Econ 311

Utility Maximization
 Putting the pieces together
• So far, we’ve done 3 things:
– Motivated the importance of “constrained
optimization”
– Learned about measuring and analyzing two-
dimensional benefit functions (utility)
– Learned about measuring and analyzing two-
dimensional cost functions (budget)
 Putting the pieces together
• Now, we’re going to put benefits and costs
together.

• Rather than start with the math and then do it

graphically, this process is much easier to
understand graphically first and then use the
intuition to figure out the math.
 Putting the pieces together
• The basic question we’re trying to answer is:
Given a specific budget constraint, what
should an individual consume in order to
maximize their utility?

• All we’re going to do to start is graph a budget

constraint and an indifference curve on the
same graph. The logic takes us from there.
 BC + IC Graph
• Budget and a Cobb-Douglas IC:
 BC + IC Graph
• If the IC never touches the budget constraint,
then none of the bundles that achieve that
level of utility are affordable.

• In other words, it is impossible to achieve that

level of utility with the given amount of
income.
– So let’s draw an IC for a lower utility level
BC + IC Graph
 BC + IC Graph
• Point A:
– Affordable, since it’s on the BC

– Achieves exactly 15 utils since it’s on the IC

BC + IC Graph
 BC + IC Graph
• Point B:
– Very affordable, since it’s within the BC

– Achieves more than 15 utils since it’s in the better-

than-set of the IC
BC + IC Graph
 BC + IC Graph
• Point C:
– Very affordable, since it’s within the BC

– Achieves exactly 15 utils since it’s on the IC

BC + IC Graph
 BC + IC Graph
• Point D:
– Unaffordable, since it’s out from the BC

– Achieves exactly 15 utils since it’s on the IC

BC + IC Graph
 BC + IC Graph
• Point e:
– Affordable, since it’s on the BC
– Achieves less than 15 utils since it’s in the worse-
than-set of the IC
 BC + IC Graph
• Takeaways from the graph:
– It is possible attain the level of utility associated
with the IC using the given income

– It is also possible to attain a more utility than the

level associated with the IC using the given
income
• So let’s draw THE IC WITH THE HIGHEST UTILITY THAT
CAN BE ATTAINED WITH THE GIVEN INCOME
BC + IC Graph
 BC + IC Graph
• Point A is a magical point:
– The IC touches the BC at exactly one point
– Every other point on the IC is unaffordable

– Point A is the utility maximizing bundle

BC + IC Graph: Zoom in
 BC + IC Graph
• So moving along the BC (to other nearby
affordable bundles) only makes you worse off:
you end up on lower ICs

• In terms of the BC line and the IC curve, what

is going on at point A that is special?
– Hint: use a term from our Calculus review
 BC + IC Graph
• In terms of the BC line and the IC curve, what
is going on at point A that is special?
– They have the exact same slope
– Math word: they are TANGENT at that point

• If you want to find the utility maximizing

bundle, you have to find the bundle where the
BC and IC have the same slope.
 BC + IC Graph
• Why?
– Let’s remember the meaning of the slope of the IC.
• The slope of the IC is the negative MRS
• The negative MRS tells you how many Y you would be willing
to give up to get another X

– Let’s remember the meaning of the slope of the BC.

• The slope of the BC is the negative price ratio
• The negative price ratio tells you how many Y you would
have to give up to get another X
 BC + IC Graph
• Think about what it would mean if those two
slopes weren’t equal:
– Imagine the negative MRS is -4. This means you’d
be willing to give up 4 units of Y to get 1 unit of X

– Imagine the negative price ratio is -3. This means

that you would only have to give up 3 units of Y to
get 1 unit of X
 BC + IC Graph
• So what would you do?
– You would give up some Y in order to get some X

– Here’s the logic: if you’re currently consuming

bundle A and given the current prices, you’d like
to move away from bundle A, bundle A cannot be
a utility maximizing bundle.
BC + IC Graph
 BC + IC Graph
• Graph takeaway:
– If MRS > Px/Py, you will trade away some Y for
some X.
– This is graphically represented by a situation in
which the IC is steeper than the BC
– Trading away some Y for some X means you will
move down and to the right in search of points in
the better-than set
 BC + IC Graph
• Let’s also work through the opposite case:
– Imagine the negative MRS is -3. This means you’d be
willing to give up 3 units of Y to get 1 unit of X.
Written another way, you’d be willing to give up 1/3 of
a unit of X to get 1 unit of Y

– Imagine the negative price ratio is -4. This means that

you would only have to give up 4 units of Y to get 1
unit of X. Written another way, you would only have
to give up 1/4 of a unit of X to get 1 unit of Y.
 BC + IC Graph
• So what would you do?
– You would give up some X in order to get some Y
BC + IC Graph
 BC + IC Graph
• Graph takeaway:
– If MRS < Px/Py, you will trade away some X for
some Y.
– This is graphically represented by a situation in
which the IC is flatter than the BC
– Trading away some X for some Y means you will
move up and to the left in search of points in the
better-than set
 BC + IC Graph
• Summary of slope logic:
– When you’ve got a curved IC, you have to set the
slope of the IC equal to the slope of the BC in
order to find a utility-maximizing bundle

– If the slopes aren’t equal, you would be willing to

make a trade to a different bundle
 BC + IC Graph
• Summary of overall utility maximizing graph
logic.

