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Outline for Tuesday, July 15
� New documents
�Quiz study sheet
� Hw2, quiz1 answers
� Hw3� Hw3
� Recap Monday
� Indifference map examples
� The budget constraint
� The best affordable bundle
Indifference maps
� Indifference maps, like contour maps, show level sets – bundles that the consumer is indifferent between
� We know that
� Indifference sets are curves, not thick bands� Indifference sets are curves, not thick bands
� Indifference curves do not cross
� Indifference curves slope down
Marginal Rate of Substitution
� The MRS is the slope of the indifference curve. It tells us what tradeoff the consumer will accept
0∆X
∆Y<=MRS
� It typically decreases with higher X
∆X
Marginal Rate of Substitution
� Imperfect substitutes are have diminishing MRS
� Perfect substitutes have the same, finite, MRS at every point
� If Y is a neutral good, the MRS is infinite at all points� If Y is a neutral good, the MRS is infinite at all points
� Perfect complements have infinite MRS at low X and zero MRS at high X
Marginal Rate of Substitution
� Imperfect substitutes are have diminishing MRS
� Perfect substitutes have the same, finite, MRS at every point
� If Y is a neutral good, the MRS is infinite at all points� If Y is a neutral good, the MRS is infinite at all points
� Perfect complements have infinite MRS at low X and zero MRS at high X
� If Y is a bad, we can reinterpret it as a good
� If they won’t pay for it, they might pay not to have it
� Paying to get trash � paying to not get trash
Marginal utility
� “More is better”, but how much better?
� Look at the slope of the utility-Y graph for fixed X
∆Y
∆UMU
Y=∆Y
MUY
=
Marginal utility
� “More is better”, but how much better?
� Look at the slope of the utility-Y graph for fixed X
∆Y
∆UMU
Y=
� It tells us how much Y is worth on the margin
� It is usually decreasing in Y, except perhaps for
� Risk – probability of safety
� Threshold goods – the last episode of Lost
� The same holds for X
∆YMU
Y=
Marginal utility � MRS
� The MRS tells us what tradeoff’s between X and Y are acceptable
0∆X
∆YMRS <=
� The MUX and MUY tell us how much X and Y are worth at the margin
∆X
∆X
∆UMU
∆Y
∆UMU
XY==
Marginal utility � MRS
� The MRS tells us what tradeoff’s between X and Y are acceptable
0∆X
∆YMRS <=
� The MUX and MUY tell us how much X and Y are worth at the margin
� To combine them, use ∆U = 1 in the MU’s
∆X
∆X
∆UMU
∆Y
∆UMU
XY==
Marginal utility � MRS
� Take a bundle (X,Y) and suppose
� ∆Y gives one utile
� ∆X gives one utile
Marginal utility � MRS
� Take a bundle (X,Y) and suppose
� ∆Y gives one utile
� ∆X gives one utile
� Then� Then
�MUY = 1/∆Y
�MUX = 1/∆X
Marginal utility � MRS
� Take a bundle (X,Y) and suppose
� ∆Y gives one utile
� ∆X gives one utile
� Then� Then
�MUY = 1/∆Y
�MUX = 1/∆X
� And the consumer will accept the tradeoff
∆Y for ∆X
Marginal utility � MRS
� Take a bundle (X,Y) and suppose
� ∆Y gives one utile
� ∆X gives one utile
� Then� Then
�MUY = 1/∆Y
�MUX = 1/∆X
� And the consumer will accept the tradeoff
∆Y for ∆X
�Which is equivalent to
1/MUY for 1/MUX
Marginal utility � MRS
� The consumer will accept the trade-off
∆Y for ∆X
� Which is equivalent to
1/MUY for 1/MUX1/MUY for 1/MUX
� The marginal rate of substitution tells us which trade-offs will be accepted, so…
Marginal utility � MRS
� The consumer will accept the trade-off
∆Y for ∆X
� Which is equivalent to
1/MUY for 1/MUX1/MUY for 1/MUX
� The marginal rate of substitution tells us which trade-offs will be accepted, so…
Y
X
MU
MU
∆X
∆Y−==MRS
Outline for Tuesday, July 15
� New documents
�Quiz study sheet
� Hw2, quiz1 answers
� Hw3� Hw3
� Recap Monday
� Indifference map examples
� The budget constraint
� The best affordable bundle
Graphing utility
� What types of goods are X and Y if…
� U = XY
� U = X+Y
� U = X-Y� U = X-Y
Graphing utility
� What types of goods are X and Y if…
� U = XY imperfect substitutes
� U = X+Y perfect substitutes
� U = X-Y Y is a bad, X is a good� U = X-Y Y is a bad, X is a good
�U = X+(Y0-Y) Choose Y0 high enough
Graphing utility
� What types of goods are X and Y if…
� U = XY imperfect substitutes
� U = X+Y perfect substitutes
� U = X-Y Y is a bad, X is a good� U = X-Y Y is a bad, X is a good
�U = X+(Y0-Y) Choose Y0 high enough
� We can graph them by…
Graphing utility
� What types of goods are X and Y if…
� U = XY imperfect substitutes
� U = X+Y perfect substitutes
� U = X-Y Y is a bad, X is a good� U = X-Y Y is a bad, X is a good
�U = X+(Y0-Y) Choose Y0 high enough
� We can graph them by…
� Fixing U0
� Finding Y as a function of X
�Graphing for several U0
Finding MU and MRS
� What is the approximate MRS of the fourth unit?
