EC 2101:

Microeconomic
Analysis I
Kwong-Yu Wong
26 Recap

§ Budget constraint is represented by a negative slope, the relative

price of x (in terms of y)
§ Given budget constraint and rational preference,
§ Optimal choice can be found even without relying on utility
$!
§ Optimal when 𝑀𝑅𝑆!,# = $"

§ Utility function assigns number to the ordinal ranking of preference.

%&!
§ In addition to the slope of indifference curve, 𝑀𝑅𝑆!,# =
%&"

§ Cobb-Douglas and other functions serve as typical utility function.

Lecture 3
Theory of the Consumer

Ø Optimal Choice: Mathematical Analysis

Ø BLTC Method
Ø Lagrange Multiplier Method
Ø Voucher vs. Cash
Ø Revealed Preference
Optimal Choice:
Mathematical Analysis
26 Finding the Optimal Choice: Example 1

§ Suppose Jessie’s utility function is:

𝑈 𝑥, 𝑦 = 𝑥𝑦

§ Suppose bread (𝑥) costs $10 a loaf, milk tea (𝑦) costs $5 a
cup, and Jessie’s income is $100.

§ What is Jessie’s optimal basket?

BLTC Method
26 Optimal Choice

§ Which consumption basket is optimal?

§ Jessie chooses the consumption basket that

gives her the highest utility
given her budget constraint.

§ The constrained optimization problem is:

max 𝑈 𝑥, 𝑦
!,#
𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 𝑝! 𝑥 + 𝑝# 𝑦 ≤ 𝑀
 Optimal Choice: Graphical Analysis
34
Milk To maximize utility,
tea Jessie should consume
(y) at the highest possible
%
$" = 20 indifference curve
that is tangent to
the budget line.
U3
D

U2

U1
#
Bread (x)
0 $!
= 10
26 Optimal Choice

§ The optimal basket is:

§ Budge Line:
§ On the budget line: 𝑝! 𝑥 + 𝑝# 𝑦 = 𝑀
§ Tangency Condition:
§ On the highest indifference curve
that is tangent to the budget line:
$! $!
−𝑀𝑅𝑆!,# = − ⟺ 𝑀𝑅𝑆!,# =
$" $"
26 Optimal Choice

§ The consumption basket is optimal when the slopes equal:

𝑝!
𝑀𝑅𝑆!,# =
𝑝#
§ But… why?
$!
§ Without loss of generality, suppose 𝑀𝑅𝑆!,# >
$"
§ This implies the consumer values good x more than how the market
values good x
§ By taking good y to the market to exchange for good x every time, the
consumer becomes happier.
§ By diminishing MRS, the consumer achieve the maximum happiness
$
by repeat the exchange until 𝑀𝑅𝑆!,# = !
$"
§ And both MRS and budget constraint are observable.
26 Alternative interpretation for Tangency Cond.

§ Since
𝑀𝑈!
𝑀𝑅𝑆!,# =
𝑀𝑈#
§ At the optimal basket,
𝑝! 𝑀𝑈!
= 𝑀𝑅𝑆!,# =
𝑝# 𝑀𝑈#
§ Equivalently,
𝑀𝑈! 𝑀𝑈#
=
𝑝! 𝑝#

§ What does this equation mean?

26 Marginal Utility per Dollar

§ What does this equation mean?

𝑀𝑈! 𝑀𝑈#
=
𝑝! 𝑝#

§ To maximize utility,
Jessie sets the marginal utility per dollar of expenditure equal
for all goods.

§ Why does it maximize utility?

 !"! !""
=
26
Why is utility maximized when ?
#! #"

%&! %&"
§ Suppose not, and hence WLOG assume $!
< $"

§ Since MU per dollar on good y is higher

§ One can gain utility by

§ Reduce 1 dollar from purchasing x and spending that dollar

on y

§ Should Jessie buy more 𝑥 or more 𝑦?

