Constrained Maximisation I

EC115 - Methods of Economic Analysis
Spring Term, Lecture 7

Constrained Maximisation I
(Basic Concepts)
Renshaw - Chapter 16
University of Essex - Department of Economics
Week 22
Domenico Tabasso (University of Essex - Department of Economics) Lecture 7 - Spring Term Week 22 1 / 33
Topics for this week
Introduction
Constrained Utility Maximization
The Constraint
The Objective Function
Relation Between Constrained and Unconstrained Optimization
Problems
Introduction
Through the study of functions with several independent variables
we have been able to understand how economists use them:
to represent production technologies and consumer preferences

(production and utility functions); and
to analyse their properties using partial dierentiation and total

dierentiation
When studying maximum points we have used production
functions to analyse rms optimal decisions (when they seek to
maximise prots) in situations where they do not face any
constraints.
Firms in a competitive market choose output to maximise prots
at given prices.
Monopolists choose output to maximise prots with a given
market demand function.
We now go one step further and analyse maximisation and
minimisation problems when agents face constraints.
Constrained Utility Maximization
A typical problem we have in mind is of the following nature.
A consumer wants to choose a combination of two goods X and
Y to maximise her utility,
u = U(x, y),
where x and y represent the quantities of the goods.
Typically this consumer will have a x monthly income to spend,
M.
If prices are positive, i.e. p
x
> 0 and p
y
> 0, then her decision on
how much to consume of each good must be constrained by the
amount of money she can spend.
Everytime the consumer has to decide how much to consume,
she faces the following budget constraint:
p
x
x + p
y
y M.
Note that by writing her budget constraint in this form, we are
implicitly assuming that she cannot borrow or lend money (so no
nancial markets).
Clearly the assumption of no nancial markets is restrictive as it
does not capture many real world situations. However,
analysing a consumers behaviour when there are no nancial
markets is helpful for understanding how a budget constraint
aects her consumption choices.
The consumers maximisation problem is described by:
max
x,y
U(x, y) s.t. p
x
x + p
y
y m.
The consumers objective is to maximise her utility and thus the
objective function of her maximisation problem problem is her
utility function U(x, y).
The consumer is constrained by her available income and thus
the constraint of her maximisation problem is given by her
budget constraint p
x
x + p
y
y m.
In almost all of the remainder of this course we will assume that
the constraint binds so that it becomes p
x
x + p
y
y = m.
The Constraint
The constraint is an implicit relation, (x, y) = 0, between x and
y that must be satised by the values of x and y that maximise
the objective function.
In the case of the consumers problem we can derive a
corresponding explicit relation, y = g(x), given by:
y =
m
p
y
p
x
p
y
x.
The term (p
x
/p
y
) describes the slope of the g() function:
dy
dx
=
p
x
p
y
.
The slope tells us how many units of Y the consumer to give up
in order to buy one extra unit of X while keeping expenditure
constant at m (so it measures opportunity cost).
The term (m/p
y
) describes the intercept of the g() function, i.e.
the value of y when x = 0.
The intercept tells how many units of Y the consumer can buy
when she has income m and spends all of it on Y.
Similarly (m/p
x
) is the number of units of X the consumer can
buy when she has income m and spends all of it on X.
Figure: The Consumers Budget Constraint
Analysing the Constraint
Changing p
x
, p
y
and/or m changes the consumers budget
constraint.
Reducing m shifts the budget line in towards the origin
(increasing m shifts it out away from the origin).
Reducing p
x
rotates the budget line by increasing the slope but
keeping the intercept constant (increasing p
x
reduces the slope
but keeps the intercept constant).
Reducing p
y
rotates the budget line by reducing the slope and
adjusting the intercept accordingly (increasing p
y
increases the
slope and adjusts the intercept accordingly).
Figure: Eect of Reducing Consumers Income
Figure: Eect of Increasing the Price of X
Figure: Eect of Increasing the Price of Y
We can also use total dierentiation to examine the slope of the
constraint.
We can rewrite the budget line as G(x, y) = 0 where
G(x, y) = p
x
x + p
y
y m.
The total dierentiation gives:
G
x
dx +
G
y
dy = 0.
But
G
x
= p
x
and
G
y
= p
y
so we have:
p
x
dx + p
y
dy = 0
and thus
dy
dx
= (p
x
/p
y
).
The Objective Function
The objective function describes the function that the agent want
to maximise or minimise.
This function is normally of several independent variables.
Hence our previous techniques for analysing this functions apply.
Assume the consumer has a Cobb-Douglas utility function
u = U(x, y) = x
1/2
y
1/2
This function describes the preferences the consumer has for
goods x and y.
Applying partial dierentiation we obtain that
MU
x
(x, y) =
U(x, y)
x
=
1
2
y
x
1/2
> 0
MU
y
(x, y) =
U(x, y)
y
=
1
2
x
y
1/2
> 0
The marginal utilities are positive for positive values of x and y.
Recall that the marginal utilities are a measure of how much does
the utility changes when the consumer increases the consumption
of x or y.
Applying partial dierentiation one more time we get
MU
x
(x, y)
x
=

