Topic 1: Consumption choice under certainty

Two-goods model (one-period model)

Model elements:
Two goods: good 1 and good 2
Prices of the goods: P1 and P2
Total budget: I
The problem: What is the optimal consumption for each good?
A representative individuals utility function: U(x1, x2) with
assumptions: marginal utility is positive (more is better), and is a
decreasing (concave) function of x1 and x2, where x1 and x2 are
the quantities consumed for good 1 and good 2, respectively.
With given income I, the Individual has a budget constraint:
P1x1+P2x2<=I
Rationality assumption: Utility maximization
The consumption choice problem in a mathematical form:
max U ( x 1, x 2 )
x 1, x2

St.

P1 x 1+ P 2 x 2=I

This is a constrained maximization problem which can be solved by

using the Lagrange multiplier method. This problem becomes
max U ( x 1, x 2 ) + ( P1 x 1+ P 2 x 2I )
x 1, x2,

Optimization conditions:
1. First-order conditions:
U
MU 1
MU 1
= P1,
=
x1
P1
U
MU 2
MU 2
= P2 ,
=
x2
P2
P1 x 1+ P 2 x 2=I
2. Second-order conditions:
U(x1, x2) is a quasi-concave function (the indifference curves are
convex). Or
2
2
U 11 U 22 U 12 U 1 U 2 +U 22 U 1< 0 (This also implies U 11 <0U 22 <0 )
Where
U
2 U
U i=
, U ij =
xi
xi xj

(
(

)
)

From the first-order conditions,

MU 1 MU 2
=
=
P1
P2
Economic interpretation: This is the equal marginal principle.
Utility is maximized when the individual has equalized the
marginal utility per dollar of expenditure of the two goods.
can be regarded as the marginal utility of an extra dollar of
consumption expenditure or the marginal utility of income.
1

Question 1: For a n-goods model (x1, x2, , xn), what is the

equation representing the equal marginal principle?
Comparative analysis:
In the model, the optimal consumptions x1 and x2 are called
endogenous variables which are determined within the model.
P1, P2 and I are exogenous variables which are given outside of
the model. A comparative analysis is to find out how changes in
exogenous variables affect changes in endogenous variables.
For instance, if P1 decreases, what will happen to the optimal
choices x1 and x2?
There are two effects when P1 decreases.
Substitution effect: X1 is relatively cheaper. Thus, optimally,
more x1 is consumed.
Income effect: The real income increases. Thus, more x1 will be
consumed if x1 is a normal good.
Totally, the demand for x1 increases when P1 decreases. This is
the law of demand.
The price elasticity of demand: the percent change in quantity
demanded by the percent change in price.
Application: under what circumstance a firm can increase its
revenue by increasing it output price?
Revenue=PQ(P) (Q is a function of P)
dQ ( P )
d (PQ ( P ))
dQ( P)
Q( P)
=Q ( P ) + P
=Q ( P ) [1+
]
dP
dP
dP
P
dQ ( P )
Q ( P)
, where
is the price elasticity of demand. If the price
dP
P
elasticity is less than 1, the revenue will increase with the price.
Topic 2: Consumption and saving under certainty
Two-period model (with one good)
Model elements:
Two periods: time 0 (now) and time 1 (future)
A representative Consumer has a flow of incomes I0 and I1 at
time 0 and time 1, respectively.
The consumer has a utility function U(c0, c1) where c0 and c1 are
the consumption at time 0 and time 1, respectively.
The consumer can lend or borrow money at a constant interest
rate r.
The consumers problem is to maximize his utility subject to the
budget constraint.
2

max U ( c 0, c 1 )
c 0,c 1

St.

c 1=I 1+ ( 1+r ) ( I 0c 0)

Where I0-c0 is the consumers saving (if it is positive) or

borrowing (if it is negative). The constraint can be rewritten as
c 0+c 1 /(1+r )=I 0+ I 1/ (1+ r )
Question: Whats the meaning of this equation?
Utility function assumptions: time additively separable utility
function U ( c 0, c 1 )=u 0 ( c 0 )+ u1( c 1) where u0 and u1 are
1
u 0 where
increasing and concave functions. And, u 1=
1+
( 0) is a parameter which indicates how impatient the
consumer is, or the preference for present consumption.
Optimization conditions:
First-order conditions:
u 0
=
c0
1 u1
1
=

1+ c 1 1+r
c 0+c 1 /(1+r )=I 0+ I 1/ (1+ r )
Second-order conditions:
u0 is a concave function.
Thus, the optimal condition is
u 0 1+r u 1
=
c 0 1+ c 1
If the interest rate r increases, then c1 will increase because both
the substitution effect and the income effect are positive.
However, if the interest rate r increases, then the direction of c0
is unclear because the substitution effect is negative, but the
income effect is positive. Thus, its unclear that high interest rate
will come with high saving rate.
Impatience consumers ( > r
future (c0>c1).

will consume more now than

Question: Can a tax break for saving cause people save more?
Yes, when government give the tax breaks for income, the income
increases more than the increasing of consume, then the saving in
present will increase. But saving in the future is unclear.