Consumer Behaviour

Handout 3
Consumer Behaviour
Dr. Subir Sen, Assistant Professor, IIT Roorkee
The problems are adapted from various textbooks.
Consumers are faced with a choice of how many hours each week to spend working and how many to
devote to leisure. In the same way, a consumer needs to decide how many items of various goods to buy
and has a preference between the options available. To analyse the behaviour of consumers quantitatively
we associate with each set of options a number, U , called utility, which indicates the level of satisfaction.
Suppose that there are two goods, G1 and G2 , and that the consumer buys x1 items of G1 and x2 items of
G2 . The variable U is then a function of x1 and x2 , which we write as
U = U (x1 , x2 )
δU δU
Utility is a function of two variables, so we can work out two first-order partial derivatives, δx1
and δx2
.
δU
The derivative δx i
gives the rate of change of U with respect to xi and is called the marginal utility
of xi . If xi changes by a small amount ∆xi and the other variable is held fixed then the change in U satisfies
δU
∆U = δxi
∆xi
If x1 and x2 both change then the net change in U can be found from the small increments formula
δU δU
∆U = δx1
∆x1 + δx2
∆x2
1 Unconstrained vs Constrained Optimisation

Everything in economics is a constrained optimisation problem. Remember the definition of micro-
economics: ”economics is the study of the behaviour of individuals who satisfy their wants, given limited
resources.” Youd like to watch television, youd like to play a game, youd like to go out with your friend(s),
youd like to do yoga. . . but there are only twenty-four hours in the day. This means that you have to
make a decision about how to spend those limited hours to produce the most happiness (or satisfaction).
This tool has two parts:
1. Objective function: is the relationship the decision maker seeks to optimise (maximise or min-
imise).
2. Constraint: limits or restrictions that are imposed on the decision maker
1
An unconstrained optimisation problem is one where you only have to be concerned with the objective
function you are trying to optimise. An objective function is a function that you are trying to optimise. For
example, reaching the maximum utility or satisfaction. In this case, none of the variables in the objective
function are constrained.
Utility maximisation is a constrained optimisation problem since the consumer is constrained by her/his
budget constraint. The consumer enjoys two goods, x1 and x2 . S/He is trying to maximise her/his hap-
piness - ”utility”- from these. However, s/he has only w rupees to spend, so her/his total purchases (x1
times its price plus x2 times its price) cannot exceed her/his wealth. We would write this problem as follows:
max U (x1 , x2 )
x1 ,x2
subject to x1 p1 + x2 p2 = w
The x1 and x2 are the things being chosen. There are three ways to solve this problem. All produce
the same result, so which technique you use is largely a matter of preference.
• Example 1: Find the maximum utility for he utility function U = 5xy, when subject to a budget
constraint of 50 and the prices of each unit of X and Y are 5 and 1 respectively.
Solution: Given information on unit prices and income, the budget constraint is:
xPx + yPy = M ⇒ 5x + y = 30
The equation of the Lagrangian is therefore:
L = 5xy + λ(30 − 5x − y)
The first order conditions:

δL
= 0 ⇒ 5y − 5λ = 0 ⇒ 5y = 5λ (1)
δx
δL
= 0 ⇒ 5x − λ = 0 ⇒ 5x = λ (2)
δy
δL
= 0 ⇒ 5x + y = 30 ⇒ y = 30 − 5x (3)
δλ
From (1) and (2) ⇒ 5y = 5(5x) ⇒ y = 5x
Putting y = 5x in (3), ⇒ 5x + 5x = 30 ⇒ 10x = 30 ⇒ x = 3
Therefore, y = 15 and the level of maximum utility is U = 5(3)(15) = 225.
• Example 2: Use Lagrange multipliers to show that a utility function U (x, y) which is subject to a
budget constraint xPx + yPy = M is maximised when Ux /Uy = Px /Py (ignoring negative signs).
Solution: The Lagrangian is:

