Lecture 1: Review of Consumer Theory

Econ 51 - Stanford University

January 10, 2017

1 Introduction and Notation

These lecture notes are meant to summarize the most relevant parts of consumer theory for our analysis of
general equilibrium in Econ 51. Theres more here than well go over in the first day of class; please review
these notes carefully and be sure youre solid on this material. The first few weeks of 51 will move fast!
The most important pieces of Econ 50, from an Econ 51 perspective, are:

Budget Constraint (Varian, Chapter 2): understanding the price ratio as an exchange rate; expressing
budget constraints in terms of a numeraire
Preferences (Ch. 3): Assumptions about preferences, preferred and dispreferred sets, indierence
curves, marginal rate of substitution

Utility (Ch. 4): Utility functions, especially Cobb-Douglas and quasilinear

Choice (Ch. 5): aordable and preferred sets; comparing MRS and the price ratio; optimization;
interior and corner solutions
Buying and Selling (Ch. 9): endowment budget constraint; gross and net demands; oer curves

If you took Econ 50 with me in the Fall, then youll be used to the notation from Varian. If you didnt,
the main dierence between Varians notation and others is that instead of using goods X and Y , he uses
goods 1 and 2; he also uses m to describe money income, rather than I. Thus instead of the budget line

px x + py y = I

well use the budget constraint

p 1 x 1 + p2 x 2 = m
Note that this is much better, in fact, than the X Y notation, because it allows for extension to any number
of goods. It also allows us to refer to points by their letters: for example, we might have point X = (x1 , x2 )
and point C = (c1 , c2 ).
In particular, rather than list an endowment of goods as (xE , y E ), well list it as (1 , 2 ). Varian and
most other economists use the Greek letter omega () to represent endowments because its kind of like a
w for wealth, but the variable w is generally used for wages, so it was taken.

1
2 Budget Constraint
2.1 General budget constraint for n goods
The budget constraint partitions the available choice space into aordable and unaordable choices. The
standard budget constraint for n goods may be written as

p 1 x 1 + p2 x 2 + + pn x n m

where pi is the price of good i, and xi is the quantity of good i. More generally, using vector notation, we
can write this constraint as a dot product:
pxm
where p = [p1 , p2 , ...pn ] is a vector of the prices of n goods, and x = [x1 , x2 , ..., xn ] is a vector of quantities
of n goods.
Note that each of the terms in this constraint is measured in dollars: for each good i, the term pi xi
represents the expenditure on good i:
dollars
! "# $
pi x i
#$!" #$!"
dollars units of i
units of i

2.2 The budget line for two goods

Visually, its useful to constrain ourselves to two goods, since thats easy to plot. In Good 1 - Good 2 space,
the budget line p1 x1 + p2 x2 = m partitions Good 1 - Good 2 space into the set of aordable bundles
(beneath the budget line) and the set of unaordable bundles (above the budget line). All bundles along
the budget line cost the same amount, and exhaust the available income m. For example, in the two-good
case with p1 = 18, p2 = 6, and m = 54, the budget line would be

18x1 + 6x2 = 54

which we can plot in Good 1 - Good 2 space as follows:

x2
9
8
7 px>m
6
5
4
px=m
3
2
1
px<m
0
x1
0 1 2 3 4 5 6 7 8 9

2
2.3 Good 2 as a numeraire
If we solve for x2 as a function of x1 , we get the equation for the budget line:
m p1
x2 = x1
p2 p2
This is a line with a vertical intercept of m/p2 units of good 2, which we can think of as the income
measured in units of good 2 in other words, if you were to convert all your money income into good 2,
its how much good 2 you would have.
Note that both sides of this equation are in units of good 2:
units of 2 units of 2
!
"# $ !
"#
$
dollars
dollars units of 1
!"#$ !"#$
m p1
x2 =
p2 p2
x1

#$!" #$!" #$!"
units of 1
dollars dollars
units of 2 units of 2
# $! "
units of 2
units of 1

In this case we call good 2 the numeraire good.

