Intermediate Microeconomic

Theory
Tools and Step-by-Step Examples

Chapter 3:
Consumer Choice
Outline
• Budget Constraint
• Utility Maximization Problem (UPM)
• Utility Maximization Problem in Extreme Scenarios
• Revealed Preference
• Kinked Budget Lines
• Appendix A. Lagrange Method to Solve the UPM
• Appendix B. Expenditure Minimization Problem

Intermediate Microeconomic Theory 2

Budget Constraint

Intermediate Microeconomic Theory 3

 Budget Constraint
• The budget constraint is the set of bundles that the
consumer can afford, given the price of each good and her
income.
• Example:
The budget set for good 𝑥𝑥 (food) and 𝑦𝑦 (clothing) is
𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 ≤ 𝐼𝐼.
where 𝑝𝑝𝑥𝑥 is the price of each unit of food;
𝑝𝑝𝑦𝑦 is the price of each unit of clothing;
𝐼𝐼 is the consumer’s available income to spend on food
and clothing.

Intermediate Microeconomic Theory 4

 Budget Constraint
The budget set says that the total $ the consumer spends on
food, 𝑝𝑝𝑥𝑥 𝑥𝑥, plus total $ she spends on clothing, 𝑝𝑝𝑦𝑦 𝑦𝑦, cannot
exceed her available income, 𝐼𝐼.
If 𝑝𝑝𝑥𝑥 = $10 and 𝑝𝑝𝑦𝑦 = $0, and 𝐼𝐼 = $400, her budget
constraint is
10𝑥𝑥 + 20𝑦𝑦 ≤ 400.

Intermediate Microeconomic Theory 5

 Budget Constraint
• Bundles (𝑥𝑥, 𝑦𝑦) that satisfy:
• 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 < 𝐼𝐼
• the consumer does not use all her income.
• 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼
• the consumer spends all her income.
• We refer to 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼 as the budget line.

Intermediate Microeconomic Theory 6

 Budget Constraint

• Rearranging the budget line and

solving for 𝑦𝑦,
𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼 − 𝑝𝑝𝑥𝑥 𝑥𝑥,
𝐼𝐼 𝑝𝑝𝑥𝑥
𝑦𝑦 = − 𝑥𝑥.
𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦
Vertical intercept Slope

• Setting 𝑦𝑦 = 0, and solving for x

we find the horizontal intercept
at
𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 0 = 𝐼𝐼, Figure 3.1
𝐼𝐼
𝑥𝑥 = .
𝑝𝑝𝑥𝑥

Intermediate Microeconomic Theory 7

 Budget Constraint
• The slope of the budget line, tells us how many units of 𝑦𝑦
the consumer must give up to buy 1 more unit of 𝑥𝑥
• If 𝑝𝑝𝑥𝑥 = $10 and 𝑝𝑝𝑦𝑦 = $20, the slope is
𝑝𝑝𝑥𝑥 10 1
− =− =− .
𝑝𝑝𝑦𝑦 20 2

• The consumer must give up 1/2 units of good 𝑦𝑦 to acquire 1

more unit of good 𝑥𝑥, because good 𝑦𝑦 is twice as expensive as
good 𝑥𝑥.
• Alternatively, she must give up 1 unit of good 𝑦𝑦 to purchase 2
more units of good 𝑥𝑥.

Intermediate Microeconomic Theory 8

 Budget Constraint
• Changes in income:

• An increase in income from

𝐼𝐼 to 𝐼𝐼𝐼, where 𝐼𝐼 ′ > 𝐼𝐼, shifts
the budget line outward in a
parallel fashion.
• As income increase, she
can afford a larger set of
bundles.

Figure 3.2

Intermediate Microeconomic Theory 9

 Budget Constraint
• Changes in income (cont.):

• A decrease in income
produces the opposite, a
shifting inward in a parallel
fashion.

Figure 3.2

Intermediate Microeconomic Theory 10

 Budget Constraint
.
• Changes in prices:
• An increase in the price of one good, such as 𝑝𝑝𝑥𝑥 , pivots the
budget line inward.

𝐼𝐼
• The vertical intercept is
𝑝𝑝𝑦𝑦
unaffected.
𝐼𝐼
• The horizontal intercept
𝑝𝑝𝑥𝑥
moves leftward.

Figure 3.3a

Intermediate Microeconomic Theory 11

 Budget Constraint
.
• Changes in prices (cont.):
• An increase in the price of one good, such as 𝑝𝑝𝑥𝑥 , pivots the
budget line inward.
• The consumer faces a more
expensive good, shrinking
the set of bundles she can
afford.
• A decrease of 𝑝𝑝𝑥𝑥 has the
opposite effect, moving the
horizontal intercept
rightward.

Figure 3.3a

Intermediate Microeconomic Theory 12

 Budget Constraint
• Changes in prices (cont.):
• A similar argument applies if the price of good 𝑦𝑦, 𝑝𝑝𝑦𝑦 ,
increases.
• The horizontal
𝐼𝐼
intercept is
𝑝𝑝𝑥𝑥
unaffected.
• The vertical intercept
𝐼𝐼
moves down.
𝑝𝑝𝑦𝑦

Figure 3.3b

Intermediate Microeconomic Theory 13

 Budget Constraint
• Changes in prices (cont.):
• A similar argument applies if the price of good 𝑦𝑦, 𝑝𝑝𝑦𝑦 ,
increases.

• A decrease in 𝑝𝑝𝑦𝑦
moves the vertical
intercept up.

Figure 3.3b

Intermediate Microeconomic Theory 14

 Budget Constraint
• Query:
What would happen if both income and the price of all goods were
doubled?
• The budget line is unaffected!
2𝐼𝐼
• The vertical intercept of the budget line would become ,
2𝑝𝑝𝑦𝑦
𝐼𝐼
which simplifies to  no change in its position.
𝑝𝑝𝑦𝑦
2𝐼𝐼 𝐼𝐼
• The horizontal intercept is now , reducing to .
2𝑝𝑝𝑥𝑥 𝑝𝑝𝑥𝑥
2𝑝𝑝𝑥𝑥 𝑝𝑝
• And the slope does not change either, − = − 𝑥𝑥 .
2𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦

This argument applies to any common increase (decrease) in

all prices and income.

Intermediate Microeconomic Theory 15

Utility Maximization Problem

Intermediate Microeconomic Theory 16

 Utility Maximization Problem
• The process by which the consumer chooses utility-
maximizing bundles, that are bundles that maximize her
utility among all of those she can afford.

Figure 3.4

• Let’s test if points 𝐴𝐴 − 𝐷𝐷 are utility-maximizing for the

consumer.
Intermediate Microeconomic Theory 17
 Utility Maximization Problem
• Bundles 𝐶𝐶 and 𝐵𝐵 cannot be
optimal. She reaches 𝑢𝑢1 spending
all her income, 𝑝𝑝𝑥𝑥 𝑠𝑠 + 𝑝𝑝𝑦𝑦 = 𝐼𝐼. But
at bundle 𝐴𝐴 (with same spending)
she reaches a higher utility 𝑢𝑢2 ,
𝑢𝑢2 > 𝑢𝑢1 .
• Bundle 𝐷𝐷 cannot be optimal. It
yields a higher utility than 𝐴𝐴, but
it is unaffordable.
• Only bundle 𝐴𝐴 is optimal, where
the budget line and indifference Figure 3.4
curves are tangent each other.

