Economics 2 Emmanuel Saez

Fall 2024

LECTURE 6
Consumers and Utility Maximization
I. INTRODUCTION TO CONSUMER OPTIMIZATION
 Why Consumer Optimization Is Important
• It has implications for how we view the desirability
of market outcomes.
• It can help us to understand the many choices that
consumers make.
II. THE BUDGET CONSTRAINT
 A Household’s Budget Constraint
• In words: The total amount the household spends
cannot exceed its income.

• In symbols:

Pa•qa + Pb•qb + Pc•qc + … + Pz•qz = Income,

where the P’s are the market prices of the various

goods, and the q’s are the quantities that the
individual household buys.
Budget Constraint for the Case of Two Goods
Pfood•qfood + Pclothing•qclothing = Income
qfood

qclothing
Budget Constraint for the Case of Two Goods
Pfood•qfood + Pclothing•qclothing = Income
qfood !"#$%&
Intercept =
'!""#

Budget constraint
'$%"&'()*
Slope = −
'!++,

!"#$%&
Intercept =
'$%"&'()*

qclothing
A Rise in the Household’s Income
qfood

Budget constraint1
qclothing
A Rise in the Household’s Income
qfood
Budget constraint2

Budget constraint1
qclothing
 A Rise in the Price of Clothing
qfood

Budget constraint1

qclothing
 A Rise in the Price of Clothing
qfood

Budget constraint1

Budget constraint2

qclothing
Recall that the slope of the budget constraint is −Pclothing /Pfood .
What point does the consumer choose on the
budget constraint?
qfood

Budget constraint1
qclothing
III. UTILITY MAXIMIZATION
What do we think consumers maximize?
 What do we think consumers maximize?
• Happiness, satisfaction, utility.

• Economists don’t make judgments about what

gives people happiness.

• Preferences of individuals are “sacred” for

economists and are revealed by their choices
 Utility
• Total utility: The total happiness one gets from
consuming a given amount of a good.

• Marginal utility: The extra utility derived from

consuming one more unit of a good.
 Diminishing Marginal Utility
• As a household consumes more of a given good,
the marginal utility of the good declines.
• Canonical example is food:
– when hungry, an extra unit of food gives you a lot of
utility
– when satiated, an extra unit of good gives you a lot less
utility, eventually negative
 Diminishing Marginal Utility
marginal
utility

q
 Diminishing Marginal Utility
marginal
utility

mu

q
 Relationship between
Total Utility and Marginal Utility
• Suppose
u = f(q)

where q is the quantity of some good a household

consumes, and u is the total utility the household
gets from consuming the good.

• Then
mu = f’(q)

where mu is marginal utility

f’(q) is derivative of function f at point q

 Recall about derivatives
• Function f(x)

• Derivative f’(x) is the slope of function at x

f’(x)=(f(x+1)-f(x))/1

assuming that 1 extra unit is small

• Formal mathematical definition is:

f’(x) = limit of (f(x+e)-f(x))/e when e goes to zero

• In economics: marginal always means

derivative (adding one extra small unit) so that
we can use calculus
Relationship between Total and Marginal Utility
total
utility

q
marginal
utility Marginal utility is
the derivative of
utility (slope of
utility function)

q
 Marginal Utility Likely Declines at Different
Rates for Different Goods
Good a Good b
mua mub

qa qb
 Marginal Utility Likely Declines at Different
Rates for Different Goods
Good a (food) Good b (clothes)
mua mub

mub
mua

qa qb
 The Condition for Utility Maximization
(the Rational Spending Rule)
• A household is doing the best that it can—that is,
it is maximizing its utility—if:

The marginal utility derived from spending one

more dollar on a good is the same for all goods.

Technical (but not substantial) assumption:

people can fine tune the exact quantity they buy
à we can apply mathematical calculus
 The Condition for Utility Maximization
with Just Two Goods (Food and Clothing)

$1 $1
𝑚𝑢( = 𝑚𝑢)
𝑃( 𝑃)

Where the P’s are the market prices of the two

goods and the mu’s are the marginal utilities of an
additional unit of the two goods for the household.

