Choice II

ECON201- MICROECONOMICS
Spring 2024
1
Consumer Theory
• We consider a rational consumer.
• We address the following two questions:
• Which combinations of goods is the consumer able to buy?
• B(p,m)
• Among the combinations of goods that the consumer is able to buy, which
combination(s) does the consumer prefers to buy?
• ≿ ⇔ u(x)
• Utility maximization problem:
Ordinary demand for
maxx u(x)
good i:
s.t. x ∈ B(p,m)
𝑥#∗ (𝑝, 𝑚)
2
Motivating Example
• Consider two goods: coffee (c) and tea (t)
• Prices are 𝑝% , 𝑝& and income is m.
• Here is what we know about three individual’s preferences for daily
consumption of coffee and tea:
• Leo: only cares about caffeine, indifferent between c and t
• Maria: likes to have c and t in a fixed proportion
• Gabriel: likes them both, but a cup of coffee gives him more pleasure than a
cup of tea
• We are going to examine their optimal consumption bundles.

3
Constrained Optimization Problem
• Utility maximization problem:

max 𝑢(𝑥)
'
𝑠. 𝑡. 𝑥 ∈ 𝐵(𝑝, 𝑚)

4
Constrained Optimization Problem
• Do I spend all my income?
• Yes, if preferences are monotonic.
• How do you check if preferences are monotonic?

5
Constrained Optimization Problem
• Do I spend all my income?
• Yes, if preferences are monotonic.
• How do you check if preferences are monotonic?
• Check if the Marginal Utility for good i is positive for all 𝑥 ∈ 0, ∞ ( :

𝜕𝑢(𝑥)
𝑀𝑈# = >0
𝜕𝑥#
• What is the implication on the utility maximization problem?

6
Constrained Optimization Problem
• Assuming monotonic preferences, the utility maximization problem
becomes:

max 𝑢(𝑥)
'
𝑠. 𝑡. 𝑝) 𝑥) + ⋯ + 𝑝( 𝑥( = 𝑚

7
Utility Maximization Problem:
1. Are preferences monotonic?
• If yes, then the optimal solution must lie on the budget constraint.

8
Utility Maximization Problem:
1. Are preferences monotonic?
• If yes, then the optimal solution must lie on the budget constraint.
2. If preferences are monotonic, two possible types of solutions are
• Corner solutions
• Interior solutions: tangency points, kinks?

9
A Cobb-Douglas Example
• Two goods (n=2)
• 𝑝) = 1 , 𝑝* = 3 , 𝑚 = 12
• 𝑢(𝑥) , 𝑥* )= 𝑥)* 𝑥*
• Here is the utility maximization problem:

max 𝑥)* 𝑥*
'! ,'"
𝑠. 𝑡. 𝑥) +3𝑥* ≤ 12

10
A Cobb-Douglas Example
• This utility function represent monotonic preferences
!
because the
marginal utilities are positive for all 𝑥 ∈ 0, ∞ :

#$ #$
𝑀𝑈" = #%!
= 2𝑥" 𝑥! and 𝑀𝑈! = #%"
= 𝑥"!

• Hence, optimal solution(s) must lie on the budget constraint.

• In other words, the consumer problem is

max 𝑥"! 𝑥!
%!,%"
𝑠. 𝑡. 𝑥" +3𝑥! = 12

11
A Cobb-Douglas Example
• Monotonic preferences: the solutions are on the budget line and there are two possible
types of candidates
• Corner solutions candidates: (12,0) and (0,4)
• Interior solutions candidate: 𝑥!∗ , 𝑥#∗ such that 𝑥!∗ > 0 and 𝑥#∗ > 0

• Indifference
∗ ∗
curve is smooth and has no kink. To find interior solutions candidates
𝑥# , 𝑥% we need to find the tangency points which are the points that solve the
tangency condition and budget constraint equation simultaneously:
∗ ∗
𝑝#
𝑀𝑅𝑆 𝑥# , 𝑥% = −
𝑝%
∗ ∗
𝑥# +3𝑥% = 12
!"
!#$ &'$
• Recall that 𝑀𝑅𝑆 𝑥# , 𝑥% = − !" =− . Hence, given 𝑢(𝑥# , 𝑥% )= 𝑥#% 𝑥% ,
&'%
!#%
%($ (% %(%
𝑀𝑅𝑆 𝑥# , 𝑥% = − =−
($% ($

