Consumer Optimisation

Today we will
 Look at 3 examples of the ‘consumer’s
problem’ and work out the optimal
consumption bundle.
 Contrast the various ways to find the
optimum.
 Contrast the different types of optimum that
may occur.
A quick review
 To find the optimum we can use:
 Option 1: We can draw the consumers budget
constraint and indifference curves and see which
consumption bundle would maximise utility.
 Option 2: We can solve this constrained
optimisation problem using mathematical
techniques such as the 1. tangency condition, or
2. Lagrangian.
 The best thing to do: Use a combination of
options 1 and 2.
Example 1
The consumer wishes to

Max U ( x, y )  2 xy
subject to p x x  p y y  m; x  0; y  0
 Draw the solution
The budget constraint is linear with equation m px
y= - x.
py py

Preferences are convex. An indifference

y curve has equation U
y
2x

The optimal bundle (x*, y*) will be

y* an interior, tangency solution.

If pX = pY = 1 the optimal
B.C. U=k bundle should be (m/2,
m/2).
x* x
 Tangency condition
 Now we know that there is a tangency
solution we can use the tangency condition
PX MU X

PY MU Y
 In this example

 (2 xy)  (2 xy )
MU X   2 y and MU Y   2 x.
x ∂y
Tangency condition cont.
 Substituting into the tangency condition we
get P 2y
X
 .
PY 2x
 Rearranging gives condition yPY  xPX .
 Note that this means the consumer will spend the
same amount on good X as good Y, irrespective of
prices or income. This signifies homothetic
preferences.
Tangency condition finished
 We can substitute yPY  xPX into the
budget constraint p x x  p y y  to
m give the
consumer’s optimum consumption bundle

m m
x*  and y*  .
2 px 2 py
Prefer the Lagrangian?
 The Lagrangian is
L  2 xy   ( p x x  p y y  m)
 We need ∂L ∂L ∂L
= 0; = 0; =0
∂x ∂y ∂λ
 This gives

2 y  p x 2 x  p y and xpx  yp y  m
 Solving this gives the optimal solution as on
the previous slide.
A note on the Lagrangian
 What does λ mean?
 It is possible to show that λ is the marginal
utility of income. dU

dm
 In the example dU m

dm p y p x
 In consumer theory this does not mean much if U
is ordinal. But, more generally λ is the marginal
change in objective from relaxing the constraint.
Sometimes this is useful to know.
Summary of Example 1
 We first of all checked that there was an
interior, tangency solution. We did this by
checking the budget constraint was linear
and preferences convex.
 We then used two mathematical methods to
obtain an answer.
 We then checked that the answer was
sensible.
Example 2
The consumer wishes to

Max U ( x, y )  x  3 y
subject to p x x  p y y  m; x  0; y  0
 Draw the solution
The budget constraint is linear with equation y  m  p x x.
py

Preferences are linear. An indifference

y curve has equation U x
y
3

The optimal bundle (x*, y*)

y* will be boundary solution.

B.C. U=k

x* x
Find the solution
 The marginal rate of substitution is
MU X 1
 .
MU Y 3
 The consumer should consume just good X if
MU X px
 or p y  3 px
MU Y py
 The consumer should consume just good Y if
MU X px
 or p y  3 px .
MU Y py
A comment on Lagrangian
 The Lagrangian (as you know it) will not work
here (try it and see).
 Instead we need to use the Kuhn-Tucker
conditions to recognize the constraints x ≥ 0
and y ≥ 0.
 Doing this gives us more conditions including
x( MU x  p x )  0 and y ( MU y  p y )  0
Summary of Example 2
 In this example it was essential to realise that
we would obtain a boundary solution.
 Once we knew the answer would be a
boundary solution we can find when the
px )  0

consumer should only buy X and when he

should only buy Y.
Example 3
The consumer wishes to

0.5
Max U ( x, y )  x  y
subject to p x x  p y y  m; x  0; y  0
 Draw the solution
The budget constraint is linear with equation y  m  p x x.
py

Preferences are convex. An indifference

y curve has equation 2
y  (U  x )

The optimal bundle (x*, y*) may be

y* an interior, tangency solution.

But, it could also be

B.C. B.C.
U=k
a boundary solution!

x* x
 Look for a tangency solution
 Let’s try the tangency condition
PX MU X

PY MU Y
 In this example
0.5 0.5
( x  y ) ( x  y )
MU X   1 and MU Y   0.5 y 0.5 .
x y
 So, we get

px 1 0.5
  0.5
 2y .
p y 0.5 y
The tangency solution
 Rearranging we get
2
1  p x 
y .
4  p y 
 Using the budget constraint gives
m py m 1 px
x y   .
px px px 4 p y
 We need to check, however, that x ≥ 0 and
y ≥ 0.
The solution
 It is clear that y is always positive so,
2
1  p x 
y .
4  p y 
 In order that x is positive we need
2
m 1 px p
  0 or m  . x
px 4 p y 4 py
2
 So x = 0 if p
m x
.
4 py
Summary of Example 3
 In this example there can be an interior,
tangency solution.
 We found what an interior tangency solution
would look like.
 We then checked when we would obtain a
boundary solution.
Need more practice?
 Try the following:
0.25 0.75
U ( x, y )  x y
U ( x, y )  x  2 y
0.25 0.25
U ( x, y )  x y
0.25
U ( x, y )  xy  x
0. 5
U ( x, y )  x  x  2y
2 2
U ( x, y )  x  y
Where to from here?
 In deriving the consumer’s optimum we have
been deriving his demand function and Engel
Curve. On Friday we shall talk about these in
more detail.
 Reading: Varian Chapter 5 including the
Appendix. Morgan, Katz and Rosen Chapter
2. Renshaw Sections 15.12, 16.4, 16.9.
 You can also now try quite a few past exam
questions.