Department of Economics (STG), ECO204, 2023-2024, Ajaz Hussain

Final Exam Prep: Consumer Theory Check-List

Consumer Theory 1 Lecture Slides
Consumer Theory 2 Lecture Slides
Consumer Theory 3 Lecture Slides
Lecture Slide(s)/Video(s):
Consumer Theory 4 Lecture Slides
Consumer Theory 5 Lecture Slides
“Missing annotations are in the Chapters”
Quercus > Tutorials: Tutorials 5 through 12
Consumer-Theory-Chapter 1
Chapter(s): Consumer-Theory-Chapter 2
Consumer-Theory-Chapter 3
[Optional: Watch these at your own risk] 2020-2021 Consumer Theory Videos
Video(s): I do not recommend watching these old and very long videos – I am posting it for students who may
want to clarify concepts/techniques. You are better off reading the chapter.

The Tutorials are the primary source of “practice-problems”.

If you have kept abreast of the course material, then it should take you about 1 to 1.5 hours to go through and
process the “algos” in this check-list for the final exam. Focus on setting up and solving UMPs followed by
computing Marginal Utilities and Elasticities.

Preferences

• We will model a consumer’s choice of “goods and services” (hereafter “goods”) that she, a price taker, can purchase from markets.
available for purchase in = choice/behavior of amounts of goods/services “goods” available for purchase in the market (consumer is
a price taker).
• For tractability, we will construct two-good models where the consumer can buy any non-negative amounts of goods 1 and 2 aka the
“consumption set” 𝐶 = {(𝑞! , 𝑞" ) ≥ 0}. Points in the consumption set are bundles where an interior bundle has positive amounts of
both goods and a boundary bundle has zero amounts of at least one good.
• Define the preference operators: ≻ “is better than”; ~ “indifferent to”; ≿ “at least as good as”
• To model consumer choice/behavior we need the consumer to have rational preferences.
§ Pick any two bundles 𝑥, 𝑦 ∈ 𝐶 à ask consumer to “rank” the two bundles
"I can't decide/make up my mind" → she has incomplete preferences
à if she responds with: 2
Either 𝑥 ≻ 𝑦 or 𝑥~𝑦 → she has complete preferences
• If she has complete preferences, check if she has transitive preferences à ask consumer to “rank” the bundles 𝑥 𝑣𝑠. 𝑦 and
𝑦 𝑣𝑠. 𝑧 à suppose she tells you that 𝑥 ≿ 𝑦 and that 𝑦 ≿ 𝑧 à if so, ask her to rank 𝑥 𝑣𝑠. 𝑧
z ≿ 𝑥 → she has intransitive preferences
§ à if she responds with 2 .
𝑥 ≿ 𝑧 → she has transitive preferences
• A consumer with complete and transitive preferences is said to have “rational preferences”.
• To check rational preferences, can we first check for transitive preferences then for complete preferences?
• Note: in reality, you and I at one time or another have had irrational preferences. But for the sake of modeling, we assume
consumers have rational preferences.

Example: To “check” whether a consumer has rational preferences, do we:

a. First check for transitive preferences and then for complete preferences?
b. Or, first check for complete preferences and then for transitive preferences?

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Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
Answer
We can’t check for transitive preferences unless she has complete preferences. So: correct answer part b.

Examples: See Quercus > Tutorials 5 through 12 and Quercus > Test 2 Solutions.

Representing Rational Preferences by an Infinite # of Utility Functions

• Rational preferences (“rankings”) can always be represented by a utility function (a function is a rule which assigns to each value in the
domain a value in the range) by the following two rules:

𝑥 ≻ 𝑦 if and only if 𝑈(𝑥) > 𝑈(𝑦)

𝑥 ~ 𝑦 if and only if 𝑈(𝑥) = 𝑈(𝑦)

• Utility values are ordinal #s. As such, given one utility function, we can obtain an infinite # of other utility functions (all representing
the same original rational preferences) by applying any one/combo of Positive Monotonic Transformations:

Examples: Positive Monotonic Transformation (PMT) Operations

“constant” = Positive #
Initial Utility PMT New Utility

𝑈 = 𝑓(𝑥) Adding a constant to the RHS 𝑈 = 𝑓(𝑥) + constant

𝑈 = 𝑓(𝑥) Multiplying the RHS by a constant 𝑈 = constant 𝑓(𝑥)
𝑈 = 𝑓(𝑥) Raising the RHS by a constant 𝑈 = [𝑓(𝑥)]#$%&'(%'
𝑈 = 𝑓(𝑥) Taking natural logs of the RHS 𝑈 = ln[𝑓(𝑥)]

𝑈 = 𝑓(𝑥) Any combination of the above 𝑈 = 𝑔T𝑓(𝑥)U where 𝑔) > 0

%&
!*"+,(. "#! / . "#! )
$
Example: Suppose a consumer’s utility function, defined over the domain 𝐶 = {(𝑞! , 𝑞" ) ≥ 0}, is 𝑈 = 𝑒 where
𝛼 is an integer (possibly, negative/zero/positive). Perform a sequence of Positive Monotonic Transformations which yields the most facile
utility function representing this consumer’s preferences.

Answer
You should be able to see the PMT used in each step below:

%&
*"+,(.!"#! / .$"#! )
𝑈=𝑒

%&
𝑈 = X204(𝑞!23! + 𝑞"23! )

𝑈 = 204(𝑞!23! + 𝑞"23!

𝑈 = 𝑞!23! + 𝑞"23!

