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Chapter I Consumer Behavior Page of
Chapter I Consumer Behavior Page of
d. Limited Money Income: The consumer has limited money income to spend on the
goods and services he/she chooses to consume making choice mandatory for the
consumer.
e. Diminishing Marginal Utility DMU: The utility derived from each successive units of
a commodity diminishes. Generally, the utility of the last unit consumed is less than the
utility of the previous item consumed of the same good. In other words, the marginal
utility of a commodity diminishes as the consumer acquires larger quantities of it.
f. The total utility of a basket of goods depends on the quantities of the individual
commodities consumed: If there are n commodities in the bundle with quantities,
X 1 , X 2 ,... X n the total utility is :
This implies total utility is a positive function of the quantities of goods consumed.
Total and Marginal Utility
Total Utility TU refers to the total amount of satisfaction a consumer gets from consuming
or possessing some specific quantities of a commodity at a particular time. As the consumer
consumes more of a good per time period his total utility increases. However, total utility
can not be increased indefinitely. There is a point in which the consumer will not be
capable of enjoying any greater satisfaction from it. There is a point at which total
satisfaction reaches maximum and this point is called saturation point.
Marginal Utility MU refers to the additional utility obtained from consuming an additional
unit of a commodity. In other words, marginal utility is the change in total utility resulting
from the consumption of one or more unit of a product per unit of time. In short, it is the
slope of the total utility function. Mathematically:
TU
MU …………………………………….. 1.1
Q
Law of Diminishing Marginal Utility LDMU
The utility that a consumer gets by consuming a commodity for the first time is not the
same as the consumption of the good for the second, third, fourth, etc. The LDMU states
that 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.
The LDMU is best explained by the MU curve that is derived from the relationship
between TU and total quantity consumed.
Table1.0: TU and MU of Oranges (X)
Quantity of 1st nd
X consumed 0 U 2 4th 5th 6th
un 3rd unit
Unit ni it
unit Unit Unit
t
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX - 10 6 4 2 0 -2
Figure 1.0: Derivation of MU TU
A
20
TUX
15
Total Utility
10
Quantity X
Marginal Utility
10 B
Quantity X
1 2 3 4 5
MUX
As the consumer consumes more of a good over time period, the total utility increases, at
an increasing rate and then increases at a decreasing rate when the marginal utility starts to
decrease and reaches maximum; the marginal utility becomes zero (see figure 1.0).
The total utility curve reaches its pick point (Saturation point) at point A. This saturation
point indicates that by consuming 5 units of X, the consumer attains its highest satisfaction
of 22 utils. However, Consumption beyond this point results in dissatisfaction because
consuming the 6th and more units of X brings a negative utility than the previous orange.
According to the Necessary Condition (First Order Condition) for Optimization, for utility
to reach maximum, the derivative of the function with respect to Qx must be equal to zero:
dU d (Q X PX )
0 MUx - PX =0
dQ X dQ X
MUx
MU X PX 1
Px
The equilibrium condition of a consumer that consumes a single good X occurs when the
marginal utility of X is equal to its market price and the whole income has been consumed
(Total Expenditure =Total Income).
B. n-Commodity Case (General 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.
For example: If the consumer consumes a bundle of n commodities i.e X 1, X2 X3, …, Xn he
would be in equilibrium or utility is maximized if and only if:
MU X 1 MU X 2 MU X n
......... MU m ………………… 1.3
PX 1 PX 2 PX n
Where: Mum = Marginal Utility of Money
P
A
C
PX
B
MUX
Quantity X
Note that: at any point above point C like point A where MUX> Px, it pays the consumer to
consume more. At any point below point C like point B where MUX< Px the consumer
consumes less of X. However, at point C where MUx=Px the consumer is at equilibrium.
