Different Types of Tastes

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1 Chapter 5 Different Types of Tastes In Chapter 4 we demonstrated how tastes can be represented by maps of indifference curves and how 5 basic assumptions about tastes result in particular features of these indifference curves. 1 In addition, we illustrated how tastes can be more formally defined and how these can be mathematically represented as utility functions. We now proceed to analyzing how maps of indifference curves can differ in important ways while still satisfying our 5 basic assumptions. This will tell us much about how different types of tastes can be modeled using our simple graphical framework as well as the more general mathematical framework that builds on our graphically derived intuitions. For instance, if two goods are close substitutes for one another, the indifference map that represents a consumer s tastes for these goods will look very different from one representing tastes for goods that are close complements even though both types of indifference maps will satisfy our 5 basic assumptions. Shapes of indifference curves then translate into specific types of functional forms of utility functions. One of the important insights that should emerge from this chapter is that our basic model of tastes is enormously general and allows us to consider all sorts of tastes that individuals might have. You may like apples more than oranges and I may like oranges more than apples; you may think peanut butter and jelly go together well while I think they can t touch each other; you may see little difference between French wine and California wine while I may think one is barely drinkable. Often students that are introduced to indifference curves get the impression that they all look pretty much the same, but we will find here that their shapes and relationships to one another can vary greatly, and that this variation produces a welcome diversity of possible tastes that is necessary to analyze a world as diverse as ours. 5A Different Types of Indifference Maps Understanding how different tastes can be graphed will therefore be important for understanding how consumer behavior differs depending on what the consumer s underlying tastes are. We will begin in Section 5A.1 by discussing the shape of individual indifference curves for different types of goods. This will give us a way of talking about the degree to which consumers feel that different goods are substitutable for one another and the degree to which goods have their own distinct 1 Chapter 4 is necessary as background reading for this chapter.

2 120 Chapter 5. Different Types of Tastes character. We then proceed in Section 5A.2 with a discussion of how indifference curves from an indifference map relate to one another depending on what kinds of goods we are modeling. This will tell us how a consumer s perception of the value of one good relative to others changes as happiness or what we will later call real income increases. Finally, we conclude in Section 5A.3 by exploring the characteristic of indifference maps that determines how essential particular goods are to our perceived well-being how some goods are the kinds of goods we just can t live without while others are not as essential for our happiness. 5A.1 Substitutability along an Indifference Curve: Coke, Pepsi and Iced Tea The extent to which two goods are substitutes depends on the nature of the two goods we are modeling as well as the types of tastes that individuals have. For instance, Coke and Pepsi are more similar to one another than many other goods. In fact, I personally have trouble telling the difference between Coke and Pepsi. As a result, when my wife and I go to a restaurant and I order Coke, I am not upset if the waiter informs me that the restaurant only serves Pepsi I simply order a Pepsi instead. My wife, on the other hand, has a strong preference for Coke and she will switch to iced tea if she finds out that a restaurant serves Pepsi instead of Coke. I think she is nuts for thinking Coke and Pepsi are so different and attribute it to still unresolved childhood issues. She, on the other hand, thinks my family might have grown up near a nuclear test site whose radiation emissions have destroyed some vital taste buds. (She thinks it might explain some of my other oddities as well.) Be that as it may, it is clear that Coke and Pepsi are less substitutable for her than for me. 5A.1.1 Perfect Substitutes Suppose, then, that we want to model my tastes for Coke and Pepsi. We could begin by thinking about some arbitrary bundle that I might presently consume say 1 can of Coke and 1 can of Pepsi. We could then ask what other bundles might be of equal value to me given that I cannot tell the difference between the two products. For instance, 2 cans of Coke and no cans of Pepsi should be just as good for me, as should 2 cans of Pepsi and no cans of Coke. Thus, each of these three bundles must lie on the same indifference curve for someone with my tastes as must any other linear combination, such as 1.5 cans of Coke and 0.5 cans of Pepsi. In Graph 5.1, these bundles are plotted and connected by a (blue) line. Each point on this line represents some combination of Coke and Pepsi that adds up to 2 cans, which is after all the only thing that matters to someone who can t tell the difference between the two products. We could of course construct other indifference curves as well such as those representing quantities of Coke and Pepsi that add up to 1 can or 3 cans as also depicted in Graph 5.1. The tastes we have graphed represent tastes over goods that are perfect substitutes. Such tastes are unusual in the sense that one of our 5 basic assumptions is already almost violated. In particular, notice that averages are no longer better than extremes rather averages are valued the same as extremes when two goods are perfect substitutes. (1 can of Coke and 1 can of Pepsi is the average between the two more extreme bundles of 2 Cokes or 2 Pepsis but it is equally valued by a consumer with the tastes we have graphed here). This also implies that the slope of each indifference curve is constant giving us constant rather than diminishing marginal rates of substitution. Upon reflection, it should make intuitive sense that marginal rates of substitution are

3 5A. Different Types of Indifference Maps 121 Graph 5.1: Indifference Curves for Perfect Substitutes constant in this case. After all, no matter how much or how little Coke I have, I will always be willing to trade 1 Coke for 1 Pepsi. Students often ask if it has to be true that one is willing to trade goods one for one (i.e. that the M RS equals -1) in order for goods to be perfect substitutes. Different textbooks give different answers to such questions, but the only answer that makes sense to me is to say no the defining characteristic of perfect substitute is not that MRS = 1 but rather that the MRS is the same everywhere. Even when MRS = 1 (as in my Coke and Pepsi example), I could change the units with which I measure quantities of Coke and Pepsi and get a different MRS without changing a person s tastes. The next within-chapter-exerercise demonstrates this, and the idea is extended in exercise 5A.2. Exercise 5A.1 How would the graph of indifference curves change if Coke came in 8 ounce cans and Pepsi came in 4 ounce cans? Exercise 5A.2 On a graph with quarters (that are worth 25 cents) on the horizontal axis and dimes (that are worth 10 cents) on the vertical, what might your indifference curves look like? Use the same method we just employed to graph my indifference curves for Coke and Pepsi by beginning with one arbitrary bundle of quarters and dimes (say 4 quarters and 5 dimes) and then asking which other bundles might be just as good. 5A.1.2 Perfect Complements When my wife orders an iced tea in restaurants (after observing that the restaurant serves Pepsi rather than Coke), I have observed that she adds exactly 1 packet of sugar to the tea before drinking it. If there is less than a packet of sugar available, she will leave the iced tea untouched, whereas if there is more than one packet of sugar available, the additional sugar will remain unused unless she gets more iced tea. 2 From this somewhat compulsive behavior, I have concluded that iced tea 2 Actually that s not quite right: I really like sugar so when she is not looking, I usually pour the remaining sugar into my mouth. Unfortunately, my wife views such behavior as thoroughly anti-social rather than charmingly quaint and I usually have to endure a speech about having been raised in a barn whenever she catches me.