12
A Cobb-Douglas Example
• Hence, the tangency condition and budget constraint equation at an interior solution are:

2𝑥!∗ 1
− ∗ =−
𝑥# 3

𝑥#∗ + 3𝑥!∗ = 12

• This is a system of two∗ equations and two unknowns. The tangency condition equation is
$
equivalent to 𝑥!∗ = !. Insert 𝑥!∗ in the budget constraint equation to obtain:
%
$!∗
𝑥#∗ + 3( ) = 12 or 𝑥#∗ = 8
%

$!∗ &
• Next, by tangency condition, 𝑥!∗ = = . Hence, the interior solution candidate is 𝑥#∗, 𝑥!∗ =
& % %
(8, )
%

13
A Cobb-Douglas Example
• Hence, the candidate solutions are:
• Corner solutions candidates: (12,0) and (0,4)
!
• Interior solution candidate: (8, )
"
• Lastly, we need to evaluate the value of the utility function at these
three points.
! !
• 𝑢 12,0 = 𝑢 0,4 = 0 < 8# "
= 𝑢(8, ").
6
• Hence, the optimal bundle is the interior solution 𝑥)∗ , 𝑥*∗ = (8, 7).

14
Fact 1
If all the following conditions hold:
(i) the marginal utilities are positive;
(ii) the solution to the tangency condition and the budget constraint equation
is positive in both coordinates (i.e., an interior solution);
(iii) the absolute value of MRS is strictly decreasing in 𝑥$ (diminishing MRS
property);
then the interior solution is the unique optimal bundle that solves the
consumer’s problem.

15
A Quasilinear Example
• Two goods (n=2)
• 𝑝) = 1 , 𝑝* = 4 , 𝑚 = 3
)/*
• 𝑢(𝑥) , 𝑥* )= 𝑥) + 𝑥*
• Here is the utility maximization problem:

)/*
max 𝑥) + 𝑥*
'! ,'"
𝑠. 𝑡. 𝑥) +4𝑥* ≤ 3

16
A Quasilinear Example
• This utility function represent monotonic preferences
!
because the
marginal utilities are positive for all 𝑥 ∈ 0, ∞ :

#$ #$
𝑀𝑈" = #%!
= .5𝑥"/.1 and 𝑀𝑈! = #%"
=1

• Hence, optimal solution(s) must lie on the budget constraint.

• In other words, the consumer problem is

"/!
max 𝑥" + 𝑥!
%!,%"
𝑠. 𝑡. 𝑥" +4𝑥! = 3
17
A Quasilinear Example
• Monotonic preferences: the solutions are on the budget line and there are two possible types of
candidates
• Corner solutions candidates: (3,0) and (0,3/4)
• Interior solutions candidate: 𝑥#∗ , 𝑥$∗ such that 𝑥#∗ > 0 and 𝑥$∗ > 0

• Indifference curve is smooth and has no kink. To find interior solutions candidates 𝑥#∗, 𝑥!∗ we
need to find the tangency points which are the points that solve the tangency condition and
budget constraint equation simultaneously:
∗ ∗ 𝑝#
𝑀𝑅𝑆 𝑥# , 𝑥! = −
𝑝!
∗ ∗
𝑥# +4𝑥! = 3

'(! #/!
• Recall that 𝑀𝑅𝑆 𝑥# , 𝑥! = − . Hence, given 𝑢(𝑥# , 𝑥! )= 𝑥# + 𝑥! ,
'(%

.+$!&.( #
𝑀𝑅𝑆 𝑥# , 𝑥! = − =−
# ! $!

18
A Quasilinear Example
• Hence, the tangency condition and budget constraint equation at an interior solution are :

1 1
− =−
∗
2 𝑥# 4

𝑥#∗ + 4𝑥!∗ = 3

• This is a system of two equations and two unknowns. The tangency condition equation is
equivalent to 2 𝑥#∗ = 4, or 𝑥#∗ = 4. Insert 𝑥#∗ in the budget constraint equation to obtain:
4 + 4𝑥!∗ = 3 or 𝑥!∗ = −1/4

• Hence, the bundle that satisfy both budget constraint equation and tangency condition has a
negative coordinate. Such a bundle is not a consumption bundle!

19
A Quasilinear Example
• Hence, the candidate solutions are only corner solutions
• Corner solutions candidates: (3,0) and (0,3/4)

• Lastly, we need to evaluate the value of the utility function at these

two points:
%
• 𝑢 3,0 = 3 > & = 𝑢 0,3/4 .

