÞ. (3.26)
Now 8 ounces of coffee and 1 ounce of cream provide 8 units of utility. But 16 ounces of
coffee and 1 ounce of cream still provide only 8 units of utility because min(16, 8) ¼ 8. The
extra coffee without cream is of no value, as shown by the horizontal section of the
indifference curves for movement away from a vertex; utility does not increase when only x
increases (with y constant). Only if coffee and cream are both doubled (to 16 and 2,
respectively) will utility increase to 16.
More generally, neither of the two goods will be in excess only if
αx ¼ βy. (3.27)
Hence
y=x ¼ α=β, (3.28)
which shows the fixed proportional relationship between the two goods that must occur if
choices are to be at the vertices of the indifference curves.

CES utility
The three specific utility functions illustrated so far are special cases of the more general
constant elasticity of substitution function (CES), which takes the form
xδ yδ
utility ¼ U ðx, yÞ ¼ þ , (3.29)
δ δ
where δ 1, δ 6¼ 0, and
utility ¼ U ðx, yÞ ¼ ln x þ ln y (3.30)
 Chapter 3 Preferences and Utility 103

when δ ¼ 0. It is obvious that the case of perfect substitutes corresponds to the limiting
case, δ ¼ 1, in Equation 3.29 and that the Cobb-Douglas9 case corresponds to δ ¼ 0 in
Equation 3.30. Less obvious is that the case of fixed proportions corresponds to δ ¼ ∞ in
Equation 3.29, but that result can also be shown using a limits argument.
The use of the term “elasticity of substitution” for this function derives from the notion
that the possibilities illustrated in Figure 3.8 correspond to various values for the substitution
parameter, σ, which for this function is given by σ ¼ 1=ð1 δÞ. For perfect substitutes, then,
σ ¼ ∞, and the fixed proportions case has σ ¼ 0.10 Because the CES function allows us to
explore all of these cases, and many cases in between, it will prove quite useful for illustrating
the degree of substitutability present in various economic relationships.
The specific shape of the CES function illustrated in Figure 3.8a is for the case δ ¼ 1.
That is,
1 1 1 1
utility ¼ x y ¼ . (3.31)
x y
For this situation, σ ¼ 1=ð1 δÞ ¼ 1=2 and, as the graph shows, these sharply curved in-
difference curves apparently fall between the Cobb-Douglas and fixed proportion cases. The
negative signs in this utility function may seem strange, but the marginal utilities of both x
and y are positive and diminishing, as would be expected. This explains why δ must appear in
the denominators in Equation 3.29. In the particular case of Equation 3.31, utility increases
from ∞ (when x ¼ y ¼ 0) toward 0 as x and y increase. This is an odd utility scale, perhaps,
but perfectly acceptable.

EXAMPLE 3.3 Homothetic Preferences

All of the utility functions described in Figure 3.8 are homothetic (see Chapter 2). That is, the
marginal rate of substitution for these functions depends only on the ratio of the amounts of
the two goods, not on the total quantities of the goods. This fact is obvious for the case of
the perfect substitutes (when the MRS is the same at every point) and the case of perfect
complements (where the MRS is infinite for y=x > α=β, undefined when y=x ¼ α=β,
and zero when y=x < α=β). For the general Cobb-Douglas function, the MRS can be
found as
∂U =∂x αx α 1 y β α y
MRS ¼ ¼ ¼ ⋅ , (3.32)
∂U =∂y βx α y β 1 β x
which clearly depends only on the ratio y=x. Showing that the CES function is also homo-
thetic is left as an exercise (see Problem 3.12).
The importance of homothetic functions is that one indifference curve is much like
another. Slopes of the curves depend only on the ratio y=x, not on how far the curve is
from the origin. Indifference curves for higher utility are simple copies of those for lower
utility. Hence, we can study the behavior of an individual who has homothetic preferences by
looking only at one indifference curve or at a few nearby curves without fearing that our
results would change dramatically at very different levels of utility.
(continued)

9
The CES function could easily be generalized to allow for differing weights to be attached to the two goods. Since the
main use of the function is to examine substitution questions, we usually will not make that generalization. In some of the
applications of the CES function, we will also omit the denominators of the function because these constitute only a scale
factor when δ is positive. For negative values of δ, however, the denominator is needed to ensure that marginal utility is
positive.
10
The elasticity of substitution concept is discussed in more detail in connection with production functions in Chapter 9.
104 Part 2 Choice and Demand

EXAMPLE 3.3 CONTINUED

QUERY: How might you define homothetic functions geometrically? What would the locus
of all points with a particular MRS look like on an individual’s indifference curve map?

EXAMPLE 3.4 Nonhomothetic Preferences

Although all of the indifference curve maps in Figure 3.8 exhibit homothetic preferences, this
need not always be true. Consider the quasi-linear utility function
utility ¼ U ðx, yÞ ¼ x þ ln y. (3.33)
For this function, good y exhibits diminishing marginal utility, but good x does not. The
MRS can be computed as
∂U =∂x 1
MRS ¼ ¼ ¼ y. (3.34)
∂U =∂y 1=y
The MRS diminishes as the chosen quantity of y decreases, but it is independent of the
quantity of x consumed. Because x has a constant marginal utility, a person’s willingness to
give up y to get one more unit of x depends only on how much y he or she has. Contrary to
the homothetic case, then, a doubling of both x and y doubles the MRS rather than leaving
it unchanged.

QUERY: What does the indifference curve map for the utility function in Equation 3.33 look
like? Why might this approximate a situation where y is a specific good and x represents
everything else?

THE MANY-GOOD CASE

All of the concepts we have studied so far for the case of two goods can be generalized to
situations where utility is a function of arbitrarily many goods. In this section, we will briefly
explore those generalizations. Although this examination will not add much to what we have
already shown, considering peoples’ preferences for many goods can be quite important in
applied economics, as we will see in later chapters.

The MRS with many goods

Suppose utility is a function of n goods given by
utility ¼ U ðx1 , x2 , …, xn Þ. (3.35)
The total differential of this expression is
∂U ∂U ∂U
dU ¼ dx1 þ dx2 þ … þ dx (3.36)
∂x1 ∂x2 ∂xn n
and, as before, we can find the MRS between any two goods by setting dU ¼ 0. In this
derivation, we also hold constant quantities of all of the goods other than those two. Hence
we have