Course: Introduction to Economics

Text: Varian’s Intermediate

Microeconomics

1
 Economists assume that consumers choose the
best bundle of goods they can afford.

 This section first specifies in detail what

consumer can afford: the budget constraint or
the consumption possibility set.
 What is best for consumer, or the preference on
the possible consumption bundles, will be
discussed in the next section.
2
 A consumption bundle containing x1 units of
commodity 1, x2 units of commodity 2 and so
on up to xn units of commodity n is denoted by
the vector (x1, x2, … , xn).

 Commodity prices are p1, p2, … , pn.

3
 Q: When is a consumption bundle (x1, … , xn)
affordable at prices p1, … , pn?

4
 Q: When is a consumption bundle (x1, … , xn)
affordable at prices p1, … , pn?

 A: When total expenditure is smaller than

income:
p1x1 + … + pnxn  m
where m is the consumer’s (disposable) income.
 That is, one’s total expenditure is smaller than
or equal to one’s income.
5
 The bundles that are only just affordable by
the consumer is one’s budget constraint.
This is the set

{ (x1,…,xn) | x1  0, …, xn  and

p1x1 + … + pnxn = m }.

6
 The consumer’s budget set is the set of all
affordable bundles;
B(p1, … , pn, m) =
{ (x1, … , xn) | x1  0, … , xn 0 and
p1x1 + … + pnxn  m }

 The budget constraint is the upper boundary of

the budget set.

7
 x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.

m /p1 x1

8
 x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.

m /p1 x1

9
 x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.

Just affordable

m /p1 x1

10
 x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.
Not affordable

Just affordable

m /p1 x1

11
 x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.
Not affordable

Just affordable

Affordable

m /p1 x1

12
 x2
Budget constraint (budget line) is
m /p2
p1x1 + p2x2 = m.

the collection
of all affordable bundles.
Budget
Set
m /p1 x1

13
 x2
p1x1 + p2x2 = m is
m /p2
x2 = -(p1/p2)x1 + m/p2
so slope is -p1/p2.

Budget
Set
m /p1 x1

14
 For n = 2 and x1 on the horizontal axis, the
constraint’s slope is -p1/p2. What does it
mean?
p1 m
x2 =  x1 
p2 p2
 Note: For a linear line: y=mx+c, m is the
slope of the line, while c is the y-intercept.

15
 For n = 2 and x1 on the horizontal axis, the
constraint’s slope is -p1/p2. What does it
mean?

p1 m
x2 =  x1 
p2 p2
 To hold income m constant, increasing x1 by
1 must reduce x2 by p1/p2 .

16
x2
Slope is -p1/p2

-p1/p2
+1

x1

17
x2
Opp. cost of an extra unit of
commodity 1 is p1/p2 units
foregone of commodity 2.
-p1/p2
+1

x1

18
x2
The opp. cost of an extra
unit of commodity 2 is
p2/p1 units foregone
of commodity 1.
+1
-p2/p1

x1

19
 The budget constraint and budget set depend
upon prices and income. What happens as
prices or income change?

20
x2

Original
budget set
x1

21
x2 New affordable consumption
choices
Original and
new budget
constraints are
parallel (same
Original slope).
budget set
x1

22
x2

Original
budget set

x1
23
x2
Consumption bundles
that are no longer
affordable.
Old and new
New, smaller constraints
budget set are parallel.
x1

24
 Increases in income m shift the constraint
outward in a parallel manner, thereby
enlarging the budget set and improving
choice.
 Decreases in income m shift the constraint
inward in a parallel manner, thereby
shrinking the budget set and reducing choice.
 The slope –p1 / p2 does not change.

25
 When income increases, NO original choice is
lost and new choices are added, so higher
income cannot make a consumer worse off.

 When income decreases, the consumer may

(typically will) be worse off, as one can no
longer afford some of the bundles anymore.

26
 What happens if just one price decreases?

 Suppose p1 decreases.

