Modeling the

Consumer

ECON 201

Outline

Optimal
Choice
Graphical
Representation
Interpretation
Modeling the Consumer
Demand Optimal Choice1
Examples
Max U
Solutions
Theoretical
Implications
Policy Erik Kimbrough
Implications

Summary
Simon Fraser University

1
Drawn from Varian (2010)
Modeling the
Consumer

ECON 201 Modeling Choice

Outline

Optimal
Choice
Graphical Earlier we talked about economists’ model of consumer choice:
Representation
Interpretation

Demand Consumers choose the best bundle they can afford.

Examples
Max U
Solutions
Theoretical With the language of budget sets, preferences, and utility
Implications
Policy
Implications
functions we can say this more precisely:
Summary

1 A consumer chooses the most preferred bundle in her

budget set.
2 A consumer chooses a bundle that maximizes utility,
subject to the budget constraint.
Modeling the
Consumer

ECON 201

Outline 1 Optimal Choice

Optimal Graphical Representation
Choice
Graphical Interpretation
Representation
Interpretation

Demand
Examples
Max U
2 Demand
Solutions
Theoretical
Examples
Implications
Policy Max U
Implications

Summary
Solutions
Theoretical Implications
Policy Implications

3 Summary
Modeling the
Consumer

ECON 201 Conditions for Optimal Choice

Outline

Optimal
Choice
Graphical
Representation
Interpretation
Assume we have well-behaved preferences. We want to pick
Demand
Examples the bundle in the budget set on the highest indifference curve?
Max U
Solutions
Theoretical
Implications This means we want to pick a bundle on the budget line.
Policy
Implications Why?
Summary

Answer: With well-behaved preferences, we can rule out

bundles inside the budget line because more is always preferred
to less!
Modeling the
Consumer

ECON 201 Optimal Choice

Outline

Optimal
Choice
Graphical
Representation
Interpretation
Indifference
Demand Curves
Examples
m
Max U
Solutions p2
x2

Theoretical
Implications
Policy
Implications
x*2
Summary

Optimal
Choice

x*1 m
p1
x1

Now start from either corner and ask, as you move towards the
center of the budget line, “am I on a higher indifference curve?”
Modeling the
Consumer

ECON 201 Optimal Choice

Outline

Optimal
Choice
Graphical
Representation
Interpretation
Indifference
Demand Curves
Examples
m
Max U
Solutions p2
x2

Theoretical
Implications
Policy
Implications
x*2
Summary

Optimal
Choice

x*1 m
p1
x1

The bundle (x1∗ , x2∗ ) is an optimal choice because the set of

more preferred bundles does not intersect the budget set.
Modeling the
Consumer

ECON 201 Optimal Choice

Outline

Optimal
Choice Notice that with well-behaved preferences, the optimal bundle
Graphical
Representation
Interpretation
puts you on an indifference curve that is tangent to the budget
Demand
line.
Examples
Max U
Solutions
Theoretical
Why?
Implications
Policy
Implications
Answer: If the indifference curve weren’t tangent, it would
Summary
either:
1 Cross the budget line, in which case some more preferred
bundles would still be affordable.
2 Be above the budget line, in which case, the bundle
wouldn’t be affordable.
Modeling the
Consumer

ECON 201 Is Tangency Necessary?

Outline
Why might the tangency condition not be necessary in all
Optimal
cases? kinky preferences
Choice
Graphical
Representation
Interpretation

Demand
Examples
Max U
Solutions
Theoretical Indifference
Implications
Curves
Policy
Implications m
Summary p2
Optimal
x2

Choice

x*2

x*1 m
p1
x1
Modeling the
Consumer

ECON 201 Is Tangency Necessary?

Outline
Why might the tangency condition not be necessary in all
Optimal
cases? boundary optima
Choice
Graphical
Representation
Interpretation

Demand
Examples
Max U
Solutions
Theoretical
Implications
Policy
Implications

Summary Indifference
x2

Curves

m
p2

Optimal
Choice

x*2
x*1

x1 m
p1
Modeling the
Consumer

ECON 201 Restrictions

Outline

Optimal
Choice
Graphical Once again, we’re going to appeal to some restrictions to make
Representation
Interpretation the math simpler.
Demand
Examples
Max U If we rule out kinky preferences and boundary optima then
Solutions
Theoretical
Implications
we will always have tangency between the indifference curve
Policy
Implications
and the budget line at the optimal bundle.
Summary
Under these restrictions, the tangency condition is called a
necessary condition for optimality.