Intermediate Microeconomic Theory 18

 Utility Maximization Problem
• This tangency condition requires that the slope of the budget line
𝑝𝑝𝑥𝑥
at bundle 𝐴𝐴, , is equal to the slope of the indifference curve,
𝑝𝑝𝑦𝑦
𝑀𝑀𝑀𝑀𝑥𝑥
𝑀𝑀𝑀𝑀𝑀𝑀 = .
𝑀𝑀𝑀𝑀𝑦𝑦

• Therefore, utility-maximizing bundles must satisfy

𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥 𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦
= or after rearranging = .
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦 𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
• This condition states that marginal utility per dollar spent on the last unit of
good 𝑥𝑥 must be equal to that of good 𝑦𝑦  bang for the buck must
coincide across all goods.
𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦
• If > , the consumer would obtain a larger bang for the
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
buck from 𝑥𝑥 than 𝑦𝑦, providing incentives to spend more $ in 𝑥𝑥.
Intermediate Microeconomic Theory 19
 Utility Maximization Problem
• Tool 3.1. Procedure to solve the UMP:
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
1. Set the tangency condition as = . Cross-multiply and
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦
simplify.
2. If the expression for the tangency condition:
a. Contains both unknowns (𝑥𝑥 and 𝑦𝑦), solve or 𝑥𝑥, and insert the
resulting expression into the budget line 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼.
b. Contains only one unknown (𝑥𝑥 or 𝑦𝑦), solve for that unknown,
and insert the result into the budget line 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼.

Intermediate Microeconomic Theory 20

 Utility Maximization Problem
• Tool 3.1. Procedure to solve the UMP (cont.):
2. If the expression for the tangency condition:
𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦
c. Contains no good 𝑥𝑥 or 𝑦𝑦, compare against .
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦
• If > , set good 𝑦𝑦 = 0 in the budget line and solve
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
for good 𝑥𝑥 (corner solution where the consumer purchases
only good 𝑥𝑥).
𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦
• If < , set 𝑥𝑥 = 0 in the budget line and solve for 𝑦𝑦
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
(corner solution where she purchases only good 𝑦𝑦).

Intermediate Microeconomic Theory 21

 Utility Maximization Problem
• Tool 3.1 Procedure to solve the UMP (cont.):
3. If, in step 2, you find that one of the goods is consumed in
negative amounts (e.g., 𝑥𝑥 = −2), then set the amount of this
good equal to 0 on the budget line (e.g., 𝑝𝑝𝑥𝑥 0 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼 ), and
solve for the remaining good.
4. If you haven’t found the values for all the unknowns, use the
tangency conditions from step 1 to find the remaining
unknown.

Intermediate Microeconomic Theory 22

 Utility Maximization Problem
• Example 3.1: UMP with interior solutions–I.
• Consider an individual with Cobb-Douglas utility function
𝑢𝑢 𝑥𝑥, 𝑦𝑦 = 𝑥𝑥𝑥𝑥.
facing 𝑝𝑝𝑥𝑥 = $20, 𝑝𝑝𝑦𝑦 = $40, and 𝐼𝐼 = $800.
• Step 1. We use the tangency condition to find optimal bundle
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
= ,
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦
𝑦𝑦 20 𝑦𝑦 1
= ⟹ = ,
𝑥𝑥 40 𝑥𝑥 2
2𝑦𝑦 = 𝑥𝑥.
This result contains both 𝑥𝑥 and 𝑦𝑦, so we move to step 2a.

Intermediate Microeconomic Theory 23

 Utility Maximization Problem
• Example 3.1 (continued):
• Step 2a. From the budget line, 20𝑥𝑥 + 40𝑦𝑦 = 800.
Inserting 2𝑦𝑦 = 𝑥𝑥 into the budget line,
20 2𝑦𝑦 + 40𝑦𝑦 = 800,
𝑥𝑥
80𝑦𝑦 = 800,
800
𝑦𝑦 = = 10 units.
80
Because the consumer purchases 10 units of 𝑦𝑦, we move to step 4 (recall
that we only need to stop at step 3 if 𝑥𝑥 or 𝑦𝑦 are negative in step 2).

• Step 4. To find the optimal consumption of 𝑥𝑥, we use the

tangency condition 𝑥𝑥 = 2𝑦𝑦 = 2 × 10 = 20 units.

Intermediate Microeconomic Theory 24

 Utility Maximization Problem
• Example 3.1 (continued):
• Summary. The optimal consumption bundle is (20,10).
𝑦𝑦 10 1
The slope of the indifference curve, = = , coincides
𝑥𝑥 20 2
𝑝𝑝𝑥𝑥 1
with that of the budget line, = .
𝑝𝑝𝑦𝑦 2

Intermediate Microeconomic Theory 25

 Utility Maximization Problem
• Example 3.2: UMP with interior solutions–II.
• Consider an individual with Cobb-Douglas utility function
𝑢𝑢 𝑥𝑥, 𝑦𝑦 = 𝑥𝑥 1/3 𝑦𝑦 2/3
facing 𝑝𝑝𝑥𝑥 = $10, 𝑝𝑝𝑦𝑦 = $20, and 𝐼𝐼 = $100.
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
Before using the tangency condition = , we first find
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦

1 13 −1 23 1 −23 23 2 1
+
𝑀𝑀𝑀𝑀𝑥𝑥 3 𝑥𝑥 𝑦𝑦
3
𝑥𝑥 𝑦𝑦 𝑦𝑦 3 3 𝑦𝑦
= = = = .
𝑀𝑀𝑀𝑀𝑦𝑦 2 13 23 −1 2 13 −13 1 2 2𝑥𝑥
𝑥𝑥 𝑦𝑦 𝑥𝑥 𝑦𝑦 2𝑥𝑥 3+3
3 3

Intermediate Microeconomic Theory 26

 Utility Maximization Problem
• Example 3.2 (continued):
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
• Step 1. We use the tangency condition =
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦
𝑦𝑦 10
= ,
2𝑥𝑥 20
𝑦𝑦 = 𝑥𝑥.
This result contains 𝑥𝑥 and 𝑦𝑦, so we move to step 2a.

Intermediate Microeconomic Theory 27

 Utility Maximization Problem
• Example 3.2 (continued):
• Step 2a. Inserting 𝑦𝑦 = 𝑥𝑥 into the budget line,
10𝑥𝑥 + 20𝑦𝑦 = 100,
20 𝑦𝑦 + 20𝑦𝑦 = 100,
30𝑦𝑦 = 100,
100
𝑦𝑦 = ≃ 3.33 units.
30

Intermediate Microeconomic Theory 28

 Utility Maximization Problem
• Example 3.2 (continued):
• Step 4. The optimal consumption of 𝑥𝑥 can be found by using
the tangency condition
𝑦𝑦 = 𝑥𝑥 ≃ 3.33 units.
• Summary. The optimal consumption bundle is (3.33, 3.33).