L = U (x, y) + (M − xPx − yPy )
The set of first order conditions are:
δL
= 0 ⇒ Ux − λPx = 0 ⇒ Ux = λPx (4)
δx
δL
= 0 ⇒ Uy − λPy = 0 ⇒ Uy = λPy (5)
δy
δL
= 0 ⇒ xPx + yPy = M (6)
δλ
2
From (4) and (5):
Ux Uy
⇒λ= =
Px Py
Note on the Lagrangian Multiplier λ: It gives the change in maximum or minimum value of a
function being optimised for each unit change in the constraint (i.e., money or wealth). If λ > 0, the
optimum value of utility will increase by λ for each unit increase in the constraint and decrease by
λ for each unit reduction on the constraint xPx + yPy = M .
• Example 3: A consumers utility function is given by U (x1 , x2 ) = 2x1 x2 + 3x1 where x1 and x2 denote
the number of items of two goods G1 and G2 that are bought. Each item costs 1 for G1 and 2 for
G2 . Use Lagrange multipliers to find the maximum value of U if the consumer’s income is rupees 83.
Estimate the new optimal utility if the consumer’s income rises by rupee 1.
Solution: The Lagrangian is:
L = 2x1 x2 + 3x1 + (83 − x1 − 2x2 )
The set of first order conditions are:

δL
= 0 ⇒ 2x2 + 3 − λ = 0 ⇒ λ = 2x2 + 3 (7)
δx1
δL
= 0 ⇒ 2x2 − 2λ = 0 ⇒ λ = x1 (8)
δx2
δL
= 0 ⇒ x1 + 2x2 = 83 (9)
δλ
From (7) and (8):
⇒ x1 = 2x2 + 3
Substituting the value of x1 in (9) we get x2 = 20. Therefore, x1 = 43.
Now, M has gone up by one rupee. Therefore, the new budget constraint is:
x1 + 2x2 = 84 (10)
The new Lagrangian function is:
L = 2x1 x2 + 3x1 + (84 − x1 − 2x2 )
Following the above set of first order conditions we get:
⇒ x1 = 2x2 + 3
Using this information in the budget constraint we have:

δL
= 0 ⇒ x1 + 2x2 = 84 ⇒ x2 = 20.5 (11)
δλ
Substituting the value of x1 in (10) we get x1 = 44.
What will be the change in utility?
3
Problems for Practice
1. An individual’s utility function is given by U = x1 x2 where x1 and x2 denote the number of items of
two goods, G1 and G2 . The prices of the goods are 2 and 10 rupees per unit respectively. Assuming
that the individual has 400 (’00) rupees available to spend on these goods, find the utility-maximising
values of x1 and x2 . Verify that the ratio of marginal utility to price is the same for both goods at
the optimum.
2. A consumers utility function is U = logx1 + 2logx2 . Find the values of x1 and x2 which maximise U
subject to the budgetary constraint 2x1 + 3x2 = 18.
3. Use Lagrange multipliers to find expressions for x1 and x2 which maximises the utility function
1/2 1/2
U = x1 + x2 subject to the general budgetary constraint P1 x1 + P2 x2 = M .
4. A consumer’s utility function is given by U = αlogx1 + βlogx2 . Find the values of x1 and x2 which
maximise U subject to the budgetary constraint P1 x1 + P2 x2 = M .

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Handout 3

The problems are adapted from various textbooks.

1 Unconstrained vs Constrained Optimisation

2. Constraint: limits or restrictions that are imposed on the decision maker

The equation of the Lagrangian is therefore:

The first order conditions:

Solution: The Lagrangian is:

Solution: The Lagrangian is:

L = 2x1 x2 + 3x1 + (83 − x1 − 2x2 )

The set of first order conditions are:

The new Lagrangian function is:

L = 2x1 x2 + 3x1 + (84 − x1 − 2x2 )

Following the above set of first order conditions we get:

Using this information in the budget constraint we have:

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