4 122 Chapter 5. Different Types of Tastes and sugar are perfect complements for my wife they complement each other to the point that she gets no satisfaction from consuming one unit of one without also consuming one unit of the other. We can model my wife s tastes for iced tea and sugar by again starting with one arbitrary point and then asking which other bundles will make her indifferent. Suppose we start with one pack of sugar and 1 glass of iced tea. Together, these two represent the ingredients for one acceptable beverage. Now suppose I gave my wife another pack of sugar without any additional iced tea giving her a bundle of 2 sugar packs and 1 glass of iced tea. Since this would still only give her 1 acceptable beverage, she would be no better (and no worse) off i.e. she would be indifferent. The same is true for a bundle containing any number of sugar packs greater than 1 so long as the bundle included only one glass of iced tea, and it would be true for any number of additional glasses of iced tea if only 1 sugar pack were available. The blue indifference curve with a right angle at 1 iced tea and 1 sugar pack in Graph 5.2 then represents all bundles that, given my wife s tastes, result in one acceptable beverage for her. Similar indifference curves exist for bundles that add up to 2 or 3 acceptable beverages. Graph 5.2: Indifference Curves for Perfect Complements Notice that, as in the case of perfect substitutes, perfect complements represent an extreme case in the sense that some of our five basic assumptions about tastes are almost violated. In particular, more is no longer necessarily better in the case of perfect complements only more of both goods is better. Similarly, averages are not always better than extremes, as for bundles of goods that lie on the linear portions of the indifference curves where averages are just as good as extremes. 3 Exercise 5A.3 What would my wife s indifference curves for packs of sugar and glasses of iced tea look like if she required 2 instead of one packs of sugar for each glass of iced tea? 3 Tastes that do not allow for substitutability between goods are sometimes referred to as Leontief tastes after Wassily Leontief ( ) who extensively used a similar notion in producer theory. Leontief was awarded the Nobel Prize in Economics in 1973.

5 5A. Different Types of Indifference Maps 123 5A.1.3 Less Extreme Cases of Substitutability and Complementarity Rarely do goods fall into either of the two extreme cases of perfect complements or perfect substitutes. Rather, goods tend to be relatively more or less substitutable depending on their inherent characteristics and the underlying tastes for the person whose tastes we are modeling. Such less extreme examples will then have shapes falling between the two extremes in Graphs 5.1 and 5.2 as for instance the tastes for goods x 1 and x 2 graphed in Graph 5.3a through 5.3c. Here, unlike for the case of perfect complements, a person is indeed willing to substitute some of x 2 for some of x 1 but not always in the same proportions as would be true for perfect substitutes. In particular, a person with such tastes would be willing to substitute x 2 for x 1 more easily if she currently has a bundle that has a lot of x 2 and little x 1, and this willingness to substitute one for the other decreases as she gets to bundles that contain relatively more x 1 than x 2. This is of course true because of the embedded assumption that averages are better than extremes an assumption that, as we showed in the previous chapter, leads to diminishing marginal rates of substitution. Graph 5.3: Indifference Curves for Less Extreme Cases of Substitutability and Complementarity For the tastes modeled in Graph 5.3a, this willingness to substitute x 1 for x 2 changes relatively little as the underlying bundle changes thus giving rise to indifference curves that are relatively flat and close in shape to those of tastes representing perfect substitutes. Tastes modeled in Graph 5.3c, on the other hand, are such that the willingness to substitute x 1 for x 2 changes relatively quickly along at least a portion of each indifference curve thus giving rise to indifference curves whose shape is closer to those of perfect complements. Keeping the extremes of perfect substitutes and perfect complements in mind, it then becomes relatively easy to look at particular maps of indifference curves and discern whether they contain a relatively high or a relatively low degree of substitutability. This degree of substitutability decreases as we move from panel (a) to panels (b) and (c) in Graph 5.3. The degree of substitutability will play an important role in our discussion of consumer behavior and consumer welfare in the next several chapters. It may at first seem like a trivial concept when applied to simple examples like Coke and Pepsi, but it becomes one of the most crucial concepts in controversies surrounding such issues as tax and retirement policy. In such debates, the degree of substitutability between current and future consumption or between consumption and leisure takes center stage, as we will see in later chapters.