Intermediate Microeconomic Theory 29

 Utility Maximization Problem
• Example 3.2 (continued):
• We can find the budget shares of each good, that is the % of
income the consumer spends on good 𝑥𝑥 and good 𝑦𝑦:
𝑝𝑝𝑥𝑥 𝑥𝑥 10 × 3.33 1
= = ,
𝐼𝐼 100 3
𝑝𝑝𝑦𝑦 𝑦𝑦 20 × 3.33 2
= = .
𝐼𝐼 100 3
which coincides with the exponent of each good in the Cobb-
Douglas utility function 𝑢𝑢 𝑥𝑥, 𝑦𝑦 = 𝑥𝑥 1/3 𝑦𝑦 2/3 .
• This result can be generalized to all types of Cobb-Douglas
utility functions 𝑢𝑢 𝑥𝑥, 𝑦𝑦 = 𝐴𝐴𝑥𝑥 𝛼𝛼 𝑦𝑦 𝛽𝛽 , where A, 𝛼𝛼, 𝛽𝛽 > 0.
• The budget share of good 𝑥𝑥 is 𝛼𝛼, and of good 𝑦𝑦 is 𝛽𝛽.
Intermediate Microeconomic Theory 30
 Utility Maximization Problem
• Example 3.3: UMP with corner solutions.
• Consider a consumer with utility function 𝑢𝑢 𝑥𝑥, 𝑦𝑦 = 𝑥𝑥𝑥𝑥 + 7𝑥𝑥,
and facing 𝑝𝑝𝑥𝑥 = $1, 𝑝𝑝𝑦𝑦 = $2, and 𝐼𝐼 = $10.
𝑀𝑀𝑀𝑀 𝑝𝑝
• Step 1. Using the tangency condition 𝑀𝑀𝑀𝑀𝑥𝑥 = 𝑝𝑝𝑥𝑥 ,
𝑦𝑦 𝑦𝑦

𝑦𝑦 + 7 1
= ,
𝑥𝑥 2
2𝑦𝑦 + 14 = 𝑥𝑥.
This result contains 𝑥𝑥 and 𝑦𝑦, so we move to step 2a.

Intermediate Microeconomic Theory 31

 Utility Maximization Problem
• Example 3.3 (continued):
• Step 2. Inserting 2𝑦𝑦 + 14 = 𝑥𝑥 into the budget line
𝑥𝑥 + 2𝑦𝑦 = 10,
2𝑦𝑦 + 14 + 2𝑦𝑦 = 10,
𝑥𝑥
4𝑦𝑦 = −4,
𝑦𝑦 = −1.

Intermediate Microeconomic Theory 32

 Utility Maximization Problem
• Example 3.3 (continued):
• Step 3. Because the amounts of 𝑥𝑥 and 𝑦𝑦 cannot be negative,
the consumer would like to reduce her consumption of good
𝑦𝑦 as much as possible (i.e., 𝑦𝑦 = 0). Inserting this result into
the budget line
𝑥𝑥 + 2 × 0 = 10  𝑥𝑥 = 10 units.
• Summary. We have found a corner solution, where the
consumer uses all her income to purchase good alone.
• Graphically, her optimal budget (𝑥𝑥, 𝑦𝑦) = (10,0) is located in
the horizontal intercept of her budget line.

Intermediate Microeconomic Theory 33

 Utility Maximization Problem
• Example 3.3 (continued):
• At the corner solution, the tangency condition does not hold,
𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦 𝑦𝑦 + 7 𝑥𝑥
≠ ⇒ ≠ .
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦 1 2
0+7 10
At 𝑥𝑥, 𝑦𝑦 = (10,0), > .
1 2
• 𝑀𝑀𝑀𝑀𝑥𝑥 > 𝑀𝑀𝑀𝑀𝑦𝑦 , inducing the
consumer to increase her
consumption of 𝑥𝑥 and decrease
that of 𝑦𝑦.
• Once she reaches 𝑦𝑦 = 0, she
cannot longer decrease her Figure 3.5
consumption of 𝑦𝑦.

Intermediate Microeconomic Theory 34

UMP in Extreme Scenarios

Intermediate Microeconomic Theory 35

 UMP in Extreme Scenarios
• Goods are regarded as perfect substitutes:
• Consider two brands of mineral water. This utility function
takes the form 𝑢𝑢 𝑥𝑥, 𝑦𝑦 = 𝑎𝑎𝑎𝑎 + 𝑏𝑏𝑏𝑏, where 𝑎𝑎, 𝑏𝑏 > 0.
𝑀𝑀𝑀𝑀𝑥𝑥 𝑎𝑎
• In this scenario, = .
𝑀𝑀𝑀𝑀𝑦𝑦 𝑏𝑏
• Three cases can emerge:
𝑎𝑎 𝑝𝑝𝑥𝑥
1. > .
𝑏𝑏 𝑝𝑝𝑦𝑦
𝑎𝑎 𝑝𝑝𝑥𝑥
2. < .
𝑏𝑏 𝑝𝑝𝑦𝑦
𝑎𝑎 𝑝𝑝𝑥𝑥
3. = .
𝑏𝑏 𝑝𝑝𝑦𝑦

Intermediate Microeconomic Theory 36

 UMP in Extreme Scenarios
• Goods are regarded as perfect substitutes (cont.):
𝑎𝑎 𝑝𝑝𝑥𝑥
1. If > , the IC is steeper than the budget line, producing a
𝑏𝑏 𝑝𝑝𝑦𝑦
corner solution. The consumer spends all income on 𝑥𝑥.
Using the “bang for the buck” approach:
𝑎𝑎 𝑏𝑏
> ,
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦

the bang for the buck from 𝑥𝑥 is larger than that of 𝑦𝑦. So she
consumer would like to increase her consumption of 𝑥𝑥
while decreasing that of 𝑦𝑦.

Intermediate Microeconomic Theory 37

 UMP in Extreme Scenarios
• Goods are regarded as perfect substitutes (cont.):
𝑎𝑎 𝑝𝑝𝑥𝑥
2. If < , a corner solution exists, where the consumer
𝑏𝑏 𝑝𝑝𝑦𝑦
spends all her income on good 𝑦𝑦.
The optimal consumption bundle lies on the vertical
intercept of the budget line.

Intermediate Microeconomic Theory 38

 UMP in Extreme Scenarios
• Goods are regarded as perfect substitutes (cont.):
𝑎𝑎 𝑝𝑝𝑥𝑥
3. If = , the slope of the indifference curves and the
𝑏𝑏 𝑝𝑝𝑦𝑦
budget line coincide, yielding a complete overlap.
Tangency occurs at all points of the budget line  a
continuum of solutions exists, any bundle (𝑥𝑥, 𝑦𝑦) satisfying
𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼 is utility maximizing.

