Econ 220

Ch. 5 Consumer Choice Part I

Ch. 5 Consumer Choice Part I Econ 220

Consumer decision making

Our problem: How do consumers choose the best bundle of

goods they can afford?
Ch. 2 (budget constraint): how to describe what is meant
by “can afford”
Ch. 3 (Preferences) and Ch. 4 (Utility): how the consumers
determine what is “best”
Ch. 5 (Choice): combine budget set and preferences to
examine the optimal choice of consumers.

Ch. 5 Consumer Choice Part I Econ 220

Combining Utility, Income and Prices
In chapters 2-4, we have shown that:
The concepts of Utility and Indifference curves describe
consumer preferences
The budget constraint describes which bundles are
feasible.

Combining these concepts, we can begin to understand

consumer choices...
The principal behavioural postulate is that a
decision-maker chooses its best alternative from those
available to it (rationality).
Now, we can re-phrase this as: the consumer chooses the
most preferred bundle (i.e. the one maximizing utility) from
his budget set. ⇒ he solves a constrained utility
maximisation problem
Ch. 5 Consumer Choice Part I Econ 220
Solving the consumer’s utility maximisation problem

How to derive the solutions to the consumer’s choice

problem? ⇒ 2 approaches:
1 Graphical approach - How is the most preferred bundle in
the budget set located?
2 Lagrange method - Maximise the utility function subject to
the budget constraint

Important remarks:Here we focus on

A. Differentiable utility functions (i.e. no kink)
B. Interior solutions , i.e. optimal quantities are strictly
positive
C. Monotonic preferences: more is preferred to less.

Ch. 5 Consumer Choice Part I Econ 220

1. Graphical approach

Objective: find the bundle in the budget set on the highest IC.

Monotonic Preferences ⇒ more is preferred to less.

We restrict our attention to bundles on the budget
constraint.

Ch. 5 Consumer Choice Part I Econ 220

1. Graphical approach

Start at the right-hand corner of the budget line and move

to the left: we are moving to higher and higher IC.
The highest indifference curve is the one that just touches
the budget line.

Ch. 5 Consumer Choice Part I Econ 220

1. Graphical approach
The optimal choice for the consumer is (x1∗ , x2∗ ). This is the best
bundle the consumer can afford.

⇒ In the diagram, the optimal choice for the consumer (i.e. the
bundle of goods associated with the highest indifference curve)
is located where the indifference curve is tangent to the budget
constraint.
Ch. 5 Consumer Choice Part I Econ 220
1. Graphical approach

The most preferred affordable bundle is called the

consumer’s ORDINARY DEMAND at the given prices and
budget.

Ordinary demands will be denoted by x1∗ (p1 , p2 , m) and

x2∗ (p1 , p2 , m).

In the figure, (x1∗ , x2∗ ) satisfies 2 conditions:

1 (x1∗ , x2∗ ) exhausts the budget: p1 x1∗ + p2 x2∗ = m
2 The indifference curve containing (x1∗ , x2∗ ) is tangent to the
budget constraint at (x1∗ , x2∗ ), i.e. the slope of the budget
constraint, −p1 /p2 , and the slope of the indifference curve
containing (x1∗ , x2∗ ) are equal at (x1∗ , x2∗ ).

Ch. 5 Consumer Choice Part I Econ 220

MRS and the budget constraint

The slope of the indifference curve is the MRS.

The slope of the budget constraint is −p1 /p2

At the optimum, these slopes are the same. What does it

mean economically?
Interpretation of the MRS: rate of exchange at which the
consumer is just willing to substitute a small amount of
good 2 for good 1.
−p1 /p2 is the rate of exchange offered by the market: if you
give up one unit of good 1, you can buy p1 /p2 units of good
2.
MRS = −p1 /p2

Ch. 5 Consumer Choice Part I Econ 220

Computing Ordinary Demands - a Cobb-Douglas
Example.

Suppose that the consumer has Cobb-Douglas

√
preferences: U(x1 , x2 ) = x1 x2
Then,
∂U 1 −1/2 1/2
MU1 = = x x2
∂x1 2 1
∂U 1 1/2 −1/2
MU2 = = x x
∂x2 2 1 2

So the MRS is
dx2 MU1 x2
MRS = =− =−
dx1 MU2 x1

Ch. 5 Consumer Choice Part I Econ 220

Computing Ordinary Demands - a Cobb-Douglas
Example.

