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Lec 2

Utility Maximization
Utility is a purely theoretical construct defined as:
- If an individual prefers bundle x-(x1,x2) to another bundle y(y1,y2) then an individual is said to get a higher level of utility
from bundle x than bundle y
- If an individual is indifferent between a bundle x and another
bundle y, then an individual is said to get the same level of
utility from bundle x and y
The only property of a utility assignment that is important is how it
orders the bundles of goods
This is a theory of ordinal utility
A utility function U is just a mathematical function that assigns a
numeric value to each possible bundle such that:
- If an individual strictly prefers bundle x to bundle y, then
- If an individual is indifferent between a bundle x and y,
All bundles in an indifference curve have the same utility level
If U(x1,x2) is a utility function, then any positive monotonic
transformation of it is a utility function that represents the same
Examples of Utility Fcns
There is no unique utility fcn representation of a preference relation
Perfect substitutes- Linear utility functions:
U(x1,x2)= ax1 + bx2, with a> and b> 0
Perfect complements- Liontief utility functions
U(x1,x2) = min{ax1, bx2} , with a> and b>0
Quasilinear utility functions
U(x1,x2) = k = v(x1) +x2
Eg. U(x1,x2) = root(x1) + x2


U(x1,x2)= lnx1 + x2

Cobb-Douglas utility fcns

U(x1,x2) = x c1 x d2 or V(x1,x2) = c lnx1 + d lnx2) with c>0 and d>0
MU1 = c x1^c-1 x2^d
MU2 = d x1^c x2^d-1
MRS = - c x2/ d x1

MU1 = c/x1
MU2= d/x2
MRS= - c x2/ d x1
Marginal Utility
The marginal utility of commodity i is the rate-of-change of total utility
as the quantity of commodity i consumed changes
M Ui=
M U i - the partial derivative of the utility fcn with respect to good i

The marginal rate of substitution (MRS) is both:

- The slope of an indifference curve at a particular point, and
- The negative ratio of the MU at that particular point

The MRS can be interpreted as the rate at which a consumer is willing

to substitute a small amount of x2 for x1

Optimal Choice
Economic theory assumes individuals choose their most preferred
bundle, or equivalently the bundle that gives them the most utility,
that is in their budget set
Consider a consumer who has the choice between 2 goods x1 and x2
at the cost p1 and p2 respectively, and an endowment m

Using Econ 201 analysis and logic, the consumer reaches an optimal
bundle when he/she does not have any further incentives to shift
consumption among the goods in the bundle

At the optimal choice (x*1 and x*2) the indifference curve is tangent to
the budget line
The optimal bundle (x*1 and x*2) satisfies 2 conditions:
1. The budget is exhausted p1x1* + p2x2* = m
2. The slope of the budget constraint, -p1/p2, and the slope of the
indifference curve containing (x1* , x2*) are equal at (x1*, x2*)
While graphs are informative we often want to solve things analytically
For two-good analysis, for each good i, we can find analytically function
xi(p1,p2,m) that map prices and endowment into an amount of that
Can use the constrained optimization approach from Econ 211
The problem of the consumer is basically to solve:

This implies that they want to find x1* and x2* s.t. U(x1*, x2*) >=
U(x1,x2) for all values of x1 and x2 that satisfy the equation p1x1 +
p2x2 = m
Objective function U(x1,x2)
Constraint p1x1 + p2x2 = m
There are 2 main ways to find the above optimal constrained choice:
1. Write down the optimality conditions and solve the system
2. Substitite the constraint into the objective function to yield an
unconstrained problem
3. Use Lagranges method
EX/ Find the optimal choice for a consumer who has a Codd-Douglas
utility fcn who has $m and p1 and p2

Lec 3
Consumer Demand Functions
In analyzing the consumers behaviour regarding their optimal choice
of a bundle of goods, we can derive the consumers demand function
for each of the goods in the bundle:
X1 = x1(p1,p2,m)
X2 = x2(p1,p2,m)
These derived demand functions tell us all we need to know about the
consumer behaviour
Comparative statics analysis of ordinary demand function:
- The study of how ordinary demands change as prices and
income changes

There is an intimate relationship between inferior goods and giffen

Slutsky Equation
What happens when a commoditys price decrases?
- A change in the relative prices occurs
- The total purchasing power o the consumers increase

The Slutsky equation says that the total change to demand from a
price change is the sum of a pure substitution effect and an income
- Substitution effect: the commodity is relatively cheaper , so
consumers substitute it for now relatively more expensive other
- Income effect: the consumers budget of $m can purchase more
than before, as if the consumers income rose, with consequent
income effects on quantities demanded
When the price of good 1 change and income stays fixed, the budget
line pivots around the vertical axis

We can view this adjustment as occurring in 2 stages: first pivot the

budget line around the original choice, and then shift this line outward
to the new demanded bundle.