Furthermore, notice that the slope of the budget line that is, p1 /p2 is measured in units of good
2 per units of good 1. In fact, as well recall, every slope in a graph has units that are the y-axis units
divided by the x-axis units. But in this case the slope explicitly reflects an exchange rate: how many units
of good 2 are being exchanged for a unit of good 1.
We will often call p1 /p2 the price ratio or the relative price of good 1; well also call the ratio p2 /p1
the relative price of good 2. This notion of a relative price is crucially important in Econ 51, because were
interested not in the money value of bundles, but rather the exchange value of bundles. Generally speaking,
well be talking about relative prices much more than absolute prices.

2.4 Good 2 as a composite good

For the times when we are interested in talking about a dollar value, well often adopt the convention of
treating good 2 as a composite good such as money or money spent on other goods. In this case
units of good 2 are dollars, so the price ratio p1 /p2 is measured in dollars per units of good 1. In this case
well write the budget line as
px1 + x2 = m
where p is the price of good 1, and the price of good 2 is fixed at 1 so we just ignore it.
One final note: while we often looked at kinked budget lines in Econ 50, we wont be as concerned
with that in 51.

3
3 Preferences
3.1 Preference Notation
Given an agent choosing between A and B:

A B means the agent strictly prefers A to B

A B means the agent weakly prefers A to B
A B means the agent is indierent between A and B

3.2 Properties of Preference Relations over Bundles

Let A = (a1 , a2 , ...an ) and B = (b1 , b2 , ..., bn ) be two dierent bundles of n goods each.
1. Monotonicity (more is better): if ai bi for every good i {1, 2, ..., n}, then A B.

2. Convexity (variety is better): if A B, and C is a convex combination of A and B, then C A

(and C B).
(Recall: Bundle C = (c1 , c2 , ..., cn ) is convex combination of A and B if it lies along a line connecting
those two bundles; mathematically, for some weight (0, 1), ci = ai + (1 )bi for each good i.)
Together, monotonicity and convexity give indierence curves over two goods a bowed-in shape, with
a decreasing marginal rate of substitution.

3.3 Indierence Curves

As long as preferences are complete, every bundle can be ranked relative to every other bundle. That means
that no matter what bundle X were considering, we can divide all other bundles into three categories:
1. bundles an agent prefers to X;
2. bundles an agent prefers X to; and
3. bundles an agent values the same amount as X

As long as were comparing continuous quantities, the set of points making up the third category form an
indierence curve that partitions the other two categories. If preferences are monotonic and both goods
are good (i.e., not something bad like risk or hours worked), then indierence curves are downward
sloping and the preferred region is above and to the right of the indierence curve.

3.4 Marginal Rate of Substitution

Since an indierence curve shows the set of goods between which a consumer is indierent, the slope of the
indierence curve shows the amount of good 2 she would be willing to give up in order to get another unit of
good 1. In other words, it represents the rate at which the agent is willing to trade good 2 for good 1. Just
like the slope of the budget line, it is measured in units of good 2 per units of good 1. Note that when one
good is a composite good (i.e. dollars spent on other things), the marginal rate of substitution of good i
with respect to that good may be thought of as the marginal utility of good i, as measured in dollars; or
equivalently, the marginal willingness to pay for good i.

4
4 Utility Functions
4.1 Utility and preferences
For the purposes of this course, well assume that agents preferences may be represented by utility functions
that assign a numerical value to every possible consumption bundle. Thus we can rewrite our definition of
preferences to say that if an agent faces choices A and B, and a utility function u() assigning a utility
number to A and B:
A B if and only if u(A) > u(B).
A B if and only if u(A) u(B).
A B if and only if u(A) = u(B).
The actual units of u(x) we can call them utils are irrelevant, as well see when we get to the
discussion of the MRS below.

4.2 Indierence curves

If we have a utility function, then the indierence curve becomes a level set of that utility function: that
is, the indierence curve passing through point A is the set of all bundles that yield the same utility: that
is, {X|u(X) = u(A)}. For example, if
2/3 1/3
u(x1 , x2 ) = x1 x2
then the indierence curve passing through the point (2,3) has the equation
u(x1 , x2 ) = u(2, 3)
2/3 1/3
x1 x2 = 22/3 31/3
x21 x2 = 22 3
12
x2 = 2
x1
We can plot this equation in Good 1Good 2 space to see the indierence curve passing through A, which
divides the choice space into the bundles preferred to A ( A) and the bundles dispreferred to A ( A):

x2
9
8
7
6
5 A
4
3 A

2
1 A
0
x1
0 1 2 3 4 5 6 7 8 9

5
4.3 Marginal Rate of Substitution
We said before that the marginal rate of substitution is the slope of the indierence curve. Since we found
that the equation of the indierence curve was x2 = 12x21 , we could just take the derivative and find that
the slope is 24x3
1 , which in this case would be 3.

