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Chia-Hui Chen
Lecture 5
Deriving MRS from Utility Function, Budget
Optimization
Outline
1. Chap 3: Utility Function, Deriving MRS
2. Chap 3: Budget Constraint
3. Chap 3: Optimization: Interior Solution
U (x, y) = ax + by.
U (x, y) = Axb y c .
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
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1 Utility Function, Deriving MRS 2
10
7
U(x,y)=ax+by=Const
6
y 5
0
0 2 4 6 8 10
x
10
5
y
U(x,y)=min{ax,by}=Const
4
0
0 2 4 6 8 10
x
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
1 Utility Function, Deriving MRS 3
10
6
y
a b
U(x,y)=Ax y =Const
4
0
0 2 4 6 8 10
10
U(x,y)=−ax+by=Const
4
0 2 4 6 8 10
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
2 Budget Constraint 4
2 Budget Constraint
The problem is about how much goods a person can buy with limited income.
Assume: no saving, with income I, only spend money on goods x and y with
the price Px and Py .
Thus the budget constraint is
Px · x + Py · y � I.
Suppose Px = 2, Py = 1, I = 8, then
2x + y � 8.
The slope of budget line is
dy Px
= −
.
dx Py
Bundles below the line are affordable.
Budget line can shift:
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
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YYYY].
2 Budget Constraint 5
10
y
4
2x+y≤8
0
0 2 4 6 8 10
10
6 2x+y≤8
5
y
4 2x+y≤6
3
0
0 2 4 6 8 10
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
3 Optimization: Interior Solution 6
10
6 2x+y≤8
5
y
4 x+y≤4
3
0
0 2 4 6 8 10
x
Since the preference has non-satiation property, only (x, y) on the budget line
can be the solution. Therefore, we can simplify the inequality to an equality:
xPx + yPy = I.
First, consider the case where the solution is interior, that is, x > 0 and y > 0.
Example solutions:
• Method 1
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
3 Optimization: Interior Solution 7
10
y
4 U(x,y)=Const
3
P x+P y=I
2 x y
0
2 4 6 8 10
x
From Figure 8, the utility function reaches its maximum when the indif
ferent curve and constraint line are tangent, namely:
Px ∂u/∂x ux
= M RS = = .
Py ∂u/∂y uy
– If
Px ux
> ,
Py uy
then one should consume more y, less x.
– If
Px ux
< ,
Py uy
Px
then one should consume more x, less y. Intuition behind Py = M RS:
Px
Pyis the market price of x in terms of y, and MRS is the price of x in
terms of y valued by the individual. If Px /Py > M RS, x is relatively
expensive for the individual, and hence he should consume more y.
On the other hand, if Px /Py < M RS, x is relatively cheap for the
individual, and hence he should consume more x.
• Method 2: Use Lagrange Multipliers
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3 Optimization: Interior Solution 8
• Method 3
I − xPx
y= .
Py
Then the problem can be written as
I − xPx
max u(x, y) = u(x, ).
x,y Py
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].