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4 - Utility Maximization

The document discusses constrained utility maximization, explaining how consumers maximize utility given their budget constraints and prices of goods. It presents the mathematical formulation of the problem, including the budget equation and the first-order conditions for maximizing utility. An example is provided to illustrate the process of determining the optimal quantities of two commodities under a fixed budget.

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20 views4 pages

4 - Utility Maximization

The document discusses constrained utility maximization, explaining how consumers maximize utility given their budget constraints and prices of goods. It presents the mathematical formulation of the problem, including the budget equation and the first-order conditions for maximizing utility. An example is provided to illustrate the process of determining the optimal quantities of two commodities under a fixed budget.

Uploaded by

kaniniyvonne242
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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LESSON FOUR

CONSTRAINED UTILITY MAXIMIZATION

Indifference curves give us consumer preferences but they do not show the situation
in real life. A consumer is always constrained by income and prices of goods. These
are shown by the budget line.

Assuming a consumer is rational and has a fixed income, or budget, M. Assume the
utility function is given as U = f(Q 1 Q2). P1 and P2 are prices. The budget equation can
be stated as;

P 1 Q1 + P 2 Q2 = M

As a rational consumer, the consumer maximizes their utility by purchasing a


combination of Q1 and Q2 lying on the highest possible indifference curve. This is the
point of tangency between the budget line and the indifference curve.

Q2

E I2

Q1

Mathematically, the problem is stated as the following constrained utility


maximization problem;

Maximize U = f(Q1, Q2) Q1, Q2 > 0 (objective function)

Subject to: M = P1 Q1 + P2 Q2 (constraint)

Solution of this problem involves the following

Construct the augmented objective function;

Rewriting the constraint: M- P1 Q1 - P2 Q2 = 0

L = f (Q1, Q2) + (M - P1 Q1 - P2 Q2 )

First order conditions;


.....................(i)

....................(ii)

..........(iii)

From equation (i) ad (ii)

f1 = P 1

f2 = P 2

Hence =

The consumer will allocate his income such that the ratio of marginal utility of Q 1 to
its price is equal to the ratio of marginal utility of Q 2 to its price.

Alternatively, by cross multiplication we can restate that:

since =

This states that the consumer allocates his income such that the slope of the budget
line is equal to the slope of the indifference curve.

Slope of indifference curve

Slope of budget line

Illustration

A consumer’s utility function is given by U = Q 1 Q2

where Q1 and Q2 are quantities of two commodities consumed. If the price of


Q1 is sh. 6 and that of Q2 is sh.3, and the budget is sh. 60.

Required

a) Write out the constrained utility maximization problem.


b) Write out the corresponding augmented objective function
c) Find the levels of Q1 and Q2 that will maximize utility.
d) Compute the optimum value of U

Solution

a) The budget constraint is given by,


6Q1 + 3Q2 = 60

Or f (Q1 Q2) = 6Q1 + 3Q2 – 60

The constrained maximization problem becomes;

Max: U = f (Q1 Q2)

Subject to; 6Q1 + 3Q2 = 60

b) The augmented objective function

U = f (Q1 Q2) + (6Q1 + 3Q2 – 60)

Differentiating each part of the equation with respect to Q 1, Q2 and and equating
each equation to zero.

= Q2 + 6 = 0 ................(i)

Q1 + 3 = 0 .................(ii)

6Q1 + 3Q2 – 60 = 0 ........(iii)

From equation (i) and (ii)

Q2 = - 6

Q1 = - 3

Therefore,

By cross multiplication

3Q2 = 6Q1
Hence Q2

And Q1

Substituting Q2 in the constraint equation { equation (iii) }

6Q1 + 3Q2 – 60 = 0

6Q1 + 3 (2Q1) – 60 = 0

Upon solving, we get 12Q1 = 60

Q1 = 5

And Q2 = 2Q1 = 10

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