l04 choice. big picture u behavioral postulate: a decisionmaker chooses its most preferred...
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MRS and Utility Function x2x2x2x2 x1x1x1x1 RS is a slope of the indifference curve at x MRS is a slope of the indifference curve at x x Q: Can we recover MRS from knowledge of U(x)?TRANSCRIPT
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L04
Choice
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Big picture
Behavioral Postulate:A decisionmaker chooses its most preferred alternative from the set of affordable alternatives.
Budget set = affordable alternatives To model choice we must have
decisionmaker’s preferences.
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MRS and Utility Function
xx22
xx11
MRS is a slope of the RS is a slope of the indifference curve at x indifference curve at x
xx Q: Can we recover MRS from knowledge of U(x)?
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Utility and Marginal Utility
)(xU235.3
1 2 3
1 2 3
)(xMU
x
U
x
MU
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MRS and Marginal Utility
Yes, but we have to find marginal utilities for both goods first (MU)
MU: How much utility we gain by adding an extra unit of good i
MU U
xii
.2
1
MUMUMRS
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Example U(x1,x2) = x1
x2
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Example V(x1,x2) = ln(x1)+ln(x2)
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Cobb Douglass utility function
Log function
Cobb-Douglass utility
baxxxxU 2121 ),(
Conclusion: preferences
yxxy lnlnln lnln xaxa
are Cobb-Douglass
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Problem: We know preferences (utility function)
and
We want to know optimal choice
10,1,1 21 mpp
2121 lnln),( xxxxU
),( *2
*1 xx
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MRS of Monotonic transformations V=f(U) and f strictly increasing Can we say something about MRS?
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Choice 10,1,1 21 mpp2121 lnln),( xxxxU
$ $ $ $ $ $ $ $ $ $
1MU 2MU
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How can we modify our argument if
Marginal utility of a dollar
Different prices
We should equalize MU of a $!
1 ,1 21 porp
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Choice 10,2,1 21 mpp2121 lnln),( xxxxU
$ $ $ $ $ $ $ $ $ $
1
1
pMU
2
2
pMU
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Problem (thinking on the margin!)Two secrets of happiness:1. Spend your total income
2. Equalize marginal utility of a $
Rearranging:
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Choice: Calculation 10,2,1 21 mpp2121 lnln),( xxxxU
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Choice: geometric solution
x1
x2
10,2,1 21 mpp2121 lnln),( xxxxU
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SOH for Well-behaved preferences
But: Perfect Complements (Right and Left
shoe) Perfect Substitutes (Example: French
and Dutch Cheese)
SOH for other preferences
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Perfect Complements (Shoes)
L
R10,2,1 21 mpp),min(),( 2121 xxxxU
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More generally
L
R10,2,1 21 mpp),2min(),( 2121 xxxxU
),min(),( 2121 bxaxxxU
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Choice: Calculation 10,2,1 21 mpp),2min(),( 2121 xxxxU
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Perfect Substitutes (F & D cheese)
F
10,2,1 21 mpp2121 ),( xxxxU
D
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More generally
X1
2121 3),( xxxxU
2121 ),( bxaxxxU
10,2,1 21 mpp
X2
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Perfect Substitutes 10,6,2 21 mpp2121 84),( xxxxU