Intermediate Microeconomic Theory 39

 UMP in Extreme Scenarios
• Goods are regarded as perfect complements:
• Consider cars and gasoline. This utility function takes the form
𝑢𝑢 𝑥𝑥, 𝑦𝑦 = 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴{𝑎𝑎𝑎𝑎, 𝑏𝑏𝑏𝑏}, where A, 𝑎𝑎, 𝑏𝑏 > 0.
• The ICs are L-shaped, and have a kink at a ray from the origin
with slope 𝑎𝑎/𝑏𝑏.
• The MRS of this function is undefined, because the kink could
admit any slope.
• We cannot use the tangency condition as we cannot guarantee
that the MRS takes specific numbers for all bundles.
• Optimal bundles require to identify bundles for which we
cannot increase the consumer’s utility given her budget
constraint.

Intermediate Microeconomic Theory 40

 UMP in Extreme Scenarios
• Goods are regarded as perfect complements (cont.):
• She consumes the bundle at the kink of her IC where it
intersects her budget line.
• Mathematically, it requires
𝑏𝑏
• 𝑎𝑎𝑎𝑎 = 𝑏𝑏𝑏𝑏 ⇒ 𝑦𝑦 = 𝑥𝑥, for the bundle to be at the kink;
𝑎𝑎
• 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼, for the bundle to be on the budget line.
• We have system of two equations and two unknowns.
• Inserting the first equation into the second,
𝑎𝑎 𝐼𝐼 𝑏𝑏𝑏𝑏
𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑥𝑥 = 𝐼𝐼 ⇒ 𝑥𝑥 = 𝑎𝑎 = 𝑏𝑏𝑝𝑝 + 𝑎𝑎𝑝𝑝 .
𝑏𝑏 𝑝𝑝𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑥𝑥 𝑦𝑦
𝑏𝑏
𝑦𝑦

Intermediate Microeconomic Theory 41

 UMP in Extreme Scenarios
• Goods are regarded as perfect complements (cont.):
• The optimal amount of y becomes
𝑎𝑎 𝑏𝑏𝑏𝑏 𝑎𝑎𝑎𝑎
𝑦𝑦 = + = .
𝑏𝑏 𝑏𝑏𝑝𝑝𝑥𝑥 + 𝑎𝑎𝑝𝑝𝑦𝑦 𝑏𝑏𝑝𝑝𝑥𝑥 + 𝑎𝑎𝑝𝑝𝑦𝑦
𝑥𝑥

• If 𝑎𝑎 = 𝑏𝑏 = 2 (when the individual needs to consume the

same amount of each good), and 𝑝𝑝𝑥𝑥 = $10, 𝑝𝑝𝑦𝑦 = $20, and
𝐼𝐼 = $100, the optimal consumptions of 𝑥𝑥 and 𝑦𝑦 are
𝑏𝑏𝑏𝑏 2×100 10
𝑥𝑥 = = = units,
𝑏𝑏𝑝𝑝𝑥𝑥 +𝑎𝑎𝑝𝑝𝑦𝑦 2×10 +(2×20) 3
𝑎𝑎𝑎𝑎 2×100 10
𝑦𝑦 = = = units.
𝑏𝑏𝑝𝑝𝑥𝑥 +𝑎𝑎𝑝𝑝𝑦𝑦 2×10 +(2×20) 3

Intermediate Microeconomic Theory 42

Revealed Preferences

Intermediate Microeconomic Theory 43

 Revealed Preference
• Previously, we have analyzed how to find optimal bundles,
assuming we observe consumer’s preferences represented with
her utility function.
• What if we only know which choices she made when facing
different combinations of prices and income?
• We still can check if the consumer made optimal choices using
the Weak Axiom of Revealed Preferences (WARP).

Intermediate Microeconomic Theory 44

 Revealed Preference
• Consider:
• 𝐴𝐴 = (𝑥𝑥𝐴𝐴 , 𝑦𝑦𝐴𝐴 ) be the optimal bundle when facing initial prices
and income (𝑝𝑝𝑥𝑥 , 𝑝𝑝𝑦𝑦 , 𝐼𝐼).
• 𝐵𝐵 = (𝑥𝑥𝐵𝐵 , 𝑦𝑦𝐵𝐵 ) be the optimal bundle when facing final prices
and income (𝑝𝑝𝑥𝑥′ , 𝑝𝑝𝑦𝑦′ , 𝐼𝐼 ′ ).

Intermediate Microeconomic Theory 45

 Revealed Preference
• Weak Axiom of Revealed Preference (WARP). If optimal
consumption bundles 𝐴𝐴 and 𝐵𝐵 are both affordable under initial
prices and income (𝑝𝑝𝑥𝑥 ,𝑝𝑝𝑦𝑦 ,𝐼𝐼), then bundle 𝐴𝐴 cannot be affordable
under final prices and income (𝑝𝑝𝑥𝑥′ , 𝑝𝑝𝑦𝑦′ , 𝐼𝐼 ′ ):
• If 𝑝𝑝𝑥𝑥 𝑥𝑥𝐴𝐴 + 𝑝𝑝𝑦𝑦 𝑦𝑦𝐴𝐴 ≤ 𝐼𝐼 and 𝑝𝑝𝑥𝑥 𝑥𝑥𝐵𝐵 + 𝑝𝑝𝑦𝑦 𝑦𝑦𝐵𝐵 ≤ 𝐼𝐼,
• then 𝑝𝑝𝑥𝑥′ 𝑥𝑥𝐴𝐴 + 𝑝𝑝𝑦𝑦′ 𝑦𝑦𝐴𝐴 > 𝐼𝐼 ′ .

Intermediate Microeconomic Theory 46

 Revealed Preference
• Weak Axiom of Revealed Preference (WARP) (cont.).
• If both bundles are initially affordable, and the consumer
selects 𝐴𝐴, she is “revealing” her preference for 𝐴𝐴 over 𝐵𝐵.
• WARP requires 𝐴𝐴 is not affordable under final prices and
income, otherwise the consumer should still select the
original bundle 𝐴𝐴.
• Think on WARP as a consistency requirement in consumer’s
choices when facing different prices and incomes.

Intermediate Microeconomic Theory 47

 Revealed Preference
• Tool 3.2. Checking for WARP:
1. Checking the premise. Check if bundles 𝐴𝐴 and 𝐵𝐵 are initially
affordable  they lie on or below the budget line, 𝐵𝐵𝐵𝐵,
(𝑝𝑝𝑥𝑥 , 𝑝𝑝𝑦𝑦 , 𝐼𝐼).
1a. If step 1 holds, move to step 2.
1b. If step 1 does not hold, stop. We can only claim that the
consumer choices do not violate WARP.
2. Checking the conclusion. Check that bundle A is no longer
affordable  it lies strictly above the final budget line 𝐵𝐵𝐵𝐵𝐵,
(𝑝𝑝𝑥𝑥′ , 𝑝𝑝𝑦𝑦′ , 𝐼𝐼′).
2a. If step 2 holds, WARP is satisfied.
2b. If step 2 does not hold, WARP is violated.
Intermediate Microeconomic Theory 48
 Revealed Preference
• Example 3.4: Testing for WARP.
• Consider a change in the budget line, from 𝐵𝐵𝐵𝐵 to 𝐵𝐵𝐵𝐵′ , due to
a simultaneous decrease in 𝑝𝑝𝑥𝑥 and 𝐼𝐼.
• For instance,
• Initial bundle line 𝐵𝐵𝐵𝐵, 𝑝𝑝𝑥𝑥 = $2, 𝑝𝑝𝑦𝑦 = 2$, and 𝐼𝐼 = $100.
• Final bundle line 𝐵𝐵𝐵𝐵′ , 𝑝𝑝𝑥𝑥′ = $1, 𝑝𝑝𝑦𝑦 = 2$, and 𝐼𝐼 ′ = $100.