x2
9
8
7
6
5
4
3 A
slope = 3
2
1
0
x1
0 1 2 3 4 5 6 7 8 9

However, theres a more elegant (and economically relevant) way to calculate the MRS: the implicit
function tells us that the slope of a level curve is the ratio of the partial derivatives: in particular, we can
express the marginal rate of substitution as
u/x1
M RS1,2 =
u/x2
As a shorthand, well often write u/x1 as M U1 and u/x1 as M U2 . And we can see that in this
case, we arrive at the same answer:
2 1/3 1/3
M U1 3 x1 x2 2x2
M RS1,2 = = =
M U2 1 2/3 2/3 x1
3 x1 x2

When x1 = 2 and x2 = 3, this is equal to 3.

Note that this expression of MRS finds the magnitude of the marginal rate of substitution, which is what
were interested in comparing to the textitmagnitude of the price ratio, p1 /p2 . Varian, in his textbook,
treats the MRS as a negative number; but we will treat the MRS as a positive number.
Also note the units of this expression. Weve said before that every slope in Good 1 - Good 2 space
is measured in units of good 2 per units of good 1. But here we have utility measured in some unknown
units lets call them utils. What happens to those? Well, if we write the units of the numerator and
denominator of the MRS equation, we can see:
utils
M U1 units of good 1
M RS1,2 =
M U2 units utils
of good 2

So the utils in the numerator and denominator cancel, leaving us just in units of good 1 per units of good 2.
This canceling means that we can scale (though a positive monotonic transformation) our utility
function, and not aect the MRS. Importantly, note that were only interested in utility functions for their

6
ability to describe preferences; and since any two utility functions that have the same equation for the MRS
at every point must have the same indierence curves, and must therefore represent the same preferences,
this means that any monotonic transformation of a utility function (i.e., one that preserves the same ordering
as the original) must represent the same preferences.
For example, multiplying our example utility function by a constant doesnt aect its MRS:
2 1/3 1/3
2/3 1/3 3 x1 x2 2x2
u(x1 , x2 ) = x1 x2 M RS1,2 = 2/3 2/3
=
1 x1
3 x1 x2

Similarly, raising the utility function to the power of doesnt aect its MRS:
2/3 1/3 1/3 1/3
2/3 1/3 [x1 x2 ]1 23 x1 x2 2x2
[u(x1 , x2 )] = [x1 x2 ] M RS1,2 = =
2/3 1/3 1 2/3 2/3 x1
[x1 x2 ]1 3 x1 x2

Finally, taking the natural log of the utility function doesnt aect its MRS:
2 1
2 1 3 x1 2x2
ln[u(x1 , x2 )] = ln x1 + ln x2 M RS1,2 = 1 1 =
3 3 3 x2
x1

All three of these utility functions represent the same set of preferences, and can therefore be used interchangeably.
This isnt a magic trick! If h(x1 , x2 ) = g(f (x1 , x2 ), then by the chain rule

h dg f
=
xi df xi
and therefore
h dg f f
x1 df x1 x1
h
= dg f
= f
x2 df x2 x2

since the dg/df term cancels from the top and bottom. If you look at the examples above, you can see that
each time something cancels, its something to do with a scaling function.

4.4 Specific utility functions

Generally speaking, well be interested in two specific utility functions in this course: Cobb-Douglas and
quasilinear. The first is useful for looking at a range of goods; the second is useful for looking at one or more
goods and a composite good (i.e., money spent on other things).

