Chapter 2.

1
OPTIMAL CHOICE
Dr. Nguyen Bich Diep
[email protected]
OPTIMAL CHOICE

• Consumers choose the most preferred bundle from those available to

them.
• The available choices constitute the choice set (the budget set).
INTERIOR OPTIMUM
x2

(x1*,x2*) is the most

preferred affordable
bundle.
x2*

x1* x1
INTERIOR OPTIMUM

• The most preferred affordable bundle is called the consumer’s

ordinary demand (Marshallian demand) at the given prices and
budget.
• Ordinary demands will be denoted by x1*(p1,p2,m), x2*(p1,p2,m).
INTERIOR OPTIMUM
x2

When x1* > 0 and x2* > 0, the

demanded bundle (x1*,x2*) is
interior
x2*

x1* x1
INTERIOR OPTIMUM
x2

(x1*,x2*) exhausts the budget:

p1x1* + p2x2* = m

x2*

x1* x1
INTERIOR OPTIMUM
x2

The slope of the indifference curve

at (x1*,x2*) equals the slope of the
budget constraint.
x2*

x1* x1
BOUNDARY OPTIMUM
x2
The optimal point occurs
where the consumption
of one of the goods is
zero. (Here x2* = 0).

x1* x1
BOUNDARY OPTIMUM
x2
The slope of the
indifference curve at
(x1*,x2*) and the slope of
the budget line are
different, but the
indifferent curve does
not cross the budget line.

x1* x1
KINKY TASTES
x2 The indifference
curve has a kink at
the optimal choice,
and a tangent is not
defined.

x2*

x1* x1
COMPUTING ORDINARY DEMANDS

• The optimal choice (x1*,x2*) is called the consumer’s demanded

bundle.
• The demand function is the function that relates the optimal choice –
the quantities demanded – to the different values of prices and
incomes.
INTERIOR DEMANDS

• When x1* > 0 and x2* > 0 and (x1*,x2*) exhausts the budget, and
indifference curves have no kinks, the ordinary demands can be obtained
by solving 2 equations:
(a) budget constraint: p1x1* + p2x2* = m
(b) tangency condition: the slopes of the budget and of the indifference
curve at (x1*,x2*) are equal.
INTERIOR DEMANDS: COBB-DOUGLAS
PREFERENCES
• Suppose that the consumer has Cobb-Douglas preferences:
U ( x 1 , x 2 ) = x 1a x b2
• Then: U
MU1 = = ax 1a − 1x b2
 x1
U
MU 2 = = bx 1a x b2 − 1
 x2
INTERIOR DEMANDS: COBB-DOUGLAS
PREFERENCES
• So the MRS is
a−1 b
dx 2  U/ x 1 ax 1 x 2 ax 2
MRS = =− =− =− .
dx 1  U/ x 2 bx 1a x b2 − 1 bx 1

• At (x1*,x2*), MRS = -p1/p2 so

*
ax 2 p1 * bp1 * (A)
− =−  x2 = x1 .
bx*1 p2 ap 2
INTERIOR DEMANDS: COBB-DOUGLAS
PREFERENCES
• (x1*,x2*) also exhausts the budget:
* *
p 1x 1 + p 2 x 2 = m . (B)
INTERIOR DEMANDS: COBB-DOUGLAS
PREFERENCES

• So now we know the 2 equations:

* bp1 *
x2 = x1 (A)
ap 2
* *
p 1x 1 + p 2 x 2 = m .
(B)
INTERIOR DEMANDS: COBB-DOUGLAS
PREFERENCES
• Substitute * bp1 *
x2 = x1 (A)
ap 2
into (B)
p 1x *1 + p 2 x *2 = m .

