Coursenotes_ECON301

The choice problem is essentially to balance the

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Unformatted text preview: as possible in this direction. Affordability / Budget Constraint What the consumer can afford is represented by income, prices and thus, the budget lines. The budget constraint holds the consumer back, limiting them. The basic theoretical premise of "rational behaviour" is that the consumer solves their choice problem within the context of a constrained optimization problem (i.e. Lagrangians). We call this the "utility maximization problem". The economic intuition behind the utility maximization problem is to balance the opposing forces represented by the indifference curve and the budget line. This means that consumers are choosing X and Y to achieve the highest indifference curve that is affordable given prices and income. Y Indifference curve Consumer Equilibrium Budget Line X The slope at the equilibrium point where the indifference curve and the budget line are tangent to each other will correspond to the condition: slope of the budget line = slope of the curve at the point of tangency slope of the budget line = the slope of the indifference curve 31 The slope of the budget line is: PXX + PYY = M Y = M - PX X PY PY Thus, the slope of the budget line is - PX . PY The slope of the indifference curve is MRS, as we've seen before, so... MRS = PX PY This gives us a new element to our definition of MRS, namely that MRS is simply the ratio of prices. In addition, the consumer equilibrium point must lie on the budget line to ensure the affordability requirement. This means that the budget constraint must be exactly satisfied at the consumer equilibrium point. Why do we need both equations for consumer equilibrium to occur? One equation is not enough to describe the concept of a consumer equilibrium point because: 1. MRS = PX / PY only ensures that the indifference curve and the budget line have the same slope (regardless of whether the budget constraint is satisfied or not). 2. PXX + PYY = M only ensures that the budget constraint is satisfied (regardless of whether the budget line has the same slope as the indifference curve or not). Only when both of these equations are satis...
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