2
U(x, y)
x
2
=
y
1/2
4x
3/2
< 0
MU
y
(x, y)
y
=

2
U(x, y)
y
2
=
x
1/2
4y
3/2
< 0
That is, the marginal utilities are downward sloping for positive
values of x and y.
Finally, using cross partial dierentiation we obtain that
MU
y
(x, y)
x
=

2
U(x, y)
yx
=

2
U(x, y)
xy
=
MU
x
(x, y)
y
=
1
4
1
xy
1/2
> 0
Thus increasing consumption of X while keeping consumption of
Y xed will increase the marginal utility of Y (and vice versa).
Using total dierentiation, we have that for any utility level the
indierence curve is given by the implicit function:
U(x, y) u
0
= x
1/2
y
1/2
u
0
= 0
du
0
= MU
x
(x, y)dx + MU
y
(x, y)dy = 0
The marginal rate of substitution describes how much of good y
the consumer is willing to exchange for more of good x holding
utility constant:
MRS
x,y
=
dy
dx
u=u
0
=
MU
x
(x, y)
MU
y
(x, y)
=
u
0
x
2
=
y
x
.
That the change in the MRS increases with x, implies that as we
consume more of x the consumer is less willing to substitute
more of good y:
d
2
y
dx
2
u=u
0
= 2
u
2
0
x
3
> 0.
This is a reection that the consumer prefers average
consumption of the two goods to extreme bundles in which there
is a lot of one good and only few units of the other.
Figure: Moving Down an Indierence Curve
Relation Between Constrained and Unconstrained Optimization Problems
In the unconstrained optimisation problem, we want to obtain the
maximum or minimum values of a function.
In the constrained optimisation problem, we want to obtain the
maximum or minimum values of the the function subject to the
constraint.
In general, the solutions will be dierent (in general, the solution
to the unconstrained optimisation problem does not satisfy the
constraint).
But why is all this stu useful?
Because we can prove that the optimal solution for the
maximization of a consumers utility is given by the
point where the slope of the indierence curve and the
slope of the budget constraint are identical.
But the slope of the indierence curve in every point is
the MRS!
And the slope of the budget constraint is given by
p
x
p
y
.
So for our solution to dene a maximum it is necessary
(but not sucient!) that MRS =
p
x
p
y
the MRS!
p
x
p
y
.
p
x
p
y
the MRS!
p
x
p
y
.
p
x
p
y
The other condition that need to be satised is that the
optimal point MUST lay on the budget constraint.
So the system:
MRS =
p
x
p
y
M = p
x
X + p
y
Y
gives us the necessary and sucient conditions for nding
the constrained maximum.
So can points A and B constitute optimal solutions?
Y
AA
BB
X
NO!!! In both A and B, MRS = p
x
/p
y
.
And how about points C and D?
Y
C
DD
X
In points C and D the slope of the indierence curves (i.e.
the slope of the lines tangent to the indierence curves in
those points) is equal to the slope of the budget constraint.
So:
MRS
A
= MRS
B
=
p
x
p
y
The problem is that points C and D are NOT on the
budget constraint. So C and D do not satisfy the second
equation of the system.
And the winner is...
Y
E
X
An example
A consumer problem is:
max
X,Y
U(X, Y) = X
1/2
Y
1/2
s.t. 100 = 2X + Y
First step: Find the MRS associated with the above
utility function:
MRS =
dY
dX
=
U/X
U/Y
In our case:
MRS =
U/X
U/Y
=
1
2
X
1/2
Y
1/2
1
2
X
1/2
Y
1/2
=
Y
X
Second step: Set the system:
MRS =
p
x
p
y

Y
X
=
2
1
M = p
x
X + p
y
Y 100 = 2X + Y
Third Step: Solve the system
From the rst equation we get: X = 0.5Y.
Plugging this in the second equation (the budget
constraint) we get:
100 = Y + Y.
So Y
= 50 and since X = 0.5Y X
= 25.
Graphically:
120
100
U=U*
80
60
E
40
E
20
0
13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40

Constrained Maximisation I

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Constrained Maximisation I

Uploaded by

Copyright:

Available Formats

EC115 - Methods of Economic Analysis

Spring Term, Lecture 7

to represent production technologies and consumer preferences

to analyse their properties using partial dierentiation and total

= 50 and since X = 0.5Y X

You might also like