§ Jessie should buy more 𝑦.
 Picture the Optimal Choice on graph
34
Milk
tea
(y)
%
$" = 20 A
F

D 𝑈3
B E
𝑈2
C
𝑈1
#
Bread (x)
0 $!
= 10
 Why is Basket A not optimal?
26
𝑝!
§ At basket A on the graph, 𝑀𝑅𝑆!,# >
𝑝#
𝑀𝑈! 𝑝!
>
𝑀𝑈# 𝑝#
𝑀𝑈! 𝑀𝑈#
>
𝑝! 𝑝#

§ At basket A, the per dollar marginal utility of 𝑥

is higher than
the per dollar marginal utility of 𝑦.

§ Jessie could increase her utility by spending more on 𝑥

and spending less on 𝑦.
Apply BLTC Method to
Example 1
26 Finding the Optimal Choice: Example 1

§ Suppose Jessie’s utility function is:

𝑈 𝑥, 𝑦 = 𝑥𝑦

§ Suppose bread (𝑥) costs $10 a loaf, milk tea (𝑦) costs $5 a
cup, and Jessie’s income is $100.

§ What is Jessie’s optimal basket?

26 Finding the Optimal Choice – BLTC Method

§ We need two conditions:

§ Budget line: 10𝑥 + 5𝑦 = 100 (i)
§ Tangency condition: ? (ii)
§ At the tangency,
the slope of the indifference curve equals
the slope of the budget line.
26
Finding the Optimal Choice – BLTC Method

§ The slope of the indifference curve is: 𝑀𝑈!

𝑀𝑅𝑆!,# =
𝑀𝑈#

§ The slope of the budget line is: 𝑝!

𝑝#

§ The tangency condition requires: 𝑀𝑈! 𝑝!

=
𝑀𝑈# 𝑝#
26 Finding the Optimal Choice – BLTC Method

§ Given 𝑈 𝑥, 𝑦 = 𝑥𝑦, the marginal utilities are:

𝜕𝑈
𝑀𝑈! = =𝑦
𝜕𝑥
𝜕𝑈
𝑀𝑈# = =𝑥
𝜕𝑦
𝑀𝑈! 𝑝!
§ Tangency condition: =
𝑀𝑈# 𝑝#
𝑦 10
=
𝑥 5
𝑦 = 2𝑥
26 Finding the Optimal Choice ‒ BLTC Method

§ We need two conditions:

§ Budget line: 10𝑥 + 5𝑦 = 100 (i)
§ Tangency condition: 𝑦 = 2𝑥 (ii)

§ Solve the two equations:

10𝑥 + 5 2𝑥 = 100 ⇒ 𝑥=5

𝑦 = 2(5) ⇒ 𝑦 = 10
Can we maximize the utility
without considering the
graph?
26 Maximization

§ Suppose you want to find the maximum of

ℒ 𝑥 = −𝑥 ' + 2𝑥 + 5
§ What about the maximum of
ℒ 𝑥, 𝑦 = −𝑥 ' + 2𝑥 − 𝑦 ' + 4𝑦 + 5
§ Suppose the above are 𝑈(𝑥, 𝑦), have we just solved the utility
maximization without graph just now?
§ Not so fast because utility maximization is constrained!
1. Find the maximum of 𝑈(𝑥, 𝑦)
2. Subject to the constraint: 𝑝! 𝑥 + 𝑝# 𝑦 ≤ 𝑀
§ Constrained Optimization is where we need a mathematician
to help!
26 Constrained Maximization

