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  • Budget Constraint, Indifference Curves, Utility Function

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    1. The budget constraint equation for a consumer with income M choosing between two goods priced at P1 and P2 is M = P1X1 + P2X2, where X1 and X2 represent the quantities of each good. 2. Consumer preference theory is based on five axioms including completeness, reflexivity, transitivity, monotonicity, and continuity. Indifference curves graphically represent combinations of goods that yield equal utility. 3. The marginal rate of substitution measures the rate at which a consumer is willing to substitute one good for another along an indifference curve to maintain the same utility level. It is calculated using derivatives and captures the consumer's preference ordering between bundles of goods

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    1. The budget constraint equation for a consumer with income M choosing between two goods priced at P1 and P2 is M = P1X1 + P2X2, where X1 and X2 represent the quantities of each good. 2. Consumer preference theory is based on five axioms including completeness, reflexivity, transitivity, monotonicity, and continuity. Indifference curves graphically represent combinations of goods that yield equal utility. 3. The marginal rate of substitution measures the rate at which a consumer is willing to substitute one good for another along an indifference curve to maintain the same utility level. It is calculated using derivatives and captures the consumer's preference ordering between bundles of goods

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    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
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    314 views7 pages

    Budget Constraint, Indifference Curves, Utility Function

    Uploaded by

    hishamsauk
    1. The budget constraint equation for a consumer with income M choosing between two goods priced at P1 and P2 is M = P1X1 + P2X2, where X1 and X2 represent the quantities of each good. 2. Consumer preference theory is based on five axioms including completeness, reflexivity, transitivity, monotonicity, and continuity. Indifference curves graphically represent combinations of goods that yield equal utility. 3. The marginal rate of substitution measures the rate at which a consumer is willing to substitute one good for another along an indifference curve to maintain the same utility level. It is calculated using derivatives and captures the consumer's preference ordering between bundles of goods

    Copyright:

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    of 7

    m m 

    
         
    
    
      
     
    BUDGET CONSTRAINT
     M = P1X1 + P2X2 + ... + PnXn
     In a 2-good case (most frequently encountered):

     M = P1X1 + P2X2
     P2X2 = M ² P1X1

     O m  O 

     (P1/P2) is the trade-off between the two goods in


    the market place.
     Intercepts are (M / P1) for good 1 and (M / P2) for
    good 2.
    AXIOMS
     O m  
     I ² COMPLETENESS (A decision will ALWAYS be
    made).
     II ² RELFEXIVE (Any bundle is at least as good as
    itself)
     III ² TRANSITIVE (If A is weakly preferred to B and
    B to C, then A is weakly preferred to C;  
    !"# $%& '##)
     IV ² MONOTONICITY (Any bundle Y which is
    identical to bundle X, but with at least one more of
    one good is strictly preferred to bundle X; !(#'!&
    &) *  !"#
     V ² CONTINUITY (If A > B, then any situation C
    which is close to A is also >B; $(('+#'#,''&)
      !"# and analysis of small changes
    in incomes/prices)
    UTILITY FUNCTIONS + INDIFFERENCE
    CURVES
     Utility Measures are NON-UNIQUE; they are based
    on ordinal rankings.
     This means that any monotonic (ORDER
    PRESERVING ²i.e., the derivative keeps the same
    sign) transformation is permissible.
     Utility Functions are written in the form:
    
    &(&-
    .-

      !"#$/$0) 
    0#&$&'#'0 '/.
     Along the curve are combinations of goods which the
    consumer is indifferent to. Due to Monotonicity,
    bundles above the curve are on a HIGHER utility
    level, bundles below are on a LOWER one.
    INDIFFERENCE CURVES, MRS
     Here, U·· > U· > U
    Y
     The m  
    
    
    is
    the rate of substitution of
    X and Y in order to keep U
    constant.
     Calculated by taking the
    differential of the
    Indifference curve, see
    next page.
     Because of convexity, MRS U··
    decreases as X increases. U·
     Homothetic Preferences U
    manifest themselves in
    functions where there X
    MRS depends on RATIOS
    of two goods.
    DERIVING THE MRS
     Take the differential of the Indifference Curve:
     [ ð
      
     [   ð
     ð
     
     [ · å    ð [ ·
     ð
    
    ð
    [  [ 
     
    ð
    ð 
    [  [
       ð
    FOUR UTILITY FUNCTIONS
     I ² COBB-DOUGLAS
    „
      ð [ ð
     II ² PERFECT SUBSTIUTES
     ð   „ð
     III ² PERFECT COMPLEMENTS
     ð    „ð 
     IV ² CONSTANT ELASTICITY OF
    SUBSTIUTION (CES) [Most general form, I if
    d 0, II if d=1, III if d=-Î
    ð
      ð [     o ·
     

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