27
 x2
m/p2

-p1’/p2

Original
budget set
m/p1’ m/p1” x1

28
 x2
m/p2
New affordable choices

-p1’/p2

Original
budget set
m/p1’ m/p1” x1

29
 x2
m/p2
New affordable choices
Budget constraint
-p1’/p2 pivots; slope flattens
from -p1’/p2 to
Original -p1”/p2
-p ”/p
1 2
budget set
m/p1’ m/p1” x1

30
 Reducing the price of one commodity pivots
the constraint outward. No old choice is lost
and new choices are added, so reducing one
price cannot make the consumer worse off.

 Similarly, increasing one price pivots the

constraint inwards (consider a price change
from p1” to p1’), reduces choice and may
(typically will) make the consumer worse off.

31
 Quantity/per-unit tax: price increases from p to
p+t.
 Quantity/per-unit subsidy: price decreases from
p to p-s.
 Ad valorem/value tax: price increases from p to
(1+t)p
 Ad valorem/value subsidy: price decreases from

p to (1-s)p

32
 A uniform sales tax levied at rate t on all goods
changes the constraint from
p1x1 + p2x2 = m
to
(1+t)p1x1 + (1+t)p2x2 = m
i.e.
p1x1 + p2x2 = m/(1+t).

33
 x2

m
Equivalent income loss
p2
is
m m t
m  m
(1  t ) p2 1 t 1 t

m m x1
(1  t ) p1 p1
34
 x2 A uniform ad valorem
sales tax levied at rate t
m
is equivalent to an income
p2 tax levied at rate t
m .
1 t
(1  t ) p2

m m x1
(1  t ) p1 p1
35
 Lump-sum tax: government tax a fixed sum of
money, T, regardless of individual’s behavior.
 This is equivalent to a decrease in income by T,
implying an inward parallel shift of budget line.

 Similarly, lump-sum subsidy S implies an

outward parallel shift of budget line
corresponding to an amount S.

36
 Q: What makes a budget constraint a straight
line?

 A: A straight line has a constant slope and the

constraint is
p1x1 + … + pnxn = m
so if prices are constants then a constraint is a
straight line.

37
 But what if prices are not constants?

 E.g. bulk buying discounts, or price penalties (or

tax) for buying “too much”.

 Then constraints will be curved or have kinks.

38
 Suppose p2 is constant at $1 but that p1=$2 for
0  x1  20 and p1=$1 for x1>20.

39
 Suppose p2 is constant at $1 but that p1=$2 for
0  x1  20 and p1=$1 for x1>20.
 Then the constraint’s slope is

- 2, for 0  x1  20
{
-p1/p2 =
- 1, for x1 > 20

 Also assume m=100.

40
 x2 m = $100
100 Slope = - 2 / 1 = - 2
(p1=2, p2=1)

Slope = - 1/ 1 = - 1
(p1=1, p2=1)

20 50
80 x1

41
 x2 m = $100
100 Slope = - 2 / 1 = - 2
(p1=2, p2=1)

Slope = - 1/ 1 = - 1
(p1=1, p2=1)

20 50
80 x1

42
 x2 m = $100
100

Budget Constraint

Budget Set
20 50
80 x1

43
x2

Budget
Constraint

Budget Set
x1

44
 The budget set describes what consumption
bundles are affordable to the consumers.
 The budget constraint is typically described by
p1 x1 + p2 x2 = m, which is a straight line when
prices are constant.
 When income increases, budget set shifts
outward, enlarging the budget set.
 When prices increases, the slope of budget line
changes, and the it shrinks the budget set.
45
46
 Last section we talk about what is affordable or
feasible to consumers.
 This time we talk about preferences: what the
consumer like more and what they like less.
 As a rational agent, a consumer chooses the
option in the budget set that is highest in their
preference order (i.e. one likes the most).

47
 Let x, y are consumption bundles.

p denotes strict preference so
x y means that bundle x is preferred strictly
p
to bundle y.
 ~denotes indifference; x ~ y means x and y
are equally preferred.
f denotes weak preference;

~f
x ~ y means x is preferred at least as much as is
y.
48
 Strict preference, weak preference and
indifference are all preference relations.

 Particularly, they are ordinal relations; i.e. they

state only the order in which bundles are
preferred.

 It has no indication of how much they like one

versus the other.
49
 x
f y and y f ~
x imply x ~ y.
~
 x f y and (not y f x) imply x
p
y.
~ ~

50
 Completeness: For any two bundles x and y it
is always possible to make the statement that
either
x f y
or ~
y f x.
~
 Bundles are always comparable.

