Constrained Maximisation II

EC115 - Methods of Economic Analysis
Spring Term, Lecture 8

Constrained Maximisation II
Renshaw - Chapter 16
University of Essex - Department of Economics
Week 23
Domenico Tabasso (University of Essex - Department of Economics) Lecture 8 - Spring Term Week 23 1 / 41
Recap - 1
In the last weeks we have tried to answer the following
question:
How can we maximize a function under a constraint?
The answer we gave so far is:
1
In case of a utility function U(x, y) the maximum is given by the
solution of the system:
_
Slope of the IC ( MRS) = Slope of the BC
Equation of the Budget Constraint
2
In case of a production function Y(K, L) the maximum is given by the
solution of the system:
_
Slope of the Isoquant( MRTS) = Slope of the Isocost
Equation of the Isocost
Recap - 2
The only diculty with this method consists in calculating
the MRS (or the MRTS).
Reminder:
MRS =
dy
dx
MRTS =
dK
dL
So how can we obtain an expression for
dy
dx
or
dK
dL
that we
can then insert in our systems?
Recap - 3
The way to obtain
dy
dx
or
dK
dL
is to use total
dierentiation.
Really???
Thanks to the implicit function theorem we know that:
MRS =
U/x
U/y
MRTS =
Y/L
Y/K
So we dont need to totally dierentiate the functions.
We can simply calculate the ratio of the two partial
derivatives and we are done.
Recap - 3
The way to obtain
dy
dx
or
dK
dL
is to use total
dierentiation.
Really???
MRS =
U/x
U/y
MRTS =
Y/L
Y/K
Recap - 3
The way to obtain
dy
dx
or
dK
dL
is to use total
dierentiation.
Really???
MRS =
U/x
U/y
MRTS =
Y/L
Y/K
Introduction
Last week we saw how to maximize a utility function under
a constraint using the MRS and the budget constraint.
This week we will:
1
Introduce a new method for maximizing the utility
function (direct substitution);
2
Speak again about the MRS method and study some
more details;
3
Learn how to distinguish between maxima and minima;
4
Learn in which cases the tangency condition may fails.
Solving Through Direct Substitution
Recall that the consumers problem is described by:
max
x,y
U(x, y) = x
1/2
y
1/2
s.t. p
x
x + p
y
y = m.
It is important to realise that the budget constraint
requires:
y = g(x) =
_
p
x
p
y
_
x +
_
m
p
y
_
must hold at all times!!!
The problem is thus to obtain the highest level of
utility, u
= U(x, y), such that x and y satisfy the

budget constraint.
Now substitute y = g(x) into the utility function to
give:
U(x) = U(x, g(x)) = x

1/2
_
p
x
p
y
x +
m
p
y
_
1/2
where p
x
, p
y
and m are positive constants.
Then the consumers problem can be re-written as an
unconstrained maximisation problem of one variable:
max
x
U(x), i.e. max

x
x
1/2
_
p
x
p
y
x +
m
p
y
_
1/2
The rst order condition implies that the quantity of
good X that maximises

U(x), namely x
, is given by
solving:
d
U(x)
dx
x=x
= 0.
Note that

U is not a function of y, but only of x, so our
derivative is denoted by the symbol d and not .
The second order condition implies that x
indeed
describes a maximum if:
d
U
2
(x)
dx
2
x=x
< 0.
Example
Consider the case in which:
p
x
= 1, p
y
= 1 and m = 10. Then:
U(x) = x
1/2
[x + 10]
1/2
so the problem is now:
max
x
x
1/2
[x + 10]
1/2
Using the product rule, the rst order condition implies
that x
is determined by:
d
U(x)
dx
= 0
1
2
(x
)
1/2
[x
+ 10]
1/2
1
2
(x
)
1/2
[x
+ 10]
1/2
= 0
Solving this expression for x
we get:
x
= 10 x
= x
= 5 =
1
2
m
p
x
since
m
p
x
= 10.
Verify that second order condition is satised.
Replacing the value of x
in the function g(x) we

