MicroMinor1402 Lecture03

Lecture 03: Utility Maximization and Choice
44719-Microeconomics for Minor Students

Lecture 03:
Utility Maximization and Choice
(Chapter 4 NS-Chapters 2,5 V)
Saeed Tajrishy
Graduate School of Management and Economics
Sharif University of Technology
Fall 2023
Saeed Tajrishy-GSME SUT Slide 1 of 61 Microeconomic For Minor Students-Fall 2023

So far…
• Economic Models
• Axioms of rational choices
• Utility function
• Indifference curve
• Convexity
• Marginal rate of substitution
• Examples of utility functions

This Lecture…
• The basic model of choice that economists use to explain individuals’
behavior
• Individuals are assumed to behave as though they maximize utility
subject to a budget constraint
• To maximize utility, individuals will choose bundles of commodities
for which the rate of trade-off between any two goods (the MRS) is
equal to the ratio of the goods’ market prices.

Optimization Principle

Optimization Principle
• To maximize utility, given a fixed amount of income to spend, an
individual will buy the goods and services:
• that exhaust his or her total income
• for which the psychic rate of trade-off between any goods (the MRS) is equal
to the rate at which goods can be traded for one another in the marketplace

A Numerical Illustration
• Assume that the individual’s MRS = 1
• willing to trade one unit of x for one unit of y
• Suppose the price of x = $2 and the price of y = $1
• The individual can be made better off
• trade 1 unit of x for 2 units of y in the marketplace

A Numerical Illustration
• Therefore, the individual’s spending could not have been allocated
optimally in the first place.
• A similar method of reasoning can be used whenever the MRS and
the price ratio px/py differ.
• The condition for maximum utility must be the equality of these two
magnitudes.

Two Complaints about the Economic

Approach
• 1. No real individuals make the kinds of “lightning calculations”
required for utility maximization
• 2. The economic model of choice is extremely selfish because no one

has solely self-centered goals

The Budget Constraint

The Budget Constraint

• Assume that an individual has I dollars to allocate between good x
and good y
Quantity of y The individual can afford pxx + pyy  I

If all income is spent to choose only combinations
I on y, this is the amount of x and y in the shaded
py of y that can be purchased
triangle
If all income is spent

on x, this is the amount
of x that can be purchased
Quantity of x
I
px

First-Order Conditions for a

Maximum

First-Order Conditions for a Maximum

• We can add the individual’s utility map to show the utility-maximization
process
Quantity of y The individual can do better than point A

by reallocating his budget
A
U1
Quantity of x


• We can add the individual’s utility map to show the utility-maximization
process
Quantity of y The individual can do better than point A

by reallocating his budget
A
C The individual cannot have point C
B because income is not large enough
U3
Point B is the point of utility
U2 maximization
U1
Quantity of x


• Utility is maximized where the indifference curve is tangent to the
budget constraint
Quantity of y px
slope of budget constraint  
py
dy
slope of indifferen ce curve 
B dx U  constant
px dy
U2
-  MRS
py dx U  constant
Quantity of x

Second-Order Conditions for a

Maximum

Second-Order Conditions for a Maximum

• The tangency rule is only necessary but
not sufficient unless we assume that MRS
is diminishing
• if MRS is diminishing, then indifference
curves are strictly convex
• If MRS is not diminishing, then we must
check second-order conditions to ensure
that we are at a maximum

Second-Order Conditions for a Maximum

• The tangency rule is only a necessary condition
• we need MRS to be diminishing
Quantity of y
There is a tangency at point A,
but the individual can reach a higher
level of utility at point B
B
A
U2
U1
Quantity of x

Corner Solutions

Corner Solutions
• In some situations, individuals’ preferences may be such that they can
maximize utility by choosing to consume only one of the goods
At point A, the indifference curve

Quantity of y U1 U2 U3 is not tangent to the budget constraint
Utility is maximized at point A
Quantity of x
A
The n-Good Case

