EC201: Microeconomic Principles I

1.2 Consumer Theory: Utility maximization

and uncompensated demand
Utility maximisation and uncompensated demand

• In 1.1 we made some key assumptions about consumer

preferences

• These allow us to proceed to examine the consumption decisions

of a utility-maximizing consumer with particular preferences

• Once we determine ‘uncompensated’ demand we can look more

closely at what shapes demand decision

2
We explore different consumer preferences
• Cobb-Douglas: 𝑢 𝑥1, 𝑥2 = 𝑥1! 𝑥2" , where 𝛼 > 0 and 𝛽 > 0
• Quasi-linear: 𝑢 𝑥1, 𝑥2 = 𝑥1 + 𝑣(𝑥2) or 𝑢 𝑥1, 𝑥2 = 𝑣(𝑥1) + 𝑥2, where
𝑣 0 = 0, 𝑣′ - > 0 and 𝑣 ## - < 0
• Perfect substitutes: 𝑢 𝑥1, 𝑥2 = 𝛼𝑥1 + 𝛽𝑥2 , where 𝛼 > 0 and 𝛽 > 0
• Perfect complements: 𝑢 𝑥1, 𝑥2 = min[𝛼𝑥1, 𝛽𝑥2], where 𝛼 > 0 and 𝛽 > 0
• Non-convex: for example 𝑢 𝑥1, 𝑥2 = 𝛼𝑥$% + 𝛽𝑥%% , where 𝛼 > 0 and 𝛽 > 0

• These have particular properties and implications for consumer choice and
welfare effects.
3
Utility maximisation and uncompensated demand
1. The budget set and budget line
2. Definition of uncompensated demand
3. Finding uncompensated demand
4. Homogeneity of uncompensated demand
5. From uncompensated demand to the demand curve
6. Elasticities; normal and inferior goods; substitutes and
complements
7. Consumer demand with different preferences

4
1. The budget set and budget line
• Our objective is to examine the consumption decisions of a consumer with
particular preferences

• Suppose the consumer has a budget of income 𝑚, which can be allocated

over two goods 𝑥$ and 𝑥% with prices 𝑝$ and 𝑝% , respectively

• The budget set contains all affordable consumption bundles, where

expenditure does not exceed income:
𝑝1𝑥1 + 𝑝2𝑥2 ≤ 𝑚 , where 𝑥1 ≥ 0, 𝑥2 ≥ 0

• The budget line is where 𝑝1𝑥1 + 𝑝2𝑥2 = 𝑚, where 𝑥1 ≥ 0, 𝑥2 ≥ 0

5
1. The budget set and budget line
• Budget line: 𝑝1𝑥1 + 𝑝2𝑥2 = 𝑚 𝑥2
𝑚/𝑝2
& '" budget line
• Rearranging: 𝑥2 = − 𝑥
'! '! 1

'"
• Gradient: −
'!
& budget set
• 𝑥1 intercept:
'"
&
• 𝑥2 intercept:
'!
0 𝑚/𝑝1 𝑥1

• Key question: where will the consumer choose to consume? 6

2. Definition of uncompensated demand
The consumer’s uncompensated demand functions 𝑥1(𝑝1, 𝑝2, 𝑚) and
𝑥2(𝑝1, 𝑝2, 𝑚) maximize utility 𝑢(𝑥1, 𝑥2) subject to:
• the budget constraint 𝑝1𝑥1 + 𝑝2𝑥2 ≤ 𝑚
• and non negativity constraints 𝑥1 ≥ 0, 𝑥2 ≥ 0

• The amount of goods 1 and 2 consumed will depend on the consumer’s

income and prices, given his or her preferences.

• Note some books use the term Marshallian demand

7
2. Definition of uncompensated demand
• Assume fixed income and price; 𝑥2
this pins down the budget line 𝑚/𝑝2

• The consumer aims to get onto the

highest possible indifference curve
𝑥2(𝑝1, 𝑝2, 𝑚) ●
• Uncompensated demand functions
are those that maximise utility
given income and prices
0 𝑥1(𝑝1, 𝑝2, 𝑚) 𝑚/𝑝1 𝑥1
• But is this diagram a good
representation of the decision? 8
3. Finding uncompensated demand
• Key point: non-satiation and 𝑥2
convexity assumptions imply Solve:
𝑚/𝑝2 #$!
downward sloping, convex • 𝑀𝑅𝑆 =
#%&
=
"!
#$!
indifference curves #%' ""
• 𝑝1𝑥1 + 𝑝2𝑥2 = 𝑚
• If non-satiation and convexity 𝑥2(𝑝1, 𝑝2, 𝑚) ●
conditions are satisfied, then any
tangency point on the budget line
'"
at which MRS = and where
'!
𝑥1 ≥ 0, 𝑥2 ≥ 0, maximizes
utility and is uncompensated 0 𝑥1(𝑝1, 𝑝2, 𝑚) 𝑚/𝑝1 𝑥1
demand!
9
Interpreting the tangency condition: 𝑀𝑅𝑆 = 𝑝1/𝑝2
$ $ ./
• £1 more on x1 gives more units of good 1 and increases utility by
'" '" .0!
$ $ ./
• £1 less on x2 gives ' fewer units of good 2 and lowers utility by ' .0"
! !

