choice
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5. Choice. Economic Rationality. The principal behavioral postulate is that 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?. - PowerPoint PPT PresentationTRANSCRIPT
© 2010 W. W. Norton & Company, Inc. 2
Economic Rationality
The principal behavioral postulate is that 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?
© 2010 W. W. Norton & Company, Inc. 11
Rational Constrained Choice
Utility
x1
x2
Affordable, but not the most preferred affordable bundle.
© 2010 W. W. Norton & Company, Inc. 12
Rational Constrained Choice
x1
x2
Utility
Affordable, but not the most preferred affordable bundle.
The most preferredof the affordablebundles.
© 2010 W. W. Norton & Company, Inc. 20
Rational Constrained Choice
x1
x2
Affordablebundles
More preferredbundles
© 2010 W. W. Norton & Company, Inc. 21
Rational Constrained Choice
Affordablebundles
x1
x2
More preferredbundles
© 2010 W. W. Norton & Company, Inc. 23
Rational Constrained Choice
x1
x2
x1*
x2*
(x1*,x2*) is the mostpreferred affordablebundle.
© 2010 W. W. Norton & Company, Inc. 24
Rational Constrained Choice
The most preferred affordable bundle is called the consumer’s ORDINARY DEMAND at the given prices and budget.
Ordinary demands will be denoted byx1*(p1,p2,m) and x2*(p1,p2,m).
© 2010 W. W. Norton & Company, Inc. 25
Rational Constrained Choice
When x1* > 0 and x2* > 0 the demanded bundle is INTERIOR.
If buying (x1*,x2*) costs $m then the budget is exhausted.
© 2010 W. W. Norton & Company, Inc. 26
Rational Constrained Choice
x1
x2
x1*
x2*
(x1*,x2*) is interior.
(x1*,x2*) exhausts thebudget.
© 2010 W. W. Norton & Company, Inc. 27
Rational Constrained Choice
x1
x2
x1*
x2*
(x1*,x2*) is interior.(a) (x1*,x2*) exhausts thebudget; p1x1* + p2x2* = m.
© 2010 W. W. Norton & Company, Inc. 28
Rational Constrained Choice
x1
x2
x1*
x2*
(x1*,x2*) is interior .(b) The slope of the indiff.curve at (x1*,x2*) equals the slope of the budget constraint.
© 2010 W. W. Norton & Company, Inc. 29
Rational Constrained Choice (x1*,x2*) satisfies two conditions: (a) the budget is exhausted;
p1x1* + p2x2* = 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*).
© 2010 W. W. Norton & Company, Inc. 30
Computing Ordinary Demands
How can this information be used to locate (x1*,x2*) for given p1, p2 and m?
© 2010 W. W. Norton & Company, Inc. 31
Computing Ordinary Demands - a Cobb-Douglas Example.
Suppose that the consumer has Cobb-Douglas preferences.
U x x x xa b( , )1 2 1 2
© 2010 W. W. Norton & Company, Inc. 32
Computing Ordinary Demands - a Cobb-Douglas Example.
Suppose that the consumer has Cobb-Douglas preferences.
Then
U x x x xa b( , )1 2 1 2
MUUx
ax xa b1
1112
MUUx
bx xa b2
21 2
1
© 2010 W. W. Norton & Company, Inc. 33
Computing Ordinary Demands - a Cobb-Douglas Example.
So the MRS is
MRSdxdx
U xU x
ax x
bx x
axbx
a b
a b
2
1
1
2
112
1 21
2
1
//
.
© 2010 W. W. Norton & Company, Inc. 34
Computing Ordinary Demands - a Cobb-Douglas Example.
So the MRS is
At (x1*,x2*), MRS = -p1/p2 so
MRSdxdx
U xU x
ax x
bx x
axbx
a b
a b
2
1
1
2
112
1 21
2
1
//
.
© 2010 W. W. Norton & Company, Inc. 35
Computing Ordinary Demands - a Cobb-Douglas Example.
So the MRS is
At (x1*,x2*), MRS = -p1/p2 so
MRSdxdx
U xU x
ax x
bx x
axbx
a b
a b
2
1
1
2
112
1 21
2
1
//
.
ax
bx
pp
xbpap
x2
1
1
22
1
21
*
** *. (A)
© 2010 W. W. Norton & Company, Inc. 36
Computing Ordinary Demands - a Cobb-Douglas Example.
