Choice. Q: What is the Optimal Choice? Budget constraint Indifference curves More preferred bundles.

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UTILITY MAXIMIZATION AND CHOICE
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Presentation transcript:

Choice

Q: What is the Optimal Choice? Budget constraint Indifference curves More preferred bundles

A: Optimal Choice is X Optimal choice: indifference curve tangent to budget line. Does this tangency condition necessarily have to hold at an optimal choice?

Perfect Substitutes

Perfect Complements

Q: Is Tangency Sufficient?

What is the General Rule? If: Preferences are well-behaved. Indifference curves are “smooth” (no kinks). Optima are interior. Then: Tangency between budget constraint and indifference curve is necessary and sufficient for an optimum.

Multiple Optima A way to avoid multiplicity of optima, is to assume strictly convex preferences. This assumption rules out “flat spots” in indifference curves.

Economic Interpretation At optimum: “Tangency between budget line and indifference curve.” Slope of budget line: Slope of indifference curve: Tangency:

Interpretation At Z: At Y:

Tangency with Many Consumers Consider many consumers with different preferences and incomes, facing the same prices for goods 1 and 2. Q: Why is it the case that at their optimal choice the MRS between 1 and 2 for different consumers is equalized?

Tangency with Many Consumers A: Because if a consumer makes an optimal choice, then: Implication: everyone who is consuming the two goods must agree on how much one is worth in terms of the other.

Tangency with 2 Consumers Indifference curves of consumer 1: Indifference curves of consumer 2: Budget line:

Finding the Optimum in Practice: a Cobb-Douglas Example Preferences represented by: Budget line:

Finding the Optimum in Practice: a Cobb-Douglas Example Mathematically, we would like to: such that

Finding the Optimum in Practice: a Cobb-Douglas Example Replace budget constraint into objective function: New problem:

Finding the Optimum in Practice: a Cobb-Douglas Example New problem: First-Order Condition:

Finding the Optimum in Practice: a Cobb-Douglas Example First-Order Condition: Rearranging:

Finding the Optimum in Practice: a Cobb-Douglas Example First-Order Condition: Solve for : Expenditures share in 1:

Finding the Optimum in Practice: a Cobb-Douglas Example Q: How do I find ? A: Use the budget constraint:

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