X 1 2 3 4 5 6
Y 20 16 13 11 10 9
Finding MU and MRS
� What is the approximate MRS of the fourth unit?
� Take the average…
X 1 2 3 4 5 6
Y 20 16 13 11 10 9
� Take the average…
∆+
∆≈ +−
112
1 YYMRS
Finding MU and MRS
� What is the approximate MRS of the fourth unit?
� Take the average…
X 1 2 3 4 5 6
Y 20 16 13 11 10 9
� Take the average…
( )2
312
2
1
112
1
−=−−=
∆+
∆≈ +− YY
MRS
Finding MU and MRS
� What is the approximate MRS of the fourth unit?
� Take the average…
X 1 2 3 4 5 6
Y 20 16 13 11 10 9
� Take the average…
�We don’t need utility – only tradeoffs – to find MRS
( )2
312
2
1
112
1
−=−−=
∆+
∆≈ +− YY
MRS
Finding MU and MRS
� What is the approximate MRS of the fourth unit?
� Take the average… 3/2
X 1 2 3 4 5 6
Y 20 16 13 11 10 9
� Take the average… 3/2
� What is the approximate MUY of the fourth unit?
Y 1 2 3 4 5 6 7 8 9
Utility 15 35 50 62 70 74 76 77 77
Finding MU and MRS
� What is the approximate MRS of the fourth unit?
� Take the average… -3/2
X 1 2 3 4 5 6
Y 20 16 13 11 10 9
� Take the average… -3/2
� What is the approximate MUY of the fourth unit?
� Take the average…10
Y 1 2 3 4 5 6 7 8 9
Utility 15 35 50 62 70 74 76 77 77
Finding MU and MRS
� What is the approximate MRS of the fourth unit?
� Take the average… -3/2
X 1 2 3 4 5 6
Y 20 16 13 11 10 9
� Take the average… -3/2
� What is the approximate MUY of the fourth unit?
� Take the average…10
� What is MUX at (1,4) if the cross-section above is for X=1?
Y 1 2 3 4 5 6 7 8 9
Utility 15 35 50 62 70 74 76 77 77
Setting up a basketball match
� The rules: neither team can have more
� Than 5 players on the court
� Players on the court than the other team
� Than 10 players total – for substitutes� Than 10 players total – for substitutes
A has B has On Court
10 5 5
3 5 3
1 4 1
Setting up a basketball match
� The promoter wants more people on the court, to sell more tickets. What is his indifference map?
Setting up a basketball match
� The promoter wants more people on the court, to sell more tickets. What is his indifference map?
� The A team coach wants more players than B. What is his indifference map?is his indifference map?
Setting up a basketball match
� The promoter wants more people on the court, to sell more tickets. What is his indifference map?
� The A team coach wants more players than B. What is his indifference map?is his indifference map?
�What is his indifference map if we change the bad, B, into a good?
Outline for Tuesday, July 15
� New documents
�Quiz study sheet
� Hw2, quiz1 answers
� Hw3� Hw3
� Recap Monday
� Indifference map examples
� The budget constraint
� The best affordable bundle
Budget set
� Given $100, and facing prices PX = $10, PY = $5, what can the consumer afford?
Budget set
� Given $100, and facing prices PX = $10, PY = $5, what can the consumer afford?
� How does this set change if…
� the consumer gets $200� the consumer gets $200
Budget set
� Given $100, and facing prices PX = $10, PY = $5, what can the consumer afford?
� How does this set change if…
� the consumer gets $200� the consumer gets $200
� PX = $5
Budget set
� Given $100, and facing prices PX = $10, PY = $5, what can the consumer afford?
� How does this set change if…
� the consumer gets $200� the consumer gets $200
� PX = $5 and PY = $2.50
Budget set
� Given $100, and facing prices PX = $10, PY = $5, what can the consumer afford?
� How does this set change if…
� the consumer gets $200� the consumer gets $200
� PX = $5
� There is a quota of 5 units on Y
Budget set
� Given $100, and facing prices PX = $10, PY = $5, what can the consumer afford?
� How does this set change if…
� the consumer gets $200� the consumer gets $200
� PX = $5
� There is a quota of 5 units on Y
� The consumer gets a non-saleable coupon for 10 X
Budget set
� Given $100, and facing prices PX = $10, PY = $5, what can the consumer afford?
� How does this set change if…
� the consumer gets $200� the consumer gets $200
� PX = $5
� There is a quota of 5 units on Y
� The consumer gets a non-saleable coupon for 10 X
� We know from supply and demand that coupons and quotas can change the price, too
Budget set
� Suppose food stamps can only be spent on food and may not be resold
Budget set
� Suppose food stamps can only be spent on food and may not be resold
� Given I = $1000, PFood = $10, PNot= $5…
� Suppose the consumer is given $100 of food stamps. � Suppose the consumer is given $100 of food stamps. What is their budget line?
Budget set
� Suppose food stamps can only be spent on food and may not be resold
� Given I = $1000, PFood = $10, PNot= $5…
� Suppose the consumer is given $100 of food stamps� Suppose the consumer is given $100 of food stamps
� Suppose those $100 of food stamps can be resold at half their value on the black market. What is the new budget set?
Budget set
� Given I = $1000, PFood = $10, PNot= $5…
� Suppose the government sets individual food quotas of 50 units. What is the budget set?
Budget set
� Given I = $1000, PFood = $10, PNot= $5…
� Suppose the government sets individual food quotas of 50 units
� Suppose those 50 units can be sold at $5 each on the black market. What is the new budget set?
Budget set
� The budget set includes all affordable bundles
� The edge of the budget set is the budget line
Budget set
� The budget set includes all affordable bundles
� The edge of the budget set is the budget line
� The slope of the budget line is the Marginal Rate of TransformationTransformation
Y
X
P
P
X
YMRT −=
∆
∆=
Budget set
� The budget set includes all affordable bundles
� The edge of the budget set is the budget line
� The slope of the budget line is the Marginal Rate of TransformationTransformation
� Tells us what tradeoff the consumer can make between X and Y
Y
X
P
P
X
YMRT −=
∆
∆=
Budget set
� The budget set includes all affordable bundles
� The edge of the budget set is the budget line
� The slope of the budget line is the Marginal Rate of TransformationTransformation
� Tells us what tradeoff the consumer can make between X and Y
� Recall that MRS tells us what tradeoff the consumer is willing to make
Y
X
P
P
X
YMRT −=
∆
∆=
Outline for Tuesday, July 15
� New documents
�Quiz study sheet
� Hw2, quiz1 answers
� Hw3� Hw3
� Recap Monday
� Indifference map examples
� The budget constraint
� The best affordable bundle
The best affordable bundle
� The consumer will choose a bundle in the budget set that gives them the highest utility
The best affordable bundle
� The consumer will choose a bundle in the budget set that gives them the highest utility. We call this
� The consumer’s optimum or
� The solution to the consumer’s problem� The solution to the consumer’s problem
The best affordable bundle
� The consumer will choose a bundle in the budget set that gives them the highest utility
� Because more is better, the optimum will be on the budget linebudget line
The best affordable bundle
� The consumer will choose a bundle in the budget set that gives them the highest utility
� Because more is better, the optimum will be on the budget linebudget line