* bp1 *
to get p1x 1 + p 2 x1 = m.
ap 2
INTERIOR DEMANDS: COBB-DOUGLAS
PREFERENCES
• We have: am
x*1 = .
( a + b )p1
• Substituting for x1* in budget equation
* *
p 1x 1 + p 2 x 2 = m
to get
bm
x*2 = .
( a + b )p 2
INTERIOR DEMANDS: COBB-DOUGLAS
PREFERENCES
• The most preferred affordable bundle for a consumer with Cobb-
Douglas preferences

U ( x 1 , x 2 ) = x 1a x b2
is

( x*1 , x*2 ) = ( am
,
bm
( a + b )p1 ( a + b )p 2
) .
INTERIOR DEMANDS: COBB-DOUGLAS
PREFERENCES
x2
a b
U( x 1 , x 2 ) = x 1 x 2
*
x2 =
bm
( a + b)p2

am x1
x*1 =
( a + b )p1
EXERCISE 1

A consumer has the following utility function: U(X,Y) = X ½ Y ½ . The

consumer’s disposable income is $100. The prices of the goods are PX
= $2 and PY = $4.
• What is this consumer’s optimal bundle?
• If the price of good X doubles, how will this consumer’s optimal
bundle change?
CORNER SOLUTION

• But what if x1* = 0 or x2* = 0, given consumer preferences?

• If either x1* = 0 or x2* = 0, then ordinary demand (x1*,x2*) is at a corner
solution to the problem of utility maximization.
CORNER: PERFECT SUBSTITUTES
x2
Indifference curve: MRS = -1

x1
CORNER: PERFECT SUBSTITUTES
x2
y
m
Indifference curve: MRS = -1
x*2 =
p2

Budget slope = -p1/p2

When p1 > p2

x*1 = 0 x1
CORNER: PERFECT SUBSTITUTES
x2
Indifference curve: MRS = -1

Budget slope = -p1/p2

when p1 < p2
x*2 = 0
* y
m x1
x1 =
p1
CORNER: PERFECT SUBSTITUTES

• So, when U(x1,x2) = x1+x2, the most preferred affordable bundle

(x1*,x2*) is:

 my 
( x1 , x 2 ) =  ,0 
* *
 p1  if p1 < p2
and
 m y 
( x1 , x 2 ) =
* *
 0,  if p1 > p2
 p2 
CORNER: PERFECT SUBSTITUTES
x2
Indifference curve: MRS = -1
y
m
p2 Budget slope = -p1/p2 with p1 = p2

x1
m
y
p1
CORNER: PERFECT SUBSTITUTES
x2
y
m All the bundles in the
p2 indifference curve are
equally preferred when
p1 = p2.

x1
y
m
p1
EXERCISE 2

Anne has a budget of $300 per month for meals. Her utility function is
2X + Y, where X is the number of home-cooked meals, and Y is the
number of restaurant meals. The cost of a home-cooked meal is $5, the
cost of a restaurant meal is $10.
• Write Anne’s budget constraint.
• What is special about Anne’s indifference curves?
• Find Anne’s optimal choice.
CORNER: NON-CONVEX PREFERENCES
x2

x1
CORNER: NON-CONVEX PREFERENCES
x2 The “tangency solution” is not
the most preferred affordable
bundle.
The most preferred
affordable bundle

x1
KINKY SOLUTIONS: PERFECT COMPLEMENTS
U(x1,x2) = min{ax1, x2}
x2

Demand: x2 = ax1

x1
KINKY SOLUTIONS: PERFECT COMPLEMENTS
x2 U(x1,x2) = min{ax1, x2}
MRS = - 
MRS is undefined
x2 = ax1
MRS = 0

x1
KINKY SOLUTIONS: PERFECT COMPLEMENTS
U(x1,x2) = min{ax1, x2}
x2
The most preferred
affordable bundle

x2 = ax1

x1
KINKY SOLUTIONS: PERFECT COMPLEMENTS
U(x1,x2) = min{ax1, x2}
x2
(a) p1x1* + p2x2* = m
(b) x2* = ax1*

x2 = ax1

x2*
x1
x1*
KINKY SOLUTIONS: PERFECT COMPLEMENTS

• From
a) p1x1* + p2x2* = m; (b) x2* = ax1*

Substituting x2* from (b) in (a), we have:

p1x1* + p2ax1* = m
KINKY SOLUTIONS: PERFECT COMPLEMENTS

• After rearrangement, we have:

m
*
x1 =
p1 + ap 2
• Then, from (b):
m am
*
x1 = ; x2 =
*
.
p1 + ap 2 p1 + ap 2
KINKY SOLUTIONS: PERFECT COMPLEMENTS
x2 U(x1,x2) = min{ax1, x2}

x*2 = x2 = ax1
am
p1 + ap2
m
x1
x*1 =
p1 + ap 2
EXERCISE 3

Peter likes to go to the movies, and whenever he goes there to watch a

movie, he always buys a popcorn bucket. He never buys popcorn on
any other occasions. Every month he spends $300 on this hobby.
Suppose that a movie ticket costs $40, and a popcorn bucket costs $10.
• Write Peter’s budget constraint.
• What is Peter’s optimal choice?
DISCRETE GOODS

Rice
The optimal bundle is
the one on the highest
indifference “curve”.

Automobiles
0 1 2 3 4
DISCRETE GOODS

Rice
If the price of automobiles
is very high, then the
consumer will choose zero
units of consumption.

Automobiles
0 1 2 3 4
DISCRETE GOODS

• Arithmetically, we can compare the utility of each bundle to see which

has the highest utility.
NEUTRALS AND BADS

• If one of the two commodities is a neutral or a bad, and the other

commodity is a good, the consumer will spend all of her money on the
good.
PROPERTIES OF DEMAND FUNCTIONS

• Comparative statics analysis of ordinary demand functions:

The study of how ordinary demands x1*(p1,p2,y) and x2*(p1,p2,y)
change as prices p1, p2 and income m change.
INCOME CHANGES

• How does the value of x1*(p1,p2,y) change as m changes, holding both

p1 and p2 constant?
• Income offer curve (income expansion path) illustrates the bundles of
goods that are demanded at different levels of income.
x2’’’
x2’’
x2’

x1’ x1’’ x1’’’

 Income
offer curve
x2’’’
x2’’
x2’

x1’ x1’’ x1’’’

INCOME CHANGES

• A plot of quantity demanded against income is called an Engel curve.

 y Engel
curve;
y’’’ good 2
y’’
y’
Income
offer curve y x2’x ’’ x ’’’ x2*
2 2

x2’’’ y’’’
x2’’ Engel
y’’ curve;
x2’ y’ good 1
x1’ x1’’ x1’’’ x1’ x1’’ x1’’’ x1*
INCOME CHANGES: COBB-DOUGLAS UTILITY

• An example of computing the equations of Engel curves; the Cobb-

Douglas case.
U ( x 1 , x 2 ) = x 1a x b2 .
• The ordinary demand equations are
* ay * by
x1 = ; x2 = .
( a + b )p1 ( a + b )p 2
INCOME CHANGES: COBB-DOUGLAS UTILITY

• Rearranged to isolate y:
( a + b )p1 *
y= x1 Engel curve for good 1
a
( a + b )p 2 *
y= x2 Engel curve for good 2
b
INCOME CHANGES: COBB-DOUGLAS UTILITY
y ( a + b )p1 *
y= x1
a Engel curve for good 1

x1*
y
( a + b )p 2 *
y= x2 Engel curve for good 2
b

x2*
INCOME CHANGES: PERFECT COMPLEMENTS

• The perfectly-complementary case:

U ( x 1 , x 2 ) = m in  x 1 , x 2  .
The ordinary demand equations are:

* * y
x1 = x 2 = .
p1 + p 2
INCOME CHANGES: PERFECT COMPLEMENTS

• Rearranged to isolate y, these are:

*
y = ( p1 + p 2 ) x1 Engel curve for good 1
*
y = ( p1 + p 2 )x 2 Engel curve for good 2
 y Engel
curve;
y’’’ good 2
y’’
x2 y’

x2’ x2’’ x2’’’ x2*

y
x2’’’
y’’’ Engel
x2’’
y’’ curve;
X2’ y’ good 1
x1’ x1’’ x1’’’ x1 x1’ x1’’ x1’’’ x1*
INCOME CHANGES: PERFECT SUBSTITUTES

