Chapter 4

Utility Maximization and

Choice

Nicholson and Snyder, Copyright ©2008 by Thomson South-Western. All rights reserved.
 Complaints about the
Economic Approach
• Do individuals make the “lightning
calculations” required for utility
maximization?
– the utility-maximization model predicts many
aspects of behavior
– economists assume that people behave as
if they made such calculations
 Complaints about the
Economic Approach
• The economic model of choice is
extremely selfish
– nothing in the model prevents individuals
from getting satisfaction from “doing good”
 Optimization Principle
• To maximize utility, given a fixed amount
of income, an individual will buy the
goods and services:
– that exhaust total income
– for which 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
– 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
If all income is spent
on y, this is the amount
to choose only combinations
of y that can be purchased of x and y in the shaded
triangle

If all income is spent

on x, this is the amount
of x that can be purchased

Quantity of x
 FOCs for a Maximum
• We can add the individual’s utility map
to show the utility-maximization process

Quantity of y The individual can do better than point A

by reallocating his budget
A
C The individual cannot have point C
B because income is not large enough

U3
Point B is the point of utility
U2 maximization
U1
Quantity of x
 FOCs for a Maximum
• Utility is maximized where the indifference
curve is tangent to the budget constraint

Quantity of y

U2

Quantity of x
 SOCs for a Maximum
• The tangency rule is 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, we must check
second-order conditions to ensure that we are
at a maximum
 SOCs for a Maximum
• The tangency rule is only a necessary
condition
– we need MRS to be diminishing
Quantity of y
There is a tangency at point A,
but the individual can reach a higher
level of utility at point B
B

A
U2
U1
Quantity of x
 Corner Solutions
• Individuals may maximize utility by choosing
to consume only one of the goods

At point A, the indifference curve

Quantity of y U1 U2 U3 is not tangent to the budget constraint

Utility is maximized at point A

Quantity of x
A
 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) + λ(I - p1x1 - p2x2 -…- pnxn)
 The n-Good Case
• FOCs for an interior maximum:
∂ℒ/∂x1 = ∂U/∂x1 - λp1 = 0
∂ℒ /∂x2 = ∂U/∂x2 - λp2 = 0

•
•
•
∂ℒ /∂xn = ∂U/∂xn - λpn = 0
∂ℒ /∂λ = I - p1x1 - p2x2 - … - pnxn = 0
 Implications of FOCs
• For any two goods,

• This implies that at the optimal

allocation of income
Interpreting the Lagrangian
Multiplier

• λ is the marginal utility of an extra dollar

of consumption expenditure
– the marginal utility of income
Interpreting the Lagrangian
Multiplier
• At the margin, the price of a good
represents the consumer’s evaluation of
the utility of the last unit consumed
– how much the consumer is willing to pay
for the last unit
 Corner Solutions
• A corner solution means that the
first-order conditions must be modified:
∂ℒ/∂xi = ∂U/∂xi - λpi ≤ 0 (i = 1,…,n)
• If ∂ℒ/∂xi = ∂U/∂xi - λpi < 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) = xαyβ
• Setting up the Lagrangian:
ℒ = xαyβ + λ(I - pxx - pyy)
• FOCs:
∂ℒ/∂x = αxα-1yβ - λpx = 0
∂ℒ/∂y = βxαyβ-1 - λpy = 0
∂ℒ/∂λ = I - pxx - pyy = 0
Cobb-Douglas Demand Functions
• First-order conditions imply:
αy/βx = px/py
• Since α + β = 1:
pyy = (β/α)pxx = [(1- α)/α]pxx
• Substituting into the budget constraint:

I = pxx + [(1- α)/α]pxx = (1/α)pxx

Cobb-Douglas Demand Functions
• Solving for x yields

• Solving for y yields

• The individual will allocate α percent of

his income to good x and β percent of
his income to good y
Cobb-Douglas Demand Functions
• Cobb-Douglas utility function is limited in
its ability to explain actual consumption
behavior
– the share of income devoted to a good often
changes in response to changing economic
conditions