The n-Good Case

• The individual’s objective is to maximize
utility = U(x1,x2,…,xn)
subject to the budget constraint
I = p1x1 + p2x2 +…+ pnxn
• Set up the Lagrangian:

L = U(x1,x2,…,xn) + (I - p1x1 - p2x2 -…- pnxn)

The n-Good Case

• First-order conditions for an interior maximum:
L/x1 = U/x1 - p1 = 0
L/x2 = U/x2 - p2 = 0

•
•
•
L/xn = U/xn - pn = 0
L/ = I - p1x1 - p2x2 - … - pnxn = 0

Implications of First-Order Conditions

• For any two goods,
U / xi pi

U / x j p j
• This implies that at the optimal allocation of income
pi
MRS ( xi for x j ) 
pj

Interpreting the Lagrangian Multiplier
U / x1 U / x2 U / xn

   ... 
p1 p2 pn
MUx1 MUx2 MUxn

   ... 
p1 p2 pn
•  is the marginal utility of an extra dollar of consumption expenditure

• the marginal utility of income

Interpreting the Lagrangian Multiplier
• At the margin, the price of a good represents the consumer’s

evaluation of the utility of the last unit consumed
• how much the consumer is willing to pay for the last unit: Willingness
to pay
MUxi
pi 


Corner Solutions
• When corner solutions are involved, the first-order conditions must be
modified:
L/xi = U/xi - pi  0 (i = 1,…,n)
• If L/xi = U/xi - pi < 0, then xi = 0
• This means that
U / xi MUxi
pi  
 
– any good whose price exceeds its marginal value to the
consumer will not be purchased
Cobb-Douglas Demand Functions

Charles Wiggins Cobb & Paul Howard Douglas

• Charles Wiggins Cobb (1875–1949) was an
American mathematician and economist and a 1912 Ph.D.
graduate of the University of Michigan.
• Paul Howard Douglas (March 26, 1892 – September 24, 1976) was
an American politician and Georgist economist. A member of
the Democratic Party, he served as a U.S. Senator from Illinois for
eighteen years, from 1949 to 1967. During his Senate career, he
was a prominent member of the liberal coalition.
• In economics and econometrics, the Cobb–Douglas production function is a particular functional form of
the production function, widely used to represent the technological relationship between the amounts of two or more
inputs (particularly physical capital and labor) and the amount of output that can be produced by those inputs. The
Cobb–Douglas form is developed and tested against statistical evidence by Charles Cobb and Paul Douglas between
1927 and 1947; according to Douglas, the functional form itself was developed earlier by Philip Wicksteed.


• Cobb-Douglas utility function:
U(x,y) = xy
• Setting up the Lagrangian:
L = xy + (I - pxx - pyy)
• First-order conditions:
L/x = x-1y - px = 0
L/y = xy-1 - py = 0
L/ = I - pxx - pyy = 0


• First-order conditions imply:
𝑦 𝑝𝑥
=
𝑥 𝑝𝑦
• Since  +  = 1:
 1− 
pyy = ( )pxx = [ ]p x
  x
• Substituting into the budget constraint:

I = pxx + [(1- )/]pxx = (1/)pxx

• Solving for x yields
I
x* 
px
• Solving for y yields
I
y* 
py
• The individual will allocate  percent of his income to good x and 
percent of his income to good y


• The Cobb-Douglas utility function is limited in its ability to explain
actual consumption behavior
• the share of income devoted to particular goods often changes in response to
changing economic conditions (Extension 1)
• A more general functional form might be more useful in explaining
consumption decisions

CES Demand
• Assume that  = 0.5
U(x,y) = x0.5 + y0.5
• Setting up the Lagrangian:
L = x0.5 + y0.5 + (I - pxx - pyy)
• First-order conditions:
L/x = 0.5x -0.5 - px = 0
L/y = 0.5y -0.5 - py = 0
L/ = I - pxx - pyy = 0
CES Demand
• This means that
(y/x)0.5 = px/py
• Substituting into the budget constraint, we can solve for the demand
functions
I I
x*  y* 
px py
px [1  ] py [1  ]
py px