The condition is logically necessary because the bundle couldn’t

be optimal if the condition weren’t fulfilled.
Modeling the
Consumer

ECON 201 Is Tangency Sufficient?

Outline
Why might the tangency condition not be sufficient? multiple
Optimal
optima
Choice
Graphical
Representation
Interpretation

Demand
Examples
Max U Indifference
Solutions Curves
Theoretical Optimal
Implications Bundles
Policy
Implications

Summary
x2

Nonoptimal
Bundle

x1
Modeling the
Consumer

ECON 201 Well-Behaved Preferences

Outline

Optimal
Choice
Graphical When preferences are convex, any tangency point between the
Representation
Interpretation indifference curve and the budget line must also be an
Demand
Examples
optimum.
Max U
Solutions
Theoretical
Implications
But this still doesn’t rule out multiple optima.
Policy
Implications

Summary Why?

Answer: There could be a flat spot on the indifference curve.

But, if preferences are strictly convex, the there will be a

unique optimum for each budget line!
Modeling the
Consumer

ECON 201 Return of the MRS

Outline

Optimal
Choice
Graphical
Representation
Interpretation

Demand
Examples
Max U Our graphical analysis implies the following:
Solutions
Theoretical
Implications
Policy At an interior optimum, the marginal rate of substitution
Implications

Summary
(MRS) must equal the slope of the budget line.
Modeling the
Consumer

ECON 201 MRS and Optimality

Outline

Optimal
Choice Recall that we can think of the MRS as specifying the rate of
Graphical
Representation exchange between goods 1 and 2 at which a consumer is
Interpretation

Demand
willing to keep their current bundle.
Examples
Max U
Solutions When the market offers an exchange rate of −p1 /p2 , the
Theoretical
Implications
Policy
consumer can give up one unit of good 1 to buy p1 /p2 units of
Implications
good 2.
Summary

If the consumer has a bundle that they would prefer not to

change, then it must be the one where:
−p1
MRS =
p2
Modeling the
Consumer

ECON 201 MRS and Optimality

Outline

Optimal Suppose you had a bundle where your MRS was different from
Choice
Graphical
Representation
the price ratio.
Interpretation

Demand
Examples
Say, your MRS = ∆x2 /∆x1 = −3/2 but the price ratio is 1/1.
Max U
Solutions
What would you want to do?
Theoretical
Implications
Policy
Implications
Answer: At your current MRS, you would give up 3 units of
Summary good 2 to get an additional 2 units of good 1, but at market
rates you only need to give up 2 units of good 2 to get 2 units
of good 1!

So you couldn’t be at an optimal bundle! You’d want to trade

to get a better bundle, and you’d continue to trade until you
got to a bundle where MRS = −p 1
p2 .
Modeling the
Consumer

ECON 201 Quiz Prep

Outline

Optimal
Choice
Graphical
Representation
Interpretation Suppose that the consumer has purchased the bundle
Demand (x1 , x2 ) = (4, 4) and that her MRS at that bundle is -1/2. If
Examples
Max U the price of good 1 is $1 and the price of good 2 is $5, which
Solutions
Theoretical
Implications
of the following decisions should she make?
Policy
Implications
(a) Sell some of good 1 to buy more of good 2.
Summary
(b) Sell some of good 2 to buy more of good 1.
(c) Do nothing.
(d) Not enough information.
Modeling the
Consumer

ECON 201 Optimality and Demand

Outline
We call the optimal bundle, given prices and a budget, the
Optimal
Choice consumer’s demanded bundle.
Graphical
Representation
Interpretation
Typically, when prices and income change, the demanded
Demand
Examples bundle will also change.
Max U
Solutions
Theoretical
Implications For that reason, we can define a demand function that
Policy
Implications explains how the demanded bundle (the optimal quantities of
Summary
x1 and x2 ) changes as we change prices and income.

x1 (p1 , p2 , m) and x2 (p1 , p2 , m)

Note that the demand function will depend on the consumer’s

preferences, and this will provide an even more convenient way
to represent consumer preferences than the utility function!
Modeling the
Consumer

