Utility Maximization and Expenditure Minimization

1 Cobb-Douglass
We begin with a Cobb-Douglass Utility Function:
U (q1 , q2 ) = q1a q2b

1.1 Utility Maximization

We want to find the maximum amount of Utility (U ) that it is possible to achieve given
some prices and income. That means we want to solve:
max U = q1a q2b
s.t. Y ≥ p1 q1 + p2 q2
With normal preferences we know that the constraint “s.t. Y ≥ p1 q1 + p2 q2 ” holds with
equality (because more is better). So we can solve the constraint for q1 as a function
of q2 :
Y = p 1 q1 + p 2 q2
Y − p 2 q2 = p 1 q1
Y − p 2 q2
q1 (q2 ) =
p1
Now we can substitute this into the utility and maximize:
! "a
Y − p 2 q2
U= q2b
p1
Taking the natural log of both sides gives the same solution because natural log is a
positive increasing function and so ln(U ) and U represent the same preferences:
! "
Y − p 2 q2
ln(U ) = aln + bln(q2 )
p1
! "! "
dln(U ) p1 p2 b
=0=a − +
dq2 Y − p 2 q2 p1 q2
! "! "
p1 p2 b
a =
Y − p 2 q2 p1 q2
ap2 q2 = bY − bp2 q2
(a + b)p2 q2 = bY
! "
∗ b Y
q2 =
a + b p2
Rewriting this gives
p 2 q2 b
= .
Y a+b
The left hand side of this is the share of income spent on good 2. The demand for good
1 can be found analogously and so the Marshallian demands for good 1 and good 2 in
the Cobb-Douglass case are:
! "
∗ a Y
q1 = D1 (p1 , p2 , Y ) =
a + b p1
! "
∗ b Y
q2 = D2 (p1 , p2 , Y ) = .
a + b p2
1
1.2 Expenditure Minimization
We want to find the minimum amount of expenditure (E) necessary to achieve some
minimum level of utility (Ū ). That means we want to solve:

min E = p1 q1 + p2 q2
s.t. Ū ≤ q1a q2b

With normal preferences we know that the constraint “s.t. Ū ≤ qqa q2b ” holds with equality
(because more is better). So we can solve the constraint for q1 as a function of q2 :

q1a q2b = Ū
Ū
q1a =
q2b
! "1/a
Ū
q1 =
qb
# 2 $
Ū 1/a
q1 (q2 ) = b/a
q2

Now we can substitute this into the expenditure and minimize:

# $
Ū 1/a
E = p1 b/a
+ p 2 q2
q2

! "% &
dE 1/a −b −b
−1
= 0 = p1 Ū q2a + p2
dq2 a
−(b+a)
p2
q2 a = 'b(
p1 Ū 1/a
a
! " (b+a)
−a
ap2
q2 =
bp1 Ū 1/a
! " a
∗ bp1 b+a a+b 1
H2 (p1 , p2 , Ū ) = q2 = Ū
ap2
and similarly
! " b
∗ ap2 b+a a+b 1
H1 (p1 , p2 , Ū ) = q1 = Ū
bp1

So the minimum expenditure needed in order to get utility Ū is

E =p1 H1 (p1 , p2 , Ū ) + p2 H2 (p1 , p2 , Ū )

! " b ! " a
ap2 b+a a+b 1 ap1 b+a a+b 1
E =p1 Ū + p2 Ū
bp1 bp2
If we wanted to know how much it costs to have the same utility at different prices we
can plug in p1 and p2 and the fixed level of utility, Ū , into the Expenditure function:
E(p1 , p2 , Ū ). This gives the minimum amount of money required to purchase utility
level Ū at prices p1 and p2 .

2
2 Quasi-Linear
We begin with a Quasi-Linear Utility Function:
U (q1 , q2 ) = q1 + f (q2 )

2.1 Utility Maximization

We want to find the maximum amount of Utility (U ) that it is possible to achieve given
some prices and income. That means we want to solve:
max U = q1 + f (q2 )
s.t. Y ≥ p1 q1 + p2 q2
With normal preferences we know that the constraint “s.t. Y ≥ p1 q1 + p2 q2 ” holds with
equality (because more is better). So we can solve the constraint for q1 as a function
of q2 :
Y = p 1 q1 + p 2 q2
Y − p 2 q2 = p 1 q1
Y − p 2 q2
q1 (q2 ) =
p1
Now we can substitute this into the utility and maximize:
! "
Y − p 2 q2
U= + f (q2 )
p1

dU p2
= 0 = − + f # (q2 )
dq2 p1
p2
= f # (q2 )
p1
! "
∗ #−1 p2
q2 = f
p1
Where f #−1 (·) is the inverse of the derivative of f (·). Now substitute into the budget
constraint to find q1∗ :
! ! ""
#−1 p2
Y = p 1 q1 + p 2 f
p
% % &&1
Y − p2 f #−1 pp21
∗
q1 =
p1
This might be negative! You will need to find the conditions under which demand for q1
is positive and write the Marshallian demands as the appropriate piecewise functions.

2.2 Expenditure Minimization

We want to find the minimum amount of expenditure (E) necessary to achieve some
minimum level of utility (Ū ). That means we want to solve:
min E = p1 q1 + p2 q2
s.t. Ū ≤ q1 + f (q2 )
3
With normal preferences we know that the constraint “s.t. Ū ≤ q1 + f (q2 )” holds with
equality (because more is better). So we can solve the constraint for q1 as a function
of q2 :

Ū = q1 + f (q2 )
q1 (q2 ) = Ū − f (q2 )

Now we can substitute this into the expenditure and minimize:

' (
E = p1 Ū − f (q2 ) + p2 q2

dE
= 0 = p1 (−f # (q2 )) + p2
dq2
p2
f # (q2 ) =
p1
! "
∗ #−1 p2
q2 = f
p1

Where f #−1 (·) is the inverse of the derivative of f (·). Now substitute into the required
utility to find q1∗ :
! ! ""
#−1 p2
Ū = q1 + f f
p
! ! 1 ""
p2
q1∗ = Ū − f f #−1
p1
This might be negative! You will need to find the conditions under which demand for
q1 is positive and write the Hicksian demands as the appropriate piecewise functions.

