CHOICE

Consumer Problem
• Consumer Problem: The problem of the consumer is
to solve: Max u x1 , x2 ,, xn 
x1 , x2 ,, xn

s.t. p x
i
i i M xi  0

i  1, 2,, n
• Interior Solution: Assume that the non-negativity
constraint is not binding such that xi* > 0. This means
that we can use the ordinary Lagrangian technique.
 Consumer Problem
Hence,
 
L  u x1 , x2 ,, xn     M 

 i
pi xi 

L
 ui  pi  0 i  1, 2,, n
xi
L

M  px
i
i i 0

so that
u1 u 2 un du*
     marginal utility of income
p1 p2 pn dM
 Consumer Problem
• Corner Solution: We drop the assumption that
xi* > 0. Then
 
L  u  x1 , x2 ,, xn     M 
 i

pi xi 

L
i   ui  * pi  0 ii  xi*  0
xi
iii  xi* ui  * pi   0 i  1, 2,, n
L
iv 

M  px
i
i i 0
 Consumer Problem
Note that in the case of corner solution, if we have
ui
 
*
pi
then the marginal utility of expenditure on good i is
less than the marginal utility of money. Therefore,
good xi will not be purchased, i.e. xi* = 0.
Then, the complementary slackness condition is
* ui *  ui *
xi      0 since xi*  0 if      0
 pi   pi 
 Optimal Choice for the Consumer
• The optimal choice for the consumer or
“consumer equilibrium” is the point where the
budget line is tangent to the highest possible
indifference curve.
x2

x2*

x1* x1
 Mathematical Condition for Optimal
Choice
• At the point of tangency between budget line
and indifference curve:
MU1 p1
MRS12  
MU 2 p2
Note: At the tangency point, the slope of the
indifference curve is equal to the slope of the
budget line. Since both slopes are negative,
we express the condition by ignoring the
negative sign of both slopes.
 What if we are not at a point of
tangency?
• When the budget line and IC intersect, it
means that consumer equilibrium has not
been attained yet. The consumer needs to
change his plan. x2
• Example:
MU 1 p A
At A, MRS12   1
MU 2 p2 B
MU 1 MU 2
  Buy more x1 , less x2
p1 p2
x1
 Other Possibilities: Unusual Cases
• 1) Boundary Solution
x2

x2
x1
• 2)Multiple Solutions

x1
 Substitutes
Max u  x1  x2
s.t. p1 x1  p2 x2  m

m
Solution: x1  when p1  p2
p1
 m
x1   0,  when p1  p2
 p1 
x1  0 when p1  p2
 Complements
Max u  min x1 , x2 
s.t. p1 x1  p2 x2  m
(T herefore, p1 x1  p2 ( x1 )  m and
p1 ( x2 )  p2 x2  m)
m
Solution: x1  x2 
p1  p2
 Complements
• In the more general case where
u  minx1 , x2  Similarly,
 
x1  x2  x2  x1 x1  x2
 
   
M  p1 x1  p2  x1   0 M  p1  x2   p2 x2  0
   
    
x1  p1  p2   M x2  p1  p2   M
    
M M
x1 
*
x2 
*
    
 p1  p2   1
p  p 2
    
 Cobb-Douglas
Max u  x1c x2d
s.t . p1 x1  p2 x2  m
p1
Solution #1 : Equate MRS to
p2
MU 1 cx2
( a ) ln u  c ln x1  d ln x2  
MU 2 dx1
cx2 p
  1
dx1 p2
(b) Substitute in Budget Line :
 dp1 x1  cd  m
p1 x1  p2 
 cp 
m  x1  
 2   c  p1
 c  m
 x1   
 c  d  p1
 Cobb-Douglas: Solution by
Substitution
• Substitute the budget line equation into the utility
function and then maximize:
 m p1x1 
Max c ln x1  d ln   
 p 2 p2 