§ Write out what we want (aka utility maximization) in math

max 𝑈(𝑥, 𝑦) 𝑠. 𝑡. 𝑝! 𝑥 + 𝑝# 𝑦 ≤ 𝑀
!,#
§ Mathematician Lagrange showed us it is equivalent to solve
max ℒ(𝑥, 𝑦, 𝜆)
!,#,(
§ In other words, it can be solved by a few steps
1. Make up a new function ℒ with an (mysterious) constant λ>0
ℒ = 𝑈 𝑥, 𝑦 + 𝜆(𝑀 − 𝑝! 𝑥 − 𝑝# 𝑦)
2. Solve for x,y as if we are to maximize ℒ instead of U
%ℒ %ℒ %ℒ
• Use = 0, = 0, = 0 to find x and y
%! %# %&
§ Solving the constrained maximization by our familiar
(unconstrained) maximization
26 Specifying the Lagrangian

§ Breaking down the Lagrangian when λ>=0

ℒ 𝑥, 𝑦, 𝜆 = 𝑜𝑏𝑗𝑒𝑐𝑡𝑖𝑣𝑒 + 𝜆(𝑝𝑒𝑛𝑎𝑙𝑡𝑦)
§ Why maximizing ℒ works as if utility maximization under
constraint?
§ Objective is maximized. Just write the U(x,y) as the objective
§ When constraint is violated, penalty term gives a negative number and
hence lower the overall ℒ value
§ Penalty is written as 𝑀 − 𝑝! 𝑥 − 𝑝# 𝑦 to give negative whenever
constraint is violated.
§ There are numerous alternative ways to write/understand Lagrangian,
but this EC2101 would not discuss given our scope.
Lagrange Multiplier
Method
26 Lagrange Multiplier Method

§ The general form of the constrained maximization problem is:

max 𝑓 𝑥, 𝑦
!,#
𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 𝑔 𝑥, 𝑦 ≤ 0

§ In consumer theory, the constrained maximization problem is:

max 𝑈 𝑥, 𝑦
!,#
𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 𝑀 − 𝑝! 𝑥 − 𝑝# 𝑦 ≤ 0
26 Lagrange Multiplier Method

§ The Lagrangian function is:

ℒ 𝑥, 𝑦, 𝜆 = 𝑈(𝑥, 𝑦) + 𝜆(𝑀 − 𝑝! 𝑥 − 𝑝# 𝑦)

§ First-order conditions:
𝜕ℒ
= 𝑀𝑈! − 𝜆𝑝! = 0
𝜕𝑥
𝜕ℒ
= 𝑀𝑈# − 𝜆𝑝# = 0
𝜕𝑦
𝜕ℒ
= 𝑀 − 𝑝! 𝑥 − 𝑝# 𝑦 = 0 Ø Budget line
𝜕𝜆
26 Lagrange Multiplier Method

§ Rearrange the first two equations:

𝜕ℒ 𝑀𝑈!
= 𝑀𝑈! − 𝜆𝑝! = 0 ⇒ 𝜆=
𝜕𝑥 𝑝!
𝜕ℒ 𝑀𝑈#
= 𝑀𝑈# − 𝜆𝑝# = 0 ⇒ 𝜆=
𝜕𝑦 𝑝#
§ Therefore:
𝑀𝑈! 𝑀𝑈#
=
𝑝! 𝑝#
𝑀𝑈! 𝑝!
=
𝑀𝑈# 𝑝#
26 Lagrange Multiplier Method

§ The Lagrangian function is:

ℒ 𝑥, 𝑦, 𝜆 = 𝑈(𝑥, 𝑦) + 𝜆(𝑀 − 𝑝! 𝑥 − 𝑝# 𝑦)

§ First-order conditions:
𝜕ℒ
= 𝑀𝑈! − 𝜆𝑝! = 0 Ø Tangency condition
𝜕𝑥
𝜕ℒ
= 𝑀𝑈# − 𝜆𝑝# = 0
𝜕𝑦
𝜕ℒ
= 𝑀 − 𝑝! 𝑥 − 𝑝# 𝑦 = 0 Ø Budget line
𝜕𝜆
26 What would the Lagrange Multiplier be?

§ What would the Lagrange multiplier be?

