Chapter 4 continued

Constrained Consumer Choice

- Mathematically

1
Constrained Consumer Choice
◼ Given information on your preferences i.e.
Max U = U (X1 X2)
[ X1* X2* ]

and your budget constraint i.e.

P1X1 + P2X2= Y
we can determine your optimal bundle.

◼ The optimal bundle is the bundle out of all the

bundles that you can afford that gives you the
most pleasure.
2
Examples of Utility Functions

◼ Cobb-Douglas
❑ U(x,y) = Axayb with A, a, b > 0

❑ Example: x0.5y0.2

◼ Complements
❑ U(x,y) = min{ax, by} with a, b > 0

❑ Example min {2x, y}

◼ Substitutes
❑ U(x,y)=ax+by with a, b > 0

❑ Example 2x+y

◼ Quasi-Linear
❑ U(x,y)=ax+u(y) with a>0

❑ Example x+ y0.5

3
Perfect Complements/Leontief
Pie and Ice-cream will
be consumed in a fixed
Ice cream, Scoops perweek

proportion
e c U = min {x, y}
3 I3

d b
2 I2 U = min {Pie, Ice Cream}
a
U = min {1, 1} = 1
1 I1 U = min {1, 2} = 1
U = min {1, 3} = 1
0 1 2 3
Pie, Slices per week
Curvature of Indifference Curves
◼ MRS (willingness to trade) diminishes along many typical
indifference curves that are concave to the origin.
◼ Different utility functions generate different indifference
curves:
Curvature of Indifference Curves
◼ Perfect Substitutes
❑ Goods that a consumer is completely indifferent

between
❑ Example: Clorox (C) and Generic Bleach (G)
U(C,G) = iC + jG
❑ MRS = -MUC/MUG = −i/j (constant)
◼Perfect Complements
❑Goods that are consumed in fixed proportions
❑Example: Apple pie (A) and Ice cream (I)
U ( A,V ) = min(iA, jV )
❑MRS is undefined
Curvature of Indifference Curves
◼ Imperfect Substitutes
❑ Between extreme examples of perfect substitutes and
perfect complements are standard-shaped, convex
indifference curves.
❑ Cobb-Douglas utility function
U ( q1, q2 ) = q1aq21−a
indifference curves never
hit the axes.
Curvature of Indifference Curves
◼ Imperfect Substitutes
❑ Between extreme examples of perfect substitutes and
perfect complements are standard-shaped, convex
indifference curves.

❑ Quasilinear utility function

U (q1,q2 ) = u(q1 ) + q2

indifference curves hit one

of the axes.
Constrained Consumer Choice
Three ways to solve constrained max problem:
◼ Method 1: Lagrange Multiplier

◼ Method 2: By substitution

◼ Method 3: MRS = MRT

◼ THESE METHODS ALL WORK WELL FOR COBB DOUGLAS

BUT NOT FOR PERFECT SUBSTITUTES OR COMPLEMENTS.

◼ WE WILL TACKLE COMPLEMENTS AND SUBSTITUTES

SEPARATELY

9
Method 1: Lagrangian Method
The Lagrangian function is a technique that
combines the function being optimised (Utility)
with a function describing the constraint
(budget) into a single equation.

Solving this function allows you to optimise

Utility, subject to a budget constraint.

Lagrangian Function L
L= objective function +  constraint
10
Lagrangian: What does  represent?
 - called the Lagrangian Multiplier

Equals the marginal utility of each good divided by it’s

price.

The extra pleasure one gets from one’s last dollar of

expenditure.

See Appendix 4B for mathematical explanation!

11
Example 1

◼ A consumers preferences can be represented

by the Utility Function, U(x1,x2)=x1.x2 .

◼ How much will the utility maximising consumer

demand of goods x1 and x2 if they have an
income of €100, the price of good x1 is €10
and the price of good x2 is €2?

12
Key Steps
1) Write out the budget constraint

2) Use the Lagrangian Method to find out the optimal

bundle of goods 1 and 2 for the consumer that
maximises utility subject to their budget constraint
❑ Step 1: Define the Lagrangian Function L= objective function +  constraint
❑ Step 2: Find all first order partial derivatives, and set = 0
❑ Step 3: Solve the system of equations

3) Calculate the total expenditure on each good

4) Calculate the consumer’s corresponding optimal utility

level

13
Step 1) Write the budget constraint….
◼ Budget constraint: Y = p1x1 + p2x2
Income (Y) = price of good 1 x quantity of good 1
+
price of good 2 x quantity of good 2

Thus, with px1 = 10, px2 = 2, income = 100

100 = 10x1 + 2x2
Then set the constraint = 0
100 - 10x1 - 2x2 = 0
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Step 2.1: Write Lagrangian function
L= objective function +  constraint
◼ Maximise utility U = x1x2 subject to
constraint 100 - 10x1 - 2x2

Objective function (L): x1x2

+
Constraint: (100 - 10x1 - 2x2)

L = x1 x2 + (100 − 10x1 − 2x2 )

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Lagrangian: is it + or -?

