[Math] From utility function (3 products) to demand function (2 products)

economicslagrange multiplier

I am struggling with this exercise and would appreciate some help.

Consider two goods and a representative consumer whose utility is given by:

$U(q_{0}, q_{1}, q_{2})= q_{0}+5q_{1}+5q_{2}-\frac{1}{2}((q_{1})^{2}+(q_{2})^{2}+2dq_{1}q_{2})$

located with unit density on a road with unit distance. Consider two firms producing each good and having unit marginal cost.

I need to compute the demand and inverse demand functions and say when they are complements or substitutes.

I do not know really how to set the income constraint because it says two goods but then there are three variables. Any hints?

Thanks a lot.

Best Answer

In this case, $q_0$ is all of the "outside" goods, that is, the more it is consumed, the higher the utility will be. This is because the utility function is monotonically increasing in $q_0$, which suggests that the budget constraint should be \begin{equation} q_0 + p_1 q_1 + p_2 q_2 \le Y \end{equation} for budget level of $Y$, and prices of $p_1$ and $p_2$ for the good 1 and good 2. By using Lagrangian method or considering that a rational customer would spend all its budget, we can set $q_0 = Y- p_1 q_1 - p_2 q_2$. Plugging this back into the utility function, one needs to solve the following maximization problem \begin{equation} \max_{q_1,q_2} (Y- p_1 q_1 - p_2 q_2) + 5q_1+5q_2−\frac{1}{2}(q_1^2+q_2^2+2dq_1q_2). \end{equation} First order conditions then suggest that \begin{align} q_1^*(p_1,p_2) &= \frac{5(1-d)-p_1+dp_2}{1-d^2} \\ q_2^*(p_1,p_2) &= \frac{5(1-d)-p_2+dp_1}{1-d^2}. \end{align} These are well-known linear demand functions and the cross-price effects are given as \begin{align} \frac{\partial q_1}{ \partial p_2} = \frac{\partial q_2}{\partial p_1}=\frac{d}{1-d^2}. \end{align} Hence, these two goods are substitutes if $\frac{d}{1-d^2}>0$. They are complements if $\frac{d}{1-d^2}<0$.

Related Question