$ ./ $ ./
• £1 more on x1 and £1 less on x2 increases utility if >
'" .0! '! .0"
$ ./ $ ./
• £1 less on x1 and £1 more on x2 increases utility if ' <'
" .0! ! .0"

#$1
$ ./ $ ./ #%! '"
• Utility maximization requires ' .0!
=' .0"
, hence MRS = #$1 =' !
" ! #%" !

10
3. Finding uncompensated demand
• Alternative approach: use 𝑥2
Lagrangian optimisation to find
𝑚/𝑝2
uncompensated demand (see
lecture Appendix)

• Constrained optimisation: 𝑥2(𝑝1, 𝑝2, 𝑚) ●

maximize utility subject to the
budget constraint

• The first order conditions of the

constrained optimisation 0 𝑥1(𝑝1, 𝑝2, 𝑚) 𝑚/𝑝1 𝑥1
'"
problem also give: MRS =
'!
11
What if non-satiation and convexity are not satisfied?
• Watch out! If the assumptions do not hold, then a tangency point on the
'"
budget line where MRS = will not necessarily maximize utility
'!

x2
Example 1: failure of non-satiation
'"
• MRS = holds at bundle A (tangency)
'!
• But bundle A does not maximise utility! A
●
preferred
• There exist bundles, such as B, that are set
preferred to point A ●B

0 x1
12
What if non-satiation and convexity are not satisfied?
Example 2: failure of convexity
• Bundle A is at a tangency point but does not maximize utility
• Bundle B maximizes utility

13
Steps for finding uncompensated demand
1. Identify the maximization problem to be solved and what the
solution is a function of; draw an indifference curve diagram.

2. Check for non-satiation and convexity using calculus (if the utility
function has partial derivatives) and explain the implications

3. If satisfied, then solve the tangency and budget line conditions and
express the solution as a function of prices and income
I. If non-negativity constraints x1 ≥ 0 and x2 ≥ 0 are satisfied, then this solution
is uncompensated demand for goods 1 and 2
II. If violated look for a corner solution (see example with quasi-linear
preferences) to find uncompensated demand
14
Example: Cobb-Douglas preferences
A consumer has income m and preferences described by utility
"⁄ '⁄
function 𝑢 𝑥1, 𝑥2 = 𝑥1 𝑥2 & .
&

Prices are fixed at 𝑝1 and 𝑝2 . Find uncompensated demands

𝑥1(𝑝1, 𝑝2, 𝑚) and 𝑥2(𝑝1, 𝑝2, 𝑚).

Step 1: Identify the maximisation problem to be solved and what the

solution is a function of; draw a indifference curve diagram.
"⁄ '⁄
The problem is to maximize 𝑢 𝑥1, 𝑥2 = 𝑥1 𝑥2 subject to:
& &

• the budget constraint 𝑝1𝑥1 + 𝑝2𝑥2 ≤ 𝑚 and

• non-negativity constraints 𝑥1 ≥ 0, 𝑥2 ≥ 0
to find uncompensated demands as a function of prices and income
𝑥1(𝑝1, 𝑝2, 𝑚) and 𝑥2(𝑝1, 𝑝2, 𝑚) 15
 Example: Cobb-Douglas preferences
%1 41
𝑢 𝑥1, 𝑥2 = 𝑥1 3 𝑥2 3 Let’s consider the indifference map
• The axes are the indifference curve for 𝑢 = 0
x2 • 𝑢 > 0 requires both 𝑥1 > 0 and 𝑥2 > 0
• If 𝑢 > 0 the indifference curve does not meet
the axes
●
• With Cobb-Douglas utility, the consumer with
𝑚 > 0 can get 𝑥1 > 0 and 𝑥2 > 0 so 𝑢 > 0
• Will thus never choose to be at a corner where
0 x1 the budget line meets one of the axes

16
Example: Cobb-Douglas preferences
Step 2: Check for non-satiation and convexity and explain the implications.
Since non-satiation and convexity are satisfied (see last lecture) any bundle on
'"
the budget line where 𝑀𝑅𝑆 = solves the problem.
'!