 If both are true, then they are indifferent to the

individual.

51
 Reflexivity: Any bundle x is always at least as
preferred as itself; i.e.

x f x.
~

52
 Transitivity: If
x is at least as preferred as y, and
y is at least as preferred as z, then
x is at least as preferred as z; i.e.

x f y and y f
~ z x f z.
~
~
 It avoids circular preference, and ensure that
there exists the best bundle.

53
 Take a reference bundle x’. The set of all
bundles equally preferred to x’ is the
indifference curve (set) containing x’; the set of
all bundles {y: y ~ x’}.

 Weakly preferred set: bundles that are weakly

preferred to x’. {y: y f x’}.
~

54
x2 x’ ~ x” ~ x”’
x’
The consumer is
indifferent between
x” every point on the
indifference curve.
x”’

x1
55
 z p x p y If consumer prefers more
x2
x to less for each goods, all
bundles on the northeast
of the indifference curve
z are strictly preferred to x,
and all bundles
southwest of the
indifference curve are
less preferred to x.
y

x1
56
 I1 All bundles in I1 are
x2 strictly preferred to
x
all in I2.
z
I2

All bundles in I2
y are strictly
I3 preferred to all in
I3.
x1
57
x2
WP(x), the set of
x bundles weakly
preferred to x.

I(x) I(x’)

x1
58
x2
WP(x), the set of
x bundles weakly
preferred to x.
WP(x)
includes
I(x) I(x).

x1
59
x2
SP(x), the set of
x bundles strictly
preferred to x,
does not
include
I(x) I(x).

x1
60
 From I1, x ~ y.
x2 I2 From I2, x ~ z.
I1 Therefore y ~ z. But because I1 and I2
represent distinct level of preference,
we see
y z, a contradiction.
p
x
y
z

x1
61
 When more of a commodity is always preferred,
the commodity is a good.

 If every commodity is a good then indifference

curves are negatively sloped.

 It is because when one has more of one good, one

has to get less of another to make this bundle
indifferent to the original one.
62
Good 2
Two goods
a negatively sloped
indifference curve.

Good 1

63
 If less of a commodity is always preferred then
the commodity is a bad.

 e.g. rotten fruits; tobacco smoke (if you do not

smoke)

 If one good is good and the other is bad, then

the indifference curve would be upward sloping.

64
Good 2 One good and one
bad a positively
sloped indifference curve.

Bad 1
If you want more of the good, you also have to
get more of the bad so that you are indifferent
between them. 65
 If one just do not care about whether or how
much to have a commodity, this is called a
neutral good.

 E.g.: goods that you don’t use and do not care

about their existence.

 If one commodity is neutral, the other is good,

the indifference curve would be vertical /
horizontal.
66
67
 If a consumer always regards units of commodities
1 and 2 as equivalent, then the commodities are
perfect substitutes.

 Only the total amount (or a weighted sum) of the

two commodities in bundles determines their
preference rank-order.

 Example: orange juice of two different brands.

Apartment in different locations.
68
x2 Slopes are constant at - 1.
15 I2 Bundles in I2 all have a total
of 15 units and are strictly
preferred to all bundles in
8
I1, which have a total of
I1 only 8 units in them.

8 15 x1
69
 If a consumer always consumes commodities 1
and 2 in fixed proportion (e.g. one-to-one), then
the commodities are perfect complements.
 Only the number of pairs of units of the two

commodities determines the preference rank-

order of bundles.
 E.g.: left shoes/right shoes; computer and
monitor.

70
x2
45o Each of (5,5), (5,9)
and (9,5) contains
5 pairs so each is
equally preferred.
9
5 I
1

5 9 x1
71
x2
45o Since each of (5,5),
(5,9) and (9,5)
contains 5 pairs,
each is less
9 I2 preferred than
the bundle (9,9)
5 I which contains 9
1
pairs.
5 9 x1
72
 A bundle strictly preferred to any others is a
satiation point or a bliss point.

 The satiation point is the best bundle. More of

anything are not better.

