Econ 50: Modified Section 4

October 16, 2015

1 Clarification
1. Perfect complements: e.g. five Polo-shirts (x) with every pair of jeans (y).
2. Free disposal: will be made explicit in exams.

2 The Consumers Problem

When faced with a consumers problem of the form

max U (x, y)
s.t. Px x + Py y I and x, y 0
the standard way to solve the problem is to combine the tangency condition
M Ux Px
M Uy = Py (intuition?)
and the budget constraint written as an equality
Px x + Py y = I
to solve for the demand functions x(Px , Py , I) and y(Px , Py , I). However, there are a
caveats before jumping in and applying this method.
You will want to consider the following:
1) Is U (x, y) strictly monotonic in x and y? If U is strictly monotonic in x and y, the
budget constraint will hold with equality, meaning the consumer will spend all his income.
That is, we will have Px x + Py y = I . What if U is strictly monotonic in x but not y?
Here the consumer will also spend all his income, because he can always increase his utility
through buying more x.

A substantial part of these notes is based on notes from a previous TA. These notes are at best a
summary of the section. They are not intended to and will not serve as a substitute to attending the section.

1
 2) Is U strictly monotonic and strictly convex, and is the budget constraint linear? If
these three conditions hold, we can use the tangency condition:
M Ux Px
M Uy = Py

3) Do we have to worry about corner solutions? That is, will the consumer ever want
to buy zero of one of the goods? When should we worry about corner solutions? Some
common places are if the goods are perfect substitutes (e.g. U (x, y) = x + y) or if utility is
quasilinear (e.g. U (x, y) = ln(x) + y). In general, if the indifference curves intersect either
the x or y axis you may need to worry about corner solutions. (Another way: Do we satisfy
the positivity constraints?)

3 Examples with Common Utility Functions

Perfect substitutes: e.g. U (x, y) = 2x+5y. Beware of corner solutions. Utility is not strictly
convex, so we cant use the tangency condition. It is likely the consumer will demand only
one of the two goods, that being the one that gives better value for money.

Px
I 2
( Px , 0)
Py < 5
Px

(x , y ) = (0, PIy ) Py > 2
5
(x, 2I 2 x) for 0 x
I Px 2
5Px 5 Px Py = 5

Perfect complements: e.g. U (x, y) = min(2x, 3y). Utility is not strictly convex, and indif-
ference curves dont have a slope at every point. We cant use the tangency condition, but
the intuition applies.

2
 3I 2I
(x , y ) = ( , )
3Px + 2Py 3Px + 2Py

Quasilinear: e.g. U (x, y) = ln(x) + y. We can use the tangency condition, but watch out
for corner solutions. Check that the demand you find is not negative, and if it is then look
for corner solutions. Demand functions may need to be defined piecewise.

(
P
( Pxy , PIy 1) I Py
(x , y ) =
( PIx , 0) I < Py

Cobb-Douglas: e.g. U (x, y) = x3 y 2 . The most well-behaved of all utility functions. The
tangency condition can be used safely, and you never need to worry about corner solutions.
(constant income share)

3I 2I
(x , y ) = ( , )
5Px 5Py

Utility where one good is a bad: e.g. U (x, y) = x y. If one good gives negative marginal
utility (i.e. it is a bad), the consumer will spend all his income on the other good.
I
(x , y ) = ( , 0)
Px
Utility that gives concave indifference curves: e.g. U (x, y) = x2 + y 2 . The usual tangency

3
condition will yield the point of minimum utility on the budget line. Look for corner
solutions.

I
( Px , 0)
Px < PY
I
(x , y ) = (0, Py ) P x > Py
( I , 0) or (0, I ) P = P

Px Py x y

4
4 Practice Exam Problem

Practice exam question: demand functions

Ran has a total monthly budget of I dollars, which he allocates to chocolate bars (c) and
boxes of salad (s).

His utility function is given by U(c,s) = c 0.7 s0.5 .

1) Derive Rans demand functions c * (Pc ,Ps,I) and s* (Pc ,Ps,I) , showing your work.

2) Draw the Price Consumption Curve (PCC) given that income is fixed at I=$24
and the price of boxes of salad is fixed at $5.

3) Referring to your PCC, explain whether chocolate bars and salads are substitutes
or complements.

4) Draw the Income Consumption Curve (ICC), given that Pc = $1 and Ps = $5 .

5) Explain using the ICC you have drawn whether each good is normal or inferior.

6) Draw the Engel Curve for boxes of salad for P

c = $1 and Ps = $5 .

5
5 Practice Exam Problem: Solutions

6
7
8
9