ECON 201 Perfect Substitutes

Outline

Optimal
Indifference
Choice Curves
Graphical
Representation Slope = -1

Interpretation

Demand Budget
Examples Line

x2
Max U
Solutions
Theoretical
Implications
Policy
Implications
Optimal
Choice
Summary

x*1 = m/p1

x1


 m/p1 when p1 < p2
x1 = [0, m/p1 ] when p1 = p2
0 when p1 > p2

Modeling the
Consumer

ECON 201 Perfect Substitutes

Outline

Optimal
Choice
Graphical
Representation
Interpretation

Demand
If goods are perfect substitutes, the consumer exclusively buys
Examples
Max U
the cheaper the two goods.
Solutions
Theoretical
Implications
Policy
If both prices are the same, it doesn’t matter which
Implications
combination of goods the consumer buys.
Summary

Think about what happens to the previous figure when the

price of good 1 increases.
Modeling the
Consumer

ECON 201 Perfect Substitutes

Outline

Optimal
Choice
Indifference
Graphical Curves
Representation
Slope = -1
Interpretation

Demand xl2 = m/pl2

Examples Budget
Line
Max U
Solutions x2
Theoretical
Implications
Policy
Implications

Summary

x*1 = m/p1

x1

When the price of good 1 rises, the budget line rotates inward,
and if it rises high enough, consumers will substitute good 2 for
good 1.
Modeling the
Consumer

ECON 201 Perfect Complements

Outline

Optimal
Choice
Graphical
Representation
Interpretation

Demand
Examples Indifference
Max U Curves
Solutions x2
Theoretical
Implications
Policy
Implications Optimal
Choice
Summary x2*

Budget
Line

x1*

x1

m
x1 = x2 = x =
p1 + p2
Modeling the
Consumer

ECON 201 Perfect Complements

Outline

Optimal Where does the demand function come from?

Choice
Graphical
Representation
Interpretation
Since the goods must be purchased together to have any value,
Demand we know the consumer buys the same quantity of each good,
Examples
Max U call it x.
Solutions
Theoretical
Implications
Policy Then, we must have:
Implications

Summary
p1 x + p2 x = m

Then we can solve for x to get:

m
x1 = x2 = x =
p1 + p2
Modeling the
Consumer

ECON 201 Quiz Prep

Outline

Optimal
Choice
Graphical
Representation
Interpretation

Demand
Examples
Max U
Solutions
Theoretical
Suppose that goods 1 and 2 are perfect substitutes and that
Implications
Policy
the consumer views 4 units of good 1 as just as good as 1 unit
Implications
of good 2. What is the demand function for good 1?
Summary
Modeling the
Consumer

ECON 201 Neutrals and Bads

Outline

Optimal
Choice
Graphical
Representation
Interpretation
If either good is a neutral or a bad, the consumer will spend
Demand all of her money on the good she likes and none of it on the
Examples
Max U
neutral or bad.
Solutions
Theoretical
Implications
Policy
So the demand functions, supposing good 2 is the neutral
Implications
(bad) will be:
Summary

m
x1 =
p1
x2 = 0
Modeling the
Consumer

ECON 201 Discrete Goods

Outline

Optimal
Choice
Graphical
Representation
Interpretation

Demand
When a consumer chooses between discrete goods and
Examples
Max U
spending money on everything else, the bundles can be written
Solutions
Theoretical
as (1, m − p1 ), (2, m − 2p1 ), (3, m − 3p1 ) . . .
Implications
Policy
Implications
Then we just want to find out which bundle has the highest
Summary
utility.

We can also do this graphically...

Modeling the
Consumer

ECON 201 Discrete Goods

Outline Zero Units Demanded 1 Unit Demanded

Optimal
Choice
Graphical Optimal
Representation Choice
Interpretation
x*2
Demand
Examples
Max U Optimal
x2

Solutions Choice
Theoretical
Implications
Policy
x*2
Implications

Summary

0 1 2 0 1 2

x1 x1

The optimal bundle is the one on the highest indifference

curve. As the price of good 1 falls, the consumer will continue
not to purchase it until some threshold.
Modeling the
Consumer

ECON 201 Concave Preferences

Outline
Optimal
Optimal Bundle
Choice
Indifference
Graphical Curves
Representation
Interpretation

Demand
Examples
Max U
Solutions
Theoretical
Implications
x2

Budget
Policy
Implications Line

Summary
Nonoptimal
Bundle

Nonoptimal
Bundle

x1

These will always yield boundary optima.