This is the same as:

𝑚𝑢( 𝑚𝑢)
=
𝑃( 𝑃)
 The General Condition for Utility
Maximization (the Rational Spending Rule)
!"! !"" !"#
= =…= ,
#! #" ##

where the P’s are the market prices of the different

goods, and the mu’s are the marginal utilities of an
additional unit of the different goods for the
household.
IV. CONSUMER OPTIMIZATION AND THE DEMAND
CURVE
 A Rise in the Price of Clothing
• Suppose the household starts with:
𝑚𝑢! 𝑚𝑢"
=
𝑃! 𝑃"
• If Pc rises, and the household didn’t change its
purchases, then:
𝑚𝑢( 𝑚𝑢)
<
𝑃( 𝑃)
 Diminishing Marginal Utility
marginal
utility

mu

q
 A Rise in the Price of Clothing
• Suppose the household starts with:
𝑚𝑢! 𝑚𝑢"
=
𝑃! 𝑃"
• If Pc rises, and the household didn’t change its
purchases, then:
𝑚𝑢( 𝑚𝑢)
<
𝑃( 𝑃)
• The household will need to buy less clothing (and
more food) until:
𝑚𝑢( 𝑚𝑢)
=
𝑃( 𝑃)
 Why Demand Curves Slope Down
• Substitution effect: When the price of a good
rises, a household wants less of the good and
more of other goods, because the good becomes
relatively more expensive.
 A Rise in the Price of Clothing
qfood

Budget constraint1

Budget constraint2

qclothing
 Why Demand Curves Slope Down
• Substitution effect: When the price of a good
rises, a household wants less of the good and
more of other goods, because the good is
relatively more expensive.

“if price increases, I buy something else”

• Income effect: When the price of a good rises, a

household wants less of all goods, because its
budget constraint has changed for the worse.

“if price increases, I can’t buy as much”

 Demand Curves

Individual Household Market

P P

q Q
 Demand Curves

Individual Household Market

P P

d
q Q
 Household and Market Demand Curves
• The market demand curve is the horizontal sum of
each individual household’s demand curve.

• Because each household’s demand curve (d)

slopes down, the market demand curve (D) slopes
down.
 Demand Curves

Individual Household Market

P P

d D
q Q
 Household and Market Demand Curves
• The market demand curve is the horizontal sum of
each individual household’s demand curve.

• Because each household’s demand curve (d)

slopes down, the market demand curve (D) slopes
down.

• Because each household’s demand curve is

derived from optimizing behavior, the market
demand curve is as well.
Blueberries may help prevent Alzheimer's, new
research suggests
4:41PM GMT 13 Mar 2016

Scientists say the fruit is loaded with healthful antioxidants

which could help prevent the effects of the increasingly
common form of dementia
Blueberries, already classified as a “superfruit” for its health boosting properties, could now
also help fight dementia, new research suggests. The study shows the berry, which can
potentially lower the risk of heart disease and cancer, could also be a weapon in the battle
against Alzheimer's disease. Scientists say the fruit is loaded with healthful antioxidants
which could help prevent the devastating effects of the increasingly common form of
dementia. One study involved 47 adults aged 68 and older, who had mild cognitive
impairment, a risk condition for Alzheimer’s disease.
Positive News about Blueberries
mu

mu1
q
Positive News about Blueberries
mu

mu1 mu2
q1 q
 Positive News about Blueberries
• An optimizing consumer sets:
𝑚𝑢#$%&#&''(&) 𝑚𝑢&*&'+,-(./ &$)&
=
𝑃#$%&#&''(&) 𝑃&*&'+,-(./ &$)&
• A rise in the mublueberries causes:
𝑚𝑢*+,-*-../-0 𝑚𝑢-1-.234/56 -+0-
>
𝑃*+,-*-../-0 𝑃-1-.234/56 -+0-

• The optimizing consumer will want to consume more

blueberries at the same Pblueberries.
Positive News about Blueberries
mu

mu1 mu2
q1 q
Effect of Positive News on the Demand Curve
P

d1
q
Effect of Positive News on the Demand Curve
P

d1 d2
q
 Utility of Income
• Consumer has income c that is used to buy all
sorts of goods: Pa•qa + Pb•qb + Pc•qc + … + Pz•qz = c
where c is total amount spent on consumption.

• This consumer optimization generates utility u(c)

with u(.) an increasing function of c.