Example: Can you tell which PMT was used in each step below?
𝛼 1 "
𝑈= 𝑞! − 𝑞 + 𝑞"
𝛽 2𝛽 !

2𝛼 1 " 𝛼" 𝛼"

𝑈= 𝑞! − 𝑞 + − + 𝑞" (completing the square)
2𝛽 2𝛽 ! 2𝛽 2𝛽

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Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
 (𝛼 − 𝑞! )" 𝛼 "
𝑈=− − + 𝑞"
2𝛽 2𝛽

(𝛼 − 𝑞! )"
𝑈= − + 𝑞"
2𝛽

From Utility Functions to Gleaning Insights about the Consumer’s Preferences

Suppose we are given a consumer’s utility function1 of which the four functions commonly used are the:
4
• Cobb-Douglas Utility Function:: 𝑈 = 𝑞!2 𝑞" where (generally) 𝛼, 𝛽 > 0 and 𝛼 + 𝛽 = 1.
• Note: It’s possible you’re given 𝑈 = 𝑞!5 𝑞"6 where 𝑎, 𝑏 > 0 and 𝑎 + 𝑏 ≠ 1. From lectures/tutorials, you know that we
4
can use PMT(s) to transform 𝑈 = 𝑞!5 𝑞"6 where 𝑎 + 𝑏 ≠ 1 into 𝑈 = 𝑞!2 𝑞" where 𝛼 + 𝛽 = 1 (simply raise 𝑞!5 𝑞"6 to the
power 1/(𝑎 + 𝑏))
• Note: The Log-Linear Cobb-Douglas Utility function 𝑈 = 𝛼 ln 𝑞! + 𝛽 ln 𝑞" represents the same set of preferences as
the Cobb-Douglas Utility Function.
• Linear Utility Function: 𝑈 = 𝛼𝑞! + 𝛽𝑞" where (generally) 𝛼, 𝛽 > 0
• Complements Utility Function: 𝑈 = min(𝛼𝑞! , 𝛽𝑞" ) where (generally) 𝛼, 𝛽 > 0
• Quasi-Linear Utility Function: 𝑈 = 𝑞! + 𝑓(𝑞" ) or 𝑈 = 𝑓(𝑞! ) + 𝑞" where 𝑓(𝑞) is any function of 𝑞 and where generally
𝑓 ) ( ) > 0.
• Note: The mean-variance utility function 𝑈 = 𝐸[𝑟] − 𝑐𝜎 " is a Quasi-Linear utility function where good 1 is 𝜎 and good
2 is 𝐸[𝑟] where notice that one good is good and the other good is bad (which ones?). Verify that overall utility goes up
in the NW direction.
• Example of a Quasi-Linear Utility function of the form 𝑈 = 𝑓(𝑞! ) + 𝑞" :
(𝛼 − 𝑞! )"
𝑈= − + 𝑞"
2𝛽
where 𝑓 ) (𝑞! ) > 0 for certain values of 𝑞! (which ones)?
Once you have a utility function, you can obtain “insights” into the consumer’s preferences by the following algos (valid for differentiable
utility functions only):
89
• Marginal Utility of Good 𝑖 = 𝑀𝑈7 = 8. (at interior bundles) to gauge whether good 𝑖 is a “good”, “bad”, or “neutral” good:
'

𝜕𝑈 > 0, then good 𝑖 is a good good at that bundle

If at an interior bundle: 𝑀𝑈7 = n < 0, then good 𝑖 is a bad good at that bundle
𝜕𝑞7
= 0, then good 𝑖 is a neutral good at that bundle

Example: Suppose a consumer’s utility function, defined over the domain 𝐶 = {(𝑞! , 𝑞" ) ≥ 0}, is 𝑈 = 𝑞!23! + 𝑞"23! . What is the smallest
integer value of 𝛼 for which this consumer perceives both goods as “good” goods?

Answer
For good goods we require marginal utilities to be positive at all interior bundles. Consider good 𝑖:

𝜕𝑈
𝑀𝑈7 = = (𝛼 − 1)𝑞753"
𝜕𝑞7

Thus, 𝑀𝑈7 > 0 so long as 𝛼 is an integer > 1.

• You should know how to tell the “direction of higher overall utility values”. For example:
• If both goods are good goods, then both goods have 𝑀𝑈 > 0 à direction of overall higher utility values will be NE.
• If both goods are bad goods, then both goods have 𝑀𝑈 < 0 à direction of overall higher utility values will be SW.
• The “shape” of indifference curves tells us, for example, whether the consumer will purchase only interior or boundary bundles or
whether the consumer can possibly purchase interior and/or boundary bundles; whether the two goods are (im)perfect substitutes; the
intensity of preferences at a particular interior bundle; and, whether she has (strictly) convex preferences. To do this, you need to
know how to plot the indifference curve for a given utility value (the following algos are for differentiable utility functions; as such,
you can’t use the algos to plot the indifference curves of a “complements” utility function):
• Start with 𝑈 = 𝑓(𝑞! , 𝑞" )

1
Assume throughout that the utility function is for 2 goods defined on (𝑞! , 𝑞" ) ≥ 0.
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Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
 • Express 𝑞" in terms of 𝑞! and 𝑈 (assumed fixed) à this is your IC equation
• Compute y-axis (good 2) intercept by subbing 𝑞! = 0 in the IC equation. The intercept may be finite (i.e. IC touches y-axis) or
infinite (i.e. IC approaches y-axis and touches it at infinity). If intercept is finite, find the |slope|: if it is finite (infinite) the consumer
may (will not) consume this boundary bundle [can you jump ahead to UMP cases to see why consumer will not buy y-axis bundle if
the IC|slope| at that bundle is infinite?
• Repeat this ↑ for the x-axis (good 1) intercept and slope (obviously, you’ll have to modify the results).
:. @9
• Compute the slope of the IC at an interior bundle as :.$ = 𝑀𝑅𝑆 = − @9! (make sure you practice this)
! 9 ;<=>?5=? $
• You should be able to deduce the “shape” of the IC from the intercepts and slope. For example, what’s the “curvature” of an
2. 2.
IC with 𝑀𝑅𝑆 = − 4 .$ vs. 𝑀𝑅𝑆 = − 4 .! (assume parameters are positive)?
! $
• If both goods are good goods à IC is downward sloping (why?) and if:

varies with 𝑞! and or 𝑞" → the two goods are perceived as imperfect substitutes (not ECO101)
|𝑀𝑅𝑆| 2
constant → the two goods are perceived as perfect substitutes (not ECO101)

• We used 𝑀𝑅𝑆 to do three mini-cases for broadband services: (1) How much improvement in a service attribute required to leave
customer indifferent to higher cost of broadband service? (2) How much more can we charge consumer by improving some
service attribute and leave customer indifferent? (3) If provider improves some service attribute then how much can it worsen
some other service attribute and leave the consumer indifferent?
• Suppose the two good are good goods and perceived as substitutes. At a particular interior bundle, if:
> 1 then greater intensity of preference for good 1 over good 2 (why?)
𝑑𝑞"
x x = |𝑀𝑅𝑆| n< 1 then greater intensity of preference for good 2 over good 1 (why?)
𝑑𝑞! 9 ;<=>?5=?
= 1 equal intensity of preference for good 1 and good 2 (why?)
• We showed how to use “intensity of preferences” for market segmentation (teens vs. parents)
• To see if consumer has “strictly convex preferences”:
• “Graphical IC method”: Pick two bundles 𝐴 and 𝐵 on an IC. Obviously, 𝐴 ~ 𝐵. Draw a straight line connecting 𝐴 and 𝐵: any
combination of 𝐴 and 𝐵 is going to be on this line. Pick a point 𝐶 on the line. Again, 𝐶 is a combination of 𝐴 and 𝐵 where
𝐶 = 𝛼𝐴 + (1 − 𝛼)𝐵 for 𝛼 ∈ (0,1) [why not 𝛼 ∈ [0,1]?].
≻ 𝐴 (and 𝐵) → consumer has strictly convex preferences
If every possible combo bundle 𝐶 (on the line) is 2
≿ 𝐴 (and 𝐵) → consumer has convex preferences
otherwise the consumer does not have convex preferences. Exercise: sketch IC graphs depicting these scenarios.
• “Math method”: If the two goods are goods goods, then if:
𝑑|𝑀𝑅𝑆| < 0 for all interior bundles → consumer has strictly convex preferences
~ = 0 for all interior bundles → consumer has convex preferences
𝑑𝑞!
≤ 0 for all interior bundles → consumer has convex preferences
otherwise consumer does not have convex preferences. Exercise: how would you modify this rule if (say) one good is good
while the other good is bad (for example, the mean-variance utility function 𝑈 = 𝐸[𝑟] − 𝑐𝜎 " ?).

Example: Suppose a consumer’s utility function, defined over the domain 𝐶 = {(𝑞! , 𝑞" ) ≥ 0}, is 𝑈 = 𝑞!23! + 𝑞"23! . From the previous
example, we know that both goods will have 𝑀𝑈 > 0 so long as 𝛼 is an integer > 1 (i.e. 2 is the smallest integer value for both goods to
be good goods). Now suppose that 𝛼 = 2 ∗ Smallest Integer Value for both goods to be good goods à 𝛼 = 2 ∗ 2 = 4.

(a) Graph the indifference curve for a fixed level of utility. You need show all necessary calculations.

Answer
The smallest integer > 1 is 2. Going forward 𝛼 = 4 so that the utility function is:

𝑈 = 𝑞!23! + 𝑞"23! = 𝑞!A + 𝑞"A

Fixing utility at 𝑈, the IC equation is derived below:

𝑞"A = 𝑈 − 𝑞!A

!
𝑞" = [𝑈 − 𝑞!A ]A

!
As 𝑞! = 0 à the y-axis intercept 𝑈 &

!
As 𝑞" = 0 à the x-axis intercept 𝑈 &
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Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
 To gauge the shape of IC at interior bundles, compute the slope:

𝑑𝑞" 𝑀𝑈! 3 𝑞!" 𝑞! "

|9 = 𝑀𝑅𝑆 = − = − " = −„ …
𝑑𝑞! 𝑀𝑈" 3 𝑞" 𝑞"

.
In absolute terms, the slope is proportional to .! (opposite of Cobb-Douglas Utility Function). As such, the ICs look like:
$

𝑞2

𝑞1

(b) Does the consumer perceive goods 1 and 2 as (im)perfect substitutes?

Answer
Imperfect substitutes. She’s willing to sub good 2 for good 1 and still have the same level of utility as before, albeit where the rate
of substitution varies from bundle to bundle.

(c) For which bundles does the consumer have a greater intensity of preferences for good 1?
Answer
If she has a greater intensity of preferences for good 1, then to consume another unit of good 1, she must be willing to give up
more than one unit of good 2; i.e. at all bundles where the absolute value of the IC slope > 1:

𝑞 "
|𝑀𝑅𝑆| = „ ! … > 1 → 𝑞! > 𝑞" → all bundles below the 45 degree line
𝑞"

(d) Use a “graphical” argument to tell if the consumer has/doesn’t have convex preferences.

Answer
In the following graph, notice that every combo 𝐶 of bundles 𝐴 ~ 𝐵, where 𝐶 = 𝛼𝐴 + (1 − 𝛼)𝐵, 𝛼 ∈ (0,1), is “worse off” than
either 𝐴 or 𝐵, i.e. this consumer does not have convex preferences:

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Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
 A

𝑞2 C

𝑞1

(e) Use a “math” argument for whether or not the consumer has convex preferences. For your convenience, see formulas at the
“end” of this note.

Answer
:|@CD|
According to the formula sheet, if :. < 0 then the consumer has convex preferences. Let’s check:
!

𝑞! "
|𝑀𝑅𝑆| = „ …
𝑞"
:|@CD| .
:.!
= 2 .!$ > 0 at all interior bundles.
$

Thus, the consumer does not have convex preferences.

• Special note on the Complements Utility Function: 𝑈 = min(𝛼𝑞! , 𝛽𝑞" ) where (generally) 𝛼, 𝛽 > 0. The IC’s look like L-shaped curves
2
whose corners lie on the locus 𝑞" = 4 𝑞! (the plot below is for 𝑈 = min(2𝑞! , 𝑞" )):

2 2
• The fact that the corners line is 𝑞" = 𝑞! means that 𝑈 = min(𝛼𝑞! , 𝛽𝑞" ) à the consumer prefers to combine units of good
4 4
2 per unit of good 1.
"
• Example: 𝑈 = min(2𝑞! , 𝑞" ) à consumer prefers to combine ! = 2 units of good 2 per unit of good 1.
!
• Example: 𝑈 = min(𝑞! , 2 𝑞" ) à consumer prefers to combine " units of good 2 per unit of good 1 or put another
way, she prefers to combine 1 unit of good 2 per 2 units of good 1.
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Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
 • Example: Jazzy prefers to combine 3 units of good 2 per 4 units of good 1. What’s his utility function?
§ Answer
2
Recall that 𝑈 = min(𝛼𝑞! , 𝛽𝑞" ) à the consumer prefers to combine 4 units of good 2 per unit of good 1.
A
Now, Jazzy prefers to combine 3 units of good 2 per 4 units of good 1 à Jazzy prefers to combine , units of
2 A 2 A
good 2 per unit of good 1 à = , à 𝛼 and 𝛽 can have any value so long as 4 = ,.
4

For example, 𝛼 = 3 and 𝛽 = 4 so that 𝑈 = min(3𝑞! , 4𝑞" ).

For example, 𝛼 = 6 and 𝛽 = 8 so that 𝑈 = min(6𝑞! , 8𝑞" ).

• You should review the Complements Utility Model covered in Quercus > Tutorials 5 through 12 and in the Consumer-
Theory Chapters.

Examples: See Quercus > Tutorials 5 through 12 and Quercus > Test 2 Solutions.

Modelling the Consumer’s Choice of 𝒒𝟏 and 𝒒𝟐 by the Utility Maximization Problem (UMP)
&
How to compute Marginal Utilities and Elasticities of, for example, own price, cross price, and income

The standard model of consumer choice in micro-economics is the UMP: the consumer chooses amounts of goods 1 and 2 (𝑞!∗ and 𝑞"∗ ) to
maximize utility subject to two constraints: (1) at the optimal choice expenditure equals income, and (2) the optimal choice should be
≥ 𝑞!H7= and 𝑞"H7= which are almost always nil so that we require 𝑞!∗ and 𝑞"∗ to be ≥ 0. Formally:

max 𝑈(𝑞! , 𝑞" ) 𝑠. 𝑡. 𝑃! 𝑞! + 𝑃" 𝑞" = 𝑌, 𝑞! ≥ 𝑞!H7= = 0, 𝑞" ≥ 𝑞"H7= = 0

.! , .$

Where 𝑃! , 𝑃" , 𝑌 > 0.

• Note: Technically, the optimal choice expenditure must be less than or equal to income (i.e. 𝑃! 𝑞! + 𝑃" 𝑞. ≤ 𝑌). In ECO204, we
assume both goods are good goods so that the budget constraint becomes 𝑃! 𝑞! + 𝑃" 𝑞. = 𝑌 (why?).
• Notes on budget constraint 𝑃! 𝑞! + 𝑃" 𝑞. = 𝑌:
J
• The maximum amount of good 1 you can buy with your income and current prices is K
!
J
• The maximum amount of good 2 you can buy with your income and current prices is K .
$
• If you have purchased a bundle “on the budget line” (so that expenditure = income), then in order to buy another unit of
:. K
good 1 and remain within your means, you will need to “give up” :.$ |LMNL=:7?OPL = − K! units of good 2.
! $
Example: Suppose 𝑃! = $10, 𝑃" = $5 à If you are at a bundle where expenditure equals income then in order to consume
K $!+
another unit of good 1 and still have expenditure equal income you’d have to give up ! = = 2 units of good 2.
K$ $R
J K!
• The budget set is invariant to uniform inflation. The budget line 𝑞" = − 𝑞! intercepts and slope are unaffected by
K$ K$
uniform inflation so that the set of affordable bundles before and after uniform inflation are the same. This implies that so
long as preferences haven’t changed the optimal choice before and after uniform inflation are the same. This is a very
powerful result: the demand functions for goods 1 and 2 remain the same before and after uniform inflation.
2 J 4 J
Example: Jumping ahead, we know that the Cobb-Douglas demand functions are 𝑞!∗ = 2/4 K and 𝑞"∗ = 2/4 K . Now
! $
suppose we experience uniform inflation at, say, the rate 𝜋 (not the 𝜋 in insurance). Then the post-inflation demands will be:
2 J(!/ S) 2 J 4 J(!/ S) 4 J
𝑞!∗ = (!/
= and 𝑞"∗ = (!/
= .
2/4 K! S) 2/4 K! 2/4 K$ S) 2/4 K$

Back to the UMP:

max 𝑈(𝑞! , 𝑞" ) 𝑠. 𝑡. 𝑃! 𝑞! + 𝑃" 𝑞" = 𝑌, 𝑞! ≥ 𝑞!H7= , 𝑞" ≥ 𝑞"H7=
.! , .$

In ECO204, assume that at least one good is a good good and the consumer has (at the very minimum) convex preferences.

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Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
 UMP with Differentiable Utility Functions (NOT for the Complements Utility Function):

“Solution”: Solve the UMP as a mixture of equality and inequality constraints optimization problem by setting up the following Lagrange
equation:

max 𝑈(𝑞! , 𝑞" ) 𝑠. 𝑡. 𝑃! 𝑞! + 𝑃" 𝑞" = 𝑌, 𝑞! ≥ 𝑞!H7= , 𝑞" ≥ 𝑞"H7=

.! , .$

You should know the following steps:

max 𝑈(𝑞! , 𝑞" ) 𝑠. 𝑡. 𝑃! 𝑞! + 𝑃" 𝑞" = 𝑌, 𝑞! ≥ 0, 𝑞" ≥ 0

.! , .$

max 𝑈(𝑞! , 𝑞" ) 𝑠. 𝑡. 𝑃! 𝑞! + 𝑃" 𝑞" = 𝑌, 𝑞! ≥ 𝑞!H7= , 𝑞" ≥ 𝑞"H7=

.! , .$

max 𝑈(𝑞! , 𝑞" ) 𝑠. 𝑡. 𝑃! 𝑞! + 𝑃" 𝑞" − 𝑌 = 0, −𝑞! ≤ −𝑞!H7= , −𝑞" ≤ −𝑞"H7=

.! , .$

max 𝑈(𝑞! , 𝑞" ) 𝑠. 𝑡. 𝑃! 𝑞! + 𝑃" 𝑞" − 𝑌 = 0, −𝑞! + 𝑞!H7= ≤ 0, −𝑞" + 𝑞"H7= ≤ 0

.! , .$

max L = 𝑈(𝑞! , 𝑞" ) − 𝜆! [𝑃! 𝑞! + 𝑃" 𝑞" − 𝑌] − 𝜆" •−𝑞! + 𝑞!H7= ‘ − 𝜆A •−𝑞" + 𝑞"H7= ‘
.! , .$ , T! , T$ , T&

• Note: Almost always, the min amount thresholds are zero units (i.e. 𝑞!H7= , 𝑞"H7= = 0)
• The UMP above has three possible “solutions” – cases B, C, or D (you are allowed to use the “UMP short-cuts” on the final exam):

• Example/Exercise (See Quercus > Tutorials 5 through 12): The solution to the Cobb-Douglas, or Log-Linear Cobb-Douglas, UMP
2 J 4 J
is Case D in where 𝑞!∗ = 2/4 K and 𝑞"∗ = 2/4 K (if 𝛼 + 𝛽 = 1 à the consumer spends fractions 𝛼 and 𝛽 of her income on goods 1
! $
@9! @9$
and 2 respectively) and 𝜆!∗ = K!
= K$
and 𝜆∗" = 𝜆∗A = 0. Here are the steps to the solution:
J
• The solution to the Cobb-Douglas UMP will be “Case B” – or “Bundle B”: ’𝑞! = K , 𝑞" = 0“ -- so long as
!
?
K! 2 + K!
|𝑀𝑅𝑆 𝑎𝑡 𝐵𝑢𝑛𝑑𝑙𝑒 𝐵| > à ⏞ → No. Case B is not the solution
>
K$ 4 J/K! K $
J
• The solution to the Cobb-Douglas UMP will be “Case C” – or “Bundle C”: ’𝑞! = 0, 𝑞" = K “ -- so long as
$
( ?
K! 2 )$ K!
|𝑀𝑅𝑆 𝑎𝑡 𝐵𝑢𝑛𝑑𝑙𝑒 𝐶| < → ⏞ → No. Case C is not the solution
<
K$ 4 + K $
K 2 .$ K
• That leaves us with Case D as the solution à |𝑀𝑅𝑆 𝑎𝑡 𝐵𝑢𝑛𝑑𝑙𝑒 𝐷| = K! → 4 .!
= K!. Solve this equation together with 𝑃! 𝑞! +
$ $
2 J 4 J
𝑃" 𝑞" = 𝑌 to get 𝑞!∗ = and 𝑞"∗ = .
2/4 K! 2/4 K$

8
Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
• Example/Exercise (See Quercus > Tutorials 5 through 12): The solution to the Linear UMP is:
2 K
• Case B whenever 4 > K! (see above table for values of 𝑞!∗ , 𝑞"∗ , 𝜆!∗ , 𝜆∗" , 𝜆∗A )
$
2 K
• Case C whenever 4 < K! (see above table for values of 𝑞!∗ , 𝑞"∗ , 𝜆!∗ , 𝜆∗" , 𝜆∗A )
$
2 K
• Case D whenever 4 = K! (see above table for values of 𝑞!∗ , 𝑞"∗ , 𝜆!∗ , 𝜆∗" , 𝜆∗A )
$
• The intuition is that the consumer buys the “cheapest” good adjusted for intensity of preferences.

