CH 05 Choice

Economic Rationality
The behavioral postulate: a

decisionmaker chooses its most
preferred alternative from those
available to it.
The available choices constitute the
choice set.
How is the most preferred bundle in
the choice set located?
Rational Constrained Choice
x2
x1
Utility x2
x1
Utility
x2
x1
Utility
x2
x1
Utility
x2
x1
Utility
x2
x1
Utility The most preferred

of the affordable
bundles.
Affordable, but not the
most preferred affordable
bundle.
x2
x1
Utility
x2
x1
x2
Utility
x1
x2
Utility
x1
x2
x1
x2
More preferred
bundles
Affordable
bundles
x1
x2
More preferred
bundles
Affordable
bundles
x1
x2
(x1*,x2*) is the most

preferred affordable
bundle.
x2*
x1* x1
The most preferred affordable bundle
is called the consumer’s ordinary
demand (Marshallian demand) at the
given prices and budget.
Ordinary demands will be denoted by:

x1*(p1,p2,m), x2*(p1,p2,m).
When x1* > 0 and x2* > 0, the
demanded bundle is interior.
If buying (x1*,x2*) costs $m then the

budget is exhausted.
x2
(x1*,x2*) is interior
x2*
x1
x1*
x2
(x1*,x2*) exhausts the budget:

p1x1* + p2x2* = m
x2*
x1
x1*
x2
The slope of the IC curve

at (x1*,x2*) equals
the slope of the budget
constraint.
x2*
x1
x1*
(x1*,x2*) satisfies two conditions:
the budget is exhausted:

p1x1* + p2x2* = m
the slope of the budget constraint,

-p1/p2, and the slope of the IC
containing (x1*,x2*) are equal.
Computing Ordinary Demands
How do we compute demand (x1*,x2*)
for given p1, p2 and m?
Interior Demands: C-D Utility
Suppose that the consumer has
Cobb-Douglas preferences:
U( x 1 , x 2 ) = x 1a x b2
U
Then: MU1 = = ax 1a − 1x b2
 x1
U
MU2 = = bx1a xb2 − 1
 x2
So the MRS is
a−1 b
dx 2  U/ x1 ax1 x 2 ax 2
MRS = =− =− =− .
dx1  U/ x 2 bx1a xb2 − 1 bx1
At (x1*,x2*), MRS = -p1/p2 so

ax*2 p1 * bp1 *
− =−  x2 = x1 . (A)
* p2 ap 2
bx1
Ordinary Demands: C-D Utility
(x1*,x2*) also exhausts the budget:
* *
p 1x 1 + p 2 x 2 = m . (B)
So now we know the 2 equations:
* bp1 *
x2 = x1 (A)
ap 2
p 1x*1 + p 2 x*2 = m . (B)
Now substitute
* bp1 *
x2 = x1 (A)
ap 2
into
p 1x*1 + p 2 x*2 = m . (B)
and get
* bp1 *
p1x1 + p 2 x 1 = m.
ap 2
This simplifies to ….
* am
x1 = .
( a + b ) p1
am
x*1 = .
( a + b ) p1
Substituting for x1* in budget eq.

p 1x*1 + p 2 x*2 = m
then gives
* bm
x2 = .
( a + b )p 2
So the most preferred affordable bundle
for a consumer with Cobb-Douglas
preferences
U( x 1 , x 2 ) = x 1a x b2
is
( x*1 , x*2 ) = ( am
,
bm
( a + b ) p1 ( a + b ) p 2
) .
x2
a b
U( x 1 , x 2 ) = x 1 x 2
*
x2 =
bm
( a + b)p2
x1
am
x*1 =
( a + b ) p1
When x1* > 0 and x2* > 0
and (x1*,x2*) exhausts the budget,
and ICs have no kinks,
the ordinary demands can be obtained
by solving 2 eqs:
(a) budget: p1x1* + p2x2* = y
(b) tangency: the slopes of the budget
and of the IC at (x1*,x2*) are equal.
But what if x1* = 0 or x2* = 0, given
consumer preferences?
If either x1* = 0 or x2* = 0, then

ordinary demand (x1*,x2*) is at a
corner solution to the problem of
utility maximization.
Corner: Perfect Substitutes
x2
IC: MRS = -1
x1
x2
y IC: MRS = -1
*
x2 =
p2
Budget slope = -p1/p2

When p1 > p2
x*1 = 0 x1
x2
IC: MRS = -1
Budget slope = -p1/p2

when p1 < p2
x*2 = 0
* y x1
x1 =
p1
So, when U(x1,x2) = x1+x2, the most
preferred affordable bundle (x1*,x2*) is:
y 
( x1 , x 2 ) =
* *
 ,0  if p1 < p2
 p1 
and
 y 
( x1 , x 2 ) =
* *
 0,  if p1 > p2
 p2 
x2
IC: MRS = -1
y
p2 Budget slope = -p1/p2 with p1 = p2
x1
y
p1
x2
y All the bundles in the IC
p2 are equally preferred
when p1 = p2.
x1
y
p1
Corner: Non-Convex Preferences
x2
x1
Corner: Non-Convex Preferences
The “tangency solution” is not the most
x2 preferred affordable bundle.
The most preferred

affordable bundle
x1
Kinky Solutions: Perfect Complements
x2 U(x1,x2) = min{ax1, x2}
Demand: x2 = ax1
x1
U(x1,x2) = min{ax1, x2}
x2
MRS = - 
MRS is undefined
x2 = ax1
MRS = 0
x1
U(x1,x2) = min{ax1, x2}

x2
The most preferred

affordable bundle
x2 = ax1
x1
U(x1,x2) = min{ax1, x2}
x2
(a) p1x1* + p2x2* = m
(b) x2* = ax1*
x2 = ax1
x2*
x1
x1*
From (a) p1x1* + p2x2* = m; (b) x2* = ax1*.

Substituting x2* from (b) in (a),
we have:
p1x1* + p2ax1* = m
After rearrangement, we have:
m
*
x1 =
p1 + ap 2
Then, from (b):

m am
*
x1 = ; x2 =
*
.
p1 + ap 2 p1 + ap 2
m am
*
x1 = ; x2 =
*
.
p1 + ap 2 p1 + ap 2
A bundle of 1 commodity 1 unit and
a commodity 2 units costs p1 + ap2.
Hence, m/(p1 + ap2) such bundles are

affordable.
x2 U(x1,x2) = min{ax1, x2}
x*2 = x2 = ax1
am
p1 + ap2
m
x1
x*1 =
p1 + ap 2

CH 05 Choice

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CH 05 Choice

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Economic Rationality

The behavioral postulate: a

Utility The most preferred

(x1*,x2*) is the most

Ordinary demands will be denoted by:

If buying (x1*,x2*) costs $m then the

(x1*,x2*) exhausts the budget:

The slope of the IC curve

the budget is exhausted:

the slope of the budget constraint,

At (x1*,x2*), MRS = -p1/p2 so

Substituting for x1* in budget eq.

If either x1* = 0 or x2* = 0, then

Budget slope = -p1/p2

Budget slope = -p1/p2

The most preferred

x2 U(x1,x2) = min{ax1, x2}

U(x1,x2) = min{ax1, x2}

The most preferred

From (a) p1x1* + p2x2* = m; (b) x2* = ax1*.

After rearrangement, we have:

Then, from (b):

Hence, m/(p1 + ap2) such bundles are

x2 U(x1,x2) = min{ax1, x2}

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(x1,x2) is the most

If buying (x1,x2) costs $m then the

(x1,x2) exhausts the budget:

At (x1,x2), MRS = -p1/p2 so