Table1.1: Utility Schedule for a Single Commodity
Marginal utility
Quantity of Marginal utility
Total utility Marginal utility per Birr(price=2
Orange of money
birr)
0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.5 1
5 13 0 0 1
6 11 -2 -1 1
For consumption level lower than three quantities of oranges, since the marginal utility of
orange is higher than the price, the consumer can increase his/her utility by consuming
more quantities of oranges. On the other hand, for quantities higher than three, since the
marginal utility of orange is lower than the price, the consumer can increase his/her utility
by reducing its consumption of oranges.
Suppose that a consumer consumes two commodities, Orange and Banana. The total
income of the consumer is Birr 20.If price of Orange is Birr 2 per unit and Birr 4 per unit
for Banana. If the utility schedule of the consumer is as indicated below the optimum
combination of the two goods can be calculated as follows.
Utility is maximized when the condition of marginal utility of one commodity divided by
its market price is equal to the marginal utility of the other commodity divided by its
MU 1 MU 2
market price ( ) and income equals expenditure.
P1 P2
Thus, the consumer will be at equilibrium when he consumes 2 quantities of Orange and 4
MU orange MU banana 4 8
quantities of banana because 2 and his total income of
Porange Pbanana 2 4
birr 20 equals to the total expenditure on 2 units of orange (2X2= birr 4) and 4 units of
banana (4x4=birr16)
Derivation of the Demand Curve under Cardinalist Approach
The derivation of demand curve is based on the concept of diminishing marginal utility. If
the marginal utility is measured using monetary units the demand curve for a commodity is
the same as the positive segment of the marginal utility curve.
a
P1
b
P
Price
c
P2
MUX
O Quantity
P1
Price
P
Demand
P2 Curve
O Quantity
Q1 Q Q2
II. Ordinal Utility Approach
consumer continues to substitute X for Y the rate goes on decreasing as the two goods
are assumed to be imperfect substitutes in a standard case.
iv. The total utility of the consumer depends on the quantities of the commodities
consumed, i.e., U=f (X1 ,X2, X3,--- Xn,)
v. Preferences are transitive or consistent: It is transitive in the senses that if the
consumer prefers market basket X to market basket Y, and prefers Y to Z, and then the
consumer also prefers X to Z. Consistency of preference implies that If market basket X
is preferred to market basket Y (X>Y) then Y can not be preferred to X at another
time(Y not >X).
vi. Limited Money Income: The consumer is confronted with limited money income so
that optimization is mandatory.
vii. Non – satiation assumption: Consumers always prefer more of any good to less and
they are never satisfied or satiated. In any two consumption bundles A and B, A is
preferred to B if A contains at least more of one commodity. However, bad goods are
not desirable and consumers will always prefer less of them.
The ordinal utility approach is expressed or explained with the help of indifference curves.
An indifference curve is a concept used to represent an ordinal measure of the tastes and
preferences of the consumer and to show how he maximizes utility in spending income.
Since it uses ICs to study the consumer’s behavior, the ordinal utility theory is also known
as the Indifference Curve Analysis.
Indifference Set, Indifference Curve and Indifference Map
Indifference Set/Schedule: It is a combination of goods for which the consumer is
indifferent, preferring none of the consumption bundles. It is a tabular presentation of the
various combinations of goods from which the consumer derives the same level of utility.
Table 1.3: Indifference Schedule
Bundle (Combination) A B C D
Orange(X) 1 3 5 7
Banana (Y) 23 15 9 6
Each combination of good X and Y gives the consumer equal level of total utility. Thus,
the individual is indifferent whether he consumes combination A, B, C or D.
Indifference Curves: An indifference curve shows the various combinations of two goods
that provide the consumer the same level of utility or satisfaction. It is the
locus of points (particular combinations or bundles of good), which yield the
same utility (level of satisfaction) to the consumer, so that the consumer is
indifferent as to the particular combination he/she consumes. An
indifference curve is an iso or equal utility curve. By transforming the above
indifference schedule into graphical representation, we get an indifference
curve.