4
3 Perfect Substitutes
We begin with a Perfect Substitutes Utility Function:
U (q1 , q2 ) = aq1 + bq2

3.1 Utility Maximization

We want to find the maximum amount of Utility (U ) that it is possible to achieve given
some prices and income. That means we want to solve:
max U = aq1 + bq2
s.t. Y ≥ p1 q1 + p2 q2
With normal preferences we know that the constraint “s.t. Y ≥ p1 q1 + p2 q2 ” holds with
equality (because more is better). So we can solve the constraint for q1 as a function
of q2 and for q2 as a function of q1
Y = p 1 q1 + p 2 q2 Y = p 1 q1 + p 2 q2
Y − p 2 q2 = p 1 q1 Y − p 1 q 1 = p 2 q2
Y − p 2 q2 Y − p 1 q1
q1 (q2 ) = q2 (q1 ) =
p1 p2
We know that because this is perfect substitutes the solution will be a “corner solution”:
consume only good 1 or only good 2. Plugging these in to the equations above gives:
Y Y
q1 (0) = q2 (0) =
p1 p2
So the maximum utility will be:
) *
Y Y
U = max a , b
p1 p2
When we write down the Marshallian demand we will have a piecewise function.
) Y
∗ p1
if a pY1 ≥ b pY2
q1 = D1 (p1 , p2 , Y ) =
0 if a pY1 ≤ b pY2
)
∗ 0 if a pY1 ≥ b pY2
q2 = D2 (p1 , p2 , Y ) = Y
p2
if a pY1 ≤ b pY2

3.2 Expenditure Minimization

We want to find the minimum amount of expenditure (E) necessary to achieve some
minimum level of utility (Ū ). That means we want to solve:
min E = p1 q1 + p2 q2
s.t. Ū ≤ aq1 + bq2
With normal preferences we know that the constraint “s.t. Ū ≤ aq1 + bq2 ” holds with
equality (because more is better). So we can solve the constraint for q1 as a function
of q2 and q2 as a function of q1 :
Ū = aq1 + bq2
Ū − bq2 Ū − aq1
q1 (q2 ) = q2 (q1 ) =
a b
5
We know that because this is perfect substitutes the solution will be a “corner solution”:
consume only good 1 or only good 2. Plugging these in to the equations above gives:

Ū Ū
q1 (0) = q2 (0) =
a b
So the minimum expenditure will be:
) *
Ū Ū
E = min p1 , p2
a b
When we write down the Hicksian demand we will have a piecewise function.
) Ū
∗ a
if p1 Ūa ≤ p2 Ūb
q1 = H1 (p1 , p2 , Y ) =
0 if p1 Ūa ≥ p2 Ūb
)
∗ 0 if p1 Ūa ≤ p2 Ūb
q2 = H2 (p1 , p2 , Y ) = Ū
b
if p1 Ūa ≥ p2 Ūb

6
4 Perfect Complements
We begin with a Perfect Complements Utility Function:

U (q1 , q2 ) = min{aq1 , bq2 }

4.1 Utility Maximization

We want to find the maximum amount of Utility (U ) that it is possible to achieve given
some prices and income. That means we want to solve:

max U = min{aq1 , bq2 }

s.t. Y ≥ p1 q1 + p2 q2

With normal preferences we know that the constraint “s.t. Y ≥ p1 q1 + p2 q2 ” holds with
equality (because more is better). So we can solve the constraint for q1 as a function
of q2 :

Y = p 1 q1 + p 2 q2
Y − p 2 q2 = p 1 q1
Y − p 2 q2
q1 (q2 ) =
p1
I can plug this into the utility function.
) ! " *
Y − p 2 q2
U = min a , bq2
p1
and I use the fact that I know that this utility function is maximized when aq1 = bq2 .
So I can solve for q2
! "
Y − p 2 q2
a =bq2
p1
aY ap2 q2
− =bq2
p1 p1
! "
aY bp1 + ap2
= q2
p1 p1
! "! "
aY p1
q2 =
p1 bp1 + ap2
aY
q2∗ = D1 (p1 , p2 , Y ) =
bp1 + ap2
and similarly
bY
q1∗ = D1 (p1 , p2 , Y ) =
bp1 + ap2

4.2 Expenditure Minimization

We want to find the minimum amount of expenditure (E) necessary to achieve some
minimum level of utility (Ū ). That means we want to solve:

min E = p1 q1 + p2 q2
s.t. Ū ≤ min{aq1 , bq2 }
7
With normal preferences we know that the constraint “s.t. Ū ≤ min{aq1 , bq2 }” holds
with equality (because more is better). With perfect complements I know that Ū = aq1
or Ū = bq2 , whichever is smaller. So the expenditure to purchase utility Ū will be
 % &
 p1 Ū + p2 q2 if aq1 ≤ bq2
a
E= % &
 p1 q1 + p2 Ū if aq1 ≥ bq2
b

In the first case (aq1 ≤ bq2 ) expenditure is increasing in q2 and in the second (aq1 ≥ bq2 )
expenditure is increasing in q1 . Minimizing expenditure is going to push us toward the
boundary of the two cases: where aq1 = bq2 = Ū So the Hicksian demands are:

Ū
H1 (p1 , p2 , Ū ) =
a
Ū
H2 (p1 , p2 , Ū ) = .
b