Utility maximisation

In this class we shall look closely at the typical consumer maximisation problem under certainty: max u(x) s.t. p1x1 + p2x2 w and xi 0 i = 1, 2 x where pi is the unit price of good i, and w is the consumers xed wealth. We assume that the utility function for goods, u(x) is strictly increasing in both x1 and x2, and strictly concave in the vector x. We also assume that it is a continuous function, with continuous derivatives, u(x) and so our assumptions on increasingness can be written more easily as x > i 0 i = 1, 2. (1)

Our assumption on concavity is; u(x1 + (1 )x2) > u(x1) + (1 )u(x2) Thus, the indierence curves corresponding to u(x), drawn in (x1, x2) space, are decreasing and strictly convex, and indierence curves located further from the origin correspond to greater levels of utility. From the implicit function theorem, the slope of the indierence curve passing through any given point x at that point is
u(x) x1 dx2 = u(x) dx1 du(x)=0 x2

x1, x2 and (0, 1)

This quantity is normally known as the marginal rate of substitution, or MRS(x) for short. The budget constraint for the problem is p1x1 + p2x2 w. The expenditure function, g(p, x) = p1x1 + p2x2 is linear in both of the x variables, and so the expenditure function is linear in the x vector. Its contours, drawn in (x1, x2) space, and holding g(p, x) constant, are straight lines. Again, directly from the implicit function theorem, the slope of a contour of the expenditure function is
g(p,x) x1 dx2 p = 1 = g(p,x) dx1 dg(p,x)=0 p2 x2

One of these contours is that corresponding to g(p, x) = w, and this particular contour of the expenditure function is what is commonly known as the budget line in elementary microeconomics courses. The feasible set for our problem, as always viewed in (x1, x2) space, is simply the triangle formed by the two axes of the cartesian coordinate graph and the budget line. This feasible set is commonly called the budget set for the problem. Our problem is to determine the point x located within the feasible set for which utility is maximised. Graphically, the solution is very simple to locate. If we denote the solution by x, then it must hold that p1x + p2x = w. 1 2

Secondly, note that unless the optimal point is at one of the extreme vertices of the budget set, it must correspond to a point of tangency between the budget line and an indierence curve

u(x) x1

p = 1 u(x) p2 x2

This tangency condition can be thought of as one equation in two unkowns, the two elements of the optimal x vector. The other equation in the same two unknowns that we need is, of course, the budget line in question p1x +p2x = 1 2 w. The simultaneous solution to these two equations will give a unique solution to the problem.

It is worthwhile to re-do the above problem using the Kuhn-Tucker method. The Lagrange function for the problem at hand is: L(x, ) = u(x) + 1 [0 + x1] + 2 [0 + x2] + 3 [w p1x1 p2x2] where the variables are the Lagrange multipliers. Denoting the solution vector by x, the rst-order conditions are: u(x) + i 3pi = 0 i = 1, 2 xi and the complementary slackness conditions are: ix = 0 , i = 1, 2 ; 3 [w p1x p2x] = 0 1 2 i (2)

(3)

The rst thing to notice is that again we can be sure that the budget constraint will saturate, w = p1x + p2x. 1 2 To see why, note that if we can show that in any solution we always get 3 > 0, then directly from the third complementary slackness condition we would know that w = p1x + p2x. 1 2 So, write the rst-order conditions as: u(x) + i = 3pi i = 1, 2 xi and multiply this by x, so that from the complementary slackness conditions i we can ignore the term ix, and so we get i u(x) xi = 3pix i = 1, 2 i xi

Now, we sum these two equations to obtain

2 X u(x) x = 3 (p1x + p2x) 3w 1 2 xi i i=1

Thus, any solution must statisfy

2 1 X u(x) 3 xi w i=1 xi

(4)

The RHS of this is necessarily positive (given w > 0 at least one of the optimal quantities x must be strictly positive since marginal utility is positive i by assumption, and so any vector with at least one positive component will always give greater utility than the point xi = 0 i = 1, 2). Thus, we have indeed shown that, conditional upon the logical requisite that w is strictly positive, 3 > 0 and so the budget constraint will always saturate.