4.4.1 Cobb-Douglas
The example above was Cobb-Douglas; it may have the form

u(x1 , x2 ) = xa1 xb2

or equivalently, if we take the natural log (which we saw earlier we could do),

u(x1 , x2 ) = a ln x1 + b ln x2

More generally, for n goods, we can think of the Cobb-Douglas utility function as being of the form
n
+
u(x1 , x2 , ..., xn ) = ai ln xi
i=1

7
Note that the marginal utility of good i is given by

u(x1 , x2 , ..., xn ) ai
M Ui = =
xi xi
so the marginal rate of substitution between goods i and j is given by
M Ui ai xj
M RSij = =
M Uj aj xi
,
Finally, note that we will often assume that ai = 1; in the case of two goods, this means we may write

u(x1 , x2 ) = ln x1 + (1 ) ln x2

for 0 1, where becomes shorthand for how much the consumer likes good 1, relative to good 2.

4.4.2 Quasilinear
Quasilinear utility is a general term for any utility function of the form

u(x1 , x2 ) = v(x1 ) + x2

where v(x1 ) is its own utility function; monotonicity implies that v (x) > 0, and convexity implies that
v (x) < 0.
Generally quasilinear utility functions are used in conjunction with an assumption that good 2 is a
composite good. Indeed, we can think of a utility function of many goods plus a composite as

u(x1 , x2 , ..., xn ) = v(x1 , x2 , ..., xn1 ) + xn = m

The critical feature of a quasilinear utility function is that the marginal rate of substitution does not depend
on the quantity of the good that enters the function linearly (i.e., the composite good). Therefore the
marginal rate of substitution of good i with respect to the composite good n does not depend on your level
of good n at all:
M Ui M Ui
M RSin = = = M Ui
M Un 1
Note that while the magnitude of the M RS and the magnitude of M U1 are the same, their units are not
the same! If were precise about the units in the previous equation, we have
M Ui utils per unit of good i
M RSin =
M Un utils per unit of good n
Since unit of good n is dollars, and since M Un = 1, this becomes
M Ui utils per units of good i
= M Ui dollars per unit of good i
1 util per dollar

8
5 Optimization Subject to a Budget Line
5.1 Preferred and Aordable Sets
Lets think of a general definition of optimality: a choice is optimal if there is no other aordable choice that
is also preferred.
We saw before that a budget line partitions the choice space into aordable bundles and unaordable
bundles; and that an indierence curve partitions the choice space into preferred and dispreferred sets. So
making an optimal choice means choosing a point X where there is no other point that both (a) costs no
more than X and (b) is preferred to X .
In the diagram below, we overlay the budget set for 18x1 + 6x2 54 (denoted B) and the preferred set
2/3 1/3
to (2,3) when u(x1 , x2 ) = x1 x2 that we derived before (denoted A). There is no overlap between these
two sets; so this would be the optimal choice for someone with that utility function facing those prices.

x2
9
8
7
6
5 A
4
3 A
2
1 B
0
x1
0 1 2 3 4 5 6 7 8 9

Suppose this same person were to face a dierent budget set: for example, if p1 = p2 = 10 and m = 50.
In this case there would be an overlap between the budget set and the preferred set, so A would not be an
optimal choice:

x2
9
8
7
6
5 A
4
3 A
2
1 B
0
x1
0 1 2 3 4 5 6 7 8 9

9
5.2 Comparing MRS and the price ratio
As long as utility functions are smooth that is, as long as the MRS changes continuously as you move along
an indierence curve then there is an easy test to see if a point along a budget line is optimal: compare the
consumers MRS at that point to the price ratio. If the two are equal, then the indierence curve is tangent
to the budget line, and as long as the consumers preferences are convex, that is an optimal consumption
bundle. (If the preferences are strictly convex, it is also the unique optimal consumption bundle.)
We found before that the MRS at point A was 3 units of good 2 per unit of good 1; so in the first graph,
when p1 = 18 and p2 = 6, the price ratio is also 3, and therefore the indierence curve is tangent to the
budget line. In the second graph, when p1 = p2 = 10, the price ratio is 1, so the MRS is greater than the
price ratio, and the indierence curve is steeper than the budget line; this means that there is an area thats
both aordable and preferred to the right of point A.
As a general rule, if a consumers MRS is greater than the price ratio at a point along the budget line,
then they like good 1, relative to good 2, more than the market does (as reflected in the market prices),
so they want to move down and to the right along their budget line. Conversely, if a consumers MRS is less
than the price ratio, then they like good 1, relative to good 2, less than the market does, so they want to
move up and to the left along their budget line.
There is one caveat to this rule: it may not be possible for the consumer to move further along the budget
line, because the budget line may end. For example, consider the quasilinear utility function

