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Utility Maximization
Utility is a purely theoretical construct defined as:
- If an individual prefers bundle x-(x1,x2) to another bundle y(y1,y2) then an individual is said to get a higher level of utility
from bundle x than bundle y
- If an individual is indifferent between a bundle x and another
bundle y, then an individual is said to get the same level of
utility from bundle x and y
The only property of a utility assignment that is important is how it
orders the bundles of goods
This is a theory of ordinal utility
A utility function U is just a mathematical function that assigns a
numeric value to each possible bundle such that:
- If an individual strictly prefers bundle x to bundle y, then
U(x1,x2)>U(y1,y2)
- If an individual is indifferent between a bundle x and y,
U(x1,x1)=U(y1,y2)
All bundles in an indifference curve have the same utility level
If U(x1,x2) is a utility function, then any positive monotonic
transformation of it is a utility function that represents the same
preferences
Examples of Utility Fcns
There is no unique utility fcn representation of a preference relation
Perfect substitutes- Linear utility functions:
U(x1,x2)= ax1 + bx2, with a> and b> 0
Perfect complements- Liontief utility functions
U(x1,x2) = min{ax1, bx2} , with a> and b>0
Quasilinear utility functions
U(x1,x2) = k = v(x1) +x2
Eg. U(x1,x2) = root(x1) + x2
or
U(x1,x2)= lnx1 + x2
MU1 = c/x1
MU2= d/x2
MRS= - c x2/ d x1
Marginal Utility
The marginal utility of commodity i is the rate-of-change of total utility
as the quantity of commodity i consumed changes
U
M Ui=
xi
M U i - the partial derivative of the utility fcn with respect to good i
Ex/
Optimal Choice
Economic theory assumes individuals choose their most preferred
bundle, or equivalently the bundle that gives them the most utility,
that is in their budget set
Consider a consumer who has the choice between 2 goods x1 and x2
at the cost p1 and p2 respectively, and an endowment m
Using Econ 201 analysis and logic, the consumer reaches an optimal
bundle when he/she does not have any further incentives to shift
consumption among the goods in the bundle
At the optimal choice (x*1 and x*2) the indifference curve is tangent to
the budget line
The optimal bundle (x*1 and x*2) satisfies 2 conditions:
1. The budget is exhausted p1x1* + p2x2* = m
2. The slope of the budget constraint, -p1/p2, and the slope of the
indifference curve containing (x1* , x2*) are equal at (x1*, x2*)
While graphs are informative we often want to solve things analytically
For two-good analysis, for each good i, we can find analytically function
xi(p1,p2,m) that map prices and endowment into an amount of that
good
Can use the constrained optimization approach from Econ 211
The problem of the consumer is basically to solve:
This implies that they want to find x1* and x2* s.t. U(x1*, x2*) >=
U(x1,x2) for all values of x1 and x2 that satisfy the equation p1x1 +
p2x2 = m
Objective function U(x1,x2)
Constraint p1x1 + p2x2 = m
There are 2 main ways to find the above optimal constrained choice:
1. Write down the optimality conditions and solve the system
2. Substitite the constraint into the objective function to yield an
unconstrained problem
3. Use Lagranges method
EX/ Find the optimal choice for a consumer who has a Codd-Douglas
utility fcn who has $m and p1 and p2
Lec 3
Consumer Demand Functions
In analyzing the consumers behaviour regarding their optimal choice
of a bundle of goods, we can derive the consumers demand function
for each of the goods in the bundle:
X1 = x1(p1,p2,m)
X2 = x2(p1,p2,m)
These derived demand functions tell us all we need to know about the
consumer behaviour
Comparative statics analysis of ordinary demand function:
- The study of how ordinary demands change as prices and
income changes
The Slutsky equation says that the total change to demand from a
price change is the sum of a pure substitution effect and an income
effect
- Substitution effect: the commodity is relatively cheaper , so
consumers substitute it for now relatively more expensive other
commodities
- Income effect: the consumers budget of $m can purchase more
than before, as if the consumers income rose, with consequent
income effects on quantities demanded
When the price of good 1 change and income stays fixed, the budget
line pivots around the vertical axis
Lec 4
Profit Maximization
Short-Run PM
The firms problem is to locate the production plan that attains the
highest possible isoprofit line, given the firms constraint on choices of
production plans
A
FOC:
FOCs:
The choices of inputs that yield the maximum profit for the firm,
x1*(w1,w2,p) and x2*(w1,w2,p), are the profit maximizing factor
demand functions
Cost Minimization
Standard assumption: firms make decisions to maximize profits, or
maximize total revenue minus total costs
Decision process can be broken up into 2 parts:
1. For any given level of output, what combination of inputs should the
firm use?