Modeling the
Consumer

ECON 201 Cobb-Douglas Preferences

Outline

Optimal
Choice
Graphical
Representation
Interpretation

Demand Recall the Cobb-Douglas utility function u(x1 , x2 ) = x1c x2d .

Examples
Max U
Solutions
Theoretical
Implications
We want to find the demand function that gives the optimal
Policy
Implications
choices (x1 , x2 ) for all prices (p1 , p2 ) and m.
Summary
Before we solve this particular case, let’s go back and look at
the utility maximization problem more generally.
Modeling the
Consumer

ECON 201 Utility (Preference) Maximization

Outline

Optimal
Choice
Graphical
Representation
Interpretation

Demand
The reason we developed the utility function representation of
Examples
Max U
preferences was so that we can treat the consumer’s choice
Solutions
Theoretical
problem as a simple maximization problem (hopefully you
Implications
Policy remember these from calculus).
Implications

Summary
The goal is to solve this maximization problem.

The good news is that we already have the tools to do it!

Modeling the
Consumer

ECON 201 Optimal Choice and MRS

Outline

Optimal
Choice
Recall that an optimal choice, that is, a bundle (x1 , x2 ) that
Graphical
Representation
solves the utility maximization problem, must satisfy the
Interpretation
following condition:
Demand
Examples
p1
Max U
Solutions MRS(x1 , x2 ) = −
Theoretical p2
Implications
Policy
Implications

Summary And recall from the Utility lecture (Chapter 4) that the MRS
can be expressed as:

∂u(x1 , x2 )/∂x1 p1
MRS(x1 , x2 ) = − =−
∂u(x1 , x2 )/∂x2 p2

And the negative signs cancel out.

Modeling the
Consumer

ECON 201 Optimal Choice and the Budget

Outline Constraint
Optimal
Choice
Graphical
Representation
Interpretation

Demand From the Budget Set lecture (Chapter 2) we also know that
Examples
Max U
Solutions
optimal choice must satisfy:
Theoretical
Implications
Policy
Implications p1 x1 + p2 x2 = m
Summary

Therefore, we’re left with two equations and two unknowns,

and we just need to solve for the optimal choices of x1 and x2
as a function of prices and income.
Modeling the
Consumer

ECON 201 Solution Concept #1: Substitution

Outline
We can solve the budget constraint for one of the choices and
Optimal
Choice then substitute that choice into the MRS condition.
Graphical
Representation
Interpretation
E.g. we can solve the budget constraint for x2 :
Demand
Examples
Max U m p1
Solutions x2 = − x1
Theoretical
Implications
p2 p2
Policy
Implications

Summary When we substitute that into the MRS condition, we get:

p1
∂u(x1 , pm2 − p2 x1 )/∂x1 p1
p1 =
∂u(x1 , pm2 − p2 x1 )/∂x2 p2

Since this equation only has one unknown (x1 ), it can then be
solved for x1 in terms of (p1 , p2 , m), and substitution back in
the budget constraint will yield a solution for x2 .
Modeling the
Consumer

ECON 201 Back to Cobb-Douglas

Outline
How can we solve for the general form of the demand function
Optimal
with Cobb-Douglas utility?
Choice
Graphical
Representation
Interpretation
u(x1 , x2 ) = x1c x2d
Demand
Examples
Max U
Solutions First, to make life easier, let’s take a monotonic transformation:
Theoretical
Implications
Policy
Implications
ln u(x1 , x2 ) = c ln x1 + d ln x2
Summary

Then, we can write the maximization problem:

max c ln x1 + d ln x2
(x1 ,x2 )

s.t. p1 x1 + p2 x2 = m
Modeling the
Consumer

ECON 201 Solution #1

Outline

Optimal
Choice Using the expression for the MRS from Chapter 4:
Graphical
Representation
Interpretation

Demand cx2 p1
Examples =
Max U dx1 p2
Solutions
Theoretical
Implications p1 x1 + p2 x2 = m
Policy
Implications

Summary

These are two equations in two unknowns, so we can solve

them by substituting the second equation into the first:

c(m/p2 − x1 p1 /p2 ) p1
=
dx1 p2
Modeling the
Consumer

ECON 201 Solution #1

Outline

Optimal
Then, cross multiplying the last expression gives:
Choice
Graphical
Representation
Interpretation
c(m − x1 p1 ) = dp1 x1
Demand
Examples
Max U
Solutions We can rearrange this to get:
Theoretical
Implications
Policy
Implications
cm = (c + d)p1 x1
Summary

Which is equivalent to:

c m
x1 =
c + d p1

And this is the demand function for x1 .