6 124 Chapter 5. Different Types of Tastes Exercise 5A.4 Suppose I told you that each of the indifference maps graphed in Graph 5.3 corresponded to my tastes for one of the following sets of goods, which pair would you think corresponds to which map? Pair 1: Levi Jeans and Wrangler Jeans; Pair 2: Pants and Shirts; Pair 3: Jeans and Dockers pants. 5A.2 Some Common Indifference Maps In our discussions of the degree of substitutability between goods, our focus was solely on the shape of particular indifference curves and in particular on the curvature of the indifference curves and the rate at which the marginal rates of substitution change as one moves along a single indifference curve. A second important feature of indifference maps centers around the relationship of indifference curves to one another rather than the shape of individual indifference curves. How, for instance, do marginal rates of substitution change along a linear ray from the origin? How do they change holding fixed one of the goods? Do indifference curves touch the axes? And what do such features of indifference maps tell us about the underlying tastes of individuals? Below, we will take each of these questions and define particular types of tastes that represent important special cases which may be relevant for modeling tastes over different kinds of goods. 5A.2.1 Homothetic Tastes Let s begin by assuming that I currently consume bundle A in Graph 5.4a 3 pants and 3 shirts. And suppose that you know that the indifference curve that contains bundle A has a marginal rate of substitution of 1 at bundle A implying that I am willing to exchange 1 shirt for 1 pair of pants whenever I have three of each. Now suppose you give me 3 additional pants and 3 additional shirts, thus doubling what I had originally at bundle A. This will put me on a new indifference curve one that contains the new bundle B. Would it now be reasonable for us to expect that my marginal rate of substitution is still 1 at B? Graph 5.4: Homothetic Tastes, Marginal Rates of Substitution & Indifference Curves Perhaps it would be reasonable for this particular example. After all, the reason my marginal rate of substitution might be 1 at point A is that I like to change pants and shirts roughly at the same intervals when I have equal numbers of pants and shirts. If so, the important determinant of

7 5A. Different Types of Indifference Maps 125 my marginal rate of substitution is the number of pants I have relative to the number of shirts which is unchanged between points A and B. Put differently, if I change pants and shirts at equal intervals when I have 3 of each, I am probably changing them at equal intervals when I have 6 of each and am thus willing to trade them off for one another (at the margin) one for one. (Remember, however, that when we say that the M RS is -1 at A, we mean that you are willing to trade very small quantities of pants and shirts one for one not necessarily 1 entire pair of pants for one entire shirt. This is what I mean when I say that I am willing to trade them one-for-one on the margin. As we noted before, while it is awkward to think of pants and shirts as divisible goods, it is a useful modeling simplification and one that usually is not overly restrictive when we talk about bigger examples that matter more than pants and shirts.) A similar argument could hold for other bundles on the indifference curve that contains bundle A. For instance, bundle A contains 4 shirts and 2 pants, and the indifference curve shows a marginal rate of substitution of 2 at A. Thus, I would be willing to give up 2 shirts to get 1 more pair of pants if I were currently consuming bundle A because shirts are not of as much value to me when I have so few pants relative to shirts. But then it sounds plausible for the marginal rate of substitution to remain the same if you doubled A to B I still have relatively many shirts compared to pants and thus might still be willing to trade 2 shirts for 1 pair of pants at B. Whenever tastes exhibit the property that marginal rates of substitution at particular bundles depend only on how much of one good relative to the other is contained in that bundle, we will say that tastes are homothetic. This technical term means nothing more than what we have already described for my tastes for pants and shirts: whenever you determine the marginal rate of substitution at one particular bundle, you know that the marginal rate of substitution at all other bundles that lie on a ray connecting the origin and the original bundle is exactly the same. This is true because the amount of one good relative to the other is unchanged along this ray. Graph 5.4b illustrates three indifference curves of such a homothetic indifference map. In Chapter 6 we will see how consumers with homothetic tastes will choose to double their current consumption basket whenever their income doubles. Tastes for certain big-ticket consumption goods can thus be quite accurately modeled using homothetic tastes because they represent goods that we consume in rough proportion to our income. For many consumers, for instance, the square footage of housing consumed increases linearly with income. Similarly, as we think of modeling our tastes for consumption across different time periods, it may be reasonable to assume that our tastes are homothetic and that we will choose to increase our consumption this year and next year by the same proportion if our yearly income doubles. In concluding our discussion of homothetic tastes, it is important to note that when we say that someone s tastes are homothetic, we are making a statement about how different indifference curves relate to one another we are not saying anything in particular about the shape of individual indifference curves. For instance, you should be able to convince yourself that homothetic tastes could incorporate many different degrees of substitutability by thinking about the following: Exercise 5A.5 Are my tastes over Coke and Pepsi as described in Section 5A.1 homothetic? Are my wife s tastes over iced tea and sugar homothetic? Why or why not? 5A.2.2 Quasilinear Tastes While the assumption that marginal rates of substitution at different consumption bundles depend only on the relative quantities of goods at those bundles is plausible for many applications, there are also many important instances when the assumption does not seem reasonable. Consider, for

8 126 Chapter 5. Different Types of Tastes instance, my tastes for weekly soft drink consumption and a composite good representing my weekly consumption of all other goods in dollars. Graph 5.5: Quasilinear Tastes, Marginal Rates of Substitution & Indifference Curves Suppose we begin with a bundle A in Graph 5.5a a bundle that contains 25 soft drinks and $500 in other consumption. My indifference curve has a slope of 1 at that bundle indicating that, given my current consumption bundle A, I am willing to give up $1 in other consumption for 1 additional soft drink. Now suppose that you enabled me to consume at double my current consumption point B with 50 soft drinks and $1,000 in other consumption. Does it seem likely that I would value the 50 th soft drink in bundle B the same as I valued the 25 th soft drink in bundle A? If so, my tastes would again be homothetic. But it is much more likely that there is room for only so many soft drinks in my stomach during any week, and even if you enable me to consume a lot more in other goods, I would still not value additional soft drinks very highly. In that case, my marginal rate of substitution at point B would be less than 1 in absolute value i.e. I would be willing to consume additional soft drinks at bundle B only if I had to give up less than $1 in additional consumption. In many examples like this, a more accurate description of tastes might be that my marginal rate

