Utility

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In economics, utility is a measure of the satisfaction that a certain person has from a certain state of the world. Over time, the term has been used in at least two different meanings.

Contents

The relationship between these two kinds of utility functions is highly controversial among both economists and ethicists.

Utility function

Consider a set of alternatives among which a person has a preference ordering. A utility function represents that ordering if it is possible to assign a real number to each alternative in such a manner that alternative a is assigned a number greater than alternative b if and only if the individual prefers alternative a to alternative b. In this situation someone who selects the most preferred alternative is necessarily also selecting the alternative that maximizes the associated utility function.

Suppose James has utility function such that is the number of apples and is the number of chocolates. Alternative A has apples and chocolates; alternative B has apples and chocolates. Putting the values into the utility function yields for alternative A and for B, so James prefers alternative B. In general economic terms, a utility function ranks preferences concerning a set of goods and services.

Gérard Debreu derived the conditions required for a preference ordering to be representable by a utility function. [1] For a finite set of alternatives, these require only that the preference ordering is complete (so the individual is able to determine which of any two alternatives is preferred or that they are indifferent), and that the preference order is transitive.

If the set of alternatives is not finite (for example because even if the number of goods is finite, the quantity chosen can be any real number on an interval) there exists a continuous utility function representing a consumer's preferences if and only if the consumer's preferences are complete, transitive and continuous. [2]

Applications

Utility can be represented through sets of indifference curve, which are level curves of the function itself, and which plot the combination of commodities that an individual would accept to maintain a given level of satisfaction. Combining indifference curves with budget constraints allows for derivation of individual demand curves.

A diagram of a general indifference curve is shown below (Figure 1). The vertical axes and the horizontal axes represent an individual's consumption of commodity Y and X respectively. All the combinations of commodity X and Y along the same indifference curve are regarded indifferently by individuals, which means all the combinations along an indifference curve result in the same value of utility.

Figure 1 A simple diagram of Indifference curve.png
Figure 1

Individual utility and social utility can be construed as the value of a utility function and a social welfare function respectively. When coupled with production or commodity constraints, by some assumptions these functions can be used to analyze Pareto efficiency, such as illustrated by Edgeworth boxes in contract curves. Such efficiency is a major concept in welfare economics.

Preference

While preferences are the conventional foundation of choice theory in microeconomics, it is often convenient to represent preferences with a utility function. Let X be the consumption set, the set of all mutually-exclusive baskets the consumer could conceivably consume. The consumer's utility function ranks each possible outcome in the consumption set. If the consumer strictly prefers x to y or is indifferent between them, then .

For example, suppose a consumer's consumption set is X = {nothing, 1 apple,1 orange, 1 apple and 1 orange, 2 apples, 2 oranges}, and his utility function is u(nothing) = 0, u(1 apple) = 1, u(1 orange) = 2, u(1 apple and 1 orange) = 5, u(2 apples) = 2 and u(2 oranges) = 4. Then this consumer prefers 1 orange to 1 apple, but prefers one of each to 2 oranges.

In micro-economic models, there are usually a finite set of L commodities, and a consumer may consume an arbitrary amount of each commodity. This gives a consumption set of , and each package is a vector containing the amounts of each commodity. For the example, there are two commodities: apples and oranges. If we say apples is the first commodity, and oranges the second, then the consumption set is and u(0, 0) = 0, u(1, 0) = 1, u(0, 1) = 2, u(1, 1) = 5, u(2, 0) = 2, u(0, 2) = 4 as before. For u to be a utility function on X, however, it must be defined for every package in X, so now the function needs to be defined for fractional apples and oranges too. One function that would fit these numbers is

Preferences have three main properties:

Assume an individual has two choices, A and B. By ranking the two choices, one and only one of the following relationships is true: an individual strictly prefers A (A>B); an individual strictly prefers B (B>A); an individual is indifferent between A and B (A=B). Either a ≥ b OR b ≥ a (OR both) for all (a,b)

Individuals' preferences are consistent over bundles. If an individual prefers bundle A to bundle B, and prefers bundle B to bundle C, then it can be assumed that the individual prefers bundle A to bundle C. (If a ≥ b and b ≥ c, then a ≥ c for all (a,b,c)).

If a bundle A contains all the goods that a bundle B contains, but A also contains more of at least one good than B, then the individual prefers A over B. [3] If, for example, bundle A={1 apple,2 oranges}, and bundle B={1 apple,1 orange}, then A is preferred over B.