Step 3: Solve the tangency and budget line conditions and express the solution
as a function of prices and income; check non-negativity constraints.
%0! '"
Solving 𝑝1𝑥1 + 𝑝2𝑥2 = 𝑚 and 𝑀𝑅𝑆 = 40 = ' (see last lecture)
" !
simultaneously for 𝑥1 and 𝑥2 gives uncompensated demand functions:
%& 4&
𝑥1(𝑝1, 𝑝2, 𝑚) = > 0 and 𝑥2(𝑝1, 𝑝2, 𝑚) = >0
3'" 3'!

That satisfy non-negativity constraints. 17

Example: Cobb-Douglas preferences
• Let’s think about our result…a consumer with utility function 𝑢 𝑥1, 𝑥2 =
"⁄ '⁄
𝑥1 𝑥2 & chooses:
&
%& 4&
𝑥1(𝑝1, 𝑝2, 𝑚) = and 𝑥2(𝑝1, 𝑝2, 𝑚) = to maximize utility
3'" 3'!

% 4
• So: 𝑝1𝑥1(𝑝1, 𝑝2, 𝑚) = 𝑚 and 𝑝2𝑥2(𝑝1, 𝑝2, 𝑚) = 𝑚
3 3

• The consumer spends a fixed proportion of income on each good!

• In general, if 𝑢 𝑥1, 𝑥2 = 𝑥1! 𝑥2$5! then

𝑝1𝑥1 𝑝1, 𝑝2, 𝑚 = 𝛼𝑚 and 𝑝2𝑥2(𝑝1, 𝑝2, 𝑚) = 1 − 𝛼 𝑚

• What about if 𝑢 𝑥1, 𝑥2 = 𝑥1! 𝑥2" ?

18
4. Homogeneity of uncompensated demand
• What happens to uncompensated demand functions if prices and
income are multiplied by a factor 𝑡 > 0?

• Maths recap: a function 𝑓(𝑧1, 𝑧2, 𝑧3 … . . 𝑧𝑛) is homogeneous of degree

𝑘 if for all numbers 𝑡 > 0:
𝑓 𝑡𝑧1, 𝑡𝑧2, 𝑡𝑧3 … . . 𝑡𝑧𝑛 = 𝑡 6 𝑓(𝑧1, 𝑧2, 𝑧3 … . . 𝑧𝑛)

• What degree of homogeneity do demand functions have?

19
4. Homogeneity of uncompensated demand
• Budget constraint unchanged so 𝑥2
demand functions are unchanged 𝑡𝑚 𝑚
𝑡𝑝2 = 𝑝2
#"! "!
Gradient: − #" = −"
• Hence 𝑥1 𝑝1, 𝑝2, 𝑚 and " "

𝑥2 𝑝1, 𝑝2, 𝑚 are homogeneous of

𝑥2(𝑡𝑝1, 𝑡𝑝2, 𝑡𝑚) ●
degree 0 in prices and income

• That is, if 𝑡 > 0:

𝑥1 𝑡𝑝1, 𝑡𝑝2, 𝑡𝑚 = 𝑡 $ 𝑥1 𝑝1, 𝑝2, 𝑚 = 𝑥1 𝑝1, 𝑝2, 𝑚
𝑥1(𝑡𝑝1, 𝑡𝑝2, 𝑡𝑚) 𝑡𝑚 𝑚 𝑥1
𝑥2 𝑡𝑝1, 𝑡𝑝2, 𝑡𝑚 = 𝑡 $ 𝑥2 𝑝1, 𝑝2, 𝑚 = 𝑥2 𝑝1, 𝑝2, 𝑚
𝑡𝑝1 = 𝑝1
20
4. Homogeneity of uncompensated demand

• All uncompensated demand functions are homogeneous of degree 0

in prices and income
"⁄ '⁄
• Let’s confirm in our Cobb-Douglas example: 𝑢 𝑥1, 𝑥2 = 𝑥1 & 𝑥2 &

%8& %&
𝑥1(𝑡𝑝1, 𝑡𝑝2, 𝑡𝑚) = = = 𝑥1(𝑝1, 𝑝2, 𝑚)
38'" 3'"

48& 4&
𝑥2(𝑡𝑝1, 𝑡𝑝2, 𝑡𝑚) = 38' = 3' = 𝑥2(𝑝1, 𝑝2, 𝑚)
! !

