Lecture 3: Constrained Optimisation

ECON7073 – Microeconomic Analysis

Ronald Stauber
Research School of Economics
Australian National University
Semester 1, 2023

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References and required reading

• Bowles & Halliday, Chapter 3 (you can skip sections

3.10, 3.13 and 3.14)

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Objectives

• See how the rational choice framework from Chapter 2 forms the
basis for mathematical models of economic behaviour.
• Recognize how preferences can be represented both in
mathematical form (a utility function) and graphical form (an
indifference curve map).
• Explain the difference between ordinal and cardinal utility.
• Understand constrained optimisation as method that economists
use to explain the actions that people take.
• Explain how people are constrained (e.g., by limited time) and
how these constraints give rise to opportunity costs and, along
with our preferences, to trade-offs.
• Use the rational choice framework to analyse difficult
policy-making choices, including how much of society’s resources
should be devoted to the abatement of environmental damages.

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Economic models: The map and the territory

• Maps are useful because they convey the necessary information,

not because they are an exact representation of the territory.
• In the same way, a good model is not an exact description of
reality, but a helpful guide that allows us to focus on the problem
we are trying to analyse/understand, without complicating the
picture with details that are not directly relevant to the problem
at hand.
• For example, most decision-making in an economic context
involves agents who are doing the best they can given the
circumstances they are in, and thus, preferences, beliefs and
constraints/rational choice models can be used as the foundation
for the analysis of most problems in economics.

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Scarce resources, trade-offs, and opportunity costs

• Economics is sometimes defined (rather narrowly) as the study of

how scarce resources should be best allocated.
• Many constraints that people face arise from the scarcity of
available resources (e.g., time, money, natural resources, etc.),
and thus choosing “the best they can” requires them to resolve
the resulting trade-offs in how to best allocate scarce resources
(should you spend your weekend studying or having fun?).

When two goods or activities x and y are both valued by a

decision-maker, but are constrained by the availability of the
same resources, the opportunity cost of x in terms of y is the
amount of y that the decision-maker must give up to be able to
get one additional unit of x.
More generally, the opportunity cost of a choice or activity is
sometimes defined as the (value of) the next-best option that
one must give up when selecting this choice or activity.
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Using mathematical methods to analyse trade-offs

• While the analysis of various trade-offs resulting from scarcity

just requires an application of the rational choice approach, it
can cumbersome to perform such an analysis based directly on a
description of the decision-maker’s preferences.
• Much more tractable rational choice models can be constructed
by first translating the decision-maker’s preferences into a
numerical representation (as we have done in previous lectures
when we used payoffs to describe preferences!).
• Such a numerical representation of preferences allows the
analyst/economist to use the mathematical methods of
constrained optimisation to describe the decision-making process
of an economic agent.

A constrained optimisation problem is a problem in which a

decision-maker chooses the values of one or more variables to
achieve an objective, subject to a constraint that determines the
feasible set of actions.
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Aside: The real line

• A real number is a decimal number of potentially infinite length,

such as 10.5, −4546, 0, −2.846666666 . . ., 1034.454466. (This is
not a rigorous formal mathematical definition, but it will do for
our purposes!)
• The set of all real numbers (the real line) is denoted by R, the set
of all non-negative (i.e., including zero) real numbers is denoted
by R+ , and the set of strictly positive real numbers is denoted by
R++ .
• For any two distinct a, b ∈ R such that a < b, (a, b) denotes the
open interval in R of numbers that are strictly greater than a and
strictly smaller than b, and [a, b] the closed interval in R of
numbers that are greater than or equal to a and smaller than or
equal to b.

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Aside: The real plane

• The real plane is the set of all ordered pairs (x, y) of two real
numbers x, y ∈ R. The real plane is denoted by R2 , as it is (by
definition) the Cartesian product R × R of the real line with itself.
Warning: Be careful to distinguish ordered pairs of real
numbers (x, y) ∈ R2 , from intervals (a, b) ⊂ R! (The distinction
should be clear from the context, and not from whether we use x
and y vs. a and b!)
• The set of all ordered pairs of non-negative real numbers, i.e., the
Cartesian product R+ × R+ , also referred to as the non-negative
orthant of R2 , is denoted by R2+ .

