Preference Printout
Preference Printout
Preference Printout
; y
) ; is when x = y
Replacing y with x into the budget constraint since x = y, we have the following:
p
x
x + p
y
x = m
x(p
x
+ p
y
) = m
Hence,
x
= y
=
m
p
x
+ p
y
1.3. Perfect Substitutes
U1
U2
Budget line
Y
X
Consider the above graph:
The slope of the budget line is Steeper than the slope of the indierence curves.
The slope of the budge line in absolute value is
px
py
, where p
x
and p
y
is the price of good x and y respectively.
The slope of the indierence curves in absolute value is jMRSj, where MRS is the Marginal Rate of
Substitutions
MRS =
_
Marginal Utility of Good x
Marginal Utility of Good y
_
=
_
MU
x
MU
y
_
=
_
@U(x;y)
@x
@U(x;y)
@y
_
The slope of the budget line is Steeper than the slope of the indierence curves. This is equivalent to
having the following:
p
x
p
y
> jMRSj
The Optimal Allocation (x
; y
) is
_
0;
m
py
_
. Equivalently, the quantity of good x and y demanded is
_
0;
m
py
_
:
Example:
Suppose we have two goods, Pepsi (x) and Coke (y). Which good would you prefer to purchase?
Spending all income m on Coke (y), i.e. purchasing only Coke (y) ; will put you on the highest indierence
curve given the budget constraint.
The budget line is tangent to a higher indierence curve at the y Axis; than it is at the x Axis:
2
U2
U1
Budget line
X
Y
Consider the above graph:
The slope of the budget line is Flatter than the slope of the indierence curves.
The slope of the budge line in absolute value is
px
py
, where p
x
and p
y
is the price of good x and y respectively.
The slope of the indierence curves in absolute value is jMRSj, where MRS is the Marginal Rate of
Substitutions
MRS =
Marginal Utility of Good x
Marginal Utility of Good y
=
MU
x
MU
y
=
@U(x;y)
@x
@U(x;y)
@y
The slope of the budget line is Flatter than the slope of the indierence curves. This is equivalent to having
the following:
p
x
p
y
< jMRSj
The Optimal Allocation (x
; y
) is
_
m
px
; 0
_
. Equivalently, the quantity of good x and y demanded is
_
m
px
; 0
_
:
Example:
Suppose we have two goods, Pepsi (x) and Coke (y). Which good would you purchase?
Spending all income m on Pepsi (x), i.e. purchasing only Pepsi (x) ; will put you on the highest indierence
curve given the budget constraint.
The budget line is tangent to a higher indierence curve at the x axis; than it is at the y axis:
Perfect Substitutes:
Rules to follow:
If the slope of the budget constraint is Steeper than the slope of the indierence curve, we consume the
good on the y axis:
In particular,
p
x
p
y
> jMRSj
Where p
x
and p
y
is the price of good x and y respectively.
If the slope of the budget constraint is Flatter than the slope of the indierence curve, we consume the
good on the x axis:
In particular,
p
x
p
y
< jMRSj
Where p
x
and p
y
is the price of good x and y respectively.
If we were to consume the good on the x axis; we represent it as:
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Example:
Suppose we have the utility function:
U (x; y) = 4x + 5y
and the budget constraint is as follows:
2x + 3y = 10
The Marginal Rate of Substitution is as follows:
MRS =
4
5
The MRS in absolute value is:
jMRSj =
4
5
=
4
5
The slope of the budget line is as follows:
Slope (BC) =
2
3
The slope of the budget line in absolute value
jSlope (BC)j =
2
3
=
2
3
Hence,
jMRSj > jSlope (BC)j
As a result, agents consume only goods x. The quantity of good x and y demanded, i.e. the Optimal
Allocation, is (x
; y
) =
_
10
2
; 0
_
Note that when y
= 0 we have 2x
= 5; y
= 0
The highest level of utility is
U (5; 0) = (4) (5) + (5) (0) = 20
1.4. Cobb-Douglas Utility Function
The Cobb-Douglas utility function:
U(x; y) = x
a
y
b
; where a > 0 and b > 0
Alternatively, using monotonic transformation, Cobb-Douglas utility function could also be represented as
follows:
U (x; y) = a log (x) + b log (y) ; where a > 0 and b > 0
:
This indierence curve will have a negative slope, which will incorporate the individuals willingness to make
tradeos between good x and y.
How to solve for an Optimal Bundle or Optimal Allocation given a Cobb-Douglas function:
MRS =
_
p
x
p
y
_
MRS =
_
ax
a1
y
b
bx
a
y
b1
_
=
_
a
b
__
y
x
_
4
_
a
b
__
y
x
_
=
p
x
p
y
To solve for y
=
_
b
a + b
__
m
p
y
_
And, now to solve for x
Substitute y
=
_
a
a + b
_
m
The Optimal Bundle is:
(x
; y
) = (
_
a
a + b
__
m
p
x
_
;
_
b
a + b
__
m
p
y
_
)
This should be similar to the case presented in the textbook.
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1.5. Quasilinear Utility Functions
A Quasilinear utility function is as follows:
U(x; y) = ln(x) + y
where ln(x) is the natural logarithm.
The function U(x; y) is linear in y:
Let us solve for the above function:
At the Optimal Bundle (x
; y
=
p
x
p
y
x
=
p
y
p
x
Substitute the above into the following budget constraint:
p
x
x + p
y
y = m
p
x
(
p
y
p
x
) + p
y
y = m
y
=
m p
y
p
y
=
m
p
y
1
So our optimal bundle is:
(x
; y
) = (
p
y
p
x
;
m
p
y
1)
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2. Practice Problems:
2.1. Complements:
Utility function is
U (x
1
; x
2
) = Min(x
1
; 2x
2
)
Suppose an accountant needs 1 eraser for every 2 pencils he/she uses. Any more pencils will not be useful
as the accountant will not be able to erase the caluclations. Any more erasers will also not serve his purpose
also. Therefore, x
1
is pencil and x
2
is eraser.
To solve for maximization problem:
Max U (x
1
; x
2
)
where
U (x
1
; x
2
) = Min(x
1
; 2x
2
)
The budget constraint:
p
1
x
2
+ p
2
x
2
= m
where p
1
and p
2
is the price of good x
1
and x
2
respectively.
With x
1
= 2x
2
!
m = 2p
1
x
2
+ p
2
x
1
x
2
=
m
2p
1
+ p
2
And for x
1
:
m = p
1
x
1
+
1
2
p
2
x
1
x
1
=
m
p
1
+
1
2
p
2
2.2. Substitutes:
U = 3 (Coke) + 6 (Pepsi)
The price of Pepsi is $2, and the price of Coke is $0.8. What is the Optimal Consumption Bundle for the
individual?
First assume, Coke to be on y axis
MRS =
_
3
6
_
=
_
1
2
_
slope of budget line =
_
2
4
5
_
=
_
10
4
_
= 2:5
We know that the slope of the budget line is greater than the MRS, the slope of the indierence curve. So
what good will the individual consume and why?
2.3. Cobb-Douglas:
Find the Optimal Consumption Bundles of x and y for the following utility functions:
U (x; y) = x
2
3
y
4
5
U (x; y) = x
2
+ y
Where the price of good x is $2 and the price of good y is $1, and income is $10:
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