𝑀𝑈! 𝑀𝑈#
𝜆= =
𝑝! 𝑝#

§ The Lagrange multiplier is

the additional utility
from an additional dollar of consumption.
Apply Lagrange Multiplier
Method to Example 1
26 Finding the Optimal Choice: Example 1

§ Suppose Jessie’s utility function is:

𝑈 𝑥, 𝑦 = 𝑥𝑦

§ Suppose bread (𝑥) costs $10 a loaf, milk tea (𝑦) costs $5 a
cup, and Jessie’s income is $100.

§ What is Jessie’s optimal basket?

26
Finding the Optimal Choice – Lagrange
Multiplier Method

§ Rewrite the budget constraint:

max 𝑈 𝑥, 𝑦 = 𝑥𝑦
!,#
𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 100 − 10𝑥 − 5𝑦 = 0

§ The Lagrangian function is:

ℒ 𝑥, 𝑦, 𝜆 = 𝑥𝑦 + 𝜆(100 − 10𝑥 − 5𝑦)
26
Finding the Optimal Choice – Lagrange
Multiplier Method

§ The Lagrangian function is:

ℒ 𝑥, 𝑦, 𝜆 = 𝑥𝑦 + 𝜆(100 − 10𝑥 − 5𝑦)

§ First-order conditions:
𝜕ℒ
= 𝑦 − 10𝜆 = 0
𝜕𝑥
𝜕ℒ
= 𝑥 − 5𝜆 = 0
𝜕𝑦
𝜕ℒ
= 100 − 10𝑥 − 5𝑦 = 0
𝜕𝜆
§ Solving the three equations, 𝑥 = 5, 𝑦 = 10, and 𝜆 = 1.
 Exercise
26
Finding the Optimal Choice

§ Suppose Hermia’s utility function is:

𝑈 𝑥, 𝑦 = 𝑥𝑦 '

§ Suppose bread (𝑥) costs $10 a loaf, milk tea (𝑦) costs $5 a cup,
and Hermia’s income is $90.

§ Find Hermia’s optimal choice using:

(a) the BLTC method
(b) the Lagrange multiplier method
 Exercise
BLTC Method
26
 Exercise
Lagrange Multiplier Method
26
Optimal Choice:
Example 2
26 Finding the Optimal Choice: Example 2

§ Suppose Billie’s utility function is:

𝑈 𝑥, 𝑦 = 𝑥𝑦 + 20𝑥

§ Suppose bread (𝑥) costs $10 a loaf, milk tea (𝑦) costs $5 a
cup, and Billie’s income is $80.

§ What is Billie’s optimal basket?

§ The utility maximization problem is:

max 𝑈 𝑥, 𝑦 = 𝑥𝑦 + 20𝑥
!,#
𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 10𝑥 + 5𝑦 = 80
26 Finding the Optimal Choice: Example 2

§ Budget line: 10𝑥 + 5𝑦 = 80 (i)

𝑝!
§ Tangency condition: 𝑀𝑅𝑆!,# =
𝑝#
𝑀𝑈! 𝑝!
=
𝑀𝑈# 𝑝#
𝑦 + 20 10
=
𝑥 5
𝑦 + 20 = 2𝑥 (ii)
26 Finding the Optimal Choice: Example 2

§ The solution is 𝑥 = 9, 𝑦 = −2.

§ Is this the optimal basket?

§ The utility maximization problem is:

max 𝑈 𝑥, 𝑦 = 𝑥𝑦 + 20𝑥
!,#
𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 10𝑥 + 5𝑦 = 80
26 Rewriting the Utility Maximization Problem

§ The consumption of each good cannot be negative.

§ The utility maximization problem should be:

max 𝑈 𝑥, 𝑦 = 𝑥𝑦 + 20𝑥
!,#
𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 10𝑥 + 5𝑦 = 80
𝑥≥0
𝑦≥0
26 Solving the Utility Maximization Problem

§ How should we solve the problem?