-Minimizing costs of production a given level of
output
2. Given the optimal combination of inputs, how much should the firm
produce/supply?
For given w1, w2, and y, the firms cost-minimization problem is to
solve
Given w1, w2 and y, how is the least costly input bundle located?
And how is the total cost function computed?
A curve that contains all of the input bundles that cost the same
amount is an isocost curve
The equation of the $C isocost line is
C = w1x1 + w2x2
It can also be rearranged to give
Slope is w1/w2
Of all input bundles yielding y units of output. Which one is the
cheapest?
Tangency condition:
The technical rate of substitution must equal the factor price ratio
The choices of inputs that yield minimal costs for the firm,
x1*(w1,w2,y) and x2*(w1,w2,y), are the conditional factor demand
functions or derived factor demands
Recall that we can use several analytical techniques to solve this kind
of problem
1. Write down the optimality conditions and solve the system
2. Substitute the constraint into the objective function to yield an
unconstrained problem
3. Use Lagranges method
Short-Run & Long-Run Total Costs
In the long-run a firm can vary all of its input levels
The long-run cost-minimization problem is
Consider a firm that cant change its input 2 level from x2-bar units
The short-run cost-minimization problem is
How does the short-run total cost of producing y output units compare
to the long-run total cost of producing y units of output?
- In general the short-run total cost exceeds the long-run total cost
of producing y output units
The short-run cost-min problem is the long-run problem subject to the
extra constraint that x2=x2-bar
- If long-run choice for x2 was x2-bar then the long-run and shortrun total costs of production y output units are the same
- If long-run choice for x2 != x2-bar then the extra constraint
x2=x2-bar prevents the firm in the short-run from achieving its
long-run production cost
Lec 5-6-7
General Equilibrium of Exchange Economy
Exchange
Consider an island with 2 consumers A and B, 2 goods 1 and 2
Their endowments of goods 1 and 2 are wA= (w1A, w2A) and
wB=(w1B, w2B)
All points in the box, including the box boundary, represent feasible
allocation of the combined endowments
Which allocations will be blocked by one or both consumers?
Which allocations make both consumers better off?
Adding preferences to the box
Trade
What is the region of the box where A and B are both made better off?
Presumable, A and B will trade to some point in this region
Pareto Efficient Allocations
An allocation of the endowment that improves the welfare of a
consumer without reduction the welfare of another is a Paretoimproving allocation
Trade improves both As and Bs welfare; this is a Pareto-improvement
over the endowment allocation
Where are the Pareto-improving allocations?
Pareto Optimality
New mutual gains-to-trade region is the set of all further Paretoimproving reallocations
An allocation is Pareto-optimal(or Pareto efficient) when the only was
one consumers welfare can be increased is to decrease the welfare of
the other consumer
The allocation is Pareto-optimal since the only way one consumers
welfare can be increased is to decrease the welfare of the other
consumer
At any Pareto efficient allocation, the indifference curves of the 2
agents must be tangent in the interior of the box
Why is that the case?
Further trade from point M cant improve both A and Bs welfares
An allocation where convex indifference curves are only just back-toback is Pareto-optimal
In a typical case, the contract curve will stretch from As origin (OA) to
Bs origin (Ob
But to which of the many allocations on the contract curve will
consumers trade?
That depends upon how trade is conducted
In perfectly competitive markets? By one-on-one bargaining?
The core is the set of Pareto-optimal allocations that are welfareimproving for both consumers relative to their own endowments
Rational trade should achieve a core allocation
But which core allocation?
- Again , that depends upon the manner in which trade is
conducted
Core allocations
The gross demand of agent A for goods 1 is the total amount of the
good that he wants at the going prices
The net demand of agent A for good 1 is the difference between his
total demand and the initial endowment of good 1 that agent A holds
So given p1 and ps
This is equivalent to
Lets denote the net demand functions or excess demand for good 1 by
consumer A and B as follows
Walras Law
Walras Law states that
This is Walras Law- it says that the summed market value of excess
demands is zero for any positive prices p1 and p2
Implications of Walras Law
One implication of Walras Law for a 2 commodity exchange economy
is that is one market is in equilibrium then the other market must also
be in equilibrium
Proof: