2

UTILITY MAXIMIZATION
AND CHOICE
Topics
• Lagrange multipliers method. First-
order conditions. Second-order
conditions. Interior and corner
solutions. Demand functions.
• Duality. Indirect utility function.
Expenditure minimization.
Properties of expenditure functions.
Reading
[В, гл 5],
[ЧФ, гл 1, 1.5; гл 7, 7.1-7.3],
[К, гл 4, 4.5-4.6],
[ДР, гл 1, 1.3-1.5]
Indirect Utility Function
We can obtain the indirect utility function by
substituting the optimal 𝑥𝑖∗ in the direct utility
function
𝑈𝑚𝑎𝑥 = 𝑈(𝑥1∗ , 𝑥2∗ ) =
= 𝑈 𝑑1 𝑝1 , 𝑝2 , 𝑚 , 𝑑2 𝑝1 , 𝑝2 , 𝑚 = 𝑉 𝑝1 , 𝑝2 , 𝑚
The optimal level of utility will depend indirectly
on prices and income
• if either prices or income were to change, the
maximum possible utility will change
Indirect Utility Function
• Because of the individual’s desire to maximize utility given a
budget constraint, the optimal level of utility obtainable will
depend indirectly on the prices of the goods being bought
and the individual’s income.
• This dependence is reflected by the indirect utility function
𝑉. If either prices or income were to change, the level of
utility that could be attained would also be affected.
• Sometimes, in both consumer theory and many other
contexts, it is possible to use this indirect approach to study
how changes in economic circumstances affect various
kinds of outcomes, such as utility or (in 3rd module’s topics)
firms’ costs.
Indirect Utility Function: Characteristics
The indirect utility function is non-increasing in
prices:
if 𝑝1′ , 𝑝2′ ≥ 𝑝1 , 𝑝2 then 𝑉 𝑝1′ , 𝑝2′ , 𝑚 ≤ 𝑉 𝑝1 , 𝑝2 , 𝑚
and non-decreasing (strictly increasing) in
income:
if 𝑚′ > 𝑚 then 𝑉 𝑝1 , 𝑝2 , 𝑚′ > 𝑉 𝑝1 , 𝑝2 , 𝑚
The indirect utility function is homogeneous of
degree zero in prices and income:
𝑉 𝑡𝑝1 , 𝑡𝑝2 , 𝑡𝑚 = 𝑡 0 𝑉 𝑝1 , 𝑝2 , 𝑚 = 𝑉(𝑝1 , 𝑝2 , 𝑚)
Indirect Utility Function: Examples
𝛼 𝛽
For Cobb-Douglas utility function 𝑈 𝑥1 , 𝑥2 = 𝑥1 𝑥2 ,
optimal purchases (solutions, demand functions) are:
𝛼 𝑚 𝛽 𝑚
𝑥1∗ = and 𝑥2∗ =
𝛼+𝛽 𝑝1 𝛼+𝛽 𝑝2
So the indirect utility function in this case is
𝑉 𝑝1 , 𝑝2 , 𝑚 = 𝑈(𝑥1∗ , 𝑥2∗ ) = (𝑥1∗ )𝛼 (𝑥2∗ )𝛽
𝛼 𝛽
𝛼 𝑚 𝛽 𝑚
=
𝛼 + 𝛽 𝑝1 𝛼 + 𝛽 𝑝2
𝛼 𝛼 𝛽 𝛽
𝛼 1 𝛽 1
= 𝑚𝛼+𝛽
𝛼+𝛽 𝑝1 𝛼+𝛽 𝑝2
Indirect Utility Function: Examples
Now let’s look at a specific numerical example for
the Cobb-Douglas utility function.
Suppose 𝑈 𝑥1 , 𝑥2 = 𝑥10,5 𝑥20,5 . Budget constraints
are 𝑝1 = 1, 𝑝2 = 4, 𝑚 = 8. Then optimal choices
are:
1𝑚 1𝑚
𝑥1∗ = = 4 and 𝑥2∗ = =1
2 𝑝1 2 𝑝2

and, at these optimal choices

𝑈 𝑥1 , 𝑥2 = 40,5 10,5 = 2
Indirect Utility Function: Examples
The indirect utility function in this case is
1 𝑚 0,5 1 𝑚 0,5
𝑉 𝑝1 , 𝑝2 , 𝑚 = 𝑈(𝑥1∗ , 𝑥2∗ ) = (2𝑝 ) ( 2𝑝 )
1 2
𝑚
= 0,5 0,5
2𝑝1 𝑝2
Notice that when 𝑝1 = 1, 𝑝2 = 4, 𝑚 = 8 we have
8
𝑉= = 2, which is the utility that we
2∙1∙2
calculated before.
 Duality
• Earlier, we showed how our consumer chooses
quantities of goods so as to maximize his utility
subject to a budget constraint.
• In a related or dual constrained minimization
problem, he wants to find that combination of goods
that achieves a particular level of utility for the least
expenditure.
• Dual minimization problem for utility maximization
• allocating income in such a way as to achieve a given level
of utility with the minimal expenditure
• this means that the goal and the constraint have been
reversed
Expenditure Minimization
Three possible expenditure amounts
(𝐸1 , 𝐸2 , and 𝐸3 ) are shown as three
“budget constraint” lines

Expenditure level 𝐸2
𝑥2

Expenditure level 𝐸3

Expenditure level 𝐸1

𝑥1
Expenditure Minimization
There, the individual must attain utility level 𝑈1 ; this is
now the constraint in the problem