CES Demand
• In these demand functions, the share of income spent on either x or y
is not a constant
• depends on the ratio of the two prices
• The higher is the relative price of x (or y), the smaller will be the share
of income spent on x (or y)

CES Demand
• If  = -1,
U(x,y) = -x -1 - y -1
• First-order conditions imply that
y/x = (px/py)0.5
• The demand functions are
I I
x*  y* 
  py 0.5
  p 
0.5

 py 1   x  
px 1     
  px     py  
 
CES Demand
• If  = -,
U(x,y) = Min(x,4y)
• The person will choose only combinations for which x = 4y
• This means that
I = pxx + pyy = pxx + py(x/4)
I = (px + 0.25py)x

CES Demand
• Hence, the demand functions are
I
x* 
px  0.25 py
I
y* 
4 px  py

‫‪Lecture 03: Utility Maximization and Choice‬‬
‫‪Break-Examples‬‬
‫• چگونه مقداری شکالت را بین دو فرزند خود تقسیم کنیم که تقسیم مد نظر عادالنه باشد؟‬
‫• ‪:John Stuart Mill and Jeremy Bentham:‬رفتاری فضیلت اخالقی به شمار می رود که لذت همگانی را بیشینه کند‪.‬‬
‫• میزان افزایش مطلوبیت باید برابر شود یا میزان مطلق مطلوبیت؟ یا جمع مطلوبیت ها بیشینه شود؟‬
‫• اگر ‪ ۸۰‬درصد جامعه ای با یک انتخاب موافق بودند و ‪ ۲۰‬درصد مخالف بودند آیا لزوما باید به آن رأی موافق داده شود و اجرا‬
‫شود؟(انتخاب عمومی)‪ -‬مثال تعدد زوجین و لزوم رضایت یا حق طالق‪.‬‬
‫• ‪Kaldor-Hicks Efficiency‬‬
‫• ‪ ۱۰‬میلیون تومان قطعی یا ‪ ۲۲‬میلیون با احتمال ‪ ۵۰‬درصد و صفر با احتمال ‪ ۵۰‬درصد؟ مطلوبیت امید ریاضی یا امیدریاضی‬
‫مطلوبیت؟(‪ -)Plous,1993‬ریسک پذیر‪ ،‬ریسک گریز یا ریسک خنثی‪ -‬قاعده تناسب ریسک و بازده‬
‫‪Saeed Tajrishy-GSME SUT‬‬ ‫‪Slide 39 of 61‬‬ ‫‪Microeconomic For Minor Students-Fall 2023‬‬
Indirect Utility Function


• It is often possible to manipulate first-order conditions to solve for
optimal values of x1,x2,…,xn
• These optimal values will depend on the prices of all goods and
income
x*1 = x1(p1,p2,…,pn,I)
x*2 = x2(p1,p2,…,pn,I)
•
•
•
x*n = xn(p1,p2,…,pn,I)


• We can use the optimal values of the xs to find the indirect utility
function
maximum utility = U(x*1,x*2,…,x*n)
• Substituting for each x*i, we get
maximum utility = V(p1,p2,…,pn,I)
• The optimal level of utility will depend indirectly on prices and income
• if either prices or income were to change, the maximum possible utility will
change

The Lump Sum Principle


• Taxes on an individual’s general purchasing power are superior to
taxes on a specific good
• an income tax allows the individual to decide freely how to allocate remaining
income
• a tax on a specific good will reduce an individual’s purchasing power and
distort his choices


• A tax on good x would shift the utility-maximizing choice from point
A to point B
Quantity of y
B A
U1
U2
Quantity of x