9 5A. Different Types of Indifference Maps 127 of substitution depends only on how many soft-drinks I am consuming, not on how much in other consumption I have during the same week. Consider, for instance, point C in Graph 5.5a a bundle containing $1,000 in other consumption and 25 soft-drinks. It may well be that my willingness to trade dollars for additional soft-drinks does not change at all between points A and C whether I am consuming $500 or $1,000 in other goods, I will still only consume any soft-drinks beyond 25 if I can get them for less than $1 in other consumption. If this is the case, then my tastes will be such that my marginal rate of substitution is the same along any vertical line in Graph 5.5a. Two examples of indifference maps that satisfy this property are depicted in Graphs 5.5b and 5.5c. Tastes for goods that are valued at the margin the same regardless of how much of the other good we are consuming are called quasilinear tastes. Goods that are likely to be modeled well using quasilinear tastes tend to be goods that represent a relatively small fraction of our income goods that we tend to consume the same quantity of even if we get a big raise. Many goods that we consume probably fall into this category milk, soft-drinks, paperclips, etc. but some clearly do not. For instance, we cited tastes for housing as an example better modeled as homothetic because housing is, at the margin, valued more highly as we become better off. More generally, it will become clearer in Chapter 6 that tastes for many big-ticket consumption items are not likely to be well modeled using the quasilinear specification of indifference maps. Exercise 5A.6 Are my tastes over Coke and Pepsi as described in Section 5A.1 quasilinear? Are my wife s tastes over iced tea and sugar quasilinear? Why or why not? 5A.2.3 Homothetic versus Quasilinear Tastes Tastes, then, are quasilinear in a particular good if the marginal rate of substitution between this and the other good depends only on the absolute quantity of the quasilinear good (and is thus independent of how much of the other good a consumer has in her consumption bundle.) Graphically, this means that the marginal rate of substitution is the same along lines that are perpendicular to the axis on which we model the good that is quasilinear. Tastes are homothetic, on the other hand, if the marginal rate of substitution at any given bundle depends only on the quantity of one good relative to the quantity of the other. Graphically, this means that the marginal rates of substitution across indifference curves are the same along rays emanating from the origin of the graph. You will understand the difference between these if you feel comfortable with the following: Exercise 5A.7 Can you explain why tastes for perfect substitutes are the only tastes that are both quasilinear and homothetic? 4 5A.3 Essential Goods There is one final dimension along which we can categorize indifference maps: whether or not the indifference curves intersect one or both of the axes in our graphs. Many of the indifference maps we have drawn so far have indifference curves that converge to the axes of the graphs without ever touching them. Some like those representing quasilinear tastes, however, intersect one or both 4 In end-of-chapter exercise 5.1, you will work with limit cases of perfect substitutes cases where the indifference curves become perfectly vertical or perfectly horizontal. For purposes of our discussions, we will treat such limiting cases as members of the family of perfect substitutes.

10 128 Chapter 5. Different Types of Tastes Graph 5.6: x 2 is Essential in (b) but not in (a) of the axes. The distinction between indifference maps of the first and second kind will become important in the next chapter as we consider what we can say about the best bundle that will be chosen by individuals who are seeking to do the best they can given their circumstances. For now, we will say little more about this but simply indicate that the difference between these two types of tastes has something to do with how essential both goods are to the well-being of an individual. Take, for example, my tastes for Coke and Pepsi. When we model such tastes, neither of the two goods is in and of itself very essential since I am indifferent between bundles that contain both goods and bundles that contain only one of the two goods. This is not true for the case of perfect complements such as iced tea and sugar for my wife. For her, neither iced tea nor sugar are of any use unless she has both in her consumption bundle. In that sense, we could say both goods are essential for her well-being, at least so long as our model assumes she consumes only iced tea and sugar. More generally, suppose we compare the indifference map in Graph 5.6a to that in Graph 5.6b. In the first graph, the indifference curves converge to the vertical axis (without touching it) while they intersect the horizontal axis. Therefore, there are bundles that contain no quantity of good x 2 (such as A and C) that are just as good as bundles that contain both x 1 and x 2 (such as B and D). In some sense, x 2 is therefore not as essential as x 1. In the second graph (Graph 5.6b), on the other hand, bundles must always contain some of each good in order for the individual to be happier than she is without consuming anything at all at the origin. And, an individual is indifferent to any bundle that contains both goods (like bundle E) only if the second bundle also contains some of both goods. In that sense, both goods are quite essential to the well-being of the individual. Exercise 5A.8 True or False: Quasilinear goods are never essential. 5B Different Types of Utility Functions The different types of tastes we have illustrated graphically so far can of course also be represented by utility functions, with particular classes of utility functions used to represent different degrees of substitutability as well as different relationships of indifference curves to one another. We therefore

11 5B. Different Types of Utility Functions 129 now take the opportunity to introduce some common types of utility functions that generalize precisely the kinds of intuitive concepts we illustrated graphically in Section 5A. 5B.1 Degrees of Substitutability and the Elasticities of Substitution In Section 5A.1, we described different shapes of indifference curves that imply different levels of substitutability. For instance, my tastes for Coke and Pepsi were illustrated with linear indifference curves in Graph 5.1 a shape for indifference curves that indicates perfect substitutability between the two goods. The opposite extreme of no substitutability was illustrated using my wife s tastes for sugar and iced tea with L-shaped indifference curves in Graph 5.2. And less extreme indifference curves ranging from those that implied a relatively large degree of substitutability to a relatively small degree of substitutability were illustrated in a sequence of graphs in Graph 5.3. From this discussion, one quickly walks away with the sense that the degree of substitutability is directly related to the speed with which the slope of an indifference curve changes as one moves along the indifference curve. The slope, for instance, changes relatively slowly in Graph 5.3a where two goods are relatively substitutable, and much more quickly in Graph 5.3c where goods are less substitutable. What we referred to informally as the degree of substitutability in our discussion of these graphs is formalized mathematically through a concept known as the elasticity of substitution. 5 As we will see again and again throughout this book, an elasticity is a measure of responsiveness. We will, for instance, discuss the responsiveness of a consumer s demand for a good when that good s price changes as the price elasticity of demand in later chapters. In the case of formalizing the notion of substitutability, we are attempting to formalize how quickly the bundle of goods on an indifference curve changes as the slope (or marginal rate of substitution) of that indifference curve changes or, put differently, how responsive the bundle of goods along an indifference curve is to the changes in the marginal rate of substitution. Consider, for instance, point A (with marginal rate of substitution of 2) on the indifference curve graphed in Graph 5.7a. In order for us to find a point B where the marginal rate of substitution is 1 instead of 2, we have to go from the initial bundle (2, 10) to the new bundle (8, 4). In Graph 5.7b, a similar change from an initial point A with marginal rate of substitution of 2 to a new point B with marginal rate of substitution of 1 implies a significantly smaller change in the bundle, taking us from (2, 10) to (4, 8). Put differently, the ratio of x 2 over x 1 declines quickly (from 5 to 1/2) in panel (a) as the marginal rate of substitution falls (in absolute value from 2 to 1) while it declines less rapidly (from 5 to 2) in panel (b) for the same change in the marginal rate of substitution. Economists have developed a mathematical way to give expression to the intuition that the degree of substitutability between two goods is related to the speed with which the ratio of two goods along an indifference curve changes as the marginal rate of substitution changes. This is done by defining the elasticity of substitution (denoted σ) at a particular bundle of two consumption goods as the percentage change in the ratio of those two goods that results from a 1 percent change in the marginal rate of substitution along the indifference curve that contains the bundle, or, put 5 This concept was introduced independently in the early 1930 s by two of the major economists of the 20th Century Sir John Hicks ( ) and Joan Robinson ( ). Hicks was awarded the Nobel Prize in Economics in 1972.