Revealed preference

It was recognized that utility could not be measured or observed directly, so instead economists devised a way to infer relative utilities from observed choice. These 'revealed preferences', as termed by Paul Samuelson, were revealed e.g. in people's willingness to pay:

Utility is assumed to be correlative to Desire or Want. It has been argued already that desires cannot be measured directly, but only indirectly, by the outward phenomena which they cause: and that in those cases with which economics is mainly concerned the measure is found by the price which a person is willing to pay for the fulfillment or satisfaction of his desire. [4] :78

Functions

Utility functions, expressing utility as a function of the amounts of the various goods consumed, are treated as either cardinal or ordinal, depending on whether they are or are not interpreted as providing more information than simply the rank ordering of preferences among bundles of goods, such as information concerning the strength of preferences.

Cardinal

Cardinal utility states that the utilities obtained from consumption can be measured and ranked objectively and are representable by numbers. [5] There are fundamental assumptions of cardinal utility. Economic agents should be able to rank different bundles of goods based on their own preferences or utilities, and also sort different transitions of two bundles of goods. [6]

A cardinal utility function can be transformed to another utility function by a positive linear transformation (multiplying by a positive number, and adding some other number); however, both utility functions represent the same preferences. [7]

When cardinal utility is assumed, the magnitude of utility differences is treated as an ethically or behaviorally significant quantity. For example, suppose a cup of orange juice has utility of 120 "utils", a cup of tea has a utility of 80 utils, and a cup of water has a utility of 40 utils. With cardinal utility, it can be concluded that the cup of orange juice is better than the cup of tea by exactly the same amount by which the cup of tea is better than the cup of water. Formally, this means that if a person has a cup of tea, he or she would be willing to take any bet with a probability, p, greater than .5 of getting a cup of juice, with a risk of getting a cup of water equal to 1-p. One cannot conclude, however, that the cup of tea is two thirds of the goodness of the cup of juice, because this conclusion would depend not only on magnitudes of utility differences, but also on the "zero" of utility. For example, if the "zero" of utility was located at -40, then a cup of orange juice would be 160 utils more than zero, a cup of tea 120 utils more than zero. Cardinal utility can be considered as the assumption that utility can be measured by quantifiable characteristics, such as height, weight, temperature, etc.

Neoclassical economics has largely retreated from using cardinal utility functions as the basis of economic behavior. A notable exception is in the context of analyzing choice with conditions of risk (see below).

Sometimes cardinal utility is used to aggregate utilities across persons, to create a social welfare function.

Ordinal

Instead of giving actual numbers over different bundles, ordinal utilities are only the rankings of utilities received from different bundles of goods or services. [5] For example, ordinal utility could tell that having two ice creams provide a greater utility to individuals in comparison to one ice cream but could not tell exactly how much extra utility received by the individual. Ordinal utility, it does not require individuals to specify how much extra utility he or she received from the preferred bundle of goods or services in comparison to other bundles. They are only required to tell which bundles they prefer.

When ordinal utilities are used, differences in utils (values assumed by the utility function) are treated as ethically or behaviorally meaningless: the utility index encodes a full behavioral ordering between members of a choice set, but tells nothing about the related strength of preferences. For the above example, it would only be possible to say that juice is preferred to tea to water. Thus, ordinal utility utilizes comparisons, such as "preferred to", "no more", "less than", etc.

If a function is ordinal and non-negative, it is equivalent to the function , because taking the square is an increasing monotone (or monotonic) transformation. This means that the ordinal preference induced by these functions is the same (although they are two different functions). In contrast, if is cardinal, it is not equivalent to .

Examples

In order to simplify calculations, various alternative assumptions have been made concerning details of human preferences, and these imply various alternative utility functions such as:

Most utility functions used for modeling or theory are well-behaved. They are usually monotonic and quasi-concave. However, it is possible for rational preferences not to be representable by a utility function. An example is lexicographic preferences which are not continuous and cannot be represented by a continuous utility function. [8]

Marginal utility

Economists distinguish between total utility and marginal utility. Total utility is the utility of an alternative, an entire consumption bundle or situation in life. The rate of change of utility from changing the quantity of one good consumed is termed the marginal utility of that good. Marginal utility therefore measures the slope of the utility function with respect to the changes of one good. [9] Marginal utility usually decreases with consumption of the good, the idea of "diminishing marginal utility". In calculus notation, the marginal utility of good X is . When a good's marginal utility is positive, additional consumption of it increases utility; if zero, the consumer is satiated and indifferent about consuming more; if negative, the consumer would pay to reduce his consumption. [10]

Law of diminishing marginal utility

Rational individuals only consume additional units of goods if it increases the marginal utility. However, the law of diminishing marginal utility means an additional unit consumed brings a lower marginal utility than that brought by the previous unit consumed. For example, drinking one bottle of water makes a thirsty person satisfied; as the consumption of water increases, he may feel begin to feel bad which causes the marginal utility to decrease to zero or even become negative. Furthermore, this is also used to analyze progressive taxes as the greater taxes can result in the loss of utility.