• An income tax that collected the same amount would shift the
budget constraint to I’
Quantity of y Utility is maximized now at point C

I’ on U3
A
B C
U3 U1
U2
Quantity of x

Indirect Utility and the Lump Sum

Principle

Indirect Utility and the Lump Sum Principle
• If the utility function is Cobb-Douglas with  =  = 0.5, we know that
I I
x*  y* 
2 px 2 py
• So the indirect utility function is
I
V ( p x , p y , I )  (x *) 
0 .5 0 .5
(y *) 0.5 0.5
2px py


• px = 1, py = 4, and I= 8
• If a tax of $1 was imposed on good x
• the individual will purchase x*=2
• indirect utility will fall from 2 to 1.41
• An equal-revenue tax will reduce income to $6
• indirect utility will fall from 2 to 1.5


• If the utility function is fixed proportions with U = Min(x,4y), we know
that
I I
x*  y* 
px  0.25 py 4 px  py
• So the indirect utility function is

I
V ( px , py , I )  Min( x *,4 y *)  x* 
px  0.25 py
4 I
 4y *  
4 px  py px  0.25 py

• If a tax of $1 was imposed on good x
• indirect utility will fall from 4 to 8/3
• An equal-revenue tax will reduce income to $16/3
• indirect utility will fall from 4 to 8/3
• Since preferences are rigid, the tax on x does not
distort choices

Expenditure Minimization

• A mathematical statement
• Two Expenditure Functions
• Properties of Expenditure Functions
• Concavity of Expenditure Function

• Dual minimization problem for utility maximization
• allocating income in such a way as to achieve a given level of utility with the
minimal expenditure
• this means that the goal and the constraint have been reversed

• Point A is the solution to the dual problem
Expenditure level E2 provides just enough to reach U1

Quantity of y
Expenditure level E3 will allow the

individual to reach U1 but is not the
minimal expenditure required to do so
A Expenditure level E1 is too small to achieve U1

U1
Quantity of x

A mathematical statement
• The individual’s problem is to choose x1,x2,…,xn to minimize
total expenditures = E = p1x1 + p2x2 +…+ pnxn
subject to the constraint
utility = U1 = U(x1,x2,…,xn)
• The optimal amounts of x1,x2,…,xn will depend on the prices of the
goods and the required utility level

A mathematical statement
• The expenditure function shows the minimal expenditures necessary to
achieve a given utility level for a particular set of prices
minimal expenditures = E(p1,p2,…,pn,U)
• The expenditure function and the indirect utility function are inversely
related
• both depend on market prices but involve different constraints

Two Expenditure Functions

• The indirect utility function in the two-good, Cobb-Douglas case is
I
V ( p x , py , I ) 
2px0.5 py0.5
• If we interchange the role of utility and income (expenditure), we will

have the expenditure function
E(px,py,U) = 2px0.5py0.5U

Two Expenditure Functions

• For the fixed-proportions case, the indirect utility function is
I
V ( px , py , I ) 
px  0.25 py
• If we again switch the role of utility and expenditures, we will have

the expenditure function
E(px,py,U) = (px + 0.25py)U

Properties of Expenditure Functions

• Homogeneity
• a doubling of all prices will precisely double the value of required expenditures
• homogeneous of degree one
• Non-decreasing in prices
• E/pi  0 for every good, i
• Concave in prices

Concavity of Expenditure Function

At p*1, the person spends E(p*1,…)
If he continues to buy the
same set of goods as p*1
E(p1,…) Epseudo changes, his expenditure
function would be Epseudo
E(p1,…)
E(p*1,…) Since his consumption

pattern will likely change,
actual expenditures will be
less than Epseudo such as
E(p1,…)
p*1 p1

SUMMARY
• To reach a constrained maximum, an individual should:
• spend all available income
• choose a commodity bundle such that the MRS between any two goods is
equal to the ratio of the goods’ prices
• the individual will equate the ratios of the marginal utility to price for every good that is
actually consumed
• Tangency conditions are only first-order conditions

