1. UTILITY MAXIMIZATION AND CHOICE
Chapter 4
UTILITY MAXIMIZATION
AND CHOICE
MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION
WALTER NICHOLSON
Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved.

2. 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

3. 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”

4. 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

5. A Numerical Illustration
Assume that the individual’s 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

6. The Budget Constraint
Assume that an individual has I dollars to allocate between good X and good Y
PXX + PYY  I
Quantity of Y
The individual can afford
to choose only combinations
of X and Y in the shaded
triangle
If all income is spent
on Y, this is the amount
of Y that can be purchased
If all income is spent
on X, this is the amount
of X that can be purchased
Quantity of X

7. First-Order Conditions for a Maximum
We can add the individual’s utility map to show the utility-maximization process U1 A
The individual can do better than point A
by reallocating his budget
Quantity of Y U3 C
The individual cannot have point C
because income is not large enough U2 B
Point B is the point of utility
maximization
Quantity of X

8. First-Order Conditions for a Maximum
Utility is maximized where the indifference curve is tangent to the budget constraint
Quantity of Y B U2
Quantity of X

9. 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

10. Second-Order Conditions for a Maximum
The tangency rule is only necessary but not sufficient unless we assume that MRS is diminishing
Quantity of Y U1 B U2 A
There is a tangency at point A,
but the individual can reach a higher
level of utility at point B
Quantity of X

11. Corner Solutions
In some situations, individuals’ preferences may be such that they can maximize utility by choosing to consume only one of the goods
At point A, the indifference curve
is not tangent to the budget constraint
Quantity of Y U2 U1 U3 A
Utility is maximized at point A
Quantity of X

12. L = U(X1,X2,…,Xn) + (I-P1X1- P2X2-…-PnXn)
The n-Good Case
The individual’s objective is to maximize
utility = U(X1,X2,…,Xn)
subject to the budget constraint
I = P1X1 + P2X2 +…+ PnXn
Set up the Lagrangian:
L = U(X1,X2,…,Xn) + (I-P1X1- P2X2-…-PnXn)

13. L/ = I - P1X1 - P2X2 - … - PnXn = 0
The n-Good Case
First-order conditions for an interior maximum:
L/X1 = U/X1 - P1 = 0
L/X2 = U/X2 - P2 = 0 •
L/Xn = U/Xn - Pn = 0
L/ = I - P1X1 - P2X2 - … - PnXn = 0

14. Implications of First-Order Conditions
For any two goods,
This implies that at the optimal allocation of income

15. Interpreting the Lagrangian Multiplier
 is the marginal utility of an extra dollar of consumption expenditure
the marginal utility of income

16. 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

17. L/Xi = U/Xi - Pi  0 (i = 1,…,n)
Corner Solutions
When corner solutions are involved, the first-order conditions must be modified:
L/Xi = U/Xi - Pi  0 (i = 1,…,n)
If L/Xi = U/Xi - Pi < 0 then Xi = 0
This means that
Any good whose price exceeds its marginal value to the consumer will not be purchased

18. Cobb-Douglas Demand Functions
Cobb-Douglas utility function:
U(X,Y) = XY
Setting up the Lagrangian:
L = XY + (I - PXX - PYY)
First-order conditions:
L/X = X-1Y - PX = 0
L/Y = XY-1 - PY = 0
L/ = I - PXX - PYY = 0

19. Cobb-Douglas Demand Functions
First-order conditions imply:
Y/X = PX/PY
Since  +  = 1:
PYY = (/)PXX = [(1- )/]PXX
Substituting into the budget constraint:
I = PXX + [(1- )/]PXX = (1/)PXX

20. Cobb-Douglas Demand Functions
Solving for X yields
Solving for Y yields
The individual will allocate  percent of his income to good X and  percent of his income to good Y

21. 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

22. CES Demand Assume that  = 0.5 U(X,Y) = X0.5 + Y0.5
Setting up the Lagrangian:
L = X0.5 + Y0.5 + (I - PXX - PYY)
First-order conditions:
L/X = 0.5X PX = 0
L/Y = 0.5Y PY = 0
L/ = I - PXX - PYY = 0

23. CES Demand This means that (Y/X)0.5 = Px/PY
Substituting into the budget constraint, we can solve for the demand functions:

24. 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)

25. CES Demand If  = -1, U(X,Y) = X-1 + Y-1
First-order conditions imply that
Y/X = (PX/PY)0.5
The demand functions are

26. CES Demand The elasticity of substitution () is equal to 1/(1-)
when  = 0.5,  = 2
when  = -1,  = 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

27. Indirect Utility Function
It is often possible to manipulate first-order conditions to solve for optimal values of X1,X2,…,Xn
These optimal values will depend on the prices of all goods and income •
X*n = Xn(P1,P2,…,Pn, I)
X*1 = X1(P1,P2,…,Pn,I)
X*2 = X2(P1,P2,…,Pn,I)

28. 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(P1,P2,…,Pn,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

29. Indirect Utility in the Cobb-Douglas
If U = X0.5Y0.5, we know that
Substituting into the utility function, we get

30. 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

31. Expenditure Minimization
Point A is the solution to the dual problem
Expenditure level E2 provides just enough to reach U1
Quantity of Y
Expenditure level E3 will allow the
individual to reach U1 but is not the
minimal expenditure required to do so
Expenditure level E1 is too small to achieve U1 U1
Quantity of X

32. Expenditure Minimization
The individual’s problem is to choose X1,X2,…,Xn to minimize
E = P1X1 + P2X2 +…+PnXn
subject to the constraint
U1 = U(X1,X2,…,Un)
The optimal amounts of X1,X2,…,Xn will depend on the prices of the goods and the required utility level

33. minimal expenditures = E(P1,P2,…,Pn,U)
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(P1,P2,…,Pn,U)
The expenditure function and the indirect utility function are inversely related
both depend on market prices but involve different constraints

34. Expenditure Function from the Cobb-Douglas
Minimize E = PXX + PYY subject to U’=X0.5Y0.5 where U’ is the utility target
The Lagrangian expression is
L = PXX + PYY + (U’ - X0.5Y0.5)
First-order conditions are
L/X = PX - 0.5X-0.5Y0.5 = 0
L/Y = PY - 0.5X0.5Y-0.5 = 0
L/ = U’ - X0.5Y0.5 = 0

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

36. Expenditure Function from the Cobb-Douglas
Substituting into the utility function, we can get the indirect utility function
So the expenditure function becomes
E = 2U’PX0.5PY0.5

37. 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

38. Important Points to Note:
Tangency conditions are only first-order conditions
the individual’s 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

39. Important Points to Note:
The individual’s 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

40. 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