Utility Maximisation Problem

Simon Board∗

This Version: September 20, 2009

First Version: October, 2008.

The utility maximisation problem (UMP) considers an agent with income m who wishes to
maximise her utility. Among others, we are interested in the following questions:

• How do we determine an agent’s optimal bundle of goods?

• How do we derive an agent’s demand curve for a particular good?

• What is the effect of an increase in income on an agent’s consumption?

1 Model

We make several assumptions:

1. There are N goods. For much of the analysis we assume N = 2, but nothing depends on
this.

2. The agent takes prices as exogenous. We normally assume prices are linear and denote
them by {p1 , . . . , pN }.

3. Preferences satisfy completeness, transitivity and continuity. As a result, a utility func-

tion exists. We normally assume preferences also satisfy monotonicity (so indifference
curves are well behaved) and convexity (so the optima can be characterised by tangency
conditions).
∗
Department of Economics, UCLA. http://www.econ.ucla.edu/sboard/. Please email suggestions and typos
to sboard@econ.ucla.edu.

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4. The consumer is endowed with income m.

The utility maximisation problem is:

N
X
max u(x1 , . . . , xN ) subject to pi xi ≤ m (1.1)
x1 ,...,xN
i=1
xi ≥ 0 for all i

The idea is that the agent is trying to spend her income in order to maximise her utility. The
solution to this problem is called the Marshallian demand or uncompensated demand. It is
denoted by
x∗i (p1 , . . . , pN , m)

The most utility the agent can attain is given by her indirect utility function. It is defined
by

N
X
v(p1 , . . . , pN , m) = max u(x1 , . . . , xN ) subject to pi xi ≤ m (1.2)
x1 ,...,xN
i=1
xi ≥ 0 for all i

Equivalently, the indirect utility function equals the utility the agent gains from her optimal
bundle,
v(p1 , . . . , pN , m) = u(x∗1 , . . . , x∗N ).

1.1 Example: One Good

To illustrate the problem, suppose N = 1. For example, the agent has income m and is choosing
how many cookies to consume. The agent’s utilities are given by table 1.

In general, we solve the problem in two steps. First, we determine which bundles of goods are
affordable. The collection of these bundles is called the budget set. Second, we find which
bundle in the budget set the agent most prefers. That is, which bundle gives the agent most
utility.

Suppose the price of the good is p1 = 1 and the agent has income m = 4. Then the agent can
afford up to 4 units of x1 . Given this budget set, the agent’s utility is maximised by choosing
x∗1 = 4, yielding utility v = 28.

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Units of x1 Utility
1 10
2 18
3 24
4 28
5 30
6 29
7 26
8 21

Table 1: Utilities from different bundles. Observe that this agent is satiated at 5 units.

Next, suppose the price of the good is p1 = 1 and the agent has income m = 8. Then the
agent can afford up to 8 units of x1 . Given this budget set, the agent’s utility is maximised by
choosing x∗1 = 5, yielding utility v = 30. In this example, the consumer can afford 8 units but
chooses to consume 5. If the agent’s preferences are monotone, then she will always spend her
entire budget.

Finally, suppose the price of the good is p1 = 2 and the agent has income m = 8. Then the
agent can afford up to 4 units of x1 , as in the original case. This illustrates that the budget
set is determined jointly by the prices and income: doubling both does not change the agent’s
budget set. When maximising her utility, the agent once again chooses x∗1 = 4.

2 Budget Sets

As in Section 1.1, we will solve the agent’s problem in two steps. First, we determine which
bundles of goods are affordable. Second, we find which of these bundles yields the agent the
highest utility. In this section we look at the first step.

2.1 Standard Budget Sets

In the standard model, we assume there are unit prices {p1 , p2 } for the 2 goods. The budget
set is the collection of bundles (x1 , x2 ) such that (a) the quantities are positive; and (b) the
bundle is affordable. Mathematically, the budget set is

{(x1 , x2 ) ∈ <2+ : p1 x1 + p2 x2 ≤ m}

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Figure 1: Budget Set.

where <+ is the positive part of the real line, and <2+ is the positive orthont in <2 .

Figure 1 illustrates such a budget set. The equation where the budget binds is given by

p1 x1 + p2 x2 = m (2.1)

We can rearrange this to be in the form of a standard linear equation

m p1
x2 = − x1 (2.2)
p2 p2

Hence the budget line is linear with intercept m/p2 and slope −p1 /p2 . Crucially, the slope only
depends on the relative prices.

The two endpoints are easy to calculate. If the agent spends all her money on x1 she can afford

m
x1 = and x2 = 0
p1

If the agent spends all her money on x2 she can afford

m
x1 = 0 and x2 =
p2

Figure 2 shows that an increase in the agent’s income leads the budget line to make a parallel

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Figure 2: An Increase in Income.

shift outwards. Mathematically, this can be seen from equation (2.2). Intuitively, if the agent’s
budget doubles then she can double her consumption of both goods. Since relative prices do
not change, the new budget line is parallel to the old one.

Figure 3 shows that an increase in p1 leads the budget curve to pivot around it’s left endpoint.
Mathematically, this can be seen from equation (2.2). Intuitively, if the agent only buys x2 ,
then her purchasing power is unaffected by the increase in p1 . As a result, the left endpoint does
not move. If the agent only buys x1 , then the increase in p1 reduces the amount she can buy,
forcing the right endpoint to shift in. As a result, the budget line become steeper, reflecting
the change in the relative prices.