• Hence, the optimal bundle is the corner solution 𝑥)∗ , 𝑥*∗ = (3,0).
• Exercise: draw the indifference curves and the budget constraint and
convince yourself of this result.

20
A Quasilinear Example

21
A Generalized Cobb-Douglas Example
• Maintain the assumption of two goods (n=2)
• 𝑝) > 0 , 𝑝* > 0 , 𝑚 > 0
@ ()A@)
• 𝑢 𝑥) , 𝑥* = 𝑥) 𝑥* , 𝛼 ∈ (0,1)
• Here is the utility maximization problem:

@ ()A@)
max 𝑥) 𝑥*
'! ,'"
𝑠. 𝑡. 𝑝) 𝑥) + 𝑝* 𝑥* ≤ 𝑚

22
A Generalized Cobb-Douglas Example
• This utility function represent monotonic
!
preferences because marginal
utilities are positive for all 𝑥 ∈ 0, ∞ :

#$ 3/" ("/3) #$
#%!
= 𝛼𝑥" 𝑥! and #%"
= (1 − 𝛼)𝑥"3 𝑥!/3

• Hence, optimal solution(s) must lie on the budget constraint.

• In other words, the consumer problem is

("/3)
max 𝑥"3 𝑥!
%!,%"
𝑠. 𝑡. 𝑝" 𝑥" +𝑝! 𝑥! = 𝑚

23
A Generalized Cobb-Douglas Example
• Monotonic preferences: the solutions are on the budget line and there are two possible
types of candidates
• Corner solutions candidates: (𝑚/𝑝! , 0) and (0, 𝑚/𝑝# )
• Interior solutions candidate: 𝑥!∗ , 𝑥#∗ such that 𝑥!∗ > 0 and 𝑥#∗ > 0

• Indifference
∗ ∗
curve is smooth and has no kink. To find interior solutions candidates
𝑥# , 𝑥% we need to find the tangency points which are the points that solve the
tangency condition and budget constraint equation simultaneously:
∗ ∗
𝑝#
𝑀𝑅𝑆 𝑥# , 𝑥% = −
𝑝%
∗ ∗
𝑝# 𝑥# +𝑝% 𝑥% = 𝑚

&'$ (#+))
• Recall that 𝑀𝑅𝑆 𝑥# , 𝑥% = − . Hence, given 𝑢 𝑥# , 𝑥% = 𝑥#) 𝑥% ,
&'% (!#")
$%!"#! %$ $%$
𝑀𝑅𝑆 𝑥! , 𝑥# = − =−
(!'$)%!" %$#" !'$ %!

24
A Generalized Cobb-Douglas Example
• Hence, the tangency condition and budget constraint equation at at an interior solution are:

𝛼𝑥!∗ 𝑝#
− =−
1 − 𝛼 𝑥#∗ 𝑝!

𝑝# 𝑥#∗ + 𝑝! 𝑥!∗ = 𝑚
• This is a system of two equations and two unknowns. The tangency condition equation is
equivalent to
,! #-. $!∗
𝑥!∗ = .
,% .
• Insert 𝑥!∗ in the budget constraint equation to obtain:
,! #-. $!∗
𝑝# 𝑥#∗ + 𝑝! ( ) =𝑚
,% .
• This equation is equivalent to
#-. $!∗ /
𝑝# 𝑥#∗ + 𝑝# = 𝑚 or 𝑥#∗ = 𝛼
. ,!

25
A Generalized Cobb-Douglas Example
• Next, by the tangency condition,
() $)* +)∗ () ($)*) . .
𝑥#∗ = = 𝛼 or 𝑥#∗ = (1 − 𝛼)
(* * (* * () (*

*. ($)*).
• Hence, the interior solution candidate is 𝑥$∗ , 𝑥#∗ = ( ( , (
).
) *
• Note that both coordinates are positive 𝑝$ > 0 , 𝑝# > 0 , 𝑚 > 0 , and 𝛼 ∈ (0,1)
• The preference has diminishing MRS property because by 𝛼 ∈ (0,1)
𝛼𝑥#
|𝑀𝑅𝑆 𝑥$, 𝑥# | =
1 − 𝛼 𝑥$
is strictly decreasing in 𝑥$.
. .
• Hence, by Fact 1, the interior solution 𝑥$∗ , 𝑥#∗ = (𝛼 ( , (1 − 𝛼) ( ) is the
) *
unique bundle that solves consumer’s maximization problem.
26
A Generalized Cobb-Douglas Example

