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.

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 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

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

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

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

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 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

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

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)

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

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

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

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

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

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

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

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

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  = 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-0.5 - PX = 0 L/Y = 0.5Y-0.5 - PY = 0 L/ = I - PXX - PYY = 0

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

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

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

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)

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

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

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 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

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

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

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

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*:

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

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 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

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

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