u(x1 , x2 ) = 4 x1 + x2

The MRS of this utility function is

M U1 2
M RS1,2 = =
M U2 x1
Therefore, regardless of x2 , at x1 = 4, the M RS = 1; and at x1 = 9, the M RS = 23 . If we think about
moving along a budget line x1 + 2x2 = 9, we can see that the consumer always wants to move to the right
along this budget line:

x2 x2
9 9
8 A 8 A
7 7
6 6
5 5
4 4
3 A 3
2 2
1 B 1 B
0 0 A
x1 x
0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 1

We can see that at A in the right-hand diagram, the MRS is still greater than the price ratio: that is,
the absolute value of the slope of the indierence curve (M RS = 23 ) is greater than the absolute value of the
slope of the price line (p1 /p2 = 12 ).

10

Indeed, if we were to draw the budget set x1 + 2x2 9 and the preferred set 4 x1 + x2 12 without
regard to staying in positive territory, we would see that there is an overlap:

x2
9

6
A
3
B
A
x1
0 3 6 9 12 15 18
3

Because the overlap doesnt actually exist for positive quantities, though, the point (9,0) is the only point
in the budget set B for which there is no overlap between the preferred set and the budget set.
This type of optimal solution is called a corner solution because it exists in the corner of the budget
set.

5.3 Solving for the optimal bundle

A consumer optimizes by choosing the bundle from the budget set B which yields the highest utility:

max u(x)
xB

By the monotonicity assumption on preferences, the most preferred choice in the budget set must be on the
budget line; otherwise there would be an overlap between the budget set and the set of bundles preferred
to the selected bundle. Therefore we can write the constrained optimization problem subject to an equality
constraint:

max u(x)
x
s.t. p x = m

We saw before that there are two possibilities for optimal bundles, as long as indierence curves are
smooth and convex: (a) it occurs at a point of tangency, or (b) there is a corner solution. The procedure
for finding the optimum starts out the same way: find the point of tangency. With just two goods, we
can do this by solving a system of two equations with two unknowns: the first equation is the tangency
condition M RS12 = p1 /p2 ; the second is the budget line condition p1 x1 + p2 x2 = m. The solution to this
set of equations is called the Lagrange solution because its what we get if we use the Lagrange multiplier
method.
The next step is to see whether this point of tangency occurs in the first quadrant or not. If the indierence
curves never cross the axes, as in the case of the Cobb-Douglas utility function, then this isnt a problem.
However, if the indierence curves do cross the axes, as in the case of the quasilinear utility function, then
this can be a problem, as we saw above; in this case, the solution is the closest point along the budget
constraint to the optimal point.

11
Lets solve the two concrete examples that weve talked about so far:

Example 1: Cobb-Douglas

2/3 1/3
max u(x1 , x2 ) = x1 x2
x1 ,x2

s.t. 18x1 + 6x2 = 54

The MRS of this utility function, as we found above, is

2x2
M RS12 =
x1
The price ratio is

p1 18
= =3
p2 6
The tangency condition sets these two equal to one another:

2x2
=3
x1
or, expressing x2 in terms of x1 ,

3
x2 = x1
2
We then plug this into the budget constraint and solve for x1 :

18x1 + 6x2 = 54
- .
3
18x1 + 6 x1 = 54
2
27x1 = 54
x1 = 2

and therefore x2 = 32 x1 = 3; so weve found the optimal point A that we expected to!
Example 2: Quasilinear

max u(x1 , x2 ) = 4 x1 + x2
x1 ,x2

s.t. x1 + 2x2 = 9

The MRS of this utility function, as we found above, is

2
M RS12 =
x1

The price ratio is

12
 p1 1
=
p2 2
The tangency condition sets these two equal to one another:

2 1
=
x1 2

4 = x1
x1 = 16

So the tangency condition occurs at a constant value of x1 ...to find x2 , we intersect that with the
budget constraint:

x1 + 2x2 = 9
16 + 2x2 = 9
2x2 = 7
x2 = 3.5

Uh-oh. This isnt good. The Lagrange method is finding a solution with a negative x2 :

x2

3.5
B

x1
0 4 8 12 16 20 24 28
3.5
Lagrange solution
x1 + 2x2 = 9
7.0

So in this case, the solution is to go to the closest corner i.e., the point (9,0).