At (x1∗ , x2∗ ), MRS = −p1 /p2 so

x2∗ p1 ∗
−p1 /p2 = − ⇒ x2∗ = x (1)
x1∗ p2 1

(x1∗ , x2∗ ) also exhausts the budget so

p1 x1∗ + p2 x2∗ = m (2)

System of two equations with two unknowns.

Ch. 5 Consumer Choice Part I Econ 220

Computing Ordinary Demands - a Cobb-Douglas
Example.
Substitute (1) into (2) and get:
p1 ∗
p1 x1∗ + p2 x =m
p2 1
This simplifies to...
m
x1∗ =
2p1
Substituting for x1∗ in (1), we get:
p1 m
x2∗ =
p2 2p1
This simplifies to...
m
x2∗ =
2p2
Ch. 5 Consumer Choice Part I Econ 220
Computing Ordinary Demands - a Cobb-Douglas
Example.
So we have discovered that the most preferred affordable
bundle for a consumer with Cobb-Douglas preferences
√
U(x1 , x2 ) = x1 x2 is
 
∗ ∗ m m
(x1 , x2 ) = ,
2p1 2p2
x2

Ch. 5 Consumer Choice Part I Econ 220

x1
2. Lagrange Method

Pose the utility maximisation problem as a constrained

maximisation problem:

max u(x1 , x2 )
x1 ,x2
s.t. p1 x1 + p2 x2 = m

Define an auxiliary function known as the Lagrangian:

L = u(x1 , x2 ) − λ(p1 x1 + p2 x2 − m)

where λ is the Lagrange multiplier

Ch. 5 Consumer Choice Part I Econ 220

2. Lagrange Method
The optimal choice (x1∗ , x2∗ ) must satisfy the three following
first-order conditions:
∂L ∂u(x1∗ , x2∗ )
= − λp1 = 0
∂x1 ∂x1
∂L ∂u(x1∗ , x2∗ )
= − λp2 = 0
∂x2 ∂x2
∂L
= −(p1 x1∗ + p2 x2∗ − m) = 0
∂λ
These First-Order Conditions can be solved for x1∗ , x2∗ and
λ.
The solution will have two properties:
1 x1∗ and x2∗ will obey the constraint,
2 x1∗ and x2∗ will make the value of L (and therefore u) as
large as possible.
Ch. 5 Consumer Choice Part I Econ 220
Cobb-Douglas Example

Suppose that the consumer has Cobb-Douglas

preferences:
√
U(x1 , x2 ) = x1 x2
Then, we can write the constrained maximisation problem
as:

√
max x1 x2
x1 ,x2
s.t. p1 x1 + p2 x2 = m

The Lagrangian is given by:

√
L= x1 x2 − λ(p1 x1 + p2 x2 − m)

Ch. 5 Consumer Choice Part I Econ 220

Cobb-Douglas Example

The first-order conditions are:

∂L 1 −1/2 1/2
= x1 x2 − λp1 = 0 (1)
∂x1 2
∂L 1 1/2 −1/2
= x1 x2 − λp2 = 0 (2)
∂x2 2
∂L
= −(p1 x1 + p2 x2 − m) = 0 (3)
∂λ
Divide equation (1) by equation (2):
x2 p1 p1
= ⇒ x2 = x1 (∗)
x p p2
| 1 {z 2}
−MRS = Price ratio

Ch. 5 Consumer Choice Part I Econ 220

Cobb-Douglas - Example
Substitute (*) into equation (3), i.e. the budget constraint:
p1
p1 x1 + p2 x1 = m
p2
This simplifies to...
m
x1 =
2p1
Substituting for x1 in (*), we get:
p1 m m
x2 = =
p2 2p1 2p2
The optimal choice for a consumer with Cobb-Douglas
preferences is
 
∗ ∗ m m
(x1 , x2 ) = ,
2p1 2p2
Just as before...
Ch. 5 Consumer Choice Part I Econ 220
Second order sufficient condition for a maximum
If the utility function is differentiable and the optimal choice is
interior, i.e. x1∗ > 0 and x2∗ > 0,
Then necessarily the indifference curve will be tangent to
the budget constraint at the optimum
The tangency condition is a necessary condition for a
maximum.

Ch. 5 Consumer Choice Part I Econ 220

Second order sufficient condition for a maximum
But this is not a sufficient condition for a bundle to be
optimal. For example,

However, if preferences are convex the tangency condition is

a necessary and sufficient condition for optimality (i.e. any
interior point that satisfies the tangency condition must be an
optimal point).
Ch. 5 Consumer Choice Part I Econ 220