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Utility Maximization

The document discusses consumer utility maximization, outlining the consumer's problem of choosing an affordable bundle to maximize utility given a budget constraint. It introduces the concepts of marginal rate of substitution and consumer equilibrium, and presents a method using Lagrange multipliers to find the optimal bundle. An example is provided to illustrate the application of these concepts in determining the optimal quantities of two goods.

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4 views3 pages

Utility Maximization

The document discusses consumer utility maximization, outlining the consumer's problem of choosing an affordable bundle to maximize utility given a budget constraint. It introduces the concepts of marginal rate of substitution and consumer equilibrium, and presents a method using Lagrange multipliers to find the optimal bundle. An example is provided to illustrate the application of these concepts in determining the optimal quantities of two goods.

Uploaded by

tharundatalinkework
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Utility Maximization

Let the consumer has a utility function of the form U = f (x, y) and
the total income available to her is m while the prices are Px and Py .
The consumer’s problem is choose the affordable bundle that maximi-
zes her utility.

The feasible set: The consumer cannot spend more than the total
income m. Thus,
Px ∗ x + Py ∗ y ≤ m (1)
Since monotonicity, i.e., more is better holds for the consumer’s choice
of bundle, so the inequality of eq.2 becomes equality

Px ∗ x + P y ∗ y = m (2)

Figure 1: The Budget Constraint (Feasible Set)

The slope of the budget constraint is given as:


Px
slope = − (3)
Py

We know that the indifference curve exhibit diminishing marginal rate


of substitution and this is reflected in the slope of the indifference
curves. The slope is given by
dy
M RSyx = − |du = 0 (4)
dx
i.e., the marginal rate of substitution of y for x is the negative of the
slope of the indifference curve in figure 2.

1
Figure 2: Consumer’s Equilibrium

Also, we know that:


M Ux
M RSyx = (5)
M Uy

The optimal bundle for the consumer is one where the following two
conditions are fulfilled:
a. The bundle must lie on the budget line;
b. The indifference curve must be tangent to the budget line at the
point of optimal bundle.

From (3), (4), and (5), we get that at point of consumer’s equilibrium
(ignoring the negative signs):
Px M Ux
M RSyx = = (6)
Py M Uy

2
Using Lagrange multiplier to find consumer’s equilibrium:

Let the Utility function of the consumer be given by U = f (x, y) and


the feasible set by Px ∗ x + Py ∗ y = m.
We set the Lagrange function as:

L = U (x, y) + λ(m − Px ∗ x − Py ∗ y) (7)

getting the first order conditions for the eq.7 and setting it equal to
zero shall give us values of x and y that are in the optimal bundle.

Example: Let U = x0.25 0.75


1 x2 , m = Rs100; P x1 = Rs2 and P x2 =
Rs4. Find the optimal bundle of x1 and x2 for the consumer.
Solution:
Set the Lagrangian function as:

L = x0.25
1 x2
0.75
+ λ(m − P x1 ∗ x1 − P x2 ∗ x2 ) (8)

Setting the first order conditions equal to zero, we get:

∂L
= 0.25x−0.75
1 x0.75
2 − 2λ = 0 (9)
∂x1
and,
∂L −0.25
= 0.75x0.25
1 x2 − 4λ = 0 (10)
∂x2
and,
∂L
= 100 − 2x1 − 4x2 = 0 (11)
∂λ
3
Solving eq. 9 and 10 gives x2 = x1 .
2
Substituting value of x2 in eq. 11 gives x∗1 = 12.5 and x∗2 = 18.75.

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