� The optimum must be on an indifference curve that is never below the budget line
� Everything above an indifference curve gives greater utility
� So something better would be affordable if the indifference curve crossed the budget line
The best affordable bundle
� The optimum will be on
� the budget line
� an indifference curve that does not cross the line
The best affordable bundle
� The optimum will be on
� the budget line
� an indifference curve that does not cross the line
� If the optimum has X>0 and Y>0, we call it interior� If the optimum has X>0 and Y>0, we call it interior
The best affordable bundle
� The optimum will be on
� the budget line
� an indifference curve that does not cross the line
� If the optimum has X>0 and Y>0, we call it interior� If the optimum has X>0 and Y>0, we call it interior
� In this case, the slopes of the budget line, the MRT, and that of the indifference curve, the MRS, must be the same
The best affordable bundle
� The optimum will be on
� the budget line
� an indifference curve that does not cross the line
� If the optimum has X>0 and Y>0, we call it interior� If the optimum has X>0 and Y>0, we call it interior
� In this case, the slopes of the budget line, the MRT, and that of the indifference curve, the MRS, must be the same:
� The tradeoff the consumer makes is no better or worse than the tradeoff the consumer takes
The best affordable bundle
� The optimum will be on
� the budget line
� an indifference curve that does not cross the line
� If the optimum has X>0 and Y>0, we call it interior � If the optimum has X>0 and Y>0, we call it interior and have MRS = MTS at the optimum
MTSP
P
MU
MUMRS
Y
X
Y
X =−=−=
The best affordable bundle
� The optimum will be on
� the budget line
� an indifference curve that does not cross the line
� If the optimum has X>0 and Y>0, we call it interior � If the optimum has X>0 and Y>0, we call it interior and have MRS = MTS at the optimum
� So, if this equality does not hold, either
� The consumer is not rational or
�One of the goods is not consumed
MTSP
P
MU
MUMRS
Y
X
Y
X =−=−=
The best affordable bundle
� If the optimum has X>0 and Y>0, we call it interior and have MRS = MTS at the optimum
� If the optimum has X=0, then PX/PY must be too high for the consumer to make any tradeoff, even at high for the consumer to make any tradeoff, even at zero
The best affordable bundle
� If the optimum has X>0 and Y>0, we call it interior and have MRS = MTS at the optimum
� If the optimum has X=0, then PX/PY must be too high for the consumer to make any tradeoff, even at high for the consumer to make any tradeoff, even at zero
Y
X
Y
X
MU
MU
P
P>
The best affordable bundle
� If the optimum has X>0 and Y>0, we call it interior and have MRS = MTS at the optimum
� If the optimum has X=0, then PX/PY must be too high for the consumer to make any tradeoff, even at high for the consumer to make any tradeoff, even at zero
MRTMRSMU
MU
P
P
Y
X
Y
X >⇔>
The best affordable bundle
� If the optimum has X>0 and Y>0, we call it interior and have MRS = MTS at the optimum
� If the optimum has X=0, then PX/PY must be too high for the consumer to make any tradeoff, even at high for the consumer to make any tradeoff, even at zero
� Neutral goods
� Perfect substitutes
MRTMRSMU
MU
P
P
Y
X
Y
X >⇔>
The best affordable bundle
� If the optimum has Y=0, the consumer is not willing to trade X for even one unit of Y at current prices
MRSMRTMU
MU
P
PYY >⇔> MRSMRT
MUPXX
>⇔>
The best affordable bundle
� If the optimum has Y=0, the consumer is not willing to trade X for even one unit of Y at current prices
MRSMRTMU
MU
P
PYY >⇔>
� When X = 0 or Y = 0, we have a corner solution, as opposed to an interior solution
MRSMRTMUP
XX
>⇔>
The best affordable bundle
� If X>0 and Y>0 MRS = MRT
� If X=0 MRS > MRT
� If Y=0 MRS < MRT
The best affordable bundle
� If X>0 and Y>0 MRS = MRT
� If X=0 MRS > MRT
� If Y=0 MRS < MRT
� This makes sense because
�MRS is the rate at which we want to trade Y for X
�MRT is the rate at which we can trade Y for X
� Both are inconveniently negative
Outline for Tuesday, July 15
� New documents
�Quiz study sheet
� Hw2, quiz1 answers
� Hw3� Hw3
� Recap Monday
� Indifference map examples
� The budget constraint
� The best affordable bundle