Deriving MRS From Utility Function, Budget Constraints, and Interior Solution of Optimization

1 Utility Function, Deriving MRS
14.01 Principles of Microeconomics, Fall 2007
Chia-Hui Chen
September 14, 2007
Lecture 5
Deriving MRS from Utility Function, Budget
Constraints, and Interior Solution of
Optimization
Outline
1. Chap 3: Utility Function, Deriving MRS
2. Chap 3: Budget Constraint
3. Chap 3: Optimization: Interior Solution
Utility Function, Deriving MRS
Examples of utility:
Example (Perfect substitutes).
U (x, y) = ax + by.
Example (Perfect complements).

U (x, y) = min{ax, by}.
Example (Cobb-Douglas Function).

U (x, y) = Axb y c .
Example (One good is bad).

U (x, y) = ax + by.
An important thing is to derive MRS.
M RS =
dy
= |Slope of Indierence Curve|.
dx
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
10
9
8
7
U(x,y)=ax+by=Const
6
5
4
3
2
1
0
10
Figure 1: Utility Function of Perfect Substitutes
10
9
8
7
6
5
U(x,y)=min{ax,by}=Const
4
3
2
1
0
10
Figure 2: Utility Function of Perfect Complements
YYYY].
10
6
a b
U(x,y)=Ax y =Const
4
10
Figure 3: Cobb-Douglas Utility Function
10
U(x,y)=ax+by=Const
10
Figure 4: Utility Function of the Situation That One Good Is Bad
YYYY].
2 Budget Constraint
Because utility is constant along the indierence curve,

u = (x, y(x)) = C, =
u u dy
+
= 0, =
x y dx
dy
=
dx
u
x
u
y
M RS =
u
x
u
y
Thus,
Example (Sample utility function).

u(x, y) = xy 2 .
Two ways to derive MRS:
Along the indierence curve
xy 2 = C.
r
c
y=
.
x
Thus,
dy
c
y
M RSd =
= 3/2 =
.
dx
2x
2x
Using the conclusion above
M RS =
u
x
u
y
y2
y
=
.
2xy
2x
Budget Constraint
The problem is about how much goods a person can buy with limited income.
Assume: no saving, with income I, only spend money on goods x and y with
the price Px and Py .
Thus the budget constraint is
Px x + Py y I.
Suppose Px = 2, Py = 1, I = 8, then
2x + y 8.
The slope of budget line is
dy
Px
=
.
dx
Py
Bundles below the line are aordable.
Budget line can shift:
YYYY].
2 Budget Constraint
10
2x+y8
10
Figure 5: Budget Constraint
10
8
7
2x+y8
6
5
4
2x+y6
3
2
1
0
10
Figure 6: Budget Line Shifts Because of Change in Income
YYYY].
3 Optimization: Interior Solution
10
9
8
7
2x+y8
6
5
4
x+y4
3
2
1
0
10
Figure 7: Budget Line Rotates Because of Change in Price

Change in Income Assume I = 6, then 2x + y = 6. The budget line shifts
right which means more income makes the aordable region larger.
Change in Price Assume Px = 2, then 2x + 2y = 8. The budget line
changes which means lower price makes the aordable region larger.
Optimization: Interior Solution
Now the consumers problem is: how to be as happy as possible with limited
income. We can simplify the problem into language of mathematics:
xPx + yPy I
x0
max U (x, y) subject to
.
x,y
y0
Since the preference has non-satiation property, only (x, y) on the budget line
can be the solution. Therefore, we can simplify the inequality to an equality:
xPx + yPy = I.
First, consider the case where the solution is interior, that is, x > 0 and y > 0.
Example solutions:
Method 1
YYYY].
10
9
8
7
6
5
U(x,y)=Const
4
3
2
P x+P y=I
x
1
0
10
Figure 8: Interior Solution to Consumers Problem

From Figure 8, the utility function reaches its maximum when the indif
ferent curve and constraint line are tangent, namely:
Px
u/x
ux
= M RS =
=
.
Py
u/y
uy
If
Px
ux
>
,
Py
uy
then one should consume more y, less x.

If
Px
ux
<
,
Py
uy
then one should consume more x, less y. Intuition behind
Px
Py
= M RS:
Px
Py
is the market price of x in terms of y, and MRS is the price of x in

terms of y valued by the individual. If Px /Py > M RS, x is relatively
expensive for the individual, and hence he should consume more y.
On the other hand, if Px /Py < M RS, x is relatively cheap for the
individual, and hence he should consume more x.
Method 2: Use Lagrange Multipliers
L(x, y, ) = u(x, y) (xPx + yPy I).
YYYY].
In order to maximize u, the following rst order conditions must be satis

ed:
L
= 0 =
x
L
= 0 =
y
ux
= ,
Px
uy
= ,
Py
L
= 0 = xPx + yPy I = 0.
Thus we have
Px
ux
=
.
Py
uy
Method 3
Since xPx + yPy + I = 0,
y=
I xPx
.
Py
Then the problem can be written as

max u(x, y) = u(x,
x,y
I xPx
).
Py
At the maximum, the following rst order condition must be satised:

ux + uy (
y
Px
) = ux + uy ( ) = 0.
x
Py
=
Px
ux
=
.
Py
uy
YYYY].

Deriving MRS From Utility Function, Budget Constraints, and Interior Solution of Optimization

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1 Utility Function, Deriving MRS

14.01 Principles of Microeconomics, Fall 2007

September 14, 2007

Deriving MRS from Utility Function, Budget

Constraints, and Interior Solution of

Utility Function, Deriving MRS

Example (Perfect complements).

Example (Cobb-Douglas Function).

Example (One good is bad).

1 Utility Function, Deriving MRS

Figure 1: Utility Function of Perfect Substitutes

Figure 2: Utility Function of Perfect Complements

1 Utility Function, Deriving MRS

Figure 3: Cobb-Douglas Utility Function

Figure 4: Utility Function of the Situation That One Good Is Bad

Because utility is constant along the indierence curve,

Example (Sample utility function).

Figure 5: Budget Constraint

Figure 6: Budget Line Shifts Because of Change in Income

3 Optimization: Interior Solution

Figure 7: Budget Line Rotates Because of Change in Price

Optimization: Interior Solution

3 Optimization: Interior Solution

Figure 8: Interior Solution to Consumers Problem

then one should consume more y, less x.

then one should consume more x, less y. Intuition behind

is the market price of x in terms of y, and MRS is the price of x in

3 Optimization: Interior Solution

In order to maximize u, the following rst order conditions must be satis

Then the problem can be written as

At the maximum, the following rst order condition must be satised:

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