Budget Sets and

Utility
Maximization

Topic 3:
Budget Sets and Utility Maximization

The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization

Textbook: pages 60-78 (1st edition), 57-77 (2nd edition),

58-83 (3rd edition).

Revealed
Preferences
Evidence

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Budget Sets and

Utility
Maximization

A consumer chooses how much of each of n goods she buys.

The Rational
Consumer
The Budget Set

Goods: i = 1, 2, . . . , n.

Utility Functions

Quantity of each good: qi 0.

Utility
Maximization

The consumer has preferences (, ) over (q1 , q2 , . . . , qn ).

Revealed
Preferences

The preferences are represented by a utility function:

Evidence

u(q1 , q2 , . . . , qn ).

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Budget Sets and

Utility
Maximization

The consumer has a fixed income Y > 0.

The Rational
Consumer
The Budget Set

Price of each good: pi > 0.

Utility Functions

The consumer takes prices as given.

Utility
Maximization

The consumers expenditure on good i: pi qi .

Revealed
Preferences

The consumers budget constraint:

Evidence

p1 q1 + p2 q2 + . . . + pn qn Y .

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Budget Sets and

Utility
Maximization

The Rational Consumer

chooses (q1 , q2 , . . . , qn ) to maximize
u(q1 , q2 , . . . , qn )
subject to the non-negativity constraint:

The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence

q1 0 and q2 0 and . . . and qn 0,

and subject to the budget constraint:
p1 q1 + p2 q2 + . . . + pn qn Y .

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Budget Sets and

Utility
Maximization

The Budget Set

Suppose there are only two goods: good 1 and good 2.

The Rational
Consumer
The Budget Set

I
I

The quantities are q1 and q2 .

Utility Functions
Utility
Maximization

Their prices are p1 and p2 .

The amount of money the consumer can spend is Y .

The consumers feasible choices:

q1 0, q2 0,

and

Revealed
Preferences
Evidence

p1 q1 + p2 q2 Y

The set of feasible choices is called budget set.

The line where all money is spent is called budget line.

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Budget Sets and

Utility
Maximization

The Budget Set

p1 = 2, p2 = 5, Y = 80 2q1 + 5q2 80

The Rational
Consumer
The Budget Set
Utility Functions

16=Y/p2

Utility
Maximization
Revealed
Preferences
Evidence

Budget line

Budget set

40=Y/p1
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Budget Sets and

Utility
Maximization

The Slope of the Budget Line

The Rational
Consumer

p1 q1 + p2 q2 = Y
q2 =

Y p1
q1
p2 p2

The Budget Set

Utility Functions
Utility
Maximization
Revealed
Preferences

The slope (marginal rate of transformation, price ratio):

Evidence

p1
.
p2

In our example:

p1
2
= .
p2
5
7 / 28

Utility Functions and Indifference Curves

Budget Sets and

Utility
Maximization

The Rational
Consumer

Indifference curves are the geometric location of all quantity

bundles that have the same utility.

Utility Functions
Utility
Maximization

They are the solutions to the equation:

U(q1 , q2 ) = u

The Budget Set

for some fixed utility level u.

Revealed
Preferences
Evidence

Example:
q1 q2 = u q2 =

u
q1

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Budget Sets and

Utility
Maximization

Utility Functions and Indifference Curves

q1 =

u
q2

The Rational
Consumer
The Budget Set

500

Utility Functions
Utility
Maximization

300

Evidence

u=40000
u=20000
u=5000

100

q2

Revealed
Preferences

100

200

300

400

500

600

q1
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Marginal Rates of Substitution

Budget Sets and

Utility
Maximization

The Rational
Consumer
The Budget Set
Utility Functions

The marginal rate of substitution between goods 1 and 2:

For one extra (infinitesimally small) unit of good 1
how much of good 2 are you willing to give up?

Utility
Maximization
Revealed
Preferences
Evidence

The marginal rate of substitution is the slope of an

indifference curve.

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Budget Sets and

Utility
Maximization

600

Slopes of Indifference Curves

500

The Rational
Consumer
The Budget Set

300

Utility
Maximization
Revealed
Preferences
Evidence

200

q2

400

Utility Functions

100

0.5
U(q1, q2) = q0.5
1 q2

100

200

300

400

500

600

q1
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Marginal Rates of Substitution through Calculus

Let the quantities be q1 , q2 .
We write the equation of the indifference curve as: q2 (q1 ).
The marginal rate of substitution:

dq2
dq1 :

Budget Sets and

Utility
Maximization

The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization

U(q1 , q2 (q1 )) = k
U
U dq2
+
q1 q2 dq1
dq2
dq1

[Chain Rule]

Revealed
Preferences
Evidence

= 0

U
q1
U
q2

The marginal rate of substitution is the ratio of the marginal

utilities.
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Budget Sets and

Utility
Maximization

Two Properties of Utility Functions

The Rational
Consumer

Preferences are monotonically increasing if:

The Budget Set

As the quantities increase, utility increases.

