Professional Documents
Culture Documents
Week 6 & 7
Week 6 & 7
4-2
© 2017 by McGraw-Hill Education. All Rights Reserved.
Constraints
Constraints
• Opportunities are determined by constraints
• While any decision-making environment faces a host of
constraints, the focus of managerial economics is to
examine the role prices and income play in
constraining consumer behavior.
4-3
© 2017 by McGraw-Hill Education. All Rights Reserved.
Constraints
4-4
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Constraints
𝑀
𝑃𝑌 Slope
Bundle H
𝑃𝑋 𝑀 𝑃𝑋
Budget set: 𝑌 ≤ − 𝑋
𝑃𝑌 𝑃𝑌
𝑀 𝑃
𝑃𝑌 Budget line: 𝑌 = − 𝑋𝑋
𝑃𝑌 𝑃𝑌
Bundle G
𝑀 Good 𝑋
0
𝑃𝑋
4-5
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Constraints
5
(Slope: Px/Py)
4−3 1
Market rate of substitution : =−
2−4 2
4
1
Budget line: 𝑌 = 5 − 𝑋
2
3
0 2 4 10 Good 𝑋
4-6
© 2017 by McGraw-Hill Education. All Rights Reserved.
Constraints
Changes in Income Shrink or Expand
Good 𝑌
Opportunities
𝑀1
𝑃𝑌
𝑀0
𝑃𝑌
𝑀2 𝑀↑
𝑀↓
𝑃𝑌
0 𝑀2 𝑀0 𝑀1 Good 𝑋
𝑃𝑌 𝑃𝑌 𝑃𝑌
4-7
© 2017 by McGraw-Hill Education. All Rights Reserved.
Constraints
0 𝑀 𝑀
Good 𝑋
0 1
𝑃𝑋 𝑃𝑋
4-8
© 2017 by McGraw-Hill Education. All Rights Reserved.
Constraints
The Budget Constraint in Action
• Consider the following budget line:
100 = 1𝑋 + 5𝑌
• What is the maximum amount of X that can be consumed?
• What is the maximum amount of Y that can be consumed?
• What is rate at which the market trades goods X and Y?
4-9
© 2017 by McGraw-Hill Education. All Rights Reserved.
Constraints
The Budget Constraint in Action
• Answers:
100
• Maximum X is: 𝑋 = = 100 units
1
100
• Maximum Y is: 𝑌 = = 20 units
5
𝑃 1
• Market rate of substitution: − 𝑋 = −
𝑃𝑌 5
4-10
© 2017 by McGraw-Hill Education. All Rights Reserved.
Consumer Behavior
•Utility maximization
•What factors effect our decisions?
• Prices
• Incentives
• Information
4-11
© 2017 by McGraw-Hill Education. All Rights Reserved.
Consumer Behavior
• Suppose you have a choice: 2 Big Mac and 1 Whopper OR 1 Big Mac
and 2 Whoppers
4-13
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Consumer Behavior
< +
4-14
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Consumer Behavior
If ≥ ≥
then ≥
4-19
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Consumer Behavior
Normative Consumer Theory:Properties of
Consumer Preferences
• Property 1- Completeness: For any two bundles of goods
either:
• 𝐴 ≻ 𝐵.
• 𝐵 ≻ 𝐴.
• 𝐴 ∼ 𝐵.
• Property 2- More is better
• If bundle 𝐴 has at least as much of every good as bundle 𝐵 and
more of some good, bundle 𝐴 is preferred to bundle 𝐵.
• Property 3- Diminishing marginal rate of substitution
• As a consumer obtains more of good X, the amount of good Y
the individual is willing to give up to obtain another unit of good
X decreases.
• Property 4- Transitivity: For any three bundles, 𝐴, 𝐵, and 𝐶,
either:
• If 𝐴 ≻ 𝐵 and 𝐵 ≻ 𝐶, then 𝐴 ≻ 𝐶.
• If 𝐴 ∼ 𝐵 and 𝐵 ∼ 𝐶, then 𝐴 ∼ 𝐶.
4-20
© 2017 by McGraw-Hill Education. All Rights Reserved.