2.2 Nonlinear Budget Sets

While we focus on linear budget constraints, agents often face nonlinear prices. Here we present
some examples.

Figure 4 shows an example of quantity discounts. In this example, the agent has income m = 30.
Good 1 has per–unit price p1 = 2 for x1 < 10, and per–unit price p1 = 1 for x1 ≥ 10. Good 2
has a constant price, p2 = 2. Lets consider 2 cases. First, when the agent buys x1 < 10, the
price of good 1 is p1 = 2 and the equation of the budget line is therefore 2x1 + 2x2 = 30 or

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Figure 3: An Increase in the Price of Good 1.

x2 = 15 − x1 . For example, when the agent spends all her money on good 2, she can afford
x2 = 15. Second, when x1 ≥ 10 the agent spends $20 on the first 10 units of x1 and $1 per unit
thereafter. Hence her budget constraint is

20 + (x1 − 10) + 2x2 = 30

Figure 5 shows an example of rationing. In this example, the agent has income m = 30. Good
1 has per–unit price p1 = 2 for x1 ≤ 10, but she is only allowed to purchase 10 units. Good 2
has a constant price, p2 = 2. When the agent buys x1 ≤ 10, the price of good 1 is p1 = 2 and
the budget line is 2x1 + 2x2 = 30. For example, when the agent spends all her money on good
2, she can afford x2 = 15. The agent is unable to buy more than 10 units of x1 , so the budget
set is cut off at x1 = 10.

Exercise: Excess tax on x1 . Suppose m = 30, p2 = 2, and p1 = 2 for the first 10 units and
p1 = 3 for each additional unit. Draw the agent’s budget set.

Exercise: Food stamps. Suppose m = 30, p2 = 2, and p1 = 0 for the first 10 units and p1 = 2
for each additional unit. Draw the agent’s budget set.

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Figure 4: Quantity Discounts. The dark line shows the agent’s budget set with p1 = 1 for x1 ≥ 10.
The dotted line shows her budget set if p1 = 2 for all units.

Figure 5: Rationing. The dark line shows the agent’s actual budget set given she can only buy 10
units of x1 . The dotted line shows her budget set without rationing.

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3 Solving the Utility Maximisation Problem

In this section we solve the agent’s utility maximisation problem. We make a number of
simplifying assumptions which we explore in Section 4. In particular, we assume:

• The agents utility function is differentiable. As a result there are no kinks in the indiffer-
ence curve.

• The agent’s preferences are monotone. As a result, she spends her entire budget.1

• The agent’s preferences are convex. As a result, any solution to the tangency conditions
constitute a maximum.

• There is an interior solution to the agent’s maximisation problem.

3.1 Solution Method 1: Graphical Approach

The agent wishes to choose a point in her budget set to maximise her utility. That is, the agent
wishes to choose a point in her budget set that lies on the highest indifference curve.2

Figure 6 characterises the agent’s optimal choice. Graphically, one can imagine the indifference
curve flying in from the top right corner (where utility is highest) and stopping when it touches
the budget set.

To understand this further, consider figure 7. There are 3 indifference curves. I1 yields the
highest utility, but never intersects with the budget set. I2 is corresponds to the agent’s optimal
choice (point A). I3 yields a lower level of utility which is attainable but not desirable.

At the optimal point, the budget line is tangential to the indifference curve. As a result the
budget line and the indifference curve have the same slope. This tangency condition means
that

p1
MRS(x∗1 , x∗2 ) = (3.1)
p2
1
We actually assume ∂u(x1 , x2 )/∂xi > 0 for each i. See Section 4.3.
2
Recall monotonicity and convexity implies that indifference curves are thin, downward sloping and convex.

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Figure 6: The Agent’s Optimal Demand. This figure shows how the agent’s optimal demand is
characterised by the tangency condition.

Figure 7: Understanding the Tangency Condition. In this figure I2 is the highest attainable
indifference curve. I3 is higher but unaffordable; I1 is affordable but not optimal.

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where the marginal rate of substitution is evaluated at the optimal choice, (x∗1 , x∗2 ). Since
M RS = M U1 /M U2 ,3 we can write the tangency condition as

M U1 (x∗1 , x∗2 ) p1
∗ ∗ = (3.2)
M U2 (x1 , x2 ) p2

The intuition for this result is as follows. The MRS equals the number of x2 the agent is willing
to give up to get one more unit of x1 . The price ratio equals the number of x2 the agent
has to give up in order to get one more unit of x1 if she wishes to stay within her budget. If
M RS > p1 /p2 , then the agent is more willing to give up x2 than the market requires, so she
can increase her utility by consuming less x2 and more x1 . If M RS < p1 /p2 , then the agent is
less willing to give up x2 than the market requires, so she can increase her utility by consuming
more x2 and less x1 .

One can rewrite the tangency condition as:

M U1 (x∗1 , x∗2 ) M U2 (x∗1 , x∗2 )

= (3.3)
p1 p2

Equation (3.3) says that the agent equalises the marginal utility per dollar, or the bang–per–
buck of the two goods. If the bang–per–buck from good 1 is higher than that from good 2,
then the agent buys more of good 1. If the bang–per–buck from good 1 is lower than that from
good 2, then the agent buys less of good 1. At the optimal choice, the bang–per–buck of the
two goods is equal.

3.2 Example: Symmetric Cobb–Douglas.

Suppose u(x1 , x2 ) = x1 x2 . The MRS is

M U1 x2
=
M U2 x1

The tangency condition (3.1) therefore becomes

x2 p1
=
x1 p2
3
Recall M Ui (x1 , x2 ) = ∂u(x1 , x2 )/∂xi .