Figure 1.3: Indifference Curves and Indifference Map
Banana (Y)
10 A
Good B
Indifferenc
B
6 e
Curve (IC)
Indifference Curve
C Indifference Map
2 IC3
D IC2
Indifference
1 Map: It is a set of indifference curves with different levels of satisfaction. It
IC1
is the entire set of indifference curves which reflects the complete set of tastes and
preferences
1 2of the 4consumer.7 A higher indifference curve refers to a higher level of
Good A
satisfaction and aOrangeX
lower indifference curve shows lesser satisfaction. IC 2 reflects higher
)) that
level of utility than (X) of IC1.
commodity for a movement along an indifference curve. That means, if the quantity of
one commodity increases with the quantity of the other remaining constant, the total
utility of the consumer increases. On the other hand, if the quantity of one commodity
decreases with the quantity of the other remaining constant, the total utility of the
consumer reduces. Hence, in order to keep the utility of the consumer constant, as the
quantity of one commodity is increased, the quantity of the other must be decreased.
b. Indifference curves do not intersect each other: Intersection between two
indifference curves is inconsistent with the reflection of indifference curves. If they do
intersect, the point of their intersection would mean two different levels of satisfaction
from a single combination of goods, which is impossible.
c. A higher Indifference curve is always preferred to a lower one: The further away
from the origin an indifferent curve lies, the higher the level of utility it denotes:
baskets of goods on a higher indifference curve are preferred by the rational consumer,
because they contain more of the two commodities than the lower ones.
d. Indifference curves are convex to the origin: This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve from the
left downwards to the right. This assumption implies that the commodities can
substitute one another at any point on an indifference curve but are not perfect
substitutes.
1.4: Positively Sloped and Intersected Indifference Curves
X
Banana
Banana
Orange Orange
Adigrat University Department of Economics Microeconomics 2016
since they are on the same indifference curve, IC 2.By transitivity, the consumer must also
be indifferent between C and D. However, a rational consumer would prefer D to C
because he/she can have more Orange at point D (more Orange by an amount of X).
The left panel of figure 1.4 summarizes the implication of an upward sloping indifference
curve. Point A and B are two points on the same indifference curve which must give the
consumer the same satisfaction. But the consumer is not indifferent between the two
consumption bundles since consumption bundle B contains more of both orange and
banana.
Marginal rate of substitution MRS
Marginal rate of substitution of X for Y is defined as the number of units of commodity Y
that must be given up in exchange for an extra unit of commodity of X so that the
consumer maintains the same level of satisfaction. It is the rate at which one commodity
can be substituted for another while keeping the level of satisfaction the same.
willing to give up) per unit of horizontal distance (i.e. per additional unit of x required) to
Y
remain on the same indifference curve. That is, MRS X ,Y because of the reduction
X
The rationale behind the convexity, that is, diminishing MRS, is that a consumer’s
subjective willingness to substitute X for Y (or Y for X) will depend on the amounts of Y
and X he/she possesses.
Table1.4: Level of Consumption of Good X and Y
Bundle (Combination) A B C D
Orange(X) 1 3 5 7
Banana (Y) 23 15 9 6
Y 8
MRS X ,Y (between points A and B ) 4
X 2
The consumer is willing to forgo 8 units of Banana to obtain 2 more unit of Orange (see
table 1.4). If the consumer moves from point B to point C, he is willing to give up only 6
units of Banana(Y) to obtain 2 unit of Orange (X), so the MRS is 3(∆Y/∆X =6/2). Having
still less of Banana and more of Orange at point D, the consumer is willing to give up only
3 unit of Banana so as to obtain the same 2 units of Orange. In this case, the MRS falls to
3/2. In general, as the amount of Y increases, the marginal utility of additional units of Y
decreases. Similarly, as the quantity of X decreases, its marginal utility increases. In
addition, the MRS decreases as one move downwards to the right.
