Learn Basic EconomicsLesson 4: Preference and Utility

It is the preferences of consumers that lead to the shape of the demand

curve.

Consumers want to maximise their utility, utility maximisation is influenced

by preferences and budget constraints.

Constrained maximisation is finding the combination of goods that makes

the consumer best off.

There are a few assumptions made about preference:

Completeness, when comparing 2 goods one is always preferred (valued

more) than the other, the consumer cannot be unsure which good they

prefer.

Transitivity, if a consumer prefers a to b, and they prefer b to c, then they

cannot prefer c to a.

Non-satiation, the consumer will always prefer to have more regardless of

how much they already have.

Properties of indifference curves (or preference maps)

Indifference curves show all the combinations

of consumption along which an individual is

indifferent (where utility is constant).

3 coffees and 3 donuts (a) is better than 4

coffees and 1 donut (b) or 1 coffee and 4

donuts (c).

Key properties of indifference curves:

• Consumers prefer higher indifference curves

• Indifference curves always slope downwards

• Indifference curves cannot cross

a

b

c

Utility The Utility function is a mathematical representation of preferences.

For example: Utility = 𝐶 ∗ 𝐷 (Coffee * Donuts)

Utility is an ordinal concept not a cardinal concept (we are able to rank goods but it is not

possible to measure the happiness they produce.)

Marginal Utility is how your utility changes with each additional unit of a good (derivative

of utility function).

As you can see, this is not a linear function.

Where the number of Coffees is constant at 2, we can calculate the utility for the given

number of Donuts:

1 donut and 2 coffees = 1 ∗ 2 = 2 = 1.41

2 donuts and 2 coffees = 2 ∗ 2 = 4 = 2

3 donuts and 2 coffees = 3 ∗ 2 = 6 = 2.45

4 donuts and 2 coffees = 4 ∗ 2 = 8 = 2.83

5 donuts and 2 coffees = 5 ∗ 2 = 10 = 3.16

As we saw from the previous graph the more Donuts you have the greater utility you also

have. However, there is diminishing marginal utility with each additional donut. (where U

= 𝐶 ∗ 𝐷 )

1 donut and 2 coffees the utility increases from 0 to 1.41, marginal utility = 1.41

2 donuts and 2 coffees the utility increases from 1.41 to 2, marginal utility = 0.59

3 donuts and 2 coffees the utility increases from 2 to 2.45, marginal utility = 0.45

4 donuts and 2 coffees the utility increases from 2.45 to 2.38, marginal utility = 0.38

The marginal utility clearly decreases with each additional donut, when the number of

coffees is constant.

Here is a graph of the margin

utility of donuts, where the

number of coffees is 2.

Marginal Utility always

decreases, but it also always

remains positive (due to non-

satiation).

(1,1.41)

(2,0.59)(3,0.45) (4,0.38) (5,0.33)

The Marginal Rate of Substitution is a mathematical concept that links preference utility

with preference maps.

The marginal rate of substitution is equal to the slope of the indifference curve: =∆C

∆D

(coffee and movies).

It is the rate at which you are willing to trade of the Y axis for the X axis.

The Marginal rate of substitution is always diminishing as indifference curves always slope

downwards.

The MRS from (1,4) to (2,2) = −2

1= -2, this means you

would be willing to give up 2 coffees for 1 donut.

The MRS from (2,2) to (4,1) = −1

2= -0.5, this means

you would be willing to give up 0.5 coffees for 1 donut.

When you have 4 coffees the marginal utility for the last

2 coffees is low, but there is a high marginal utility for

donuts in comparison.

The marginal rate of substitution can also be defined as:

M.R.S = −Marginal Utility (for the x axis)

Marginal Utility (for the y axis)

Marginal Utility is thus a negative function of quantity.

In this example:

M.R.S = − (

−1

1)

(3

−0.5)

= - 1

6

Thank you for viewing this lesson of learn basic economics.