Point A is the solution to the dual problem

Expenditure level 𝐸2 provides just enough to reach 𝑈1
𝑥2

Expenditure level 𝐸3 will allow the

individual to reach 𝑈1 but is not the
minimal expenditure required to do so

A
𝑥2∗
Expenditure level 𝐸1 is too small to achieve 𝑈1
𝑈1

𝑥1∗ 𝑥1
Expenditure Minimization
x2 The dual of the utility-maximization problem
is to attain a given utility level 𝑈1 with
minimal expenditures. With expenditure 𝐸2 ,
this person can just reach 𝑈1 by consuming
𝑥1∗ and 𝑥2∗ .
𝑩
With expenditures given by 𝐸3 , the
individual can reach 𝑈1 (at either of the two
points 𝑩 or 𝑪), but this is not the minimal
expenditure level required

𝑨
𝑥2∗

𝑪
𝑈1

𝑥1∗ x1
 Expenditure Minimization
𝑥2

𝑥2∗ 𝑥2∗

𝑥1∗ 𝑥1 𝑥1∗ 𝑥1

• It is obvious that both the primary utility-maximization approach and

the dual expenditure-minimization approach yield the same solution
(𝑥1∗ , 𝑥2∗ ); they are simply alternative ways of viewing the same process.
• Often the expenditure-minimization approach is more useful, however,
because expenditures are directly observable, whereas utility is not.
Expenditure Minimization
• The individual’s expenditure minimization
problem:
min 𝐸 = 𝑝1 𝑥1 + 𝑝2 𝑥2
𝑥1 ,𝑥2 ≥0
s.t. 𝑢 𝑥1 , 𝑥2 = 𝑢
• The optimal amounts of 𝑥1 , 𝑥2 will depend
on the prices of the goods and the required
utility level 𝑢
Expenditure Minimization
𝓛 = 𝑝1 𝑥1 + 𝑝2 𝑥2 + (𝑢 − 𝑢(𝑥1 , 𝑥2 ))
𝜕𝓛 𝜕𝑢(𝑥1 , 𝑥2 )
= 𝑝1 − 𝜆 =0
𝜕𝑥1 𝜕𝑥1
𝜕𝓛 𝜕𝑢(𝑥1 , 𝑥2 )
= 𝑝2 − 𝜆 =0
𝜕𝑥2 𝜕𝑥2
𝜕𝓛
= 𝑢 − 𝑢(𝑥1 , 𝑥2 ) = 0
𝜕
Expenditure Minimization
𝑝1 𝜕𝑈/𝜕𝑥1 𝑀𝑈1
= = = 𝑀𝑅𝑆
𝑝2 𝜕𝑈/𝜕𝑥2 𝑀𝑈1

𝑥1∗ = ℎ1 (𝑝1 , 𝑝2 , 𝑢)
𝑥2∗ = ℎ1 (𝑝1 , 𝑝2 , 𝑢)
 Compensated (or Hicksian) Demand
𝑥1∗ = ℎ1 (𝑝1 , 𝑝2 , 𝑢)
𝑥2∗ = ℎ1 (𝑝1 , 𝑝2 , 𝑢)
These functions tell us, for any set of prices, how much
a consumer will consume of each good assuming that
the consumer is given just enough money to be able to
reach utility level 𝑢.
For this reason, the functions are often referred to as
compensated demand functions.
They are also known as Hicksian demand functions (we
will back to it in next topic) .
 Expenditure Function
• The optimal amounts of 𝑥1∗ and 𝑥2∗ chosen in
expenditure minimization problem will depend on
the prices of the goods, 𝑝1 and 𝑝2 , and the required
utility level 𝑢.
• If any of the prices were to change or if the
individual had a different utility “target,” then
another commodity bundle would be optimal.
• This dependence can be summarized by an
expenditure function.
 Expenditure Function
• The individual’s expenditure function shows the
minimal expenditures necessary to achieve a given
utility level for a particular set of prices. That is,
minimal expenditures = 𝐸(𝑝1 , 𝑝2 , 𝑢)
• This definition shows that the expenditure function
and the indirect utility function 𝑉 𝑝1 , 𝑝2 , 𝑚 are
inverse functions of one another.
– Both depend on market prices but involve different
constraints (income or utility).
– In next topic we will see how this relationship is quite
useful in allowing us to examine the theory of how
individuals respond to price changes
 Expenditure Function
• Here we can show the relationship between
expenditure functions and indirect utility functions.
• Because these two functions are inverses of each
other, calculation of one greatly facilitates the
calculation of the other.
• We have already calculated indirect utility function
for case with 𝑈 𝑥1 , 𝑥2 = 𝑥10,5 𝑥20,5 and budget
constraints (𝑝1 = 1, 𝑝2 = 4, 𝑚 = 8):
∗ ∗
𝑚
𝑉 𝑝1 , 𝑝2 , 𝑚 = 𝑈(𝑥1 , 𝑥2 ) = 0,5 0,5 = 2
2𝑝1 𝑝2
 Expenditure Function
• If we now interchange the role of utility (which we
will now treat as a constant denoted by 𝑢) and
income (which we will now term “expenditures,” 𝐸,
and treat as a function of the parameters of this
problem), then we have the expenditure function:
0,5 0,5
𝐸 = 2𝑝1 𝑝2 𝑢
• Now we use a utility target of 𝑢 = 2 with, again, 𝑝1 =
1 and 𝑝2 = 4. With these parameters, the required
minimal expenditures are 8 (= 2 ∙ 10,5 ∙ 40,5 ∙ 2).
– Not surprisingly, both the primal utility maximization
problem and the dual expenditure minimization problem
are formally identical.
Properties of Expenditure Functions
Homogeneity
• a doubling of all prices will precisely
double the value of required
expenditures
• homogeneous of degree one in all prices
Nondecreasing in prices
• 𝐸/𝑝𝑖  0 for every good, 𝑖
Concave in prices