Marginal rate of substitution (MRS)

Marginal rate of substitution is the slope of the indifference curve, which measures how much an individual is willing to switch from one good to another. Using a mathematic equation, keeping U (x1,x2) constant. Thus, MRS is how much an individual is willing to pay for consuming a greater amount of x1.

MRS is related to marginal utility. The relationship between marginal utility and MRS is: [9]

Expected utility

Expected utility theory deals with the analysis of choices among risky projects with multiple (possibly multidimensional) outcomes.

The St. Petersburg paradox was first proposed by Nicholas Bernoulli in 1713 and solved by Daniel Bernoulli in 1738, although the Swiss mathematician Gabriel Cramer proposed taking the expectation of a square-root utility function of money in an 1728 letter to N. Bernoulli. D. Bernoulli argued that the paradox could be resolved if decision-makers displayed risk aversion and argued for a logarithmic cardinal utility function. (Analysis of international survey data during the 21st century has shown that insofar as utility represents happiness, as for utilitarianism, it is indeed proportional to log of income.)

The first important use of the expected utility theory was that of John von Neumann and Oskar Morgenstern, who used the assumption of expected utility maximization in their formulation of game theory.

In finding the probability-weighted average of the utility from each possible outcome:

Von Neumann–Morgenstern

Von Neumann and Morgenstern addressed situations in which the outcomes of choices are not known with certainty, but have probabilities associated with them.

A notation for a lottery is as follows: if options A and B have probability p and 1  p in the lottery, we write it as a linear combination:

More generally, for a lottery with many possible options:

where .

By making some reasonable assumptions about the way choices behave, von Neumann and Morgenstern showed that if an agent can choose between the lotteries, then this agent has a utility function such that the desirability of an arbitrary lottery can be computed as a linear combination of the utilities of its parts, with the weights being their probabilities of occurring.

This is termed the expected utility theorem. The required assumptions are four axioms about the properties of the agent's preference relation over 'simple lotteries', which are lotteries with just two options. Writing to mean 'A is weakly preferred to B' ('A is preferred at least as much as B'), the axioms are:

  1. completeness: For any two simple lotteries and , either or (or both, in which case they are viewed as equally desirable).
  2. transitivity: for any three lotteries , if and , then .
  3. convexity/continuity (Archimedean property): If , then there is a between 0 and 1 such that the lottery is equally desirable as .
  4. independence: for any three lotteries and any probability p, if and only if . Intuitively, if the lottery formed by the probabilistic combination of and is no more preferable than the lottery formed by the same probabilistic combination of and then and only then .

Axioms 3 and 4 enable us to decide about the relative utilities of two assets or lotteries.

In more formal language: A von Neumann–Morgenstern utility function is a function from choices to the real numbers:

which assigns a real number to every outcome in a way that represents the agent's preferences over simple lotteries. Using the four assumptions mentioned above, the agent will prefer a lottery to a lottery if and only if, for the utility function characterizing that agent, the expected utility of is greater than the expected utility of :

.

Of all the axioms, independence is the most often discarded. A variety of generalized expected utility theories have arisen, most of which omit or relax the independence axiom.

Indirect utility

An indirect utility function gives the optimal attainable value of a given utility function, which depends on the prices of the goods and the income or wealth level that the individual possesses.

