136 Part 2: Choice and Demand

SUMMARY
In this chapter we explored the basic economic model of consumption of some goods is zero. In this case, the ra-
utility maximization subject to a budget constraint. Although tio of marginal utility to price for such a good will be
we approached this problem in a variety of ways, all these below the common marginal benefit–marginal cost ra-
approaches led to the same basic result. tio for goods actually bought.
• To reach a constrained maximum, an individual should • A consequence of the assumption of constrained utility
spend all available income and should choose a com- maximization is that the individual’s optimal choices
modity bundle such that the MRS between any two will depend implicitly on the parameters of his or her
goods is equal to the ratio of those goods’ market budget constraint. That is, the choices observed will be
prices. This basic tangency will result in the individual implicit functions of all prices and income. There-
equating the ratios of the marginal utility to market fore, utility will also be an indirect function of these
price for every good that is actually consumed. Such a parameters.
result is common to most constrained optimization
• The dual to the constrained utility-maximization prob-
problems.
lem is to minimize the expenditure required to reach a
• The tangency conditions are only the first-order condi- given utility target. Although this dual approach yields
tions for a unique constrained maximum, however. To the same optimal solution as the primal constrained
ensure that these conditions are also sufficient, the maximum problem, it also yields additional insight into
individual’s indifference curve map must exhibit a the theory of choice. Specifically, this approach leads to
diminishing MRS. In formal terms, the utility function expenditure functions in which the spending required
must be strictly quasi-concave. to reach a given utility target depends on goods’ market
prices. Therefore, expenditure functions are, in princi-
• The tangency conditions must also be modified to
ple, measurable.
allow for corner solutions in which the optimal level of

PROBLEMS
4.1
Each day Paul, who is in third grade, eats lunch at school. He likes only Twinkies (t) and soda (s), and these provide him a
utility of
pffiffiffi
utility ¼ Uðt, sÞ ¼ ts:

a. If Twinkies cost $0.10 each and soda costs $0.25 per cup, how should Paul spend the $1 his mother gives him to maximize
his utility?
b. If the school tries to discourage Twinkie consumption by increasing the price to $0.40, by how much will Paul’s mother
have to increase his lunch allowance to provide him with the same level of utility he received in part (a)?

4.2
a. A young connoisseur has $600 to spend to build a small wine cellar. She enjoys two vintages in particular: a 2001 French
Bordeaux (wF) at $40 per bottle and a less expensive 2005 California varietal wine (wC) priced at $8. If her utility is
2=3 1=3
UðwF , wC Þ ¼ wF wC ,

then how much of each wine should she purchase?

b. When she arrived at the wine store, our young oenologist discovered that the price of the French Bordeaux had fallen to
$20 a bottle because of a decrease in the value of the euro. If the price of the California wine remains stable at $8 per bottle,
how much of each wine should our friend purchase to maximize utility under these altered conditions?
c. Explain why this wine fancier is better off in part (b) than in part (a). How would you put a monetary value on this utility
increase?
 Chapter 4: Utility Maximization and Choice 137

4.3
a. On a given evening, J. P. enjoys the consumption of cigars (c) and brandy (b) according to the function
Uðc, bÞ ¼ 20c # c2 þ 18b # 3b2 :

How many cigars and glasses of brandy does he consume during an evening? (Cost is no object to J. P.)
b. Lately, however, J. P. has been advised by his doctors that he should limit the sum of glasses of brandy and cigars
consumed to 5. How many glasses of brandy and cigars will he consume under these circumstances?

4.4
a. Mr. Odde Ball enjoys commodities x and y according to the utility function
pffiffiffiffiffiffiffiffiffiffiffiffiffiffi
Uðx, yÞ ¼ x2 þ y2 :

Maximize Mr. Ball’s utility if px ¼ $3, py ¼ $4, and he has $50 to spend. Hint: It may be easier here to maximize U2 rather
than U. Why will this not alter your results?
b. Graph Mr. Ball’s indifference curve and its point of tangency with his budget constraint. What does the graph say about
Mr. Ball’s behavior? Have you found a true maximum?

