Utility. Marginal Rate of Substitution The MRS is the slope of the indifference curve at a point...
-
date post
21-Dec-2015 -
Category
Documents
-
view
221 -
download
3
Transcript of Utility. Marginal Rate of Substitution The MRS is the slope of the indifference curve at a point...
Utility
Marginal Rate of Substitution
The MRS is the slope of the indifference curve at a point
MRS=derivative of indifference curve
2x
1x
),( 21 xx
1x
2x
Interpretation of MRS
The MRS measures the rate at which the consumer is willing (i.e., indifferent) to substitute one good for the other.
If good 2 is measured in dollars, the MRS measures the consumer’s willingness to pay for an extra unit of good 1.
Assumptions on Preferences and the MRS
Monotonicity: MRS negative
(Strict) Convexity: MRS decreases as
increases
2x
1x1x
2x1x
Utility Function
Idea: assign a number to each consumption bundle, with higher numbers assigned to more-preferred bundles.
A utility function represents a preference relation :
),(),(),(),( 21212121 yyuxxuyyxx
),( 21 xxu
Utility Function: Does It Always Exist?
Q: Given a preference relation can we find a utility function that represents it?
A: If preferences are complete and transitive (plus a technical assumption called “continuity” is verified) we can. [Sufficient condition]
Is Transitivity Necessary?
Q: Is it necessary that preferences are transitive for the existence of a utility function that represents them?
A: Yes. Otherwise:
)1,1()1,4.0()5.0,1()1,1(
)1,1()1,4.0()5.0,1()1,1( uuuu
Utility is Just Ordinal
E.g.: (1,1) (1,0.5) (0.4,1) (0.8,0.8)
Can be represented in different ways:
Bundle
(1,1) 3 6 -1
(1,0.5) 2 4 -2
(0.4,1) 1 2 -3
(0.8,0.8) 1 2 -3
),( 21 xxu ),(2 21 xxu 4),( 21 xxu
~
In General
If :
1) represents
2) is a positive monotonic transformation
Then, also represents
),( 21 xxu )(uf
)),(( 21 xxuf
)]()([ 2121 ufufuu
Utility Functions and Indifference Curves
2x
1x
Utility function:
Indifference curves:
or:
2121 ),( xxxxu
uxx 21
12x
ux 2
3
5.12x
1x
Indifference Curves and Monotonic Transformations
2x
1x
Utility function:
Indifference curves:
or:
22
2121 ),( xxxxv
12
x
vx 4
925.1
2x
1x
vxx 22
21
2y
1y
Perfect Substitutes
2x
1x
Utility function:
Indifference curves:
2121 ),( bxaxxxu
12 xb
a
b
ux
Perfect Complements
2x
1x
Utility function:
),min(),( 2121 bxaxxxu
12 xb
ax
Cobb-Douglas Preferences
2x
1x
Utility function:
Indifference curves:
dc xxxxu 2121 ),(
d
c
d
x
ux
1
1
2
Cobb-Douglas
Most commonly used utility function in economics
Possible to assume without loss of generality that
Why?: apply to get
1 dc
dcuuf 1
)(
dc
d
dc
c
xxxxv 2121 ),(
Marginal Utility
Consider a consumer that is consuming
Q: By how much does his utility change as we increase by a very small amount his consumption of good 1?
A: Marginal utility of good 1:
),( 21 xx
1
2,1 )(
x
xxu
Marginal Utility and Units
The marginal utilities of good 1 and good 2 depend on the specific utility function we are using.
Consider:
Then:
))((),( 2,121 xxufxxv
1
2,12,1
1
2,1 )())(()(
x
xxu
u
xxuf
x
xxv
Marginal Utility and MRS
MRS only depends on preferences and not on their specific representation (utility function).
Marginal utilities can be used to compute the MRS between two goods.
Computing the MRS
Consider an indifference curve:
Q: What is the slope of this indifference curve (MRS)?
A:
uxxu ),( 21
2
2,1
1
2,1
1
22,1
)(
)(
)(
xxxu
xxxu
x
xxxMRS
The MRS and Monotonic Transformation
Consider a monotonic transformation
Q: What is the MRS in this case?
A:
)(2),( 2,121 xxuxxv
2
2,1
1
2,1
2
2,1
1
2,1
2,1)(
)(
)(2
)(2
)(
xxxu
xxxu
xxxu
xxxu
xxMRS