Marginal Utility and Marginal Rate of Substitution
It is also possible to show the derivation of the MRS using MU concepts. The MRS X ,Y is
related to the MUx and the MUy:
MU X
MRS X ,Y
MU Y
Proof: Suppose the utility function for two commodities X and Y is defined as:
U f ( X ,Y )
Since utility is constant on the same indifference curve:
U f ( X ,Y ) C
The total differential of the utility function is:
U U
dU dX dY 0 because there is no change in utility for any
X Y
movement along the same indifference curve.
U U
MU X dX MU Y dY 0 , = MUX and = MUy
X Y
MU X dY
MRS X ,Y
MU Y dX
MU Y dX
Or, MRS Y , X
MU X dY
Example 1.0: Suppose a consumer’s utility function is given by U 10 X 2Y
.Compute MRS X ,Y .
MU X
MRS X ,Y
MU Y
dU dU
MU X and MU Y
dX dY
MU X 20 XY 2Y
MRS X ,Y
MU Y 10 X 2 X
of shoes, additional right or left shoes provide no more utility for him. MRS for perfect
complements is zero i.e. there is no substitution between the two goods (see figure 1.5
Panel b ).
3. A useless good: Figure 1.5 Panel c shows an individual’s indifference curve for food (on
the horizontal axis) and an out-dated book, a useless good, (on the vertical axis). Since they
are totally useless, increasing purchases of out-dated books does not increase utility. This
person enjoys a higher level of utility only by getting additional food consumption. For
example, the vertical indifference curve shows that utility will be the same as long as this
person has same units of food no matter how many out dated books he has.
Figure 1.5: Special cases of indifference curves
IC3
Total
IC2
IC1
Panel a Panel b Panel c
Mobile
Budget Line or Price LineLeft shoe Food
Indifference curves show how the rate at which the consumer is willing to substitute one
good for another utility remaining the same. It only tells us the consumer’s preferences for
any two goods but they can not tell us which combinations of the two goods will be chosen
or bought.
A utility maximizing consumer would like to reach the highest possible indifference curve
on his/her indifference map. But the consumer’s decision is constrained by his/her money
income and prices of the two commodities. Therefore, in addition to consumer preferences,
we need to know the consumer’s income and prices of the goods. In other words, individual
choices are also affected by budget constraints that limit people’s ability to consume in
light of prices they must pay for various goods and services. Whether or not a particular
indifference curve is attainable depends on the consumer’s money income and on
commodity prices. A consumer while maximizing utility is constrained by the amount of
income and prices of goods that must be paid. This constraint is often presented with the
help of the budget line constructed by possible alternative purchases of any two goods.
Therefore, before we discuss consumer’s equilibrium, it is better to understand his/ her
budget line.
The budget line is a line or a graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices. In other words, the budget line
shows the market basket that the consumer can purchase, given the consumer’s income and
prevailing market prices.
Assumptions for the use of Budget Line
1. There are only two goods, X and Y, bought in quantities X and Y;
2. Each consumer is confronted with market determined prices, Px and Py, of good X and good
Y respectivley; and
3. The consumer has a known and fixed money income M.
By assuming that the consumer spends all his income on two goods (X and Y), we can
express the budget constraint as:
M PX X PY Y …………………….. 1. 6
Where: PX=price of good X, PY=price of good Y, X=quantity of good X,Y=quantity of
good Y and M=consumer’s money income.
According to the above budget equation, the amount of money spent on X plus the amount
spent on Y equals the consumer’s money income.
Suppose for example a household with 60 Birr per day to spend on banana(X) at Birr 2
each and Orange(Y) at Birr 4 each. That is, PX 2, PY 4, M 60birr .
Therefore, our budget line equation will be:
2 X 4Y 60
Table1.5: Alternative Purchase Possibilities of the Two Goods
Consumption Alternatives A B C D E F
banana (X) in (kgs) 0 1 2 3 4 5
Orange(Y) in (kgs) 15 14.5 14 13.5 13 12.5
Total Expenditure 60 60 60 60 60 60
At alternative A, the consumer is using all of his /her income for good Y. Mathematically; it
is the y-intercept (0, 15). And at alternative F, the consumer is spending all his income for
good X. Mathematically it is the X-intercept (5, 0). We may present the income constraint
graphically by the budget line whose equation is derived from the budget equation.
