Optimal Choice

Solving the consumers problem Choosing the best affordable bundle

Outline
Optimization principle

The optimal choice

Graphically Analytically

Indirect utility Example

Optimization Principle
Given a fixed amount of income to spend, to

maximize utility, an individual will buy goods and services:

that exhaust his or her total income

for which the consumers rate of trade-off between

any goods (MRS) is equal to the rate at which goods can be traded for one another in the marketplace (relative price)

Optimal choice - Graphically

Affordability + preferences
Quantity of y
A C B
U3 U2 U1

The individual can do better than point A by reallocating his budget The individual cannot have point C because income is not large enough Point B is the point of utility maximization Quantity of x

Optimal choice - Graphically

Why is the optimal bundle on the budget line?

Optimal choice - Graphically

First-Order Conditions for a Maximum:

Utility is maximized where the indifference curve is tangent to the budget constraint
Quantity of y

slope of budget constraint

px py
dy dx

slope of indifference curve

px dy py dx

U constant

U2

MRS
U constant

Quantity of x
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Optimal choice - Graphically

Pay attention to the signs!!!
slope of budget constraint
slope of indifferen ce curve

px py

dy dx U constant

dy U / x MRS dx U constant U / y
px dy MRS py dx U constant
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Optimal choice - Graphically

The tangency rule is only a necessary condition
Quantity of y

U2 U1

There is a tangency at point A, but the individual can reach a higher level of utility at point B
Quantity of x

we need MRS to be diminishing

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Optimal choice - Graphically

Second order condition for a maximum
The tangency rule is necessary but not sufficient

unless we assume that

MRS is diminishing
Diminishing MRS 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

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Optimal condition - Graphically

Even if
indifference curves are strictly convex
MRS is diminishing

tangency is necessary and sufficient condition for a maximum

the shape of the indifference curve can be problematic

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Optimal choice - Graphically

Corner Solutions:

Utility is maximized by choosing to consume only one of the goods

Quantity of y
U1 U2 U3

At point A, the indifference curve is not tangent to the budget constraint

Utility is maximized at point A Quantity of x

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Optimal choice - Analytically

Problem:

Maximize subject to

utility = U(x1,x2,,xn)
p1x1 + p2x2 ++ pnxn = M

Set up the Lagrangian:

= U(x1,x2,,xn) + (M - p1x1 - p2x2 -- pnxn)

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Optimal choice - Analytically

FOCs for an interior maximum:

/x1 = 0 U/x1 = p1
/x2 = 0 U/x2 = p2

/xn = 0 U/xn = pn / = 0 M - p1x1 - p2x2 -- pnxn = 0
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Optimal choice - Analytically

FOCs for an interior maximum:

MUx1 = p1
MUx2 = p2

MUxn = pn / = 0 M - p1x1 - p2x2 -- pnxn = 0
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Optimal choice - Analytically

For any pair of commodities,

U / x i pi U / x j p j

MRS xi , x j

pi pj

Tangency condition: Market rate of exchange of xi

for xj must be equal to the consumers marginal rate of substitution of xi for xj

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Optimal choice - Analytically

The Lagrangian multiplier

U / x1 U / x 2 U / x n ... p1 p2 pn

MU x1 p1

MU x2 p2

...

MU xn pn

is the marginal utility of an extra pound of consumption

expenditure marginal utility of income

Tangency condition: the marginal utility per pound spent on each

commodity is the same

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Optimal choice - Analytically

pi MU xi

Assume constant marginal utility of income

Variations of pi are directly proportional to the extra

utility derived from that good At the margin, the price of a good represents the consumers evaluation of the utility of the last unit consumed
how much the consumer is willing to pay for the last unit

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Optimal choice - Analytically

Corner solutions
MRS price ratio
Standard FOC doesnt hold Changes:

/xi = U/xi - pi 0 (i = 1,,n)

If /xi = U/xi - pi < 0, then xi = 0

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Optimal choice - Analytically

If /xi = U/xi - pi < 0, then xi = 0 This means that

U / x i MU xi pi

any good whose price exceeds its marginal value to the consumer will not be purchased

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Indirect utility
Solving the FOCs and the budget equality we

derive the optimal values for x1,x2,,xn

x*1 = x1(p1,p2,,pn,M) x*2 = x2(p1,p2,,pn,M) x*n = xn(p1,p2,,pn,M) *= *(p1,p2,,pn,M)

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Indirect utility
Substituting the optimal values x*1,x*2, x*n in the

utility function U we obtain its maximum value

maximum utility = U(x*1,x*2,,x*n) = V(p1,p2,,pn,M)

The optimal level of utility will depend indirectly on prices and income
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Indirect utility
Consider

maximum utility =
V*(x1(p1,p2,,pn,M), x2(p1,p2,,pn,M),, xn(p1,p2,,pn,M)) = V*(M)
V* = : - Rate at which changes in M cause changes

in the optimized value of the objective function

- Marginal change in the maximum utility with respect to changes in income

- Marginal utility of income

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Indirect utility
Roys identity

Given the indirect utility function we can derive the demand function
Application of the envelope theorem The envelope theorem concerns how the optimal value for a function changes when a parameter of the function changes The change in the optimal value of a function with respect to a parameter of that function can be found by partially differentiating the objective function while holding the xs at their optimal value

dy * f da a

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Indirect utility
= U(x1,x2) + (M - p1x1 - p2x2)

U * L x1 ( p1 , p2 , M ) dp1 dp1
U * dM

U * U * x1 ( p1 , p2 , M ) dp1 dM
U * V dp1 dp1 x1 ( p1 , p2 , M ) U * V dM dM

Roys Identity

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