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Budget Constraint, Indifference Curves, Utility Function

# Budget Constraint, Indifference Curves, Utility Function

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11/09/2014

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# MICROECONOMICS: BUDGET CONSTRAINT, INDIFFERENCE CURVES, UTILITY FUNCTION

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

M = P1X1 + P2X2 P2X2 = M ² P1X1 X2 = (M / P2) ² X1. (P1/P2)

(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

AXIOMS OF RATIONAL CHOICE: 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; Indifference Curves can·t cross) 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; rules out thick indifference curves) V ² CONTINUITY (If A > B, then any situation C which is close to A is also >B; allows for smooth indifference curves 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: Utility = U(x,y) Indifference Curves are graphic representations of preference ordering. 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 The MARGINAL RATE OF SUBSTITUTION 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 decreases as X increases. Homothetic Preferences manifest themselves in functions where there MRS depends on RATIOS of two goods.

Y

U·· U· U X

DERIVING THE MRS

Take the differential of the Indifference Curve:
U ! ( x, y )

xU xU dU ! dx  dy xx xy xU xU dU ! 0, 3 U , dx  dy ! 0 xx xy xU dy  ! MRS ! xx xU dx xy 
dy MU x ! MRS ! dx U MU y

FOUR UTILITY FUNCTIONS

I ² COBB-DOUGLAS

U ( x, y ) ! x y

E

F

II ² PERFECT SUBSTIUTES

( x, y ) ! Ex  F y
III ² PERFECT COMPLEMENTS

( x, y ) ! min(Ex, Fy )

x y U ( x, y ) !  , H H

IV ² CONSTANT ELASTICITY OF SUBSTIUTION (CES) [Most general form, I if d 0, II if d=1,H III if H d=- ]

?H e 1, H { 0A

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