Consumer Preferences.

Utility Representation example

Lecture 3

Rohit Kumar

IIT Delhi

January 7, 2024

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Consumer Preferences. Utility Representation example

Consumer Preferences:

▶ Rationality in economics:

A decision maker always chooses his or her most preferred

alternative from his or her set of available alternatives.

▶ To understand and model choice, we must model decision maker’s

preferences.

▶ Preferences refer to a consumer’s ability to compare or rank one commodity

bundle over another.

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Consumer Preferences. Utility Representation example

Sneak Peak at Modeling Preferences:

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Consumer Preferences. Utility Representation example

Compare Pair of Choices:

▶ Go on a date: need a new shirt (from 3), a new pair of trousers (from 6), and
will go to a Chindian place.

▶ Will order 1 appetizer (from 9), 1 main course (from 2) and 1 rice or noodles
(from 2). 648 ways to make the choice.

▶ We will assume you can compare every pair of these 684 choices in a way
that yields a ranking from most preferred choice to least preferred.

▶ You have a budget of INR 7500 for the evening. Pick the best choice among
the 684 that also satisfies this budget.

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Consumer Preferences. Utility Representation example

Consumer Preferences:

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Consumer Preferences. Utility Representation example

Weak Preference:

▶ Preferences: a binary relation on commodity set X .

▶ ≿ denotes weak preference

x ≿ y : bundle x is preferred at least as much as bundle y.

▶ Example: you prefer (2 banana, 3 apple) ≿ (3 banana, 2 apple)

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Consumer Preferences. Utility Representation example

Example: Discrete Preference.

▶ Suppose commodity space is X = {1, 2, 3} and preference is

2 ≿ 1, 3 ≿ 1, 3 ≿ 2, 2 ≿ 3, 1 ≿ 1, 2 ≿ 2, 3 ≿ 3.

▶ Another way to represent this preference

≿ 1 2 3

back

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Consumer Preferences. Utility Representation example

Rough:

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Consumer Preferences. Utility Representation example

Example: Lexicographic Preference.

▶ Suppose the commodity space X = R2+ .

▶ Lets define Lexicographic preference as

x ≿ y ⇐⇒ either x1 ≥ y1 or x1 = y1 , x2 ≥ y2 .

▶ The individual gives priority to the first good, breaking ties by the second
good.

▶ For example, in the case of computer, x1 is the size of the memory and x2 is
the resolution of the screen.
back

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Consumer Preferences. Utility Representation example

Rough:

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Consumer Preferences. Utility Representation example

Example: Utility Preference.

▶ Let u be a function u : X → R.

▶ Then we define
x ≿ y ⇐⇒ u(x) ≥ u(y).

▶ The utility function u attaches to each alternative a number, interpreted as

her subjective “value” of the alternative.

▶ In two good case,

1/2 1/2
u(x1 , x2 ) = x1 x2 .
back

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Consumer Preferences. Utility Representation example

Example: Unanimity Rule.

▶ Suppose there are n individuals in the household and each has preference ≿i
over commodity space X .

▶ We can define household preference as

x ≿ y ⇐⇒ x ≿i y, for all i.

▶ In criminal law jury trials, many jurisdictions require a guilty verdict by a jury
to be unanimous. This is not so in civil law jury trials.

▶ United Nations Security Council resolution is not considered “unanimous” as

members can abstain.
back

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Consumer Preferences. Utility Representation example

Example: Majority Rule.

▶ Suppose there are n individuals in the household and each has preference ≿i
over commodity space X .

▶ We can define household preference as

x ≿ y ⇐⇒ a majority rank x over y.

▶ Majority rule is common in liberal democracies. It is used in legislatures and

other bodies.

▶ Mandatory referendums where the question is yes or no are also decided by

majority rule.
back

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Consumer Preferences. Utility Representation example

Strict Preference and Indifference:

▶ Given a weak preference ≿, we can define strict preference ≻

x ≻ y ⇐⇒ x ≿ y and ¬y ≿ x.

▶ Given a weak preference ≿, we can define indifference ∼

x ∼ y ⇐⇒ x ≿ y and y ≿ x.

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Consumer Preferences. Utility Representation example

Strict Preference and Indifference: Discrete Case.

≿ 1 2 3

3 3

2 2

1 1

≻ 1 2 3 ∼ 1 2 3

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Consumer Preferences. Utility Representation example

Strict Preference and Indifference: Lexicographic

Preferences.

▶ The strict preference for lexicographic preference is

x ≻ y ⇐⇒ either x1 > y1 or x1 = y1 , x2 > y2 .