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Rewriting, we see that

p1 x1 = p2 x2 (3.4)

which means that the agent’s spends the same money on each good. This is a special property
of the symmetric Cobb–Douglas model and helps make it so tractable. The budget constraint
states that

p1 x1 + p2 x2 = m

Substituting equation (3.4) into the budget constraint implies that p1 x1 = p2 x2 = m/2, so the
agent spends half her income on each good. As a result, the Marshallian demands are

m m
x∗1 (p1 , p2 , m) = and x∗2 (p1 , p2 , m) = (3.5)
2p1 2p2

We can also calculate the agent’s indirect utility, her utility from the optimal bundle. Using
the demands in equation (3.5), we have
µ ¶µ ¶
m m m2
v(p1 , p2 , m) = u(x∗1 , x∗2 ) = x∗1 x∗2 = =
2p1 2p2 4p1 p2

3.3 Solution Method 2: Lagrangian Approach

A second way to solve the agent’s utility maximisation problem is to use a Lagrangian. This
approach is equivalent to the tangency approach but can be more convenient, especially with
complex problems.

At the optimal solution, equation (3.3) tells us that the agent equalises the bang–per–buck from
each good. Let λ equal the marginal utility the agent derives from $1 at her optimal bundle.
We then have

M U1 (x∗1 , x∗2 )
λ= (3.6)
p1
M U2 (x∗1 , x∗2 )
λ= (3.7)
p2

We can encode equations (3.6) and (3.7) as the first–order conditions of one single equation.

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Consider maximising the Lagrangian,

L = u(x1 , x2 ) + λ[m − p1 x1 − p2 x2 ] (3.8)

In this equation λ is called a Lagrange multiplier. Intuitively, we are maximising the agent’s
utility plus a penalty term which punishes the agent for exceeding her budget (if m − p1 x1 −
p2 x2 < 0). If the penalty λ is too low the agent will spend more than her income; if the penalty
λ is too high the agent will spend less than her income. We must therefore choose the penalty
λ so the agent exactly spends her budget.

Mechanically, we solve the problem as follows. First, we derive the first–order–conditions of the
Lagrangian (3.8). This yields:

∂L ∂u(x1 , x2 )
= − λp1 = 0 (3.9)
∂x1 ∂x1
∂L ∂u(x1 , x2 )
= − λp2 = 0 (3.10)
∂x2 ∂x2

We also know the agent’s budget constraint binds:

p1 x1 + p2 x2 = m (3.11)

We now have three unknowns (x1 , x2 , λ) and three equations: (3.9), (3.10) and (3.11). We can
therefore solve for the agent’s optimal demands.

We can relate these results to those in Section 3.1. Rearranging, equations (3.9) and (3.10) yield
equations (3.6) and (3.7), which means we can interpret the optimal λ as the “bang–per–buck”
of the optimal bundle. In addition, dividing (3.9) by (3.10) yields

∂u(x1 , x2 )/∂x1 p1
=
∂u(x1 , x2 )/∂x2 p2

which is the tangency condition (3.2) from Section 3.1.

3.4 Solution Method 3: Substitution

The agent’s problem is to maximise her utility subject to her budget constraint. When there are
two goods one can solve for the agent’s optimal bundle by substituting the budget constraint
directly into the objective function.

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Recalling equation (2.2), the budget constraint can be written as

m p1
x2 = − x1
p2 p2

Substituting this into the agent’s utility function, she chooses x1 to maximise
µ ¶
m p1
u x1 , − x1
p2 p2

The first–order condition is

µ ¶
∂u(x1 , x2 ) ∂u(x1 , x2 ) p1
+ − =0
∂x1 ∂x1 p2

Rearranging,
∂u(x1 , x2 )/∂x1 p1
=
∂u(x1 , x2 )/∂x2 p2
which is the tangency condition (3.2) from Section 3.1. Using the budget constraint, we can
therefore solve the for agent’s optimal bundle (x∗1 , x∗2 ).

3.5 Many goods

The tangency condition (3.3) extends to many goods. In this case, the agent equates the
bang–per–buck from each of the N goods. That is,

M U1 M U2 M UN
= = ... =
p1 p2 pN

One can then derive the agent’s optimal demand using these (N − 1) equations and the budget
constraint.

Equivalently, one can set up the Lagrangian

L = u(x1 , x2 , . . . , xN ) + λ[m − p1 x1 − p2 x2 − . . . − pN xN ]

One can then solve for the agent’s optimal demand and the Lagrange multiplier using the N
first–order–conditions and the budget constraint.

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4 Problems with the UMP

In this Section we investigate the tangency conditions in more depth. In Section 4.1 we state a
formal version of the theorem we were implicitly using in Section 3. We then look at the four
assumptions we made at the start of the last section: kinks, the monotonicity of preferences,
the convexity of preferences, and boundary problems.

4.1 Kuhn–Tucker Conditions

Suppose the agent is solving the problem:

max u(x1 , x2 ) subject to p1 x1 + p2 x2 ≤ m (4.1)

x1 ,x2
x1 ≥ 0
x2 ≥ 0

Form the Lagrangian

L = u(x1 , x2 ) + λ[m − p1 x1 − p2 x2 ] + µ1 x1 + µ2 x2 (4.2)

where the last two terms are the penalties associated with constraints x1 ≥ 0 and x2 ≥ 0.

