LECTURE 16: ECONOMIC APPLICATIONS

Reference: Pemberton & Rau Sections 17.3 and 17.4

Suppose a consumer's total income to be spent on the goods is m and that the prices of the
two goods are p1 and p 2 . To reach the point of maximum satisfaction, given her budget, the

consumer must choose x1 and x 2 so as to

maximise U ( x1 , x 2 ) subject to p1 x1  p 2 x 2  m.
Non-negative consumption
To ensure that the problem makes sense, we really should supplement the budget constraint
with the non-negativity constraints x1  0, x 2  0. In some cases, however, especially when
dealing with specific functions, it will be clear from the start that the optimum will have both
components strictly positive. We will restrict our attention to this case.
Non-satiation
As far as utility maximisation is concerned, the difference between the weak inequality and
equality versions of the budget constraint is not great. For if we make the reasonable non-
satiation assumption that the consumer always prefers more of at least one of the two goods
(in other words, for every bundle ( x1 , x 2 ) , at least one of U / x1 , U / x 2 is positive), then
it is never in her interest to spend less than her income.

In the case where the solution has both components strictly positive, it occurs at a point of
tangency between the budget constraint and an indifference curve. We can therefore introduce
the Lagrangian
L( x1 , x 2 ,  )  U ( x1 , x 2 )   ( p1 x1  p 2 x 2  m)
and write down the first-order conditions in the usual way. Thus at the point of maximum
satisfaction we have
U U
 p1 ,  p 2 .
x1 x 2

These equations, together with the budget constraint, can then be solved for x1 , x 2 and the

Lagrange multiplier λ. The resulting optimal levels of x1 , x 2 can be written

x1  f 1 ( p1 , p 2 , m), x 2  f 2 ( p1 , p 2 , m)
and the functions f 1 , f 2 are called the consumer's demand functions.

We can express the maximum utility in terms of p1 , p 2 and m by substituting into the utility
function. The resulting function V ( p1 , p 2 , m) is known as the indirect utility function.
Then, it can be shown that at the optimum   V / m.
Provided the indifference curves are negatively sloped and convex, the first-order conditions
are sufficient for an optimum.

Cost functions
A firm's cost function C ( w1 , w2 , q) is defined as the minimal cost of producing q units of

output when input prices are w1 and w2 . If the firm’s production function is F ( x1 , x 2 ) , its
problem is to
minimise w1 x1  w2 x 2 subject to F ( x1 , x 2 )  q.
As in the consumer case, we are restricting attention to the case where it is clear from the start
that the optimum will have x1  0 and x 2  0 and , by stating the constraint as an equation, we
are ignoring the possibility that the firm manufactures more output than it needs to do.
The Lagrangian here is
w1 x1  w 2 x 2   ( F ( x1 , x 2 )  q),
where μ is the Lagrange multiplier. The first-order conditions are
wi   (F / x i ) for i  1,2.

As in the consumer theory case just considered, these conditions are sufficient for an
optimum provided the isoquants are negatively sloped and convex.
Quasi-concave functions
A function f ( x, y ) of two variables is said to be quasi-concave if, for any real number c, the
set of points ( x, y ) for which f ( x, y )  c is convex.
For utility functions which are increasing in both their arguments, quasi-concavity of the
utility function is equivalent to convexity of all the indifference curves.
All concave functions are quasi-concave but not all quasi-concave functions are concave eg
if the surface z  f ( x, y ) has the shape of the upward-sloping part of a bell, then f is not
concave but is quasi-concave.
If U ( x1 , x 2 ) is any quasi-concave utility function and H is an increasing function of one
~
variable, then U ( x1 , x 2 )  H (U ( x1 , x 2 )) is a quasi-concave utility function representing the
same preferences as U.
Exercises: Pemberton & Rau 17.3.1, 17.3.2, 17.4.1, 17.4.2