▶ The indifference for lexicographic preference is singleton.

x ∼ y ⇐⇒ x1 = y1 and x2 = y2 .

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Consumer Preferences. Utility Representation example

Strict Preference and Indifference: Utility Function.

▶ The strict preference for utility function is

x ≻ y ⇐⇒ u(x) > u(y).

▶ The indifference for utility function is singleton.

x ∼ y ⇐⇒ u(x) = u(y).

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Consumer Preferences. Utility Representation example

Assumptions about Preferences:

▶ Economists usually make some assumptions about the “consistency” of

consumer’s preferences.

▶ For example, it seems unreasonable to have a situation where x ≻ y and, at

the same time, y ≻ x.

▶ So we usually make some assumptions about how the preference relations

work.

▶ Some of the assumptions about preferences are so fundamental that we can

refer to them as “axioms” of consumer theory.

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Consumer Preferences. Utility Representation example

Complete Preference:

A1: A weak preference ≿ is called complete: if for any two bundles a, b ∈ X

one of the following is true:

1. a ≿ b, or

2. b ≿ a, or

3. both a ≿ b and b ≿ a.

▶ A complete preference relation requires that any two bundles in X can be

compared.

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Completeness implies Reflexivity:

▶ A weak preference ≿ is called reflexive: for any bundle a ∈ X , it must be the

case that a ≿ a.

▶ The property of reflexivity is something of a “sanity” requirement.

▶ Our complete preference definition includes reflexivity.

▶ In some books, completeness and reflexivity are defined separately.

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Consumer Preferences. Utility Representation example

Transitive Preference:

A2: weak preference ≿ is transitive: for any triplet a, b, c ∈ X ,

a ≿ b and b ≿ c =⇒ a ≿ c.

▶ Transitivity of a preference relation lies at the heart of our intuitive notion of

rationality

▶ If one bundle is at least as good as a second, and this second bundle is at least
as good as a third, then the first must be at least as good as the third.

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Consumer Preferences. Utility Representation example

Rational Preferences:

A weak preferences is called rational if it is complete and transitive.

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Consumer Preferences. Utility Representation example

Question:

▶ Which of the preferences are rational?

1. Discrete preference. link

2. Lexicographic preference. link

3. Utility preference. link

4. Unanimity rule. link

5. Majority rule. link

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Consumer Preferences. Utility Representation example

Transitivity Assumption:

▶ The assumption that preferences are transitive seems natural.

▶ When people are alerted to intransitivities in their preferences they tend to be

embarrassed and change their evaluations.

▶ However, it is not difficult to design an environment in which most of us

exhibit some degree of intransitivity.

▶ You can participate in experiment to check intransitivity in your preferences.

experiment

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Consumer Preferences. Utility Representation example

Transitivity Assumption:
▶ Questionnaire asks you to compare a pair of alternatives taken from a set of
nine alternatives.

▶ Each alternative is a description of a vacation package with four parameters:

the city, hotel quality, food quality, and price.

▶ A quarter of the participant’s expressed preferences violate transitivity among

the following alternatives.

1. A weekend in Paris, with 4 star hotel, food quality 17, for $574.

2. A weekend in Paris, for $574, food quality 17, with 4 star hotel.

3. A weekend in Paris, food quality 20, with 3–4 star hotel, for $560.

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Consumer Preferences. Utility Representation example

Transitivity Assumption:

▶ Almost all participants say they are indifferent between first two alternatives.

▶ So the intransitivity is a result of differences in the expressed preferences

between options 1 and 3 and options 2 and 3.

▶ That is, the order in which the features of the package are listed has an effect
on the expressed preferences.

▶ Individuals may follow complex criterion to choose their preferred alternatives.

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Consumer Preferences. Utility Representation example

Most Preferred Bundle Exists on Finite Set:

Lemma
Let X be a nonempty finite set and let ≿ be a weak preference on X which is
rational. There exist at least one member x0 of X such that for all y ∈ X

x0 ≿ y.

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Consumer Preferences. Utility Representation example

Rough:

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Optimal Bundle:

▶ We have enough to find the optimal bundle.

▶ But still is complicated to find the optimal bundle.

▶ For a naive person to find optimal it takes

 
n
2

comparisons.

▶ What happens if we take continuous commodity space?

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Consumer Preferences. Utility Representation example

Utility Preference:

▶ Let u be a function u : X → R.

▶ Then we defined preference as

x ≿ y ⇐⇒ u(x) ≥ u(y).

▶ It is nice to have a function which we can easily maximize to find optimal

bundle.

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Consumer Preferences. Utility Representation example

Utility Preference:

▶ One can ask a reverse question: given a preference ≿, does there always exist
u : X → R such that
x ≿ y ⇐⇒ u(x) ≥ u(y).

▶ It turns out answer is negative to this question.

▶ We now analyze conditions under which utility representation always exists.

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Consumer Preferences. Utility Representation example

Utility Representation:

Definition
Let ≿ be a preference relation on X . The preference is said to have utility
representation if there exist a function u :→ R such that

x ≿ y ⇐⇒ u(x) ≥ u(y).

▶ Not every rational preference has utility representation.

▶ Under what conditions can a preference can be represented by a utility

function?

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Consumer Preferences. Utility Representation example

Utility Representation:

all rational preferences

preferences with utility representation

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Consumer Preferences. Utility Representation example

Utility Representation:

▶ A utility representation makes it easier to compare choices

utility of a bundle a is 5 and b is 1: so I prefer a to b.

▶ A utility representation is easier to think about than an ordering.

▶ It’s also typically easier to find an optimal choice maximizing a utility

function.

▶ If utility function is also continuous, then we can use calculus tools to find
optimal choice.

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Consumer Preferences. Utility Representation example

When does Utility Representation Exists?

Theorem (Utility Representation Theorem)

Suppose the agent’s weak preferences ≽ are rational, and that X is finite. Then
there exists a utility function u : X → R which represents ≽.

▶ Utility representation exists for rational preferences on finite X .

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Consumer Preferences. Utility Representation example

Proof:

▶ Since X is finite
X = {x1 , x2 , . . . , xn }.

▶ There exist a most preferred bundle x0 in X

▶ Lets define utility

u(x0 ) = n

▶ Also for every x ∈ I(x0 )

u(x) = n.

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Consumer Preferences. Utility Representation example

Proof:

▶ Now consider the set X1 = X \ I(x0 )

▶ There exist a most preferred bundle x1 in X1

▶ Lets define utility

u(x1 ) = n − 1

▶ Also for every x ∈ I(x1 )

u(x) = n − 1.

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Consumer Preferences. Utility Representation example

Proof:

▶ An exercise to check
x ≿ y ⇐⇒ u(x) ≥ u(y).

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Consumer Preferences. Utility Representation example

Utility Representation Existence:

does utility representation exists when X ⊂ Rk+ ?

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Consumer Preferences. Utility Representation example

Lexicographic Preferences on R2+ :

there exists no utility representation for lexicographic preference on R2+ .

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Consumer Preferences. Utility Representation example

Utility Representation:

what additional restriction we need for utility representation on X ⊆ Rk+ ?

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Consumer Preferences. Utility Representation example

Utility Representation:

Definition (Continuity of Preferences)

The weak preference ≿ is called continuous if for all sequences xn → x

xn ≿ y =⇒ x ≿ y,

and for all sequences yn → y

x ≿ yn =⇒ x ≿ y.

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Consumer Preferences. Utility Representation example

When does Utility Representation Exists?

Theorem (Debreu’s Theorem)

Suppose the agent’s weak preferences ≽ are rational, continuous, and that
X ⊆ Rk . Then there exists a continuous utility function u : X → R which
represents ≽.

▶ Without continuity, utility representation may not exists.

▶ Now, we have a general utility representation theorem.

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Consumer Preferences. Utility Representation example

Lexicographic Preferences on R2+ :

▶ Lexicographic preference is not continuous.

▶ Lets see that it is not continuous

 
1
1 + , 1 ≿ (1, 2).
n

▶ But in the limit it is not true because

(1, 2) ≻ (1, 1).

▶ We know that there exist no utility representation for this preferences.

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Consumer Preferences. Utility Representation example

Upper and Lower Contour Sets:

▶ Given a utility representation, we can define indifference set

I(a) = {b ∈ X : u(b) = u(a)}.

▶ Upper contour set

U(a) = {b ∈ X : u(b) ≥ u(a)}.

▶ lower contour set

L(a) = {b ∈ X : u(b) ≤ u(a)}.