Suppose u(x1 , x2 ) is continuously differentiable and (x∗1 , x∗2 ) solves (4.1). Then four Kuhn–
Tucker conditions hold:

∂L ∂L
(a) The first order conditions hold: ∂x1 = 0 and ∂x2 = 0.

(b) The Lagrange multipliers are positive: λ, µ1 , µ2 ≥ 0.

(c) The constraints hold: m − p1 x1 − p2 x2 ≤ 0, x1 ≥ 0 and x2 ≥ 0.

(d) Complimentary slackness holds: λ[m − p1 x1 − p2 x2 ] = 0, µ1 x1 = 0 and µ2 x2 = 0.

The idea behind these conditions is exactly the same as in Section 3.3. Part (a) say that the
agent is choosing (x1 , x2 ) to maximise her utility plus the penalty functions. Part (b) says
that the penalties are positive. Part (c) says that the agent’s choice must be feasible. Part (d)
says that we cannot have a constraint slack and have the associated Lagrange multiplier being
positive. For example, consider the budget constraint and recall that the Lagrange multiplier

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can be interpreted as the bang–per–buck. Complimentary slackness says that if the budget
constraint at the optimal solution is slack, then the bang–per–buck equals zero and hence
λ = 0.

We now present the formal result.

Theorem 1. Suppose the utility function is continuously differentiable.

(i) Any optimal solution satisfies the conditions (a)–(d).
(ii) If preferences are convex and M Ui (x1 , x2 ) > 0 for each i, then the solutions to (a)–(d) are
optimal.

In Section 4.2 we look at the issue of kinks, where the optimal solution may not satisfy the
Kuhn–Tucker conditions. In Sections 4.3–4.4 we investigate what happens if monotonicity and
convexity do not hold. In this case the there may be multiple solutions to the Kuhn–Tucker
conditions, some of which are not optimal. Finally, in Section 4.5 we look at the issue of
boundary constraints, where the nonnegativity constraints may bind.

4.2 Kinks

When deriving the tangency condition, we assumed that the utility function (and hence the
indifference curve) is differentiable.

Suppose there is a kink in the indifference curve along the as shown in figure 8. At the kink,
the MRS to the left and right are different. Let the MRS to the left be denoted M RS L and
than to the right be denoted M RS R . Then the solution is at the kink if

p1
M RS L (x∗1 , x∗2 ) ≥ ≥ M RS R (x∗1 , x∗2 ) (4.3)
p2

Noting that M RS = M U1 /M U2 , equation (4.3) says that to the left of (x∗1 , x∗2 ) we have

M U1 M U2
≥
p1 p2

so the agent wishes to increase x1 . While to the right of (x∗1 , x∗2 ) we have

M U1 M U2
≤
p1 p2

so the agent wishes to decrease x1 . Putting this together, when x1 < x∗1 , the agent wishes to

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Figure 8: Indifference Curve with Kinks. The agent chooses point A. At the optimum, M RS L ≥
p1 /p2 ≥ M RS R .

buy more x1 ; when x1 > x∗1 , the agent wishes to buy less x1 . Hence the optimal solution is at
x1 = x∗1 .

One way to approach this is to think of the MRS at the kink as being an entire set of numbers
[M RS R , M RS L ]. The tangency condition then says that the solution is at the kink if p1 /p2
falls in the set.

4.2.1 Example: Perfect Complements

Suppose u(x1 , x2 ) = min{αx1 , βx2 }. In this case utility is not differentiable along the line
αx1 = βx2 , as shown in figure 9. The agent’s optimal bundle clearly has the property that
αx1 = βx2 . One can then use the agent’s budget constraint to solve for the optimal bundle.

To illustrate, suppose an agent’s utility is

u(x1 , x2 ) = min{2x1 , x2 }

The agent’s income is m = 30 and prices are p1 = 1 and p2 = 1. At the optimal bundle,
x1 = 2x2 . Using the budget constraint we thus have x∗1 = 10 and x∗2 = 10.

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Figure 9: Perfect Complements. With perfect complements there is a kink in the indifference curve
where αx1 = βx2 . The agent maximises her utility at the kink, at point A.

4.3 Monotonicity

When deriving the tangency conditions, we assumed that each good has a strictly positive
marginal utility. This is an attractive property for two reasons.

First, if preferences are monotone then indifference curves are thin and downward sloping. From
the perspective of the utility maximisation problem, monotonicity also ensures the agent spends
her entire budget. In Section 4.3.1 we look at an example where monotonicity fails and the
agent does not always wish to spend her budget.

Second, the fact that marginal utilities are strictly positive implies that the Kuhn–Tucker
conditions pick out the optimal solution. In Section 4.3.2 we look at an example where there
are two solutions to the Kuhn–Tucker conditions, only one of which is optimal.

4.3.1 Example: Bliss Point

Suppose u(x1 , x2 ) = − 12 (x1 − 10)2 − 21 (x2 − 10)2 . Figure 10 plots the corresponding indifference
curves which are concentric circles around the bliss point of (x1 , x2 ) = (10, 10).

Suppose prices are p1 = 1 and p2 = 1 and the agent has income m = 10. At this point, the

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Figure 10: Bliss Point. Utility is maximised at (10, 10). Indifference curves are circles around this
bliss point.

agent cannot afford her bliss point (which costs $20), so her budget constraint will bind. The
price ratio is p1 /p2 = 1, so the tangency condition implies

M U1 −(x1 − 10)
= =1
M U2 −(x2 − 10)

Rearranging, we see that x1 = x2 . The budget constraint states that x1 + x2 = 10. Hence we
have x∗1 = 5 and x∗2 = 5.

