Microeconomics (part I)

Silvia Tiezzi

University of Siena
mail: silvia.tiezzi@unisi.it

14 ottobre 2024
Summary of Class 5

▶ Common utility functions used in Economics

▶ The Budget Set
▶ The consumer’s utility maximization problem

JR Ch. 1 pp 19-24 or MG Ch. 1 pp 33-38

Common Utility functions: Cobb-Douglas
In the case of two goods, x1 and x2
β
u (x1 , x2 ) = Ax1α x2

where A, α, β > 0

applying logs on both sides:

log u = logA + αlogx1 + βlogx2

Hence, the exponents in the original u (·) can be interpreted as

elasticities:
∂u (x1 ,x2 ) x1
= αAx1α−1 x2 · x1
β
ε(u, x1 ) = ∂x1 · u (x1 ,x2 ) β =α
Ax1α x2

A one-percent increase in the amount of good x1 increases utility

by α percent.
Cobb-Douglas utility function

Similarly, ε(u, x2 ) = β

Special cases:

α+β = 1 u (x1 , x2 ) = Ax1α x21−α

A = 1 u (x1 , x2 ) = x1α x21−α

A=α=β=1 u (x1 , x2 ) = x1 x2
Cobb-Douglas utility function

Marginal utilities:
∂u (x1 ,x2 ) ∂u (x1 ,x2 )
∂x1 > 0 and ∂x2 >0

Diminishing MRS, since

αAx1α−1 x2
β
αx2
MRS12 = β −1 = βx1
βAx1α x2

which is decreasing in x1 .

Hence, indifference curves become flatter as x1 increases.

Cobb-Douglas indifference curve
Perfect Substitutes

In the case of two goods, x1 and x2

u (x1 , x2 ) = Ax1 + Bx2 A, B > 0

Hence, the marginal utility of every good is constant:

∂u (x1 ,x2 ) ∂u (x1 ,x2 )
∂x1 = A and ∂x2 =B

A
The MRS is also constant: MRS12 = B

Therefore, indifference curves are straight lines with a slope of − BA

Perfect Substitutes

x2
A
2A slope  
B

B 2B x1
Perfect Substitutes

Intuitively, the individual is willing to give up A/B units of x2 to

obtain one more unit of x1 and keep his utility level unaffected.

Unlike in the Cobb-Douglas case, such willingness is independent in

the relative abundance of the two goods.

Examples: two brands of butter, two brands of mineral water.

Common utility functions: Perfect Complements

In the case of two goods, x1 and x2

u (x1 , x2 ) = A · min {αx1 , βx2 } A, α, β > 0

Intuitively, increasing one of the goods without increasing the

amount of the other good entails no increase in utility.

Examples of perfect complements: all those goods that are

consumed in fixed proportions such as cars and gasoline, left and
right shoes.

The amounts of both goods must increase for utility to go up

(although they don’t need to increase by the same amount).

The indifference curve is a right angle with a kink at αx1 = βx2

 ~~
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Il ~
N ~
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Il Il
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Perfect Complements
Perfect Complements

α
β is the slope of the ray from the origin x2 = αβ x1 . This slope
indicates the rate at which goods x1 and x2 must be consumed in
order to achieve utility gains.

Special case: α = β Both goods are consumed in the same

proportion

u (x1 , x2 ) = A · min {αx1 , αx2 } = Aα · min {x1 , x2 }

Common Utility functions: CES utility function

In the case of two goods, x1 and x2

σ −1 σ −1 σ
u (x1 , x2 ) = [ax1 σ + bx2 σ ] σ−1

where σ measures the elasticity of substitution between goods 1

and 2.

σ evaluates the percentage change in the xx21 ratio that results from
a one percent change in the MRS12 as we move along the
indifference curve:
x
∂( x2 ) MRS
σ= 1 12
∂MRS12 ( xx2 )
1
CES utility function
CES utility function

The CES utility function is often presented in compact form as

ρ ρ 1
u (x1 , x2 ) = [ax1 + bx2 ] ρ
σ −1
where ρ ≡ σ

If ρ = 1 good 1 and good 2 are perfect substitutes.

Common utility functions: Quasi-linear utility function

In the case of two goods, x1 and x2

u (x1 , x2 ) = v (x1 ) + bx2

where x2 enters linearly in the utility function; b > 0; and v (x1 ) is

a nonlinear function of x1 .

Examples of v :
v (x1 ) = aln (x1 ) where a > 0
v (x1 ) = ax1α , where a > 0 and α ̸= 1.

The MRS is constant in the good that enters linearly in the utility
function (good 2 in this case).
At a given level of x1 , larger amounts of x2 (the good that enters
linearly) do not change the slope of the indifference curve.
Quasi-linear utility function

MRS of Quasi-linear preferences

Quasi-linear utility function

For u (x1 , x2 ) = v (x1 ) + bx2 , the marginal utilities are

∂u (·) ∂v ∂u (·)
MU1 = ∂x1 = ∂x1 and MU2 = ∂x2 =b
∂v
∂x1
which implies MRS12 = b

which is constant in the good entering linearly, good 2.

