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MicroMinor1402 Lecture03
MicroMinor1402 Lecture03
MicroMinor1402 Lecture03
Saeed Tajrishy
Graduate School of Management and Economics
Sharif University of Technology
Fall 2023
So far…
• Economic Models
• Axioms of rational choices
• Utility function
• Indifference curve
• Convexity
• Marginal rate of substitution
• Examples of utility functions
This Lecture…
• The basic model of choice that economists use to explain individuals’
behavior
• Individuals are assumed to behave as though they maximize utility
subject to a budget constraint
• To maximize utility, individuals will choose bundles of commodities
for which the rate of trade-off between any two goods (the MRS) is
equal to the ratio of the goods’ market prices.
Optimization Principle
Optimization Principle
• To maximize utility, given a fixed amount of income to spend, an
individual will buy the goods and services:
• that exhaust his or her total income
• for which the psychic rate of trade-off between any goods (the MRS) is equal
to the rate at which goods can be traded for one another in the marketplace
A Numerical Illustration
• Assume that the individual’s MRS = 1
• willing to trade one unit of x for one unit of y
• Suppose the price of x = $2 and the price of y = $1
• The individual can be made better off
• trade 1 unit of x for 2 units of y in the marketplace
A Numerical Illustration
• Therefore, the individual’s spending could not have been allocated
optimally in the first place.
• A similar method of reasoning can be used whenever the MRS and
the price ratio px/py differ.
• The condition for maximum utility must be the equality of these two
magnitudes.
Quantity of x
I
px
U1
Quantity of x
U3
Point B is the point of utility
U2 maximization
U1
Quantity of x
Quantity of y px
slope of budget constraint
py
dy
slope of indifferen ce curve
B dx U constant
px dy
U2
- MRS
py dx U constant
Quantity of x
Quantity of y
There is a tangency at point A,
but the individual can reach a higher
level of utility at point B
B
A
U2
U1
Quantity of x
Corner Solutions
Corner Solutions
• In some situations, individuals’ preferences may be such that they can
maximize utility by choosing to consume only one of the goods
Quantity of x
A
Saeed Tajrishy-GSME SUT Slide 19 of 61 Microeconomic For Minor Students-Fall 2023
Lecture 03: Utility Maximization and Choice
utility = U(x1,x2,…,xn)
subject to the budget constraint
I = p1x1 + p2x2 +…+ pnxn
pi
MRS ( xi for x j )
pj
MUxi
pi
Corner Solutions
• When corner solutions are involved, the first-order conditions must be
modified:
L/xi = U/xi - pi 0 (i = 1,…,n)
• If L/xi = U/xi - pi < 0, then xi = 0
• This means that
U / xi MUxi
pi
– any good whose price exceeds its marginal value to the
consumer will not be purchased
Saeed Tajrishy-GSME SUT Slide 26 of 61 Microeconomic For Minor Students-Fall 2023
Lecture 03: Utility Maximization and Choice
• In economics and econometrics, the Cobb–Douglas production function is a particular functional form of
the production function, widely used to represent the technological relationship between the amounts of two or more
inputs (particularly physical capital and labor) and the amount of output that can be produced by those inputs. The
Cobb–Douglas form is developed and tested against statistical evidence by Charles Cobb and Paul Douglas between
1927 and 1947; according to Douglas, the functional form itself was developed earlier by Philip Wicksteed.
• Since + = 1:
1−
pyy = ( )pxx = [ ]p x
x
CES Demand
• Assume that = 0.5
U(x,y) = x0.5 + y0.5
• Setting up the Lagrangian:
L = x0.5 + y0.5 + (I - pxx - pyy)
• First-order conditions:
L/x = 0.5x -0.5 - px = 0
L/y = 0.5y -0.5 - py = 0
L/ = I - pxx - pyy = 0
Saeed Tajrishy-GSME SUT Slide 33 of 61 Microeconomic For Minor Students-Fall 2023
Lecture 03: Utility Maximization and Choice
CES Demand
• This means that
(y/x)0.5 = px/py
• Substituting into the budget constraint, we can solve for the demand
functions
I I
x* y*
px py
px [1 ] py [1 ]
py px
CES Demand
• In these demand functions, the share of income spent on either x or y
is not a constant
• depends on the ratio of the two prices
• The higher is the relative price of x (or y), the smaller will be the share
of income spent on x (or y)
CES Demand
• If = -1,
U(x,y) = -x -1 - y -1
• First-order conditions imply that
y/x = (px/py)0.5
• The demand functions are
I I
x* y*
py 0.5
p
0.5
py 1 x
px 1
px py
Saeed Tajrishy-GSME SUT Slide 36 of 61 Microeconomic For Minor Students-Fall 2023
Lecture 03: Utility Maximization and Choice
CES Demand
• If = -,
U(x,y) = Min(x,4y)
• The person will choose only combinations for which x = 4y
• This means that
I = pxx + pyy = pxx + py(x/4)
I = (px + 0.25py)x
CES Demand
• Hence, the demand functions are
I
x*
px 0.25 py
I
y*
4 px py
Break-Examples
• چگونه مقداری شکالت را بین دو فرزند خود تقسیم کنیم که تقسیم مد نظر عادالنه باشد؟
• :John Stuart Mill and Jeremy Bentham:رفتاری فضیلت اخالقی به شمار می رود که لذت همگانی را بیشینه کند.
