Further on Quasi-linear Utility

Arnab Mukherji 2nd July 2012

Consider the following case: Neels preferences over two goods, x1 and x2 are captured by U (x1 , x2 ) = x1 + log (x2 ). Goods x1 and x2 are available in the market for Rs. p1 and p2 and he has Rs. m as income; let the numerical value for (p1 , p2 , m) = (4, 2, 1). Then what would the equilibrium look like? Neels choice problem is: M axx1 ,x2 s.t. x1 + log (x2 ) p1 x1 + p2 x2 M

The preferences captured by the above utility function is reexive, complete and transitive. It is monotonic, and its better-than set is convex. (Please know how to show these properties). Given that these preferences are well-behaved, it is natural to expect that there is an interior utility maximizing solution for these choice problem. However, this is not necessarily the case. With quasilinear preferences corner solutions occur when un-real levels of x1 , x2 are needed to maximize utility. In the above case if we have an interior maxima then we solve for the utility maximizing bundle as follows. U (.) x1 U (.) M U2 (x2 , x2 ) = x2 M U1 (x1 , x2 ) = M RSx1 ,x2 = 1

= x2 = x2 = p1 =2 p2 (1)

However given that income (m) is Rs. 1, there is no value of x2 at which 1 M RSx1 ,x2 = p p2 and thus, there is no interior maxima. The equilibrium solution m is a corner solution where x2 = 0 and x1 = p = 1/4. Had the income been large 1 enough there would have been no problem in identifying an interior equilibrium. To think about this a little more, we know to solve for the interior utility maximizing bundle it must be that: p2 x2 = p1 = m m

Thus, substituting this into the budget equation gives us: p1 x1 + p1 x 1 p1 x1 + p1 = m = 1 p1 p1 x 1 2 = p2

Clearly, if p1 > m then we have a problem. This is not just specic to these preferences and is a general characteristic of quasi-linear preferences. Consider for example the following choice problem M axx1 ,x2 s.t. x1 + x2

p1 x1 + p2 x2 M

Again, searching for an interior equilibrium we have: U (.) x1 U (.) M U2 (x2 , x2 ) = x2 M U1 (x1 , x2 ) = M RSx1 ,x2 p1 x1 = p2 2 4p1 = = = 1 2 x1 1 p1 1 = 2 x1 p2 (2)

Putting this back into the budget constraint we can now solve for the demand curve: p1 x1 + p2 x2 = m p2 2 + p2 x2 = m 4p1 p2 m + x2 = 4p1 p2 p2 m x2 = p2 4p1

(3)

m 2 Thus, x2 will not be consumed each time p 4p p1 < 0. In this sense, the quasi2 linear utility could always allow for a corner solution even though it is otherwise well-behaved.