13
5.4 General solutions for Cobb-Douglas and quasilinear
So far weve looked at two specific solutions for Cobb-Douglas and quasilinear utility functions. But for Econ
51, it will be useful to use some shortcuts.

General Cobb-Douglas with One Parameter

1
Consider the utility function u(x1 , x2 ) = x
1 x2 , or equivalently u(x1 , x2 ) = ln x1 + (1 ) ln x2 ,
with 0 1. We found before that the MRS of this utility function would be
- .
x2
M RS12 =
1 x1

If we set this equal to the price ratio p1 /p2 , we get the tangency condition:
- .
1
x2 = x1

This gives us a relationship between x1 and x2 that must hold at any tangency condition. If we plug
this into the generic budget constraint p1 x2 + p2 x2 = m, we find our optimal solutions are
m
x1 =
p1
(1 )m
x2 =
p2

We can interpret this as the consumer spending fraction of their income (i.e., m) on good 1, and
the remainder on good 2. Theres a nice visual interpretation of this as well: the optimal point lies
fraction of the way from the y-intercept of the budget line to the x-intercept of the budget line,
which means that x lies fraction between 0 and m/p1 , and x2 lies fraction (1 ) between 0 and
m/p2 .

x2
m
p2

1
x2 = x1

(1)m
p2

m m
p1 p1 x1

14
 General Quasilinear
Consider the utility function u(x1 , x2 ) = a ln x1 + x2
We found before that the MRS of this utility function would be
a
M RS12 =
x1

Setting this equal to the price ratio p1 /p2 gives us our optimal x1 :
- .
p2
x1 = a
p1

Plugging this into our budget constraint p1 x1 + p2 x2 = m, we find the x2 where that value of x1 lies
along the budget constraint: / - .0
m p1 p2 m
x2 = a = a
p2 p2 p1 p2
As we saw before, this has the possibility of being negative; and if it is, we need to consume at the
point (m/p1 , 0). Specifically, we arrive at the corner solution when

m
x2 = a0
p2
m ap2

(Note that we could just as easily have found this by finding the income for which x1 = m/p1 .)
Summarizing this general demand function, we have

1 2 3
a pp21 if m ap2
x1 =
m
p1 if m ap2
1
m
a if m ap2
x2 = p2
0 if m ap2

Note that there are other forms of quasilinear functions, but this is particualrly simple and easy to
deal with.

15
6 Endowment Budget Line
6.1 Starting from an Endowment
The preceding sections should hopefully be old hat to you, as they formed the core of what we did with
consumer theory in Econ 50. What may be a little foggy in your memory is the notion of starting with an
endowment, rather than a money income. This is crucially important for Econ 51.
The core material is covered well in the Varian chapter Buying and Selling, but its worth going through
some numerical examples. In fact, well go through two examples simultaneously!
Lets think about two dierent people, (Alison and Bob) and two goods, good 1 (oreos) and good 2
1 2 1 2
(twizzlers). Alison has an endowment (A , A ) = (120, 20); Bob has an endowment (B , B ) = (80, 80).
(Next lecture were going to combine these two into a single diagram called the Edgeworth Box, but for
now lets consider them individually.)
Lets suppose Alison and Bob each have preferences over oreos and twizzlers given by the simple Cobb-Douglas
utility function u(x1 , x2 ) = x1 x2 , We can therefore see each persons endowment W , the indierence curve
passing through W , and a line showing their M RS at that point.

xA
2 xB
2
Alisons Twizzlers

Bobs Twizzlers

W
80

M RSA = 1 M RSB = 1
6 W
20

xA
1 xB
1
120 80
Alisons Oreos Bobs Oreos

16
6.2 The endowment budget line
Now lets think about what Alison and Bob would do if they could buy and sell oreos at a price of p1 , and
twizzlers at a price of p2 . In this case, the money value of Alisons endowment is mA = p1 1A + p2 2A = 120p1 + 20p2 ,
and the money value of Bobs endowment is mB = p1 1B + p2 2B = 80p1 + 80p2 . In this case Alisons budget
constraint would be