• میزان افزایش مطلوبیت باید برابر شود یا میزان مطلق مطلوبیت؟ یا جمع مطلوبیت ها بیشینه شود؟
• اگر ۸۰درصد جامعه ای با یک انتخاب موافق بودند و ۲۰درصد مخالف بودند آیا لزوما باید به آن رأی موافق داده شود و اجرا
شود؟(انتخاب عمومی) -مثال تعدد زوجین و لزوم رضایت یا حق طالق.
• Kaldor-Hicks Efficiency
• ۱۰میلیون تومان قطعی یا ۲۲میلیون با احتمال ۵۰درصد و صفر با احتمال ۵۰درصد؟ مطلوبیت امید ریاضی یا امیدریاضی
مطلوبیت؟( -)Plous,1993ریسک پذیر ،ریسک گریز یا ریسک خنثی -قاعده تناسب ریسک و بازده
Saeed Tajrishy-GSME SUT Slide 39 of 61 Microeconomic For Minor Students-Fall 2023
Lecture 03: Utility Maximization and Choice
Quantity of y
B A
U1
U2
Quantity of x
A
B C
U3 U1
U2
Quantity of x
I I
x* y*
2 px 2 py
I
V ( p x , p y , I ) (x *)
0 .5 0 .5
(y *) 0.5 0.5
2px py
Expenditure Minimization
Expenditure Minimization
• A mathematical statement
• Two Expenditure Functions
• Properties of Expenditure Functions
• Concavity of Expenditure Function
Expenditure Minimization
• Dual minimization problem for utility maximization
• allocating income in such a way as to achieve a given level of utility with the
minimal expenditure
• this means that the goal and the constraint have been reversed
Expenditure Minimization
• Point A is the solution to the dual problem
A mathematical statement
• The individual’s problem is to choose x1,x2,…,xn to minimize
total expenditures = E = p1x1 + p2x2 +…+ pnxn
subject to the constraint
utility = U1 = U(x1,x2,…,xn)
• The optimal amounts of x1,x2,…,xn will depend on the prices of the
goods and the required utility level
A mathematical statement
• The expenditure function shows the minimal expenditures necessary to
achieve a given utility level for a particular set of prices
minimal expenditures = E(p1,p2,…,pn,U)
• The expenditure function and the indirect utility function are inversely
related
• both depend on market prices but involve different constraints
I
V ( p x , py , I )
2px0.5 py0.5
I
V ( px , py , I )
px 0.25 py
SUMMARY
• To reach a constrained maximum, an individual should:
• spend all available income
• choose a commodity bundle such that the MRS between any two goods is
equal to the ratio of the goods’ prices
• the individual will equate the ratios of the marginal utility to price for every good that is
actually consumed
SUMMARY
• Tangency conditions must also be modified to allow for corner
solutions
• the ratio of marginal utility to price will be below the common marginal
benefit-marginal cost ratio for goods actually bought
• The individual’s optimal choices implicitly depend on the parameters
of his budget constraint
• choices observed will be implicit functions of prices and income
• utility will also be an indirect function of prices and income
SUMMARY
• The dual problem to the constrained utility-maximization problem is
to minimize the expenditure required to reach a given utility target
• yields the same optimal solution as the primary problem
• leads to expenditure functions in which spending is a function of the utility
target and prices
Thank You!
http://gsme.sharif.edu/~saeed.tajrishy/
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ln 𝐸 𝑝𝑥 , 𝑝𝑦 , 𝑉 = 𝑎0 + 𝑎1 ln 𝑝𝑥 + 𝑎2 ln 𝑝𝑦
• +0.5𝑏1 ln 𝑝𝑥 2 + 𝑏2 ln 𝑝𝑥 ln 𝑝𝑦
2 𝑐 𝑐
+0.5𝑏3 ln 𝑝𝑦 + 𝑉𝑐0 𝑝𝑥1 𝑝𝑦2
• This form approximates any expenditure function.