12 130 Chapter 5. Different Types of Tastes Graph 5.7: Degrees of Substitutability and Marginal Rates of Substitution mathematically, Elasticity of substitution = σ = % (x 2 /x 1 ) % MRS. (5.1) The percentage change of a variable is simply the change of the variable divided by the original level of that variable. For instance, if the ratio of the two goods changes from 5 to 1/2 (as it does in Graph 5.7a), the percentage change in the ratio is given by 4.5/5 or 0.9. Similarly, the % M RS in Graph 5.7a is 0.5. Dividing 0.9 by 0.5 then gives a value of -1.8, or 1.8 in absolute value. This is approximately the elasticity of substitution in Graph 5.7a. (It is only approximate because the formula in equation (5.1) evaluates the elasticity of substitution precisely at a point when the changes are very small. The calculus version of the elasticity formula is treated explicitly in the appendix to this chapter.) Exercise 5B.1 Calculate the same approximate elasticity of substitution for the indifference curve in Graph 5.7b. We will see that our definitions of perfect complements and perfect substitutes give rise to extreme values of zero and infinity for this elasticity of substitution, while tastes that lie in between these extremes are associated with values somewhere in between these extreme values. 5B.1.1 Perfect Substitutes The case of perfect substitutes Coke and Pepsi for me in section 5A.1.1 is one where an additional unit x 1 (a can of coke) always adds exactly the same amount to my happiness as an additional unit of x 2 (a can of Pepsi). A simple way of expressing such tastes in terms of a utility function is to write the utility function as u(x 1, x 2 ) = x 1 + x 2. (5.2) In this case, you can always keep me indifferent by taking away 1 unit of x 1 and adding 1 unit of x 2 or vice versa. For instance, the bundles (2, 0), (1, 1) and (0, 2) all give utility of 2 implying all three bundles lie on the same indifference curve (as drawn in Graph 5.1).

13 5B. Different Types of Utility Functions 131 Exercise 5B.2 What numerical labels would be attached to the 3 indifference curves in Graph 5.1 by the utility function in equation (5.2)? Exercise 5B.3 Suppose you measured coke in 8 ounce cans and Pepsi in 4 ounce cans. Draw indifference curves and find the simplest possible utility function that would give rise to those indifference curves. Without doing the math explicitly, we can see intuitively that the elasticity of substitution in this case is infinity ( ). This is easiest to see if we think of an indifference map that is close to perfect substitutes such as the indifference map in Graph 5.8a in which indifference curves are almost linear. Beginning at point A, even the very small percentage change in the MRS that gets us to point B is accompanied by a very large change in the ratio of the consumption goods. Considering this in light of equation (5.1), we get an elasticity of substitution that is determined by a large numerator divided by a very small denominator giving a large value for the elasticity. The closer this indifference map comes to being linear, the larger will be the numerator and the smaller will be the denominator thus causing the elasticity of substitution to approach as the indifference map approaches that of perfect substitutes. Graph 5.8: Degrees of Substitutability and the Elasticities of Substitution Exercise 5B.4 Can you use similar reasoning to determine the elasticity of substitution for the utility function you derived in exercise 5B.3? 5B.1.2 Perfect Complements It is similarly easy to arrive at a utility function that represents the L-shaped indifference curves for goods that represent perfect complements (such as iced tea and sugar for my wife in section 5A.1.2). Since the two goods are of use to you only when consumed together, your happiness from such goods is determined by whichever of the two goods you have less of. For instance, when my wife has 3 glasses of iced tea but only 2 packs of sugar, she is just as happy with any other combination of iced tea and sugar that contains exactly two units of one of the goods and at least two units of the other. For any bundle, happiness is therefore determined by the smaller quantity of the two goods