First Order Condition :
c 1  p 
d  1   0 (chain rule)
x1  m p1x1   p2 
  
 p2 p2 

c p2  p 
 1 0
x1
d
 
m  p1x1  p 2



( solve for x1 )
 Cobb-Douglas: Solution by
Lagrangian
L  c ln x1  d ln x2    p1 x1  p2 x2  m 
L c
  p1  0
x1 x1
cx2 p1
 
dx1 p2
L d
  p 2  0
x2 x2
L
 p1 x1  p2 x2  m  0

Plug  in f .o.c #1 and f .o.c #2
in f .o.c #3
 Doing the Algebra

cx2 p1 dp1 x1
  x2 
dx1 p2 cp2
 dp1 x1   dp x 
p1 x1  p2    p1 x1   1 1   m
 cp2   c 
cd 
p1 x1  m
 c 
c m  d m 
x1  and  x2  by symmetry
c  d p1  c  d p2 
 Cobb-Douglas Utility
• The budget shares in the Cobb-Douglas case are:
p1 * p1  c m  c
s1*  x1    
m m  c  d p1  c  d
p2 * p2  d m  d
s2*  x2    
m m  c  d p2  c  d

• Note that the budget shares are constants. This is

one of the limitations of the Cobb-Douglas utility
function.
 CES: An Example
• Let u  x10.5  x20.5
• Then, L  x10.5  x20.5   M  p1 x1  p2 x2 
L
 0.5 x10.5  p1  0
x1
L
 0.5 x20.5  p2  0
x2
L
 M  p1 x1  p2 x2  0

0.5
• Hence,  x2   p1 . We substitute this in the budget.
 
 x1  p2
 CES: An Example
• By substituting,
 p12 
p12 x1  p1    M
x2  2 x1  p2 
p2
M M
 p12  x1 
*

M  p1 x1  p2  2 x1 

 0  p1 
2
 p1 
 p2   p1   p1 1  
 p2   p2 
p12
M  p1 x1  x1  0 and
p2
M M
p1 x1 
p12
x1  M
x2*  
 
p22  p2 
p2
 p2   p2 1  
 p1   p1 
 CES: An Example
• The budget shares are:
p1 * p1 M 1
s1*  x1  
M M  p1   p 

p1 1   1  1 
 p2   p2 
p p M 1
s2*  2 x2*  2 
M M  p   p 
p2 1  2  1  2 
 p1   p1 

• Unlike in the Cobb-Douglas case, the budget shares

are not constant, but depends on the relative price
ratio. This is an advantage of CES utility.
 Application: Quantity Tax vs.
Income Tax
• Quantity Tax (on good 1):  p1  t x1  p2 x2  m
– At the optimal choice,  p1  t x1*  p2 x2*  m
and R *  tx1*

• Income Tax: p1 x1  p2 x2  m  R *
p1 x1  p2 x2  m  tx1*
• The budget line under income tax must
intersect the budget line under quantity tax at
the optimal choice under quantity tax x1* , x2* 
 Graph: Quantity vs. Income Tax
• The budget line rotates inwards due to quantity tax.
Alternatively, the budget line shifts down parallel due to
income tax. Under income tax, consumer is on a higher
indifference curve.

Income Tax is superior.

x2*

x1* x1
 The Lump Sum Principle: An
Example
• Suppose utility is
u  x10.5 x20.5

• Then, x*  0.5 M
 0.5
M
and x2* 
0.5 M
0.5  0.5 p1 0.5  0.5 p2
1
p1

• Utility is
0.5 0.5
 M  M 0.50.50.5 M 0.5 0.5 M
u  0.5  0.5 
*
 0.5 0.5
 0.5 0.5 0.5
 p1   p2  p1 p2 p1 p2
8
Suppose p1  1, p2  4, and M  8. Then, u  0.5 *
2
1 4
0.5 0.5
 The Lump-Sum Principle: An
Example
• Next, let there be a tax on x1 equal to t = 1. Then,
M 8
u  0.5
*
 0.5  1.41
 p1  t 
0.5
p20.5 1  1
0.5 0.5
4

• The decrease in utility is due to the fact that the

quantity of x1 has fallen from
8 8
x1*   4 to x1 
*'
2
21 21  1
• The total tax collection is 2. Now consider just
collecting an income tax = 2. Then,→
 The Lump-Sum Principle: An
Example
• The utility after an income tax is imposed is:
82 6
u *  0.5  0.5  1.5
10.5 40.5 2

• Since 1.5 > 1.41, the income tax is superior.