 What do indifference curves look like for

preferences exhibiting satiation?
73
x2
Satiation
(bliss)
point

x1
74
x2
Satiation
(bliss)
Better point

x1
75
x2
Satiation
(bliss)
Better point

x1
76
 Typical assumptions of preferences
 A preference relation is “well-behaved” if it is

 monotonic and convex.

 Monotonicity: More of any commodity is always

preferred (i.e. no satiation and every commodity
is a good).
 This implies a negatively sloped IC.

77
 Convexity: Mixtures of bundles are (at least
weakly) preferred to the bundles themselves.
E.g., the 50-50 mixture of the bundles x and y is
z = (0.5)x + (0.5)y.
z is at least as preferred as x or y.

78
 x2 x

x2+y2 x+y Is (weakly) preferred to

z=
2 both x and y.
2
y
y2
x1 x1+y1 y1
2 79
x2 x
z =(tx1+(1-t)y1, tx2+(1-t)y2)
is preferred to x and y
for all 0 < t < 1.
y
y2
x1 y1
80
 Preferences are strictly convex
when all mixtures z
x2 x
are strictly
z preferred to their
component
bundles x and y.
y
y2
x1 y1
81
 The mixture z
x2 is less preferred
than x or y.
One likes both, but
z
does want to
consume together.
y2
x1 y1
82
x2
The mixture z
z is less preferred
than x or y.
y2
x1 y1
83
 It represents a more balanced preference rather
than a preference that induces a specialization.

 It is natural to consume the goods involved in

positive amount.

 It also implies a diminishing marginal rate of

substitution.

84
 The negative of the slope of an indifference curve
is its marginal rate of substitution (MRS).

 Note: this is slightly different from the textbook, but my definition is

more popular.

 This represents the maximum amount of x2 one is

willing to give up per unit of x1 at a specific
consumption bundle.

85
x2
MRS at x’ is the
(negative) slope of the
indifference curve at x’
x’

x1
86
x2
MRS at x’ is
lim -{Dx2/Dx1}
Dx1 0
Dx2 x’ = -dx2/dx1 at x’

Dx1

x1
87
 -dx2 = MRS ´ dx1 so, at x’,
x2 MRS is the rate at
which the consumer is
only just willing to
exchange commodity 2
dx2 x’ for a small amount of
dx1 commodity 1.

x1
88
Good 2
Two goods
a negatively sloped
indifference curve
MRS > 0.

Good 1

89
Good 2
One good and one
bad a positively
sloped indifference curve

MRS < 0.

Bad 1
Because instead of giving up, you have to
obtain more good 2 for you to be willing to
90
accept more good 1.
Good 2
MRS = 5 MRS always decreases with x1
if and only if preferences are
strictly
convex..
convex

MRS = 0.5 Good 1

We call it a diminishing marginal
rate of substitution. 91
x2 MRS increases
MRS = 0.5
as x1 increases
non--convex preferences
non

MRS = 5
x1
92
 MRS is not always decreasing as x1
x2 increases non-convex preferences.
non-

MRS=1.5

MRS
= 0.5
MRS = 2

x1
93
 In this section, we talk about how we can specify
consumer’s preference towards different
consumption bundles.

 We can use indifferent curve to depict different

kinds of preferences.

 The marginal rate of substitution is the slope of

indifference curve. It represents the willingness to
substitute one good for another one.

94
 We have talked about preference and indifference
curve in this chapter.

 To put preference in a more mathematically

convenient way, we introduce the utility function
in the coming section.

 Then we can put together preference/utility and

budget constraint to analyze consumer choices.

95
96
 Last section we talk about preference,
describing the ordering of what a consumer
likes.

 For a more convenient mathematical treatment,

we turn this ordering into a mathematical
function.

97
 Satisfaction or pleasure consumers derive from
the consumption of consumer goods is called
“utility”
 The concept of utility is characterized with the
following properties:
 ‘Utility’ and ‘Usefulness” are not synonymous.
 Utility is subjective

 The utility of a product can be different at different

places and time.

98
 A Consumer considers the following points to get
maximum utility:
 How much satisfaction he gets from buying and then consuming an
extra unit of a good or service.
 The price he pays to get the good.
 The satisfaction he gets from consuming alternative products.
 The prices of alternative goods and services.
 Approaches to measure Utility
 Cardinalist approach
 Ordinalist approach.