4.5
Mr. A derives utility from martinis (m) in proportion to the number he drinks:
UðmÞ ¼ m:

Mr. A is particular about his martinis, however: He only enjoys them made in the exact proportion of two parts gin (g) to one
part vermouth (v). Hence we can rewrite Mr. A’s utility function as
%g &
UðmÞ ¼ Uð g, vÞ ¼ min , v :
2

a. Graph Mr. A’s indifference curve in terms of g and v for various levels of utility. Show that, regardless of the prices of the
two ingredients, Mr. A will never alter the way he mixes martinis.
b. Calculate the demand functions for g and v.
c. Using the results from part (b), what is Mr. A’s indirect utility function?
d. Calculate Mr. A’s expenditure function; for each level of utility, show spending as a function of pg and pv. Hint: Because this
problem involves a fixed-proportions utility function, you cannot solve for utility-maximizing decisions by using calculus.

4.6
Suppose that a fast-food junkie derives utility from three goods—soft drinks (x), hamburgers (y), and ice cream sundaes (z)—
according to the Cobb–Douglas utility function

Uðx, y, zÞ ¼ x0:5 y0:5 ð1 þ zÞ0:5 :

Suppose also that the prices for these goods are given by px ¼ 1, py ¼ 4, and pz ¼ 8 and that this consumer’s income is given by
I ¼ 8.
a. Show that, for z ¼ 0, maximization of utility results in the same optimal choices as in Example 4.1. Show also that any
choice that results in z > 0 (even for a fractional z) reduces utility from this optimum.
b. How do you explain the fact that z ¼ 0 is optimal here?
c. How high would this individual’s income have to be for any z to be purchased?

4.7
The lump sum principle illustrated in Figure 4.5 applies to transfer policy and taxation. This problem examines this application
of the principle.
138 Part 2: Choice and Demand

a. Use a graph similar to Figure 4.5 to show that an income grant to a person provides more utility than does a subsidy on
good x that costs the same amount to the government.
b. Use the Cobb–Douglas expenditure function presented in Equation 4.52 to calculate the extra purchasing power needed to
increase this person’s utility from U ¼ 2 to U ¼ 3.
c. Use Equation 4.52 again to estimate the degree to which good x must be subsidized to increase this person’s utility from
U ¼ 2 to U ¼ 3. How much would this subsidy cost the government? How would this cost compare with the cost calcu-
lated in part (b)?
d. Problem 4.10 asks you to compute an expenditure function for a more general Cobb–Douglas utility function than the one
used in Example 4.4. Use that expenditure function to re-solve parts (b) and (c) here for the case a ¼ 0.3, a figure close to
the fraction of income that low-income people spend on food.
e. How would your calculations in this problem have changed if we had used the expenditure function for the fixed-
proportions case (Equation 4.54) instead?

4.8
Two of the simplest utility functions are:
1. Fixed proportions: Uðx, yÞ ¼ min½x, y*.
2. Perfect substitutes: Uðx, yÞ ¼ x þ y
a. For each of these utility functions, compute the following:
• Demand functions for x and y
• Indirect utility function
• Expenditure function
b. Discuss the particular forms of these functions you calculated—why do they take the specific forms they do?

4.9
Suppose that we have a utility function involving two goods that is linear of the form U(x, y) ¼ ax þ by. Calculate the
expenditure function for this utility function. Hint: The expenditure function will have kinks at various price ratios.

Analytical Problems
4.10 Cobb–Douglas utility
In Example 4.1 we looked at the Cobb–Douglas utility function U(x, y) ¼ xay1#a, where 0 " a " 1. This problem illustrates a
few more attributes of that function.
a. Calculate the indirect utility function for this Cobb–Douglas case.
b. Calculate the expenditure function for this case.
c. Show explicitly how the compensation required to offset the effect of an increase in the price of x is related to the size of
the exponent a.

4.11 CES utility

The CES utility function we have used in this chapter is given by
x d yd
Uðx, yÞ ¼ þ :
d d

a. Show that the first-order conditions for a constrained utility maximum with this function require individuals to choose
goods in the proportion
!1=ðd#1Þ
x px
¼ :
y py

b. Show that the result in part (a) implies that individuals will allocate their funds equally between x and y for the Cobb–
Douglas case (d ¼ 0), as we have shown before in several problems.