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Utility
Maximization
Topic 3:
Budget Sets and Utility Maximization
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
1 / 28
The Rational
Consumer
The Budget Set
Goods: i = 1, 2, . . . , n.
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
u(q1 , q2 , . . . , qn ).
2 / 28
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
p1 q1 + p2 q2 + . . . + pn qn Y .
3 / 28
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
4 / 28
The Rational
Consumer
The Budget Set
I
I
Utility Functions
Utility
Maximization
and
Revealed
Preferences
Evidence
p1 q1 + p2 q2 Y
5 / 28
The Rational
Consumer
The Budget Set
Utility Functions
16=Y/p2
Utility
Maximization
Revealed
Preferences
Evidence
Budget line
Budget set
40=Y/p1
6 / 28
The Rational
Consumer
p1 q1 + p2 q2 = Y
q2 =
Y p1
q1
p2 p2
Evidence
p1
.
p2
In our example:
p1
2
= .
p2
5
7 / 28
The Rational
Consumer
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
Example:
q1 q2 = u q2 =
u
q1
8 / 28
u
q2
The Rational
Consumer
The Budget Set
500
Utility Functions
Utility
Maximization
300
Evidence
u=40000
u=20000
u=5000
100
q2
Revealed
Preferences
100
200
300
400
500
600
q1
9 / 28
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
10 / 28
600
500
The Rational
Consumer
The Budget Set
300
Utility
Maximization
Revealed
Preferences
Evidence
200
q2
400
Utility Functions
100
0.5
U(q1, q2) = q0.5
1 q2
100
200
300
400
500
600
q1
11 / 28
dq2
dq1 :
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
U(q1 , q2 (q1 )) = k
U
U dq2
+
q1 q2 dq1
dq2
dq1
[Chain Rule]
Revealed
Preferences
Evidence
= 0
U
q1
U
q2
The Rational
Consumer
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
13 / 28
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
q
^
0.5q+0.5q
^
q
q2
100
200
300
400
500
600
q1
14 / 28
Utility Maximization
The Rational
Consumer
The Budget Set
Utility Functions
increasing,
convex,
Utility
Maximization
Revealed
Preferences
Evidence
15 / 28
Utility Maximization
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
16 / 28
Not Optimal
The Rational
Consumer
The Budget Set
Utility Functions
16=Y/p2
q2
Utility
Maximization
Revealed
Preferences
better
Evidence
40=Y/p1
0
q1
17 / 28
Utility Maximization
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
18 / 28
Not Optimal
The Rational
Consumer
The Budget Set
Utility Functions
16=Y/p2
better
Revealed
Preferences
Evidence
q2
Utility
Maximization
40=Y/p1
0
q1
19 / 28
Optimal
The Rational
Consumer
The Budget Set
16=Y/p2
Utility
Maximization
Revealed
Preferences
Evidence
q2
Utility Functions
40=Y/p1
0
q1
20 / 28
Intuition
Marginal rate of substitution = Slope of the Budget Line
U
q1
U
q2
U
q1
p1
=
p2
=
p1
The Rational
Consumer
Utility Functions
Utility
Maximization
U
q2
Revealed
Preferences
p2
Evidence
Marginal Utility of $1
spent on good 1
Marginal Utility of $1
spent on good 2
Revealed Preferences
16=Y/p2
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
20
40=Y/p1
22 / 28
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
The choice from the blue set reveals that A has higher utility than
B.
The choice from the green set reveals that B has higher utility
than A.
Violation of WARP.
23 / 28
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
then
I
Revealed
Preferences
Evidence
24 / 28
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
Data:
494 households
food purchases
over 104 weeks
26 / 28
The Rational
Consumer
The Budget Set
Utility Functions
Utility
Maximization
Revealed
Preferences
Evidence
First blue then green prices: I buy B at the blue prices, and
sell it to you at the green prices. Profits.
First green then blue prices: I buy A at the green prices, and
sell it to you at the blue prices. Profits.
Sum of profits measures irrationality.
27 / 28
Findings
The Rational
Consumer
494 households.
Utility
Maximization
Revealed
Preferences
Evidence
28 / 28