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Constrained Optimisation, Indirect Utility, Expenditure Function

The document discusses microeconomic concepts related to constrained optimization, indirect utility, and expenditure functions. It explains how consumers optimize utility when faced with a budget constraint, which results in the marginal rate of substitution between goods equaling the relative price ratio. This optimal point can be expressed through an indirect utility function or expenditure function, showing the duality between the two approaches. Corner solutions are also addressed, where the optimal quantity of a good is zero if its price exceeds marginal utility.

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389 views9 pages

Constrained Optimisation, Indirect Utility, Expenditure Function

The document discusses microeconomic concepts related to constrained optimization, indirect utility, and expenditure functions. It explains how consumers optimize utility when faced with a budget constraint, which results in the marginal rate of substitution between goods equaling the relative price ratio. This optimal point can be expressed through an indirect utility function or expenditure function, showing the duality between the two approaches. Corner solutions are also addressed, where the optimal quantity of a good is zero if its price exceeds marginal utility.

Uploaded by

hishamsauk
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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MICROECONOMICS:

CONSTRAINED OPTIMISATION,
INDIRECT UTILITY,
EXPENDITURE FUNCTION
OPTIMISATION
 When faced with a constraint on spending, i.e., an
INCOME, optimisation can be achieved via lagrange:
 L = u(X,Y) + n[M – Px.X – Py.Y]

 Where you are maximising X and Y when faced with a


constraint ‘M’.
 Utility will only be maximised IF INCOME IS
EXHAUSTED.
 Thus Px.X + Py.Y = M

 To solve Lagrange, Partially differentiate w.r.t x first


then y then ‘n’.
OPTIMISATION
L  u ( X , Y )  [ M  Px. X  Py.Y ]
Lx  MU x  Px  0 (1)
Ly  MU y  Py  0 (2)
L  M  Px. X  Py.Y (3)
MUx Px
(1) /(2)   MRS 
MUy Py
MU i

Pi
OPTIMISATION
 Therefore, Utility will be optimised Y
when the rate at which goods can be
substituted for one another (MRS) is
equal to the rate of exchange of those
goods in the marketplace (Relative
Price)
 In addition to Income being exhausted.
 Graphically, the optimal point is the point
of tangency between the indifference
curve and budget constraint, shown to the
right.
 ALWAYS CHECK SECOND ORDER Optimal
CONDITIONS TO ENSURE A
MAXIMUM.
 The Lagrangian Multiplier (LAMBDA)
is the change in utility from a marginal
change in the constraint – change in Budget U
utility from an extra £1 of income.
 Otherwise, it can be interpreted in the Constraint
form on the previous slide: At the
margin, the Price reflects people’s X
WILLINGNESS TO PAY FOR ONE
MORE UNIT.
OPTIMISATION – CORNER SOLUTION
 May be the scenario where the Y
optimal level of consumption of
good ‘i’ is zero – vegetarians +
hamburgers.

 Maths is slightly different: For U


lagrange, FOCs are maximised by
setting ≤ 0, not =0.
 If the FOC <0, then the optimal
quantity for that good consumed is
0.
Budget
 The Lagrange Multiplier also Constraint
becomes:
 Pi > (MUi/n) where n=Lagrange
Multiplier. Optimal
 Thus the price exceeds the marginal
value to the customer, and will not X
be purchased.
INDIRECT UTILITY
 Standard Utility function is a function of number of
goods consumed: U = u(x,y)
 Solving the constrained optimisation problem gives you
the optimal level of x and y  x*, y*
 x* = x(Px, Py, M); y* = y(Px, Py, M)

 Therefore, we can write the standard utility function as a


function of prices and income;
 Utility is INDIRECTLY determined by prices and
income:
 Max. Utility = V(Px, Py, M)

 In addition: dV/dM = λ
DUALITY – TO THE EXPENDITURE
FUNCTION
 Duality in this context means that there are TWO
EQUIVALENT methods of solving the consumer choice
problem:
 A - MAXIMISE UTILITY SUBJECT TO GIVEN
EXPENDITURE.
 B – MINIMISE EXPENDITURE GIVEN A
DESIRED UTILITY LEVEL.
 Both approaches will lead to the same conclusion.
Discussion thus far has been on the former (path A).
 The expenditure minimisation problem is described on
the next slide.
EXPENDITURE FUNCTION
 Minimise total expenditure: E = P1X1 + P2X2 + ... PnXn
 Constrained to fixed Utility Level: U = u(X1, X2, ... , Xn)

 Set up the Lagrange:

 L = Px.X + Py.Y + j[U – u(X,Y)]

 Lx = Px + j.MUx = 0 (1)

 Ly = Py + j.MUy = 0 (2)

 U – u(X,Y) = 0 (3)

 (1) / (2) = Px/Py = MRS = MUx / MUy

 Which we know to be equivalent to the result gained from utility


maximisation.
EXPENDITURE FUNCTION
 Therefore:
 UTILITY Function = U(X, Y)
 INDIRECT UTILITY Function = V(Px, Py, M)
 EXPENDITURE Function = E(Px, Py, U)
 E(Px, Py, U) = 1 / [V(Px, Py, M)]

 Properties of expenditure Functions:


 I – HOMOGENOUS OF DEGREE 1 (2x prices, therefore 2x
expenditure)
 II – NONDECREASING IN PRICES (dE/dPi > 0)
 III – CONCAVE IN PRICES (As price changes, consumption
pattern will also likely change)
 IV – INCREASING IN ‘U’ (Higher Utility requires higher
expenditure)

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