Econ 101 Principles of Microeconomics Business Learning Center Spring 2005 Week 5

Maximizing Utility

Last Monday I bored the hell out of you with a soporic lecture about consumer theory. I saw glazed eyes, students nodding o, and otherwise complete and utter terebration. So once more.....Indierence Curves are graphical representations of preferences. They are depicted over dierent consumption bundles to which the consumer is indierent. Each indierence curve represents a dierent level of utility. The budget constraint is simply the set of aordable consumption bundles that fully exhaust the income of the consumer. If we have two goods, x and y, and they have respective prices given by px and py , then the equation for the budget line is given by

I = px x + py y

(1)

The objective of the consumer is to maximize utility. To do this they need to reach the highest indierence curve possible given their budget constraint. There are three cases that we consider:

1. Typical Case - In the typical case there is some degree of substitutability between the two goods, though this is not perfect. This is the case we will work with most often.

Qy

Typical Case

20 15 10 5 M RS =
papples poranges

10

15

20

25 Qx

30

35

In the above gure utility is maximized where the slope of the budget line equals the slope of the indierence curve. This is called the tangency condition and can be stated as M RS = px py (2)

where M RS is the marginal rate of substitution (the slope of the indierence curve). 2. Perfect Complements - In this case there is NO degree of substitution between the two goods and hence, the MRS is undened. Therefore, there is no tangency condition but the principle idea still remains; nd the highest level indierence curve that is on the budget line. The following gure depicts this.

Perfect Complements Left Shoes

4 Optimal Poin of Consumption 3 2 1 BL 1 2 3 4 Right Shoes

Notice that in these cases, you will still be at an interior point, however the MRS is not dened because the indierence curves have kinks and hence, are not dierentiable. 3. Perfect Substitutes - For the perfect substitute case, the goods are perfect substitutes for one another at some ratio. In this case, there will not be an interior solution, the consumer will nd it optimal to consume all of one good and none of the other. Which one she consumes will depend on which one is relatively cheaper. The following gure depicts this.

Perfect Substitutes Wooden Pencils

4 3 2 1

Optimal Point of Consumption

Mechanical Pencils

Income and Substitution Eects

When the price of a particular good changes, there are two eects to consider when analyzing the consumers problem: 1. They will tend to try and substitute away from the eects of the price increase. That is, if the price of good x goes up, then they will try and consume more of good y instead of x because it has become relatively more cheaper. This is called the Substitution Eect. 2. Their real income has changed, and this will have an impact on their consumption decisions. For example, if the price of good x goes up, then their real income has fallen, and if good x is a normal good then they will consume less of it. However, if good x is an inferior good than they will consume more of good x as their income falls. This is known as the Income Eect. How do we quantify these? Well go through an example. 4

2.1

Example

Suppose that from consuming two goods x and y that I get utility from these two goods given by U (x, y) = xy. If I hold a utility level constant, and vary the possible x s and y s then I will back out an indierence curve. For example, suppose we x U (x, y) = 8, then look at combinations of x and y that satisfy this. x y U (x, y) = 1 64 2 32 4 16 8 8 16 4 32 2 64 1 Table 1: This would give us an indierence curve for utility level U (x, y) = 8. One can do this for dierent utility levels to construct indierence curves. Next, well add our budget constraint. Suppose that px = $2 and py = $2 and that our income is $32. Then our budget line is xy = 8 8 8 8 8 8 8 8

I = px x + py y 32 = 2x + 2y

Call this budget line BL1 . Putting our budget constraint together with our indierence curves yields the following gure:

32 30 28 26 24 22 20 18 16 BL1 14 12 10 y 8 6 4 2 U (x, y) = 8 U (x, y) = 6 U (x, y) = 4 2 4 6 8 x 10 12 14 16 18 20 22 24 U (x, y) = 12 U (x, y) = 10

One can see from the gure that the optimal consumption point is where x = 8 and y = 8. The utility level the consumer achieves at this point is U (x, y) = 8.

