Topic 1: Utility Function.: ECON30010 Microeconomics

Topic 1: Utility function.
ECON30010 Microeconomics
3 March 2016
ECON30010
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A bit of history and motivation
Classical Economics
Adam Smith, David Ricardo, Karl Marx, John Mill.
Attempted to uncover the laws of the economy, which were thought

to be similar to the laws of physics (e.g. Newtons laws).
Example
I
Kuznets curve: an inverted U-shaped relationship between

income per capita and inequality;
Kondratievs wave: a 45-60 year business cycle

These ideas are derived from observing aggregate variables, not
individual behaviour.
I
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Neoclassical Economics
Leon Walras, Francis Edgeworth, Vilfredo Pareto, Alfred Marshall.
Decision making of agents is the main focus.
Nowadays even macroeconomics, who, as the name implies, look at

aggregate variables, are concerned with microfoundations: is my
macroeconomic model consistent with the behaviour of the
individuals?
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Utility function: Motivation
In this course, we will be concerned with the decision making of

individuals.
When we talk about individuals, we immediately start to talk about a

utility function, which summarizes what individuals like and dislike.
Since we are going to use utility function all the time, we need to
have clear understanding what it is and how we could deal with it.
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ECON20002 recap
Suppose an agent consumes food (F ) and junk food (J). Given prices
PF and PJ , what is the optimal consumption bundle of this agent?
If we know the agents utility function (e.g. U = J F ), the optimal
bundle is given by:
MRSJF =
PJ
MUJ
=
MUF
PF
How many of you can write down your own function for F and J?
If not many, what are we talking about if even a group of economics
students cannot do it?
Utility function is not what agents possess. It is a useful model of agents
underlying preferences.
This model will have the underlying assumptions, a proof (that we will
defer until honours year) and a conclusion.
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Plan
I
I
I
Utility function is a model of an individual. As any model, it has its

setup and assumptions.
We start by looking at the assumptions we want to impose on
individual preferences. This is a bit of ECON20002 recap, but we will
be more careful.
As any model, it makes predictions. I will argue that these predictions
are very weak.
However, in practice we use these weak predictions to make further
strong assumptions (not implied by our original assumptions) and use
a specific form of a utility function.
This specific form is another instance of a model, which does not
always conform to the reality (and, in fact, any model should not
always conform to reality)
We then talk about testing different models.
We finish by throwing in few more assumptions on preferences.
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Model: Assumptions
Modeling individuals: the choice set
First, we need to agree what individuals choose. In most of the subject,

they would choose two very dry commodities: good 1 (the quantity of
good 1 consumed will be denoted by a letter with subindex 1, such as q1 ,
x1 , or y1 ) and good 2 (quantities q2 , x2 , or y2 ). As often as life allows us
we will deal with only two goods, for simplicity.
When we model individuals, we need to be very precise and careful about
the choice set. In many models the choice set is introduced in a single
sentence, but we will see today that this choice is important.
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Model: Assumptions
Modeling individuals: preferences

Note: this mostly reviews the concepts you have learned in ECON20002 last year.
Once we have settled on the choice set, we need to make some

assumptions on how agents choose from this choice set.
In most economic problems, the following assumptions seem reasonable:
I
Completeness: any two bundles x = (x1 , x2 ) and y = (y1 , y2 ) can be

compared.1
There may be situations where you would say I cannot

compare these two objects what do you like better,
singing or a cylinder hat? but if you cannot compare,
do you really ever need to choose between the two?
In math notation, bold letters, such as x and y, will always stand for a vector, as it
is here. Thus, x = (1, 3) should be understood as a bundle that consists of 1 unit of
good 1 and 3 units of good 2.
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Model: Assumptions

I
Transitivity: if bundle x is at least as good as y and y is at least as

good as bundle z, then x is at least as good as z.
One example of transitivity are real numbers and greater than relation
(>). It is transitive: if a > b and b > c then a > c.
What happens if transitivity does not hold? Suppose that
you prefer ECON20001 to ECON30010 (ECON20001 ECON30010),
and you prefer ECON20002 to ECON20001 (ECON20002 ECON20001),
but you prefer ECON30010 to ECON20002 (ECON30010 ECON20002).
These are not great preferences to have as a manipulator would be able to
make you whatever choice he or she likes (including taking ECON30010!).
I would hope that whenever you observe yourself making such choices
(which is, of course, possible), you would regard them as a mistake.
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Model: Assumptions
A note on the choice of the choice set.

