Consumer Optimisation
Consumer Optimisation
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
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
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
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
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.