Next, suppose prices are p1 = 1 and p2 = 1 and the agent has income m = 30. In this case the
agent can afford her bliss point and will buy x∗1 = 10 and x∗2 = 10.

One can derive the same results from the Kuhn–Tucker conditions. First, suppose that the
budget constraint binds. Ignoring boundary constraints (which are not an issue here), the
FOCs of the Lagrangian are

−(x1 − 10) − λ = 0 (4.4)

−(x2 − 10) − λ = 0 (4.5)

As above, the FOCs imply x1 = x2 . If m = 10, then the budget constraint implies that
(x∗1 , x∗2 ) = (5, 5), and we are done. If m = 30, then the budget constraint implies that (x∗1 , x∗2 ) =
(15, 15), which we know to be wrong. Substituting back into (4.4) or (4.5), we find λ = −5,

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16

12

Utility 8

0
0 1 2 3 4
x
1

Figure 11: Inflexion. The utility function is strictly increasing but has an inflexion at x1 = 2. As a
result, there are two points that satisfy the Kuhn–Tucker conditions, only one of which is optimal.

which breaks part (c) of the Kuhn–Tucker conditions. Economically, this result means that
the bang–per–buck is negative, so the solution is clearly not optimal. We thus know that the
budget constraint does not bind, so complimentary slackness implies λ = 0. The agent thus
maximises
L = −(x1 − 10)2 − (x2 − 10)2

which yields (x∗1 , x∗2 ) = (10, 10).

4.3.2 Example: Inflexion

Suppose there is one good, x1 . The utility of the agent is given by u(x1 ) = (x1 − 2)3 + 8. The
agent has income m = 4 and faces prices p1 = 1, so her budget states that x1 ≤ 4.

Figure 11 plots the utility function. Since this is increasing the optimal consumption is clearly
x∗1 = 4.

Now consider the Lagrangian:

L = (x1 − 2)3 + 8 + λ[m − p1 x1 − p2 x2 ]

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The FOC is

3(x1 − 2)2 = λ (4.6)

There are two solutions to the Kuhn–Tucker conditions. First, suppose λ > 0. By complimen-
tary slackness, the agent spends her budget. Hence x∗1 = 4. Plugging back into (4.6) we see
that
λ = 3(x1 − 2)2 = 12 > 0

as initially assumed. Hence this solution satisfies the Kuhn–Tucker conditions.

Second, suppose λ = 0. Equation (4.6) implies that x∗1 = 2, and the budget constraint is slack.
Again, one can verify this “solution” satisfies the Kuhn–Tucker conditions, even though is is
clearly wrong.

The problem is that the utility function has a inflexion at x1 = 2. When the derivative fails to
be strictly positive like this, there may be multiple solutions to the Kuhn–Tucker conditions.
By part (a) of Theorem 1, one of these is the real solution, but one has to individually check
which one.

4.4 Convexity

If preferences fail to be convex, then the solution to the tangency condition may characterise a
local maximum or, even worse, a local minimum.

Figure 12 illustrates the problem. Points A, B and C all satisfy the tangency conditions. Point
A is the global maximum; point B is a local maximum; point C is a local minimum.

4.4.1 Example: Addiction

Suppose an agent has utility u(x1 , x2 ) = 21 x21 + 12 x22 . Differentiating, M Ui = xi , so the marginal
utility of each good is increasing in the amount of the good consumed. For example, one could
imagine the agent becomes addicted to either good.

As shown in Figure 13, these preferences are concave. One can see this formally by showing

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Figure 12: Failure of Convexity. Points A, B and C satisfy the tangency condition.

the MRS is increasing in x1 along an indifference curve. Differentiating,

M U1 x1
M RS = = (4.7)
M U2 x2

The equation of an indifference curve is x21 +x22 = k. Rearranging, x2 = (k−x21 )1/2 . Substituting
into (4.7),
x1
M RS =
(k − x21 )1/2
which is increasing in x1 .

With this addiction model, the tangency condition yields

x1 p1
=
x2 p2

If m = 10, p1 = 1 and p2 = 1, then one would wrongly conclude that (x∗1 , x∗2 ) = (5, 5). However,
as we can see from figure 13, this is a local minimum.

Looking at figure 13, one can see that the agent’s optimal bundle is on the boundary. Intuitively,
if the agent becomes addicted, then she wishes to consume only one good. The left and right
endpoints of the budget line are (x1 , x2 ) = (m/p1 , 0) and (x1 , x2 ) = (0, m/p2 ) respectively.
Comparing these two points, we see that (x∗1 , x∗2 ) = (m/p1 , 0) if p1 ≤ p2 and (x∗1 , x∗2 ) = (0, m/p2 )
if p1 ≥ p2 .

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Figure 13: Addictive preferences. Point A satisfies the tangency condition but is not optimal. The
agent’s optimal bundle is point B.

4.5 Boundary Solutions

In Section 3 we assumed that the solution to the agent’s UMP is internal. In practice, there
are many goods that a typical person chooses not to buy.

Figure 14 provides an illustration. In this example,

p1
M RS(x1 , x2 ) > (4.8)
p2

for all internal (x1 , x2 ). Since the indifference curve is always steeper than the budget line, the
agent’s optimal bundle is (x∗1 , x∗2 ) = (m/p1 , 0). The intuition behind this is straightforward:
rearranging, (4.8) we see that
M U1 M U2
>
p1 p2
which means that the bang–per–buck from x1 is always bigger than that from x2 . As a result
the agent consumes only x1 .

