Prerequisites

Prerequisites

Almost
Almost essential
essential
Firm:
Firm:Optimisation
Optimisation
Consumption:
Consumption:Basics
Basics

CONSUMER OPTIMISATION
MICROECONOMICS
Principles and Analysis
Frank Cowell

April 2018 Frank Cowell: Consumer Optimisation 1

 What we’re going to do:
 We’ll solve the consumer's optimisation problem
• using methods that we've already introduced

 This enables us to re-cycle old techniques and results

 A tip:
• check the presentation for firm optimisation
• look for the points of comparison
• try to find as many reinterpretations as possible

April 2018 Frank Cowell: Consumer Optimisation 2

 The problem
 Maximise consumer’s utility U assumed to satisfy the
U(x) standard “shape” axioms

 Subject to feasibility constraint Assume consumption set X is

xX the non-negative orthant

 and to the budget constraint The version with fixed money

n income
S pixi ≤ y
i=1

April 2018 Frank Cowell: Consumer Optimisation 3

 Overview
Consumer:
Optimisation

Primal and
Two fundamental Dual problems
views of consumer
optimisation Lessons from
the Firm

Primal and
Dual again

April 2018 Frank Cowell: Consumer Optimisation 4

 An obvious approach?
 We have the elements of a standard constrained
optimisation problem:
• the constraints on the consumer
• the objective function
 The next steps might seem obvious:
• set up a standard Lagrangian
• solve it
• interpret the solution
 But the obvious approach is not always the most useful
• we will use a round-about approach
• generates extra insights
• enables connection with theory of the firm

April 2018 Frank Cowell: Consumer Optimisation 5

 Think laterally
 In microeconomics an optimisation problem can often
be represented in more than one form
 Which form you use depends on
• your interpretation of the problem
• the information you want to get from the solution
 This applies here
 The same consumer optimisation problem can be seen
in two different ways
1. “primal problem”
2. “dual problem”
• standard labels in the literature

April 2018 Frank Cowell: Consumer Optimisation 6

 A five-point plan
1. Set out the basic consumer optimisation problem
• the primal problem

2. Show that the solution is equivalent to another problem

• the dual problem

3. Show that this problem is identical to that of the firm

4. Write down the solution
• copy directly from the solution to the firm’s problem

5. Go back to the problem we first thought of

• the primal problem again

April 2018 Frank Cowell: Consumer Optimisation 7

 The primal problem
Contours  The consumer aims to
x2 Contours of
of
maximise utility…
objective
objective function
function
 Subject to budget constraint
 Defines the primal problem
 Solution to primal problem

a s ing
re e
inc ferenc
pre
Constraint
Constraint
set
set
max U(x) subject to
n
 x* S pi xi £ y
i=1

 There's another way of

looking at this
x1

April 2018 Frank Cowell: Consumer Optimisation 8

* detail on slide can only be seen if you run the slideshow

The dual problem

 Alternatively the consumer
z2 x 2
q could aim to minimise cost…

u Constraint
Constraint
set
 Subject to utility constraint
 Defines the dual problem
set
 Solution to the problem
 Cost minimisation by the
firm
cost
u c ing t minimise
Red ng cos
e duci n

 R
S pi xi
x*
z* i=1

subject to U(x)  u

z1  But where have we

x1
seen the dual problem
before?

April 2018 Frank Cowell: Consumer Optimisation 9

 Two types of cost minimisation
 The similarity between the two problems is not just a curiosity
 We can use it to save ourselves work
 All the results that we had for the firm's “stage 1” problem can
be used
 We just need to “translate” them intelligently
• Swap over the symbols
• Swap over the terminology
• Relabel the theorems

April 2018 Frank Cowell: Consumer Optimisation 10

 Overview
Consumer:
Optimisation

Primal and
Reusing results Dual problems
on optimisation
Lessons from
the Firm

Primal and
Dual again

April 2018 Frank Cowell: Consumer Optimisation 11

 A lesson from the firm
 Compare cost-minimisation for the
 firm…
…and for the consumer

z2 q x2 u  The difference is only in

notation

 So their solution
functions and response
functions must be the
same
 
z* x*
Run
Runthrough
through
z1 x1 formal
formalstuff
stuff

April 2018 Frank Cowell: Consumer Optimisation 12

Cost-minimisation: strictly quasiconcave U
 Use the objective function
 Minimise Lagrange
Lagrange  …and utility constraint
n multiplier
multiplier  …to build the Lagrangian
S pi xi u
+ λ[u – U(x)]
U(x)  Differentiate w.r.t. x1, …, xn and set
i=1 equal to 0
 … and w.r.t l
 Because of strict quasiconcavity we  Denote cost minimising values with a
have an interior solution *