obtain that:
y
= x
+ 10 = 5 =
1
2
m
p
y
.
It is important to realise that we have obtained the
individual demand functions for goods X and Y,
namely:
x
=
1
2
m
p
x
y
=
1
2
m
p
y
Of course, when we were given the values of
p
x
= 1, p
y
= 1 and m = 10, we obtained a point in
each demand function.
Solving through Total Dierentiation
To solve this problem we can use total dierentiation in
the following way:
To obtain the highest level of utility such that the
budget constraint is satised,
rst we have to look for all those indierence curves that satisfy the
budget constraint
then we can look for the highest indierence curve or highest level of
utility.
Recall that the indierence curves can described
implicitly by:
U(x, y) u
0
= x
1/2
y
1/2
u
0
= 0.
Also recall that the budget constraint is given by:
p
x
x + p
y
y = m.
Applying total dierentiation to both the indierence
curve and the budget line gives:
du
0
= MU
x
(x, y)dx + MU
y
(x, y)dy = 0,
p
x
dx + p
y
dy = 0.
From the indierence curve we get:
dy
dx
=
MU
x
(x, y)
MU
y
(x, y)
From the budget line we get:
dy
dx
=
p
x
p
y
.
Re-arranging we obtain the condition for a maximum in
the consumers problem:
MRS
x,y
=
MU
x
(x, y)
MU
y
(x, y)
=
p
x
p
y
.
The point on the budget line at which MRS
x,y
= p
x
/p
y
then gives the highest possible utility we can achieve.
When the consumer chooses x
and y
such that:
MRS
x,y
=
MU
x
(x, y)
p
x
=
MU
y
(x, y)
p
y
then she has no incentive to change his consumption.
At this level of consumption, the rate of substitution of
y for x determined by her preferences is the same as
the opportunity cost x in terms of y dictated by the
market through the relative prices.
In this cases we say that x
and y
describe an interior
solution.
Tangency condition : Optimal consumption of x and y
Y
Preference
direction
E
Optimal Choice
(Internal solution)
Y*
( )
X X*
Problems with the Total Dierentiation Approach
To better understand the intuition behind total
dierentiation approach, suppose that
MRS
x,y
= (p
x
/p
y
). What happens here?
First consider the case in which:
MU
x
(x, y)
MU
y
(x, y)
>
p
x
p
y
=
MU
x
(x, y)
p
x
>
MU
y
(x, y)
p
y
This expression describes implies that the consumer
obtains a higher marginal utility from spending one
more unit of his income in good x than y.
What do you think this consumer will do? Recall that
she is spending all of m.
Similarly, consider the case in which:
MU
x
(x, y)
MU
y
(x, y)
<
p
x
p
y
=
MU
x
(x, y)
p
x
<
MU
y
(x, y)
p
y
This expression describes implies that the consumer
obtains a higher marginal utility from spend one more
unit of her income in good y than x.
What do you think this consumer will do? Recall that
she is spending all of m.
What if the tangency condition fails?
To determine which good is bought we use our previous
inequalities:
if
MU
x
p
x
>
MU
y
p
y
= consume all in x
if
MU
x
p
x
<
MU
y
p
y
= consume all in y.
If the consumer only buys one of the two goods, then
the optimal solution will lay on one of the axes. In this
case we deal with a corner solution.
Perfect substitutes and corner solutions
Y
20
Indifference Indifference
Curve
12
Budget Budget
Constraint
20
X
What if the goods are perfect substitutes but MRS =
p
x
p
y
?
Y
Indifference Curve Indifference Curve
BudgetConstraint
X
0
How about the goods are perfect complements
(U = min{x
, y
})?
Y
Optimum
X
0
Example 1: MRS or Substitution?
A consumer problem is given by:
max
x,y
U(x, y) = x
s. t. p
x
x + p
y
y = m
where x, y, m, p
x
, p
y
> 0
Find the optimal consumption bundle (x
, y
) using both
the substitution method and the MRS approach.
Example 1: The substitution method
1
Obtain y = f (x) from the Budget Constraint
y =
m
p
y
p
x
p
y
x
2
Plug y = f (x) into the utility function U(x, y) and
obtain a new expression for the utility function:
U(x) = x
_
m
p
y
p
x
p
y
x
_
3
Maximize

U(x)
First Order Condition:
d

U(x)
dx
= 0
=
x
1
_
m
p
y
p
x
p
y
x
_
p
x
py
x
_
m
p
y
p
x
p
y
x
_
1
= 0
Rearranging:
x
1
_
m
p
y
p
x
p
y
x
_
=
p
x
py
x
_
m
p
y
p
x
p
y
x
_
1
The last equation can be rewritten as:
p
y
x
1
p
x
x
=
_
m
p
y
p
x
p
y
x
_
1
_
m
p
y
p
x
p
y
x
_
Which can be rewritten as:

p
y
_
m
p
y
p
x
p
y
x
_
p
x
x
= 1
Or:
m p
x
x = p
x
x
which implies
( + )p
x
x = m
So nally:
x
=
m
( + )p
x
Which substituted back into the budget constraint gives us:
y
=
m
( + )p
y
Little homework:
Check the sign of the second order conditions and verify
under which conditions x
, y
dene a maximum.
Solution: , < 1
Little homework:
Check the sign of the second order conditions and verify
under which conditions x
, y
dene a maximum.
Solution: , < 1
Again the same problem
max
x,y
U(x, y) = x
s. t. p
x
x + p
y
y = m
where x, y, m, p
x
, p
y
> 0
but now we nd the optimal consumption bundle (x
, y
)
using the MRS approach.
First Step: Find the MRS
We know that:
MRS =
U/x
U/y
So in our case:
MRS =
x
1
y
y
1
=
y
x
Second Step: Set Up the Following System:
_
_
_
MRS =
p
x
p
y
M = p
x
X + p
y
Y
So in our case:
_
_
_
y
x
=
p
x
p
y
M = p
x
x + p
y
y
From the rst equation we obtain:
y =
p
x
p
y
x
which we can substitute in the second equation (the budget
constraint) and get:
m = p
x
x + p
y
p
x
p
y
x
Simplifying we obtain:
x
=
m
( + )p
x
(of course!) and substituting back into y =
p
x
p
y
x we get:
y
=
m
( + )p
y
(of course!)
Which method do you nd easier?
Simplifying we obtain:
x
=
m
( + )p
x
(of course!) and substituting back into y =
p
x
p
y
x we get:
y
=
m
( + )p
y
(of course!)
Which method do you nd easier?
Distinguishing maxima and minima
Unfortunately the tangency condition for an interior
solution does not tell us if we are really maximising or
minimising the objective function.
Consider the following problem:
max
x,y
H(x, y) = x
2
+ y
2
st. x + y = 10
The tangency condition implies x
and y
must satisfy:
H
x
/
H
y
=
2x
2y
=
x
= 1
Thus the solution to the rst order conditions is given
by x
= y
= 5 with H(x
, y
) = H(5, 5) = 50.
But (x = 10, y = 0) also satises the constraint and
H(10, 0) = 100 > H(5, 5)!!!
One way to go around this problem is by analysing the
level curves of the function.
To guarantee that in the consumer problem we are
indeed nding a maximum, we assume that the
consumer prefers average consumption of x and y
instead extreme consumption of x and y.
Thus the solution to the rst order conditions is given
by x
= y
= 5 with H(x
, y
) = H(5, 5) = 50.
But (x = 10, y = 0) also satises the constraint and
H(10, 0) = 100 > H(5, 5)!!!
One way to go around this problem is by analysing the
level curves of the function.
To guarantee that in the consumer problem we are
indeed nding a maximum, we assume that the
consumer prefers average consumption of x and y
instead extreme consumption of x and y.
Hence in our standard maximization problem the
indierence curves are convex towards the origin.
In the case of
u = H(x, y) = x
2
+ y
2
if we x a level of utility u
0
, we have that the associate
indierence curve is given by the implicit function:
H(x, y) u
0
= x
2
+ y
2
u
0
= 0
Applying total dierentiation we obtain that
du
0
= 2xdx + 2ydy = 0
Hence in our standard maximization problem the
indierence curves are convex towards the origin.
In the case of
u = H(x, y) = x
2
+ y
2
if we x a level of utility u
0
, we have that the associate
indierence curve is given by the implicit function:
H(x, y) u
0
= x
2
+ y
2
u
0
= 0
Applying total dierentiation we obtain that
du
0
= 2xdx + 2ydy = 0
Therefore we nd that:
dy
dx
=
x
y
< 0
d
2
y
dx
2
=
1
y
< 0 for values of y > 0
But recall from the rst term material (Lecture 8, slides
38-45) that if a function y = f (x) shows a negative
second derivative (
d
2
y
dx
2
) then the function is concave!!!
H(x, y) has downward sloping and concave indierence
curves.
Level Curves
Y
Level Curves of
Z=X^2+Y^2
P
5
O ti
0
Optimum
0
X
0
5
X+Y=10
Level curves
So understanding how the utility function looks like is crucial for
correctly identifying the optimal consumption bundle. Take two
dierent utility functions: u(x, y) = x
2
+ y
2
and
u(x, y) = (x
2
+ y
2
). In both cases the indierence curves can be
represented as:
Y
00
X 0
Level curves
BUT:
U (X^2+Y^2) U=(X^2+Y^2)
U=X^2+Y^2
Level curves
In the case of u(x, y) = (x
2
+ y
2
) the two goods x and y
actually represent bads. The more we consume of them,
the lower our utility. So the only optimal solution is:
x
= 0, y
= 0
and this solution is totally independent from the constraint.

Constrained Maximisation II

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EC115 - Methods of Economic Analysis

Spring Term, Lecture 8

= U(x, y), such that x and y satisfy the

U(x) = U(x, g(x)) = x

U(x), i.e. max

in the function g(x) we

Which can be rewritten as:

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