• The perfectly-substitution case:

U( x1 , x 2 ) = x1 + x 2 .
• The ordinary demand equations are:
* 0 , if p1  p 2
x 1 ( p1 , p 2 , y ) = 
 y / p1 , if p1  p 2
* 0 , if p1  p 2
x 2 ( p1 , p 2 , y ) = 
 y / p 2 , if p1  p 2 .
INCOME CHANGES: PERFECT SUBSTITUTES

• Suppose p1 < p2. Then

*
*
x1 =
y and x2 = 0
p1
*
*
y = p 1x 1 and x 2 = 0.
INCOME CHANGES: PERFECT SUBSTITUTES
y y

y = p 1x *1 x*2 = 0 .

x1* x2*
0
Engel curve Engel curve
for good 1 for good 2
INCOME CHANGES

• Q: Are Engel curves straight lines in general?

• A: No. Engel curves are straight lines if the consumer’s preferences
are homothetic.
HOMOTHETICITY

• A consumer’s preferences are homothetic if and only if

(x1,x2) p (y1,y2)  (kx1,kx2) p (ky1,ky2)
for every k > 0.
• i.e., consumer’s MRS is the same on a straight line from the origin.
A NON-HOMOTHETIC EXAMPLE

• Quasilinear preferences are not homothetic:

U( x1 , x 2 ) = f ( x1 ) + x 2 .
• For example,
U( x 1 , x 2 ) = x1 + x 2 .
INCOME CHANGES: QUASI-LINEAR UTILITY
y
Engel curve
x2 for good 2

y x2*

Engel curve
for good 1
x1
~ x1*
x1 ~
x1
INCOME EFFECTS

• A good for which quantity demanded rises with income is called

normal.
• Therefore, Engel curves of normal goods are positively sloped.
INCOME EFFECTS

• A good for which quantity demanded falls as income increases is

called (income) inferior.
• Therefore, Engel curve of an income inferior good is negatively sloped.
 Engel
1 & 2 NORMAL y curve;
good 2
y’’’
y’’
y’
Income
x2’ x2’’ x2’’’ x2*
offer curve y
x2’’’ y’’’ Engel
x2’’ y’’ curve;
x2’ y’ good 1

x1’ x1’’ x1’’’ x1’ x1’’ x1’’’ x1*

1 INFERIOR & 2 NORMAL
y
x2 Engel curve
for good 2

x2*
y
Engel curve
for good 1

x1 x1*
OWN-PRICE CHANGES

• How does x1*(p1,p2,y) change as p1 changes, holding p2 and y

constant?
• Suppose only p1 increases, from p1’ to p1’’ and then to p1’’’.
• Price offer curve depicts the bundles of goods that are demanded at
different prices.
x2

p1= p1= p1’’ p1 = p1’

p1’’’
x1
x1*(p1’)
 p1

p1’

x 1*
x1*(p1’)

x1*(p1’)
 p1

p1’’

p1’

x1*(p1’’) x1*(p1’) x 1*

x1*(p1’’) x1*(p1’)
 p1

p1’’’

p1’’

p1’

x1*(p1’’’) x1*(p1’’) x1*(p1’) x1*

x1*(p1’’’) x1*(p1’’) x1*(p1’)

 p1
Ordinary
demand curve
p1’’’
for commodity 1

p1’’

p1’

x1*(p1’’’) x1*(p1’’) x1*(p1’) x1*

x1*(p1’’’) x1*(p1’’) x1*(p1’)

 p1
Ordinary
demand curve
p1’’’
for commodity 1

p1’’
p1 price
p1’
offer
curve
x1*(p1’’’) x1*(p1’’) x1*(p1’) x1*

x1*(p1’’’) x1*(p1’’) x1*(p1’)

