Econ 101 Principles of Microeconomics Business Learning Center Spring 2005 Week 5

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Maximizing Utility

Last Monday I bored the hell out of you with a soporific lecture about consumer theory. I saw glazed eyes, students nodding off, and otherwise complete and utter terebration. So once more.....Indifference Curves are graphical representations of preferences. They are depicted over different consumption bundles to which the consumer is indifferent. Each indifference curve represents a different level of utility. The budget constraint is simply the set of affordable consumption bundles that fully exhaust the income of the consumer. If we have two goods, x and y, and they have respective prices given by px and py , then the equation for the budget line is given by

I = px x + py y

(1)

The objective of the consumer is to maximize utility. To do this they need to reach the highest indifference curve possible given their budget constraint. There are three cases that we consider:

1. Typical Case - In the “typical case” there is some degree of substitutability between the two goods, though this is not perfect. This is the case we will work with most often.

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In this case there is NO degree of substitution between the two goods and hence. the MRS is undefined. 2 .Qy Typical Case 20 15 10 5 M RS = papples poranges 5 10 15 20 25 Qx 30 35 In the above figure utility is maximized where the slope of the budget line equals the slope of the indifference curve. there is no tangency condition but the principle idea still remains. Perfect Complements . This is called the tangency condition and can be stated as M RS = px py (2) where M RS is the marginal rate of substitution (the slope of the indifference curve). Therefore. The following figure depicts this. find the highest level indifference curve that is on the budget line. 2.

The following figure depicts this. the goods are perfect substitutes for one another at some ratio. Perfect Substitutes . In this case. Which one she consumes will depend on which one is relatively cheaper.For the perfect substitute case.Perfect Complements Left Shoes 4 Optimal Poin of Consumption 3 2 1 BL 1 2 3 4 Right Shoes Notice that in these cases. 3 . you will still be at an interior point. are not differentiable. the consumer will find it optimal to consume all of one good and none of the other. there will not be an interior solution. 3. however the MRS is not defined because the indifference curves have “kinks” and hence.

Their real income has changed. and this will have an impact on their consumption decisions.Perfect Substitutes Wooden Pencils 4 3 2 1 Optimal Point of Consumption 1 2 3 4 Mechanical Pencils 2 Income and Substitution Effects When the price of a particular good changes. They will tend to try and substitute away from the effects of the price increase. That is. there are two effects to consider when analyzing the consumer’s problem: 1. This is called the Substitution Effect. 4 . if the price of good x goes up. then their real income has fallen. and if good x is a normal good then they will consume less of it. This is known as the Income Effect. if good x is an inferior good than they will consume more of good x as their income falls. if the price of good x goes up. 2. However. For example. then they will try and consume more of good y instead of x because it has become relatively more cheaper. How do we quantify these? We’ll go through an example.

Putting our budget constraint together with our indifference curves yields the following figure: 5 . and vary the possible x s and y s then I will back out an indifference curve. Then our budget line is √ xy = 8 8 8 8 8 8 8 8 I = px x + py y 32 = 2x + 2y Call this budget line BL1 . x y U (x. y) = 8. If I hold a utility level constant. Suppose that px = $2 and py = $2 and that our income is $32. suppose we fix U (x. One can do this for different utility levels to construct indifference curves. y) = xy. Next. y) = 8. y) = 1 64 2 32 4 16 8 8 16 4 32 2 64 1 Table 1: This would give us an indifference curve for utility level U (x. we’ll add our budget constraint.1 Example Suppose that from consuming two goods x and y that I get utility from these two goods √ given by U (x. For example. then look at combinations of x and y that satisfy this.2.