– In the (X,Y) graph, there are an infinite number of

ICs that all correspond to different levels of utility
– There is only one BC
– Utility maximization happens when you find the
point on the BC that touches the highest-possible
IC
 BC + IC Graph
• Summary of overall utility maximizing graph
logic.

– When you have standard indifference curves

• Non-crossing
• Monotonic
• Convex
– This maximum occurs at one magical point, where
a tangency occurs between the IC and BC
BC + IC Graph
 Mathematical Approach
• Now that we’ve used the graph to get the
intuition, the math is pretty easy.

• Calculate the MRS.

• Calculate the price ratio.

• Set them equal

 Mathematical Approach
• Definition of the problem:
 Mathematical Approach
• In words, the math problem is a constrained
optimization problem.

• You are trying to maximize your utility subject

to a budget constraint.
 Mathematical Approach
• There is going to be a 4-step approach to
doing these problems.

• STEP 1: Use your intuition from the graph.

Calculate the MRS and set it equal to the price
ratio.
 Mathematical Approach
• Example:
 Mathematical Approach
• STEP 2: Re-arrange this inequality to isolate
one good (X or Y) as a function of the other. It
doesn’t matter which way you choose to do it.
The resulting equation is called the “optimality
condition”.
 Mathematical Approach
• Example:
 Mathematical Approach
• STEP 3: Write down your budget constraint
and plug the optimality condition into it. This
will allow you to solve for the demand for one
of the two goods.
 Mathematical Approach
• Example:
 Mathematical Approach
• STEP 4: Use your demand for one good and
plug it in to EITHER the optimality condition or
the budget constraint in order to solve for
demand for the other good.
 Mathematical Approach
• Example:
 Mathematical Approach
• Just to re-iterate the terminology, x* and y*
represent the consumer’s demand for x and
demand for y.

• Since this is so important, we’re going to do

another example.
 Mathematical Approach
• Example:
 Mathematical Approach
• Example:
 Mathematical Approach
• Example:
 Mathematical Approach
• Example:
 Mathematical Approach
• Example:
 Mathematical Approach
• We have the tools to draw a complete graph
of the solution:
Mathematical Approach
 Mathematical Approach
• Solving these problem is the most important
part of intermediate micro. Try and get
comfortable with it without overthinking it.
Just follow the steps.

• Now that we’ve done a Cobb-Douglas

example, we’ll do one the other type of utility
function that can be solved in this way.
 Mathematical Approach
• Remember that the way we figured out how
to maximize utility was using the graph.

• When indifference curves are:

– Convex
– Monotonic
– Non-crossing
• We can maximize utility by this MRS = price
ratio method.
 Mathematical Approach
• When indifference curves are:
– Convex
– Monotonic
– Non-crossing
• We can maximize utility by this MRS = price
ratio method.

• So which other type of utility function should

we be able to maximize using this method?
 Mathematical Approach
• So which other type of utility function should
we be able to maximize using this method?
– Quasi-linear

• It turns out that using the method for a quasi-

linear utility function is actually easier: we
only need 3 steps instead of 4.
 Mathematical Approach
• Example:
 Mathematical Approach
• Example:
 Mathematical Approach
• Example:
 Mathematical Approach
• Example:
 Mathematical Approach
• Example:
 Mathematical Approach
• We can now maximize utility subject to a
budget constraint for 2 of our 4 possible utility
functions.
– Sidenote: this process works for any utility
function that fulfills all our standard properties,
not just the Cobb-Douglas and Quasi-linear. It’s
just that those two are common types.

• What about the other 2, PS and PC?

 Mathematical Approach
• Let’s think about Perfect Substitutes
U(x,y) = ax + by

– Mathematically, the MRS is a constant, a/b, so we

can’t really set it equal to the price ratio. It’s
either bigger than, less than or equal to the price
ratio.
– What do we do?
• Let’s check out a graph for intuition.
Graph for PS
 Graph for PS
• So that indifference curve is unaffordable.
Let’s try an indifference curve with less utility.
Graph for PS
 Graph for PS
• That indifference curve is affordable
– BUT: there are bundles in the better-than set that
are also affordable

– Let’s try drawing the best indifference curve you

can get to on the budget.
Graph for PS
 Graph for PS
• So this person choose to consume only x and
no y.

• Why? What is the graphical feature of the

relationship between the BC and the IC that
pushes the best IC all the way to the corner?
 Graph for PS
• Why? What is the graphical feature of the
relationship between the BC and the IC that
pushes the best IC all the way to the corner?
– The ICs (all have the exact same slope = -MRS) are
steeper than the BC (slope = -price ratio).