• Once you have solved a UMP, you should be able to provide insights about the demands for goods 1 and 2. For instance:
• Is the demand function (𝑞7∗ as a function of 𝑃7 holding all else constant) a (non)-linear function?
• Example: The Cobb-Douglas Utility Model demand functions (or “curves” if you express price in terms of quantity) are
non-linear functions of prices.
• Example: The Linear Utility Model demand functions (or “curves” if you express price in terms of quantity) are non-
linear functions of prices.
• (Advanced not coming on Final but Interesting) Example: The only Utility Model UMP which has a linear demand
(23.! )$
function/curve is for Case D of the Utility Model 𝑈 = − "4
+ 𝑞" (for 𝑞! ≤ 𝛼).

• Is the demand for 𝑞7∗ independent of 𝑃W for 𝑖 ≠ 𝑗?

• Example: The Cobb-Douglas Utility Model demand functions (or “curves” if you express price in terms of quantity) are
independent of the other good’s price.

• Is the expenditure on goods 1 and 2 constant fractions of income?

• Example: The Cobb-Douglas expenditure on goods 1 and 2 are constant fractions 𝛼 and 𝛽 of income.

• Are goods 1 and 2 “subs” in the ECO101 sense (i.e. increase in price of one goods raises demand for the other good)?
• Example: Not for the Cobb-Douglas Utility Model.

• What are each good’s price/cross-price/income elasticities? Hint: sometimes the “log” method is faster (example: say we want
:. K : X% .
price elasticity; you can compute this as :K . or : X% K ß use whichever method is faster).
2 J
• Example: For the demand function of good 1 in the Cobb-Douglas Utility Model 𝑞!∗ = 2/4 K you are better off using
!
the “logs” trick to compute elasticities (see the Chapter and/or Quercus > Tutorials 5 through 12):
2
§ ln 𝑞!∗ = ln 2/4 + ln 𝑌 − ln 𝑃!
% Z .∗ : X% . ∗
• à Price Elasticity = % Z K! = : X% K! = −1
! !
% Z .!∗ : X% . ∗
• à Cross-Price Elasticity = % Z K = : X% K! = 0
$ $
% Z .!∗ : X% .!∗
• à Income Elasticity = = =1
%ZJ : X% J

“Computing Marginal Utilities” with respect to income, price, and cross-price”: You can use the following formulas so long as you
explain to the reader that these formulas are obtained from applying the envelope theorem on the Lagrange equation. Here is what you say:

max 𝑈(𝑞! , 𝑞" ) 𝑠. 𝑡. 𝑃! 𝑞! + 𝑃" 𝑞" = 𝑌, 𝑞! ≥ 𝑞!H7= , 𝑞" ≥ 𝑞"H7=

.! , .$

max L = 𝑈(𝑞! , 𝑞" ) − 𝜆! [𝑃! 𝑞! + 𝑃" 𝑞" − 𝑌] − 𝜆" •𝑞!H7= − 𝑞! ‘ − 𝜆A •𝑞"H7= − 𝑞" ‘
.! , .$ , T! , T$ , T&

In every constrained optimization problem solved by setting up the Lagrange equation à at the optimal solution à all 𝜆∗ [ ] terms will
be zero (because for an equality constraint the [ ] expression is zero and for an inequality constraint, by the KT conditions, the
𝜆∗ [ ] expression is zero à the optimal value of Lagrange equation = the optimal value of whatever it is you are trying to maximize
(in this case “utility”) subject to the constraints (in this the budget and min consumption constraints). In the case of the UMP:

∗
L * = 𝑈;<=>?P57=L: − 𝜆!∗ [𝑃! 𝑞!∗ + 𝑃" 𝑞"∗ − 𝑌] − 𝜆∗" •𝑞!H7= − 𝑞!∗ ‘ − 𝜆∗A •𝑞"H7= − 𝑞"∗ ‘ = 𝑈;<=>?P57=L:
∗

∗
Thus, to find 𝑑𝑈;<=>?P57=L: due to a small change in a parameter, we use the envelope theorem. Label the initial value of the parameter
𝑐 and label the new value of this parameter 𝑐̃ (for example, a new price of good 1) à By the envelope theorem, to find the new value of
∗∗
𝑈;<=>?P57=L: without solving the new problem:
:L
• Obtain :; = 𝑅𝐻𝑆 𝑒𝑥𝑝𝑟𝑒𝑠𝑠𝑖𝑜𝑛
9
Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
 :L *
• :;
= 𝑃𝑢𝑡 𝑠𝑡𝑎𝑟𝑠 𝑜𝑛 𝑅𝐻𝑆 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑠
∗
• Explain why L * = 𝑈;<=>?P57=L:
:9 ∗ *
• +,-./01'-23
= RHS expression with stars
:;
∗
• 𝑑𝑈;<=>?P57=L: =(RHS expression with stars) 𝑑𝑐
Which result in the following formulas for Marginal Utilities:

∗
Change in 𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 Due to a “Small” Change in a Parameter?
L = 𝑈 𝑞1 , 𝑞2 − 𝜆1 𝑃1 𝑞1 + 𝑃2 𝑞2 − 𝑌 − 𝜆2 𝑞1𝑚𝑖𝑛 − 𝑞1 − 𝜆3 𝑞2𝑚𝑖𝑛 − 𝑞2