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Consumer Preferences. Utility Representation example

1/2 1/2
Indifference Curve: u(x1 , x2 ) = x1 x2 .

x2

4
3
2
x1

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Consumer Preferences. Utility Representation example

1/2 1/2
Upper Contour Set: u(x1 , x2 ) = x1 x2 .

x2

x1

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Consumer Preferences. Utility Representation example

1/2 1/2
Lower Contour Set: u(x1 , x2 ) = x1 x2 .

x2

x1

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Consumer Preferences. Utility Representation example

Marginal Rate of Substitution:

▶ If we have utility representation, then MRS is defined as

∂u(x)
∂x1
MRS(x) = ∂u(x)
.
∂x2

▶ Lets understand the significance of MRS. Recall the definition of indifference

curve
u(x1 , x2 ) = constant.

▶ Differentiating this, we get

∂u(x) ∂u(x)
dx1 + dx2 = 0
∂x1 ∂x2

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Consumer Preferences. Utility Representation example

Marginal Rate of Substitution:

▶ This simplifies to gives

∂u(x)
dx2 ∂x1
= − ∂u(x) = −MRS(x).
dx1
∂x2

▶ Thus the MRS describes the slope of the indifference curve.

▶ The rate at which the consumer is just willing to substitute a little more
consumption of good 2 for a little less consumption of good 1.

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Consumer Preferences. Utility Representation example

Marginal Rate of Substitution:

x2

-MRS(x)
x1

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Marginal Rate of Substitution:

▶ Approximately
△x2 ≈ −MRS(x)△x1 .

▶ How much x2 a consumer is willing to give up for one unit of x1 to remain

on the same indifference curve.

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Consumer Preferences. Utility Representation example

Marginal Rate of Substitution:

x2

x
△x2
1

x1

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Consumer Preferences. Utility Representation example

Utility Function:

▶ Some examples of utility functions.

1. Linear Preferences.

2. Leontief Preferences.

3. Quasi-linear Preferences.

4. Cobb-Douglas Preferences.

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Consumer Preferences. Utility Representation example

Linear preferences

▶ Linear preferences can be represented by the utility function

u(x1 , x2 ) = αx1 + βx2 .

▶ The marginal rate of substitution is

α
MRS(x) = .
β

▶ To remain on same indifference curve, α units of x2 need to be substituted

by β units of x1 .

▶ Preferences like these are therefore called perfect substitutes.

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Consumer Preferences. Utility Representation example

Indifference Curve: αx1 + βx2 = c.

x2
c
β

−α
β

c
α
x1

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Consumer Preferences. Utility Representation example

Leontief Preferences:

▶ Leontief preferences are represented by utility function

u(x1 , x2 ) = min{αx1 , βx2 }.

▶ Leontief preferences refer to tastes when goods are perfect complements.

▶ No substitution between teaspoons of sugar and cups of coffee are possible,

so the notion of marginal rate of substitution is meaningless.

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Consumer Preferences. Utility Representation example

Indifference Curve: min{ax1 , bx2 } = c.

x2

α
β

x1

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Consumer Preferences. Utility Representation example

Cobb Douglas Preferences:

▶ Cobb- Douglas preferences are represented by the utility function

β
u(x1 , x2 ) = Axα
1 x2 .

▶ Marginal rate of substitution is

αx2
MRS(x) = .
βx1

▶ There is diminishing marginal rate of substitution.

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Consumer Preferences. Utility Representation example

Cobb-Douglas Preferences: u(x1 , x2 ) = x1 x2 .

x2

x1

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Consumer Preferences. Utility Representation example

Quasi-linear Preferences:

▶ Quasi-linear preferences are represented by utility function

u(x1 , x2 ) = f (x1 ) + x2 .

▶ Marginal rate of substitution is

MRS(x) = f ′ (x1 ).

▶ If f is concave, then f ′ (x1 ) decreases in x1 .

▶ Hence there is diminishing marginal rate of substitution.

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Consumer Preferences. Utility Representation example

√
Quasi-linear Preferences: u(x1 , x2 ) = x2 + x1 .
x2

x1

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Consumer Preferences. Utility Representation example

Cardinal vs Ordinal Utility:

▶ A monotonic transformation to a utility function creates another utility

function representing the same preference relation.

▶ MRS is unchanged by this positive monotonic transformation.

utility function only has ordinal property.

▶ Utility only has relative meaning rather than its absolute value.

▶ Cardinal utility gives a value of utility to different options. Ordinal utility just
ranks in terms of preference.

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Consumer Preferences. Utility Representation example

Increasing Transformation:

▶ Suppose an agent has utility function

15
u(x) = −  3
1/2 1/2
x1 + x2 + 10

▶ This utility function is algebraically messy.

▶ We can rewrite the agent’s utility as

1/2 1/2
f (u(x)) = x1 + x2

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