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Optimization principle
Optimization Principle
Given a fixed amount of income to spend, to
any goods (MRS) is equal to the rate at which goods can be traded for one another in the marketplace (relative price)
The individual can do better than point A by reallocating his budget The individual cannot have point C because income is not large enough Point B is the point of utility maximization Quantity of x
Utility is maximized where the indifference curve is tangent to the budget constraint
Quantity of y
px py
dy dx
U constant
U2
MRS
U constant
Quantity of x
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px py
dy dx U constant
dy U / x MRS dx U constant U / y
px dy MRS py dx U constant
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U2 U1
There is a tangency at point A, but the individual can reach a higher level of utility at point B
Quantity of x
MRS is diminishing
Diminishing MRS indifference curves are strictly
convex
If MRS is not diminishing, then we must check
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Maximize subject to
utility = U(x1,x2,,xn)
p1x1 + p2x2 ++ pnxn = M
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/x1 = 0 U/x1 = p1
/x2 = 0 U/x2 = p2
/xn = 0 U/xn = pn / = 0 M - p1x1 - p2x2 -- pnxn = 0
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MUx1 = p1
MUx2 = p2
MUxn = pn / = 0 M - p1x1 - p2x2 -- pnxn = 0
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U / x i pi U / x j p j
MRS xi , x j
pi pj
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U / x1 U / x 2 U / x n ... p1 p2 pn
MU x1 p1
MU x2 p2
...
MU xn pn
utility derived from that good At the margin, the price of a good represents the consumers evaluation of the utility of the last unit consumed
how much the consumer is willing to pay for the last unit
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U / x i MU xi pi
any good whose price exceeds its marginal value to the consumer will not be purchased
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Indirect utility
Solving the FOCs and the budget equality we
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Indirect utility
Substituting the optimal values x*1,x*2, x*n in the
The optimal level of utility will depend indirectly on prices and income
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Indirect utility
Consider
maximum utility =
V*(x1(p1,p2,,pn,M), x2(p1,p2,,pn,M),, xn(p1,p2,,pn,M)) = V*(M)
V* = : - Rate at which changes in M cause changes
Indirect utility
Roys identity
Given the indirect utility function we can derive the demand function
Application of the envelope theorem The envelope theorem concerns how the optimal value for a function changes when a parameter of the function changes The change in the optimal value of a function with respect to a parameter of that function can be found by partially differentiating the objective function while holding the xs at their optimal value
dy * f da a
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Indirect utility
= U(x1,x2) + (M - p1x1 - p2x2)
U * L x1 ( p1 , p2 , M ) dp1 dp1
U * dM
U * U * x1 ( p1 , p2 , M ) dp1 dM
U * V dp1 dp1 x1 ( p1 , p2 , M ) U * V dM dM
Roys Identity
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