• A more general functional form might be

more useful
 CES Demand
• Assume that δ = 0.5
U(x,y) = x0.5 + y0.5
• Setting up the Lagrangian:
ℒ = x0.5 + y0.5 + λ(I - pxx - pyy)
• FOCs:
∂ℒ/∂x = 0.5x -0.5 - λpx = 0
∂ℒ/∂y = 0.5y -0.5 - λpy = 0
∂ℒ/∂λ = 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, the

smaller will be the share of income
spent on x
 CES Demand
• If δ = -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
• If δ = -∞,
U(x,y) = Min(x,4y)
• The person will choose only combinations
for which x = 4y
• This means that
I = pxx + pyy = pxx + py(x/4)
I = (px + 0.25py)x
 CES Demand
• Hence, the demand functions are
 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 be
x*1 = x1(p1,p2,…,pn,I)
x*2 = x2(p1,p2,…,pn,I)
•
•
•
x*n = xn(p1,p2,…,pn,I)
 Indirect Utility Function
• We can use the optimal values of the
x’s to find the indirect utility function
maximum utility = U(x*1,x*2,…,x*n)

maximum utility = V(p1,p2,…,pn,I)

• The optimal level of utility will depend

indirectly on prices and income
 The Lump Sum Principle
• Taxes on an individual’s general
purchasing power are superior to taxes
on a specific good
– an income tax allows the individual to
decide freely how to allocate remaining
income
– a tax on a specific good will reduce an
individual’s purchasing power and distort
his choices
 The Lump Sum Principle
• A tax on good x would shift the
utility-maximizing choice from point A to
point B
Quantity of y

B A

U1
U2

Quantity of x
 The Lump Sum Principle
• An income tax that collected the same
amount would shift the budget constraint
to I’
Quantity of y Utility is maximized now at point
I’ C on U3

A
B C
U3 U1
U2

Quantity of x
 The Lump Sum Principle
• If the utility function is Cobb-Douglas with α
= β = 0.5, we know that

• The indirect utility function is

 The Lump Sum Principle
• If a tax of $1 was imposed on good x
– the individual will purchase x* = 2
– indirect utility will fall from 2 to 1.41

• An equal-revenue tax will reduce income to

$6
– indirect utility will fall from 2 to 1.5
 The Lump Sum Principle
• If the utility function is fixed proportions
with U = Min(x,4y), we know that

• The indirect utility function is

 The Lump Sum Principle
• If a tax of $1 was imposed on good x
– indirect utility will fall from 4 to 8/3

• An equal-revenue tax will reduce income to

$16/3
– indirect utility will fall from 4 to 8/3

• Since preferences are rigid, the tax on x

does not distort choices
 Expenditure Minimization
• Dual minimization problem for utility
maximization
– allocate income to achieve a given level of
utility with the minimal expenditure
• 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

A
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
total expenditures = E = p1x1 + p2x2 +…+ pnxn

subject to the constraint

utility = Ū = U(x1,x2,…,xn)

• The optimal amounts of x1,x2,…,xn 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(p1,p2,…,pn,U)
• The expenditure function and the indirect
utility function are inversely related
– both depend on market prices but involve
different constraints
 Two Expenditure Functions
• The indirect utility function in the two-good,
Cobb-Douglas case is

• If we interchange the role of utility and

income (expenditure), we will have the
expenditure function
E(px,py,U) = 2px0.5py0.5U
 Two Expenditure Functions
• For the fixed-proportions case, the indirect
utility function is

• If we again switch the role of utility and

expenditures, we will have the
expenditure function
E(px,py,U) = (px + 0.25py)U
 Properties of Expenditure
Functions
• Homogeneity
– a doubling of all prices will precisely double
the value of required expenditures
• homogeneous of degree one
• Nondecreasing in prices
– ∂E/∂pi ≥ 0 for every good, i
• Concave in prices
 Concavity of Expenditure
Function
At p*1, the person spends E(p*1,…)
If he continues to buy
the same set of goods as
p*1 changes, his
E(p1,…) Epseudo expenditure function
would be Epseudo
E(p1,…)
E(p*1,…) Since his consumption
pattern will likely change,
actual expenditures will
be less than Epseudo such
as E(p1,…)
p*1 p1
 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 the
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
 Important Points to Note:
• Tangency conditions must also be
modified to allow for corner solutions
– the ratio of marginal utility to price will be
below the common marginal
benefit-marginal cost ratio for goods
actually bought
 Important Points to Note:
• The individual’s optimal choices
implicitly depend on the parameters of
his budget constraint
– observed choices and utility will be implicit
functions 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
– leads to expenditure functions
• spending is a function of the utility target and
prices