p1 x A A
1 + p2 x2 = 120p1 + 20p2

and Bobs would be

p1 x B B
1 + p2 x2 = 80p1 + 80p2

So, for example, if p1 = 2 and p2 = 1, then Alisons wealth would be 2 120 + 20 = 260 and Bobs wealth
would be 2 80 + 80 = 240, so their budget lines would look like this:

xA
2 xB
2

2x1 + x2 = 260
Alisons Twizzlers

Bobs Twizzlers

W
80

W 2x1 + x2 = 240
20

xA
1 xB
1
120 130 80 120
Alisons Oreos Bobs Oreos

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6.3 Optimal choice
Given this wealth and the simple Cobb-Douglas utility function, we have the equations for each of their
optimal quantities (or gross demands) of x1 and x2 :

mA 120p1 + 20p2 p2
xA
1 = = = 60 + 10
2p1 2p1 p1
mA 120p1 + 20p2 p1
xA
2 = = = 60 + 10
2p2 2p2 p2
mB 80p1 + 80p2 p2
xB
1 = = = 40 + 40
2p1 2p1 p1
mB 80p1 + 80p2 p1
xB
2 = = = 40 + 40
2p2 2p2 p2
What would the optimal point be for the example above? Well, when p1 /p2 = 2, we can see that Alison
will demand 65 oreos and 130 twizzlers, and Bob will demand 60 oreos and 120 twizzlers:

xA
2 xB
2
X
130
X
120
Alisons Twizzlers

Bobs Twizzlers

W
80

W
20

xA
1 xB
1
65 120 60 80
Alisons Oreos Bobs Oreos

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6.4 Deriving the oer curve
Notice that all of these depend solely on the price ratio p1 /p2 , which is measured in terms of twizzlers per
oreo. Lets evaluate all four of these expressions at dierent values of p1 /p2 :

p1
p2 xA
1 xA
2 xB
1 xB
2
0.125 140 17.5 360 45
0.2 110 22 240 48
0.4 85 34 140 56
0.5 80 40 120 60
1 70 70 80 80
2 65 130 60 120
2.5 64 160 56 140

We can add these points to our diagram to see the oer curve:

xA
2 xB
2
Alisons Twizzlers

Bobs Twizzlers

W
80

W
20

xA
1 xB
1
120 80
Alisons Oreos Bobs Oreos

Note that its possible to calculate the formula for the oer curve directly: we can rearrange the budget
line p1 x1 + p2 x2 = p1 1 + p2 2 to read
p1 2 x2
=
p2 x1 1
Since M RS = p1 /p2 at any optimum, it follows that at every point along the oer curve,
2 x2
M RS =
x1 1
In this case M RS = x2 /x1 , so substituting that in and solving yields, after some algebra,
2 x1
x2 =
2x1 1

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6.5 Net Demands
Finally, lets calculate the net demand for each good, which is just the gross demand minus the original
endowment. For example, when p1 = p2 (so p1 /p2 = 1), we saw above that Alisons ideal bundle would be
(70, 70); since she starts at (120, 20) this means that her net demand for oreos is 50, and her net demand
for twizzlers is +50: in other words, if she can trade twizzlers for oreos at a rate of 1:1, she would trade 50
of her oreos for 50 more twizzlers.
Adding these to the table, we can see a pattern emerge:

p1
p2 xA1 xA A
1 1 xA
2 xA
2 2
A
xB1 xB
1 1
B
xB2 xB B
2 2
0.125 140 +20 17.5 -2.5 360 +280 45 35
0.2 110 10 22 +2 240 +160 48 32
0.4 85 35 34 +14 140 +60 56 24
0.5 80 40 40 +20 120 +40 60 20
1 70 50 70 +50 80 0 80 0
2 65 55 130 +110 60 20 120 +40
2.5 64 56 160 +140 56 24 140 +60

We can see that when either persons MRS at their endowment is greater than the price ratio, their net
demand for good 1 is positive and their net demand for good 2 is negative: that is, they value good 1 more
than the market does, and so want to trade some of their good 2 for more good 1. So, for example, we see
that Bobs MRS at his endowment is 1; so if p1 > p2 , he wants to sell good 1 and buy good 2, and if p1 < p2 ,
he wants to sell good 2 and buy good 1.

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