 A set of n + 1 First-Order Conditions

l*U1 (x* ) = p1
* *
l U2 (x ) = p2
ü one
one for
each
for
each good
good

… … … ý
* *
l Un (x ) = pn þ
u = U(x* ) utility
utility
constraint
constraint
April 2018 Frank Cowell: Consumer Optimisation 13
 If ICs can touch the axes…
 Minimise
n
S pixi + l[u – U(x)]
i=1

 Now there is the possibility of corner solutions

 A set of n + 1 First-Order Conditions

l*U1 (x*) £ p1
l*U2 (x*) £ p2
ü
… … … ý
l*Un(x*) £ pn þ Interpretation
Interpretation
u = U(x*) Can
Can get
get “<”
“<” ifif optimal
optimal
value
value of
of this
this good
good is
is 00

April 2018 Frank Cowell: Consumer Optimisation 14

 From the FOC
 If both goods i and j are purchased
and MRS is defined then…

Ui (x*) pi
——— = —
Uj (x*) pj
 MRS = price ratio  “implicit” price = market
price
 If good i could be zero then…
Ui (x*) pi
——— £ —
Uj (x )
*
pj
 MRSji £ price ratio  “implicit” price £ market price

Solution
Solution

April 2018 Frank Cowell: Consumer Optimisation 15

 The solution…

 Solving the FOC, get a cost-minimising value for each good…

xi* = Hi(p, u)

 …for the Lagrange multiplier

l* = l*(p, u)
 …and for the minimised value of cost itself
 The consumer’s cost function or expenditure function is defined
as
C(p, u) := min S pi xi
{U(x) ³ u }

vector
vector of
of Specified
Specified
goods
goods prices
prices utility
utility level
level
April 2018 Frank Cowell: Consumer Optimisation 16
 The cost function has the same properties as for the firm

 Non-decreasing in every price, increasing in at least

one price
 Increasing in utility u
 Concave in p
 Homogeneous of degree 1 in all prices p
 Shephard's lemma

April 2018 Frank Cowell: Consumer Optimisation 17

 Other results follow
 Shephard's Lemma gives
H is the “compensated” or
demand as a function of prices conditional demand function
and utility
 Hi(p, u) = Ci(p, u)
 Properties of the solution Downward-sloping with respect
function determine behaviour to its own price, etc…
of response functions

 “Short-run” results can be For example rationing

used to model side constraints

April 2018 Frank Cowell: Consumer Optimisation 18

 Comparing firm and consumer
 Cost-minimisation by the firm…
 …and expenditure-minimisation by the consumer
 …are effectively identical problems
 So the solution and response functions are the same:

Firm Consumer
 m n
Problem min S wizi + l[q – f (z)] min S pixi + l[u – U(x)]
: z i=1 x i=1
 Solution
function:
C(w, q) C(p, u)
 Response zi* = Hi(w, q) xi* = Hi(p, u)
function:

April 2018 Frank Cowell: Consumer Optimisation 19

 Overview
Consumer:
Optimisation

Primal and
Exploiting the Dual problems
two approaches
Lessons from
the Firm

Primal and
Dual again

April 2018 Frank Cowell: Consumer Optimisation 20

 The Primal and the Dual…

 There’s an attractive symmetry

about the two approaches to the n
problem S pixi+ l[u – U(x)]
i=1
 In both cases the ps are given
and you choose the xs n

 But constraint in the primal

[
U(x) + m y – S pi xi ]
i=1
becomes objective in the dual…

 …and vice versa

April 2018 Frank Cowell: Consumer Optimisation 21

 A neat connection
 Compare the primal
problem of the
consumer…
 …with the dual problem

x2 x2 u  Two aspects of
the same
problem
 So we can link
up their solution
functions and
response
 functions
 x*
x*
Run
Runthrough
through
x1 x1 the primal
the primal

April 2018 Frank Cowell: Consumer Optimisation 22

 Utility maximisation
Lagrange
Lagrange  Use the objective function
 Maximise multiplier
multiplier  …and budget constraint
nn  …to build the Lagrangian
[ – Spi xi
U(x) + μ y 
i=1
]  Differentiate w.r.t. x1, …, xn
and set equal to 0
i=1
 … and w.r.t m
 If U is strictly quasiconcave we  Denote utility maximising
have an interior solution values with a *

 A set of n+1 First-Order one Conditions

onefor
for
each
eachgood
U1(x* ) = m* p1
ü
good

U2(x* ) = m* p2 IfIf UU not

… … … ý not strictly
quasiconcave
strictly
quasiconcave then then
budget
budget
constraint
constraint
* *
Un(x n) = m pn þ
replace
replace “=”
“=” byby “”
“”
Interpretation
y = S pi xi *
Interpretation

i=1

April 2018 Frank Cowell: Consumer Optimisation 23

 From the FOC
 If both goods i and j are purchased
and MRS is defined then…

Ui (x*) pi  (same as before)