• the individual’s indifference map must exhibit diminishing MRS
• the utility function must be strictly quasi-concave

SUMMARY
• Tangency conditions must also be modified to allow for corner
solutions
• the ratio of marginal utility to price will be below the common marginal
benefit-marginal cost ratio for goods actually bought
• The individual’s optimal choices implicitly depend on the parameters
of his budget constraint
• choices observed will be implicit functions of prices and income
• utility will also be an indirect function of prices and income

SUMMARY
• The dual problem to the constrained utility-maximization problem is
to minimize the expenditure required to reach a given utility target
• yields the same optimal solution as the primary problem
• leads to expenditure functions in which spending is a function of the utility
target and prices

Thank You!
http://gsme.sharif.edu/~saeed.tajrishy/

Extensions: Engel’s law-Budget share

• His finding that the fraction of income spent on food decreases as
income increases has come to be known as Engel’s law and has been
confirmed in many studies.
• Behrman (1989) from less-developed countries showed that people’s desires
for a more varied diet as their incomes increase may in fact result in reducing
the fraction of income spent on particular nutrients.

Extensions: 1.The variability of budget shares

• Engel’s law is clearly visible in the next slide’s table: As income
increases families spend a smaller proportion of their funds on food.
• the declining share of income spent on health-care needs and the
much larger share of income devoted to retirement plans by higher-
income people. Interestingly, the shares of income devoted to shelter
and transportation are relatively constant over the range of income
shown in the table; apparently, high-income people buy bigger
houses and cars.
• budget shares in Cobb–Douglas utility function are constant for all
observed income levels and relative prices. And it is not useful for
detailed empirical studies of household behavior.

Extensions: The variability of budget shares
Back

Extensions: 2.Linear expenditure system(Stone,1954)

• A generalization of the Cobb–Douglas function that incorporates the idea
that certain minimal amounts of each good must be bought by an
individual (𝑥0 , 𝑦0 ) is the utility function
𝑈 𝑥, 𝑦 = 𝑥 − 𝑥0 𝛼 𝑦 − 𝑦0 𝛽 for 𝑥 ≥ 𝑥0 and 𝑦 ≥ 𝑦0 , where again 𝛼 + 𝛽
= 1.
• supernumerary income 𝐼 ∗ , which represents the amount of purchasing
power remaining after purchasing the minimum bundle.(𝐼 ∗ = 𝐼 − 𝑝𝑥 𝑥0
− 𝑝𝑦 𝑦0 ).
• Using this notation, the demand functions are:
𝑝𝑥 𝑥0 +𝛼𝐼 ∗ 𝑝𝑦 𝑦0 +𝛽𝐼 ∗
•𝑥= ;𝑦 =
𝑝𝑥 𝑝𝑦

Extensions: Linear expenditure system

• In this case, the individual then spends a constant fraction of
supernumerary income on each good once the minimum bundle has
been purchased.
• Manipulation of demand Equations yields the share equations which
show that this demand system is not homothetic.
𝛽𝑝𝑥 𝑥0 −𝛼𝑝𝑦 𝑦0 𝛼𝑝𝑦 𝑦0 −𝛽𝑝𝑥 𝑥0
• 𝑠𝑥 = 𝛼 + 𝑠𝑦 = 𝛽 +
𝐼 𝐼
• the budget share of a good is positively related to the minimal
amount of that good needed and negatively related to the minimal
amount of the other good required.

Extensions: 3.CES utility

𝑥𝛿 𝑦𝛿
• the CES utility function(𝑈(𝑥, 𝑦) = + for𝛿 ≤ 1, 𝛿 ≠ 0). 𝐾 = 𝛿/(𝛿 − 1)
𝛿 𝛿
1
𝑠𝑥 = 𝐾
1+ 𝑝𝑦 /𝑝𝑥
• the CES function yields the share equations( 1 ).
𝑠𝑦 = 𝐾
1+ 𝑝𝑥 /𝑝𝑦
• The homothetic nature of the CES function is shown by the fact that
these share expressions depend only on the price ratio.
• Behavior of the shares in response to changes in relative prices
depends on the value of the parameter K.