OWN-PRICE CHANGES

• The curve containing all the utility-maximizing bundles traced out as

p1 changes, with p2 and y constant, is the p1-price offer curve.
• The plot of the x1-coordinate of the p1- price offer curve against p1 is
the ordinary demand curve for commodity 1.
OWN-PRICE CHANGES: COBB-DOUGLAS
UTILITY
• What does a p1 price-offer curve look like for Cobb-Douglas preferences?
• Take U ( x 1 , x 2 ) = x 1a x b2 .
Then the ordinary demand functions for commodities 1 and 2 are:
a y
x*1 ( p1 , p 2 , y ) = 
a + b p1
* b y
x 2 ( p1 , p 2 , y ) =  .
a + b p2
OWN-PRICE CHANGES: COBB-DOUGLAS
UTILITY
• Notice that x2* does not vary with p1 so the p1-price offer curve is flat,
and the ordinary demand curve for commodity 1 is a rectangular
hyperbola.
 Fixed p2 and y.
x2

x*2 =
by
( a + b )p 2

x1*(p1’’’) ay1’)
x1*(p x1
*
x1 =
( a + b )p1
x1*(p1’’)
OWN-PRICE CHANGES: PERFECT
COMPLEMENTS
• What does a p1 price-offer curve look like for perfect complements?
U ( x 1 , x 2 ) = m in  x 1 , x 2  .

• Then the ordinary demand functions for commodities 1 and 2 are:

y
x*1 ( p1 , p 2 , y ) = x*2 ( p1 , p 2 , y ) = .
p1 + p 2
OWN-PRICE CHANGES: PERFECT
COMPLEMENTS
• With p2 and y fixed, higher p1 causes smaller x1* and x2*.

* * y
As p1 → 0 , x1 = x 2 → .
p2
* *
As p1 →  , x1 = x 2 → 0.
x2

x1
 p1

x2
y/p2

x*2 = p1’
y
p1’+ p2 y x 1*
x*1 =
1 + p2
p’

x1
y
x*1 =
’+ p2
p1
 p1

x2
y/p2 p1’’

p1’
x*2 =
y y x 1*
p1’’+ p2 x*1 =
p1” + p 2

x1
y
x*1 =
p1’’ + p 2
 p1

P1’’’

x2
y/p2 P1’’

P1’

x*2 = y x 1*
y x*1 =
p1’” + p 2
p1’’’ + p2
x1
y
x*1 =
p1’’’ + p 2
 p1
Ordinary
demand curve
P1’’’
for commodity 1
is:
x2 y
y/p2 p1’’ x*1 = .
p1 + p 2
p1’
x*2 =
y
p1 + p2 y x 1*
p2

x1
y
x*1 =
p1 + p 2
OWN-PRICE CHANGES: PERFECT
SUBSTITUTES
• What does a p1 price-offer curve look like for perfect substitutes?
U( x1 , x 2 ) = x1 + x 2 .
• Then the ordinary demand functions for commodities 1 and 2 are

* 0 , if p1  p 2
x 1 ( p1 , p 2 , y ) = 
 y / p1 , if p1  p 2
* 0 , if p1  p 2
x 2 ( p1 , p 2 , y ) = 
 y / p 2 , if p1  p 2 .
 x2

p1 = p1’ < p2

x*2 = 0 x1
* y
x1 =
p1’
 p1

x2

p1 = p1’ < p2
p1’

x 1*
* y
x1 =
p1’

*
x2 = 0 x1
* y
x1 =
p1’
 p1

x2

p1 = p1’’ = p2 p2 = p1’’

* y p1’
x2 =
p 2
    
 x 1*
 0  x*1 
y
 p2

x2 = 0 
*
   x1
* y
x1 = 0 *
x1 =
p2
 p1

p1’’’
x2

p1 = p1’’’ > p2 p2 = p1’’

* y p1’
x2 =
p2
x*1 = 0 x 1*

x1
x*1 = 0
 p1
Ordinary
demand curve
for commodity 1
P1’’’
x2 * y
x1 =
p1
p2 = p1’’
p1 price
y offer p1’
p2 curve
   
* y x 1*
0  x1 
p2

x1