(1 − 𝛼)𝑚
𝑥'∗ =
𝑝'
(&*()
𝑢 𝑥& , 𝑥' = 𝑥&( 𝑥'

𝛼𝑚
𝑥&∗ =
𝑝&

Copyright © 2019 Hal R. Varian

Perfect Substitutes revisited
• Maintain the assumption of two goods (n=2)
• 𝑝) > 0 , 𝑝* > 0 , 𝑚 > 0
• 𝑢 𝑥) , 𝑥* = 𝑎) 𝑥) + 𝑎* 𝑥* where 𝑎) and 𝑎* are positive.
• Here is the utility maximization problem:

max 𝑎) 𝑥) + 𝑎* 𝑥*
'! ,'"
𝑠. 𝑡. 𝑝) 𝑥) + 𝑝* 𝑥* ≤ 𝑚

28
Perfect Substitutes
• This utility function represent monotonic preferences because the
marginal utilities are positive for all 𝑥 ∈ 0, ∞ ! :

𝑀𝑈" = 𝑎" and 𝑀𝑈! = 𝑎!

• Hence, optimal solution(s) must lie on the budget constraint.

• In other words, the consumer problem is

max 𝑎" 𝑥" + 𝑎! 𝑥!

%!,%"
𝑠. 𝑡. 𝑝" 𝑥" + 𝑝! 𝑥! = 𝑚
29
Perfect Substitutes
• Hence, the solutions are on the budget line and there are two possible types of
candidates
• Corner solutions candidates: (𝑚/𝑝! , 0) and (0, 𝑚/𝑝# )
• Interior solutions candidate: 𝑥!∗ , 𝑥#∗ such that 𝑥!∗ > 0 and 𝑥#∗ > 0

• Indifference
∗ ∗
curves are linear and have no kink. To find interior solutions candidates
𝑥# , 𝑥% we need to find the tangency points which are the points that solve the
tangency condition and budget constraint equation simultaneously:
∗ ∗
𝑝#
𝑀𝑅𝑆 𝑥# , 𝑥% = −
𝑝%
∗ ∗
𝑝# 𝑥# +𝑝% 𝑥% = 𝑚

&'$
• Recall that 𝑀𝑅𝑆 𝑥# , 𝑥% = − . Hence, given 𝑢 𝑥# , 𝑥% = 𝑎# 𝑥# + 𝑎% 𝑥% ,
&'%
-$
𝑀𝑅𝑆 𝑥# , 𝑥% = −
-%

30
Perfect Substitutes
• Since the- MRS
.
is constant,
-
there
.
are three
-
possible
.
cases:
$ $ $ $ $ $
Case (i) > ; Case (ii) < ; Case (iii) =
-% .% -% .% -% .%

• The tangency condition and budget constraint equation at the given prices
are:
𝑎" 𝑝"
− =−
𝑎! 𝑝!

𝑝" 𝑥"∗ + 𝑝! 𝑥!∗ = 𝑚

• This is a system of two equations and two unknowns. But, the tangency
condition is violated in the Case (i) and Case (ii) and it is only satisfied in
Case (iii).

31
Perfect Substitutes
D! E!
• Case (i) > : violates the tangency condition. Hence, the
D" E"
tangency condition and the budget constraint equation do not admit
any solution.
• Hence, there is only one possible type of candidates
• Corner solutions candidates: (𝑚/𝑝$, 0) and (0, 𝑚/𝑝#)
• Lastly, we need to evaluate the value of the utility function at these
points:
8) . 8* .
• 𝑢 𝑚/𝑝$, 0 = ()
> (*
= 𝑢(0, 𝑚/𝑝#).
• Hence, the optimal bundle is the corner solution 𝑥)∗ , 𝑥*∗ =
(𝑚/𝑝) , 0).
32
Perfect Substitutes
D! E!
• Case (ii) < : violates the tangency condition. Hence, the
D" E"
tangency condition and the budget constraint equation do not admit
any solution.
• Hence, there is only one possible type of candidates
• Corner solutions candidates: (𝑚/𝑝$, 0) and (0, 𝑚/𝑝#)
• Lastly, we need to evaluate the value of the utility function at these
two points:
8) . 8* .
• 𝑢 𝑚/𝑝$, 0 = ()
< (*
= 𝑢(0, 𝑚/𝑝#).
• Hence, the optimal bundle is the corner solution 𝑥)∗ , 𝑥*∗ =
(0, 𝑚/𝑝* ).
33
Perfect Substitutes
D! E!
• Case (iii) = : Thus, the tangency condition is always satisfied.
D" E"
• So the system of tangency condition and the budget constraint
equation reduces to 𝑝) 𝑥)∗ + 𝑝* 𝑥*∗ = 𝑚
• Every point that satisfies the budget equation is a potential
candidate.
• Hence, there are two possible types of candidates
• Corner solutions candidates: (𝑚/𝑝$, 0) and (0, 𝑚/𝑝#)
• Interior solutions candidate: 𝑥$∗ , 𝑥#∗ such that 𝑥$∗ > 0 and 𝑥#∗ > 0 and
𝑝$𝑥$∗ + 𝑝#𝑥#∗ = 𝑚