Utility Functions
Utility
Maximization

(Interpretation: more is better.)

Revealed
Preferences
Evidence

Preferences are convex (with 2 goods) if:

The absolute value of the marginal rates of substitution
decreases as we move to the right on an indifference curve.
(Interpretation: a mixture of two indifferent consumption
bundles is better than each of the consumption bundles.)

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Interpretation of Convex Preferences

100 200 300 400 500 600

The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence

q
^
0.5q+0.5q
^
q

q2

A mixture of two indifferent consumption bundles is better

than each of the consumption bundles.

Budget Sets and

Utility
Maximization

100

200

300

400

500

600

q1
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Utility Maximization

Budget Sets and

Utility
Maximization

The Rational
Consumer
The Budget Set
Utility Functions

Assume the utility function is

I
I

increasing,
convex,

Utility
Maximization
Revealed
Preferences

Assume the optimum is such that the consumer

consumes a strictly positive amount of both goods:

Evidence

q1 > 0 and q2 > 0.

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Utility Maximization

Budget Sets and

Utility
Maximization

The Rational
Consumer
The Budget Set
Utility Functions

Observation 1: If preferences are monotone, the optimal

consumption bundle will be on the budget line.

Utility
Maximization
Revealed
Preferences
Evidence

Reason: Otherwise the consumer could buy more of both

goods.

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Budget Sets and

Utility
Maximization

Not Optimal

The Rational
Consumer
The Budget Set
Utility Functions

16=Y/p2

q2

Utility
Maximization
Revealed
Preferences

better

Evidence

40=Y/p1

0
q1

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Utility Maximization

Budget Sets and

Utility
Maximization

The Rational
Consumer
The Budget Set

Observation 2: If preferences are convex, in the optimal

consumption bundle:
marginal rate of substitution = slope of the budget line.

Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence

Reason: Otherwise, the consumer could do better buying

more of one, and less of another good.

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Budget Sets and

Utility
Maximization

Not Optimal

The Rational
Consumer
The Budget Set
Utility Functions

16=Y/p2

better

Revealed
Preferences
Evidence

q2

Utility
Maximization

40=Y/p1

0
q1

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Budget Sets and

Utility
Maximization

Optimal

The Rational
Consumer
The Budget Set

16=Y/p2

Utility
Maximization
Revealed
Preferences
Evidence

q2

Utility Functions

40=Y/p1

0
q1

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Budget Sets and

Utility
Maximization

Intuition
Marginal rate of substitution = Slope of the Budget Line

U
q1
U
q2
U
q1

The Budget Set

p1
=
p2
=

p1

The Rational
Consumer

Utility Functions
Utility
Maximization

U
q2

Revealed
Preferences

p2

Evidence

Marginal Utility of $1
spent on good 1

Marginal Utility of $1
spent on good 2

Otherwise it would be better to:

I

take $1 away from the good with the lower marginal

utility per 1$;

spend $1 more on the good with the higher marginal

utility per 1$.
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Budget Sets and

Utility
Maximization

Revealed Preferences

16=Y/p2

The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences

Evidence

20

40=Y/p1

The consumer reveals that A yields higher utility than B or

C.

22 / 28

The Weak Axiom of Revealed Preferences

Suppose we observe the consumer choose twice:

Budget Sets and

Utility
Maximization

The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences

Evidence

The choice from the blue set reveals that A has higher utility than
B.
The choice from the green set reveals that B has higher utility
than A.
Violation of WARP.

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Budget Sets and

Utility
Maximization

Observed choices satisfy the Weak Axiom of Revealed

Preferences (WARP) if for all pairs of options x and y :

The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization

If x was chosen when y was also available,

then
I

Revealed
Preferences
Evidence

y was never chosen when also x was available.

A rational economic agent will satisfy WARP.

24 / 28

The Weak Axiom of Revealed Preferences

Budget Sets and

Utility
Maximization

The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence

The blue choice reveals that A has higher utility than B.

But A is not in the green budget set.
No Violation of WARP.
25 / 28

What do Real People Do?

Budget Sets and

Utility
Maximization

Enchenique, Lee, Shum:

The Rational
Consumer

The Money Pump

as a Measure of Revealed Preference Violations,
With an Application to Supermarket Data
Journal of Political Economy, December 2011, 201-1223.

The Budget Set

Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence

Data:
494 households
food purchases
over 104 weeks
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Budget Sets and

Utility
Maximization

The Money Pump

The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization

Revealed
Preferences
Evidence

First blue then green prices: I buy B at the blue prices, and
sell it to you at the green prices. Profits.
First green then blue prices: I buy A at the green prices, and
sell it to you at the blue prices. Profits.
Sum of profits measures irrationality.

27 / 28

Budget Sets and

Utility
Maximization

Findings

The Rational
Consumer

494 households.

The Budget Set

Utility Functions

395 do not maximize utility.

Utility
Maximization

6.22% average money pump index.

(% of total food expenditure.)

Revealed
Preferences
Evidence

Many violations of utility maximization.

But they are quite small.

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