Consider a dinner where you are to choose the wine (red or white) and the
main dish (fish or beef).
Suppose: red wine white wine fish beef.
Shall we conclude from this that you would choose red wine and fish for
your dinner? If not, whats wrong?
The choice set is incorrectly defined. If you want to choose a drink and a
main dish, then the choice set should be: (red wine, beef), (white wine,
fish), (red wine, fish), (white wine, beef).
The choice of the choice set should be appropriate for the question you
want to ask.
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Model: Assumptions

I
Continuity (not an exact definition): if bundle x is better than bundle

y and bundle z is sufficiently close to y, then x is better than z.
If you prefer (x =) 1` of red wine and 1 kg of beef to (y =) 1` of white

wine and 1 kg of fish, then you would prefer x to 1.01y (that is, to 1.01`
of white wine and 1.01 kg of fish).
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Model: Assumptions

I
Completeness: any two bundles x = (x1 , x2 ) and y = (y1 , y2 ) can be

compared.
Transitivity: if bundle x is at least as good as y and y is at least as

good as bundle z, then x is at least as good as z.
Continuity (not an exact definition): if bundle x is better than bundle

y and bundle z is sufficiently close to y, then x is better than z.
What do we need it for? With these assumptions, we can start to use very
powerful math tools.
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Model: Results
Utility Function Representation

Even though people simply make a choice from the choice set, we can
pretend that they have a utility function.
Specifically, we will assign to each bundle (such as 1` of red wine and 1 kg
of beef) a (real) number and then compare numbers instead of bundles.
Formally: We say that a utility function u(x) represents the preferences if,
whenever x better than y, we have u(x) > u(y).
This leads to a very important theorem:
Theorem
If preferences over bundles of goods x satisfy completeness, transitivity,
and continuity, then there exists a continuous utility function u(x) that
represents these preferences.
Why is this theorem important? Because mathematicians are very good at
working with functions, and we can use a lot of their tools.
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Model: Results
Remarks on Utility Function Representation

I
Some preferences cannot be represented by a continuous utility

function (but they would not satisfy our assumptions).
If preferences are represented by a utility function, this utility function
is not unique. Any positive monotonic transformation of the utility
function will represent the same preferences.
I
Why: The only important thing about a utility function is how two
numbers compare (e.g., u(x) > u(y)). But the very definition of a
positive monotonic transformation is that this inequality is preserved!
Example:
I u 1 (x) = x1 x2
I u 3 (x) =
x1 x2
I
u 2 (x) = ln(x1 ) + ln(x2 )
u 4 (x) = x12 x22
all represent the same preferences (e.g. all four of these utility
functions could be utility functions of the same individual).
How could you check it? Take any two consumption bundles, e.g.
(1, 3) and (2, 1), and calculate u 1 , u 2 , u 3 , u 4 for these two bundles.2
2
Note: this is not a proof. For a proof, you need to show that the same holds for any
two bundles, (x1 , x2 ) and (y1 , y2 ); that is, if for given x, y, u i (x) > u i (y) for one of these
functions, the same holds for all three others.
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Model: Results
Summary
A utility function is a fake. When I say consider an agent with utility
function u = F J, this is short for: consider an agent who, when faced
with the choice between food and junk food, make a choice as if his or her
utility function is u = F J.
If you ever hear someone say:
Economists are silly, they assume people have utility function,
but if I ask them to write their own utility function, they cannot
do even that
then you would need to say that economists do not assume that people
have utility function. Economists assume that peoples preferences are (1)
complete; (2) transitive; (3) monotone. Which one do you have a problem
with?
This is, of course, not to say that utility function cannot be incorrectly
specified. We will look at it next.
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Model: Results
A tutorial question: Examples of utility functions

Do the preferences described by the following utility functions3 satisfy
(1) completeness;
(3) continuity;
(2) transitivity?
1. u(x) = x for x [0, 1]
2. u(x) = 1 for x [0, 1), u(x) = 2 for x [1, 2].
3. u(x) = 1/x for x (0, 1], u(x) = 0 for x = 0.
x , for x [0, 1],

4. u(x) = 10, for x (1, 2),
2
x , for x [2, 3].
Note: here x is not bold, so it is just a number.