21
5. From uncompensated demand to the demand curve

• So far we’ve worked with indifference curve diagrams with quantities

(x1 and x2) on the axes

• We now want to go from the indifference curve map to the demand

curve diagram with quantity and price (x1 and p1) on the axes

• And to see how changes in income m and p2 affect the demand curve
for good 1 (and how m and p1 affect the demand curve for good 2)

22
5. From uncompensated demand to the demand curve
• Method: Rearrange uncompensated demand 𝑥1 𝑝1, 𝑝2, 𝑚 and to get
𝑝1 as a function of 𝑥1 (and 𝑥2 𝑝1, 𝑝2, 𝑚 to get 𝑝2 as a function of 𝑥2 )

"⁄ '⁄
• Example: Cobb-Douglas utility 𝑢 𝑥1, 𝑥2 = 𝑥1 & 𝑥2 &

%& %&
𝑥1(𝑝1, 𝑝2, 𝑚) = ⟹ 𝑝$ =
3'" 30!

4& 4&
𝑥2(𝑝1, 𝑝2, 𝑚) = ⟹ 𝑝% =
3'! 30"

• The demand curves for goods 1 and 2 of a consumer with Cobb-Douglas

preferences are downward sloping and increasing in income
• In this special case income is spend in fixed proportions so a price change of
one good do not affect quantity demanded of the other!
23
5. From uncompensated demand to the demand curve
%1 41
𝑢 𝑥1, 𝑥2 = 𝑥1 3 𝑥2 3

𝑥2
• Let price of good 1 rise from 𝑝1𝐴 to 𝑝1𝐵:
𝑚/𝑝2𝐴
• Budget constraint pivots inwards

● ●
−""!#
• Uncompensated demand for good 1 falls
"#

−""!$
"# • Note uncompensated demand for good 2
unchanged (Cobb-Douglas special case)
0 𝑚/𝑝1𝐵 𝑚/𝑝1𝐴 𝑥1
24
5. From uncompensated demand to the demand curve
%1 41 %&
𝑢 𝑥1, 𝑥2 = 𝑥1 3 𝑥2 3 𝑝$ = 30
!

𝑥2 𝑝1

𝑚/𝑝2𝐴

𝑝1𝐵 ●𝐵
●𝐵 ● 𝐴
−""!#
"# 𝑝1𝐴 ●𝐴
−""!$
"#

0 𝑚/𝑝1𝐵 𝑚/𝑝1𝐴 𝑥1 0 𝑥1𝐵 𝑥1𝐴 𝑥1

25
Price expansion path
%1 41
𝑢 𝑥1, 𝑥2 = 𝑥1 3 𝑥2 3

𝑥2
• We can trace out the locus of optimal
𝑚/𝑝2 consumption bundles as 𝑝1 changes

• This is a price expansion path

●● ● ●
• Horizontal with Cobb-Douglas preferences

• What about the locus of optimal bundles as

0 𝑥1 𝑝2 changes?
26
Income expansion path
%1 41
𝑢 𝑥1, 𝑥2 = 𝑥1 3 𝑥2 3

𝑥2
• We can trace out the locus of optimal
𝑚/𝑝2 consumption bundles as 𝑚 changes

● • This is the income expansion path

●
●
• Ray from the origin with Cobb-Douglas
preferences (fixed proportions)
0 𝑥1
27
 5. From uncompensated demand to the demand curve
%1 41 %&
𝑢 𝑥1, 𝑥2 = 𝑥1 3 𝑥2 3 𝑝$ = 30
!
𝑥2
𝑝1
𝑚𝐶 /𝑝2𝐴
𝑚𝐴/𝑝2𝐴

●𝐶
●𝐴
𝑝1A 𝐴 𝐶
● ●

0 𝑥1 0 𝑥1𝐴 𝑥1𝐶 𝑥1
𝑚𝐴/𝑝2𝐴 𝑚𝐶 /𝑝1𝐴
28
6. Elasticities

• Our model of demand allows us to calculate elasticities for consumers

with different preferences:
• Own price elasticity of demand
• Income elasticity
• Cross-price elasticity

• Not unexciting…elasticities matter!

• For every decision on prices: e.g. for a monopoly or oligopolistic
firm deciding what price to set
• For a government deciding on taxes e.g. sugar tax
29
6. Elasticities
• Own price elasticity of demand:
#%!
% :;<=>? @= A/<=8@8B C?&<=C?C 1%! .0! '!
𝜀$$ = = #*! =
% :;<=>? @= DE= 'F@:? 1*! .'! 0!

