Chapter 4

UTILITY MAXIMIZATION
AND CHOICE

Our Consumption Choices

Our decisions can be divided into two
parts
We have to determine all available
choices, given our income: BUDGET
CONSTRAINT
Of all the available choices we choose the
one that we prefer: PREFERENCES and
INDIFFERENCE CURVES
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The Budget Constraint

If an individual has I dollars to allocate between
good x and good y with prices px and py:
pxx + pyy I
Quantity of y
I
py

If all income is spent

on y, this is the amount
of y that can be purchased

The individual can afford

to choose only combinations
of x and y in the shaded
triangle

If all income is spent

on x, this is the amount
of x that can be purchased

I
px

Quantity of x
3

First-Order Conditions for a Maximum

We can add the individuals preferences
to show the utility-maximization process
Quantity of y

The individual can do better than point A

by reallocating his budget
A

The individual cannot have point C

because income is not large enough

C
B
U3
U2
U1

Point B is the point of utility

maximization
Quantity of x
4

First-Order Conditions for a Maximum

Utility is maximized where the indifference
curve is tangent to the budget constraint
At the optimum the slope of the
indifference curve is equal to the
slope of the budget constraint

Quantity of y

slope of budget constraint

slope of the indifference curve

U2

px
U

x
py

px
py

dy
U

x
dx U constant

U
MRS
y

px
U
MRS
x
py

U
y

Quantity of x
5

U
y

Second-Order Conditions for a Maximum

The tangency rule is only necessary but not
sufficient unless we assume that MRS is
diminishing
if MRS is diminishing, then indifference curves are
strictly convex and we always have a maximum

If MRS is not diminishing, then we should

check second-order conditions to ensure that
we are at a maximum
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Second-Order Conditions for a

Maximum
Example in which the tangency condition is
satisfied but we are not at the optimal bundle
Quantity of y

There is a tangency at point A,

but the individual can reach a higher
level of utility at point B
B
A
U2
U1

Quantity of x

Corner Solutions

In some situations, individuals preferences

may be such that they can maximize utility
by choosing to consume only one of the
goods
Quantity of y

U1

U2

At point A, the indifference curve

is not tangent to the budget constraint

U3

Utility is maximized at point A

Quantity of x
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Indirect Utility Function

The indirect utility function measures how the
welfare/utility of an individual changes when
the prices and her income vary
If we substitute optimal consumption in the
utility function we find the indirect utility
function
indirect utility = U(x*1(p1,,pn,I),,x*n(p1,,pn,I))

We will denote it as follows:

V(p1,p2,,pn,I) = U(x*1(p1,,pn,I),,x*n(p1,,pn,I))
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