∗
By Envelope Theorem: 𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 due to (not shown here change in utility parameters):
𝑑𝑌 ↑? 𝑑𝑞1𝑚𝑖𝑛 ↑? 𝑑𝑞2𝑚𝑖𝑛 ↑? 𝑑𝑃1 ↑? 𝑑𝑃2 ↑?
𝑑L 𝑑L 𝑑L 𝑑L 𝑑L
= 𝜆1 = −𝜆2 = −𝜆3 = −𝜆1 𝑞1 = −𝜆1 𝑞2
𝑑𝑌 𝑑𝑞1𝑚𝑖𝑛 𝑑𝑞2𝑚𝑖𝑛 𝑑𝑃1 𝑑𝑃2

𝑑L ∗ 𝑑L ∗ 𝑑L ∗ 𝑑L ∗ 𝑑L ∗
= 𝜆1∗ = −𝜆∗2 = −𝜆∗3 = −𝜆1∗ 𝑞1∗ = −𝜆1∗ 𝑞2∗
𝑑𝑌 𝑑𝑞1𝑚𝑖𝑛 𝑑𝑞2𝑚𝑖𝑛 𝑑𝑃1 𝑑𝑃2
∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 ∗ ∗ ∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 ∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑
= 𝜆1∗ 𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 = −𝜆1∗ 𝑞1∗ = −𝜆1∗ 𝑞2∗
𝑑𝑌 = −𝜆∗2 = −𝜆∗3 𝑑𝑃1 𝑑𝑃2
𝑑𝑞1𝑚𝑖𝑛 𝑑𝑞2𝑚𝑖𝑛
Marginal Utility of 𝑌
Marginal Utility of 𝑃1 Marginal Utility of 𝑃2
(With “good” goods, what is Marginal Utility of 𝑞1𝑚𝑖𝑛 Marginal Utility of 𝑞2𝑚𝑖𝑛
sign of 𝑀𝑈𝑖𝑛𝑐𝑜𝑚𝑒 ?)

∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 = 𝜆1∗ 𝑑𝑌 ∗ ∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 = −𝜆1∗ 𝑞1∗ 𝑑𝑃1 ∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 = −𝜆1∗ 𝑞2∗ 𝑑𝑃2
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 = −𝜆∗2 𝑑𝑞1𝑚𝑖𝑛 ∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 = −𝜆∗3 𝑑𝑞2𝑚𝑖𝑛

∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 >0 ∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 ≤0 ∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 ≤0 ∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 ≤0 ∗
𝑑𝑈𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 ≤0

27

• Example/Exercise (See Quercus > Tutorials 5 through 12): The solution to the Cobb-Douglas, or Log-Linear Cobb-Douglas, UMP
2 J 4 J
is Case D where 𝑞!∗ = 2/4 K and 𝑞"∗ = 2/4 K (if 𝛼 + 𝛽 = 1 à the consumer spends fractions 𝛼 and 𝛽 of her income on goods 1 and
! $
@9! @9$
2 respectively) and 𝜆!∗ = K!
= K$
and 𝜆∗" = 𝜆∗A = 0.
@9! @9$
• The Marginal Utility of Income = 𝜆!∗ = K!
= K$
. Compute and sub the 𝑀𝑈.
• The Marginal Utilities of 𝑞!H7= and 𝑞"H7= are −𝜆∗" = 0 and −𝜆∗A = 0 respectively.
@9 2 J
• The Marginal Utility of the Price of Good 1 = − 𝜆!∗ 𝑞!∗ = − K ! 2/4 K . Compute and sub the 𝑀𝑈.
! !
@9$ 4 J
• The Marginal Utility of the Price of Good 2 = − 𝜆!∗ 𝑞"∗ = − K$ 2/4 K$
. Compute and sub the 𝑀𝑈.

Application (don’t dwell on this): In Consumer-Theory-Lecture-5, we established the following general result for a consumer with an
arbitrary, differentiable, utility function: a Flat Income Tax $𝑇 which is “calibrated” to be revenue-equivalent to an excise tax rate 𝑡 on the
price of good 1, will make consumer less worse off than the excise tax rate scheme:

Decline in Utility due to Flat Income Tax < Decline in Utility due to Excise Tax on Good 1

Flat Income Tax Excise Tax on Good 1

∗
𝑑𝑈;<=>?P57=L: = 𝜆!∗ 𝑑𝑌 ∗
𝑑𝑈;<=>?P57=L: = −𝜆!∗ 𝑞!∗ 𝑑𝑃!
@9 @9 !
In an earlier question, we used the UMP shortcuts to show that for the Log-Linear-Cobb-Douglas 𝜆∗ = K ! = K $ = J > 0
! $
Thus we cross out 𝜆!∗ (below, we’ll cross out any positive terms on both sides)
∗ ∗
𝑑𝑈;<=>?P57=L: ∝ 𝑑𝑌 𝑑𝑈;<=>?P57=L: ∝ − 𝑞!∗ 𝑑𝑃!
Now: 𝑑𝑌 = (𝑌 − 𝑇) − 𝑌 = −𝑇 Now, 𝑑𝑃! = (1 + 𝑡)𝑃! − 𝑃! = 𝑡𝑃!
∗ ∗
𝑑𝑈;<=>?P57=L: ∝ −𝑇 𝑑𝑈;<=>?P57=L: ∝ −𝑞!∗ 𝑡 𝑃!
∗ ∗
𝑑𝑈;<=>?P57=L: ∝𝑇 𝑑𝑈;<=>?P57=L: ∝ 𝑞!∗ 𝑡 𝑃!
We haven’t ensured the tax schemes are revenue equivalent (for this consumer)
Now, Flat Income Tax Revenue = 𝑇 Now, Excise Tax on Good 1 Revenue = 𝑡 𝑃! 𝑞!∗∗
10
Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
 Flat Income Tax Excise Tax on Good 1
∗
𝑑𝑈;<=>?P57=L: ∝ 𝑇 = 𝑡 𝑃! 𝑞!∗∗ ∗
𝑑𝑈;<=>?P57=L: ∝ 𝑞!∗ 𝑡 𝑃!
∗ ∗∗
𝑑𝑈;<=>?P57=L: ∝ 𝑡 𝑃! 𝑞! 𝑑𝑈;<=>?P57=L: ∝ 𝑡 𝑃! 𝑞!∗
∗