14 132 Chapter 5. Different Types of Tastes in the bundle, or u(x 1, x 2 ) = min{x 1, x 2 }. (5.3) Exercise 5B.5 Plug the bundles (3,1), (2, 1), (1, 1), (1,2) and (1, 3) into this utility function and verify that each is shown to give the same utility thus lying on the same indifference curve as plotted in Graph 5.2. What numerical labels does this indifference curve attach to each of the 3 indifference curves in Graph 5.2? Exercise 5B.6 How would your graph and the corresponding utility function change if we measured iced tea in half glasses instead of glasses. We can again see intuitively that the elasticity of substitution for goods that are perfect complements will be zero. As in the case of perfect substitutes, this is easiest to see if we begin by considering an indifference map that is close to one representing perfect complements such as the indifference map drawn in Graph 5.8b. Beginning at point A, even the very large percentage change in the MRS that gets us to point B implies a small percentage change in the ratio of the inputs. Considering this in light of equation (5.1), this implies a small numerator divided by a large denominator giving a small number for the elasticity of substitution. As this map comes closer and closer to one that represents perfect complements, the numerator becomes smaller and the denominator rises. This leads to an elasticity of substitution that approaches zero as the indifference map approaches that of perfect complements. Exercise 5B.7 Can you determine intuitively what the elasticity of substitution is for the utility function you defined in exercise 5B.6? 5B.1.3 The Cobb-Douglas Function Probably the most widely used utility function in economics is one that gives rise to indifference curves that lie between the extremes of perfect substitutes and perfect complements and that, as we will see, exhibits an elasticity of substitution of 1. It is known as the Cobb-Douglas utility function and takes the form u(x 1, x 2 ) = x γ 1 xδ 2 where γ > 0, δ > 0. 6 (5.4) While the exponents in the Cobb-Douglas function can in principle take any positive values, we often restrict ourselves to exponents that sum to 1. But since we know from Chapter 4 that we can transform utility functions without changing the underlying indifference map, restricting the exponents to sum to 1 turns out to be no restriction at all. We can, for instance, transform the function u by taking it to the power 1/(γ + δ) to get (u(x 1, x 2 )) 1/(γ+δ) = (x γ 1 xδ 2 )1/(γ+δ) = x γ/(γ+δ) 1 x δ/(γ+δ) 2 = = x α 1 x(1 α) 2 (where α = γ/(γ + δ)) = = v(x 1, x 2 ). (5.5) 6 This function was originally derived for producer theory where it is (as we will see in later chapters) still heavily used. It was first proposed by Knut Wicksell ( ). It is named, however, for Paul Douglas ( ), an economist, and Charles Cobb, a mathematician. They first used the function in empirical work (focused on producer theory) shortly after Wicksell s death. Paul Douglas went on to serve three terms as an influential U.S. Senator from Illinois ( ).

15 5B. Different Types of Utility Functions 133 Exercise 5B.8 Demonstrate that the functions u and v both give rise to indifference curves that exhibit the same shape by showing that the MRS for each function is the same. We can therefore simply write the utility function in Cobb-Douglas form as u(x 1, x 2 ) = x α 1 x (1 α) 2 where 0 < α < 1. (5.6) In the n-good case, the Cobb-Douglas form extends straightforwardly to u(x 1, x 2,..., x n ) = x α1 1 xα2 2...xαn n with α 1 + α α n = 1. (5.7) We will show in the next section that this Cobb-Douglas function is just a special case of a more general functional form the special case in which the elasticity of substitution is equal to 1 everywhere. Before doing so, however, we can get some intuition about the variety of tastes that can be represented through Cobb Douglas functions by illustrating how these functions change as α changes in expression (5.6). The series of graphs in Graph 5.9 provide some examples. Graph 5.9: Different Cobb Douglas Utility Functions While each of these graphs belongs to the family of Cobb Douglas utility functions (and thus each represents tastes with elasticity of substitution of 1), you can see how Cobb-Douglas tastes can indeed cover many different types of indifference maps. When α = 0.5 (as in panel (b) of the graph), the function places equal weight on x 1 and x 2 resulting in an indifference map that is symmetric around the 45-degree line. Put differently, since the two goods enter the utility function symmetrically, the portions of indifference curves that lie below the 45-degree line are mirror images of the corresponding portions that lie above the 45-degree line (when you imagine putting a mirror along the 45 degree line). This implies that the MRS on the 45-degree line must be equal to -1 when individuals with such tastes have equal quantities of both goods, they are willing to trade them one-for-one. When α 0.5, on the other hand, the two goods do not enter the utility function symmetrically and so the symmetry around the 45-degree line is lost. If α > 0.5 (as in panel (c) of the graph), relatively more weight is put on x 1. Thus, if a consumer with such tastes has equal quantities of x 1

16 134 Chapter 5. Different Types of Tastes and x 2, she is not willing to trade them one-for-one. Rather, since x 1 plays a more prominent role in the utility function, she would demand more than 1 unit of x 2 to give up one unit of x 1 when she starts with an equal number of each (i.e. on the 45 degree line) implying an MRS greater than 1 in absolute value along the 45-degree line. As α increases above 0.5, the points where MRS = 1 therefore fall below the 45-degree line. The reverse is, of course, true as α falls below 0.5 when more emphasis is placed on x 2 rather than x 1 (as in panel (a) of the graph). Exercise 5B.9 Derive the MRS for the Cobb-Douglas utility function and use it to show what happens to the slope of indifference curves along the 45-degree line as α changes. 5B.1.4 A More General Model: Constant Elasticity of Substitution (CES) Utility So far, we have explored the extremes of perfect substitutes (with elasticity of substitution of ) and perfect complements (with elasticity of substitution of 0), and we have identified the Cobb- Douglas case which lies in-between with an elasticity of substitution of 1. Of course there exist other in-between cases where the elasticity of substitution lies between 0 and 1 or between 1 and. And economists have identified a more general utility function that can capture all of these (including the cases of perfect substitutes, Cobb-Douglas tastes and perfect complements). All utility functions that take this form have one thing in common: the elasticity of substitution is the same at all bundles and it is for this reason that these functions are called constant elasticity of substitution utility functions or just CES utility functions. 7 For bundles that contain two goods, these functions take on the following form: u(x 1, x 2 ) = (αx ρ 1 + (1 α)x ρ 2 ) 1/ρ, (5.8) where 0 < α < 1 and 1 ρ. 8 It is mathematically intensive to derive explicitly the formula for an elasticity of substitution for utility functions that take this form if you are curious, you can follow this derivation in the appendix. As it turns out, however, the elasticity of substitution σ takes on the following very simple form for this CES function: σ = 1/(1 + ρ). (5.10) Thus, as ρ gets close to, the elasticity of substitution approaches 0 implying that the underlying indifference curves approach those of perfect complements. If, on the other hand, ρ gets close to 1, the elasticity approaches implying that the underlying indifference curves approach those of perfect substitutes. Thus, as the parameter ρ moves from 1 to, the underlying indifference map changes from that of perfect substitutes to perfect complements. This is illustrated graphically in Graph 5.10 for the case where α is set to 0.5. As we move left across the three panels of the graph, ρ increases which implies the elasticity of substitution decreases and we move from tastes over goods that are relatively substitutable to tastes over goods that are more complementary. 7 This function was first derived (and explored within the context of producer theory) in 1961 by Ken Arrow (1921- ) and Robert Solow (1924-) together with H.B. Cherney and B.S. Minhas. Arrow went on to share the 1972 Nobel Prize in Economics with Sir John Hicks (who had originally developed the concept of an elasticity of substitution). Solow was awarded the Nobel Prize in The CES form can also be generalized to more than two goods, with the n-good CES function given by u(x 1, x 2,...,x n) = nx i=1! 1/ρ α i x ρ i where nx α i = 1. (5.9) i=1