There are two ways to solve problems where boundary constraints may bind. First, one can
insert Lagrange multipliers for the boundary constraints as in equation (4.2). One can then use
the Kuhn–Tucker conditions to derive the agent’s optimal bundle.

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Figure 14: Boundary Solutions. In this figure the indifference curves are always steeper than the
budget line. As a result, the solution is at point A, on the boundary.

Second, if preferences are convex, one can simply ignore the boundary constraints. If one finds
that x∗i < 0, then set x∗i = 0 and resolve.

For a certain class of preferences, boundary problems will never be an issue. An indifference
curve implicitly defines x2 as a function of x1 . Let this function be denoted x2 (x1 ), so that
u(x1 , x2 (x1 )) = k. The Inada conditions state that:

lim M RS(x1 , x2 (x1 )) = ∞ and lim M RS(x1 , x2 (x1 )) = 0 (4.9)

x1 →0 x1 →∞

Under these assumptions, the agent places a huge value on the first unit of both goods, and so
will consume a positive amount of each. Notably, these Inada conditions are satisfied by Cobb
Douglas preferences, u(x1 , x2 ) = xα1 xβ2 , where

M U1 αxα−1
1 xβ2 αx2
M RS = = β−1
= (4.10)
M U2 α
βx1 x2 βx1

−α/β
Along an indifference curve xα1 xβ2 = k, so x2 = k 1/β x1 and substituting into (4.10),

αx2 α −(α+β)/β
M RS = = k 1/β x1
βx1 β

which satisfies the Inada conditions (4.9).

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Figure 15: Perfect Substitutes. The slope of the agent’s indifference curve is −α/β, while the slope
of the agent’s budget line is −p1 /p2 . In this figure α/β < p1 /p2 , so the bang–per–buck is higher from
good 2 than good 1 and the agent chooses point A on the boundary.

4.5.1 Example: Perfect Substitutes

Suppose an agent has a utility function

U (x1 , x2 ) = αx1 + βx2

The indifference curves are straight lines with slope −α/β. The budget line has slope −p1 /p2 .
As shown in figure 15, the agent’s optimal choice will occur at one of the endpoints. If

α β
>
p1 p2

then the bang–per–buck from good 1 exceeds that from good 2, so the agent’s optimal bundle
is (x∗1 , x∗2 ) = (m/p1 , 0). If
α β
<
p1 p2
then the bang–per–buck from good 2 exceeds that from good 1, so the agent’s optimal bundle
is (x∗1 , x∗2 ) = (0, m/p2 ). If
α β
=
p1 p2
then the agent is indifferent between all points on the budget line.

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5 General Properties of Solutions

It is useful to know some general properties of Marshallian demand (1.1) and indirect utility
(1.2).

The Marshallian demand is homogenous of degree zero in prices and income. That is,

x∗i (p1 , p2 , m) = x∗i (αp1 , αp2 , αm) for α > 0

This means that a doubling of prices and income has no affect on the agent’s demand. In-
tuitively, the agent buys the same goods whether the currency is denominated in Euros or
Dollars.

The indirect utility function has three attractive properties.

1. The indirect utility function is homogenous of degree zero in prices and income. That is,

v(p1 , p2 , m) = v(αp1 , αp2 , αm) for α > 0

The agent’s utility depends on what she buys, which is unaffected by the form of the currency
(see above).

2. The indirect utility function is increasing in income and decreasing in prices. An increase
in the agent’s income expands the budget set and thereby increases the agent’s utility from her
most preferred choice. Conversely, an increase in a price contracts the agent’s budget set and
thereby decreases the agent’s utility from her most preferred choice.

3. Roy’s Identity: 4

∂v(p1 , p2 , m) ∂v(p1 , p2 , m)
= −x∗i (p1 , p2 , m) (5.1)
∂pi ∂m

Suppose p1 increases by 1¢. Then there is a direct and indirect effect on the agent’s utility. The
direct effect is that, holding demand constant, the agent’s effective income falls by x∗1 × 1¢. The
indirect effect is that as relative prices change, the agent rebalances her optimal choice. This
indirect effect, however, is small since the agent’s initial choice was optimal under the initial
price, so is almost optimal under the new price. Putting this together, we see that the effect of
a 1¢ price rise on utility equals x∗1 times the effect of a 1¢ drop in income. This is exactly what
4
Advanced.

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equation (5.1) says.

Roy’s identity is useful since it enables us to calculate the agent’s Marshallian demand from
her indirect utility function. To illustrate this result, consider the symmetric Cobb–Douglas
model. The agent has utility u(x1 , x2 ) = x1 x2 , income m and faces prices p1 and p2 . Using the
results in Section 3.2 we know that the agent has indirect utility

m2
v(p1 , p2 , m) =
4p1 p2

Using Roy’s identity (5.1), we therefore have,

· ¸· ¸
∂v(p1 , p2 , m) ∂v(p1 , p2 , m) −1
x1 ∗ (p1 , p2 , m) = −
∂pi ∂m
· 2
¸· ¸−1
m 2m
=− − 2
4p1 p2 4p1 p2
m
=
2p1

which is the optimal demand we found in Section 3.2.