99
 Utility could be measured by the amount of money the
consumer is willing to pay for another unit of commodity
and its measuring unit is called ‘utils’.
Assumptions of Cardinal Utility theory:
 Rationality of Consumers
 Utility is Cardinally Measurable
 Constant Marginal Utility of Money
 Diminishing Marginal Utility (DMU)
 Utility is additive

100
 Total Utility (TU) - total amount of satisfaction
a consumer gets from consuming or possessing
some specific quantities of a commodity at a
particular time.
 Marginal Utility (MU) - additional utility
obtained from consuming an additional unit of
a commodity.
 Mathematically

101
102
 As the quantity consumed of a commodity increases
per unit of time, the utility derived from each
successive unit decreases, consumption of all other
commodities remaining constant.
Equilibrium of a consumer
 For a Single commodity case

A consumer that maximizes utility reaches his/her

equilibrium position when allocation of his/her
expenditure is such that the last birr spent on each
commodity yields the same utility.
103
 If MUx > Px, consumer purchases more of X so as to
increase his/her welfare and if MUx < Px, the consumer
have to reduce or cutting down the quantity X and
keeping more of his income unspent to reach at
equilibrium.
 For n commodities case

Where: MUm –marginal utility of money

 Consider that Marta has Birr 10 and she consumes two
goods, X and Y. Px = 1Birr and Py= 2 Birr. Based TU
given below identify the optimal combinations.

105
 Candidates: (1x,2y), (2x,4y).(4x,5y)
 But(2x,4y) is the correct answer, why?

106
 A consumer gets the maximum total utility
when she buys 2 units of X and 4 units of Y.
Why?
 Because the last Birr spent on each good gives
her equal marginal utility when she buys these
levels of the two goods, and at that point, her
income is exhausted.
 Numerical example,
MUx/Px = MUy/Py  8/1=16/2=8
Px.Qx+ Py.Qy= M(1*2)+(2*4)=10 2+8= 10 10=10

107
108
109
 or

110
i. Satisfaction cannot be measured objectively
ii. The assumption of constant marginal utility of
money is unrealistic. because MU of money is
subject to change
iii. The LDMU has been established from
introspection. The law accepted as axiom without
empirical verification.
iv. This theory ignores substitution and income effects.
v. It considers that effect of price changes on demand
curve is exclusively price effect. Exclude income and
substitution effects
111
 The Ordinal Utility theory
In the ordinal utility approach, utility cannot be
measured absolutely but different consumption
bundles are ranked according to preferences

The concept is based on the fact that it may not be

possible for consumers to express the utility of
various commodities they consume in absolute
terms, like, 1 util, 2 util, or 3 util, but it is always
possible for the consumers to express the utility in
relative terms
It is practically possible for the consumers to rank
commodities in the order of their preference as and
so on.
112
Assumptions of Ordinal Utility theory
 The Consumers are rational they aim at maximizing
their satisfaction or utility given their income and
market prices.

 Utility is ordinal , i.e. utility is not absolutely

(cardinally) measurable. Consumers are required only
to order or rank their preference for various bundles
of commodities.

 Diminishing Marginal Rate of Substitution (MRS)

 The total utility of the consumer depends on the
quantities of the commodities consumed
i.e., U=f (X1, X2, X3 ,… xn)

 Preferences are transitive and consistent

 The ordinal utility approach is expressed with the

help of ICs.

114
 A utility function U: R+nR maps each
consumption bundle of n goods into a real
number that satisfies the following conditions:
p
 x’ x” U(x’) > U(x”)

x’p x” U(x’) < U(x”)

x’ ~ x” U(x’) = U(x”).
115
 Indifference Set - A combination of goods for
which the consumer is indifferent.
Combinations Quantity of Good X Quantity of Good Y

A 10 2
B 6 4
C 3 6
D 2 8

116
 When the indifference set is expressed
graphically, it called an indifference curve.
 An indifference curve contains equally preferred
bundles.

