Chapter 4

UTILITY MAXIMIZATION
AND CHOICE
Copyright 2002 by South-Western, a division of Thomson Learning. All rights reserved.
MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION
WALTER NICHOLSON
Complaints about Economic
Approach
No real individuals make the kinds of
lightning calculations required for utility
maximization

The utility-maximization model predicts
many aspects of behavior even though
no one carries around a computer with
his utility function programmed into it
Complaints about Economic
Approach
The economic model of choice is
extremely selfish because no one has
solely self-centered goals

Nothing in the utility-maximization
model prevents individuals from deriving
satisfaction from doing good
Optimization Principle
To maximize utility, given a fixed amount
of income to spend, an individual will buy
the goods and services:
that exhaust his or her total income
for which the psychic rate of trade-off
between any goods (the MRS) is equal to
the rate at which goods can be traded for
one another in the marketplace
A Numerical Illustration
Assume that the individuals MRS = 1
He is willing to trade one unit of X for one
unit of Y
Suppose the price of X = $2 and the
price of Y = $1
The individual can be made better off
Trade 1 unit of X for 2 units of Y in the
marketplace
The Budget Constraint
Assume that an individual has I dollars
to allocate between good X and good Y
P
X
X + P
Y
Y s I


Quantity of X
Quantity of Y The individual can afford
to choose only combinations
of X and Y in the shaded
triangle
Y
P
I
If all income is spent
on Y, this is the amount
of Y that can be purchased
X
P
I
If all income is spent
on X, this is the amount
of X that can be purchased
First-Order Conditions for a
Maximum
We can add the individuals utility map
to show the utility-maximization process


Quantity of X
Quantity of Y
U
1

A
The individual can do better than point A
by reallocating his budget
U
3

C
The individual cannot have point C
because income is not large enough
U
2

B
Point B is the point of utility
maximization
First-Order Conditions for a
Maximum
Utility is maximized where the indifference
curve is tangent to the budget constraint


Quantity of X
Quantity of Y
U
2

B
constraint budget of slope
Y
X
P
P
=
constant
curve ce indifferen of slope
=
=
U
dX
dY
MRS
dX
dY
P
P
U Y
X
= =
= constant
-
Second-Order Conditions for a
Maximum
The tangency rule is only necessary but
not sufficient unless we assume that MRS
is diminishing
if MRS is diminishing, then indifference curves
are strictly convex
If MRS is not diminishing, then we must
check second-order conditions to ensure
that we are at a maximum


Second-Order Conditions for a
Maximum
The tangency rule is only necessary but
not sufficient unless we assume that MRS
is diminishing


Quantity of X
Quantity of Y
U
1

B
U
2

A
There is a tangency at point A,
but the individual can reach a higher
level of utility at point B
Corner Solutions
In some situations, individuals preferences
may be such that they can maximize utility
by choosing to consume only one of the
goods


Quantity of X
Quantity of Y U
2
U
1
U
3

A
Utility is maximized at point A
At point A, the indifference curve
is not tangent to the budget constraint
The n-Good Case
The individuals objective is to maximize
utility = U(X
1
,X
2
,,X
n
)
subject to the budget constraint
I = P
1
X
1
+ P
2
X
2
++ P
n
X
n


Set up the Lagrangian:
L = U(X
1
,X
2
,,X
n
) + (I-P
1
X
1
- P
2
X
2
--P
n
X
n
)

The n-Good Case
First-order conditions for an interior
maximum:
cL/cX
1
= cU/cX
1
- P
1
= 0
cL/cX
2
= cU/cX
2
- P
2
= 0



cL/cX
n
= cU/cX
n
- P
n
= 0
cL/c = I - P
1
X
1
- P
2
X
2
- - P
n
X
n
= 0
Implications of First-Order
Conditions
For any two goods,
j
i
j
i
P
P
X U
X U
=
c c
c c
/
/
This implies that at the optimal
allocation of income
j
i
j i
P
P
X X MRS = ) for (
Interpreting the Lagrangian
Multiplier
is the marginal utility of an extra dollar
of consumption expenditure
the marginal utility of income
n
n
P
X U
P
X U
P
X U c c
= =
c c
=
c c
=
/
...
/ /
2
2
1
1
n
X X X
P
MU
P
MU
P
MU
n
= = = = ...
2 1
2 1
Interpreting the Lagrangian
Multiplier
For every good that an individual buys,
the price of that good represents his
evaluation of the utility of the last unit
consumed
how much the consumer is willing to pay
for the last unit