Quasilinear preferences are often used to represent the

consumption of goods that are relatively insensitive to income.

The consumption of good 1 (the good entering non-linearly)

remains constant after income increases. All additional income is
spent on good 2 (the good entering linearly).

Examples of good 1: garlic, toothpaste.

Lexicographic Preferences

Preference relations that do not satisfy Continuity cannot be

represented by a utility function.

Suppose a bundle x = (x1 , x2 ) is weakly preferred to another

bundle y = (y1 , y2 ), x ⪰ y, iff

x1 > y1 or if x1 = y1 and x2 > y2

This individual prefers bundle x if it contains more units of good 1

than bundle y.

When both bundles contain the same amount of good 1, the

individual starts comparing the number of units of good 2 across
bundles and prefers the bundle that contains more units of good 2.
Lexicographic Preferences

With this preference relation, the indifference set cannot be drawn

as an indifference curve.
′ ′ ′
For a given bundle x = (x1 , x2 ), there are no more bundles for
which the consumer is indifferent.

Indifference sets are then singletons (sets containing only one

element).
Lexicographic Preferences
Example of Lexicographic Preferences

Consider a consumer that wants to rank choices that involve both

money and playing tennis, denoted as good 1 = amount of time
devoted to tennis, good 2 = amount of money.

Suppose this consumer enjoys both money and tennis and has
lexicographic preference.

How to rank between choices involving different amounts of tennis

and money?

Choices that have more tennis will always be preferred over choices
that have less tennis. If two choices have the same amount of
tennis, the consumer will want the one with more money.
Checking the properties of a utility function

Exercize 1.16 MG
The Consumer’s Problem (Section 1.3 JR)

Behavioral assumptions of our theory of consumer choice.

We assume the consumer is motivated to choose the most

preferred feasible alternative according to his preference relation.

Formally, the consumer seeks:

x∗ ∈ B such that x∗ ⪰ x for all x ∈ B

The Consumer’s Problem (Section 1.3 JR)

We make the following assumption that will be maintained unless

otherwise stated:

ASSUMPTION: The consumer’s preference relation ⪰ is

complete, transitive, continuous, strictly monotonic, and strictly
convex on Rn+ . Therefore, it can be represented by a real-valued
utility function, u, that is continuous, strictly increasing, and
strictly quasiconcave on Rn+ .

Preferences such as these can be represented by an indifference

map whose levels are non-intersecting, strictly convex away from
the origin, and increasing north-easterly.
 Indifference map

CHAPTER 1

x2
1.2.
Why can’t two indifference curves intersect each other?
Why can’t two indifference curves intersect each other?
The market circumstances and the structure of the feasible
set

We deal with consumers operating within a market economy:

transactions are mediated by markets.

We assume there is a market for each commodity i and a price pi

prevails for each commodity i.

We assume that prices are strictly positive pi > 0, i = 1, ..., n and

that the individual consumer is an insignificant force on every
market. The individual consumer’s purchasing behavior has no
perceptible effect on any market price.

This means the vector of market prices p ≫ 0 is fixed from the

consumer’s point of view (consumer is a price taker).
The market circumstances and the structure of the feasible
set

The feasible set B could also be limited by physical constraints.

For example an individual maximum amount of daily leisure is 24h.

So any consumption bundle including leisure cannot contain more
than 24h of leisure.

Also, individuals usually work and sleep so the quantity of

consumable leisure time is less than 24h.

This is a physical constraint on the consumption set imposed by

the labour market.
Physical constraint on the feasible set
Physical constraint on the feasible set

Some goods cannot be enjoyed simultaneously in the same

consumption bundle.

Example: good 1 is beer consumption in Seattle at noon and good

2 is beer consumption in Barcelona at noon on the same day.

Consumer can consume any amount of beer in Seattle at noon or

in Barcelona at noon of the same day, but no combinations of the
two goods are possible.

The feasible consumption set coincides with the two axes.

Physical constraint on the feasible set

Beer in
Seattle
at noon

Beer in
Barcelona
at noon
The Budget set

The consumer is endowed with a fixed money income: y ≥ 0.

Purchasing xi units of commodity i costs pi xi Euros.

The requirement that expenditure must not exceed income can be

stated as ∑ni=1 pi xi ≤ y or p · x ≤ y .

With this requirement the feasible set B reduces to the budget

set:

B = {x|x ∈ Rn+ , p · x ≤ y }
The Budget line for the two goods case

For the two goods case, take the budget constraint satisfied with
equality :

p1 x1 + p2 x2 = y
y p1
Rearranging, we get the following budget line: x2 = p2 − p2 x1

with slope: ∂x2

∂x1 = − pp12
In the two goods case, B consists of all bundles lying inside or on the boundaries of
the shaded area.
The consumer problem

The consumer’s problem can thus be cast equivalenty as the

problem of maximizing the utility function subject to the budget
constraint.

Formally, the consumer’s utility maximization problem is written

as

max u (x) s.t. p · x ≤ y

Note that if x∗ solves this problem, then u (x∗ ) ≥ u (x) for all
x ∈ B, which means that x∗ ⪰ x for all x ∈ B.