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**Unformatted text preview: **Chapter 5 NAME Choice Introduction. You have studied budgets, and you have studied prefer- ences. Now is the time to put these two ideas together and do something with them. In this chapter you study the commodity bundle chosen by a utility-maximizing consumer from a given budget. Given prices and income, you know how to graph a consumer’s bud- get. If you also know the consumer’s preferences, you can graph some of his indifference curves. The consumer will choose the “best” indifference curve that he can reach given his budget. But when you try to do this, you have to ask yourself, “How do I find the most desirable indifference curve that the consumer can reach?” The answer to this question is “look in the likely places.” Where are the likely places? As your textbook tells you, there are three kinds of likely places. These are: ( i ) a tangency between an indifference curve and the budget line; ( ii ) a kink in an indi ff erence curve; ( iii ) a “corner” where the consumer specializes in consuming just one good. Here is how you find a point of tangency if we are told the consumer’s utility function, the prices of both goods, and the consumer’s income. The budget line and an indifference curve are tangent at a point ( x 1 ,x 2 ) if they have the same slope at that point. Now the slope of an indifference curve at ( x 1 ,x 2 ) is the ratio- MU 1 ( x 1 ,x 2 ) /MU 2 ( x 1 ,x 2 ). (This slope is also known as the marginal rate of substitution.) The slope of the budget line is- p 1 /p 2 . Therefore an indi ff erence curve is tangent to the budget line at the point ( x 1 ,x 2 ) when MU 1 ( x 1 ,x 2 ) /MU 2 ( x 1 ,x 2 ) = p 1 /p 2 . This gives us one equation in the two unknowns, x 1 and x 2 . If we hope to solve for the x ’s, we need another equation. That other equation is the budget equation p 1 x 1 + p 2 x 2 = m . With these two equations you can solve for ( x 1 ,x 2 ). * Example: A consumer has the utility function U ( x 1 ,x 2 ) = x 2 1 x 2 . The price of good 1 is p 1 = 1, the price of good 2 is p 2 = 3, and his income is 180. Then, MU 1 ( x 1 ,x 2 ) = 2 x 1 x 2 and MU 2 ( x 1 ,x 2 ) = x 2 1 . There- fore his marginal rate of substitution is- MU 1 ( x 1 ,x 2 ) /MU 2 ( x 1 ,x 2 ) =- 2 x 1 x 2 /x 2 1 =- 2 x 2 /x 1 . This implies that his indi ff erence curve will be tangent to his budget line when- 2 x 2 /x 1 =- p 1 /p 2 =- 1 / 3. Simplifying this expression, we have 6 x 2 = x 1 . This is one of the two equations we need to solve for the two unknowns, x 1 and x 2 . The other equation is the budget equation. In this case the budget equation is x 1 + 3 x 2 = 180. Solving these two equations in two unknowns, we find x 1 = 120 and * Some people have trouble remembering whether the marginal rate of substitution is- MU 1 /MU 2 or- MU 2 /MU 1 . It isn’t really crucial to remember which way this goes as long as you remember that a tangency happens when the marginal utilities of any two goods are in the same proportion as their prices.proportion as their prices....

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