X and Z denotes the initial and final choice

Y denotes the optimal choice on the pivoted line
The movement from X to Y is the substitution effect
The movement from Y to Z is the income effect
The movement from X to Z is the total change in demand
Income Effect:
- Isolated change in demand due only to the change in purchasing
- Slutsky asserted that if, at the new prices, less (more) income is
needed to buy the original bundle then real income is
increased (decreased)
- Income effect can be either +ve or ve
Pure Substitution Effect:
- Isolated change in demand due only to the change in relative
- What is the change in demand when the consumers income is
adjusted so that, at the new prices, they can only just buy the
original bundle?
- Substitution effect is always negative (opposite to the direction
of price change)
Slutskys Effect for Normal Goods
- The substitution and income effects reinforce each other when a
normal goods own price changes

The Law of Downward-Sloping Demand therefore always applies

to normal goods

Slutskys Effect for Income-Inferior Goods:

- The substitution and income effects oppose each other when an
income-inferior goods own price changes
- The income effect may be larger in size than the substitution
effect, causing quantity demanded to increase as own-price rises
=> Giffen goods
Example- Demand change, Sub and Income effects

Lec 4
Profit Maximization
Short-Run PM
The firms problem is to locate the production plan that attains the
highest possible isoprofit line, given the firms constraint on choices of
production plans

$ isoprofit lines equation is

= pyw1 x 1w2 x2

Output level is y and input levels are x1 and x2- bar

Product price is p and input prices are w1 and w2

The constraint is the production function

Given p, w1 and x2 = x2-bar the short-run profit-maximizing plan is

The profit-maximizing problem facing the firm can be written as:


The condition for the optimal choice of factor 1 is

Profit Maximization in the Long Run

Now the firm can vary both input levels and the profit-maximization
problem can be posed as


The same condition must hold for each factor choice

The choices of inputs that yield the maximum profit for the firm,
x1*(w1,w2,p) and x2*(w1,w2,p), are the profit maximizing factor
demand functions
Cost Minimization
Standard assumption: firms make decisions to maximize profits, or
maximize total revenue minus total costs
Decision process can be broken up into 2 parts:
1. For any given level of output, what combination of inputs should the
firm use?
-Minimizing costs of production a given level of
2. Given the optimal combination of inputs, how much should the firm
For given w1, w2, and y, the firms cost-minimization problem is to

The levels x1*(w1,w2,y) and x2*(w1,w2,y) in the least-costly input

bundle are the firms conditional demands for inputs 1 and 2
The (smallest possible) total cost for production y output units is

Given w1, w2 and y, how is the least costly input bundle located?
And how is the total cost function computed?
A curve that contains all of the input bundles that cost the same
amount is an isocost curve
The equation of the $C isocost line is
C = w1x1 + w2x2
It can also be rearranged to give

Slope is w1/w2
Of all input bundles yielding y units of output. Which one is the

At an interior cost-min input bundle:

Tangency condition:

The technical rate of substitution must equal the factor price ratio
The choices of inputs that yield minimal costs for the firm,
x1*(w1,w2,y) and x2*(w1,w2,y), are the conditional factor demand
functions or derived factor demands
Recall that we can use several analytical techniques to solve this kind
of problem
1. Write down the optimality conditions and solve the system
2. Substitute the constraint into the objective function to yield an
unconstrained problem
3. Use Lagranges method
Short-Run & Long-Run Total Costs
In the long-run a firm can vary all of its input levels
The long-run cost-minimization problem is

Consider a firm that cant change its input 2 level from x2-bar units
The short-run cost-minimization problem is

How does the short-run total cost of producing y output units compare
to the long-run total cost of producing y units of output?
- In general the short-run total cost exceeds the long-run total cost
of producing y output units
The short-run cost-min problem is the long-run problem subject to the
extra constraint that x2=x2-bar
- If long-run choice for x2 was x2-bar then the long-run and shortrun total costs of production y output units are the same
- If long-run choice for x2 != x2-bar then the extra constraint
x2=x2-bar prevents the firm in the short-run from achieving its
long-run production cost

Lec 5-6-7
General Equilibrium of Exchange Economy
Consider an island with 2 consumers A and B, 2 goods 1 and 2
Their endowments of goods 1 and 2 are wA= (w1A, w2A) and
wB=(w1B, w2B)

Then that means on the whole island, there are

6+2=8 units of good 1
4+2=6 units of good 2
Consider first each persons well-being in the absence of any market
Each person must simply consume his endowment
What is wrong with this allocation of island resources?
Edgeworth Box
Are there feasible allocations that make both individuals better off than
simply consuming what they are endowed with?
How do we picture all of the feasible allocations?
Edgeworth and Bowley devised a diagram, called an Edgeworth box, to
show all possible allocations of the available quantities of goods 1 and
2 between two consumers
What allocations of the 8 units of good 1 and the 6 of good 2 are
Starting an Edgeworth Box

How can all of the feasible allocations be depicted by the Edgeworth

box diagram?
Endowment allocation

One feasible allocation is the before-trade allocation, the endowment

Other feasible allocation

All points in the box, including the box boundary, represent feasible
allocation of the combined endowments
Which allocations will be blocked by one or both consumers?
Which allocations make both consumers better off?
Adding preferences to the box


What is the region of the box where A and B are both made better off?
Presumable, A and B will trade to some point in this region
Pareto Efficient Allocations
An allocation of the endowment that improves the welfare of a
consumer without reduction the welfare of another is a Paretoimproving allocation
Trade improves both As and Bs welfare; this is a Pareto-improvement
over the endowment allocation
Where are the Pareto-improving allocations?