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Preferences and utility functions

• To analyse trade-offs when different goods or activities can be

chosen in various amounts, we often use ordered pairs (x, y) ∈ R2+
to denote consumption bundles of two goods, where x is the
amount consumed of the first good, and y the amount consumed
of the second good. (Higher-dimensional consumption bundles
described by ordered tuples of more than two numbers can also
be considered [⇝ ECON8025], but most relevant trade-offs can
be described and analysed based on two-good bundles.)
• Since R2+ is a “large” set, using the rational choice model based
directly on preferences defined over R2+ is cumbersome, so we
instead consider preferences that can be represented using a
numerical-valued utility/payoff function that maps R2+ to R:

A utility function u that maps R2+ to R represents preferences

over R2+ , if whenever a bundle (x, y) is at least as good as
a bundle (x′ , y ′ ) according to the given preferences, we have
u(x, y) ≥ u(x′ , y ′ ).
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Utility functions: Properties and interpretation

• Preferences that can be represented by a utility function must be

complete and transitive!
• In general, a utility function is a just a way of describing
preference rankings numerically, so that utility values and
differences in utility values have no intrinsic meaning, such as
happiness or “utility,” and we cannot say that a bundle (x, y)
whose utility is double the utility of another bundle (x′ , y ′ ), is
twice as good for the decision-maker.
• When a utility representation u only captures an ordinal ranking
over consumption bundles, then any other function v from R2+ to
R that maintains the same ranking of bundles is an equivalent
utility representation.
• If we want to use the expected payoff/utility decision rule, we
must interpret the corresponding utility function as a cardinal
measure, where relative differences in utility have a fixed
meaning/value according to some scale (e.g., like differences in
temperature according to the Celsius/Fahrenheit scale).
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Example: Planting in Palanpur

For each farmer there are four possible outcomes in terms of the
amount of grain produced—each farmer strictly prefers Best over
Good over Bad over Worst.
An ordinal utility function u must only satisfy the requirement that
u(Best) > u(Good) > u(Bad) > u(Worst).

A cardinal utility function must

still satisfy the same ranking, but
measures differences in outcomes
according to a fixed specific scale
that allows comparability of mag-
nitudes, such as, for example,
based on the kilograms of grain
produced in each case.

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Indifference curves: Graphing preferences

Consider a decision-maker/consumer who has preferences over

consumption bundles in R2+ (e.g., mobile phone data vs. coffee, or
study hours vs. leisure time).

• Indifference curves in R2+ visualise such preferences by connecting

all bundles among which the consumer is indifferent as part of
the same curve in R2+ .
• If a utility function represents these preferences, then all bundles
that lie on the same indifference curve must attain the same
utility value/level, i.e., if both (x, y) and (x′ , y ′ ) lie on the same
indifference curve, then u(x, y) = u(x′ , y ′ ).
⇒ Any two utility functions that represent the same preferences
must have identical indifference curves!

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Example: Anmei’s indifference curves

Anmei is indifferent between the bundles a = (xa , ya ) = (2, 8),

b = (xb , yb ) = (4, 4) and c = (xc , yc ) = (8, 2), and has preferences
represented by the utility function uA , where
uA (xa , ya ) = uA (xb , yb ) = uA (xc , yc ) = 4.

Warning: Indifference curve can have many different shapes, and

must not all look like the ones drawn in the graph above or on the
next slide! 13/44
Indifference maps

• Each point/bundle in R2+ lies on some indifference curve.

• Adding a few additional (representative) indifference curves to
the one corresponding to uA
4 yields a corresponding indifference
map associated with Anmei’s preferences.
• We can think of an
indifference map as a contour
map, such as the ones
representing different
altitudes on a map.
• Anmei would like to reach
the “highest” indifference
curve that is feasible given
the constraints she faces—if
she prefers more of each good
to less, she would like to be
as far “north east” on the
indifference map as possible. 14/44
Marginal utilities

To characterise the solutions of constrained utility maximisation

problems, we will contradict our previous discussion and start by
treating utility functions u as cardinal—later, we will see that the
solution we find is independent of the particular utility function that
we use to represent ordinal preferences!
• Given a utility function u(x, y), the marginal utility of x
measures the rate of change in u that results from increasing the
consumption of x, while keeping the consumption of y constant
at a fixed amount.
• Mathematically, the marginal utility with respect to a change in
x is measured by the partial derivative of u with respect to x,
defined as
∂u(x, y) u(x + ∆x, y) − u(x, y)
ux (x, y) = = lim .
∂x ∆x→0 ∆x
The partial derivative ux (x, y) approximates the change in u (at
the point (x, y)!) that results from an increase in x by one unit,
while holding y constant. 15/44
Example: Keiko’s optimisation problem

• Keiko has two important priorities, “Living” and “Learning”:

◦ Learning comprises all the aspects of her life as a student that
contribute to her goals of becoming an educated person and
becoming qualified for an interesting career,
◦ Living comprises everything else, including keeping up with
friends, meeting new people, and taking care of herself.
• As there are only so many hours in a day, Keiko faces a trade-off
between Learning and Living.
• If we assume that Keiko’s preferences over different levels of
Living, x, and Learning, y, are represented by a utility function
u, her optimal trade-offs between Living and Learning can be
analysed using the (constrained) utility maximisation approach.