32 30 28 26 24 22 20 18 16 BL1 14 12 10 y∗ 8 6 4 2 U (x. y) = 10 One can see from the figure that the optimal consumption point is where x∗ = 8 and y ∗ = 8. y) = 12 U (x. 6 . y) = 4 2 4 6 8 x∗ 10 12 14 16 18 20 22 24 U (x. y) = 8. The utility level the consumer achieves at this point is U (x. y) = 8 U (x. y) = 6 U (x.

draw in the new budget line. Then how do we get to the x income and substitution effects of this price change? First. This is shown in the following figure: 7 .Now suppose that the price of x changes so that pnew = $8. this is given by : I = pnew x + py y x 32 = 8x + 2y Call this budget line BL2 .

y) = 4 2 4 6 8 10 12 14 16 18 20 22 24 U (x. y) = 6 U (x. y) = 12 U (x. y) = 10 x∗ new x∗ 8 .32 30 28 26 24 22 20 18 16 BL1 14 12 10 y∗ 8 6 4 BL2 2 U (x. y) = 8 U (x.

So we need to get the consumer back to this level of utility: x y U (x. This is step 2. Now look at the optimal new consumption point that uses the new price pnew but the x old income level.One can see that the new optimal consumption point is where x∗ = 2 and y ∗ = 8. Step 3 is to shift the NEW budget line BL2 for this new income level and call it BL3 . 3. we do the following: 1. Look at the new hypothetical optimal consumption point given this new budget line. 6. find the smallest income necessary to get the consumer back to their OLD level of utility. Label the optimal bundle prior to the the price increase point A. 4. y) pnew x + py y x 1 64 8 $136 2 32 8 $80 4 16 8 $64 8 8 8 $80 Table 2: It looks like the minimum income needed to achieve the old utility level at the new prices is $64. Label this point C. First. 5. Given new prices. This is shown in the following figure. We’ll do each of these steps in turn. Now to new get at the substitution and income effect. The difference between point B and point C is the income effect. The change in consumption levels from point A to this hypothetical point B is the substitution effect. Shift the NEW budget line up by the amount of income needed to achieve this. given the new price increase what is the smallest amount of income the consumer needs to get back to their old utility level? Their old utility level was U (x∗ . 2. y ∗ ) = 8. Call this point B. 9 .

y) = 12 U (x. y) = 4 2 4 6 8 10 12 14 16 18 20 22 24 U (x. y) = 8 C A U (x. y) = 10 x∗ new x∗ h Income Effect x∗ Substitution Effect 10 .32 30 28 BL3 26 24 22 20 18 B 16 BL1 14 12 10 y∗ 8 6 4 BL2 2 U (x. y) = 6 U (x.

They are mostly a theoretical curiosity. change in consumption = substitution effect + income effect (3) The first case is probably the “typical” case where we know the law of demand will hold because the substitution and income effect move in the same direction.What is the optimal consumption bundle at this new point? We see that given the budget line BL3 that the optimal consumption of x is x∗ = 4. In this rare case the law of demand is violated. Income effect is the same direction as substitution effect for normal goods. The difference between x∗ = 4 and x∗ = 2 is 2. That is. the substitution effect will be a decrease in the quantity demanded of that good. h substitution effect is equal to 4. they oppose one another. Note that at point A. That is. 2. the real new consumption point is given at point C where x∗ = 2. the overall change in consumption is the some of these two effects. However. hence the income new h new effect is equal to 2. The income effect is in the opposite direction as the substitution effect for inferior goods. they reinforce one another. x∗ = 8 and at point B. if the price goes up. x∗ is for optimal hypothetical h h consumption bundle. 11 . they are called Giffen goods. Now. 1. The income effect can go either way. However. That is. 3 Income Effect and Inferior Goods The substitution effect of a price increase always follows the law of demand. Therefore. the second case it is unclear what will happen? Will the substitution or income effect dominate? Most of the time economists think that the substitution effect dominates. Here. it is perfectly possible for the income effect to dominate the substitution effect. For these goods that violate the law of demand. Next. but nonetheless are possible to exist. x∗ = 4.

that is entirely due to substitution between the two goods. but in fact this makes perfect sense. 12 . it may seem counter-intuitive that we vary income to get at the substitution effect. we vary the income to get the consumer back on their old indifference curve so that any change in consumption is entirely due to the substitutability between the two goods.4 What the Heck are we Doing? First. Anything left over is entirely due to income effect. Well. This is the substitution effect. We want to find the change in consumption from a price increase.

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