∗
𝑌 𝑌
𝑑𝑈;<=>?P57=L: ∝ 𝑞!∗∗ = 𝛼 ∗
𝑑𝑈;<=>?P57=L: ∝ 𝑞!∗ = 𝛼
(1 + 𝑡)𝑃! 𝑃!
∗
1 ∗
𝑑𝑈;<=>?P57=L: ∝1
𝑑𝑈;<=>?P57=L: ∝
1+𝑡
! ∗ ∗
Since 0 < 𝑡 < 1 à !/? < 1 so that 𝑑𝑈;<=>?P57=L: 𝐹𝑙𝑎𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥 < 𝑑𝑈;<=>?P57=L: 𝐸𝑥𝑐𝑖𝑠𝑒 𝑇𝑎𝑥 𝑜𝑛 𝐺𝑜𝑜𝑑 1

The expressions will make more sense if you use the following expressions from the Log-Linear-Cobb-Douglas UMP (where𝑈 =
𝛼 ln 𝑞! + 𝛽 ln 𝑞" where 𝛼, 𝛽 > 0 and 𝛼 + 𝛽 = 1 defined on the choice set 𝐶 = {(𝑞! , 𝑞" ) ≥ 0}). Let:

𝑇 = Flat Income Tax

𝑡 = Excise Tax Rate on Good 1

𝑌
𝑞!∗ = Amount of good 1 consumed before any tax scheme = 𝛼
𝑃!

𝑌
𝑞"∗ = Amount of good 2 consumed before any tax scheme = 𝛽
𝑃"

𝑌
𝑞!∗∗ = Amount of good 1 consumed after excise tax on good 1 scheme = 𝛼
(1 + 𝑡)𝑃!

𝑌
𝑞"∗∗ = Amount of good 2 consumed after excise tax on good 1 scheme = 𝛽 (why didn) t this change? )
𝑃"

𝑌−𝑇
𝑞!@@ = Amount of good 1 consumed after Flat Tax scheme = 𝛼
𝑃!

𝑌−𝑇
𝑞"@@ = Amount of good 2 consumed after Flat Tax scheme = 𝛽
𝑃"

11
Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)
 UMP for the Non-Differentiable Complements Utility Function:

Consider the UMP:

max 𝑈 = min(𝛼𝑞! , 𝛽𝑞" ) 𝑠. 𝑡. 𝑃! 𝑞! + 𝑃" 𝑞" = 𝑌, 𝑞! ≥ 𝑞!H7= , 𝑞" ≥ 𝑞"H7=

.! , .$

“Solution”: We cannot solve this UMP by the “Lagrange equation method” because 𝑈 = min(𝛼𝑞! , 𝛽𝑞" ) is not differentiable. Instead,
see the Chapter and/or Quercus > Tutorials 5 through 12, we solve this by arguing that the optimal bundle is on the intersection of the
budget line and the “L-shaped” IC “corners line”, i.e. by solving these two equations simultaneously:

𝑃! 𝑞! + 𝑃" 𝑞" = 𝑌
𝛼
𝑞" = 𝑞 (we derived this earlier)
𝛽 !

The solution will be (you should double check since you would have to show your derivations):
𝛽 𝛼
𝑞!∗ = 𝑌 , 𝑞"∗ = 𝑌
𝛽𝑃! + 𝛼𝑃" 𝛽𝑃! + 𝛼𝑃"

“Computing Marginal Utilities” with respect to income, price, and cross-price”: Because we can’t solve this UMP by the “Lagrange
equation method”, we are left with the “Value Function” approach (which can also be used for differentiable UMPs but are more tedious
than the envelope theorem). At the optimal solution:

𝛽 𝛼 𝛼𝛽
𝑈 ∗ = min(𝛼𝑞!∗ , 𝛽𝑞"∗ ) = min „𝛼 𝑌, 𝛽 𝑌… = 𝑌
𝛽𝑃! + 𝛼𝑃" 𝛽𝑃! + 𝛼𝑃" 𝛽𝑃! + 𝛼𝑃"

Note: It’s cool that the Complements Utility-Function for arbitrary values of 𝑞’s isn’t differentiable but the Complements Utility-Function
at the optimal demands is differentiable. From this expression:
:9 ∗ 24
• The Marginal Utility of Income = =
:J 4K! /2K$
:9 ∗ :9 ∗
• The Marginal Utilities of 𝑞!H7= and 𝑞"H7= are :.4'- = 0 and :.4'- = 0.
! $
:9 ∗
• The Marginal Utility of the Price of Good 1 = = Compute on your own.
:K!
:9 ∗
• The Marginal Utility of the Price of Good 2 = :K = Compute on your own.
$

12
Copyright Sayed Ajaz Hussain, Economics, University of Toronto (STG)