Intermediate Microeconomic Theory 49

 Revealed Preference
• Example 3.4 (continued):
• The vertical intercept of the budget line
𝐼𝐼 10 𝐼𝐼 ′ 7
decreases from = = 5 units to = = 3.5 units.
𝑝𝑝𝑦𝑦 2 𝑝𝑝𝑦𝑦 2

• The vertical intercept of the budget line

𝐼𝐼 10 𝐼𝐼 ′ 7
increases from = = 5 units to ′ = = 7 units.
𝑝𝑝𝑥𝑥 2 𝑝𝑝𝑥𝑥 1

Intermediate Microeconomic Theory 50

 Revealed Preference
• Example 3.4 (continued):
• Scenario (a). WARP is satisfied.

Step 1 holds. Bundles 𝐴𝐴 and 𝐵𝐵

are affordable under 𝐵𝐵𝐵𝐵:
• 𝐴𝐴 lies on 𝐵𝐵𝐵𝐵.
• 𝐵𝐵 lies strictly below 𝐵𝐵𝐵𝐵.
Step 2 holds. Bundle A is
unaffordable under 𝐵𝐵𝐵𝐵′ :
• 𝐴𝐴 lies strictly above 𝐵𝐵𝐵𝐵′ .

Figure 3.6a

Intermediate Microeconomic Theory 51

 Revealed Preference
• Example 3.4 (continued):
• Scenario (b). WARP is violated.

Step 1 holds. Bundles 𝐴𝐴 and 𝐵𝐵

are affordable under 𝐵𝐵𝐵𝐵:
• 𝐴𝐴 lies on 𝐵𝐵𝐵𝐵.
• 𝐵𝐵 lies strictly below 𝐵𝐵𝐵𝐵.
Step 2 does not hold. Bundle A
is affordable under 𝐵𝐵𝐵𝐵′ :
• A lies strictly below 𝐵𝐵𝐵𝐵′ .

The consumer is not consistent

in her choices.
Figure 3.6b

Intermediate Microeconomic Theory 52

 Revealed Preference
• Example 3.4 (continued):
• Scenario (c). WARP is not violated.

Step 1 does not hold.

Bundle 𝐴𝐴 is affordable under
𝐵𝐵𝐿𝐿 but 𝐵𝐵 is unaffordable:
• 𝐴𝐴 lies on 𝐵𝐵𝐵𝐵.
• 𝐵𝐵 lies strictly above 𝐵𝐵𝐵𝐵.

Figure 3.6c

Intermediate Microeconomic Theory 53

 Revealed Preference
• Example 3.4 (continued):
• Scenario (d). WARP is not violated.

Step 1 does not hold.

Bundle 𝐴𝐴 is affordable under
𝐵𝐵𝐵𝐵 but 𝐵𝐵 is unaffordable :
• 𝐴𝐴 lies on 𝐵𝐵𝐵𝐵.
• 𝐵𝐵 lies strictly above 𝐵𝐵𝐵𝐵.

Figure 3.6d

Intermediate Microeconomic Theory 54

Kinked Budget Lines

Intermediate Microeconomic Theory 55

 Quantity Discounts
• Sellers offer quantity discounts making first units more
expensive than each unit afterwards.
Formally,
• the consumer faces a price 𝑝𝑝𝑥𝑥 for all units of 𝑥𝑥 between 0 and
𝑥𝑥̅ (i.e., for all 𝑥𝑥 ≤ 𝑥𝑥);
̅
• but she faces a lower price 𝑝𝑝𝑥𝑥′ , where 𝑝𝑝𝑥𝑥′ < 𝑝𝑝𝑥𝑥 , for each
subsequent unit (i.e., for all 𝑥𝑥 > 𝑥𝑥).
̅

Intermediate Microeconomic Theory 56

 Quantity Discounts
• Graphically,

Figure 3.7

Intermediate Microeconomic Theory 57

 Quantity Discounts
• Mathematically, the equation of the budget line is
• For all 𝑥𝑥 ≤ 𝑥𝑥,̅
𝐼𝐼 𝑝𝑝𝑥𝑥
𝑦𝑦 = − 𝑥𝑥.
𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦

Vertical intercept Slope

• For all 𝑥𝑥 > 𝑥𝑥,̅

𝐼𝐼 𝑝𝑝𝑥𝑥 −𝑝𝑝𝑥𝑥′ 𝑝𝑝𝑥𝑥′
𝑦𝑦 = − 𝑥𝑥̅ − 𝑥𝑥.
𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦

Vertical intercept Slope Figure 3.7

𝑝𝑝𝑥𝑥′ 𝑝𝑝𝑥𝑥 𝐼𝐼 𝑝𝑝𝑥𝑥 −𝑝𝑝𝑥𝑥′ 𝐼𝐼

Note < , and − 𝑥𝑥̅ < .
𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦

Intermediate Microeconomic Theory 58

 Quantity Discounts
• Effect of a large or small price discount:
• A large discount makes the
difference 𝑝𝑝𝑥𝑥 − 𝑝𝑝𝑥𝑥′ larger,
shifting the vertical intercept
downward and flattering the
right segment of the budget
line.
• A small discount produces a
small difference 𝑝𝑝𝑥𝑥 − 𝑝𝑝𝑥𝑥′ ,
pushing the vertical intercept
upward and steepening the Figure 3.7
right segment of the budget
line.

Intermediate Microeconomic Theory 59

 Quantity Discounts
• Example 3.5: Quantity discounts.
• Eric has 𝐼𝐼 = $100 to purchase video games (good 𝑥𝑥) and food
(good 𝑦𝑦).
• The price of food is 𝑝𝑝𝑦𝑦 = $5, regardless of how many units he
buys.
• The price of video games is 𝑝𝑝𝑥𝑥 = $4 for the first 2 units, but
𝑝𝑝𝑥𝑥′ = $1 for unit 3 and beyond.
• Cutoff is at 𝑥𝑥̅ = 2.