– Intuition: the willingness to trade y to get x is

always greater than the ability to trade y to get x
• So go get all the x you can!
 Graph for PS
• Logically, what happens if the ICs are flatter
than the BC?
 Graph for PS
• Logically, what happens if the ICs are flatter
than the BC?

– The exact opposite. The willingness to trade y for

x is always less than the ability to trade y for x.
– Therefore, the willingness to trade x for y is always
greater than the ability to trade x for y.
• So go get all the y you can!
Graph for PS
 Graph for PS
• So PS utility functions lead to one of 2
outcomes:
– Either you consume all x and no y or all y and no x
– Which outcome it is depends on the relationship
between the BC and IC slope (MRS and price ratio)
that you should have an firm understanding of

• Except for one weird case…

 Graph for PS
• It could end up being the case that the IC
slope and the BC slope are the same (MRS =
price ratio).

• This means that every single point on the BC

lies on the same indifference curve:
– You can consume any bundle on the BC and your
utility will be the same.
 Mathematical Approach - PS
• Again, the graphing exercise tells us how to do
the math.

• Calculate the MRS.

• Compare it to the price ratio.
– If MRS > price ratio, consume all x
– If MRS < price ratio, consume all y
 Mathematical Approach - PS
• Example:
 Mathematical Approach - PS
• A mathematical justification for this approach:
– With PS utility, the goods don’t interact at all (why
we used Burritos and Staplers as an example)
– So you might as well size each good up
independently and just ask yourself:
• Which of these two goods is more cost-effective at
generating utility?
– Or in other words:
• Which of these two goods is giving me more utility per
dollar I spend on it?
 Mathematical Approach - PS
• It turns out that the method of comparing the
MRS to the price ratio is exactly equivalent to
making this decision. More math with units.
 Mathematical Approach - PS
• When you say the MRS is less than the price
ratio, you are also saying:
– I get fewer utils per dollar I spend on X than utils
per dollar I spend on Y. Therefore, I should buy
only Y.

• Important to remember that this intuition

only works with PS. This works because the
MRS is constant and won’t work otherwise.
 Mathematical Approach - PS
• Example:
 Mathematical Approach
• By using the MRS and the price ratio, we can
thus do utility maximization for 3 of 4 utility
functions.

• What about Perfect Complements?

– The problem is deeper since there is no MRS for a
PC function.
– Once again, we’ve got to go back to the graph.
Graph for PC
 Graph for PC
• The bundles on both the IC and the BC involve
wasting one good or the other.
– Remember the “no-waste” condition is that you
should achieve a certain utility level with the
fewest possible units of x and y.
– In other words, you want to be at the “kink”.
 Graph for PC
• There are also affordable bundles in the better
than set.
– So, let’s find the highest utility level on the
budget.
Graph for PC
 Graph for PC
• So the most utility you can achieve on a
budget is going to be the point where you are
also fulfilling the no-waste condition.

• Mathematically, this says you want to take the

no-waste equation and plug it into the budget
constraint.
 Mathematical Approach - PC
• This ends up being one of the simpler utility
functions to maximize. You just have to
remember the procedure.

• STEP 1: solve the no-waste condition for one

of the goods (doesn’t matter which).
 Mathematical Approach - PC
• Example:
 Mathematical Approach - PC
• Example:
 Mathematical Approach - PC
• Example:
 Mathematical Approach - PC
• Let’s graph this solution, and use a shortcut.

• The no-waste condition mathematically can

be thought of as a line. Along the line is
where all of the kinks in the indifference
curves are.
Mathematical Approach - PC
 Mathematical Approach - PC
• Really, all the math is doing for PC is finding
the intersection of two lines:
– The no-waste line
– The BC
 Mathematical Approach - PC
• Example:
 Mathematical Approach - PC
• Example:
 Mathematical Approach - PC
• Example:
 Mathematical Approach - PC
• Summary:

– Using graphical intuition, we developed

mathematical techniques for maximizing 4
different kinds of utility functions subject to
budget constraints.

– The graphical intuition is powerful. It works even

when you have messed up preferences:
Graph with Non-convex ICs
 Graph with Non-convex ICs
• Remember that the direction of increase is
still up and right.

– What is the highest IC you can get to?

Graph with Non-convex ICs
 Graph with Non-convex ICs
• A utility function that generates these types of
ICs is:

– What does this function look like to you?

 Graph with Non-convex ICs
• What I call it “Perfect Substitutes on Steroids”
– X and Y terms are separated by a plus, so the
goods are independent.
– But they’re also raised to a power greater than 1,
so they feature increasing marginal utility

– Just like PS, you consume only X or Y, never both.

– You can figuring out which is better just by
comparing the bundles (M/Px,0) and (0,M/Py)
 Graph with Non-convex ICs
• I’m emphasizing this and doing this example
to show how useful these graphs are.

• If you ever forget the mathematical approach,

but you remember how to draw and interpret
the graphs, you will always remember how to
do utility maximization for a specific utility
function.