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An application: altruistic behaviour
Selfish behaviour: Motivation

Next we will talk about selfish behaviour (or the lack of thereof). Why do
we want to talk about it?
Specific knowledge:
1. We have made assumptions on preferences; I want to show you that
these assumptions still allow for a variety of different utility functions.
Generic skills:
2. I want a simple environment that I can use to talk about different
models.
3. I want to drive home a point that models are not fixed, received
knowledge. They are subject to testing and modifications and may be
suitable in some cases and unsuitable in some other cases.
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Selfish behaviour
Sometimes you can hear that
Economists assume selfish behaviour, which is silly as we see
many instances of altruistic behaviour, such as when people
share their money with others.
This description is a bit too generic, so let us think about a concrete
situation: suppose that agent 1 is given $5 that agent 1 can allocate
between herself and agent 2. Suppose that we observe that agent 1 gives
y > 0 to agent 2. I will call this situation Situation 1.4
Is it a contradiction to anything we have assumed so far?
Sometimes I will call an invented situation, such as Situation 1, an experiment. It

may sometimes be confusing, but in many cases we will indeed look at experiments from
Experimental Economics literature.
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A standard model
Choice set is (x, y ), x 0, y , 0. I interpret x as the amount of money
kept to oneself and y as an amount of money given to the other person.
Utility function u(x, y ) defined over this choice set. The utility function
that is consistent with selfish behaviour is u(x, y ) = x.
In Situation 1, there is an additional requirement, x = 5 y .
What standard model predicts? Since agent 1s utility function is
u(x, y ) = x, then her optimal choice is y = 0.
I assumed that agent 1 splits the money so that y > 0. This is
inconsistent with the prediction of the standard model.
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Alternative utility functions

There is a number of theories that can rationalise giving. Let us look at
few of these theories (which, in this instance, take a form of an
assumption on utility function but they do not have to!).
1. u FS (x, y ) = x |x y |, 0 < < 1: a person cares about own
payoff, but also cares about the difference in payoffs (Fehr and
Schmidt, 1999);
0
2. u FS (x, y ) = x (x y )2 , > 0: a person cares about own payoff,

but also cares about the difference in payoffs (inspired by FS);
2

x
12 , > 0: a person cares about own
3. u BO (x, y ) = x x+y
payoff and about her share of the payoff (inspired by Bolton and
Ockenfels, 2000);
4. u LL (x) = x (x x e )2 , > 0: x e is an expected decision (e.g.
dictated by social norms) and (x x e )2 is the moral cost of deviating
from an expected decision (inspired by Levitt and List, 2007).
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Prediction for u FS in Situation 1.

0
Suppose that u FS is the true model of agent 1. What agent 1 will do in

Situation 1?
0
We can re-write u FS as (I write it as a function of x for convenience):

0
u FS (x, 5 x) = x (x (5 x))2 = x (5 2x)2

What choice does it predict in our environment?
d FS 0
U (x, 5 x) = 1 + 4(5 2x) = 0
dx
1
5
1
5 2x =
x = +
4
2 8
Note that is not known and may vary among individuals; the only thing
we assume about is that > 0. Thus, the prediction is that agent 1 will
keep more than 1/2 of $5 (nothing more can be said).
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Predictions for u LL in Situation 1.

Given our situation, we conjecture that x e = 5/2 (wait to ask me why),
hence we can re-write u LL as
u LL (x) = x (x 5/2)2
What choice does it predict in our environment?
d LL
u (x) = 1 2(x 5/2) = 0
dx
1
x = 5/2 +
2
Recall that is not known; so the prediction here is that agent 1 will keep
more than 1/2 of $5 to herself.
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Summary: Comparing predictions for u FS and u LL

0
First, to avoid confusion, I will denote s from previous slides as FS and

LL .
x = 5/2 +
1
8FS 0
x = 5/2 +
1
2LL
Given that we do not know FS and LL , there is no difference in

prediction in our Situation 1: we cannot distinguish between two models.
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Data for Situation 1

This lack of different predictions is bad news for us: if we want to test
0
whether u FS or u LL better describe giving, we could not say. We may,
however, try to make a less precise statement whether they seem to fit
well the reality or not. Let us look at the data:
$
% The right column is a % of people who give the $ amount in
0
.29 the left column. For example, $0 is given by 29% of the
0.5 .17 subjects and $2.5 is given by 25% of the subjects.
1
.15 Recall (previous slide) that if an agent has FS 0 and LL
2
.07 preferences, she would always give less then 2.5 to agent 2.5
2.5 .25 Hence, because we observe so much of $2.5 choices, we may
3
.03 conclude that neither model does a good job explaining all the
5
.04 data; yet we may still want to know which one does better.
Situation 1 does not allow us to distinguish two models, we move to
Situation 2.
5
A bit of a problem for my interpretation is that subjects could give in $.5
increments; we will discuss this separately.
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Situation 2
Now, we change the situation a little: suppose that agent 1 can not only
give some y 5 to agent 2, but also can take up to $1 from agent 2. So,
in Situation 1 0 y 5 and in Situation 2 1 y 5.
What are the predictions for FS 0 and LL?
FS 0 :
For these who gave $0 in Situation 1, they could either give $0 or -$1.
I
Indeed, if is very small, then such an agent would have loved to take
everything for agent 2, but was more constrained in Situation 1 (could
take at most $0) than in Situation 2 (could take at most -$1).
For these who gave more than $0 in Situation 1, their choice should
not change.
I
For them, optimal choice has been x < 5, so giving an opportunity to

