DERIVING THE DEMAND FUNCTIONS: COBB-

DOUGLAS EXAMPLE
• Consider the following Cobb-Douglas type function
U = x1a x2b
• We can then set up the Lagrangian as follows
L = x1a x2b + λ (m − p1 x1 − p2 x2 )
and take the three first order derivatives and set them equal
to zero for optimisation
∂L
= ax1a −1 x2b − λ p= 0 (1)
∂x1
1

∂L
= bx1a x2b −1 − λ p= 0 (2)
∂x2
2

∂L
=m − p1 x1 − p2 x2 =0 (3)
∂λ
DERIVING THE DEMAND FUNCTIONS: COBB-
DOUGLAS EXAMPLE
• Rearranging (1) and (2)
ax1a −1 x2b = λ p1
bx1a x2b −1 = λ p2
• Dividing the first expression with the second
ax1a −1 x2b λ p1
=
a b −1
bx1 x2 λ p2
ax1a −1 x2b p1
a b −1
=
bx1 x2 p2
ax2b −b +1 p1
a − a +1
=
bx1 p2
ax2 p1
=
bx1 p2
DERIVING THE DEMAND FUNCTIONS: COBB-
DOUGLAS EXAMPLE
• Next we rewrite x2 in terms of x1 by rearranging the previous
expression
bp1
x2 = x1 (4)
ap2
• Now we substitute this in equation 3 and solve for x1
bp1
m − p1 x1 − p2 x1 =
0
ap2
b
m − p1 x1 − p1 x1 =
0
a
b
=
m p1 x1 + p1 x1
a
 b
m= 1 +  p1 x1
 a
DERIVING THE DEMAND FUNCTIONS: COBB-
DOUGLAS EXAMPLE
 a+b
m=  p1 x1
 a 
 a m
x1* =  
 a + b  p1
• This is the demand function for x1 (a function of prices and
income)
• To derive the demand function for x2 substitute the demand
function for x1 in equation (4)

bp1  a  m
x2 =  
ap2  a + b  p1
 b m
x2 = 
*

 a + b  p2
DERIVING THE DEMAND FUNCTIONS: COBB-
DOUGLAS EXAMPLE
• So the best bundle that a consumer with Cobb-Douglas
preferences can afford is
 a  m  b  m 
( x , x2 ) = 
* *
 ,  
+ +
1
  a b  p1  a b  p2 
x2

Optimal choice

 b m
x2* =  
 a + b  p2

 a m x1
x1* =  
 a + b  p1
DERIVING THE DEMAND FUNCTIONS: PERFECT
• Consider the following function SUBSTITUTES
U= x1 + x2
• Here
∂U ( x1 , x2 ) ∂U ( x1 , x2 )
= = 1
∂x1 ∂x2
=
MU x1 =
MU x2 1
MU x1
=
MRS x1,x 2 = 1
MU x2
• We now have three possibilities
• If p2 > p1, then the budget line is flatter than the indifference
curves (p1/p2<1)
• In this case, the optimal bundle is where the consumer spends
all of his or her money on good 1.
DERIVING THE DEMAND FUNCTIONS: PERFECT
SUBSTITUTES

x2

Indifference curves
Slope = –1

Budget
line

Optimal
choice

x*1 = m/p1 x1

Optimal choice with perfect substitutes. If the goods are

perfect substitutes, the optimal choice will usually be on the
boundary.
DERIVING THE DEMAND FUNCTIONS: PERFECT
SUBSTITUTES
• If p1 > p2, then the budget line is steeper than the indifference
curves (p1/p2>1)
• In this case, the optimal bundle is where the consumer spends
all of his or her money on good 2.
Optimal
choice
x2

Indifference curves
x*2 = m/p2 Slope = –1
Budget
line

x1

Optimal choice with perfect substitutes. If the

goods are perfect substitutes, the optimal choice will
usually be on the boundary.
DERIVING THE DEMAND FUNCTIONS: PERFECT
SUBSTITUTES
• If p1 = p2 (p1/p2=1), there is a whole range of optimal choices
— any amount of goods 1 and 2 that satisfies the budget
constraint is optimal in this case.

x2

Indifference curves
Slope = –1
Budget
line
Optimal
choices

x1

Optimal choice with perfect substitutes. If the

goods are perfect substitutes, the optimal choice will
usually be on the boundary.
DERIVING THE DEMAND FUNCTIONS: PERFECT
SUBSTITUTES
• Thus the demand function for good 1 will be
m
p when p1 < p2
 1
x1 0 when p1 > p2
 m
between 0 and when p1 = p2
 p1
• And the demand function for good 2 will be
m
p when p1 > p2
 2
x2 0 when p1 < p2
 m
between 0 and when p1 = p2
 p2
DERIVING THE DEMAND FUNCTIONS: PERFECT
SUBSTITUTES
• What do these demand functions mean?
• If two goods are perfect substitutes, then a consumer will
purchase the cheaper one.
• If p1<p2 then consumer will only purchase good 1
• If p2<p1 then consumer will only purchase good 2
• If both goods have the same price, then the consumer
doesn’t care which one he or she purchases.

• And the best bundle that a consumer can afford in this

case is m 
= ( x1 , x2 )  , 0  , if p1 < p2
* *

 p1 
 m
=
( x , x2 )  0,  if p1 > p2
1
* *

 p2 
DERIVING THE DEMAND FUNCTIONS: PERFECT
COMPLEMENTS
• Consider the following function
U = min( x1 , x2 )

• Solving for the optimal choice algebraically

• We know that this consumer is purchasing the same
amount of good 1 and good 2, no matter what the prices,
• Let this amount be denoted by x, i.e., x1=x2=x.

• Then we have to satisfy the budget constraint

p1 x + p2 x =
m

• Solving for x gives us the optimal choices of goods 1 and 2

m
x= x= x=
p1 + p2
1 2
DERIVING THE DEMAND FUNCTIONS: PERFECT
COMPLEMENTS
• What does this demand function mean?
• Since the two goods are always consumed together, it is
just as if the consumer were spending all of her money on a
single good that had a price of p1 + p2

x2
Indifference curves

Optimal choice
x*2

Budget
line

x1* x1
DERIVING THE DEMAND FUNCTIONS: PERFECT
COMPLEMENTS
• Also notice that the optimal choice must always lie on
the diagonal, where the consumer is purchasing equal
amounts of both goods, no matter what the prices are.
Budget line 2 x1=x2
x2
Indifference curves

Budget line 3 Budget line 1

x
1
Optimal choice with perfect complements. If
the goods are perfect complements, the quantities
demanded will always lie on the diagonal since the
optimal choice occurs where x1 equals x2.
 OPTIMAL CHOICES: CONCAVE
PREFERENCES
 Consider the concave preferences illustrated in the
following figure
x2

Indifference
curves

Nonoptimal choice

X
Budget line
Optimal choice
Z
x1
Optimal choice with concave preferences. The optimal
choice is the boundary point, Z, not the interior tangency point,
X, because Z lies on a higher indifference curve.

 Is X the optimal choice?

 No!
 OPTIMAL CHOICES: CONCAVE
PREFERENCES

• The optimal choice for these preferences is always going

to be a boundary choice, like bundle Z.
• If you have money to purchase ice cream and tomato
ketchup, and
• you don’t like to consume them together
• You’ll spend all of your money on one or the other.