Money

One use of the indirect utility concept is the notion of the utility of money. The (indirect) utility function for money is a nonlinear function that is bounded and asymmetric about the origin. The utility function is concave in the positive region, representing the phenomenon of diminishing marginal utility. The boundedness represents the fact that beyond a certain amount money ceases being useful at all, as the size of any economy at that time is itself bounded. The asymmetry about the origin represents the fact that gaining and losing money can have radically different implications both for individuals and businesses. The non-linearity of the utility function for money has profound implications in decision-making processes: in situations where outcomes of choices influence utility by gains or losses of money, which are the norm for most business settings, the optimal choice for a given decision depends on the possible outcomes of all other decisions in the same time-period. [11]

Budget constraints

Individuals' consumptions are constrained by their budget allowance. The graph of budget line is a linear, downward-sloping line between X and Y axes. All the bundles of consumption under the budget line allow individuals to consume without using the whole budget as the total budget is greater than the total cost of bundles (Figure 2). If only considers prices and quantities of two goods in one bundle, a budget constraint could be formulated as , where and are prices of the two goods, and are quantities of the two goods.

Figure 2 General version of budget constraint.png
Figure 2

Constrained utility optimisation

Rational consumers wish to maximise their utility. However, as they have budget constraints, a change of price would affect the quantity of demand. There are two factors could explain this situation:

Discussion and criticism

Cambridge economist Joan Robinson famously criticized utility for being a circular concept: "Utility is the quality in commodities that makes individuals want to buy them, and the fact that individuals want to buy commodities shows that they have utility". [12] :48 Robinson also stated that because the theory assumes that preferences are fixed this means that utility is not a testable assumption. This is so because if we observe changes of peoples' behavior in relation to a change in prices or a change in budget constraint we can never be sure to what extent the change in behavior was due to the change of price or budget constraint and how much was due to a change of preference. [13] [ unreliable source ] This criticism is similar to that of the philosopher Hans Albert who argued that the ceteris paribus (all else equal) conditions on which the marginalist theory of demand rested rendered the theory itself a meaningless tautology, incapable of being tested experimentally. [14] [ unreliable source ] In essence, a curve of demand and supply (a theoretical line of quantity of a product which would have been offered or requested for given price) is purely ontological and could never have been demonstrated empirically [ dubious discuss ].

Other questions of what arguments ought to be included in a utility function are difficult to answer, yet seem necessary to understanding utility. Whether people gain utility from coherence of wants, beliefs or a sense of duty is important to understanding their behavior in the utility organon. [15] Likewise, choosing between alternatives is itself a process of determining what to consider as alternatives, a question of choice within uncertainty. [16]

An evolutionary psychology theory is that utility may be better considered as due to preferences that maximized evolutionary fitness in the ancestral environment but not necessarily in the current one. [17]

Measuring utility functions

There are many empirical works trying to estimate the form of utility functions of agents with respect to money. [18]

See also

Related Research Articles

In welfare economics, a Pareto improvement formalizes the idea of an outcome being "better in every possible way". A change is called a Pareto improvement if it leaves everyone in a society better-off. A situation is called Pareto efficient or Pareto optimal if all possible Pareto improvements have already been made; in other words, there are no longer any ways left to make one person better-off, without making some other person worse-off.

<span class="mw-page-title-main">Indifference curve</span> Concept in economics

In economics, an indifference curve connects points on a graph representing different quantities of two goods, points between which a consumer is indifferent. That is, any combinations of two products indicated by the curve will provide the consumer with equal levels of utility, and the consumer has no preference for one combination or bundle of goods over a different combination on the same curve. One can also refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. In other words, an indifference curve is the locus of various points showing different combinations of two goods providing equal utility to the consumer. Utility is then a device to represent preferences rather than something from which preferences come. The main use of indifference curves is in the representation of potentially observable demand patterns for individual consumers over commodity bundles.

In welfare economics and social choice theory, a social welfare function—also called a socialordering, ranking, utility, or choicefunction—is a function that ranks a set of social states by their desirability. A social welfare function may yield several possible outcomes; each person's preferences are combined in some way to determine which outcome is considered better by society as a whole.

The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption, by maximizing utility subject to a consumer budget constraint. Factors influencing consumers' evaluation of the utility of goods include: income level, cultural factors, product information and physio-psychological factors.

<span class="mw-page-title-main">Maximal and minimal elements</span> Element that is not ≤ (or ≥) any other element

In mathematics, especially in order theory, a maximal element of a subset of some preordered set is an element of that is not smaller than any other element in . A minimal element of a subset of some preordered set is defined dually as an element of that is not greater than any other element in .

In economics, the marginal rate of substitution (MRS) is the rate at which a consumer can give up some amount of one good in exchange for another good while maintaining the same level of utility. At equilibrium consumption levels, marginal rates of substitution are identical. The marginal rate of substitution is one of the three factors from marginal productivity, the others being marginal rates of transformation and marginal productivity of a factor.

