Chapter 4: Utility Maximization and Choice

16

CHAPTER 4
UTILITY MAXIMIZATION AND CHOICE
The problems in this chapter focus mainly on the utility maximization
assumption. Relatively simple computational problems (mainly based on CobbDouglas and CES utility functions) are included. Comparative statics exercises are
included in a few problems, but for the most part, introduction of this material is
delayed until Chapters 5 and 6.

Comments on Problems
4.1

This is a simple Cobb-Douglas example. Part (b) asks students to compute

income compensation for a price rise and may prove difficult for them. As a
hint they might be told to find the correct bundle on the original indifference
curve first, then compute its cost.

4.2

This uses the Cobb-Douglas utility function to solve for quantity demanded at
two different prices. Instructors may wish to introduce the expenditure shares
interpretation of the function's exponents (these are covered extensively in the
Extensions to Chapter 4 and in a variety of numerical examples in Chapter 5).

4.3

This starts as an unconstrained maximization problem -- there is no income

constraint in part (a) on the assumption that this constraint is not limiting. In
part (b) there is a total quantity constraint. Students should be asked to interpret
what Lagrangian Multiplier means in this case.

4.4

This problem shows that with concave indifference curves first order conditions
do not ensure a local maximum.

4.5

This is an example of a "fixed proportion" utility function. The problem might

be used to illustrate the notion of perfect complements and the absence of
relative price effects for them. Students may need some help with the min ( )
functional notation by using illustrative numerical values for v and g and
showing what it means to have "excess" v or g.

4.6

This problem introduces a third good to the Cobb-Douglas case for which
optimal consumption is zero until income reaches a certain level.

4.7

This problem repeats the lessons of the lump sum principle for the case of a
subsidy. Numerical examples are based on the Cobb-Douglas expenditure
function.

4.8

This problem shows how various considerations can be grafted onto a simple
utility-maximization problem.

Chapter 4: Utility Maximization and Choice

17

4.9

Asks students to construct the expenditure function for a linear utility function.
Notice that this problem cannot be solved with calculus rather students must
work through the various possibilities logically.

Analytical Problems
4.10

Cobb-Douglas utility: Provides a simple example of the Cobb-Douglas

expenditure function and seeks to build some intuition about how a goods
relative importance affects that function.

4.11

CES utility: This problem provides some practice with the CES function. Parts
a-c are relatively straightforward, but part d is computationally difficult. A
somewhat different form for this function is examined in Problem 4.13.

4.12

Stone-Geary utility: Introduces a simple two-good Stone-Geary function in

which a certain amount must be devoted to x consumption before any y
consumption occurs. More detail on this functional form is provided in the
Extensions to the chapter.

4.13

CES indirect utility and expenditure functions: Uses a more standard form
for the CES utility function and asks students to delve more deeply into the
characteristics of that functions indirect utility function and expenditure
function analogues.

Solutions
4.1

a.

Set up Lagrangian
ts + (1.00 .10t .25s ) .

( s / t )0.5 .10
t

(t / s )0.5 .25
s

= 1.00 .10t .25s = 0

Ratio of first two equations implies

t
= 2.5
s

t = 2.5s

Hence
1.00 = .10t + .25s = .50s.
s=2

t=5

Chapter 4: Utility Maximization and Choice

Utility =
b.

10

New utility
and

t=

18

10

or ts = 10

t .25 5
=
=
s .40 8
5s
8

Substituting into indifference curve:

5s2
= 10
8
s2 = 16

s=4

t = 2.5

Cost of this bundle is 2.00, so Paul needs another dollar.

4.2

Use a simpler notation for this solution: U ( f , c ) = f 2/3 c1/3

a.

I = 300

= f 2/3 c1/3 + (300 20f 4c )

2 / 3(c / f )1/ 3 20
f

1/ 3( f / c) 2 / 3 4
c
Hence,
5= 2

c
, 2c = 5f
f

Substitution into budget constraint yields f = 10, c = 25.

b.

With the new constraint: f = 20, c = 25

Note: This person always spends 2/3 of income on f and 1/3 on c.
Consumption of California wine does not change when price of French
wine changes.

c.

In part a U ( f , c ) f 2 3c1 3 102 3251 3 13.5 . In part b,

U ( f , c ) 202 3251 3 21.5 .
To achieve the part b utility with part a prices, this person will need
more income.

Chapter 4: Utility Maximization and Choice

19

23
13
2 3 1 3
23
2 3 1 3
Indirect utility is 21.5 (2 3) (1 3) Ip f pc (2 3) I 20 4 .
Solving this equation for the required income gives I = 482. With such
an income, this person would purchase f = 16.1, c = 40.1, U = 21.5.

4.3

U (c, b) 20c c 2 18b 3b 2

a.

b.