§ Assuming the non-negative constraints are satisfied,

we just need to solve:
max 𝑈 𝑥, 𝑦 = 𝑥𝑦 + 20𝑥
!,#
𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 10𝑥 + 5𝑦 = 80

§ Check if the solution satisfies 𝑥 ≥ 0 and 𝑦 ≥ 0.

§ If the answer is yes, we are done.
§ If the answer is no, our assumption (that the non-negative
constraints are satisfied) is incorrect.
26 Solving the Utility Maximization Problem

§ We found that 𝑥 = 9, 𝑦 = −2.

§ As 𝑦 = −2 is not possible, 𝑦 = 0 is the best we can get.

§ Plug 𝑦 = 0 into the budget constraint 10𝑥 + 5𝑦 = 80:

10𝑥 + 5 0 = 80
𝑥=8

§ The correct solution is 𝑥 = 8, 𝑦 = 0.

26 Solving the Utility Maximization Problem

§ Here, the constraint 𝑦 ≥ 0 is binding.

§ I.e., the constraint holds with equality, 𝑦 = 0.

§ When there are inequality constraints,

the constraints may or may not be binding.
§ In this example, the constraint 𝑦 ≥ 0 is binding
while the constraint 𝑥 ≥ 0 is not binding.
26 Is (8,0) the Optimal Basket?

§ Compare Billie’s per dollar marginal utility of 𝑥 and of 𝑦:

𝑀𝑈! 𝑦 + 20 0 + 20
= = =2
𝑝! 10 10
𝑀𝑈# 𝑥 8
= =
𝑝# 5 5

%&! ) %&"
§ Since =2> = ,
$! * $"
Billie would like to increase her utility by consuming
more 𝑥 and less 𝑦.
§ But her consumption of 𝑦 is already zero.
 Binding and Non-binding Constraints
34
y At basket B (8, 0),
the indifference curve
is steeper than
16 𝑈+ 𝑈' 𝑈, the budget line:
$!
𝑀𝑅𝑆!,# > $"
%&! $!
C >
%&" $"
%&! %&"
$!
> $"
B
0
8 9
x
-2 A
26 Interior Solution vs. Corner Solution

§ Interior solution: an optimal basket

where strictly positive amounts of both goods are consumed.

§ Corner solution: an optimal basket

where the consumption of at least one good is zero.
§ The optimal basket is either on the horizontal axis or
on the vertical axis.
§ The indifference curve may not be tangent
to the budget line.
 Exercise
Perfect Substitutes
26

§ Naomi’s utility function is 𝑈 𝑥, 𝑦 = 𝑥 + 𝑦,

and she has an income of $3.

(a) Suppose 𝑝! = 1 and 𝑝# = 2.

%&! %&"
§ Compare and .
$! $"

§ Find Naomi’s optimal choice.

(b) Suppose 𝑝! = 2 and 𝑝# = 1.

%&! %&"
§ Compare and .
$! $"

§ Find Naomi’s optimal choice.

 Exercise
Perfect Substitutes (𝑝! = 1, 𝑝# = 2)
26
 Exercise
Perfect Substitutes (𝑝! = 2, 𝑝# = 1)
26
Voucher vs. Cash
26 Voucher

§ Examples of voucher programs:

§ Supplemental Nutrition Assistance Program (SNAP)
in the U.S.
§ School vouchers for private schools in the U.S.
§ In April 2020 in China, digital vouchers for supermarkets,
food catering, restaurants, shopping malls, sports,
entertainment, tourism.
§ In December 2020 in Singapore, $100 SingapoRediscovers
Vouchers for hotels, attractions, and tours.
26 Voucher: Example

§ NTUC used to offer back-to-school vouchers

to low-income families.
§ $125 voucher per school-going child for school-related
merchandise (e.g., school bags and shoes, assessment
books, stationery).

