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Chapter Five Choice

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Page 1: Ch5

Chapter Five

Choice

Page 2: Ch5

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?

Page 3: Ch5

Rational Constrained Choice

x1

x2

Page 4: Ch5

Rational Constrained Choice

x1

x2Utility

Page 5: Ch5

Rational Constrained Choice

Utility x2

x1

Page 6: Ch5

Rational Constrained Choice

x1

x2

Utility

Page 7: Ch5

Rational Constrained Choice

Utility

x1

x2

Page 8: Ch5

Rational Constrained Choice

Utility

x1

x2

Page 9: Ch5

Rational Constrained Choice

Utility

x1

x2

Page 10: Ch5

Rational Constrained Choice

Utility

x1

x2

Page 11: Ch5

Rational Constrained Choice

Utility

x1

x2

Affordable, but not the most preferred affordable bundle.

Page 12: Ch5

Rational Constrained Choice

x1

x2

Utility

Affordable, but not the most preferred affordable bundle.

The most preferredof the affordablebundles.

Page 13: Ch5

Rational Constrained Choice

x1

x2

Utility

Page 14: Ch5

Rational Constrained Choice

Utility

x1

x2

Page 15: Ch5

Rational Constrained Choice

Utility

x1

x2

Page 16: Ch5

Rational Constrained Choice

Utilityx1

x2

Page 17: Ch5

Rational Constrained Choice

x1

x2

Page 18: Ch5

Rational Constrained Choice

x1

x2

Affordablebundles

Page 19: Ch5

Rational Constrained Choice

x1

x2

Affordablebundles

Page 20: Ch5

Rational Constrained Choice

x1

x2

Affordablebundles

More preferredbundles

Page 21: Ch5

Rational Constrained Choice

Affordablebundles

x1

x2

More preferredbundles

Page 22: Ch5

Rational Constrained Choice

x1

x2

x1*

x2*

Page 23: Ch5

Rational Constrained Choice

x1

x2

x1*

x2*

(x1*,x2*) is the mostpreferred affordablebundle.

Page 24: Ch5

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).

Page 25: Ch5

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.

Page 26: Ch5

Rational Constrained Choice

x1

x2

x1*

x2*

(x1*,x2*) is interior.

(x1*,x2*) exhausts thebudget.

Page 27: Ch5

Rational Constrained Choice

x1

x2

x1*

x2*

(x1*,x2*) is interior.(a) (x1*,x2*) exhausts thebudget; p1x1* + p2x2* = m.

Page 28: Ch5

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.

Page 29: Ch5

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*).

Page 30: Ch5

Computing Ordinary Demands

How can this information be used to locate (x1*,x2*) for given p1, p2 and m?

Page 31: Ch5

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

Page 32: Ch5

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

Page 33: Ch5

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

//

.

Page 34: Ch5

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

//

.

Page 35: Ch5

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)

Page 36: Ch5

Computing Ordinary Demands - a Cobb-Douglas Example.

(x1*,x2*) also exhausts the budget so

p x p x m1 1 2 2* * . (B)

Page 37: Ch5

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)

Page 38: Ch5

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

Page 39: Ch5

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 ….

Page 40: Ch5

Computing Ordinary Demands - a Cobb-Douglas Example.

xam

a b p11

*

( ).

Page 41: Ch5

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

*

( ).

Page 42: Ch5

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

Page 43: Ch5

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

Page 44: Ch5

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*).

Page 45: Ch5

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.

Page 46: Ch5

Examples of Corner Solutions -- the Perfect Substitutes Case

x1

x2

MRS = -1

Page 47: Ch5

Examples of Corner Solutions -- the Perfect Substitutes Case

x1

x2

MRS = -1

Slope = -p1/p2 with p1 > p2.

Page 48: Ch5

Examples of Corner Solutions -- the Perfect Substitutes Case

x1

x2

MRS = -1

Slope = -p1/p2 with p1 > p2.

Page 49: Ch5

Examples of Corner Solutions -- the Perfect Substitutes Case

x1

x2

xy

p22

*

x1 0*

MRS = -1

Slope = -p1/p2 with p1 > p2.

Page 50: Ch5

Examples of Corner Solutions -- the Perfect Substitutes Case

x1

x2

xyp11

*

x2 0*

MRS = -1

Slope = -p1/p2 with p1 < p2.

Page 51: Ch5

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.

Page 52: Ch5

Examples of Corner Solutions -- the Perfect Substitutes Case

x1

x2

MRS = -1

Slope = -p1/p2 with p1 = p2.

yp1

yp2

Page 53: Ch5

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

Page 54: Ch5

Examples of Corner Solutions -- the Non-Convex Preferences Case

x1

x2Better

Page 55: Ch5

Examples of Corner Solutions -- the Non-Convex Preferences Case

x1

x2

Page 56: Ch5

Examples of Corner Solutions -- the Non-Convex Preferences Case

x1

x2

Which is the most preferredaffordable bundle?

Page 57: Ch5

Examples of Corner Solutions -- the Non-Convex Preferences Case

x1

x2

The most preferredaffordable bundle

Page 58: Ch5

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.

Page 59: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

x1

x2U(x1,x2) = min{ax1,x2}

x2 = ax1

Page 60: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

x1

x2

MRS = 0

U(x1,x2) = min{ax1,x2}

x2 = ax1

Page 61: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

x1

x2

MRS = -

MRS = 0

U(x1,x2) = min{ax1,x2}

x2 = ax1

Page 62: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

x1

x2

MRS = -

MRS = 0

MRS is undefined

U(x1,x2) = min{ax1,x2}

x2 = ax1

Page 63: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

x1

x2U(x1,x2) = min{ax1,x2}

x2 = ax1

Page 64: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

x1

x2U(x1,x2) = min{ax1,x2}

x2 = ax1

Which is the mostpreferred affordable bundle?

Page 65: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

x1

x2U(x1,x2) = min{ax1,x2}

x2 = ax1

The most preferredaffordable bundle

Page 66: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

x1

x2U(x1,x2) = min{ax1,x2}

x2 = ax1

x1*

x2*

Page 67: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

x1

x2U(x1,x2) = min{ax1,x2}

x2 = ax1

x1*

x2*

(a) p1x1* + p2x2* = m

Page 68: Ch5

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*

Page 69: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

(a) p1x1* + p2x2* = m; (b) x2* = ax1*.

Page 70: Ch5

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

Page 71: Ch5

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

Page 72: Ch5

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

Page 73: Ch5

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

Page 74: Ch5

Examples of ‘Kinky’ Solutions -- the Perfect Complements Case

x1

x2U(x1,x2) = min{ax1,x2}

x2 = ax1

xm

p ap11 2

*

x

amp ap

2

1 2

*