Extensions: CES utility

• For the Cobb–Douglas case, 𝛿 = 0and so 𝑘 = 0and𝑠𝑥 = 𝑠𝑦 = 0.5 .
• When 𝛿 > 0, substitution possibilities are great and𝑘 < 0. In this
case, 𝑠𝑥 and 𝑝𝑥 /𝑝𝑦 move in opposite directions. If 𝑝𝑥 /𝑝𝑦 increases, the
individual substitutes y for x to such an extent that 𝑠𝑥 decreases.
• Alternatively, if𝛿 < 0,then substitution possibilities are limited,𝑘 > 0,
and 𝑠𝑥 and 𝑝𝑥 /𝑝𝑦 move in the same direction. In this case, an increase
in 𝑝𝑥 /𝑝𝑦 causes only minor substitution of y for x, and 𝑠𝑥 actually
increases because of the relatively higher price of good x.

Extensions: CES utility-North American Free Trade

• Because the CES model stresses that shares respond to changes in
relative prices, it is particularly appropriate for looking at innovations
such as changes in tax policy or in international trade restrictions,
where changes in relative prices are likely.
• One important area of such research has been on the impact of the
North American Free Trade Agreement for Canada, Mexico, and the
United States. In general, these models find that all the countries
involved might be expected to gain from the agreement, but that
Mexico’s gains may be the greatest because it is experiencing the
greatest change in relative prices.(Kehoe and Kehoe (1995)- Chapter 13)

Angus Deaton-Nobel winner 2015

• Sir Angus Stewart Deaton (born 19 October 1945)
• Economics Department at Princeton University
• Research: poverty, inequality, health, wellbeing, and economic development
• Nobel In 2015 for his analysis of consumption, poverty, and welfare and specially AIDS.
• Deaton's first work to become known: Almost Ideal Demand System (AIDS)
• published in The American Economic Review (AER) in 1980
• As a consumer demand model, it provides a first order approximation to any demand system which satisfies
the axioms of order, aggregates over consumers without invoking parallel linear Engel curves, is consistent
with budget constraints, and is simple to estimate.
• According to a review by the American Economic Review, the paper "introduces a practical system
of demand equations that are consistent with preference maximization and have sufficient
flexibility to support full welfare analysis of policies that have an impact on consumers."
• The paper was listed as one of the top 20 published works in the AER in the first 100 years of the
journal

Extensions: 4.The almost ideal demand system

• An alternative way to study budget shares is to start from a specific
expenditure function. This approach is especially convenient because
the envelope theorem shows that budget shares can be derived
directly from expenditure functions through logarithmic
differentiation.(next lecture)
𝜕ln 𝐸 𝑝𝑥 ,𝑝𝑦 ,𝑉 1 𝜕𝐸 𝜕𝑝𝑥 𝑥𝑝𝑥
• = ⋅ ⋅ = =𝑆𝑥
𝜕ln 𝑝𝑥 𝐸 𝑝𝑥 ,𝑝𝑦 ,𝑉 𝜕𝑝𝑥 𝜕ln 𝑝𝑥 𝐸
• Deaton and Muellbauer (1980) make extensive use of this
relationship to study the characteristics of a particular class of
expenditure functions that they term as an almost ideal demand
system (AIDS).

Extensions: The almost ideal demand system

• Their expenditure function takes the form
ln 𝐸 𝑝𝑥 , 𝑝𝑦 , 𝑉 = 𝑎0 + 𝑎1 ln 𝑝𝑥 + 𝑎2 ln 𝑝𝑦
• +0.5𝑏1 ln 𝑝𝑥 2 + 𝑏2 ln 𝑝𝑥 ln 𝑝𝑦
2 𝑐 𝑐
+0.5𝑏3 ln 𝑝𝑦 + 𝑉𝑐0 𝑝𝑥1 𝑝𝑦2
• This form approximates any expenditure function.