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Diminishing marginal utilities
• If Keiko values more of
each good while keeping
the other constant, her
marginal utilities (of x
and y) are both positive.
• If each additional unit of
a good (while keeping the
other constant) raises her
utility by a successively
smaller increment, her
marginal utilities are
decreasing/diminishing
(e.g., because Keiko
values every additional
unit of Living less the
more Living she already
consumes).
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The marginal rate of substitution

The marginal rate of substitution at (x, y), mrs(x, y), is the rate at
which a consumer is willing to substitute good y for x as long as his
utility is kept constant (so that he remains on the same indifference
curve)—when this derivative exists, mrs(x, y) is the negative of the
derivative/slope of the indifference curve at (x, y).
The marginal rate of substitution approximates the maximum amount
of y that the consumer would be willing to give up to get one more
unit of x, as well as the least amount of y that the consumer would
view as an adequate substitute for losing one unit of x.
Assume downward-sloping indifference curves, and consider a point
(x, y) such that u(x, y) = ū. If we add ∆x > 0 to x, we need to
subtract an appropriate amount ∆y(∆x) > 0 from
y to remain at the utility level ū, i.e., so that
u(x + ∆x, y − ∆y(∆x)) = u(x, y) = ū.
∆y(∆x)
Then mrs(x, y) = lim∆x→0 ∆x .
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Mathematical derivation of mrs(x, y)

More formally, if we consider the equation u(x, y) = ū that defines the

indifference curve associated with ū, then if we vary x, while at the
same time keeping the utility at ū, we must adjust y as a function of
x so that the equation u(x, y) = ū remains satisfied—through such an
adjustment this equation implicitly defines y as a function of x, so we
can write y(x) to get
u(x, y(x)) = ū.
If certain mathematical conditions are satisfied (⇝ ECON6012), we
can use the chain rule to differentiate with respect to x on both sides
of the above equation, to get
∂u(x, y) ∂u(x, y) dy(x)
+ = 0,
∂x ∂y dx
which yields
dy(x) ∂u(x, y)/∂x
mrs(x, y) = − = .
dx ∂u(x, y)/∂y
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Keiko’s marginal rate of substitution

At any point (x, y), if Keiko could acquire one unit of x for p units of
y, where p < mrs(x, y), would she engage in such a trade?

Yes, she would buy at least some

additional amount of x! (Why
only some?!)
⇒ mrs(x, y) is Keiko’s
maximum willingness to pay
for x by trading away y.

What if Keiko could trade away

one unit of x for q units of y,
where q > mrs(x, y)?

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Application: Cobb-Douglas utility function

The Cobb-Douglas utility function is a function u mapping con-

sumption bundles in R2+ to R, which is defined by

u(x, y) = xα y (1−α) ,

where α ∈ (0, 1).

• When either x = 0 or y = 0 (or both), then u(x, y) = 0; when

(x, y) ∈ R2++ (so both x > 0 and y > 0), then u(x, y) > 0—hence,
we restrict our subsequent analysis to bundles (x, y) ∈ R2++ .
• The marginal utilities are

∂[xα y (1−α) ] y 1−α

ux (x, y) = = αxα−1 y 1−α = α 1−α > 0,
∂x x
∂[xα y (1−α) ] xα
uy (x, y) = = (1 − α)xα y 1−α−1 = α α > 0.
∂y y
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 ∂ 2 u(x,y) ∂ 2 u(x,y)
• Taking the second-order derivatives ∂x2 and ∂y 2 , yields

∂ 2 u(x, y) ∂[αxα−1 y 1−α ]

= = α(α − 1)xα−2 y 1−α < 0,
∂x2 ∂x
∂ 2 u(x, y) ∂[(1 − α)xα y −α ]
2
= = (1 − α)(−α)xα y −α−1 < 0,
∂y ∂y
so marginal utilities are decreasing as more of x or y are
consumed (keeping the consumption of the other good constant).
• The marginal rate of substitution is

dy(x) ux (x, y) αxα−1 y 1−α α y

mrs(x, y) = − = = = ,
dx uy (x, y) (1 − α)xα y −α 1−αx

which implies that as y is kept constant, the slopes of subsequent

indifference curves decrease as x increases (and increase as x
decreases).