Intermediate Microeconomic Theory 60

 Quantity Discounts
• Example 3.5 (continued):
• Then, Eric’s budget line is:
• For all 𝑥𝑥 ≤ 2,
100 4
𝑦𝑦 = − 𝑥𝑥
5 5
4
= 20 − 𝑥𝑥.
5
• For all 𝑥𝑥 > 2,
100 4 − 1 1
𝑦𝑦 = − 2 − 𝑥𝑥
5 5 5
3 1
= 20 − 2 − 𝑥𝑥
5 5
94 1
= − 𝑥𝑥.
5 5
Intermediate Microeconomic Theory 61
 Quantity Discounts
• Example 3.5 (continued):
• Graphically,
𝐼𝐼 100
• For 𝑥𝑥 ≤ 2, the budget line originates at = = 20 units in
𝑝𝑝𝑦𝑦 5
𝑝𝑝 4
the vertical axis and decreases at a rate of − 𝑥𝑥 = − = −0.8.
𝑝𝑝𝑦𝑦 5
94
• For 𝑥𝑥 > 2, the budget line originates at 𝑦𝑦 = ≅ 18.8 units,
5
𝑝𝑝𝑥𝑥′ 1
has a slope of − = − , becoming flatter, and cross the
𝑝𝑝𝑦𝑦 5
𝐼𝐼 𝑝𝑝𝑥𝑥 −𝑝𝑝𝑥𝑥′ 100 4−1
horizontal axis at 𝑥𝑥 = − 𝑥𝑥̅ = − ×2 =
𝑝𝑝𝑥𝑥′ 𝑝𝑝𝑥𝑥′ 1 1
100 − 6 = 94 units.

Intermediate Microeconomic Theory 62

 Introducing Coupons
• Consider a market where the government offers coupons,
letting consumers purchase the first 𝑥𝑥̅ units of good 𝑥𝑥 for
free.

𝐵𝐵𝐵𝐵𝐶𝐶 , budget line with coupons.

𝐵𝐵𝐵𝐵𝑁𝑁𝑁𝑁 , budget line without coupons.

Figure 3.8

• The coupons expand the set of bundles the consumer can afford.
Intermediate Microeconomic Theory 63
 Introducing Coupons
• Mathematically, this kinked budget line 𝐵𝐵𝐵𝐵𝐶𝐶 is
𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼 for all 𝑥𝑥 < 𝑥𝑥,̅ and
𝐵𝐵𝐵𝐵𝐶𝐶 �
𝑝𝑝𝑥𝑥 𝑥𝑥 − 𝑥𝑥̅ + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼 for all 𝑥𝑥 ≥ 𝑥𝑥.̅

• For 𝑥𝑥 < 𝑥𝑥,̅ the consumer faces 𝑝𝑝𝑥𝑥 = $0, thanks to the
coupons. Then 𝐵𝐵𝐵𝐵𝐶𝐶 is 𝑝𝑝𝑦𝑦 𝑦𝑦 + 0𝑥𝑥 = 𝐼𝐼 ⇒ 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼.
• For 𝑥𝑥 ≥ 𝑥𝑥,̅ the consumer exhausted all coupons and faces
market prices 𝑝𝑝𝑥𝑥 and 𝑝𝑝𝑦𝑦 . Then, 𝐵𝐵𝐵𝐵𝐶𝐶 becomes 𝑝𝑝𝑥𝑥 𝑥𝑥 − 𝑥𝑥̅ +
𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼.

Intermediate Microeconomic Theory 64

 Introducing Coupons
• Solving for 𝑦𝑦, we can represent 𝐵𝐵𝐵𝐵𝐶𝐶 as
𝐼𝐼
• For 𝑥𝑥 < 𝑥𝑥,̅ 𝑦𝑦 =
𝑝𝑝𝑦𝑦
𝐼𝐼 𝑝𝑝𝑥𝑥
• For 𝑥𝑥 ≥ 𝑥𝑥,̅ 𝑦𝑦 = + (𝑥𝑥 − 𝑥𝑥)̅
𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦
or
𝐼𝐼 𝑝𝑝𝑥𝑥 𝑝𝑝𝑥𝑥
𝑦𝑦 = + 𝑥𝑥̅ − 𝑥𝑥
𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦
Vertical intercept Slope

Setting 𝑦𝑦 = 0, and solving for 𝑥𝑥,

we find the horizontal intercept Figure 3.8
𝐼𝐼
at 𝑥𝑥 = + 𝑥𝑥.̅
𝑝𝑝𝑥𝑥
Intermediate Microeconomic Theory 65
 Introducing Coupons
• Example 3.6: Coupons.
• John income is 𝐼𝐼 = $100, the price of electricity is 𝑝𝑝𝑥𝑥 = $1,
and the price of bikes is 𝑝𝑝𝑦𝑦 = $4.
• The government agency distributes coupons for the first 200
kWh per month, making them free.
• Because 𝑥𝑥̅ = 200, John’s budget line 𝐵𝐵𝐵𝐵𝐶𝐶 is
𝐼𝐼 100
• For 𝑥𝑥 < 200, 𝑦𝑦 = = = 25 units.
𝑝𝑝𝑦𝑦 4
𝐼𝐼 𝑝𝑝𝑥𝑥 𝑝𝑝𝑥𝑥 100 1 1
• For 𝑥𝑥 ≥ 200, 𝑦𝑦 = + 𝑥𝑥̅ − 𝑥𝑥 = + 200 − 𝑥𝑥 =
𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦 4 4 4
1
75 − 𝑥𝑥.
4

Intermediate Microeconomic Theory 66

 Introducing Coupons
• Example 3.6 (continued):
• Graphically, the dashed segment of the 𝐵𝐵𝐵𝐵𝐶𝐶
• originates at 𝑦𝑦 = 75,
1
• decreases at a rate of ,
4
• and hits the horizontal axis at
𝐼𝐼 100
𝑥𝑥 = + 𝑥𝑥̅ = + 200 = 300 units.
𝑝𝑝𝑥𝑥 1

Figure 3.8

Intermediate Microeconomic Theory 67

 Appendix A.
Lagrange Method to Solve UMP

Intermediate Microeconomic Theory 68

A. Lagrange Method to Solve UMP
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
• We have used the tangency condition = to find
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦
optimal consumption bundles.
• Now, we show that this condition must be satisfied at the
optimum of the UMP. The UMP can be expressed as
max 𝑢𝑢(𝑥𝑥, 𝑦𝑦)
𝑥𝑥,𝑦𝑦
subject to 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼.
• We use the budget line 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝐼𝐼, rather than the budget
constraint 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 ≤ 𝐼𝐼, because the consumer will always spend
all her available income.
• The consumer faces a “constrained maximization problem.”

Intermediate Microeconomic Theory 69

A. Lagrange Method to Solve UMP
• Constrained maximization problems are often solved by
setting up a Lagrangian function,
ℒ 𝑥𝑥, 𝑦𝑦; 𝜆𝜆 = 𝑢𝑢 𝑥𝑥, 𝑦𝑦 + 𝜆𝜆 𝐼𝐼 − 𝑝𝑝𝑥𝑥 𝑥𝑥 − 𝑝𝑝𝑦𝑦 𝑦𝑦 ,
where 𝜆𝜆 represents the Lagrange multiplier, which multiplies the budget line.

