Review of Consumer Theory

# Review of Consumer Theory - ECO339Y 2011 Review of Consumer...

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ECO339Y 2011 Review of Consumer Choice A consumer’s preferences allow him/her to choose the best or most highly ranked bundle in the budget set. We analyze this problem graphically using the budget constraint and indifference curves. The assumption of non satiation ensures that we only have to consider bundles along the budget constraint. Therefore, the optimal choice ( x 1 O , x 2 O ) satisfies the budget equation p 1 x 1 O + p 2 x 2 O = m . The optimal choice (for an interior solution) is the point along the budget constraint where the indifference curve is tangent to the budget constraint. Therefore, the optimal choice ( x 1 O , x 2 O ) also satisfies MRS = p 1 / p 2 . In cases of boundary solutions either x 1 O = 0 or x 2 O = 0 , and the tangency condition will not hold (although the budget equation condition will). Summary of the consumer problem: Choose x 1 and x 2 to max U ( x 1 , x 2 ) subject to p 1 x 2 + p 2 x 2 = m . The optimal choices ( x 1 O , x 2 O ) satisfy the conditions (for interior solutions 1. p 1 x 1 O + p 2 x 2 O = m 2.

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Review of Consumer Theory - ECO339Y 2011 Review of Consumer...

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