=
i
X
i
MU
P
Corner Solutions
When corner solutions are involved, the
first-order conditions must be modified:
cL/cX
i
= cU/cX
i
- P
i
s 0 (i = 1,,n)
If cL/cX
i
= cU/cX
i
- P
i
< 0 then X
i
= 0
This means that

c c
>
i
X
i
i
MU
X U
P
/
Any good whose price exceeds its marginal
value to the consumer will not be purchased

Cobb-Douglas Demand
Functions
Cobb-Douglas utility function:
U(X,Y) = X
o
Y
|

Setting up the Lagrangian:
L = X
o
Y
|
+ (I - P
X
X - P
Y
Y)
First-order conditions:
cL/cX = oX
o-1
Y
|
- P
X
= 0
cL/cY = |X
o
Y
|-1
- P
Y
= 0
cL/c = I - P
X
X

- P
Y
Y

= 0


Cobb-Douglas Demand
Functions
First-order conditions imply:
oY/|X = P
X
/P
Y

Since o + | = 1:
P
Y
Y = (|/o)P
X
X = [(1- o)/o]P
X
X
Substituting into the budget constraint:
I = P
X
X + [(1- o)/o]P
X
X = (1/o)P
X
X

Cobb-Douglas Demand
Functions
Solving for X yields


Solving for Y yields


X
P
X
I o
= *
Y
P
Y
I |
= *
The individual will allocate o percent of
his income to good X and | percent of
his income to good Y


Cobb-Douglas Demand
Functions
The Cobb-Douglas utility function is
limited in its ability to explain actual
consumption behavior
the share of income devoted to particular
goods often changes in response to
changing economic conditions
A more general functional form might be
more useful in explaining consumption
decisions


CES Demand
Assume that o = 0.5
U(X,Y) = X
0.5
+ Y
0.5

Setting up the Lagrangian:
L =

X
0.5
+ Y
0.5
+ (I - P
X
X - P
Y
Y)
First-order conditions:
cL/cX = 0.5X
-0.5
- P
X
= 0
cL/cY = 0.5Y
-0.5
- P
Y
= 0
cL/c = I - P
X
X

- P
Y
Y

= 0

CES Demand
This means that
(Y/X)
0.5
= P
x
/P
Y

Substituting into the budget constraint,
we can solve for the demand functions:

] 1 [
*
Y
X
X
P
P
P
X
+
=
I
] 1 [
*
X
Y
Y
P
P
P
Y
+
=
I
CES Demand
In these demand functions, the share of
income spent on either X or Y is not a
constant
depends on the ratio of the two prices

The higher is the relative price of X (or
Y), the smaller will be the share of
income spent on X (or Y)

CES Demand
If o = -1,
U(X,Y) = X
-1
+ Y
-1

First-order conditions imply that
Y/X = (P
X
/P
Y
)
0.5

The demand functions are

] 1 [
*
5 . 0
|
|
.
|

\
|
+
=
X
Y
X
P
P
P
X
I
] 1 [
*
5 . 0
|
|
.
|

\
|
+
=
Y
X
Y
P
P
P
Y
I
CES Demand
The elasticity of substitution (o) is equal
to 1/(1-o)
when o = 0.5, o = 2
when o = -1, o = 0.5
Because substitutability has declined,
these demand functions are less
responsive to changes in relative prices
The CES allows us to illustrate a wide
variety of possible relationships
Indirect Utility Function
It is often possible to manipulate first-
order conditions to solve for optimal
values of X
1
,X
2
,,X
n

These optimal values will depend on the
prices of all goods and income



X*
n
= X
n
(P
1
,P
2
,,P
n
, I)
X*
1
= X
1
(P
1
,P
2
,,P
n
,I)
X*
2
= X
2
(P
1
,P
2
,,P
n
,I)