L = x1x2 +  (100 −10x1 − 2x2 )

L = x1x2 −  (10x1 + 2x2 −100)

Both are correct – just be careful with your

signs!

16
Step 2.2) Now find all first order partial
derivatives, and set = 0
L = x1x2 +  (100 −10x1 − 2x2 )
L
= x2 − 10 = 0 EQ. 1
x1
L
= x1 − 2 = 0 EQ. 2
x2
L
= 100 − 10 x1 − 2 x2 = 0 EQ. 3


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 Step 2.3) Solve the three equations to
find values for x1 and x2 …
x1
=
◼ x1 = 2 2
 x1 
x2 − 10  = 0
2

100 − 10x1 − 2(5x1 ) = 0

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Step 3) Expenditure on the goods…

◼ Total expenditure on good 1 = p1x1

With p1 = 10 and x1 = 5
p1x1 = 50

◼ Total expenditure on good 2 = p2x2

With p2 = 2 and x2 = 25
p2x2 = 50

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Step 4) Optimal level of Utility

◼ Substitute values into utility function

U = x1x2

Utility maximising consumer demand 5 units of

good 1 and 25 units of good 2

This gives an optimal level of utility = U = 5 * 25

= 125

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Example 2

◼ A consumers preferences can be

represented by the Utility Function,
U (X1 X2) = X12 X 2

◼ How much will the utility maximising

consumer demand of goods X1 and X2 if they
have an income of €300, the price of good X1
is €10 and the price of good X2 is €2?

21
Step 1) Write the budget constraint….

◼ Budget constraint:
Income (Y) = price of good 1 x amount of good 1
+
price of good 2 x amount of good 2
Y = p1x1 + p2x2

Thus, with px1 = 10, px2 = 2, income = 300

300 = 10X1 + 2X2
Then set the constraint = 0
300 - 10X1 - 2X2 22
Step 2.1): Write Lagrangian function
L= objective function +  constraint
2
◼ Maximise utility U = 1 X 2 subject to
X
constraint 300 - 10X1 - 2X2
Objective function (L): x21x2
+
Constraint: (300 - 10X1 - 2X2)

L = X21X2 + (300 - 10X1 - 2X2)

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Step 2.2) Now find all first order partial
derivatives, and set = 0

24
Step 2.3) Solve the three equations to find
values for x1 and x2…
◼ Eq. 1: 2X1X2 – 10 = 0   = 2X1X2/10
◼ Eq. 2: X12 – 2 = 0   = X12/2

2
2 X1 X 2 X
= = 1
10 2
so 4 X 1 X 2 = 10 X 12

so 4 X 2 = 10 X 1
4X2
so X1 =
10 25
Step 2.3) Solve the three equations to find
values for x1 and x2…
▪ Substitute into Eq. 3: 300 - 10X1 - 2X2 = 0

Since X1 = 4/10 X2

We now have 300 - 10 [ 4/10 X2 ] - 2X2 = 0

and hence 6X2= 300 , thus X2* = 50

and hence X1 * = 4/10(50) = 20

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Step 3) Expenditure on the goods…

◼ Total expenditure on good 1 = p1x1

With p1 = 10 and x1 = 20
p1x1 = 200

◼ Total expenditure on good 2 = p2x2

With p2 = 2 and x2 = 50
p2x2 = 100

◼ Note that Y = 300, so 2/3 of income is spent on

good 1, and 1/3 on good 2.
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Step 4) Optimal level of Utility

◼ Substitute values into utility function

U = X12 X 2

Utility maximising consumer demands 20 units

of good 1 and 50 units of good 2

This gives an optimal level of utility = U = (202)

* 50 = 20000

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Method 2: By Substitution
Max U = U (X1 X2) = X12 X 2
[ X1* X2* ]

subject to P1X1 + P2X2= Y

where the price of good 1 is €10, the price of

good 2 is €2 and income Y is €300.

So the budget constraint can now be written

as.....
10X1 + 2X2 = 300
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Step 1: Use the budget constraint to
express X2 in terms of X1 (or vice-versa)

Given 10X1 + 2X2 = 300

Then X2 = 150 – 5X1

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Step 2: Substitute expression for X2
into the objective function

U = X12X2

Can now be written as a function of one

variable.... X2 = 150 – 5X1

U = X12 [150 – 5X1]

U = 150X12 – 5X13

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 Step 3: Find the value of x1 that
maximises the objective function
Max U = 150X12 – 5X13
[x1]

Necessary First Order Condition

(set first derivative dU/dX1 = 0)
U X1 = 300 X1 − 15 X12 = 0
Thus, Dividing across by X1:
300 = 15 X1 and rearranging gives, X 1 = 20
(the value of x1 that maximises the objective function)
(Note, P1X1 = 10 [20] = 200 which is equivalent to 2/3 M.... in this case,
expenditure on good 1 is 2/3 of income)
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Step 4: Substitute this value into constraint to
find corresponding value of the other good
that maximises objective function

Since 10X1 + 2X2 = 300

And hence X2 = 150 – 5X1

we can solve for X2 as

X *2 = 150 − 5(20)
= 50
(Note, P2X2 = 2 [50] =100 which is equivalent to 1/3 M....
in this case, expenditure on good 2 is 1/3 of income)