Modeling the
Consumer

ECON 201 Solution #1

Outline

Optimal
Choice To get the demand function for x2 , we can substitute back into
Graphical
Representation the budget constraint to get:
Interpretation

Demand
Examples
Max U m p1 c m
Solutions x2 = −
Theoretical p2 p2 c + d p1
Implications
Policy
Implications
d m
Summary =
c + d p2

Notice, these demand functions imply that with Cobb-Douglas

preferences, the consumer will spend a fixed percentage of her
income on each good!
Modeling the
Consumer

ECON 201 Constrained Maximization

Outline

Optimal
Choice
We can also use the calculus conditions for maximization to
Graphical
Representation
solve the following constrained maximization problem:
Interpretation

Demand
Examples
Max U
Solutions
max u(x1 , x2 )
Theoretical
(x1 ,x2 )
Implications
Policy
Implications
s.t. p1 x1 + p2 x2 = m
Summary

This says that we want to choose x1 and x2 to maximize the

objective (utility) function, subject to the (budget) constraint
that the chosen bundle must be affordable.

There are two ways to solve this problem.

Modeling the
Consumer

ECON 201 Solution Concept #2: Convert to

Outline Unconstrained Maximization
Optimal
Choice The first is to solve the budget constraint for one of the
Graphical
Representation variables (say x2 ) and then to substitute it into the objective
Interpretation
function.
Demand
Examples
Max U
Solutions E.g. given x1 , the amount of x2 needed to ensure we’re on the
Theoretical
Implications budget line, that is x2 as a function of x1 , is:
Policy
Implications

Summary
m p1
x2 (x1 ) = − x1
p2 p2

Then, substitute this back into the objective function to get:

m p1
max u(x1 , − x1 )
x1 p2 p2

Which is an unconstrained maximization problem.

Modeling the
Consumer

ECON 201 Solution Concept #2

Outline

Optimal Then, all we need to do is differentiate (take the partial

Choice
Graphical
Representation
derivative of) the new objective function with respect to x1 and
Interpretation set the result equal to 0 to get the first-order condition:
Demand
Examples
Max U ∂u(x1 , x2 (x1 )) ∂u(x1 , x2 (x1 ) dx2
Solutions + =0
Theoretical
Implications
∂x1 ∂x2 dx1
Policy
Implications

Summary The first term shows how utility changes as x1 increases.

The second term shows:

1 The rate of increase of utility as x2 increases
2 The rate of decrease of x2 as x1 increases in order to
continue to satisfy the budget constraint
Modeling the
Consumer

ECON 201 Solution Concept #2

Outline
Differentiate the equation for x2 (x1 ) in order to get the second
Optimal
Choice part of the second term:
Graphical
Representation
Interpretation dx2 p1
Demand
=−
Examples
dx1 p2
Max U
Solutions
Theoretical
Implications Then, substituting that back into our equation from the last
Policy
Implications slide gives:
Summary

∂u(x1∗ , x2∗ )/∂x1 p1

∗ ∗ =
∂u(x1 , x2 )/∂x2 p2

Which just says (again) that the MRS between x1 and x2 must
equal the price ratio at the optimal choice (x1∗ , x2∗ ), which must
also satisfy the budget constraint p1 x1∗ + p2 x2∗ = m, giving us
two equations and two unknowns.
Modeling the
Consumer

ECON 201 Solution #2

Outline

Optimal Let’s try this concept out with the Cobb-Douglas Utility
Choice
Graphical function.
Representation
Interpretation

Demand We can also just substitute the budget constraint into the
Examples
Max U maximization problem:
Solutions
Theoretical
Implications
Policy
Implications
max c ln x1 + d ln(m/p2 − x1 p1 /p2 )
x1
Summary