U
= 20 2c = 0,
c
U
= 18 6b = 0,
b
So, U = 127.

c = 10

b= 3

Constraint: b + c = 5
20c c 2 18b 3b 2 (5 c b)

= 20 2c = 0
c

= 18 6b = 0
b

=5 c b=0

c = 3b + 1 so b + 3b + 1 = 5, b = 1, c = 4, U = 79

4.4

U ( x, y ) ( x 2 y 2 ) 0.5
Maximizing U 2 in will also maximize U.
a.

x 2 y 2 (50 3x 4 y )

= 2x 3 = 0
x

= 2x 3

= 2y 4 = 0
y

= y 2

= 50 3x 4y 0

First two equations give y 4 x 3 . Substituting in budget constraint

gives x = 6, y = 8 , U = 10.

Chapter 4: Utility Maximization and Choice

b.

4.5

20

This is not a local maximum because the indifference curves do not have
a diminishing MRS (they are in fact concentric circles). Hence, we have
necessary but not sufficient conditions for a maximum. In fact the
calculated allocation is a minimum utility. If Mr. Ball spends all income
on x, say, U = 50/3.

U (m ) U ( g , v ) Min[ g 2, v ]
a.

No matter what the relative price are (i.e., the slope of the budget
constraint) the maximum utility intersection will always be at the vertex
of an indifference curve where g = 2v.

b.

Substituting g = 2v into the budget constraint yields:

2 pg v pv v I or v =
Similarly, g =

I
.
2pg + pv

2I
2pg + pv

It is easy to show that these two demand functions are homogeneous of

degree zero in PG , PV , and I.
c.

U g 2 v so,
Indirect Utility is V ( pg , pv , I )

d.

I
2pg + pv

The expenditure function is found by interchanging I (= E) and V,

E ( pg , pv ,V ) (2 p g pv )V .

4.6

a.

If x = 4 y = 1 U (z = 0) = 2.
If z = 1 U = 0 since x = y = 0.
If z = 0.1 (say) x = .9/.25 = 3.6, y = .9.
U = (3.6).5 (.9).5 (1.1).5 = 1.89 which is less than U(z = 0)

b.

At x = 4 y = 1 z =0
MU x / p x MU y / p y 1

MU z / p z 0.5

So, even at z = 0, the marginal utility from z is "not worth" the good's
price. Notice here that the 1 in the utility function causes this

Chapter 4: Utility Maximization and Choice

21

individual to incur some diminishing marginal utility for z before any is

bought. Good z illustrates the principle of complementary slackness
discussed in Chapter 2.
c.

If I = 10, optimal choices are x = 16, y = 4, z = 1. A higher income

makes it possible to consume z as part of a utility maximum. To find the
minimal income at which any (fractional) z would be bought, use the
fact that with the Cobb-Douglas this person will spend equal amounts on
x, y, and (1+z). That is:
p x x p y y pz (1 z )
Substituting this into the budget constraint yields:
2 pz (1 z ) p z z I

or 3 p z z I 2 p z

Hence, for z > 0 it must be the case that I 2 pz or I 4 .

4.7

a.

b.

p x 1, p y 4,U 2, E 8 . To raise
E ( p x , p y ,U ) 2 px0.5 p 0.5
y U . With
utility to 3 would require E = 12 that is, an income subsidy of 4.

0.5 0.5
0.5
c. Now we require E 8 2 px 4 3 or p x 8 12 2 3 . So p x 4 9 -- that
is, each unit must be subsidized by 5/9. at the subsidized price this person
chooses to buy x = 9. So total subsidy is 5 one dollar greater than in part
c.
0.3 0.7
d. E ( p x , p y ,U ) 1.84 p x p y U . With p x 1, p y 4,U 2, E 9.71 . Raising
U to 3 would require extra expenditures of 4.86. Subsidizing good x alone
would require a price of p x 0.26 . That is, a subsidy of 0.74 per unit.
With this low price, this person would choose x = 11.2, so total subsidy
would be 8.29.

Chapter 4: Utility Maximization and Choice

4.8

22

a. U ( x, y ) 500 x x 2 1000 y . But y x / 10 so U ( x ) 400 x x 2 .

Hence, x* = 200. Clearly this is within the budget constraint.
b. Now y x / 5, U ( x ) 300 x x 2 , x * 150 -- In this case the utilitymaximizing miles driven exceeds the budget constraint. The constrained
maximum is x* = 125.
c. U ( x, y , z ) 500 x x 2 1000 y 50000 z . But y = x/10 + 50z, z = 0.001x
so
y = 3x/20 and U ( x ) 500 x x 2 150 x 50 x 300 x x 2 , x * 150 . Now the
expected cost is $15 for gas and $7.5 in expected tire costs, so this is within the
budget constraint.