——— = —
Uj (x )
*
pj
 MRS = price ratio  “implicit” price = market
price
 If good i could be zero then…
Ui (x*) pi
——— £ —
Uj (x )
*
pj
 “implicit” price £ market price
 MRSji £ price ratio
Solution
Solution

April 2018 Frank Cowell: Consumer Optimisation 24

 The solution…
 Solving the FOC, you get a utility-maximising value for each
good…
xi* = Di(p, y)

 …for the Lagrange multiplier

m* = m*(p, y)
 …and for the maximised value of utility itself
 The indirect utility function is defined as

V(p, y) := max U(x)

{S pixi  y}
vector
vector of
of money
money
goods
goods prices
prices income
income

April 2018 Frank Cowell: Consumer Optimisation 25

 A useful connection
 The indirect utility function maps The indirect utility function works
prices and budget into max utility like an "inverse" to the cost
function
u = V(p, y)

 The cost function maps prices The two solution functions have
and utility into min budget to be consistent with each other.
Two sides of the same coin
y = C(p, u)
 Therefore we have: Odd-looking identities like these
u = V(p, C(p, u )) can be useful

y = C(p, V(p, y))

April 2018 Frank Cowell: Consumer Optimisation 26

 The Indirect Utility Function has some familiar properties…

(All of these can be established using the known

properties of the cost function)

 Non-increasing in every price, decreasing in at least

one price
 Increasing in income y

 quasi-convex in prices p

 Homogeneous of degree zero in (p, y)

 Roy's Identity
Explanation
Explanationofof
Roy’s
Roy’sIdentity
Identity

April 2018 Frank Cowell: Consumer Optimisation 27

 Roy's Identity
u = V(p, y) = V(p, C(p,u)) “function-of-a-
“function-of-a-  Use the definition of the
function”
function” rule
rule optimum
 Differentiate w.r.t. pi
0 = Vi (p,C(p,u)) + Vy (p,C(p,u)) Ci (p,u)  Use Shephard’s
 Lemma
Rearrange to get…
 So we also have…
0 = Vi (p, y) + Vy (p, y) xi*
Marginal
Marginal disutility
disutility
of
of price
price ii
Vii (p, y) Marginal
Marginal utility
utility of
of
money
money income
income
xii* = – ————
Vyy (p, y) Ordinary
Ordinary demand
demand
function
function
xi* = –Vi (p, y)/Vy (p, y) = Di(p, y)

April 2018 Frank Cowell: Consumer Optimisation 28

 Utility and expenditure
 Utility maximisation
 …and expenditure-minimisation by the consumer
 …are effectively two aspects of the same problem
 So their solution and response functions are closely
connected:
Primal Dual
n n

x
[
Problem max U(x) + μ y – Spi xi
i=1
] min S pixi + l[u – U(x)]
x i=1
:
 Solution
function:
V(p, y) C(p, u)
 Response x * = Di(p, y) xi* = Hi(p, u)
function: i

April 2018 Frank Cowell: Consumer Optimisation 29

 Summary
 A lot of the basic results of the consumer theory can be
found without too much hard work

 We need two “tricks”:

1.A simple relabelling exercise:

• cost minimisation is reinterpreted from output targets to
utility targets
[Link] primal-dual insight:
• utility maximisation subject to budget is equivalent to
cost minimisation subject to utility

April 2018 Frank Cowell: Consumer Optimisation 30

 1. Cost minimisation: two applications

 THE FIRM  THE CONSUMER

 min cost of inputs  min budget

 subject to output  subject to utility

target target

 Solution is of the  Solution is of the

form C(w,q) form C(p,u)

April 2018 Frank Cowell: Consumer Optimisation 31

 2. Consumer: equivalent approaches


PRIMAL  DUAL


max utility  min budget


subject to budget  subject to utility
constraint constraint


Solution is a  Solution is a
function of (p,y) function of (p,u)

April 2018 Frank Cowell: Consumer Optimisation 32

 Basic functional relations
Utility
Utility

cost (expenditure)
 C(p,u) H
H is
is also
also known
"Hicksian"
known as
as
"Hicksian" demand
demand
compensated demand for
 Hi(p,u) good i

 V(p, y) indirect utility

 Di(p, y) ordinary demand for input i

money
money
income
income

April 2018 Frank Cowell: Consumer Optimisation 33

 What next?
 Examine the response of consumer demand to changes
in prices and incomes
 Household supply of goods to the market
 Develop the concept of consumer welfare

April 2018 Frank Cowell: Consumer Optimisation 34