117
 Indifference map: it is a set of indifference
curves. Each successive curve to the right
represents better bundles.

118
Properties of Indifference Curves:
 Indifference curves have negative slope
 Indifference curves do not intersect each other

 A higher Indifference curve is always preferred

to a lower one
 Indifference curves are convex to the origin

119
 An indifference curve contains equally
preferred bundles.

 Equal preference  same utility level.

 Therefore, all bundles in an indifference

curve have the same utility level.

120
x2

U6
U4
U2
x1
121
 Consider

V(x1,x2) = x1 + x2.

 What does the indifference curve look like?

 What relation does this function represent for
these goods?

122
x2

x1 + x2 = 5
13
x1 + x2 = 9
9
x1 + x2 = 13
5
V(x1,x2) = x1 + x2.

5 9 13 x1

These goods are perfect substitutes.

123
 Consider

W(x1,x2) = min{x1,x2}.
 What does the indifference curve look like?

 What relation does this function represent for

these goods?

124
x2
45o

W(x1,x2) = min{x1,x2}

8 min{x1,x2} = 8

5 min{x1,x2} = 5

3
min{x1,x2} = 3

3 5 8 x1

125
 In general, utility function for perfect
substitutes can be expressed as
u(x , y) = ax + by

 Utility function for perfect complement can be

expressed as:
u(x , y) = min{ ax , by }

for constants a and b.

126
 Any utility function of the form

U(x1,x2) = x1a x2b

with a > 0 and b > 0 is called a Cobb-Douglas

utility function.
 E.g. U(x1,x2) = x11/2 x21/2 (a = b = 1/2)
V(x1,x2) = x1 x23 (a = 1, b = 3)

127
x2
All curves are hyperbolic,
asymptoting to, but never
touching any axis.

x1

128
 Marginal means “incremental”.
 The marginal utility of commodity i is the rate-

of-change of total utility as the quantity of

commodity i consumed changes; i.e.

U
MU i 
 xi

129
 E.g. if U(x1,x2) = x11/2 x22 then

 U 1 1/ 2 2
MU 1 = = x1 x2
 x1 2

 U 1/ 2
MU 2 = = 2 x1 x2
 x2
130
 Marginal utility is positive if it is a good,
negative if it is a bad, zero if it is neutral.
 Its value changes under a monotonic
transformation: (Consider the differentiable
case)
 f (U ) U
MU i = = f ' (U )
 xi xi

 So its value is not particularly meaningful.

131
 The general equation for an indifference curve
is
U(x1,x2)  k, a constant.

 Totally differentiating this identity gives

U U
dx1  dx2  0
 x1  x2

132
 U U
dx1  dx2  0
 x1  x2
We can rearrange this to
U U
dx2   dx1
 x2  x1
Rearrange further:

d x2  U /  x1
 .
d x1  U /  x2
133
 d x2  U /  x1
 .
d x1  U /  x2
 Recall that the definition of MRS:

The negative of the slope of an indifference

curve is its marginal rate of substitution.

d x2
MRS = 
d x1 U
134
 Therefore,
 U /  x1 MU 1
MRS = =
U /  x2 MU 2

 The Marginal Rate of Substitution is the ratio

of marginal utilities.

135
 MRS also means how many quantities of good
2 you are willing to sacrifice for one more unit
of good 1.
 One unit of good 1 is worth MU1.

 One unit of good 2 is worth MU2.

 Number of good 2 you are willing to sacrifice

for a unit of good 1 is thus
MU1 / MU2.

136
 Suppose U(x1,x2) = x1x2. Then
U
 (1)( x2 )  x2
 x1
U
 ( x1 )(1)  x1
 x2
so
d x2  U /  x1 x2
MRS =  = = .
d x1  U /  x2 x1
137
 U(x1,x2) = x1x2;
x2 x2
MRS =
x1
8
MRS(1,8) = - 8/1 = -8
MRS(6,6) = - 6/6 = -1.
6

U = 36

U=8

1 6 x1
138
Example
 Suppose a consumer’s utility function is given by:

 Compute the

139
Course: Microeconomics
Text: Varian’s Intermediate
Microeconomics

140
 The principal behavioral postulate is that a
decision-maker chooses its most preferred
alternative from those available to it.
 The available choices constitute the budget set.

 How is the most preferred bundle in the budget

set located?