get $6 does not change this optimal choice.
LL: We can argue that x e changes in LL, so the split may be different not
only for these 29% who gave nothing in Situation 1, but for everyone
else.
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Data for Situations 1 and 2

$
-1
0
0.5
1
1.5
2
2.5
3
5
% in S1
0
.29
.17
.15
0
.07
.25
.03
.04
% in S2
.21
.44
.09
.07
.04
.04
.09
.03
0
This table combines the data for both

situations and has the same structure as the
previous table. We see that in Situation 2
44% give $0 to the other agent.
This is inconsistent with FS 0 prediction (for
these who gave more than $0 in Situation 1, their
choice should not change), but consistent
with LL prediction (which allows for change).6
6
The Econometricians among us may like to see a formal test of this claim, but we
will rely on a visual test (and a claim that it is obvious that LL fits the data better).
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Is LL better than FS 0 ?
LL explains our Situation 2 data better. Does it mean that LL is a better

theory?
Note x e : there is an extra parameter in this model and there is no
expectation that this parameter should stay the same in different
situations. So, without a theory how x e is formed, LL has very low
predictive power: by suitably choosing parameter x e it is possible to explain
almost any data. In the form I presented this theory, it is not falsifiable.7
7
The theory is falsifiable, or refutable, if it is possible to design a test which proves
the theory false.
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Selfish behaviour revisited (a teaser), 1

FS 0 may not explain the data very well, but selfish model (with u(x) = x)
clearly explain it even worse. Why would we routinely assume selfish
behaviour?
It appears that in many situations of our interest that is, in a natural
environment they are OK. They also give extremely sharp (no and x e )
and simple predictions.
John List run the following experiment. Let us consider a slightly more
complex game, called gift exchange game, in which agent 1 first pays
agent 2 some amount of money and then agent 2 return some money back
to agent 1. Note that the second part is similar to our Situation 1 (called
dictator game).
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Selfish behaviour revisited (a teaser), 2

For added realism, in Lists experiment, agent 2 does not return money.
Agent 2 return baseball cards of different quality. An altruistic agent 2
would return a high-quality, valuable baseball card after receiving high
payment and a low-quality, not valuable card after low payment. Selfish
agent 2 would return a low-quality card no matter what.
As an interesting twist, List uses actual baseball card dealers.
He first puts them in the lab. The results are in line with other lab
experiments: baseball card dealers are altruistic.
He then run field experiment (that is, the same rules of trade but in real
life; dealers are unaware of the experiment). The dealers are much less
altruistic than in the lab experiment.
As a side note, LL model explain that as well, because x e could change.
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Sources
Textbooks
Varian:
I
Preferences: Ch. 3
Utility: Ch. 4
Behavioural Economics: Ch. 31.4
Serrano-Feldman:
I
Ch. 2
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Sources
Papers
I
FS and FS 0 preferences: Fehr, Ernst and Klaus M. Schmidt. 1999. A

theory of fairness, competition and cooperation. Quarterly Journal of
Economics, 114, 81768.
BO preferences: Bolton, Gary E., and Axel Ockenfels. 2000. ERC: A
Theory of Equity, Reciprocity, and Competition. American Economic
Review, 90 (3): 16693.
LL preferences: Levitt, Steven and John List. 2007. What Do
Laboratory Experiments Measuring Social Preferences Reveal About
the Real World? Journal of Economic Perspectives, 21(2), 15374.
Lists experiment with -$1: List, John A. 2007. On the interpretation
of giving in dictator games. Journal of Political Economy, 115,
482493.
Lists experiment with baseball card dealers: List, John A. 2006. The
Behavioralist Meets the Market: Measuring Social Preferences and
Reputation Effects in Actual Transactions. Journal of Political
Economy, 114, 137.
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