The formal proof is in two steps. First, we show that λ measures the marginal utility of income,
i.e. the bang–per buck. Observe that an agent’s indirect utility is defined by

v(p1 , p2 , m) = u(x∗1 (p1 , p2 , m), x∗2 (p1 , p2 , m)) (5.2)

Differentiating with respect to m,

∂v(p1 , p2 , m) ∂u(x∗1 , x∗2 ) ∂x∗1 (p1 , p2 , m) ∂u(x∗1 , x∗2 ) ∂x∗2 (p1 , p2 , m)

= +
∂m ∂x1 ∂m ∂x2 ∂m
∂x∗1 (p1 , p2 , m) ∂x∗2 (p1 , p2 , m)
= λp1 + λp2 (5.3)
∂m ∂m

where the second line uses the FOCs (3.9) and (3.10). At the optimum the agent’s budget
holds:

p1 x∗1 (p1 , p2 , m) + p1 x∗2 (p1 , p2 , m) = m (5.4)

Differentiating (5.4) with respect to m,

∂x∗1 (p1 , p2 , m) ∂x∗ (p1 , p2 , m)

p1 + p2 2 =1
∂m ∂m

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Substituting into (5.3) we obtain,

∂v(p1 , p2 , m)
=λ (5.5)
∂m

as required.

We can now prove Roy’s identity. Differentiating (5.2) with respect to p1 ,

∂v(p1 , p2 , m) ∂u(x∗1 , x∗2 ) ∂x∗1 (p1 , p2 , m) ∂u(x∗1 , x∗2 ) ∂x∗2 (p1 , p2 , m)

= +
∂p1 ∂x1 ∂p1 ∂x2 ∂p1
∗
∂x (p1 , p2 , m) ∗
∂x (p1 , p2 , m)
= λp1 1 + λp2 2 (5.6)
∂p1 ∂p1

where the second line uses the FOCs (3.9) and (3.10). Differentiating the budget constraint
(5.4) with respect to p1 ,

∂x∗1 (p1 , p2 , m) ∂x∗ (p1 , p2 , m)

x∗1 (p1 , p2 , m) + p1 + p2 2 =0
∂p1 ∂p1

Substituting into (5.6),

∂v(p1 , p2 , m)
= −λx∗1 (p1 , p2 , m) (5.7)
∂p1

Using (5.7) we obtain,

∂v(p1 , p2 , m) ∂v(p1 , p2 , m)
= −x∗1 (p1 , p2 , m)
∂p1 ∂m

as required.

6 Comparative Statics

In this Section we consider how demand for good 1 is affected by the agent’s income, the price
of good 1 and the price of good 2. These effects are further analysed in the EMP notes. First,
we introduce the notion of elasticities.

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6.1 Elasticities

Suppose we are interested in how the price of a good, p, affects the demand for that good, x(p).
We can measure this change in absolute terms or percentage terms.

First, we might be interested in the impact of a 1¢ increase in the price. This is measured by
the derivative dx(p)/dp. This is simple to calculate but has the disadvantage that the measure
depends on the currency we are using. For example, suppose a consumer is buying a good in
US dollars and has demand:

x(p) = 10 − 10p (6.1)

Differentiating, dx/dp = −10. Suppose we now change the currency to British pounds, and
suppose $2 = £1. The demand function becomes:

x(p) = 10 − 20p (6.2)

Differentiating, dx/dp = −20. We see that, while nothing fundamental has changed, the sensi-
tivity of demand to price has doubled, simply because we have relabelled the currency.

In order to overcome this problem, we can measure the effect of a 1% increase in price. Define
the price elasticity of demand to equal the percentage increase in demand caused by a 1%
increase in the price. Since the percentage change in x equals the absolute change, ∆x, divided
by the level, the elasticity is given by

∆x/x ∆x p
²x,p = =
∆p/p ∆p x

In differential terms, we have

dx(p) p
²x,p = (6.3)
dp x

In example (6.1) we therefore have

p p
²x,p = (−10) =−
10 − 10p 1−p

Observe that we obtain exactly the same number if the price is denominated in pounds (6.2)
since percentage changes are independent of the currency. We can also write the elasticity (6.3)

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as
d ln x(p)
²x,p =
d ln p
The proof is as follows:

d ln x(p) d dx(eln p ) eln p dx(p) p

= ln x(eln p ) = ln p
=
d ln p d ln p dp x(e ) dp x(p)

There are different kinds of elasticities we can define. In the two good model, the agent’s
demand for good 1, x∗1 (p1 , p2 , m), depends on her income and the price of both goods. We can
correspondingly define the income elasticity of demand:

dx∗1 (p1 , p2 , m) m
²x1 ,m =
dm x∗1 (p1 , p2 , m)

The own–price elasticity of demand:

dx∗1 (p1 , p2 , m) p1
²x1 ,p1 = ∗
dp1 x1 (p1 , p2 , m)

And the cross–price elasticity of demand:

dx∗1 (p1 , p2 , m) p2
²x1 ,p2 = ∗
dp2 x1 (p1 , p2 , m)

The fact that demand is homogenous of degree zero (see Section 5) implies that a 1% increase
in income and both prices does not affect the agent’s demand. Hence

²x1 ,m + ²x1 ,p1 + ²x1 ,p2 = 0.

6.2 Income Effects

Suppose an agent’s income increases. Figure 16 shows that her budget constraint shifts out-
wards. The line linking her optimal bundles for different levels of income is called the income
offer curve or the income expansion path.5

Figure 17 show how the consumption of one particular good varies with the agent’s income.
This is called the Engel curve.
5
If the income offer curve is linear, preferences are said to be homothetic. Perfect substitutes, perfect
complements and Cobb Douglas preferences are all examples of homothetic preferences.