• Let 𝜀@G denote the elasticity of demand for good 𝑖 with respect to 𝑗

"⁄ '⁄ %&

• Cobb-Douglas example: 𝑢 𝑥1, 𝑥2 = 𝑥1 & 𝑥2 & gives 𝑥1(𝑝1, 𝑝2, 𝑚) =
3'"

.0! '! %& 3'"

𝜀$$ = =− 𝑝1 = −1
.'! 0! 3'"" %&

30
6. Elasticities
• Income elasticity of demand:
#%!
% :;<=>? @= A/<=8@8B C?&<=C?C 1%! .0! &
𝜀$& = = #+⁄ =
% :;<=>? @= @=:D&? + .& 0!

• 𝜀%& > 0: normal good

• 𝜀%& < 0: inferior good

"⁄ '⁄ %&

• Cobb-Douglas example: 𝑢 𝑥1, 𝑥2 = 𝑥1 & 𝑥2 & gives 𝑥1(𝑝1, 𝑝2, 𝑚) =
3'"

.0! & % 3'"

𝜀$& = = 𝑚=1
.& 0! 3'" %&

31
6. Elasticities
• Cross-price elasticity of demand:
#%!
% :;<=>? @= A/<=8@8B C?&<=C?C DH >DDC $ 1%! .0! '"
𝜀$% = = #*" =
% :;<=>? @= 'F@:? DH >DDC % 1*" .'" 0!

• 𝜀%' > 0: substitutes

• 𝜀%' < 0: complements
• 𝜀%' = 0: independent

"⁄ '⁄ %&

• Cobb-Douglas example: 𝑢 𝑥1, 𝑥2 = 𝑥1 & 𝑥2 & gives 𝑥1(𝑝1, 𝑝2, 𝑚) =
3'"

.0! '" 3'"

𝜀$% = .' =0 𝑝2 = 0
" 0! %&
32
Many studies estimate elasticities!
Davis, Peter, and Pasquale Schiraldi (LSE). "The flexible coefficient
multinomial logit (FC-MNL) model of demand for differentiated
products." The RAND Journal of Economics 45, no. 1 (2014): 32-63

33
7. Consumer demand with different preferences

• So far our examples have focused on Cobb-Douglas preferences

• Other interesting preference types we examine are:

• Quasi-linear preferences
• Perfect complements
• Perfect substitutes
• Non-convex preferences

34
Uncompensated demand with quasi-linear preferences

• Quasi-linear preferences take the form:

𝑢 𝑥1, 𝑥2 = 𝑣 𝑥1 + 𝑥2 or 𝑢 𝑥1, 𝑥2 = 𝑥1 + 𝑣(𝑥2)

where 𝑣 0 = 0, 𝑣′ C > 0 and 𝑣 ## C < 0 (concave)

• These preferences have some very interesting features as we will see!

!
• Example: 𝑢 𝑥1, 𝑥2 = 𝑥1 + 𝑥2
"

𝑥1: heating (e.g. degrees on thermostat or hours heating is on)

𝑥2: all other goods
35
Example: quasi-linear preferences
Consider a consumer with income m and preferences described by
!
utility function 𝑢 𝑥1, 𝑥2 = 𝑥1" + 𝑥2. Prices are fixed at 𝑝1 and 𝑝2 . Find
uncompensated demands 𝑥1(𝑝1, 𝑝2, 𝑚) and 𝑥2(𝑝1, 𝑝2, 𝑚).

Step 1: Identify the maximisation problem to be solved and what the

solution is a function of; draw a indifference curve diagram.
!
The problem is to maximize 𝑢 𝑥1, 𝑥2 = 𝑥1 + 𝑥2 subject to:
"

• the budget constraint 𝑝1𝑥1 + 𝑝2𝑥2 ≤ 𝑚 and

• non-negativity constraints 𝑥1 ≥ 0, 𝑥2 ≥ 0
to find uncompensated demands as a function of prices and income
𝑥1(𝑝1, 𝑝2, 𝑚) and 𝑥2(𝑝1, 𝑝2, 𝑚)
36
Example: quasi-linear preferences
• Step 2: Check for non-satiation and convexity and explain the implications.
! '
./ $ 5 ."/ $ 5
D.0! = % 𝑥$ " > 0 and D.0 " = − 𝑥$ " <0
! I
./
D.0" = 1 > 0
Hence non-satiation is satisfied
! !
𝑢 = 𝑥1 + 𝑥2 ⇒ 𝑥2 = 𝑢 − 𝑥1
" "
! '
.0" $ 5 . " 0" $ 5
D.0! = − 𝑥$ " < 0 and D.0 " = 𝑥$ " >0
% ! I
Hence convexity is satisfied
'"
It follows that a bundle on the budget line where 𝑀𝑅𝑆 = ' and which
!
satisfies non-negativity constraints solves the utility maximization problem
37
Example: quasi-linear preferences
Step 3: Solve the tangency and budget line conditions and express the solution
as a function of prices and income; check non-negativity constraints.
Solving !
#$1 ! , !
0 " $ '"
#%! " ! 5
𝑀𝑅𝑆 = #$1 = $
= % 𝑥$ " ='
#%" !
and
𝑝1𝑥1 + 𝑝2𝑥2 = 𝑚

gives uncompensated demand functions:

'!" & '!
𝑥1 = and 𝑥2 = −
I'"" '! I'"

But are non-negativity constraints satisfied? Not necessarily… 38

Example: quasi-linear preferences
& '!
When is 𝑥2 = − non-negative?
'! I'"

'!"
• Case 1 (interior solution): If 𝑚 ≥ I' then non-negativity constraints are
"
satisfied, so:
'!" & '!
𝑥1(𝑝1, 𝑝2, 𝑚) = " and 𝑥2(𝑝1, 𝑝2, 𝑚) = −
I'" '! I'"

'!"
• Case 2 (corner solution): If 𝑚 < then non-negativity constraints are not
I'"
satisfied, so:
&
𝑥1(𝑝1, 𝑝2, 𝑚) = ' and 𝑥2(𝑝1, 𝑝2, 𝑚) = 0
"

What is driving this consumer’s behaviour? Let’s have a closer look… 39

Example: quasi-linear preferences
• What is going on? Let’s have another look at marginal utilities:
! '
./ $ 5 ."/ $ 5
D.0! = % 𝑥$ " >0, D.0 " = − 𝑥$ " <0
! I
./
D.0" = 1 > 0

'!" & '!

• Interior solution: 𝑥1(𝑝1, 𝑝2, 𝑚) = and 𝑥2(𝑝1, 𝑝2, 𝑚) = −
I'"" '! I'"

• Optimal amount of good 1; remaining income spent on good 2

• Corner solution: If income is not enough to buy the amount of good 1 the
consumer would like…the best that can be done is to spend their entire
budget on good 1!
40
Example: quasi-linear preferences
%
𝑢 𝑥1, 𝑥2 = 𝑥1' + 𝑥2
𝑥2
!
$ 5
• Recall 𝑀𝑅𝑆 = 𝑥$ "
%

• MRS does not depend on 𝑥%

• MRS is thus the same along a
vertical line
• Indifference curves are vertical
shifts of each other (in this
example)

𝑥1
0 41
Example: quasi-linear preferences
%
𝑢 𝑥1, 𝑥2 = 𝑥1' + 𝑥2
𝑥2
• Case 1: interior solution

• Income enough to cover

'!"
𝑥1(𝑝1, 𝑝2, 𝑚) = "
I'"
𝑚/𝑝2
• Rest of income on good 2 𝑥2 ●

−""!
"

0 𝑥1 𝑚/𝑝1 𝑥1 42
Example: quasi-linear preferences
%
𝑢 𝑥1, 𝑥2 = 𝑥1' + 𝑥2
𝑥2
• Case 2: corner solution
'!"
• If m is I' or lower all income is
"
spent on good 1
𝑚/𝑝2

0 ●
𝑥1 𝑚/𝑝1 𝑥1 43
Income expansion path with quasi-linear preferences
%
𝑢 𝑥1, 𝑥2 = 𝑥1' + 𝑥2
𝑥2
• Traces the locus of optimal
demand as income changes ●

• What shape would it have if

the function was of the form ●
𝑢 𝑥1, 𝑥2 = 𝑥1 + 𝑣(𝑥2)?
−""!
● "

0 ● ● 𝑥1 44
Uncompensated demand under perfect complements
• Perfect complements: 𝑢 𝑥1, 𝑥2 = min 𝛼𝑥1, 𝛽𝑥2 , where 𝛼 and 𝛽 are
positive constants
$
• Example: 𝑢 𝑥1, 𝑥2 = min 𝑥 ,𝑥
% 1 2
𝑥1 = wheels, 𝑥2 = bicycle frames
2 wheels to each frame

• Adding wheels only cannot increase utility

• 𝑢 4,2 = min 2,2 = 2
• 𝑢 6,2 = min 3,2 = 2
• Similarly adding a bicycle frame only cannot increase utility
• 𝑢 4,3 = min 2,3 = 2
• Only increasing both in proportion raises utility
• 𝑢 6,3 = min 3,3 = 3 45
Uncompensated demand under perfect complements
$
• Example: 𝑢 𝑥1, 𝑥2 = min 𝑥1, 𝑥2 , 𝑥1 = wheels, 𝑥2 = bicycle frames
%
• Not differentiable, so we need to explore the diagram
Frames
𝑥2 $ $
𝑢 𝑥1, 𝑥2 = % 𝑥1 when 𝑥2 > % 𝑥1
$
𝑥2 = ½ 𝑥1 𝑢 𝑥1, 𝑥2 = 𝑥2 when 𝑥2 < % 𝑥1
$ $
𝑢 𝑥1, 𝑥2 = 𝑥2 = 𝑥 when 𝑥2 = 𝑥1
% %