M PX X PY Y
M XPX YPY
By rearranging the above equation we can derive the general equation of a budget line:
M PX
Y X
PY PY
M
= Vertical Intercept (Y-intercept), when X=0.
PY
PX
= slope of the budget line (the ratio of the prices of the two goods)
PY
The horizontal intercept (i.e., the maximum amount of X the individual can consume or
purchase given his income) is:
M PX
X 0
PY PY
M PX
X
PY PY
M
X
PX
Figure 1.6: Derivation of the Budget Line
M/PY
B
A
M/PX
Therefore, the budget line is the locus of combinations or bundle of goods that can be
purchased if the entire money income is spent. Given any budget line, there are two
possible areas indicated by point A and point B. The area outside the budget line represents
non- feasible (un-attainable) area because it is beyond the reach of the consumer. On the
other hand, the area inside or on the budget line denotes feasible or achievable area.
Factors Affecting the Budget Line
Budget line depends on the price of the two goods and the income of the consumer. Any
change in the income of the goods or the income of the consumer results in a shift in the
budget line. Let us examine the impact of these changes one by one.
a. Effects of Changes in Income
If the income of the consumer changes (keeping the prices of the commodities unchanged)
the budget line also shifts (changes). Increase in income causes an upward shift of the
budget line that allows the consumer to buy more goods and services and decreases in
income causes a downward shift of the budget line that leads the consumer to buy less
quantity of the two goods. It is important to note that the slope of the budget line (the ratio
of the two prices) does not change when income rises or falls. The budget line shifts from
Bo to B1 when income decreases and to B2 when income rises.
Figure2 1.7: Effects of Change in Income
M /Py
Where M2>Mo>M1
Mo/Py
M1/Py
Bo B2
B1
notice that changes in the prices of the commodities change the position and the slope of
the budget line. But, proportional increases or decreases in the price of the two
commodities (keeping income unchanged) do not change the slope of the budget line if it is
in the same direction.
Y Y
B1 B1
B
B
X X
Panel a Panel b
Let us now consider the effects of each price changes on the budget line:
1. What would happen if price of x falls, while the price of good Y and money incme
remaining constant?
Figure 1.9: Effect of a Decrease in Price of x on Budget Line
Y
A
M/py
B B’
M/PX0 M/Px1 X
Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y
by spending the entire money income on Y regardless of the price of X. We can see from
the above figure that a decrease in the price of X, money income and price of Y held
constant, pivots the budget line out-ward, as from AB to AB’.
2. What would happen if price of X rises, while the price of good Y and money incme
remaining constant?
Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y
by spending the entire money income on Y regardless of the price of X. We can see from
the figure below that an increase in the price of X, money income and price of Y held
constant, pivots the budget line in-ward, as from AB to AB’.
Figure 1.10: Effect of an Increase in Price of x on Budget Line
A
M/Py
B
B’
M/Px1 M/Px2
3. What would happen if price of Y rises, while the price of good X and money incme
remaining constant?
Figure1.11: Effect of a Raise in Price of Y on Budget Line
YA
M/py
A’
M/py'
B
M/Px X
Since the X-intercept (M/Py) is constant, the consumer can purchase the same amount of X
by spending the entire money income on X regardless of the price of Y. We can see from
the above figure that an increase in the price of Y, money income and price of X held
constant, pivots the budget line in-ward, as from AB to A’B.
4. What would happen if price of Y falls, while the price of good X and money incme
remaining constant?
M/py A
B
M/Px X
The above figure shows what happens to the budget line when the price of Y increases while the
price of good X and money income held constant. Since P y decreases, M/Py increases thereby the
budget line shifts outward.
Some times the price of the two commodities may change proportionally in the same direction and
this will have a shifting impact on the budget line.