17 5B. Different Types of Utility Functions 135 Graph 5.10: Different CES Utility Functions when α = 0.5 and ρ varies Exercise 5B.10 What is the elasticity of substitution in each panel of Graph 5.10? The best way to see how the CES function gives rise to different indifference maps is to derive its marginal rate of substitution; i.e. MRS = u/ x 1 u/ x 2 = = (αx ρ 1 + (1 α)x ρ 2 ) (ρ+1)/ρ αx (ρ+1) 1 (αx ρ 1 + (1 α)x ρ 2 ) (ρ+1)/ρ (1 α)x (ρ+1) 2 αx (ρ+1) 1 (1 α)x (ρ+1) 2 = ( α 1 α ) ( ) ρ+1 x2. x 1 (5.11) Note, for instance, what happens when ρ = 1: the MRS simply becomes α/(1 α) and no longer depends on the bundle (x 1, x 2 ). Put differently, when ρ = 1, the slopes of indifference curves are just straight parallel lines indicating that the consumer is willing to perfectly substitute α/(1 α) of x 2 for one more unit of x 1 regardless of how many of each of the two goods she currently has. We have also indicated that the Cobb-Douglas utility function u(x 1, x 2 ) = x α 1 x (1 α) 2 represents a special case of the CES utility function. To see this, consider the MRS for the Cobb-Douglas function which is 1 x (1 α) 2 MRS = u/ x 1 = αx(α 1) u/ x 2 (1 α)x α 1 x α 2 ( α = 1 α ) ( x2 x 1 ). (5.12) Note that the MRS from the CES function in equation (5.11) reduces to the MRS from the Cobb-Douglas function in equation (5.12) when ρ = 0. Thus, when ρ = 0, the indifference curves of the CES function take on the exact same shapes as the indifference curves of the Cobb-Douglas function implying that the two functions represent exactly the same tastes. This is not easy to

18 136 Chapter 5. Different Types of Tastes see by simply comparing the actual CES function to the Cobb-Douglas function because the CES function ceases to be well defined at ρ = 0 when the exponent 1/ρ is undefined. But by deriving the respective marginal rates of substitution for the two functions, we can see how the CES function in fact does approach the Cobb-Douglas function as ρ approaches zero. Finally, since we know that the elasticity of substitution for the CES utility function is σ = 1/(1 + ρ), we know that σ = 1 when ρ = 0. This, then, implies that the elasticity of substitution of the Cobb-Douglas utility function is in fact 1 as we had foreshadowed in our introduction of the Cobb-Douglas function. Exercise 5B.11 * Can you describe what happens to the slopes of the indifference curves on the 45 degree line, above the 45 degree line and below the 45 degee line as ρ becomes large (and as the elasticity of substitution therefore becomes small)? Exercise 5B.12 On the Exploring Relationships animation associated with Graph 5.10, develop an intuition for the role of the α parameter in CES utility functions and compare those to what emerges in Graph B.2 Some Common Indifference Maps In Section 5A, we drew a logical distinction between shapes of individual indifference curves that define the degree of substitutability between goods and the relation of indifference curves to one another within a single indifference map. We have just formalized the degree of substitutability by exploring the concept of an elasticity of substitution and how tastes that have a constant elasticity of substitution at all consumption bundles can vary and be modeled using CES utility functions. We now turn toward exploring two special cases of indifference maps those defined as homothetic and those defined as quasilinear in Section 5A.2. 5B.2.1 Homothetic Tastes and Homogeneous Utility Functions Recall that we defined tastes as homothetic whenever the indifference map has the property that the marginal rate of substitution at a particular bundle depends only on how much of one good relative to the other is contained in that bundle. Put differently, the MRS of homothetic tastes is the same along any ray emanating from the origin of our graphs implying that, whenever we increase each of the goods in a particular bundle by the same proportion, the MRS will remain unchanged. Consider, for instance, tastes that can be represented by the Cobb Douglas utility function in equation (5.6). The MRS implied by this function is αx 2 /(1 α)x 1. Suppose we begin at a particular bundle (x 1, x 2 ) and then increase the quantity of each of the goods in the bundle by a factor t to get to the bundle (tx 1, tx 2 ) which lies on a ray from the origin that also contains (x 1, x 2 ). This implies that the new MRS is αtx 2 /(1 α)tx 1, but this reduces to αx 2 /(1 α)x 1 since the t appears in both the numerator and the denominator and thus cancels. Cobb Douglas utility functions therefore represent homothetic tastes because the M RS is unchanged along a ray from the origin. More generally, homothetic tastes can be represented by any utility function that has the mathematical property of being homogeneous. A function f(x 1, x 2 ) is defined to be homogeneous of degree k if and only if f(tx 1, tx 2 ) = t k f(x 1, x 2 ). (5.13)