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Constraints

• We have considered situations where a decision-maker/consumer

chooses a bundle of activities/goods (x, y), and have shown how
preferences over such bundles can be described using utility
functions and indifference maps.
• To analyse a consumer’s constrained optimisation problem, we
need to complete the description of the associated decision
problem by specifying the constraints that the consumer faces
when choosing their most preferred feasible bundle.
• In the case where choices are bundles in R2+ , the constraints must
be defined by subsets of R2+ , which contain all those bundles that
are feasible choices for the consumer—which bundles are feasible,
and therefore what form the constraint will take, depends on the
specific problem that we want to analyse.
• Next, we analyse three specific applications, the choice of how
many hours to devote to studying, the choice of an optimal
environmental/abatement policy, and the choice of a bundle of
consumption goods.
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Application: Optimal study time

• To determine Keiko’s optimal trade-off between Living x and

Learning y, we need to specify how the hours that she spends
Studying, denoted by h, are used to generate Learning y.
• Assuming that Keiko has only 16 per day at her disposal to divide
between Studying and Living, we can then use the resulting
equality x = 16 − h to derive the feasible combinations/bundles
(x, y) from which Keiko must choose her most preferred bundle.

A production function describes mathematically the relation be-

tween the quantity of inputs devoted to production on the one
hand, and the maximum quantity of output that the given
amount of input allows.

• Keiko’s production function f maps hours spent Studying h (her

inputs), to an appropriately measured resulting amount of
Learning y (her output), and hence defines a relation y = f (h)
between the variables h and y.
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Keiko’s production function

The graph below is drawn based on the production function

y = f (h) = h 12 − 64
h


, so that
df (h) 1 h d2 f (h) 1
f ′ (h) = = − , and f ′′ (h) = 2
=− < 0.
dh 2 32 dh 32

• For h < 16, f ′ (h) > 0, so

the marginal productivity
is positive—any
additional amount of
Studying increases
Learning.
• Moreover, f ′′ (h) < 0, so
the production function
exhibits diminishing
marginal productivity.

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Keiko’s feasible set

By substituting h = 16 − x into the production function y = f (h), we

get the following relation between the feasible bundles (x, y):
x2
   
1 h 1 16 − x
y ≤ f (h) = h − = (16 − x) − =4− .
2 64 2 64 64

• The set of feasible bundles

(x, y) is the set of all
points that lie on or below
the graph of this function.
• The feasible frontier,
which is just the upper
boundary of the feasible
set, is just a flipped
version of the graph of
the production function.

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Keiko’s opportunity cost of Living

The marginal rate of transformation at (x, y), mrt(x, y), is the

negative of the slope of the feasible frontier, so
x2
 
d x
mrt(x, y) = − 4− = > 0.
dx 64 32
• mrt(x, y) approximates
the smallest amount of y
that Keiko must give up
(at the point (x, y)) to get
an additional unit of x.
• Thus, mrt(x, y) measures
the opportunity cost of x
in terms of y.
• mrt(x, y) is increasing in
x because f (h) has
diminishing marginal
productivity. (Why?)
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Constrained utility maximization: The mrs = mrt rule

We can combine Keiko’s feasible frontier and indifference curves to

understand her constrained utility maximising choice—at her optimal
bundle, she attains the highest-utility indifference curve that still lies
within her feasible set.

On the graph to the right, the

optimal bundle is the point b =
(x∗ , y ∗ ) at which the feasible
frontier is tangent to the uK2 in-
difference curves, i.e., the point
(x∗ , y ∗ ) where

mrs(x∗ , y ∗ ) = mrt(x∗ , y ∗ ),

so the willingness to pay for x

equals the opportunity cost of x.

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Solving for mrs = mrt algebraically

If Keiko’s utility function has the Cobb-Douglas form

u(x, y) = x0.4 y 0.6 , we know from our previous analysis that
0.4 y 2y
mrs(x, y) = = .
0.6 x 3x
x2
The marginal rate of transformation of the feasible frontier y = 4 − 64
x
was also shown to be mrt(x, y) = 32 . Thus, the optimal bundle
∗ ∗
(x , y ) satisfies
2 y∗ x∗ 3 ∗ 2
mrs(x∗ , y ∗ ) = mrt(x∗ , y ∗ ) ⇔ ∗
= ⇔ y∗ = (x ) .
3x 32 64

Since (x∗ , y ∗ ) also lies on the feasible frontier, it must also satisfy
∗ 2
y ∗ = 4 − (x64) , which, together with the equation derived from
mrs(x∗ , y ∗ ) = mrt(x∗ , y ∗ ), yields (x∗ , y ∗ ) = (8, 3).