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Figure 16: Income Effects: A Normal Good. This figure shows the effect of an increase in the
agent’s income on her demand for both goods. Her choice moves from point A to point B, increasing
her consumption of both goods.

Figure 17: Engel Curve. This figure shows the effect of an increase in the agent’s income on her
demand for good 1. Points A and B correspond to those in figure 16.

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Figure 18: Income Effects: An Inferior Good. This figure shows the effect of an increase in the
agent’s income on her demand for both goods. Her choice moves from point A to point B, increasing
her consumption of x2 but reducing her consumption of x1 . Good 1 is therefore inferior.

When an agent’s income rises her demand may rise or fall. If her demand rises with income, the
good is normal (see figure 16). If her demand falls with income, the good is inferior (see figure
18). Many goods are normal for some ranges of income and inferior for others. For example, for
very poor people in China, rice consumption increases in income; for well off people in China,
rice consumption falls in income as people substitute towards meat.

The normal/inferior distinction concerns the effect of income on the absolute consumption of
the good. One may also wonder about the effect of income on the budget share of a good.
For example, housing often accounts for around 30% of people’s spending, independent of their
income. A good is a luxury if a 1% increase in income leads to a more than 1% increase in
consumption. That is, ²x1 ,m > 1. A good is a necessity if a 1% increase in income leads to a
less than 1% increase in consumption. That is, ²x1 ,m < 1.

6.3 Own Price Effects

Suppose the price of good 1 increases. Figure 19 shows that the budget line pivots inwards
and, in this case, leads the agent to consume less x1 and more x2 . The line linking her optimal
bundles for different levels of p1 is called the price offer curve.

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Figure 19: Price Effects. This figure shows the effect of an increase in the price of good 1 on the
agent’s demand for both goods. As p1 rises, the agent’s choice moves from A to B. As a result, the
consumption of x1 falls while the consumption of x2 rises.

Figure 20 shows how the consumption of good 1 varies with p1 . This is, surprisingly enough,
called the demand curve. Good 1 is called ordinary if an the demand curve is downward
sloping, so an increase in p1 causes a reduction in x∗1 . Good 1 is a Giffen good if the demand
is locally upward sloping, so an increase in p1 causes an increase in x∗1 .

To understand how price affects demand, note that we can decompose the impact of an increase
in p1 into two effects. First, holding the agent’s purchasing power constant, there is a change
in change in relative prices causing good 1 to become more expensive relative to good 2. This
is called the substitution effect and causes the demand for good 1 to fall. Second, holding
relative prices fixed, the increase in p1 reduces the agent’s purchasing power. This is called
the income effect and causes the demand for good 1 to fall if it is normal, and rise if it
is inferior. With a Giffen good, the increase in p1 causes demand for good 1 to fall a little
via the substitution effect and causes demand for good 1 to rise a lot via the income effect.
For example, when the price of rice rises in China some poor people experience a cut in their
purchasing power, can no longer afford meat and consequently consume more rice.6 For more
on income and substitution effects see the EMP notes.

We end with some more jargon. If a 1% increase in price changes demand by less than 1%,
demand is called inelastic. That is, −1 < ²x1 ,p1 < 1. If a 1% increase in price changes demand
6
See Jensen and Miller (2009), “Giffen Behaviour and Subsistence Consumption”, American Economic Review.

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Figure 20: Demand Curve for Good 1. As the price of good 1 falls, the demand for good 1 increases.
Hence the good is ordinary.

by more than 1%, demand is called elastic. That is, ²x1 ,p1 < −1 or ²x1 ,p1 > 1.

Exercise: The spending on good 1 is given by p1 x∗1 (p1 , p2 , m). Show that an increase in p1
reduces the agent’s spending on the good if and only if the good is ordinary and demand is
elastic.

6.4 Cross Price Effects

Suppose the price of good 1 increases. Such an increase may cause the demand for good 2 to
rise (as in figure 19) or fall (as in figure 21).

Goods 1 and 2 are gross substitutes if an increase in the price of one increases the demand
for the other. Mathematically,

∂x∗1 ∂x∗2
>0 and >0
∂p2 ∂p1

For example, when the price of pizza rises, the demand for hamburgers goes up (and vice versa).
Hence pizza and hamburgers are gross substitutes.

Goods 1 and 2 are gross complements if an increase in the price of one decreases the demand

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Figure 21: Price Effects. This figure shows the effect of an increase in the price of good 1 on the
agent’s demand for both goods. As p1 rises, the agent’s choice moves from A to B. As a result, the
consumption of both goods rises.

for the other. Mathematically,

∂x∗1 ∂x∗2
<0 and <0
∂p2 ∂p1

For example, when the price of buns rises, the demand for hamburgers goes down (and vice
versa). Hence buns and hamburgers are gross complements.

There is a problem with the idea of gross substitutes/complements: the cross derivatives may
have different signs. For example, suppose x1 are domestic flights and x2 are international
flights. We may have the following scenario. An increase in p1 causes the agent to become
poorer, since she often flies home to see her parents, leading her to cut back on international
holidays and reducing x∗2 . An increase in p2 causes the agent to take fewer international holidays
and more domestic holidays, leading to an increase in x∗1 . Hence we have

∂x∗1 ∂x∗2
>0 and <0
∂p2 ∂p1

It is unclear whether these goods are complements or substitutes. In the EMP notes we intro-
duce the idea of net substitutes, where we can never have problems like this.

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