Then take the derivative w.r.t. x1 to get the first-order

condition:
c p2 p1
−d =0
x1 m − p1 x1 p2
Modeling the
Consumer

ECON 201 Solution #2

Outline
Then, p2 cancels out to give:
Optimal
Choice
Graphical c dp1
Representation
− =0
Interpretation
x1 m − p1 x1
Demand
Examples
Max U
Solutions Adding the second term to both sides and multiplying by x1
Theoretical
Implications
Policy
gives:
Implications

Summary dp1 x1
c=
m − p1 x1

Multiplying both sides by the denominator and adding cp1 x1 to

both sides leaves:

cm = dp1 x1 + cp1 x1 = (c + d)p1 x1

Modeling the
Consumer

ECON 201 Solution #2

Outline

Optimal
Choice
Graphical Finally, divide by (c + d)p1 to get:
Representation
Interpretation
c m
Demand
x1 =
Examples
Max U
c + d p1
Solutions
Theoretical
Implications
Policy
Implications
Again, by substituting into the budget constraint, we can solve
Summary for x2 :

d m
x2 =
c + d p2

Which is the same solution we got before!

Modeling the
Consumer

ECON 201 Solution Concept #3: Lagrange

Outline Multipliers
Optimal We can also solve the maximization problem using Lagrange
Choice
Graphical
Representation
Multipliers.
Interpretation

Demand We start by defining a new function called the Lagrangian:

Examples
Max U
Solutions
Theoretical L = u(x1 , x2 ) − λ(p1 x1 + p2 x2 − m)
Implications
Policy
Implications

Summary
The new variable λ is known as the Lagrange multiplier,
because it multiplies the constraint. Lagrange’s theorem says
that an optimal choice (x1∗ , x2∗ ) must satisfy:
∂L ∂u(x1∗ ,x2∗ )
∂x1 = ∂x1 − λp1 = 0
∂L ∂u(x1∗ ,x2∗ )
∂x2 = ∂x2 − λp2 = 0
∂L
∂λ = p1 x1∗ + p2 x2∗ − m = 0
Modeling the
Consumer

ECON 201 Solution Concept #3

Outline
The three equations are just the partial derivatives of the
Optimal
Lagrangian with respect to x1 , x2 and λ.
Choice
Graphical
Representation
Interpretation
Now we have 3 equations and 3 unknowns, and we can solve
Demand
for x1 and x2 in terms of (p1 , p2 , m).
Examples
Max U
Solutions Note that we will not need to prove Lagrange’s Theorem (or
Theoretical
Implications
Policy
necessarily to use it), but in some cases you may find it
Implications
convenient to use.
Summary

But note, that by dividing the first condition by the second, we

end up with:

∂u(x1∗ , x2∗ )/∂x1 p1

∗ ∗ =
∂u(x1 , x2 )/∂x2 p2

And the budget constraint (condition 3) as before, and we’re

back to 2 equations and 2 unknowns.
Modeling the
Consumer

ECON 201 Solution #3: Cobb-Douglas

Outline

Optimal
Choice As before, we start with u(x1 , x2 ) = c ln x1 + d ln x2
Graphical
Representation
Interpretation
Set up the Lagrangian:
Demand
Examples
Max U
Solutions L = c ln x1 + d ln x2 − λ(p1 x1 + p2 x2 − m)
Theoretical
Implications
Policy
Implications

Summary Differentiate to get the three first-order conditions:

∂L c
∂x1 = x1 − λp1 = 0
∂L d
∂x2 = x2 − λp2 = 0
∂L
∂λ = p1 x1∗ + p2 x2∗ − m = 0
Modeling the
Consumer

ECON 201 Solution #3

Outline
To solve them, let’s start by solving for λ.
Optimal
Choice
Graphical
Rearranging and cross multiplying the first two equations leaves
Representation
Interpretation
us with:
Demand
Examples
Max U
c = λp1 x1
Solutions
Theoretical
Implications d = λp2 x2
Policy
Implications

Summary
Adding these together gives us:

c + d = λ(p1 x1 + p2 x2 ) = λm

Which implies:

c +d
λ=
m
Modeling the
Consumer

ECON 201 Solution #3

Outline

Optimal
Choice
Graphical
Representation
Interpretation

Demand Then, substituting back into the first two equations and solving
Examples
Max U for x1 and x2 gives us:
Solutions
Theoretical
c m
Implications
Policy
x1 = c+d p1
Implications

d m
Summary
x2 = c+d p2

Which is the same solution as in the other two cases!