• To solve this problem, we take FOP with respect to 𝑥𝑥, 𝑦𝑦, and
𝜆𝜆,
𝜕𝜕𝜕
= 𝑀𝑀𝑀𝑀𝑥𝑥 − 𝜆𝜆𝑝𝑝𝑥𝑥 = 0,
𝜕𝜕𝑥𝑥
𝜕𝜕𝜕
= 𝑀𝑀𝑀𝑀𝑦𝑦 − 𝜆𝜆𝑝𝑝𝑦𝑦 = 0, and
𝜕𝜕𝑦𝑦
𝜕𝜕𝜕
= 𝐼𝐼 − 𝑝𝑝𝑥𝑥 𝑥𝑥 − 𝑝𝑝𝑦𝑦 𝑦𝑦 = 0.
𝜕𝜕𝜆𝜆

Intermediate Microeconomic Theory 70

A. Lagrange Method to Solve UMP
• The first and the second conditions can be rearranged to
𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦
= 𝜆𝜆 and = 𝜆𝜆.
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦

• Because both conditions are equal to 𝜆𝜆, we obtain

𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦
= 𝜆𝜆 =
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
This is the “bang for the buck” coinciding across goods.
• Alternatively, this condition can be expressed as
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
= ,
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦
which coincides with the tangency condition used in the previous analysis.

Intermediate Microeconomic Theory 71

 Appendix B.
Expenditure Minimization Problem

Intermediate Microeconomic Theory 72

Expenditure Minimization Problem
• The UMP considers a fixed budget and finds which bundle
provides the consumer with the highest utility.
• Alternatively, the consumer could minimize her expenditure
while reaching a fixed utility level.
• This is the approach that the expenditure minimization
problem (EMP) follows.

Intermediate Microeconomic Theory 73

Expenditure Minimization Problem
• Graphically, the EMP is understood as the consumer seeking
to reach an IC with a target utility level 𝑢𝑢� , but shifting her
budget line as close to the origin as possible.
• Bundles 𝐵𝐵 or 𝐶𝐶 cannot be
optimal despite reaching 𝑢𝑢� . She
spends more income than in 𝐴𝐴.
• Bundle 𝐷𝐷 cannot be optimal.
She can find cheaper bundles
and reach 𝑢𝑢� .

Figure 3.9

Intermediate Microeconomic Theory 74

Expenditure Minimization Problem
• Bundle 𝐴𝐴 must be optimal.
There are no other bundles
reaching at a lower expenditure
than 𝐵𝐵𝐵𝐵2 .
At 𝐴𝐴, the indifference curve and
the budget line are tangent,
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
= .
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦
Her constraint is 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑢𝑢� ,
rather than 𝑢𝑢(𝑥𝑥, 𝑦𝑦) ≥ 𝑢𝑢� . She
would never choose bundle
satisfying 𝑢𝑢 𝑥𝑥, 𝑦𝑦 > 𝑢𝑢� , such as Figure 3.9
𝐷𝐷.

Intermediate Microeconomic Theory 75

Expenditure Minimization Problem

• Bundle 𝐷𝐷 cannot be optimal.

She can find cheaper bundles
and reach 𝑢𝑢� . These bundles
that still satisfy the constraint
and can be purchased at lower
cost.

Figure 3.9

Intermediate Microeconomic Theory 76

Expenditure Minimization Problem
• Tool 3.3. Procedure to solve the EMP:
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
1. Set the tangency condition as = . Cross-multiply and
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦
simplify.
2. If the expression for the tangency condition:
a. Contains both unknowns (𝑥𝑥 and 𝑦𝑦), solve or 𝑦𝑦, and insert the
resulting expression into the utility constraint 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑢𝑢� .
b. Contains only one unknown (𝑥𝑥 or 𝑦𝑦), solve for that unknown,
and insert the result into the utility constraint 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑢𝑢� .

Intermediate Microeconomic Theory 77

Expenditure Minimization Problem
• Tool 3.3. Procedure to solve the EMP (cont.):
2. If the expression for the tangency condition:
𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦
c. Contains no good 𝑥𝑥 or 𝑦𝑦, compare against .
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦
• If > , set good 𝑦𝑦 = 0 in the utility constraint and
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
solve for good 𝑥𝑥
𝑀𝑀𝑀𝑀𝑥𝑥 𝑀𝑀𝑀𝑀𝑦𝑦
• If < , set 𝑥𝑥 = 0 in the utility constraint and solve for
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
𝑦𝑦.

Intermediate Microeconomic Theory 78

Expenditure Minimization Problem
• Tool 3.3. Procedure to solve the EMP (cont.):
3. If, in step 2, you find that one of the goods is consumed in
negative amounts (e.g., 𝑥𝑥 = −2), then set the amount of this
good equal to 0 on the utility constraint (e.g., 𝑢𝑢 0, 𝑦𝑦 = 𝑢𝑢� ),
and solve for the remaining good.
4. If you haven’t found the values for all the unknowns, use the
tangency conditions from step 1 to find the remaining
unknown.

Intermediate Microeconomic Theory 79

Expenditure Minimization Problem
• Example 3.7: EMP with a Cobb-Douglas utility function.
• Consider an individual with Cobb-Douglas utility function
1 2
𝑢𝑢 𝑥𝑥, 𝑦𝑦 = 𝑥𝑥 3 𝑦𝑦 3 ,
facing 𝑝𝑝𝑥𝑥 = $10, 𝑝𝑝𝑦𝑦 = $20, and a utility target 𝑢𝑢� .
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
• We seek to apply the tangency condition, = . We first
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦
𝑀𝑀𝑀𝑀𝑥𝑥
need to find ,
𝑀𝑀𝑀𝑀𝑦𝑦
1 −23 23
𝑀𝑀𝑀𝑀𝑥𝑥 3 𝑥𝑥 𝑦𝑦 𝑦𝑦
= 1 1 = .
𝑀𝑀𝑀𝑀𝑦𝑦 2 2𝑥𝑥
𝑥𝑥 3 𝑦𝑦 −3
3
Next, we apply the steps in Tool 3.3.
Intermediate Microeconomic Theory 80
Expenditure Minimization Problem
• Example 3.7 (continued):
• Step 1. The tangency condition reduces to
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
= ,
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦
𝑦𝑦 10
= ⟹ 𝑦𝑦 = 𝑥𝑥.
2𝑥𝑥 20
This result contains both 𝑥𝑥 and 𝑦𝑦, so we move to step 2a.
1 2
• Step 2a. The utility constraint 𝑢𝑢 𝑥𝑥, 𝑦𝑦 = 𝑢𝑢� becomes 𝑥𝑥 𝑦𝑦 = 𝑢𝑢� .
3 3

Inserting 𝑦𝑦 = 𝑥𝑥,
1 2
𝑥𝑥 3 𝑥𝑥 3 = 𝑢𝑢� ⟹ 𝑥𝑥 = 𝑢𝑢� .
𝑦𝑦
For instance, if 𝑢𝑢� = 5, the optimal amount of 𝑥𝑥 is 𝑥𝑥 = 5.
Intermediate Microeconomic Theory 81
Expenditure Minimization Problem
• Example 3.7 (continued):
Because we found a positive amount of good 𝑥𝑥, we move to step 4.
• Step 4. Using the tangency condition, 𝑦𝑦 = 𝑥𝑥,
𝑦𝑦 = 𝑢𝑢� .
• Summary. The optimal consumption bundle is 𝑥𝑥 = 𝑦𝑦 = 𝑢𝑢� ,
consuming the same amount of each.
For instance, if the consumer seeks to reach a utility target of 𝑢𝑢� ,
the optima bundle is (5,5).