Since each consumer can refuse to trade, the only possible

outcomes from exchange are Pareto-improving allocations

But which particular Pareto-improving allocation will be the outcome of


Pareto Optimality
New mutual gains-to-trade region is the set of all further Paretoimproving reallocations
An allocation is Pareto-optimal(or Pareto efficient) when the only was
one consumers welfare can be increased is to decrease the welfare of
the other consumer
The allocation is Pareto-optimal since the only way one consumers
welfare can be increased is to decrease the welfare of the other
At any Pareto efficient allocation, the indifference curves of the 2
agents must be tangent in the interior of the box
Why is that the case?
Further trade from point M cant improve both A and Bs welfares

An allocation where convex indifference curves are only just back-toback is Pareto-optimal

Where are all of the Pareto-optimal allocations of the endowment?

All the allocations marked by a dot are Pareto-optimal

The contract curve is the set of all Pareto-optimal allocations

In a typical case, the contract curve will stretch from As origin (OA) to
Bs origin (Ob
But to which of the many allocations on the contract curve will
consumers trade?
That depends upon how trade is conducted
In perfectly competitive markets? By one-on-one bargaining?
The core is the set of Pareto-optimal allocations that are welfareimproving for both consumers relative to their own endowments
Rational trade should achieve a core allocation
But which core allocation?
- Again , that depends upon the manner in which trade is
Core allocations

Trade in Competitive Markets

Each consumer is a price-taker trying to maximize her own utility given
p1, p2 and her own endowment
For consumer A, that is

And similarly for consumer B

The gross demand of agent A for goods 1 is the total amount of the
good that he wants at the going prices
The net demand of agent A for good 1 is the difference between his
total demand and the initial endowment of good 1 that agent A holds
So given p1 and ps

A general equilibrium occurs when prices p1 and p2 cause both the

markets for commodities 1 and 2 to clear

For any prices p1 and p2 there is no guarantee that an equilibrium will

always occur

At the given prices p1 and p2 there is an excess supply of commodity 1

and an excess demand for commodity 2
Neither market clears so the prices p1 and p2 do not cause a general
Since there is an excess demand for commodity 2, p2 will rise
Since there is an excess supply of commodity 1, p1 will fall
The slope of the budget constraints is p1/p2 so the budget constraints
will pivot about he endowment point and become less steep
Which Pareto Optimal allocations can be achieved by competitive
Walrasian equilibrium

At the new prices p1 and p2 both markets clear, there is a general

Trading in competitive markets achieves a particular Pareto-optimal
allocation of the endowments
We can describe the equilibrium as a set of prices (p1,p2) such that

This is equivalent to

Lets denote the net demand functions or excess demand for good 1 by
consumer A and B as follows

Summing together the above excess demand functions gives the

aggregate excess demand for good 1

We can derive the aggregate excess demand for good 2 in a similar

way and describe an equilibrium (p1,p2), by saying that aggregate
demand for each good is zero

Walras Law
Walras Law states that

Walras Law is an identity

Every consumers preferences are well-behaved so, for any positive
prices (p1,p2), each consumer spends all of his budget

Summing the above equations and some manipulation gives:

This is Walras Law- it says that the summed market value of excess
demands is zero for any positive prices p1 and p2
Implications of Walras Law
One implication of Walras Law for a 2 commodity exchange economy
is that is one market is in equilibrium then the other market must also
be in equilibrium

A second implication of Walras Law for a 2 commodity ex-change

economy is than an excess supply in one market implies an excess
demand in the other market

Equilibrium and Efficiency

All competitive market equilibria are Pareto efficient: a result known as
the first fundamental thm of Welfare Economics
First Fundamental Theorem of Welfare Economics
Given that consumers preferences are well-behaved, trading in
perfectly competitive markets implements a Pareto-optimal allocation
of the economys endowment
An easy proof can be based on the previous graph of the equilibrium in
the Edgeworth box

Second Fundamental Theorem of Welfare Economics

If all agents have convex preferences, any Pareto-optimal allocation
can be achieved by trading in competitive markets provided that
endowments are first appropriately rearranged amongst the consumers
This theorm is illustrated in the following graph:

Implication of the two Welfare Theorems

The First Welfare thm shows that the particular structure of competitive
market has the desiriable property of achieveing a Pareto efficient
- competitive markets economize on the info needed for efficient
resource allocation
The Second Welfare thm implie that the problems of efficiency and
distribution can be separated
- Prices should be used to reflect scarcity and income transfers should
be used to adjust for distributional goals