Proportional increase in the prices of both goods (X and Y), income remaining the same, reduces
the total quantity of the two goods that the consumer can buy with the given income. For example
if the price of the two goods doubles, the quantity of the two goods bought decreases by half. Since
the slope of the budget line which is the ratio of the prices of the two goods remains the same,
there will be a parallel inward shift of the budget line.
When there is proportional (equal) decrease in price of the two goods income remaining the same,
the quantity bought of the two goods increases which leads o a parallel out ward shift in the budget
line M/Py 2
Figure 1.13: Effect of Proportional Price Change on Budget Line
M/Pyo
Where PX1>PXo > PX2 and
Bo B2
M/Py
Chapter
1 I Consumer Behavior Page 21 of 31
B1
Adigrat University Department of Economics Microeconomics 2016
A’
B’ B
20 X
If the budget decreases by 50%, then the budget will be reduced to 30.As a result, the
budget line will be shifted in-ward as indicated by (A’B’).This forces the person to buy less
quantity of the two goods. The equation for the new budget line can be solved as:
3 X 6Y 30
6Y 30 3 X
30 3
Y X
6 6
1
Y 5 X
2
Y 5 0 .5 X
Therefore, the Y-intercept decreases to 5 units while the X-intercept is only 10 units.
However, since the ratio of the prices does not change the slope of the budget line remains
constant.
If the price of good Y doubles the equation of the budget line will be 3 X 12Y 60 and if
the price of good X falls to Birr 2, the equation for the new budget line is 2 X 6Y 60 .
If price of both X and Y is doubled, the new budget line equation will be 6X+12Y=60.The
X-intercept and Y-intercept decreases to 10 units and 5 unity respectively. The slope
remaining the same (-0.5), the budget line shifts inward in a parallel way.
Equilibrium of the Consumer
A rational consumer seeks to maximize his utility or satisfaction by spending his or her
income. It maximizes the utility by trying to attain the highest possible indifference curve,
given the budget line. This occurs where an indifference curve is tangent to the budget line
so that the slope of the indifference curve ( MRS X ,Y ) is equal to the slope of the budget
line ( PX / PY ).
Thus, the condition for utility maximization, consumer optimization, or consumer
equilibrium occurs where the consumer spends all income (i.e. he/she is on the budget line)
and the slope of the indifference curve equals to the slope of the budget line
MRS X ,Y PX / PY .
The preferences of the consumer (what he/she wishes) are indicated by the indifference
curve and the budget line specifies the different combinations of X and Y the consumer can
purchase with the limited income. Therefore, the consumer tries to obtain the highest
possible satisfaction with in his budget line.
However, the consumer cannot purchase any bundle lying above and to the right of the
budget line. Because, Indifference curves above the region of the budget line are beyond
the reach of the consumer and are irrelevant for equilibrium consideration. The question
then arises as to which combinations of X and Y the rational consumer will purchase.
Figure 1.14: Consumer Equilibrium
Y
A
B
E
IC4
C IC3
IC2
D
IC1
At point ‘A’ on the budget line, the consumer gets IC 1 level of satisfaction. When he/she
moves down to point ‘B’ by reallocating his/her total income inXfavor of X he/she derives
greater level of satisfaction that is indicated by IC2. Thus, point ‘B’ is preferred to point ‘A’.
Moving further down to point ‘E’, the consumer obtains the greatest level of satisfaction
(IC3) relative to other indifference curves.
Therefore, point ‘E’ (which represents combination X and Y) is the most preferred position
by the consumer since he/she attains the highest level of satisfaction within his/her reach
and point ’E’ is known as the point of consumer equilibrium (or consumer optimum). This
equilibrium occurs at the point of tangency between the highest possible indifference curve
and the budget line. Put differently, equilibrium is established at the point where the slope
of the budget line is equal to the slope of the indifference curve.
