UTILITY and DEMAND

ECON 8500 – Iryna Dudnyk

Brief Reminder
Utility function depends on consumer’s
preferences.

Graphically preferences are represented using

indifference curves

When consumers go shopping they treat income

and prices as given and choose optimal bundle
that maximizes utility given the budget.
CONSUMERS RESPOND TO
CHANGES IN PRICES AND INCOME
When you go shopping and see that price of a
product has changed, you will respond by
adjusting the quantity you buy.

When your income increases you

• Buy more of normal goods
• Buy less of inferior goods

Note: if nominal prices change while money

income stays the same, real income changes and
demands change.
DEMAND
You don’t want to solve another Lagrange to find
optimal bundle every time budget changes.
That’s why we use demands:

DEMAND is a relationship between quantity of the

good a consumer wishes to buy and good’s price,
keeping income and prices of related goods fixed.

Along the D curve:

• Only price of the good and quantity change
• Income and prices of other goods are kept
fixed
DEMAND
When you are asked to find demands, you are
expected to find functions:

𝑞1 = 𝑞1 (𝑃1 , 𝑃2 , 𝑌) and 𝑞2 = 𝑞2 𝑃2 , 𝑃1 , 𝑌

This means that you will USE GENERIC BUDGET

CONSTRAINT:
𝑃1 𝑞1 + 𝑃2 𝑞2 = 𝑌

Once you have the demand functions, substitute

values for prices and income to find optimal bundle
on specific budget line.
Important: P’s and Y are PARAMETERS, treat as
constant
EXAMPLE: COBB-DOUGLAS
Suppose consumer has utility function

𝑈 = 𝑞10.4 𝑞20.6

Derive demands.

Notice that you do not have any information

about the budget. That’s because you do not
need it for finding the demands.
LAGRANGE SET UP

max 𝑞10.4 𝑞20.6

𝑞1 ,𝑞2

S. t. 𝑃1 𝑞1 + 𝑃2 𝑞2 = 𝑌

Set up the Lagrange:

ℒ = 𝑞10.4 𝑞20.6 + λ( 𝑌 − 𝑃1 𝑞1 − 𝑃2 𝑞2 )
λ 𝑌 − λ𝑃1 𝑞1 − λ𝑃2 𝑞2
LAGRANGE F.O.C.

0.4 0.6
ℒ= 𝑞1 𝑞2 + λ 𝑌 − λ𝑃1 𝑞1 − λ𝑃2 𝑞2

ℒ1 = =0 (1)

ℒ2 = =0 (2)

ℒλ = =0
LAGRANGE F.O.C.
Carry terms with λP’s in (1) and (2) to RHS:
= (1)
= (2)
Divide (1) by (2)

0.4𝑞20.4 𝑞20.6 𝑃1
0.6 0.4 = 𝑃
0.6𝑞1 𝑞1 2

In the above the LHS is …..

Simplify
0.4𝑞20.4 𝑞20.6 𝑃1
0.6 0.4 = 𝑃
0.6𝑞1 𝑞1 2

Isolate 𝑞2 :

3𝑃1
𝑞2 = 𝑞1
2𝑃2
 3𝑃1 𝑞1
Sub for 𝒒𝟐 into budget:
2𝑃2

3𝑃1 𝑞1
𝑃1 𝑞1 + 𝑃2 =𝑌
2𝑃2

Find 𝑞1 as a function of income and prices:

FINALLY
0.4𝑌
Demand for good 1 is 𝑞1 =
𝑃1

3𝑃1 3𝑃1 0.4𝑌 0.6Y

𝑞2 = 𝑞 = =
2𝑃2 1 2𝑃2 𝑃1 P2

0.6𝑌
Demand for good 2 is 𝑞2 =
𝑃2
RESPONSE to CHANGE in PRICE
Suppose initially the budget is:
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏

Find optimal bundle, label A:

0.4𝑌 0.6𝑌
𝑞1 = = ------- = ; 𝑞2 = = ------- =
𝑃1 𝑃2

𝟐𝒒𝟐
In this bundle MRS = = −−= −
𝟑𝒒𝟏
RESPONSE to CHANGE in PRICE
Now suppose good 1 goes on sale:
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟎. 𝟓, 𝑷𝟐 = $𝟏

Find optimal bundle, label B:

0.4𝑌 0.6𝑌
𝑞1 = = ------- = ; 𝑞2 = = ------- =
𝑃1 𝑃2

𝟐𝒒𝟐
In this bundle MRS = = −− =
𝟑𝒒𝟏
DIAGRAMS: ICs and BL’s
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏
q2
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟎. 𝟓, 𝑷𝟐 = $𝟏

B
A
IC’

IC0 BL’

BL0 q1
DIAGRAMS: DEMAND
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏
P

𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟎. 𝟓, 𝑷𝟐 = $𝟏
1
Demand:

0.4𝑌 𝟒
0.5 ’ 𝑞1 = =
𝑃1 𝑷𝟏
D

4 8 q1
PRICE-CONSUMPTION CURVE
connects optimal bundles such that
• Income and prices of other goods (P2) are fixed
• Only P1 changes.