Modeling the
Consumer

ECON 201 Cobb-Douglas Utility

Outline To summarize, the Cobb-Douglas utility function:
Optimal
Choice
Graphical
Representation
u(x1 , x2 ) = x1c x2d
Interpretation

Demand Generates demand functions (found in many ways):

Examples
Max U c m
Solutions x1 = c+d p1
Theoretical
Implications
d m
Policy
Implications x2 = c+d p2
Summary

Which imply that the consumer will always spend a fixed

percentage of her income on each good.

This is why it is convenient to normalize the exponents so that

they sum to 1!

u(x1 , x2 ) = x1α x21−α

Modeling the
Consumer

ECON 201 The Utility of Utility Functions

Outline

Optimal
Choice
Graphical
Representation
One situation in which you might expect people to have
Interpretation Cobb-Douglas preferences is where good 1 is something like the
Demand
Examples
percent of income that people spend on housing and good 2 is
Max U
Solutions
the percent left over for everything else.
Theoretical
Implications
Policy
Implications There’s some evidence that this is pretty stable within countries
Summary (e.g. 15-20% in the UK).

So then the utility function might look like:

1 4
u(x1 , x2 ) = x15 x25
Modeling the
Consumer

ECON 201 The Utility of Utility Functions

Outline Since x2 is a composite good we can assume p2 is 1.
Optimal
Choice
Graphical Suppose m = 1000, and suppose the population is growing.
Representation
Interpretation The government is considering a policy that would restrict the
Demand ability of developers to build new units.
Examples
Max U
Solutions
Theoretical
Implications
With a growing population and a fixed supply, suppose that
Policy
Implications
would raise the price of 1 “unit of housing”, say 1000 sq. ft.,
Summary (p1 ) from 100 to 200.

Then demand for x1 and x2 at initial prices is:

1 1000
x1 = 5 100 =2
4 1000
x2 = 5 1 = 800

1 4
And the initial utility is: u(x1 , x2 ) = 2 5 800 5 = 241.4
Modeling the
Consumer

ECON 201 The Utility of Utility Functions

Outline

Optimal
Choice
After the building restriction is imposed and p1 = 200, the
Graphical
Representation
demand becomes:
Interpretation

1 1000
Demand
Examples
x1 = 5 200 =1
Max U
4 1000
Solutions
Theoretical
x2 = 5 1 = 800
Implications
Policy
Implications
1 4
Summary Which generates utility: u(x1 , x2 ) = 1 5 800 5 = 210.1

Remember, the actual number is meaningless. What is

important is that the policy moves the consumer to a lower
indifference curve (e.g. to a smaller housing unit).

What might be some of the other responses by homeowners?

Modeling the
Consumer

ECON 201 More on the MRS

Outline

Optimal Think about it, if:

Choice
Graphical
Representation 1 The market generates a single price for each good, say
Interpretation

Demand
butter and milk, (as is often the case in well-organized
Examples markets),
Max U
Solutions
Theoretical
2 Everyone is choosing optimally,
Implications
Policy
Implications
3 Everyone is at an interior solution
Summary
Then, everyone must have exactly the same MRS for butter
and milk!

The market offers everyone the same rate of exchange for milk
and butter to everyone, and everyone is adjusting their
consumption until their own marginal valuation of the two
goods equals the market’s marginal valuation.
Modeling the
Consumer

ECON 201 More on the MRS

Outline
Crucially, this is true regardless of income and preferences!
Optimal
Choice
Graphical
Representation Some people will value their total consumption differently, and
Interpretation
some will have more milk while others will have more butter.
Demand
Examples
Max U
Solutions And wealthier people may have more of both.
Theoretical
Implications
Policy
Implications But, everyone who has optimized consumption will have exactly
Summary
the same marginal rate of substitution.

Which says that everyone will agree on the rate at which they
would exchange one good for the other.

And because everyone has consumed to the point where that

rate equals the market exchange rate, no one will want to
engage in further trade.
Modeling the
Consumer

ECON 201 More on the MRS

Outline

Optimal
Choice
Graphical Now, we might doubt that people actually optimize perfectly. . .
Representation
Interpretation

Demand BUT the combination of utility-driven choice and market prices

Examples
Max U will allow choices to tend in the direction of optimality over
Solutions
Theoretical
Implications
time.
Policy
Implications

Summary Prices contain information, and that information creates

incentives.