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Step 5: Substitute values for X1 and X2 to
find optimal value of objective function
Maximum utility is:
U = X1 X 2
2

= (20 ) (50 )
2

U = 20000

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Method 3: MRS=MRT
▪ The budget constraint and the indifference curve have the
same slope at point e where they touch. Therefore, at point e:
B , Burritos per semester

MU Z PZ
MRS = − =− = MRT
MU B PB
25

Slope of I2
e Slope of BL

I2

0 50
Z , Pizzas per semester
Method 3: MRS=MRT
MU X 1 PX 1
=
MU X 2 PX 2

Max U = U (X1 X2) = 2

[ X1* X2* ]
X1 X 2

subject to P1X1 + P2X2= Y

where the price of good 1 is €10, the price of good

2 is €2 and income Y is €300.

so the budget constraint can now be written as.....

10X1 + 2X2 = 300 36

 MU X 1 PX 1
Method 3: MRS=MRT =
MU X 2 PX 2

U = X12X2 and PX1 = 10, PX2 = 2, Y = 300

Find MUx1 – marginal utility of X1 by differentiating U with respect

to X1
U = X12X2 → MUx1 = 2X1X2

Find MUx2 – marginal utility of X2 by differentiating U with respect

to X2
U = X12X2 → MUx2 = X12

Plug the terms into the expression

37
Method 3: MRS=MRT
MU X 1 PX 1
=
MU X 2 PX 2

2 X 1 X 2 10
2
=
X1 2
so 4 X 1 X 2 = 10 X 1
2

so 4 X 2 = 10 X 1
so X 1 = 4 / 10( X 2 )
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Method 3: MRS=MRT
▪ And substituting into the budget constraint
10X1 + 2X2 – 300 = 0
Since X1 = 4/10 X2 we now have:
10 [ 4/10 X2 ] + 2X2 – 300 = 0
and hence 6X2= 300 , thus X2 * = 50
and hence X1 * = 4/10(50) = 20

Solve for utility: U = X12X2  U= (20)2 (50) = 20000

Same solution as with the full Lagrangian & substitution
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Calculating the optimal bundle for
non-Cobb Douglas utility functions

1. Perfect Substitutes
2. Perfect Complements

40
Constrained Consumer Choice with Perfect
Substitutes
◼ With perfect substitutes, if the marginal rate of substitution
does not equal the marginal rate of transformations, then
the consumer’s optimal bundle occurs at a corner
solution, bundle b.
Perfect Substitute: Why Americans
Buy E-Books and Germans Do Not
◼ Background:
❑ E-books accounted for 20% of trade books sold in the

U.S., but only 4.5% in Germany.

◼ Questions:
❑ Why are e-books more successful in the U.S. than in

Germany?
❑ Do Germans prefer reading printed books, while

Americans prefer reading e-books?

❑ Alternatively, do (after-tax) price differences explain the

differences in book formats?

Perfect Substitutes and Budget Lines
◼ Max, a German, and Bob, an American, have the same
preferences – perfect substitutes. The U.S. relative after-
tax price of e-books is lower than the German relative
after-tax price. Due to the relative price differences, Max
reads printed books, and Bob reads e-books.
MRS=MRT: Case of Perfect MU X 1 PX 1
Substitutes =
MU X 2 PX 2
◼ U = 2x + y and Px= 3, Py=2, and Income=60
MUx = 2 and MUy = 1

◼ Set MUx/MUy = Px/Py 

2/1 = 3/2 ????

◼ This method does not work as x and y are perfect

substitutes (U is a straight line)
❑ Consumer does not care whether they consumes x or y
❑ Picks whichever gives most utility for money

44
MRS=MRT: Case of Perfect
Substitutes
Y = 60
◼ Suppose consumer buys all x Px = 3
❑ X=20 and U = 2x + y = 2*20 + 0 = 40 Py = 2

◼ Suppose consumer buys all y

❑ Y=30 and U = 2x + y = 0 + 30 = 30

◼ Therefore optimal strategy is for consumer to buy

all of X (X*=20), and no Y (Y*=0).

◼ Gets higher utility if only buys X (U* = 40)

45
Constrained Consumer Choice with Perfect
Complements
◼ The optimal bundle is on the budget line and at the right
angle (i.e. vertex) of an indifference curve.
MRS=MRT: Case of Perfect
Complements
◼ U = min {2x, y} and Px= 2, Py=3, and Income=50

◼ MUx and MUy method does not work with this function as
x and y are perfect complements.
❑ Consumer combines x and y in a fixed proportion so that 2x* = y*

◼ Budget Constraint: 2x+3y = 50

❑ Substitute in 2x* = y*

❑ y* + 3y* = 4y* = 50, so, y* = 50/4

❑ 2x* = y*, so 2x* = 50/4, so x* = 50/8

◼ U* = min {2x*, y*} = min {50/4, 50/4} = 50/4 47

Chapter 4 Summary

1. Preferences.

2. Utility.

3. Budget Constraint.

4. Constrained Consumer Choice.

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