4.9

If U ( x, y ) ax by then x I / p x , y 0 if a / p x b / p y or p x / p y a / b
Alternatively, y I / p y , x 0 if p x / p y a / b . Hence,
E p xU / a for p x / p y a / b and E p yU / b for p x / p y a / b . For
p x / p y a / b, E p xU / a p yU / b .

Analytical Problems:
4.10

Cobb-Douglas Utility
U ( x, y ) x y1
a.

The demand functions in this case are x I p x , y (1 ) I p y .

Substituting these into the utility function gives
V ( px , p y , I ) [ I p x ] [(1 ) I p y ] BIp x p y (1 ) where
B (1 )(1 ) .

4.11

b.

1 (1 )
Interchanging I and V yields E ( p x , p y ,V ) B px p y V .

c.

The elasticity of expenditures with respect to p x is given by the

exponent . That is, the more important x is in the utility function the
greater the proportion that expenditures must be increased to
compensate for a proportional rise in the price of x.

CES Utility
a.

b.

MRS =

U/ x
1
= ( x y ) = p x /p y for utility maximization.
U/ y

1 ( 1)
( p x p y )
Hence, x/y = ( p x p y )
If = 0, x y p y p x so px x p y y .

where 1 (1 ) .

Chapter 4: Utility Maximization and Choice

23

c.

1
Part a shows p x x p y y ( p x p y )

Hence, for 1 the relative share of income devoted to good x is

positively correlated with its relative price. This is a sign of low
substitutability.
For 1 the relative share of income devoted to good x is negatively
correlated with its relative price a sign of high substitutability.
d.

The algebra is a bit tricky here, but worth doing once. Lets solve for
indirect utility
x p x

y p y

p
or x y x
p
y

Substituting into the budget constraint yields

p
I px y x
p
y

py y

or

Ip y
p1x p1y

Similarly,
Ip
x 1 x 1
px p y

p
Hence, U x y I 1 x 1
px p y

p y

1
1

p1 p1
y
x

Now 1 so U I
1
1 1
(
p

p
)
x
y

V ' I ( p1x p1y )

where V ' (U )

or

This is the indirect utility function. Clearly it is homogeneous of degree

zero in income and prices. Inverting the expression yields the
expenditure function:

E I V ' ( p1x p1y )

(1 )

Clearly this is homogeneous of degree one in the prices. Note that the
odd form for V here suggests the use of the CES for given in Problem
4.13 in applications involving these functions.
4.12

Stone-Geary Utility
a.

For x < x0 utility is negative so will spend px x0 first. With I- px x0 extra

income, this is a standard Cobb-Douglas problem:
p x ( x x0 ) = ( I p x x0 ),

p y y ( I p x x0 )

Chapter 4: Utility Maximization and Choice

b.

Calculating budget shares from part a yields

(1 ) p x x0
p xx
= +
,
I
I
lim( I )

4.13

py y
I

p x x0
I

p y
p xx
, lim( I ) y .
I
I

CES Indirect Utility and Expenditure Functions

1

U ( x y ) ;

L ( x y ) ( I x px y p y )

L 1
( x y )
x

a.

24

( x

( x y )
Similarly ,
py

( x y )
) px 0
px

x 1

y 1

Equating the ' s

x 1
y 1

px
py

(or ( x y )

0 N . A. as we assume U 0)

1
1

p
x y x
p
y

L
I x px y py 0

Substituting the above exp ression for x int o this equation,

Also,

p
I x
p
y

1
1

y px y p y
1

I p y 1

y
p

1
x

1
y

I p x 1

Similarly, x

1
1
x

Ip
Now, V ( x y )

p 1 p 1
y

p xr p ry

( p r p r )
x
y

p x 1 p y 1

I ( p xr p ry )

Ip

1
x

p
1

I ( p xr p ry ) r

1
1
y

1
y

where r

b. Scale all variables by t and the function is unchanged.

c. The partial derivative of V w.r.t. I is positive as the prices are positive.

25

Chapter 4: Utility Maximization and Choice

d. Again, partial derivatives of V w.r.t. the prices are both negative: for
r 1
r
r (1 r ) / r
0.
example, V p x Ip x ( p x p y )
e. Simply reversing the positions of V and I in the indirect utility function
E V ( p xr p ry )1 / r .
yields
f. Multiplying prices by any factor t multiplies expenditures by t.
r 1
r
r (1 r ) / r
0.
g. For example, E / p x Vp x ( p x p y )
2
2
2 r 2
(1 2 r ) / r
( r 1)Vp xr 2 K (1 r ) / r where
h. E / p x (1 r ) Vp x K
K ( p xr p ry ) . Division of this expression by Vp xr 2 K (1 r ) / r yields

( r 1)(1 k ) 0 where k p xr / K 1 .