Just thinking about a) how policies/events change relative

prices and b) how changes in relative prices will change choices
will help you understand a lot about how the world works.
Modeling the
Consumer

ECON 201 The Role of the Entrepreneur

Outline

Optimal
Choice
Graphical Entrepreneurs get rich by finding a way to transform goods at
Representation
Interpretation better than the current market rate of exchange!
Demand
Examples
Max U If the current exchange rate has 1 quart of milk going for $2
Solutions
Theoretical
Implications
and 1 pound of butter for $2, then an entrepreneur can profit
Policy
Implications
by finding a way to convert butter to milk more efficiently.
Summary
Suppose she develops a technology that converts a pound of
butter into 2 quarts of milk!

She can then buy up pounds of butter for $2, convert them to
2 quarts of milk and sell the result for a $4!
Modeling the
Consumer

ECON 201 The Role of Prices

Outline

Optimal
Choice
Graphical
Representation
Interpretation

Demand
This all points to one of the most important insights in
Examples
Max U
economics, the resolution to the water-diamond paradox:
Solutions
Theoretical
Implications
Policy
Prices are not arbitrary numbers, they tell us how people value
Implications
goods at the margin.
Summary

Diamonds are more expensive than water because of their value

at the margin which is caused by their scarcity.
Modeling the
Consumer

ECON 201 Tax Policy

Outline
Quantity taxes impact the budget constraint by increasing the
Optimal
price of one good, and the optimal bundle will satisfy:
Choice
Graphical
Representation
Interpretation
(p1 + t)x1∗ + p2 x2∗ = m
Demand
Examples

This tax raises total revenue R ∗ = tx1∗ .

Max U
Solutions
Theoretical
Implications
Policy
Implications Income taxes impact the budget constraint by reducing
Summary income (for this example, we’ll use a revenue-equivalent lump
sum tax).

p1 x1 + p2 x2 = m − R ∗

Which can be rewritten as:

p1 x1 + p2 x2 = m − tx1∗
Modeling the
Consumer

ECON 201 Tax Policy

Outline

Optimal Under the income tax the budget line will have the same slope
Choice
Graphical
as it did initially.
Representation
Interpretation

Demand And a revenue-equivalent, lump-sum income tax will ensure

Examples
Max U that the optimal bundle under the quantity tax will still be
Solutions
Theoretical available.
Implications
Policy
Implications

Summary
This is true because when we rearrange the budget constraint
under the quantity tax, we get:

p1 x1∗ + p2 x2∗ = m − tx1∗

Thus, it will be affordable under the income tax, but will it be

optimal?
Modeling the
Consumer

ECON 201 Tax Policy

Outline

Optimal
Choice m Indifference
Graphical Curves
p2
Representation
Interpretation

Demand
Examples
Max U
Solutions
Theoretical
x*2
x2

Implications
Policy
Implications

Summary

x*l1 x*1 m m
pl1 p1
x1

This shows the effect of a tax on good 1.

Modeling the
Consumer

ECON 201 Revenue-Equivalent Lump-Sum Tax

Outline

Optimal m Indifference
Choice Curves
p2
Graphical
Representation
Interpretation
ml
Demand
p2
Examples
Max U
Solutions
x*2
x2

Theoretical
Implications
Policy
Implications x*l2

Summary

x*l1 x*1 m ml m
p1l p1 p1
x1

Answer: No, the consumer is better off with an income tax

(and the government gets the same revenue)!
Modeling the
Consumer

ECON 201 Optimal Choice

Outline

Optimal
Choice
Graphical
Representation
1 The optimal choice is the bundle in the budget set that
Interpretation puts the consumer on the highest indifference curve. This
Demand
Examples
is what we mean by the best bundle a consumer can afford.
Max U
Solutions 2 For well-behaved preferences the optimal bundle will
Theoretical
Implications usually require MRS = −p1 /p2 = slope of the budget line.
Policy
Implications

Summary
3 We can use choice data to estimate utility functions (see
the textbook for an example), and these functions can be
used to evaluate policy proposals.
4 When everyone faces the same prices for two goods, then
everyone will have identical MRSs and will be willing to
trade off the two goods in the same way!