Indirect Utility Function
We can use the optimal values of the Xs
to find the indirect utility function
maximum utility = U(X*
1
,X*
2
,,X*
n
)
Substituting for each X*
i
we get
maximum utility = V(P
1
,P
2
,,P
n
,I)
The optimal level of utility will depend
indirectly on prices and income
If either prices or income were to change,
the maximum possible utility will change
Indirect Utility in the Cobb-
Douglas
If U = X
0.5
Y
0.5
, we know that
x
P
X
2
I
= *
Y
P
Y
2
I
= *
Substituting into the utility function, we get
5 0 5 0
5 0 5 0
2 2 2
. .
. .
utility maximum
Y X Y X
P P P P
I I I
=
|
|
.
|

\
|
|
|
.
|

\
|
=
Expenditure Minimization
Dual minimization problem for utility
maximization
allocating income in such a way as to achieve
a given level of utility with the minimal
expenditure
this means that the goal and the constraint
have been reversed
Expenditure level E
2
provides just enough to reach U
1

Expenditure Minimization
Quantity of X
Quantity of Y
U
1

Expenditure level E
1
is too small to achieve U
1

Expenditure level E
3
will allow the
individual to reach U
1
but is not the
minimal expenditure required to do so
A
Point A is the solution to the dual problem
Expenditure Minimization
The individuals problem is to choose
X
1
,X
2
,,X
n
to minimize
E = P
1
X
1
+ P
2
X
2
++P
n
X
n

subject to the constraint
U
1
= U(X
1
,X
2
,,U
n
)
The optimal amounts of X
1
,X
2
,,X
n
will
depend on the prices of the goods and
the required utility level
Expenditure Function
The expenditure function shows the
minimal expenditures necessary to
achieve a given utility level for a particular
set of prices
minimal expenditures = E(P
1
,P
2
,,P
n
,U)
The expenditure function and the indirect
utility function are inversely related
both depend on market prices but involve
different constraints
Expenditure Function from
the Cobb-Douglas
Minimize E = P
X
X + P
Y
Y subject to
U=X
0.5
Y
0.5
where U is the utility target
The Lagrangian expression is
L = P
X
X + P
Y
Y + (U - X
0.5
Y
0.5
)
First-order conditions are
cL/cX = P
X
- 0.5X
-0.5
Y
0.5
= 0
cL/cY = P
Y
- 0.5X
0.5
Y
-0.5
= 0
cL/c = U - X
0.5
Y
0.5

= 0

Expenditure Function from
the Cobb-Douglas
These first-order conditions imply that
P
X
X = P
Y
Y
Substituting into the expenditure function:
E = P
X
X* + P
Y
Y* = 2P
X
X*
Solving for optimal values of X* and Y*:



X
P
E
X
2
= *
Y
P
E
Y
2
= *
Expenditure Function from
the Cobb-Douglas
Substituting into the utility function, we
can get the indirect utility function



5 0 5 0
5 0 5 0
2 2 2
. .
. .
'
Y X Y X
P P
E
P
E
P
E
U =
|
|
.
|

\
|
|
|
.
|

\
|
=
So the expenditure function becomes
E = 2UP
X
0.5
P
Y
0.5



Important Points to Note:
To reach a constrained maximum, an
individual should:
spend all available income
choose a commodity bundle such that the
MRS between any two goods is equal to the
ratio of the goods prices
the individual will equate the ratios of marginal utility
to price for every good that is actually consumed

Important Points to Note:
Tangency conditions are only first-order
conditions
the individuals indifference map must exhibit
diminishing MRS
the utility function must be strictly quasi-
concave
Tangency conditions must also be modified
to allow for corner solutions
ratio of marginal utility to price will be lower for
goods that are not purchased
Important Points to Note:
The individuals optimal choices implicitly
depend on the parameters of his budget
constraint
choices observed will be implicit functions of
prices and income
utility will also be an indirect function of prices
and income
Important Points to Note:
The dual problem to the constrained utility-
maximization problem is to minimize the
expenditure required to reach a given utility
target
yields the same optimal solution as the primary
problem
leads to expenditure functions in which
spending is a function of the utility target and
prices