Can slope upward, downward, or be vertical or

horizontal.

The slope of PCC Depends on elasticity of

demand.
DIAGRAMS: ICs and BL’s
In this example PCC is
q2 horizontal.

10 Let’s try to figure out elasticity

of demand in this case
6 B PCC
A
IC’

IC0 BL’

BL0 10 q1
ELASTICITY AND PCC

Recall our first lecture: when price changes

firm’s revenue (consumer spending) can
increase, decrease or stay constant depending on
elasticity.

Let’s look back at the budget for our situation:

Generic: 𝑃1 𝑞1 + 𝑃2 𝑞2 = 𝑌

Our BLs: 𝑃1 𝑞1 + $1 ∙ 𝑞2 = $10

ELASTICITY AND PCC

Our BL: 𝑃1 𝑞1 + $1 ∙ 𝑞2 = $10

As P1 decreased from $1 to $0.5, what happened

to spending on good 1?

What does it imply about elasticity?

RESPONSE to CHANGE in INCOME
Suppose initially the budget is:
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏

Optimal bundle A (4, 6), MRS = 1

Income increases: 𝒀 = $𝟐𝟎, 𝑷𝟏 = $1, 𝑷𝟐 = $𝟏

Find new optimal bundle, label C:

0.4𝑌 0.6𝑌
𝑞1 = = ------- = ; 𝑞2 = = ------- =
𝑃1 𝑃2

𝟐𝒒𝟐
In this bundle MRS = = −−= −
𝟑𝒒𝟏
DIAGRAMS: ICs and BL’s
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏
q2
20 𝒀 = $𝟐𝟎, 𝑷𝟏 = $1, 𝑷𝟐 = $𝟏

10

IC’’

A IC0 BL’’

10 BL0 20 q1
DIAGRAMS: DEMAND
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏
P
𝒀 = $𝟐𝟎, 𝑷𝟏 = $1, 𝑷𝟐 = $𝟏

1 Demand:

D’ 𝟎. 𝟒𝐘
𝑞1 =
’
𝑷𝟏
0
𝟒
𝑞1 =
Do 𝑷𝟏
′
𝟖
𝑞1 =
4 8 q1 𝑷𝟏
INCOME-CONSUMPTION CURVE
connects optimal bundles such that
• Prices are held fixed
• Income changes.

Can slope upward, downward, be vertical or

horizontal.

Depends whether both goods are normal, one of

the goods is inferior or one of the goods does not
respond to change in income (neutral).
DIAGRAMS: ICs and BL’s
𝒀 = $𝟏𝟎, 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏
q2
20 𝒀 = $𝟐𝟎, 𝑷𝟏 = $1, 𝑷𝟐 = $𝟏

ICC Is q1 normal or inferior?

10 Is q2 normal or inferior?
IC’’

IC0 BL’’

10 BL0 20 q1
Engel Curve
is a relationship between income and consumption of
a good keeping prices fixed.
For our initial BL: 𝑷𝟏 = $𝟏, 𝑷𝟐 = $𝟏

0.4Y
𝑞1 =
𝑃1

𝟎.𝟒𝐘
Substitute prices: 𝑞1 = , isolate income:
𝟏
𝑞1
𝑌= = 2.5 𝑞1
0.4
UTILITY AND DEMAND

More examples
(In Lieu of Lab)
Consider the following example
From BLo to BL” what changed:
q2
P1 , P2, Y?

Is q1 normal or inferior?
IC’’

Is q2 normal or inferior?
IC0 BL’’

BL0 q1
Elasticity and PPC:
Mary spends all her income on magazines (𝑞1 )
and cookies (𝑞2 ). Her demand for magazines is
elastic. If price of magazines decreases, what
will happen to her consumption of cookies?
Explain and demonstrate on a diagram.

Solution:
If demand for magazines is elastic, as price of
magazines decreases her spending on 𝑞1 will
Her income is constant, as magazines become
cheaper, what happens to spending on cookies?

Price of cookies did not change, therefore

Her income is constant, as magazines become
cheaper, what happens to spending on cookies?
Price of cookies did not change, therefore
q2

IC0

BL0 q1
Demand for Perfect Substitutes
Suppose 𝑈 = 𝑞1 + 2𝑞2 𝑌 = $15, 𝑃1 = $1.50, 𝑃2 = $4.00
Which good the consumer will buy?

1 2
As long as > = 0.5 all money will be spent on …
P1 4.00
Demand:
P1 q1

2.50
2.00
1.50
1.00
Perfect Complements
Olivia consumes 1 scoop of ice cream (q1) with
one cup of coffee (q2) in fixed ratio.

Her income is $10 and price of a cup of coffee is

$1.

Use the diagram on the next slide to derive

Olivia’s demand for ice cream
PERFECT COMPLEMENTS
q2
𝒀 = $𝟏𝟎, 𝑷𝟐 = $𝟏

P1 q1

q1