0 𝑥1 Wheels
46
Uncompensated demand under perfect complements
$
• Example: 𝑢 𝑥1, 𝑥2 = min 𝑥1, 𝑥2 , 𝑥1 = wheels, 𝑥2 = bicycle frames
%

Frames
𝑥2
• If 𝑥2 > ½ 𝑥1 increasing 𝑥1 does
increase utility
𝑥2 = ½ 𝑥1

0 𝑥1 Wheels
47
Uncompensated demand under perfect complements
$
• Example: 𝑢 𝑥1, 𝑥2 = min 𝑥1, 𝑥2 , 𝑥1 = wheels, 𝑥2 = bicycle frames
%

Frames
𝑥2
• If 𝑥2 < ½ 𝑥1 increasing 𝑥1
does not change utility
𝑥2 = ½ 𝑥1

0 𝑥1 Wheels
48
Uncompensated demand under perfect complements
$
• Example: 𝑢 𝑥1, 𝑥2 = min 𝑥1, 𝑥2 , 𝑥1 = wheels, 𝑥2 = bicycle frames
%

Frames
𝑥2
• Starting from A where
𝑥2 = ½ 𝑥1 increasing
𝑥2 = ½ 𝑥1 both 𝑥1 and 𝑥2 increases
utility

𝐴 • Increasing only 𝑥1 and 𝑥2

does not increase utility.
0 𝑥1 Wheels
49
Uncompensated demand under perfect complements
$
• Example: 𝑢 𝑥1, 𝑥2 = min 𝑥1, 𝑥2 , 𝑥1 = wheels, 𝑥2 = bicycle frames
%

• Utility maximization implies (𝑥1, 𝑥2)

Frames is at the kink so: 𝑥2 = ½ 𝑥1
𝑥2
• Also satisfies 𝑝1𝑥1 + 𝑝2𝑥2 = 𝑚
𝑚/𝑝2
𝑥2 = ½ 𝑥1
• Solving gives:
2𝑚
𝑥1(𝑝1, 𝑝2, 𝑚) =
● 2𝑝1 + 𝑝2
−""!
"
𝑚
0 𝑚/𝑝1 𝑥1 Wheels 𝑥2(𝑝1, 𝑝2, 𝑚) =
2𝑝1 + 𝑝2
50
Demand curve under perfect complements
• Method: Rearrange uncompensated demand 𝑥1 𝑝1, 𝑝2, 𝑚 and to get
𝑝1 as a function of 𝑥1 (and 𝑥2 𝑝1, 𝑝2, 𝑚 to get 𝑝2 as a function of 𝑥2 )

$
• Example: 𝑢 𝑥1, 𝑥2 = min 𝑥1, 𝑥2 , 𝑥1 = wheels, 𝑥2 = bicycle frames
%
𝑝1
%& & $
• 𝑥1(𝑝1, 𝑝2, 𝑚) = ⇒ 𝑝1 = − 𝑝2
%'"J'! 0" %

• Increase in 𝑝2 results in left shift in the demand curve.

• Increase in 𝑚 results in shift right in demand curve.
0 𝑥1
What have we achieved?
• We have developed a model of consumer demand, given preferences
and satisfying assumptions

• Our model shows how consumers with different preferences allocate

their income, given prices

• Also, how their demand responds to changes in own price, price of

other good and income

• Our model has only two goods, but with more mathematics can easily
be extended to many goods
52
What are the strengths and limitations of this model?
• The model helps us appreciate how the demand of people with
different preferences responds to price and income changes

• It shows how people respond to incentives such as taxes or subsidies

(that would affect prices and income)

• Consumers are assumed to be rational and to anticipate perfectly how

their decisions affect their well-being…they would never experience
buyer’s remorse, or be affected by how choices are presented e.g.
positioning of products in a supermarket (choice architecture)

• The model fails to account for a range of cognitive biases – for these
we need a different model. 53
Review checklist:
1. Define uncompensated demand.
2. Why is checking for non-satiation and convexity important when
finding uncompensated demand?
3. If non-satiation and convexity are satisfied, what is the condition for
finding uncompensated demand? Why are the non-negativity
constraints important?
4. When would we expect to see a corner solution?
5. How can we go from the indifference map to the demand curve for a
good?
6. Define own price, income and cross price elasticities.
7. Provide intuition for why the price expansion and income expansion
paths have the shape they do for the different preferences we have
studied. 54
Appendix –Finding uncompensated demand using the
Lagrangian method
Lagrangian method for finding uncompensated demand
• The consumer maximizes utility subject to the budget constraint

• If the utility function is differentiable then this constrained

optimisation problem can be solved using the Lagrangian method

• Step 1: Set up the Lagrangian function

• Step 2: Partially differentiate to find the First Order Conditions (FOCs)
• Step 3: Solve the FOCs to find uncompensated demand; check non-
negativity constraints are satisfied.