Extensions: The almost ideal demand system
• In other words, the AIDS

share equations state that
budget shares are linear in
the logarithms of prices and
in total real expenditures.

Extensions: British expenditure patterns

• Deaton and Muellbauer(1980) find that food and housing have
negative coefficients of real expenditures, implying that the share of
income devoted to these items decreases (at least in Britain) as
people get richer.
• The authors also find significant relative price effects in many of their
share equations, and prices have especially large effects in explaining
the share of expenditures devoted to transportation and
communication.
• Deaton, Angus, and John Muellbauer. ‘‘An Almost Ideal Demand
System.’’ American Economic Review (June 1980): 312–26.

Application: What’s a Rich Uncle’s Promise

Worth?
• One of the strangest legal cases of the nineteenth century was the
New York case of Hamer v. Sidway, in which nephew Willie sued his
uncle for failing to carry through on the promise to pay him $5,000 if
he did not smoke, drink, or gamble until he reached the age of 21.
• No one in the case disagreed that the uncle had made this deal with
Willie when he was about 15 years old. The legal issue was whether
the uncle’s promise was a clear ‘‘contract,’’ enforceable in court.
• An examination of this peculiar case provides an instructive
illustration of how economic principles can help to clarify legal issues.

What’s a Rich Uncle’s Promise Worth?

• Figure 1 shows Willie’s choice between ‘‘sin’’ (that is, smoking,
drinking, and gambling) on the X-axis and his spending on everything
else on the Y-axis.
• Left to his own devices, Willie would prefer to consume point A—
which involves some sin along with other things. This would provide
him with utility of U2.
• Willie’s uncle is offering him point B—an extra $5,000 worth of other
things on the condition that sin=0.


Left to his own devices, Willie
consumes point A and gets utility U2.
His uncle’s offer would increase utility
to U3. But, when his uncle reneges,
Willie gets U1 (point C).
• In this graph, it is clear that the

offer provides more utility (U3)
than point A, so Willie should
take the offer and spend his
teenage years sin-free.


• When the Uncle reneges:
• When Willie came to collect the $5,000 for his abstinence, his uncle
assured him that he would place the funds in a bank account that
Willie would get once he was ‘‘capable of using it wisely.’’ But the
uncle died and left no provision for payment in his will. So Willie
ended up with no money. The consequences of being stiffed for the
$5,000 can be shown in Figure 1 by point C—this is the utility Willie
would get by spending all his income on non-sin items.


• Willie Goes to Court!
• In contract law the promise of party A to do something for party B is
enforceable only if there is evidence that an actual bargain was
reached. One sign that such an agreement has been reached is the
payment of some form of consideration from B to A that seals the
deal. Although there was no explicit payment from Willie to his uncle
in this case, the court ultimately ruled that Willie’s 6 years of
abstinence itself played that role here. Apparently the uncle derived
pleasure from seeing a ‘‘sin-free’’ Willie so this was regarded as
sufficient consideration in this case. After much wrangling, Willie
finally got paid.

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Lecture 03: Utility Maximization and Choice