Warning: Depending on the functional form of the utility and

production functions, the mrs = mrt rule may not always yield an
optimal solution! (See also M-Note 3.8 in the textbook.)
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Trade-offs between goods and bads

Keiko’s problem of determining an optimal study time can

equivalently be framed in terms of choosing a bundle (h, y), where the
trade-off is between a “bad” represented by Studying h, and a “good”
represented by Learning y.

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Application: Environmental trade-offs

• The same methods used to determine the optimal study time in

the previous example can be used to analyse optimal trade-offs
between increasing the output of consumption goods y in an
economy, or spending some resources on abatement of pollution
to increase environmental quality x.
• The indifference curves over different combinations (x, y) of
environmental quality x and consumption goods y reflect the
preferences and priorities of a policymaker.
• The feasible frontier describes the technological possibilities of
using resources to either produce consumption goods or improve
the quality of the environment.
• Warning: We assume here that the policymaker has well-defined
preferences, but preferences across the whole population may
differ, and the costs of abatement may not be distributed
uniformly over the population!
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The mrs = mrt rule and improvements in technology

The mrs = mrt rule imposes an optimal trade-off between the

policymaker’s willingness to pay for environmental quality, and the
opportunity cost of improving environmental quality measured in
terms of foregone consumption goods.

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Application: Consumer demand

• The most famous application of the constrained optimisation

approach in economics involves the analysis of trade-offs between
various consumption goods that can be purchased at fixed
per-unit monetary prices.
• We will consider an example with a consumer who chooses how
to allocate her monetary income/wealth m > 0 between a
consumption good x (e.g., amount of fish, or food) and left-over
money y (which can also be viewed as a composite good that
represents a mixed bundle containing all other goods that the
consumer may desire).
• We denote the price of one unit of fish x by p > 0, and since the
composite good y can be interpreted as left-over money, the
per-unit price of y is fixed at 1.

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The budget constraint

The constraint set for the optimisation problem is defined by all the
bundles (x, y) that the consumer can afford, given her income m, and
is thus given by the (feasible) set of bundles (x, y) ∈ R2+ that satisfy
px + y ≤ m ⇔ y ≤ m − px.
• The feasible frontier is the
budget line defined by
y = m − px.
• The mrt, i.e., the
opportunity cost of one
additional unit of x, is
constant and equal to p.
• If p decreases, the budget
line pivots outward and
becomes flatter, so that
the new budget set is
larger than before. 38/44
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Utility-maximising choices

If the consumer has preferences over bundles (x, y) that can be

represented by a utility function u with “well-behaved” indifference
curves, the consumer’s utility-maximising bundle (x∗ , y ∗ ) must satisfy
the mrs = mrt rule.

Since mrt(x, y) = p irrespective

of (x, y), the mrs = mrt rule
implies that

mrs(x∗ , y ∗ ) = p,

so at an optimum (x∗ , y ∗ ), the

consumer’s maximum willing-
ness to pay (money) for good
x is equal to the price p of x.

(What about at points a or c?)

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The consumer’s demand curve
By considering the optimal
choice of x for varying prices
p, we can trace out the con-
sumer’s demand curve for x,
which characterises her pre-
ferred consumption level for
good x as a function of its unit
price p—given our standard-
shapes indifference curves, as
the price decreases, the quan-
tity demanded of x increases,
and vice-versa.
Notice: If we view the quan-
tity demanded as a function of
price, then the graph on the
right in fact depicts the inverse
demand function!
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Rational choice theory: An assessment

• Are people really that selfish? ⇝ The preference-based approach

does not preclude that decision-makers have other-regarding
preferences based on altruism, reciprocity, fair-mindedness, etc.
• People do not consciously solve constrained optimisation
problems! ⇝ A model does not need to be an exact and accurate
description of a decision-maker’s mental processes—as long as
people behave in a manner that approximates “doing the best
they can given scarce or limited resources,” it is possible to
understand and analyse the resulting behaviour based on rational
choice theory.
• Economists still need to be careful when considering the
relevance of emotions/visceral reactions, temporal
interdependencies, behavioural inconsistencies, or aggregating
individual preferences to determine social objectives.
⇝ Extensions of the standard rational choice model that include
most of these features have been developed (but we will not be
able to discuss these in our introductory course).
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