§ What is the impact of the $125 back-to-school voucher on:

§ Consumer’s choice.
§ Consumer’s utility.
 Jessieʼs Indifference Curve and Optimal
Choice
Other (y)
7

%
$"

S1
𝑦+

%
School (x)
0 𝑥+ $!
 Impact of Voucher on Jessie
7
Other (y)
With the voucher,
Jessie’s new optimal
% choice is S2.
$"

S2
𝑦'
S1
𝑦+

School (x)
0 𝑥+ +'*
$!
𝑥' %
$!
%-+'*
$!
 Hermia’s Indifference Curve and Optimal Choice
7
Other (y)

%
$"

V1
𝑦+

%
School (x)
0 𝑥+ $!
 Impact of Voucher on Hermia
7
Other (y)
With the voucher,
Hermia’s new optimal
% V2 choice is V2.
#% .
$"

V1
𝑦+

+'* % %-+'*
School (x)
0 𝑥+ $!
.!%
$! $!
26 Voucher vs. Cash

§ We saw the impact of the $125 back-to-school voucher on:

§ Consumer’s choice.
§ Consumer’s utility.

§ What is the impact of $125 in cash on:

§ Consumer’s choice.
§ Consumer’s utility.
 Impact of Cash on Jessie
7
Other (y)

%
$"

S2
𝑦'
S1
𝑦+

School (x)
0 𝑥+ +'*
$!
𝑥' %
$!
%-+'*
$!
 Impact of Cash on Jessie
7
Other (y)
With cash,
Jessie’s new optimal
% choice is still S2.
$"

S2
𝑦'
S1
𝑦+

School (x)
0 𝑥+ +'*
$!
𝑥' %
$!
%-+'*
$!
 Impact of Cash on Hermia
7
Other (y)
𝑦, V3 With cash, Hermia’s new
optimal choice is V3.
% V2
#% .$ Cash gives Hermia more
"
utility.
V1
𝑦+

𝑥,
+'* % %-+'*
School (x)
0 𝑥+ $! .!% $! $!
 Application
Voucher vs. Cash
26

§ Between $𝑉 in vouchers and $𝑉 in cash,

§ Some consumers are indifferent between the two.
§ Some consumers prefer cash to vouchers.

§ Cash is never worse than vouchers.

§ So why use vouchers?

Revealed Preference
26 Preference and Optimal Choice

§ What have we been doing so far?

§ Given preference (indifference curves/utility functions)
and the budget constraint …
§ We can find the consumer’s optimal choice.

§ Can we go the other way round?

§ Given the consumer’s optimal choice
and the budget constraint …
§ Can we get any information on preference?
26 Revealed Preference

§ Revealed preference:
§ The analysis that enables us to infer preference
based on observed prices and choices.
26 Strictly Preferred vs. Weakly Preferred

§ A is strictly preferred to B : 𝐴≻𝐵

§ A is weakly preferred to B : 𝐴≽𝐵

⟺ 𝐴≻𝐵 or
𝐴∼𝐵
26 From Choice to Preference

§ Suppose we observe Pandora’s budget constraint.

§ We also know the optimal basket that she has chosen

given the budget constraint.

§ But we do not know Pandora’s preference.

§ We know her preference satisfies the three assumptions.
§ We also know her preference does not change
with prices or with income.

§ Our goal is to infer Pandora’s preference —

how she ranks different consumption baskets.
 Basket A is the Optimal Choice in January
7
y

16
Strictly preferred to A

10
A

Strictly
less
preferred
to A Budget line in January
x
0 3 8
 Basket A vs. Other Baskets on the Budget Line
7
y

16

B A is revealed to be weakly preferred

10
A to other baskets on the budget line.
C

x
0 3 8
 Basket A vs. Other Baskets below the Budget Line
7
y Since 𝐴 ≽ 𝐶
and 𝐶 ≻ 𝐷,
16
by transitivity, 𝐴 ≻ 𝐷.