56
Lagrangian method for finding uncompensated demand
Example: Consider a consumer with income m and preferences
"⁄ '⁄
described by utility function 𝑢 𝑥1, 𝑥2 = 𝑥1 𝑥2 & . Prices are fixed at 𝑝1
&

and 𝑝2 . Find uncompensated demands 𝑥1(𝑝1, 𝑝2, 𝑚) and 𝑥2(𝑝1, 𝑝2, 𝑚).

• Step 1: Set up the Lagrangian function

"⁄ '⁄
ℒ = 𝑥1 & 𝑥2 & − λ 𝑝1𝑥1 + 𝑝2𝑥2 − 𝑚

where λ is the Lagrangian multiplier

57
Lagrangian method for finding uncompensated demand
• Step 2: Partially differentiate to find the First Order Conditions (FOCs)
"⁄ '⁄
ℒ = 𝑥1 & 𝑥2 & − λ 𝑝1𝑥1 + 𝑝2𝑥2 − 𝑚

Hence:
.ℒ % ,'⁄ '⁄
.0"
= 3 𝑥1 & 𝑥2 & − λ𝑝1 = 0 FOC1

.ℒ 4 "⁄ ,"⁄
= 𝑥1 & 𝑥2 & − λ𝑝2 = 0 FOC2
.0! 3

.ℒ
= − 𝑝1𝑥1 + 𝑝2𝑥2 − 𝑚 = 0 FOC3
.L

58
Lagrangian method for finding uncompensated demand
• Step 3: Solve the FOCs to find uncompensated demand; check non-
negativity constraints are satisfied

%0! '" '"

Divide FOC 1 by FOC 2 to give: 40"
=' MRS = '!
!

FOC3 gives: 𝑝1𝑥1 + 𝑝2𝑥2 = 𝑚 (budget line)

%&
Solve simultaneously to give: 𝑥1(𝑝1, 𝑝2, 𝑚) = > 0 and
3'"
4&
𝑥2(𝑝1, 𝑝2, 𝑚) = > 0, which satisfy the non-negativity constraints
3'!

59
 Appendix – Alternative method for finding
uncompensated demand with quasi-linear preferences
Alternative method for quasi-linear preferences

• In LT you will use quasi-linear preferences regularly (as there are some
nice properties and the maths is straightforward)

• It will be implicitly assumed that income is sufficiently high to exclude

the possibility of a corner solution

• Given this, you can use an alternative method to find uncompensated

demand (though setting MRS equal to the price ratio will lead to the
same answer)

61
Alternative method for quasi-linear preferences
!
• Maximize 𝑢 𝑥1, 𝑥2 = 𝑥1 + 𝑥2 subject to the budget constraint
"

• The budget constraint binds so: 𝑝1𝑥1 + 𝑝2𝑥2 = 𝑚

• Rearrange the budget constraint and substitute into the utility

!
& '"0" & '"0"
function: 𝑥2 = ' − '!
so 𝑢 = 𝑥1 + ' −
"
'!
! !

• Maximise to find 𝑥1(𝑝1, 𝑝2, 𝑚) and then substitute back to find

𝑥2(𝑝1, 𝑝2, 𝑚)

62
Alternative method for quasi-linear preferences
!
& '"0"
• Maximise 𝑢 = 𝑥1 + ' −
"
'!
with respect to 𝑥1
!

!
C/ $ 5 '"
• First order condition: = 𝑥$ " − =0
C0" % '!

'
."/ $ 5
• Second derivative: D.0 " = − 𝑥$ " < 0 , confirming a maximum
! I

• This FOC is the same as the MRS = price ratio condition and gives
'!"
𝑥1(𝑝1, 𝑝2, 𝑚) = "
I'"

& '!
• Substituting into the budget constraint gives 𝑥2(𝑝1, 𝑝2, 𝑚) = − 63
'! I'"
Alternative method for quasi-linear preferences

• You could use this substitution method with Cobb-Douglas, but the
algebra and calculus is much harder than working with the MRS = price
ratio and the budget constraint

• The two methods will give you the same answer

64