• The marginal utility of income is u’(c), the slope of

utility function u(c) = extra utility from having +$1

• We expect u’(c) to decrease with c which means

that u(c) is concave in c.
 Quiz 1:
Question: Suppose UC Berkeley gives you an extra
$500/month stipend this academic year. The extra
stipend is most useful to you if:

• A. My current stipend is low ($1000/month)

• B. My current stipend is medium ($2000/month)

• C. My current stipend is high ($3000/month)

• D. It is equally useful to me in all A,B,C cases

Answer based on YOUR feelings (not ECON2 theory)

 Utility Function
u(c) is increasing
Utility u(c) is concave (means u’(c) is decreasing)
u(c)

0 $ consumption c
 Utility Function
u(c) is increasing
Utility u(c) is concave (means u’(c) is decreasing)
u(c)

Example:
u(c)=log(c)
u’(c)=1/c
10% increase in c gives
same utility whether c is
high or low

0 $ consumption c
 Utility of Income
• Even though consumer satiates with any specific
good, you never satiate with total income c
because there are always more expensive goods
to start consuming (fancier house, car, etc.)

• With concave u(c): u’(poor)>u’(rich) => taking $1

from rich to give $1 to poor increases total utility

• Non-satiation (“it’s never enough”) is what drives

perpetual economic growth

• Sociologically: non-satiation arises because utility

is always relative to what others consume
 How to Measure Society’s Well-Being?
• Libertarian: social well-being is the sum of $ of
economic surplus across agents regardless of who gets
it => Inequality irrelevant, no value in redistribution.

• Utilitarian: social well-being is sum of utilities. If u(c) is

concave, value in redistributing from rich to poor.
Traditional criterion for economists.

• Rawlsian: (after John Rawls) social well-being is the

utility of the worst-off person in society. Aim is to
make the poorest as well-off as possible.

All these measures are based on individualistic outcomes

and miss fairness, rights, process considerations
 Quiz 2:
Question: Which measure of social welfare fits best
with your views?

• A. Libertarian ($ sum of economic surplus)

• B. Utilitarian (sum of utilities)

• C. Rawlsian (utility of the poorest person)

• D. None of these fit with my views

Answer based on YOUR feelings (not ECON2 theory)

V. “FAIRNESS AS A CONSTRAINT ON PROFIT SEEKING”
BY KAHNEMAN, KNETSCH, AND THALER
 Behavioral Economics
• Brings the complexity of human behavior into the
analysis of economic decision-making.

• Blends psychology and economics.

• The Undoing Project by Michael Lewis and

Misbehaving by Richard Thaler are fun books on
the birth of the field.
 Lab Experiments
• Another way to gather information about
economic behavior.

• Watch behavior in a controlled laboratory setting.

 Empirical Strategy of Kahneman, et al.
• Asking people to respond to vignettes.

• I-Clicker quiz: A. Completely Fair, B. Acceptable,

C. Unfair, D. Very Unfair.

• Answer based on feelings, not ECON2 theory

 Some Findings from Kahneman, et al.

Price increases based on a shift in demand are

viewed as unfair.
 Some Findings from Kahneman, et al.

Price increases based on increased production

costs are viewed as acceptable.
 Some Findings from Kahneman, et al.

Price increases based on increased opportunity

cost are viewed negatively.
 Some Findings from Kahneman, et al.

Reference transactions matter.

What do you think of the research?
 What do I think of the research?
• People have a sense of fairness that’s relevant to
basic economic choices

• Taking advantage of disaster to increase prices is

wrong = price gouging.

• Market logic does not always seem fair to humans,

explains anti-price gouging laws, allocation of some
goods such as COVID vaccines in non-market ways

• These fairness effects are even bigger for wage

determination in the labor market as workers care a
lot about pay fairness
 Implications of Findings for Analysis of
Household and Firm Optimization
• Need a broad definition of utility.

• There are important deviations from simple

optimizing behavior for people.

• Firms may need to think about customer

relationships and workers’ morale in figuring out
how to maximize long-run profits.

• But basic insights and implications of utility and

profit maximization still useful.
 References
• CORE-The Economy, Unit 3.

• Principles of Economics, Chapter 5.

• Kahneman, Daniel, Jack L. Knetsch, and Richard

Thaler. "Fairness as a constraint on profit seeking:
Entitlements in the market." The American
economic review (1986): 728-741.