Normative Consumer Theory
• The marginal rate of substitution (MRS)
I, II, III: Indifference curves is the absolute value of the slope of an
indifference curve. MRS: the rate at
which a consumer is willing to
substitute one good for the other and
still maintain the same level of
satisfaction
• Diminishing MU
Consumer Equilibrium
• Consumer equilibrium
• Consumption bundle that is affordable and yields the
greatest satisfaction to the consumer.
• Consumption bundle where the rate a consumer chooses
(marginal rate of substitution) to trade between goods X and
Y equals the rate at which these goods are traded in the
market (market rate of substitution).
𝑷𝑿
𝑴𝑹𝑺 =
𝑷𝒀
MUy/MUx =
4-22
© 2017 by McGraw-Hill Education. All Rights Reserved.
Consumer Equilibrium
Consumer Equilibrium
Good 𝑌 Max U(X,Y) subject to the budget constraint 𝑴 = 𝑷𝑿 𝑿 + 𝑷𝒀 𝒀
A
B Consumer equilibrium
C
y*
III
II
I
0 x* Good 𝑋
4-23
© 2017 by McGraw-Hill Education. All Rights Reserved.
Consumer Equilibrium
• The utility function of two goods X and Y is given by 𝑼 = 𝑼(𝑿, 𝒀).
• The Budget Constraint (line) is 𝑴 = 𝑷𝑿 𝑿 + 𝑷𝒀 𝒀.
• Graphically, the optimum consumption bundle is at the tangency of
the indifference (utility) curve and the budget line.
• In other words, the slopes (derivatives) of the indifference curve and
the budget line must be equal.
• The slope of the budget line is clear from previous slides, which is
𝑷𝑿
−
𝑷𝒀
24
Consumer Equilibrium
• But, how to find the slope of the indifference curve?
• Recall, moving along the indifference curve, the utility level for
different consumption bundle is the same. Hence,
𝒅𝑼 = 𝑼𝑿 𝒅𝑿 + 𝑼𝒀 𝒅𝒀 = 𝟎
𝝏𝑼 𝝏𝑼
• Here 𝑼𝑿 = and 𝑼𝒀 =
𝝏𝑿 𝝏𝒀
𝒅𝒀 𝑼𝑿
• Then, = − , which is the slope of the indifference curve. It is
𝒅𝑿 𝑼𝒀
called the marginal rate of substitution, MRS.
25
Consumer Equilibrium
𝑼𝑿 𝑷𝑿
• Therefore, 𝑴𝑹𝑺 = − =− .
𝑼𝒀 𝑷𝒀
• Alternatively, the utility-maximizing level of consumption bundle can
be solved by the constrained optimization (Lagrange method).
• Our goal is to maximize 𝑼(𝑿, 𝒀) subject to the constraint 𝑴 =
𝑷𝑿 𝑿 + 𝑷𝒀 𝒀. We can combine the objective function with constraint
as follows:
𝓛(𝑿, 𝒀, 𝝀) = 𝑼 𝑿, 𝒀 + 𝝀(𝑴 − 𝑷𝑿 𝑿 − 𝑷𝒀 𝒀)
26
Consumer Equilibrium
• Now, take the derivatives with respect to 𝑿, 𝒀, and 𝝀. That is,
𝓛𝑿 = 𝑼𝑿 − 𝝀𝑷𝑿 = 𝟎 (𝟏)
𝓛𝒀 = 𝑼𝒀 − 𝝀𝑷𝒀 = 𝟎 (𝟐)
𝓛𝝀 = 𝑴 − 𝑷𝑿 𝑿 − 𝑷𝒀 𝒀 = 𝟎 (𝟑)
𝑼𝑿 𝑼𝒀 𝑼𝑿 𝑷𝑿
• From (1) and (2), we receive 𝝀 = = => 𝑴𝑹𝑺 = =
𝑷𝑿 𝑷𝒀 𝑼𝒀 𝑷𝒀
• Whatever you obtain from the last expression, you plug it into
equation (3).