A is revealed to be strictly preferred

10
A to any other basket in the budget set
that is not on the budget line.
C

x
0 3 8
 How Optimal Choice “Reveals” Preference
7
y

16
Strictly preferred to A

Strictly
less
preferred
to A

x
0 8
26 Another Way to Understand Revealed Preference

§ Suppose basket A = 𝑥/ , 𝑦/ is the optimal basket

given prices 𝑝! , 𝑝# , and income 𝑀.
§ Basket A must be on the budget line.
𝑝! 𝑥/ + 𝑝# 𝑦/ = 𝑀
26 Another Way to Understand Revealed Preference

§ No other affordable basket is strictly preferred to basket A.

§ Suppose basket B = 𝑥0 , 𝑦0 is strictly preferred to basket A.

§ Basket B cannot be affordable,
i.e., basket B must lie above the budget line.
𝑝! 𝑥0 + 𝑝# 𝑦0 > 𝑝! 𝑥/ + 𝑝# 𝑦/ = 𝑀
26 Another Way to Understand Revealed Preference

§ Suppose Pandora is indifferent between

the chosen basket A and a basket C = 𝑥1 , 𝑦1 .
§ Basket C cannot cost strictly less than basket A,
i.e., basket C cannot lie below the budget line.
𝑝! 𝑥1 + 𝑝# 𝑦1 ≥ 𝑝! 𝑥/ + 𝑝# 𝑦/ = 𝑀
 Basket B is the Optimal Choice in February
7
y Suppose basket A is the optimal choice
in January and basket B is the optimal
Budget line
16 choice in February.
in January
Since 𝐴 ≻ 𝐵
and 𝐵 ≽ 𝐶
11 A and 𝐵 ≻ 𝐷,
by transitivity, 𝐴 ≻ 𝐶 and 𝐴 ≻ 𝐷.
7
B
C
Budget line in February
D
x
0 4 8 11
 More Choices Observed,
More Information on Preference Revealed
7
y

16
Strictly preferred to A

11 A

Strictly
less B
preferred C
to A
D
x
0 8 11
 Exercise
Revealed Preference
7
y Suppose Q is the optimal choice given
the budget line. What can you say
about each of the following (true /
false / unable to determine)?
(a) 𝑄 ≻ 𝑆
P (b) 𝑄 ≻ 𝑃
R (c) 𝑅 ≻ 𝑆
Q
(d) 𝑅 ≻ 𝑄
(e) 𝑅 ≻ 𝑃
S

x
 Exercise
Revealed Preference
7
y Suppose Q is the optimal choice but
we do not observe the budget line.
What can you say about how the
consumer ranks the four baskets?
A. 𝑅 ≻ 𝑄
P B. 𝑅 ≻ 𝑄 ≻ 𝑃
R C. 𝑆 ≻ 𝑄 ≻ 𝑃
Q D. 𝑅 ≻ 𝑄 ≻ 𝑃 and 𝑆 ≻ 𝑄 ≻ 𝑃
S

x
 Exercise
Revealed Preference
7
y Suppose we do not know the optimal
choice. Which of the following is true?
A. 𝑃 ∼ 𝑄
B. 𝑅 ≻ 𝑃
C. 𝑅 ≻ 𝑄
P D. 𝑆 ≻ 𝑅
R
Q

x
26 Summary

§ Optimal choice can be found using Mathematical Analysis

§ BLTC Method: use Budget Line and Tangency Condition
'(! '("
§ = condition implies equal MU per dollar at optimal choice
$! $"

§ Lagrangian Multiplier Method

§ max ℒ(𝑥, 𝑦, 𝜆) = max 𝑜𝑏𝑗𝑒𝑐𝑡𝑖𝑣𝑒 + 𝜆(𝑝𝑒𝑛𝑎𝑙𝑡𝑦)
!,#,& !,#,&
'(
§ Lagrange multiplier 𝜆 = at optimal choice
$
§ Further caution is required for handling corner solutions
§ Voucher is inferior to Cash in improving the welfare
§ Information of unknown preference is revealed in optimal choices