44719-Microeconomics for Minor Students

Saeed Tajrishy-GSME SUT Slide 1 of 61 Microeconomic For Minor Students-Fall 2023

Saeed Tajrishy-GSME SUT Slide 2 of 61 Microeconomic For Minor Students-Fall 2023

Saeed Tajrishy-GSME SUT Slide 3 of 61 Microeconomic For Minor Students-Fall 2023

Saeed Tajrishy-GSME SUT Slide 4 of 61 Microeconomic For Minor Students-Fall 2023

Saeed Tajrishy-GSME SUT Slide 5 of 61 Microeconomic For Minor Students-Fall 2023

Saeed Tajrishy-GSME SUT Slide 6 of 61 Microeconomic For Minor Students-Fall 2023

Saeed Tajrishy-GSME SUT Slide 7 of 61 Microeconomic For Minor Students-Fall 2023

Two Complaints about the Economic

• 2. The economic model of choice is extremely selfish because no one

Saeed Tajrishy-GSME SUT Slide 8 of 61 Microeconomic For Minor Students-Fall 2023

The Budget Constraint

Saeed Tajrishy-GSME SUT Slide 9 of 61 Microeconomic For Minor Students-Fall 2023

The Budget Constraint

Quantity of y The individual can afford pxx + pyy  I

If all income is spent

Saeed Tajrishy-GSME SUT Slide 10 of 61 Microeconomic For Minor Students-Fall 2023

First-Order Conditions for a

Saeed Tajrishy-GSME SUT Slide 11 of 61 Microeconomic For Minor Students-Fall 2023

First-Order Conditions for a Maximum

Quantity of y The individual can do better than point A

Saeed Tajrishy-GSME SUT Slide 12 of 61 Microeconomic For Minor Students-Fall 2023

First-Order Conditions for a Maximum

Quantity of y The individual can do better than point A

Saeed Tajrishy-GSME SUT Slide 13 of 61 Microeconomic For Minor Students-Fall 2023

First-Order Conditions for a Maximum

Saeed Tajrishy-GSME SUT Slide 14 of 61 Microeconomic For Minor Students-Fall 2023

Second-Order Conditions for a

Saeed Tajrishy-GSME SUT Slide 15 of 61 Microeconomic For Minor Students-Fall 2023

Second-Order Conditions for a Maximum

Saeed Tajrishy-GSME SUT Slide 16 of 61 Microeconomic For Minor Students-Fall 2023

Second-Order Conditions for a Maximum

Saeed Tajrishy-GSME SUT Slide 17 of 61 Microeconomic For Minor Students-Fall 2023

Saeed Tajrishy-GSME SUT Slide 18 of 61 Microeconomic For Minor Students-Fall 2023

At point A, the indifference curve

Utility is maximized at point A

The n-Good Case

Saeed Tajrishy-GSME SUT Slide 20 of 61 Microeconomic For Minor Students-Fall 2023

The n-Good Case

• Set up the Lagrangian:

Saeed Tajrishy-GSME SUT Slide 21 of 61 Microeconomic For Minor Students-Fall 2023

The n-Good Case

L/x2 = U/x2 - p2 = 0

Saeed Tajrishy-GSME SUT Slide 22 of 61 Microeconomic For Minor Students-Fall 2023

Implications of First-Order Conditions

• This implies that at the optimal allocation of income

Saeed Tajrishy-GSME SUT Slide 23 of 61 Microeconomic For Minor Students-Fall 2023

Interpreting the Lagrangian Multiplier

U / x1 U / x2 U / xn

MUx1 MUx2 MUxn

•  is the marginal utility of an extra dollar of consumption expenditure

Saeed Tajrishy-GSME SUT Slide 24 of 61 Microeconomic For Minor Students-Fall 2023

Interpreting the Lagrangian Multiplier

• At the margin, the price of a good represents the consumer’s

Saeed Tajrishy-GSME SUT Slide 25 of 61 Microeconomic For Minor Students-Fall 2023

Cobb-Douglas Demand Functions

Saeed Tajrishy-GSME SUT Slide 27 of 61 Microeconomic For Minor Students-Fall 2023

Charles Wiggins Cobb & Paul Howard Douglas

Saeed Tajrishy-GSME SUT Slide 28 of 61 Microeconomic For Minor Students-Fall 2023

Cobb-Douglas Demand Functions

Saeed Tajrishy-GSME SUT Slide 29 of 61 Microeconomic For Minor Students-Fall 2023