27
Utility maximization problem
• Suppose the utility
𝟏 𝟏
function is a function of two goods (X and Y) given
by 𝑼 𝑿, 𝒀 = 𝑿𝟐 𝒀𝟐 . The respective prices of goods are 𝑷𝑿 = $𝟏 and
𝑷𝒀 = $𝟐. The money income is M=$100. Find the utility-maximizing
levels of consumption bundle, 𝑿∗ and 𝒀∗ .
𝟏 𝟏
𝓛(𝑿, 𝒀, 𝝀) = 𝑿𝟐 𝒀𝟐 + 𝝀(𝟏𝟎𝟎 − 𝑿 − 𝟐𝒀)
𝟏
𝟏 𝒀 𝟐
𝓛𝑿 = −𝝀=𝟎 (𝟏)
𝟐 𝑿
𝓛𝒀 = 𝑼𝒀 − 𝝀𝟐 = 𝟎 (𝟐)
𝓛𝝀 = 𝑴 − 𝑷𝑿 𝑿 − 𝑷𝒀 𝒀 = 𝟎 (𝟑)
28
Utility maximization problem
𝟏
𝟏 𝒀 𝟐
𝓛𝑿 = −𝝀=𝟎 (𝟏)
𝟐 𝑿
𝟏
𝟏 𝑿 𝟐
𝓛𝒀 = − 𝝀𝟐 = 𝟎 (𝟐)
𝟐 𝒀
𝓛𝝀 = 𝟏𝟎𝟎 − 𝑿 − 𝟐𝒀 = 𝟎 (𝟑)
29
Consumer Equilibrium
𝒀 𝟏 𝟏
• From (1) and (2), we receive = or 𝒀 = 𝑿
𝑿 𝟐 𝟐
• Now, plug the last expression into equation (3). That is,
𝟏
𝟏𝟎𝟎 = 𝑿 + 𝟐 𝑿 = 𝟐𝑿
𝟐
𝟏𝟎𝟎
• Hence, the optimal bundle of consumptions is 𝑿∗ = = 𝟓𝟎 and
𝟐
𝟏 𝟏
𝒀∗ = 𝑿∗ = 𝟓𝟎 = 𝟐𝟓. That is, the utility is maximized at 50
𝟐 𝟐
units of X and 25 units of Y.
30
Consumer Equilibrium
Consumer Equilibrium
Good 𝑌
50
Consumer equilibrium
A
25
𝟏 𝟏
𝑼 𝑿, 𝒀 = 𝑿𝟐 𝒀𝟐
0 50 100 Good 𝑋
4-31
© 2017 by McGraw-Hill Education. All Rights Reserved.
Constraints
4-33
© 2017 by McGraw-Hill Education. All Rights Reserved.
Comparative Statics
4-34
© 2017 by McGraw-Hill Education. All Rights Reserved.
Comparative Statics
I II
0 𝑋0 𝑀 𝑋 𝑀
1 Good 𝑋
0 1
𝑃𝑋 𝑃𝑋
4-35
© 2017 by McGraw-Hill Education. All Rights Reserved.
Comparative Statics
Income Changes and Consumer
Behavior
• An increase in income expands a consumer’s budget set.
• A decrease in income reduces a consumer’s budget set.
• The new consumer equilibrium resulting from an
income change depends on consumer preferences:
• Good X is:
• a normal good when an increase (decrease) in income
leads to an increase (decrease) in the consumption of X.
• an inferior good when an increase (decrease) in income
leads to a decrease (increase) in the consumption of X.
4-36
© 2017 by McGraw-Hill Education. All Rights Reserved.
Comparative Statics
Good 𝑌
A
II
0 𝑀0 𝑀1 Good 𝑋
𝑃𝑋 𝑃𝑋
4-37
© 2017 by McGraw-Hill Education. All Rights Reserved.
The Relationship Between Indifference
Curve Analysis and Demand Curves
𝑃𝑋1 𝐴
A 𝐵
𝑃𝑋2
B
I
II
𝑋1 𝑋2
39
The Relationship Between Indifference
Curve Analysis and Demand Curves
$40
DemandA
A B A B A+B
Demandmkt
DemandB
10 20 10 20 30
Good 𝑋 Good 𝑋
0
© 2017 by McGraw-Hill Education. All Rights Reserved. 40