(x1*,x2*) also exhausts the budget so
p x p x m1 1 2 2* * . (B)
© 2010 W. W. Norton & Company, Inc. 37
Computing Ordinary Demands - a Cobb-Douglas Example.
So now we know that
xbpap
x21
21
* * (A)
p x p x m1 1 2 2* * . (B)
© 2010 W. W. Norton & Company, Inc. 38
Computing Ordinary Demands - a Cobb-Douglas Example.
So now we know that
xbpap
x21
21
* * (A)
p x p x m1 1 2 2* * . (B)
Substitute
© 2010 W. W. Norton & Company, Inc. 39
Computing Ordinary Demands - a Cobb-Douglas Example.
So now we know that
xbpap
x21
21
* * (A)
p x p x m1 1 2 2* * . (B)
p x pbpap
x m1 1 21
21
* * .
Substitute
and get
This simplifies to ….
© 2010 W. W. Norton & Company, Inc. 40
Computing Ordinary Demands - a Cobb-Douglas Example.
xam
a b p11
*
( ).
© 2010 W. W. Norton & Company, Inc. 41
Computing Ordinary Demands - a Cobb-Douglas Example.
xbm
a b p22
*
( ).
Substituting for x1* in p x p x m1 1 2 2
* *
then gives
xam
a b p11
*
( ).
© 2010 W. W. Norton & Company, Inc. 42
Computing Ordinary Demands - a Cobb-Douglas Example.
So we have discovered that the mostpreferred affordable bundle for a consumerwith Cobb-Douglas preferences
U x x x xa b( , )1 2 1 2
is( , )
( ),( )
.* * ( )x xam
a b pbm
a b p1 21 2
© 2010 W. W. Norton & Company, Inc. 43
Computing Ordinary Demands - a Cobb-Douglas Example.
x1
x2
xam
a b p11
*
( )
x
bma b p
2
2
*
( )
U x x x xa b( , )1 2 1 2
© 2010 W. W. Norton & Company, Inc. 44
Rational Constrained Choice When x1* > 0 and x2* > 0
and (x1*,x2*) exhausts the budget,and indifference curves have no ‘kinks’, the ordinary demands are obtained by solving:
(a) p1x1* + p2x2* = y
(b) the slopes of the budget constraint, -p1/p2, and of the indifference curve containing (x1*,x2*) are equal at (x1*,x2*).
© 2010 W. W. Norton & Company, Inc. 45
Rational Constrained Choice
But what if x1* = 0?
Or if x2* = 0?
If either x1* = 0 or x2* = 0 then the ordinary demand (x1*,x2*) is at a corner solution to the problem of maximizing utility subject to a budget constraint.
© 2010 W. W. Norton & Company, Inc. 46
Examples of Corner Solutions -- the Perfect Substitutes Case
x1
x2
MRS = -1
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Examples of Corner Solutions -- the Perfect Substitutes Case
x1
x2
MRS = -1
Slope = -p1/p2 with p1 > p2.
© 2010 W. W. Norton & Company, Inc. 48
Examples of Corner Solutions -- the Perfect Substitutes Case
x1
x2
MRS = -1
Slope = -p1/p2 with p1 > p2.
© 2010 W. W. Norton & Company, Inc. 49
Examples of Corner Solutions -- the Perfect Substitutes Case
x1
x2
xy
p22
*
x1 0*
MRS = -1
Slope = -p1/p2 with p1 > p2.
© 2010 W. W. Norton & Company, Inc. 50
Examples of Corner Solutions -- the Perfect Substitutes Case
x1
x2
xyp11
*
x2 0*
MRS = -1
Slope = -p1/p2 with p1 < p2.
© 2010 W. W. Norton & Company, Inc. 51
Examples of Corner Solutions -- the Perfect Substitutes Case
So when U(x1,x2) = x1 + x2, the mostpreferred affordable bundle is (x1*,x2*)where
0,py
)x,x(1
*2
*1
and
2
*2
*1 p
y,0)x,x(
if p1 < p2
if p1 > p2.
© 2010 W. W. Norton & Company, Inc. 52
Examples of Corner Solutions -- the Perfect Substitutes Case
x1
x2
MRS = -1
Slope = -p1/p2 with p1 = p2.
yp1
yp2
© 2010 W. W. Norton & Company, Inc. 53
Examples of Corner Solutions -- the Perfect Substitutes Case
x1
x2
All the bundles in the constraint are equally the most preferred affordable when p1 = p2.
yp2
yp1
© 2010 W. W. Norton & Company, Inc. 54
Examples of Corner Solutions -- the Non-Convex Preferences Case
x1
x2Better
© 2010 W. W. Norton & Company, Inc. 55
Examples of Corner Solutions -- the Non-Convex Preferences Case
x1
x2
© 2010 W. W. Norton & Company, Inc. 56
Examples of Corner Solutions -- the Non-Convex Preferences Case
x1
x2
Which is the most preferredaffordable bundle?
© 2010 W. W. Norton & Company, Inc. 57
Examples of Corner Solutions -- the Non-Convex Preferences Case
x1
x2
The most preferredaffordable bundle
© 2010 W. W. Norton & Company, Inc. 58
Examples of Corner Solutions -- the Non-Convex Preferences Case
x1
x2
The most preferredaffordable bundle
Notice that the “tangency solution”is not the most preferred affordablebundle.
© 2010 W. W. Norton & Company, Inc. 59
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
x1
x2U(x1,x2) = min{ax1,x2}
x2 = ax1
© 2010 W. W. Norton & Company, Inc. 60
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
x1
x2
MRS = 0
U(x1,x2) = min{ax1,x2}
x2 = ax1
© 2010 W. W. Norton & Company, Inc. 61
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
x1
x2
MRS = -
MRS = 0
U(x1,x2) = min{ax1,x2}
x2 = ax1
© 2010 W. W. Norton & Company, Inc. 62
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
x1
x2
MRS = -
MRS = 0
MRS is undefined
U(x1,x2) = min{ax1,x2}
x2 = ax1
© 2010 W. W. Norton & Company, Inc. 63
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
x1
x2U(x1,x2) = min{ax1,x2}
x2 = ax1
© 2010 W. W. Norton & Company, Inc. 64
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
x1
x2U(x1,x2) = min{ax1,x2}
x2 = ax1
Which is the mostpreferred affordable bundle?
© 2010 W. W. Norton & Company, Inc. 65
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
x1
x2U(x1,x2) = min{ax1,x2}
x2 = ax1
The most preferredaffordable bundle
© 2010 W. W. Norton & Company, Inc. 66
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
x1
x2U(x1,x2) = min{ax1,x2}
x2 = ax1
x1*
x2*
© 2010 W. W. Norton & Company, Inc. 67
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
x1
x2U(x1,x2) = min{ax1,x2}
x2 = ax1
x1*
x2*
(a) p1x1* + p2x2* = m
© 2010 W. W. Norton & Company, Inc. 68
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
x1
x2U(x1,x2) = min{ax1,x2}
x2 = ax1
x1*
x2*
(a) p1x1* + p2x2* = m(b) x2* = ax1*
© 2010 W. W. Norton & Company, Inc. 69
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
(a) p1x1* + p2x2* = m; (b) x2* = ax1*.
© 2010 W. W. Norton & Company, Inc. 70
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
(a) p1x1* + p2x2* = m; (b) x2* = ax1*.
Substitution from (b) for x2* in (a) gives p1x1* + p2ax1* = m
© 2010 W. W. Norton & Company, Inc. 71
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
(a) p1x1* + p2x2* = m; (b) x2* = ax1*.
Substitution from (b) for x2* in (a) gives p1x1* + p2ax1* = mwhich gives
21
*1 app
mx
© 2010 W. W. Norton & Company, Inc. 72
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
(a) p1x1* + p2x2* = m; (b) x2* = ax1*.
Substitution from (b) for x2* in (a) gives p1x1* + p2ax1* = mwhich gives .
appam
x;app
mx
21
*2
21
*1
© 2010 W. W. Norton & Company, Inc. 73
Examples of ‘Kinky’ Solutions -- the Perfect Complements Case
(a) p1x1* + p2x2* = m; (b) x2* = ax1*.
Substitution from (b) for x2* in (a) gives p1x1* + p2ax1* = mwhich gives
A bundle of 1 commodity 1 unit anda commodity 2 units costs p1 + ap2;m/(p1 + ap2) such bundles are affordable.
.app
amx;
appm
x21
*2
21
*1