Now suppose that the price of x changes so that pnew = $8. Then how do we get to the x income and substitution eects of this price change? First, draw in the new budget line, this is given by :

I = pnew x + py y x 32 = 8x + 2y

Call this budget line BL2 . This is shown in the following gure:

32 30 28 26 24 22 20 18 16 BL1 14 12 10 y 8 6 4 BL2 2 U (x, y) = 6 U (x, y) = 4 2 4 6 8 10 12 14 16 18 20 22 24 U (x, y) = 8 U (x, y) = 12 U (x, y) = 10

x new

One can see that the new optimal consumption point is where x = 2 and y = 8. Now to new get at the substitution and income eect, we do the following:

1. Label the optimal bundle prior to the the price increase point A. 2. Given new prices, nd the smallest income necessary to get the consumer back to their OLD level of utility. 3. Shift the NEW budget line up by the amount of income needed to achieve this. 4. Look at the new hypothetical optimal consumption point given this new budget line. Call this point B. The change in consumption levels from point A to this hypothetical point B is the substitution eect. 5. Now look at the optimal new consumption point that uses the new price pnew but the x old income level. Label this point C. 6. The dierence between point B and point C is the income eect.

Well do each of these steps in turn. First, given the new price increase what is the smallest amount of income the consumer needs to get back to their old utility level? Their old utility level was U (x , y ) = 8. So we need to get the consumer back to this level of utility: x y U (x, y) pnew x + py y x 1 64 8 $136 2 32 8 $80 4 16 8 $64 8 8 8 $80 Table 2: It looks like the minimum income needed to achieve the old utility level at the new prices is $64. This is step 2. Step 3 is to shift the NEW budget line BL2 for this new income level and call it BL3 . This is shown in the following gure.

32 30 28 BL3 26 24 22 20 18

B
16 BL1 14 12 10 y 8 6 4 BL2 2 U (x, y) = 6 U (x, y) = 4 2 4 6 8 10 12 14 16 18 20 22 24 U (x, y) = 8

A
U (x, y) = 12 U (x, y) = 10

x new x h Income Eect

Substitution Eect

10

What is the optimal consumption bundle at this new point? We see that given the budget line BL3 that the optimal consumption of x is x = 4. Here, x is for optimal hypothetical h h consumption bundle. Note that at point A, x = 8 and at point B, x = 4. Therefore, h substitution eect is equal to 4. Next, the real new consumption point is given at point C where x = 2. The dierence between x = 4 and x = 2 is 2, hence the income new h new eect is equal to 2.

Income Eect and Inferior Goods

The substitution eect of a price increase always follows the law of demand. That is, if the price goes up, the substitution eect will be a decrease in the quantity demanded of that good. The income eect can go either way.

1. Income eect is the same direction as substitution eect for normal goods. That is, they reinforce one another. 2. The income eect is in the opposite direction as the substitution eect for inferior goods, they oppose one another.

Now, the overall change in consumption is the some of these two eects. That is,

change in consumption = substitution eect + income eect

(3)

The rst case is probably the typical case where we know the law of demand will hold because the substitution and income eect move in the same direction. However, the second case it is unclear what will happen? Will the substitution or income eect dominate? Most of the time economists think that the substitution eect dominates. However, it is perfectly possible for the income eect to dominate the substitution eect. In this rare case the law of demand is violated. For these goods that violate the law of demand, they are called Gien goods, They are mostly a theoretical curiosity, but nonetheless are possible to exist.

11

What the Heck are we Doing?

First, it may seem counter-intuitive that we vary income to get at the substitution eect, but in fact this makes perfect sense. We want to nd the change in consumption from a price increase, that is entirely due to substitution between the two goods. Well, we vary the income to get the consumer back on their old indierence curve so that any change in consumption is entirely due to the substitutability between the two goods. This is the substitution eect. Anything left over is entirely due to income eect.

12