Since all of the wealth will be spent, we can infact eliminate the inequality from equation (4), and so we can calculate the exact value of the Lagrange multiplier corresponding to the budget constraint as
2 1 X u(x) xi 3 = w i=1 xi

(5)

So to calculate the optimal vector, we canisubstitute the third complementary h slackness condition, 3 w p1x p2x = 0, for the equation w = p1x + 1 2 1 . p2x2 Now, since i 0 i = 1, 2, if the solution were to satisfy x > 0 i = 1, 2, then i the complementary slackness conditions would indicate that i = 0, i = 1, 2. In this case, the rst-order conditions would be written as u(x) = 3pi; i = 1, 2 xi (6)

Dividing the rst equation of (6) by the second gives the tangency condition

u(x) x1 u(x) x2

p1 p2

(7)

Of course, since the left-hand-side of the tangency condition is the absolute value of marginal rate of substitution, and the right-hand-side is the absolute value of the slope of the budget line, we know that any internal solution must be a point of tangency between an indierence curve and the budget line. [tbp]

Mathematically, for the case of an interior solution, the equations (7) and p1x + p2x = w, form a system of two simultaneous equations in the two 1 2 unknowns (x, x), the solution of which is the optimal vector for the problem. 1 2 If the solution is not interior, that is one of the two quantities x or x is 1 2 equal to zero, then the solution will not in general be given by the tangency

condition. These types of cases, known as corner solutions can still be easily e calculated from the tangency condition. If we denote by x the point that does satisfy (7), then the optimal vector (the point x that simultaneously satises (2) and (3)) is found as: x =
n e e x if xi 0; i = 1, 2 w e (xi = 0, xj = p ) if xi < 0; i, j = 1, 2; i 6= j
j

In all that follows, unless we specically state otherwise, we shall simply assume that the solution to the problem is interior, and so is calculated directly from the tangency condition and the budget line.

Marshallian Demand and Indirect Utility

The optimal vector is in eect a function of the price vector, p = (p1, p2), and the consumers wealth, w. We can write this as x = (x(p, w), x(p, w)). The functions x(p, w) are 1 2 i known as the Marshallian demand curves for the two goods in question. An important function that can be dened from the Marshallian demand curves is the indirect utility function, which is found by substituting the demand curves back into the direct utility function; u(x) = v(p, w). In order to dierentiate between direct utility (the utility of goods), and indirect utility (a function of prices and wealth), it is customary to dene the latter by v.

Since we are assuming a strictly interior solution, we have i = 0 i = 1, 2, and so we can dene 3 . The three equations that determine the optimal values of the three unknowns, x, x and , are: 1 2 p1x + p2x = w ; 1 2 u(x) = pi; i = 1, 2 xi (8)

Consider the eect on the level of utility in the optimal solution of an increase in wealth. The derivative of v(p, w) = u(x) with respect to w is: v(p, w) u(x) x u(x) x 1+ 2 = w x1 w x2 w

Using the rst-order conditions (8), this can be written as: v(p, w) = w

x x p1 1 + p2 2 w w

In any optimal solution (that is, both before and after the increase in w) p1x + p2x = w, and so we can derive this restriction with respect to w, 1 2 which reveals the result: x x p1 1 + p2 2 = 1 w w Substituting this into the previous equation, it turns out that: v(p, w) =>0 w

So we will refer to as the marginal utility of wealth, an important concept in microeconomics. Since is always strictly positive, we know that an increase in wealth will always increase utility. The nal result that we should look at here is also perhaps the most important; the concavity of the indirect utility function in wealth. That utility should be concave in wealth is an often assumed characteristic, and it is most important to the economics of risk and uncertainty, which we shall look at later on. It turns out that it is true that indirect utility is concave in wealth, but only conditional upon the direct utility function being concave in the vector of goods.

The result can be proved as follows. Hold prices constant, and compare the optimal solution to the utility maximisation problem with two dierent levels of wealth, say w1 and w2. Call the solutions to these two problems, respectively, x1 and x2. Now consider the utility maximisation problem with wealth equal to w1 + (1 )w2 = w3. Call the solution to that problem x3. We know that p1x1 + p2x1 = w1 and that p1x2 + p2x2 = w2. 1 2 1 2 Multiplying the rst of these equations by and the second by (1 ), and summing them gives (p1x1 + p2x1) + (1 )(p1x2 + p2x2) = w1 + (1 )w2 = w3 1 2 1 2

Bringing together common terms, p1[x1 + (1 )x2] + p2[x1 + (1 )x2] = w3 1 1 2 2

However, this implies that the vector x1 + (1 )x2 is feasible (but not necessarily optimal) when wealth is w3 i.e. u(x3) u(x1 + (1 )x2)

Finally, then, if utility is concave, we have u(x1) + (1 )u(x2) < u(x1 + (1 )x2) u(x3) v(p, w1) + (1 )v(p, w2) < v(p, w3) that is, the indirect utility function is concave in wealth.

But since, by denition, u(xi) = v(p, wi), this reads

In some instances, we are also interested in the slope of the indirect utitility function in prices, but not for Econ 321. For the rest of the course we shall hold prices constant, and we shall be explicitly interested in the relationship between indirect utility and wealth.