141
x2

x1 142
Utility

Affordable, but not

the most preferred
affordable bundle.

x2
x1 143
Utility The most preferred
of the affordable
bundles.
Affordable, but not
the most preferred
affordable bundle.

x2
x1 144
x2 One will choose the
bundle on the outermost
indifference curve.
Therefore, it is the one
that just touch the
budget constraint.

Affordable
bundles

x1 145
x2
(x1*,x2*) is the most
preferred affordable
bundle.

x2*

x1* x1

146
 The most preferred affordable bundle is called
the consumer’s ORDINARY DEMAND at the
given prices and budget.

 Ordinary demands will be denoted by

x1*(p1,p2,m) and x2*(p1,p2,m).

147
 When x1* > 0 and x2* > 0 the demanded
bundle is INTERIOR.

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

exhausted.

148
 Assuming monotonicity and smooth indifference
curve, for an interior solution (x1*,x2*), it satisfies
two conditions:

 (a) the budget is exhausted;

p1 x 1 * + p2 x 2 * = m

 (b) the slope of the budget constraint,

-p1/p2, and the slope of the indifference curve
containing (x1*,x2*) are equal at (x1*,x2*).

149
 Condition (b) can be written as:

dx2 MU 1 p1
 = MRS = =
dx1 MU 2 p2
 So, at the optimal choice, the marginal willingness
to pay for an extra unit of good 1 in terms of good
2 is the same as the price you actually need to pay.
 If the price is lower than your willingness to pay,
you would buy more, otherwise buy less. Adjust
until they are equal.

150
 Suppose that the consumer has Cobb-Douglas
preferences.

U( x1 , x 2 )  x1axb2
 Then MU1 
U
 ax1a  1xb2
 x1
U
MU2   bx1axb2  1
 x2
151
 So the MRS is
a 1 b
 U / x1 ax x ax2 1 2
MRS = = = . a b 1
 U / x2 bx x bx1 1 2

 At (x1*,x2*), MRS = p1/p2 so

*
ax2 p1 * bp1 *
*
=  x2 = x1 .
bx1 p2 ap2
152
 So now we know that
* bp1 * (A)
x2  x1
ap 2
p1x*1  p 2x*2  m. (B)

153
 So now we know that
* bp1 * (A)
x2  x1
Substitute ap 2
p1x*1  p 2x*2  m. (B)

and get
* bp1 *
p1x1  p 2 x1  m.
ap 2
This simplifies to ….

154
 am
x*1  .
( a  b )p1

155
 am
x*1  .
( a  b )p1
Substituting for x1* in

p1x*1  p 2x*2  m
then gives

* bm
x2  .
( a  b )p 2

156
So we have discovered that the most
preferred affordable bundle for a consumer
with Cobb-Douglas preferences

U( x1 , x 2 )  x1axb2

is
( x*1 , x*2 )  ( am
,
bm
)
( a  b )p1 ( a  b )p 2
.

157
 x2
a b
U( x1 , x 2 )  x1 x 2

*
x2 
bm
( a  b)p2

x1
* am
x1 
( a  b)p1 158
 With the optimal bundle:
* *
( x1 , x 2 )  ( am
,
bm
)
( a  b )p1 ( a  b )p 2
.

 Note the expenditures on each good:

* *  a b 
( p1 x1 , p2 x2 ) =  m, m .
 ( a  b) ( a  b) 
 It is a property of Cobb-Douglas Utility
function that expenditure share on a particular
good is a constant.
159
 In this chapter we put together budget
constraint and preference together to analyze
consumption decision.
 Typically, if we have interior solution, then the

optimal condition is
MRS=p1 / p2.
 It can also have corner solution if one good is
not consumed at all.

160
 Mr X faces a Cobb–Douglas utility function on two
0.4 0.6
goods (x and y ) given by: U ( x, y) = 20x y
Suppose that x and y are purchased in the market at a
constant unit price of birr 200 and birr 400 respectively
and the consumer has a money income of birr 6,000,
which he spend on the two goods.
a. Formulate the consumer maximization problem

b. Compute and interpret MRSx,y at x = 2 and y = 8

c. Use lagrangian method to find the values of x and y

that maximize utility