Intermediate Microeconomic Theory 82

Expenditure Minimization Problem
• Example 3.8: EMP with a quasilinear utility.
• Consider the quasilinear utility from example 3.3
𝑢𝑢 𝑥𝑥, 𝑦𝑦 = 𝑥𝑥𝑥𝑥 + 7𝑥𝑥,
facing 𝑝𝑝𝑥𝑥 = $1, 𝑝𝑝𝑦𝑦 = $2, and a utility target 𝑢𝑢� = 70.
• Step 1. The tangency condition reduces is
𝑀𝑀𝑀𝑀𝑥𝑥 𝑝𝑝𝑥𝑥
= ,
𝑀𝑀𝑀𝑀𝑦𝑦 𝑝𝑝𝑦𝑦
𝑦𝑦 + 7 1
= ⟹ 2𝑦𝑦 + 14 = 𝑥𝑥.
𝑥𝑥 2
This result contains both 𝑥𝑥 and 𝑦𝑦, so we move to step 2a.

Intermediate Microeconomic Theory 83

Expenditure Minimization Problem
• Example 3.9 (continued):
• Step 2a. Inserting the result from the tangency condition,
2𝑦𝑦 + 14 = 𝑥𝑥, into the utility target 𝑥𝑥𝑥𝑥 + 7𝑥𝑥 = 70,
2𝑦𝑦 + 14 𝑦𝑦 + 7 2𝑦𝑦 + 14 = 70,
𝑥𝑥 𝑥𝑥
2(7 + 𝑦𝑦)2 = 70 ⟹ 7 + 𝑦𝑦 2
= 35,
7 + 𝑦𝑦 2 = 35 ⟹ 7 + 𝑦𝑦 = 35,
𝑦𝑦 ≃ −1.08 units.
Because we found negative units of at least one good, we need to
apply step 3 next.

Intermediate Microeconomic Theory 84

Expenditure Minimization Problem
• Example 3.9 (continued):
• Step 3. The individual consumes 0 amounts of 𝑦𝑦, and
dedicates all her income to buy 𝑥𝑥. 𝑀𝑀𝑀𝑀𝑥𝑥 > 𝑀𝑀𝑀𝑀𝑦𝑦 , regardless of
the amount consumed, which drives her to purchase only
good 𝑥𝑥.
Because 𝑦𝑦 = 0, her utility constraint becomes 𝑢𝑢 𝑥𝑥, 0 = 70,
or
𝑥𝑥𝑥 + 7𝑥𝑥 = 70,
𝑥𝑥 = 10 units.
• Summary. The optimal consumption bundle is 𝑥𝑥 = 10 and 𝑦𝑦 =
0, regardless of the utility target the individual seeks to reach.

Intermediate Microeconomic Theory 85

Relationship between UMP and EMP
• Similarities and differences of UMP and EMP approaches:

UMP EMP

Tangency
condition,
MRS = px/py

Budget constraint Utility constraint

pxx+pyy = I u(x,y) = u

Figure 3.10

Intermediate Microeconomic Theory 86

Relationship between UMP and EMP
• Both approaches lead as to the same optimal consumption
bundle. The EMP is dual representation of UMP.
• Consider a consumer that solves her UMP and finds optimal
bundle
𝑥𝑥 𝑈𝑈 , 𝑦𝑦 𝑈𝑈 .
• In this situation, the utility she can reach when purchasing
this bundle is
𝑢𝑢 𝑥𝑥 𝑈𝑈 , 𝑦𝑦 𝑈𝑈 .

Intermediate Microeconomic Theory 87

Relationship between UMP and EMP
• If we ask the consumer to solver her EMP to reach a target
utility level of
𝑢𝑢 𝑥𝑥 𝑈𝑈 , 𝑦𝑦 𝑈𝑈 = 𝑢𝑢� ,
the bundle that solves her EMP coincides with that of UMP.
• We can draw the opposite relationship, starting from EMP.
• Let 𝑥𝑥 𝐸𝐸 , 𝑦𝑦 𝐸𝐸 be the optimal bundle solving EMP.

Intermediate Microeconomic Theory 88

Relationship between UMP and EMP
• Let 𝐼𝐼 𝐸𝐸 be the income the consumer needs to purchase her
optimal bundle (i.e., 𝑝𝑝𝑥𝑥 𝑥𝑥 𝐸𝐸 + 𝑝𝑝𝑦𝑦 𝑦𝑦 𝐸𝐸 = 𝐼𝐼 𝐸𝐸 ).
• If we ask her to solve her UMP, giving an income of 𝐼𝐼 = 𝐼𝐼 𝐸𝐸 ,
the optimal bundles solving her UMP,
𝑥𝑥 𝑈𝑈 , 𝑦𝑦 𝑈𝑈 ,
coincides with that solving her EMP,
𝑥𝑥 𝐸𝐸 , 𝑦𝑦 𝐸𝐸 .

Intermediate Microeconomic Theory 89

Relationship between UMP and EMP
• Example 3.9: Dual problems.
From UMP to EMP:
• Solving the UMP in example 3.2, 𝑥𝑥 𝑈𝑈 , 𝑦𝑦 𝑈𝑈 = 3.33, 3.33 ,
which yields a utility level of 𝑢𝑢 = 3.33.
• If we go to the EMP in example 3.7, and her to a target of a
utility level of 𝑢𝑢� = 3.33.
Then, her optimal bundle becomes
𝑥𝑥 𝐸𝐸 , 𝑦𝑦 𝐸𝐸 = 3.33, 3.33 ,
because in example 3.7 we found 𝑥𝑥 = 𝑦𝑦 = 𝑢𝑢� .
• Hence, optimal bundles in UMP and EMP coincide.

Intermediate Microeconomic Theory 90

Relationship between UMP and EMP
• Example 3.9 (continued):
From EMP to UMP:
• We approach the consumer again, giving her the income that
she would need to purchase the optimal bundle found in EMP
of example 3.7,
𝑝𝑝𝑥𝑥 𝑥𝑥 𝐸𝐸 + 𝑝𝑝𝑦𝑦 𝑦𝑦 𝐸𝐸 = $100.
• Solving her UMP, she obtains
𝑥𝑥 𝑈𝑈 , 𝑦𝑦 𝑈𝑈 = 3.33, 3.33 ,
which coincides with the optimal bundle solving the EMP.

Intermediate Microeconomic Theory 91