The expected utility hypothesis is a foundational assumption in mathematical economics concerning decision making under uncertainty. It postulates that rational agents maximize utility, meaning the subjective desirability of their actions. Rational choice theory, a cornerstone of microeconomics, builds this postulate to model aggregate social behaviour.

Utility maximization was first developed by utilitarian philosophers Jeremy Bentham and John Stuart Mill. In microeconomics, the utility maximization problem is the problem consumers face: "How should I spend my money in order to maximize my utility?" It is a type of optimal decision problem. It consists of choosing how much of each available good or service to consume, taking into account a constraint on total spending (income), the prices of the goods and their preferences.

In microeconomics, a consumer's Marshallian demand function is the quantity they demand of a particular good as a function of its price, their income, and the prices of other goods, a more technical exposition of the standard demand function. It is a solution to the utility maximization problem of how the consumer can maximize their utility for given income and prices. A synonymous term is uncompensated demand function, because when the price rises the consumer is not compensated with higher nominal income for the fall in their real income, unlike in the Hicksian demand function. Thus the change in quantity demanded is a combination of a substitution effect and a wealth effect. Although Marshallian demand is in the context of partial equilibrium theory, it is sometimes called Walrasian demand as used in general equilibrium theory.

In economics, an ordinal utility function is a function representing the preferences of an agent on an ordinal scale. Ordinal utility theory claims that it is only meaningful to ask which option is better than the other, but it is meaningless to ask how much better it is or how good it is. All of the theory of consumer decision-making under conditions of certainty can be, and typically is, expressed in terms of ordinal utility.

Revealed preference theory, pioneered by economist Paul Anthony Samuelson in 1938, is a method of analyzing choices made by individuals, mostly used for comparing the influence of policies on consumer behavior. Revealed preference models assume that the preferences of consumers can be revealed by their purchasing habits.

Constant elasticity of substitution (CES), in economics, is a property of some production functions and utility functions. Several economists have featured in the topic and have contributed in the final finding of the constant. They include Tom McKenzie, John Hicks and Joan Robinson. The vital economic element of the measure is that it provided the producer a clear picture of how to move between different modes or types of production.

Competitive equilibrium is a concept of economic equilibrium, introduced by Kenneth Arrow and Gérard Debreu in 1951, appropriate for the analysis of commodity markets with flexible prices and many traders, and serving as the benchmark of efficiency in economic analysis. It relies crucially on the assumption of a competitive environment where each trader decides upon a quantity that is so small compared to the total quantity traded in the market that their individual transactions have no influence on the prices. Competitive markets are an ideal standard by which other market structures are evaluated.

In decision theory, the von Neumann–Morgenstern (VNM) utility theorem demonstrates that rational choice under uncertainty involves making decisions that take the form of maximizing the expected value of some cardinal utility function. This function is known as the von Neumann–Morgenstern utility function. The theorem forms the foundation of expected utility theory.

In economics, and in other social sciences, preference refers to an order by which an agent, while in search of an "optimal choice", ranks alternatives based on their respective utility. Preferences are evaluations that concern matters of value, in relation to practical reasoning. Individual preferences are determined by taste, need, ..., as opposed to price, availability or personal income. Classical economics assumes that people act in their best (rational) interest. In this context, rationality would dictate that, when given a choice, an individual will select an option that maximizes their self-interest. But preferences are not always transitive, both because real humans are far from always being rational and because in some situations preferences can form cycles, in which case there exists no well-defined optimal choice. An example of this is Efron dice.

In economics, the Debreu's theorems are preference representation theorems—statements about the representation of a preference ordering by a real-valued utility function. The theorems were proved by Gerard Debreu during the 1950s.

In decision theory, a multi-attribute utility function is used to represent the preferences of an agent over bundles of goods either under conditions of certainty about the results of any potential choice, or under conditions of uncertainty.

In economics, dichotomous preferences (DP) are preference relations that divide the set of alternatives to two subsets, "Good" and "Bad".

In utility theory, the responsive set (RS) extension is an extension of a preference-relation on individual items, to a partial preference-relation of item-bundles.

In theoretical economics, an abstract economy is a model that generalizes both the standard model of an exchange economy in microeconomics, and the standard model of a game in game theory. An equilibrium in an abstract economy generalizes both a Walrasian equilibrium in microeconomics, and a Nash equilibrium in game-theory.

References

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Further reading

Archived 30 October 2015 at the Wayback Machine , Possession and perhaps also Task