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ClassOf1_utility_maximisation_choice

# ClassOf1_utility_maximisation_choice

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Utility maximization choice with current income & prices of two goods - wine & cheese
Utility maximization choice with current income & prices of two goods - wine & cheese

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05/11/2014

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# Sub: Economics

Topic: Micro Economics

Question: Utility maximization choice with current income & prices of two goods - wine & cheese
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Bridget has limited income and consumers only wine and cheese; her current consumption choice is four bottles of wine and 10 pounds of cheese. The price of wine is \$10 per bottle, and the price of cheese is \$4 per pound. The last bottle of wine added 50 units to Bridget’s utility, while the last pound of cheese added 40 units. a. Is Bridget making the utility maximizing choice? Why or why not. b. If not, what should she do instead.

Solution:
Part a We assume well behaved preference ordering for Bridget, i.e. a concave utility function and hence convex to the origin Indifference curves. Let Marginal Utility of wine be MUw Let Marginal Utility of cheese be MUc Applying the Ordinal approach to consumer utility, the MRS = (MUw/MUc) The budget constraint of Bridget is PwQw + PcQc=M
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Sub: Economics

Topic: Micro Economics

Where Pw=price of Wine Pc=price of cheese Qw=quantity of Wine consumed Qc=quantity of cheese consumed Given constant income and prices, we write PwdQw + PcdQc=0 Or PwdQw=-PcdQc Or dQc/ dQw = - (Pw/ Pc) The above is the slope of the budget line. At optimality we must have: MRS=|-(Pw/ Pc)| At the point of Bridget’s consumption MUw=50,MUc=40.

Hence MRS=5/4. The slope of his budget line (Pw/ Pc) =10/4=5/2. Hence MRS is not equal to Price ratio.
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*The Homework solutions from ClassOf1 are intended to help the student understand the approach to solving the problem and not for

Sub: Economics

Topic: Micro Economics

Thus Bridget is not making a utility maximizing choice. Looking at the diagram, YZ is the budget line; B would have been the optimal consumption point. But Bridget is sticking on to point A. Hence she is attaining a lower level of utility.U0 as opposed to U1.