PX MU X
MRS X ,Y , But we know MRS X ,Y
PY MU Y
MU X P MU X MU X
X , or
MU Y PY Px Py
Subject to PX X PY Y M
To solve the constrained problem; we use the Lagrange Multiplier Method. The steps
involved are:
U ( X , Y ) ( M PX X PY Y )
Or, U ( X , Y ) ( PX X PY Y M )
D) The first order condition requires that the partial derivatives of the Lagrange function
with respect to the two goods and the langrage multiplier be zero.
U U
PX 0 ; PY 0 and ( PX X PY Y M ) 0
X X Y Y
From the above equations we obtain:
U U
PX and PY
X Y
U U
MU X and MU Y
X Y
Therefore, substituting and solving for we get the equilibrium condition:
MU X MU Y
PX PY
By rearranging we get:
MU X P
X = MRS x,y
MU Y PY
E) The second order condition for maximum requires that the second order partial
derivatives of the Lagrange function with respect to the two goods must be negative.
2 U 2 2 U 2
0 and 0
X 2 X 2 Y 2 Y 2
Example 1.3: A consumer consuming two commodities X and Y has the following utility
function U X 1.5Y .If the price of the two commodities are 3 and 4 respectively and
his/her budget is birr 100.
a) Find the quantities of good X and Y which will maximize utility.
b) Total utility at equilibrium.
c) Find the MRS X ,Y at optimum point
Solution:
A) The Lagrange equation will be written as follows:
X 1.5Y (3 X 4Y 100)
1.5 X 0.5Y 3 0 ……………………………………… (1)
X
X 1.5 4 0 …………………………………………. (2)
Y
100 3 X 4Y 0 …………………………… (3)
From equation (1) we get 1.5 X 0.5Y 3 and from equation (2) we get X 1.5 4 .By
1.5 X 0.5Y
1.5
further simplification, we can get that and equation (2) gives as X .
3 4
Equating with
1.5 X 0.5Y
1.5
X=2Y………………………………………………………… (4)
Substituting Equation (4) in equation (3) or the constraint function,
3X +4Y=100 Since X= 2Y from equation (4)
3(2Y) +4Y=100 X=2(10)
U= 894
MU X
C) MRS X ,Y ,
MU Y
U U
MU X 1.5 X 0.5Y and MU Y X 1.5
X Y
PX 3
ratio of the two goods ( 0.75) .
PY 4
Example 1.4: A consumer consuming two commodities X and Y has the following utility
function U X 2Y 2 .If the price of the two commodities are Birr 1 and 4 respectively and
his/her budget is birr 10.
A) Find the quantities of good X and Y which will maximize utility.
B) Find the MRS X ,Y at optimum.
C) Total utility at optimum point
D) The amount by which optimum utility changes when quantity of X or Y changes by
one unit ( ).
Solution:
A) The Lagrange equation will be written as follows:
X 2Y 2 ( X 4Y 10)
2 XY 2 0 …………………………….. (1)
X
2YX 2 4 0 …………………………… (2)
Y
X 4Y 10 0 …………………………. (3)
YX 2
From equation (1) we get 2 XY 2 and from equation (2) we get .
2
Since equals to , we can solve for either X or Y
=
2
YX
2 XY 2
=
2
YX 2 = 4 XY 2
X = 4Y……………………………………….. (4)
By substituting equation (4) in to equation (3) we get,
X+4Y=10
4Y+4Y=10, since X= 4Y
8Y=10
Y= 1.25 and X=4Y, X=4(1.25) =5
Thus optimum combination of the two goods is 5 for X and 1.25 for Y.
B) MRS X ,Y at optimum.
MU X
MRS X ,Y , MU X = 2 XY 2 and MUy = 2YX 2
MU Y
2 XY 2
2YX 2
Y
=
X
After inserting the optimum value of Y=1.25 and X=5 we get 0.25 which equals to the
PX 1
price ratio of the two goods ( 0.25) .
PY 4
C) TU 5 2 (1.25) 2
=25(1.56)
=39
D) 2 XY 2 ,x= 5& Y=1.25
2(5)(1.25) 2
=15.625