34
Perfect Substitutes
• Lastly, we need to evaluate the value of the utility function at all these points.
8) . 8* .
• Corner points: 𝑢 𝑚/𝑝$, 0 = ( = ( = 𝑢(0, 𝑚/𝑝#).
) *
• Interior points: 𝑢 𝑥$∗ , 𝑥#∗ = 𝑎$𝑥$∗ + 𝑎#𝑥#∗ where 𝑝$𝑥$∗ + 𝑝#𝑥#∗ = 𝑚.
0 0
• Multiply both sides of the budget constraint equation by ! to obtain: 𝑎# 𝑥#∗ + ! 𝑝! 𝑥!∗ =
0! / ,! ,!
.
,!
0! /
• By Case (iii) assumption, this equation is equivalent to 𝑎# 𝑥#∗ + 𝑎! 𝑥!∗ =
0 / ,!
• Hence, 𝑢 𝑥#∗, 𝑥!∗ where 𝑝# 𝑥#∗ + 𝑝! 𝑥!∗ = 𝑚 is ! .
,!

• Hence, every consumption bundle on the budget constraint equation admits the
same level of utility and are optimal.
• Note that |MRS| is constant. Hence, Fact 1 does not apply.

35
Perfect Substitutes
• In brief, given 𝑢 𝑥) , 𝑥* = 𝑎) 𝑥) + 𝑎* 𝑥* where 𝑎 and 𝑏 are positive,
𝑝) > 0 , 𝑝* > 0 , and 𝑚 > 0, the optimal consumption bundle
𝑥)∗ , 𝑥*∗ is

H D! D"
,0 , 𝑖𝑓 > ,
E! E! E"
D! D"
𝑎𝑛𝑦 𝑓𝑒𝑎𝑠𝑖𝑏𝑙𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡, 𝑖𝑓 = ,
𝑥)∗ , 𝑥*∗ = E! E"
H D! D"
E"
,0 , 𝑖𝑓 E!
<E .
"

36
Perfect Substitutes When MRS=-1

37
Perfect Substitutes When MRS=-1

𝒂𝟏 𝒑𝟏 𝒂𝟏 𝒂𝟐
𝟏= < or equivalently <
𝒂𝟐 𝒑𝟐 𝒑𝟏 𝒑𝟐

38
Perfect Substitutes When MRS=-1

𝒂𝟏 𝒑𝟏 𝒂𝟏 𝒂𝟐
𝟏= < or equivalently <
𝒂𝟐 𝒑𝟐 𝒑𝟏 𝒑𝟐

39
Perfect Substitutes When MRS=-1

𝒂𝟏 𝒑𝟏 𝒂𝟏 𝒂𝟐
𝟏= < or equivalently <
𝒂𝟐 𝒑𝟐 𝒑𝟏 𝒑𝟐

40
Perfect Substitutes When MRS=-1

𝒂𝟏 𝒑𝟏 𝒂𝟏 𝒂𝟐
𝟏= > or equivalently >
𝒂𝟐 𝒑𝟐 𝒑𝟏 𝒑𝟐

41
Perfect Substitutes When MRS=-1

𝒂𝟏 𝒑𝟏 𝒂𝟏 𝒂𝟐
𝟏 = 𝒂 = 𝒑 or equivalently 𝒑𝟏
=𝒑
𝟐 𝟐 𝟐

42
Differences in Preferences Result in Differing Choice

43
Source: “Intermediate Microeconomics and Its Applications”, Nicholson and Snyder, 12th edition