19 5B. Different Types of Utility Functions 137 For instance, the Cobb Douglas function u(x 1, x 2 ) = x γ 1 xδ 2 is homogeneous of degree (γ + δ) because u(tx 1, tx 2 ) = (tx 1 ) γ (tx 2 ) δ = t (γ+δ) x γ 1 xδ 2 = t(γ+δ) u(x 1, x 2 ). (5.14) Exercise 5B.13 Show that, when we normalize the exponents of the Cobb-Douglas utility function to sum to 1, the function is homogeneous of degree 1. Exercise 5B.14 Consider the following variant of the CES function that will play an important role in ρ β/ρ. producer theory: f(x 1, x 2) = `αx1 + (1 α)x ρ 2 Show that this function is homogeneous of degree β. It is then easy to see how homogeneous utility functions must represent homothetic tastes. Suppose u(x 1, x 2 ) is homogeneous of degree k. The MRS at a bundle (tx 1, tx 2 ) is then MRS(tx 1, tx 2 ) = u(tx 1, tx 2 )/ x 1 u(tx 1, tx 2 )/ x 2 = (tk u(x 1, x 2 ))/ x 1 (t k u(x 1, x 2 ))/ x 2 = = tk u(x 1, x 2 )/ x 1 t k u(x 1, x 2 )/ x 2 = u(x 1, x 2 )/ x 1 u(x 1, x 2 )/ x 2 = = MRS(x 1, x 2 ). (5.15) In this derivation, we use the definition of a homogeneous function in the first line in (5.15), are then able to take the t k term outside the partial derivative (since it is not a function of x 1 or x 2 ), and finally can cancel the t k that now appears in both the numerator and the denominator to end up at the definition of the MRS at bundle (x 1, x 2 ). Thus, the MRS is the same when we increase each good in a bundle by the same proportion t implying that the underlying tastes are homothetic. Furthermore, any function that is homogeneous of degree k can be transformed into a function that is homogeneous of degree 1 by simply taking that function to the power (1/k). We already showed in equation (5.5), for instance, that we can transform the Cobb-Douglas utility function u(x 1, x 2 ) = x γ 1 xδ 2 (which is homogeneous of degree (γ+δ)) into a utility function that is homogeneous of degree 1 (taking the form v(x 1, x 2 ) = x α 1 x(1 α) 2 ) by simply taking it to the power 1/(γ + δ). Exercise 5B.15 Can you demonstrate, using the definition of a homogeneous function, that it is generally possible to transform a function that is homogeneous of degree k to one that is homogeneous of degree 1 in the way suggested above? We can therefore conclude that homothetic tastes can always be represented by utility functions that are homogeneous, and since homogeneous functions can always be transformed into functions that are homogeneous of degree 1 without altering the underlying indifference curves, we can also conclude that homothetic tastes can always be represented by utility functions that are homogeneous of degree 1. 9 Many commonly used utility functions are indeed homogeneous and thus represent 9 Even if a utility function is not homogeneous, however, it might still represent homothetic tastes because it is possible to transform a homogeneous function into a non- homogeneous function by just, for instance, adding a constant term. The function w(x 1, x 2 ) = x α 1 x(1 α) 2 + 5, for example, has the same indifference curves as the utility function u(x 1, x 2 ) = x α 1 x(1 α) 2, but w is not homogeneous while u is. But given that utility functions are only tools we use to represent tastes (indifference curves), there is no reason to use non-homogeneous utility functions when we want to model homothetic tastes no economic content is lost if we simply use utility functions that are homogeneous of degree 1 to model such tastes.

20 138 Chapter 5. Different Types of Tastes homothetic tastes including, as you can see from within-chapter exercise 5B.14, all CES functions we defined in the previous sections. 5B.2.2 Quasilinear Tastes In Section 5A.2.2, we defined tastes as quasilinear in good x 1 whenever the indifference map has the property that the marginal rate of substitution at a particular bundle depends only on how much of x 1 that bundle contains (and thus NOT on how much of x 2 it contains). Formally, this means that the marginal rate of substitution is a function of only x 1 and not x 2. This is generally not the case. For instance, we derived the MRS for a Cobb Douglas utility function u(x 1, x 2 ) = x α 1 x(1 α) 2 to be αx 2 /((1 α)x 1 ). Thus, for tastes that can be represented by Cobb Douglas utility functions, the marginal rate of substitution is a function of both x 1 and x 2, which allows us to conclude immediately that such tastes are not quasilinear in either good. Consider, however, the class of utility functions that can be written as u(x 1, x 2 ) = v(x 1 ) + x 2, (5.16) where v: R + R is a function of only the level of consumption of good x 1. The partial derivative of u with respect to x 1 is then equal to the derivative of v with respect to x 1, and the partial derivative of u with respect to x 2 is equal to 1. Thus, the marginal rate of substitution implied by this utility function is MRS = u/ x 1 u/ x 2 = dv dx 1, (5.17) which is a function of x 1 but NOT of x 2. We will then refer to tastes that can be represented by utility functions of the form given in expression (5.16) as quasilinear in x 1. While some advanced textbooks refer to the good x 2 (that enters the utility function linearly) as the quasilinear good, note that I am using the term differently here I am referring to the good x 1 as the quasilinear good. This convention will make it much easier for us to discuss economically important forces in later chapters. The simplest possible form of equation (5.16) arises when v(x 1 ) = x 1. This implies u(x 1, x 2 ) = x 1 + x 2 the equation we derived in Section 5B.1.1 as representing perfect substitutes. The function v can, however, take on a variety of other forms giving utility functions that represent quasilinear tastes that do not have linear indifference curves. The indifference curves in Graph 5.11, for instance, are derived from the function u(x 1, x 2 ) = α lnx 1 + x 2, and α varies as is indicated in the panels of the graph. 5B.2.3 Homothetic versus Quasilinear Tastes It can easily be seen from these graphs of quasilinear tastes that, in general, quasilinear tastes are not homothetic because the MRS is constant along any vertical line and thus generally not along a ray emanating from the origin. The same intuition arises from our mathematical formulation of utility functions that represent quasilinear tastes. In equation (5.17), we demonstrated that the MRS implied by (5.16) is (dv/dx 1 ). In order for tastes to be homothetic, the MRS evaluated at (tx 1, tx 2 ) would have to be the same as the MRS evaluated at (x 1, x 2 ), which implies dv(tx 1 )/dx 1 would have to be equal to dv(x 1 )/dx 1. But the only way that can be true is if v is a linear function of x 1 where x 1 drops out when we take the derivative of v with respect to x 1.

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