Choice and Utility Maximization

Choice and Utility Maximization:

We have now described in detail what the consumer can do and we have also acquired a numerical function representing the consumer’s preferences and we can therefore proceed to analyze the consumer’s optimal choice behavior, using these concepts. The utility function is convenient since we can assume that the consumer make choices as if she tried to maximize this function. We’ve also seen that we can define the consumer’s external rate of exchange as the price ratio (p1/p2), and the consumer’s internal rate of exchange as the ratio of the marginal utilities, or MRS12, (−MU1/MU2). Figure below shows the solution to the consumer’s utility maximization problem, or optimal choice problem. It is obvious from the figure that the optimal condition is such that the external- and internal rate of exchange are equal, or,

MRS12 = - MU1/MU2 = - p1/p2

Example:

As before we assume that the utility function is given by, U(Q1,Q2) = Q1 . Q2. The next step is to find MU1 and MU2. We first define our initial bundle as Q0 = Q01 . Q02 and the new bundle as Q1 = (Q01 + ΔQ1) Q02, the marginal utility of good 1 is then,

145_utility maximization.jpg

 

1882_utility maximization2.jpg

Similarly, MU2 = Q01. Hence, MRS12 is equal to,

MRS12(Q0) = MU1/MU2 = Q02/Q01.

We proceed by setting this ratio equal to the price ratio,

Q2/Q1 = p1/p2,

Q2 = p1/p2Q1

This equation shows how they actually consumed quantities of the two goods are related to each other and the goods prices. But it doesn’t help us to pin down what these quantities are, this depends, of course, on how much money the consumer has available, or the budget equation,

p1Q1 + p2Q2 = Y

By using above equation we rewrite the budget equation so that we only have one unknown variable (Q1),

p1Q1 + p2 [(p1/p2) Q1] = Y,
p1Q1 + p1Q1 = Y,
2p1Q1 = Y

Solving for Q1 gives us the demand function for good 1:

Q1 (Y, p1) = Y/2p1

To find the demand function for good 2 we substitute this expression into equation, which gives,

Q2 (Y, p2) = (p1/p2) (Y/2p1)
= Y/2p2

For example if p1 = 1, p2 = 2 and Y = 15, the optimal quantities are Q1 = 7.5 and Q2 = 15/ 2.2 = 3.75. Note that the optimal bundle Q = {7.5, 3.75} cost the consumer 7.5 + 2 x  3.75 = 15, i.e., exactly equal to the consumer’s budget.

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